Several tax policy proposals have been put forward this year (e.g. Senator Sanders’ “For the 99.5% Act”) that would increase taxes on high-income individuals to pay for President Biden’s two infrastructure bills: the bipartisan $1.2 trillion Infrastructure Investment and Jobs Act, which is currently in the House, and the $3.5 trillion package, which is set for the budget reconciliation process.
On September 12, 2021, the House Ways & Means Committee released draft legislation for its own tax policy proposal titled Responsibly Funding Our Priorities as part of the Build Back Better Act.
In the draft bill, the Committee proposed major revisions to the estate tax, capital gains taxes, and retirement account taxation, as well as smaller changes to the corporate tax rate and other business-related taxes. If passed, this bill will drastically change the tax and estate planning landscape for high-income individuals and larger estates.
Pro Tip: Who counts as a “high-income individual”? In most cases, it’s singles with income over $400,000 or married couples with income over $450,000. However, beneficiaries of trusts and estates (including special needs trusts) would also feel the pain as trusts and estates would be subject to the new top income tax rate of 39.6% at just $12,500 of income.
As such, if you’re income exceeds $400,000 for single taxpayers or $450,000 for married couples, or your estate exceeds $5,000,000, you need to carefully consider your options. The bottom line: There’s something in this bill for everyone.
What’s in Play for Income Taxes?
[Text] Sec. 138101. Increase in Corporate Tax Rate.
This provision replaces the flat corporate income tax with a graduated rate structure. The rate structure provides for a rate of 18 percent on the first $400,000 of income; 21 percent on income up to $5 million, and a rate of 26.5% on income thereafter. The benefit of the graduated rate phases out for corporations making more than $10,000,000. Personal services corporations are not eligible for graduated rates. The domestic dividends received deduction is adjusted to hold constant the tax on domestic corporate-to-corporate dividends.
The new draft bill from the House creates a three-tiered structure for the corporate tax rate:
- Under $400,000: 18%
- $400,000–$5 million: 21%
- Over $5 million: 26.5%
Larger corporations would see a slightly higher rate, but smaller corporations would get a tax cut. The Biden administration’s earlier proposal would have raised the corporate tax rate from 21% to 28% across the board. So, although the 26.5% tax of the top bracket is higher than the current flat 21% rate, it is still lower than other proposals.
The bill also states personal service corporations will be subject to a flat 26.5% rate because they are not eligible for the graduated rates.
These changes would go into effect after December 31, 2021.
[Text] Sec. 138201. Increase in Top Marginal Individual Income Tax Rate.
The provision increases the top marginal individual income tax rate in section 1(j)(2) to 39.6%. This marginal rate applies to married individuals filing jointly with taxable income over $450,000, to heads of households with taxable income over $425,000, to unmarried individuals with taxable income over $400,000, to married individuals filing separate returns with taxable income over $225,000, and to estates and trusts with taxable income over $12,500. The amendments made by this section apply to taxable years beginning after December 31, 2021.
The Committee’s proposal would increase the top marginal income tax rate to 39.6% (currently 37%) for:
- Individuals earning over $400,000,
- Heads of household earning over $425,000, and
- Married couples filing jointly earning over $450,000,
- Married couples filing separately earning over $225,000, and
- Estates and trusts with taxable income over $12,500.
The current thresholds for the top 37% tax bracket are $628,301 (married filing jointly), $523,601 (individuals), and $13,050 (estates and trusts). Under the Committee’s proposal, more taxpayers would fall into the highest marginal bracket than would have under Biden’s earlier proposal, which set the top rate to kick in at $452,700 (individual) and $509,300 (married filing jointly).
On top of this, the Committee’s plan includes a 3% surtax on modified adjusted gross incomes above:
- $5 million for individuals,
- $2.5 million for married persons filing separately, and
- $100,000 for trusts.
Luckily this 3% tax on ultra-high incomes is a far cry from the broader “wealth tax” that has been proposed in other plans. Both of these provisions would go into effect after December 31, 2021.
[Text] Sec. 138203. Application of Net Investment Income Tax to Trade or Business Income of Certain High-Income Individuals.
