On Monday, September 13, 2021, the House Ways and Means Committee released draft legislation, which represents a major step toward anticipated tax law changes. The draft legislation scales back some of President Biden’s proposals and includes some new changes aimed at gaining the necessary consensus among the Democratic caucus in both the House and Senate. All of the proposed changes in this draft legislation would take effect January 1, 2022, with two notable exceptions: the capital gains tax rate and changes to the treatment of grantor trusts.
This is just the opening move in the barrage of negotiations and deal making over the next few weeks. As such, the legislation will most likely change and continue to evolve as the Senate introduces its own budget bill. However, it does provide some clarity as to the direction of future changes to tax law. Below is summary of the bill and the provisions we will continue to monitor.
Draft Proposals: Individual Tax and Pass-Through Entities
- Income tax rate: Increases the top marginal tax rate from 37 percent to 39.6 percent and makes the top tax bracket apply at a reduced taxable income level as compared to 2020. These changes would be effective January 1, 2022 for taxpayers as follows:
- Married filing jointly with taxable income over $450,000;
- Heads of household with taxable income over $425,000;
- Unmarried individuals with taxable income over $400,000;
- Married individuals filing separately with taxable income over $225,000; and
- Trusts or estates with taxable income over $12,500.
- Capital gains tax rate: Increases