This provision amends section 1411 to expand the net investment income tax to cover net investment income derived in the ordinary course of a trade or business for taxpayers with greater than $400,000 in taxable income (single filer) or $500,000 (joint filer), as well as for trusts and estates. The provision clarifies that this tax is not assessed on wages on which FICA is already imposed. The amendments made by this section apply to taxable years beginning after December 31, 2021.
Under current law, business income that is passed through to an individual who materially participates in the business is not subject to the 3.8% Net Investment Income Tax (NIIT, aka “Medicare Tax”). The House’s proposal would expand the tax base for the NIIT to include all taxable income greater than $400,000 for individuals (or $500,000 for joint filers).
In effect, all earnings from pass-through businesses will be subject to the 3.8% NIIT, regardless of whether the income is from a passive or nonpassive activity.
This change would be effective for tax years beginning after December 31, 2021.
[Text] Sec. 138202. Increase in Capital Gains Rate for Certain High-Income Individuals.
The provision increases the capital gains rate in section 1(h)(1)(D) to 25%. The amendments made by this section apply to taxable years ending after the date of introduction of this Act. A transition rule provides that the preexisting statutory rate of 20% continues to apply to gains and losses for the portion of the taxable year prior to the date of introduction. Gains recognized later in the same taxable year that arise from transactions entered into before the date of introduction pursuant to a written binding contract are treated as occurring prior to the date of introduction.
Nearly all tax proposals thus far have taken aim at capital gains taxes. Some sought to raise the tax rate and others to reclassify which events would trigger capital gains taxes.
The House Committee’s proposal would raise the top capital gains rate to 25%, up from 20%. Fortunately, this 5% bump is far smaller than Biden’s original plan which would have retroactively taxed capital gains at ordinary income rates, if adjusted gross income exceeded $1 million.
Most importantly, however, this provision would go into effect after the legislation was introduced—that is, September 13, 2021.
[Text] Sec. 138204. Limitation on Deduction of Qualified Business Income for Certain High-Income Individuals.
The provision amends section 199A by setting the maximum allowable deduction at $500,000 in the case of a joint return, $400,000 for an individual return, $250,000 for a married individual filing a separate return, and $10,000 for a trust or estate. The amendments made by this section apply to taxable years beginning after December 31, 2021.
The TCJA in 2017 created the new Sec 199a, which allowed a 20% deduction for “qualified business income.” There has been much discussion on what exactly is covered by the definition of “qualified business income.”
The House Committee’s proposal would severely limit who is eligible for this deduction, effectively eliminating the 20% QBI deduction for high income earners. The proposed maximum allowable deduction would be $500,000 for joint filers, $400,000 for an individual, $250,000 for a married individual filing separately, and $10,000 for a trust or estate.
In other words, after December 31, 2021, there will be no Sec 199a deduction if you earn over those thresholds. Ouch.
What’s in Play for Estate Taxes?
[Text] Sec. 138207. Termination of Temporary Increase in Unified Credit.
This provision terminates the temporary increase in the unified credit against estate and gift taxes, reverting the credit to its 2010 level of $5,000,000 per individual, indexed for inflation.
I have been encouraging my clients to take full advantage of the gift and estate tax exemptions (aka “Unified Credit”) for a while now, especially since the current exemption levels are historically high: $11.7 million per person ($23.4 million per couple).
The 2017 Tax Cuts & Jobs Act, which set the current exemption amounts, also included a sunset date of January 1, 2026, so many people felt they had ample time to plan. However, every recent tax proposal has included a massive reduction to the estate and gift tax exemptions.
For example, under Sanders’ proposal from March married couples could have seen their combined estate tax exemption drop from $23.4 million to $7 million (70% decrease) and their gift tax exemption drop from $23.4 million to $2 million (108% decrease)!
The new House Committee’s proposal would similarly cut the gift and estate tax exemptions to $5 million each, or $10 million for a married couple, effectively pushing up the original sunset date by four years.
The effective date of the lower exemption would be after December 31, 2021.
[Text] Sec. 138209. Certain Tax Rules Applicable to Grantor Trusts.
This provision adds section 2901, which pulls grantor trusts into a decedent’s taxable estate when the decedent is the deemed owner of the trusts. Prior to this provision, taxpayers were able to use grantor trusts to push assets out of their estate while controlling the trust closely. The provision also adds a new section 1062, which treats sales between grantor trusts and their deemed owner as equivalent to sales between the owner and a third party. The amendments made by this section apply only to future trusts and future transfers.
As with previous policy proposals, the House’s draft legislation aims to limit the versatility and viability of grantor trusts. Under current law, a grantor trust is treated as owned by the grantor for income tax purposes, meaning that transactions between the grantor and the trust are generally not income tax events.
Grantor Retained Annuity Trusts (GRATs) are particularly tax-efficient mechanisms for transferring wealth to future generations. In short, a GRAT is an irrevocable trust established by a grantor, who receives a fixed distribution for a fixed term. At the expiration of the term, the remaining assets are distributed to the beneficiaries tax free.
Under both Biden’s and Senator Van Hollen’s proposal, transfers involving grantor trusts would trigger a capital gains tax event. The House’s proposal takes a different tack, with three main points:
- Estate tax: Grantor trusts will now be included in a decedent’s taxable estate if they are determined to be the trust’s owner,
- Gift tax: If during the grantor’s lifetime the grantor trust’s status is terminated or distributions are made from the trust, the value of the distribution or the trust’s assets will be treated as taxable gifts, and
- Income tax: Sales between a grantor and a grantor trust will be subject to income tax (i.e. treated as third-party sales).
These various technical changes would essentially end the use of grantor trusts like GRATs and defective grantor trusts. The policy would only apply to new and future trusts or transfers, so you may still have time to address these concerns.
What’s in Play for Retirement Accounts?
[Text] Sec. 138301. Contribution Limit for Individual Retirement Plans of High-Income Taxpayers with Large Account Balances.
Under current law, taxpayers may make contributions to IRAs irrespective of how much they already have saved in such accounts. To avoid subsidizing retirement savings once account balances reach very high levels, the legislation creates new rules for taxpayers with very large IRA and defined contribution retirement account balances.
Specifically, the legislation prohibits further contributions to a Roth or traditional IRA for a taxable year if the total value of an individual’s IRA and defined contribution retirement accounts generally exceed $10 million as of the end of the prior taxable year. The limit on contributions would only apply to single taxpayers (or taxpayers married filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of households with taxable income over $425,000 (all indexed for inflation).
The legislation also adds a new annual reporting requirement for employer defined contribution plans on aggregate account balances in excess of $2.5 million. The reporting would be to both the Internal Revenue Service and the plan participant whose balance is being reported. The provisions of this section are effective tax years beginning after December 31, 2021.
In late June, ProPublica ran a story about how ultrawealthy investors like Peter Thiel have leveraged Roth Individual Retirement Accounts (IRAs) to amass hordes of tax-free wealth, even though most Roth IRAs have a $6,000 per year contribution limit.
Thiel himself, through various intricate stock purchases, turned a retirement account worth around $2,000 in 1999 and into a $5 billion un-taxable whale by 2019. It may seem like a crazy amount to accumulate, but with the right knowledge and enough time it can be done—or could be done.
The House’s proposal seeks to curb what many see as the ultrawealthy’s manipulation of a middle-class retirement tool by implementing new contribution limits for both traditional IRAs and Roth IRAs. In short, if an IRA balance exceeds $10 million at the end of the year, further contributions are prohibited. The balance cap only applies to individuals earning over $400,000 or married couples earning over $450,000.
Moreover, account holders whose balances exceed the yearly $10 million threshold would be required to make a special minimum withdrawal equal to 50% of the amount over $10 million—this is the case regardless of a person’s age. For example, an account with $10,200,000 at the end of a tax year, would be required to make a minimum distribution of $100,000.
Both of these measures would go into effect after December 31, 2021.
[Text] Sec. 138311. Tax Treatment of Rollovers to Roth IRAs and Accounts.
Under current law, contributions to Roth IRAs have income limitations. For example, the income range for single taxpayers for making contributions to Roth IRAs for 2021 is $125,000 to $140,000. Those single taxpayers with income above $140,000 generally are not permitted to make Roth IRA contributions.
However, in 2010, the similar income limitations for Roth IRA conversions were repealed, which allowed anyone to contribute to a Roth IRA through a conversion, irrespective of the still in-force income limitations for Roth IRA contributions. As an example, if a person exceeds the income limitation for contributions to a Roth IRA, he or she can make a nondeductible contribution to a traditional IRA – and then shortly thereafter convert the nondeductible contribution from the traditional IRA to a Roth IRA.
In order to close these so-called “back-door” Roth IRA strategies, the bill eliminates Roth conversions for both IRAs and employer-sponsored plans for single taxpayers (or taxpayers married filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of households with taxable income over $425,000 (all indexed for inflation). This provision applies to distributions, transfers, and contributions made in taxable years beginning after December 31, 2031.
Furthermore, this section prohibits all employee after-tax contributions in qualified plans and prohibits after-tax IRA contributions from being converted to Roth regardless of income level, effective for distributions, transfers, and contributions made after December 31, 2021.
Another abused mechanism that is noted in the ProPublica story is the Roth IRA conversion. Under current law taxpayers earning over $140,000 cannot contribute to Roth IRAs. However, there are no corresponding income limitations on conversions from a traditional to a Roth IRA.
The House Committee’s proposal takes aim at this wealth building strategy by imposing an income cap on conversions of traditional IRAs or employer-sponsored retirement plans (e.g. pensions or 401(k)s) into Roth IRAs. The restriction would only apply to individuals earning over $400,000 or a married couple earning over $450,000.
This provision wouldn’t be effective until after December 31, 2031.
Pro Tip: After-tax contributions to workplace retirement plans would be prohibited as well, no matter your income level. This provision would apply to distributions, transfers, and contributions made after December 31, 2021 (i.e. 3 months from now).
What’s Not Included in the House Proposal?
There is some good news. First, the wealth tax idea trumpeted by the progressive branch of the Democratic party that would tax the assets of the ultrawealthy is not included in the House Committee’s draft legislation.
Also absent is the elimination of the step-up in basis. As the law functions currently, assets such as stocks and real estate receive an increase (“step up”) to fair market value at the original owner’s death, thereby avoiding any capital gains taxes. Elimination of the step-up in basis would assess capital gains taxes on these assets when they are inherited by wealthy heirs, based on the gain in value from the date of original purchase.
What Should You Not Do?
[Text] Sec. 138401. Funding of the Internal Revenue Service.
This provision appropriates $78,935,000,000 for necessary expenses for the IRS for strengthening tax enforcement activities and increasing voluntary compliance, and modernizing information technology to effectively support enforcement activities. No use of these funds is intended to increase taxes on any taxpayer with taxable income below $400,000. Further, $410,000,000 is appropriated for necessary expenses for the Treasury Inspector General for Tax Administration to provide oversight of the IRS. Finally, $157,000,000 is appropriated for the Tax Court for adjudicating tax disputes. These appropriated funds are to remain available until September 30, 2031.
Using any and all legal avenues to minimize one’s tax burdens is something we strongly support. However, some individuals choose to reduce their tax bills by illegal means or by avoiding them altogether—this is tax fraud, it is illegal, and we (obviously) do not condone it.
Unfortunately, for decades the IRS has been underfunded and understaffed, meaning that some people found the risk-reward calculus for tax evasion acceptable. To address this concern, the House proposal earmarks $78.9 billion for the IRS to bulk up their tax enforcement activities and another $157 million for the Tax Court to resolve tax disputes.
A better funded and more agile IRS will hopefully deter individuals from illegal tax avoidance schemes, which in the long run will benefit all the law-abiding taxpayers.
What Should You Do?
With just over three months left in 2021, we are fast approaching the event horizon.
Exactly which provisions of which bills will be included in the final piece of legislation is still unknown. But do not miss the forest for the trees: Virtually every iteration of every provision in every bill focuses on incomes above a $400,000–$450,000 threshold and estates valued above $5 million.
If your taxable incomes are at or above this mark, or if your estate’s value is anywhere near $5 million, serious consideration should be given to addressing these problems before the end of the year.
Finally, do not forget that it takes time to assess, plan, and implement these changes properly. If you wait until November or December, there may not be sufficient time to make the changes needed to protect your wealth from these new tax policies.
Please call us or email us soon so we can find a time to discuss your planning options.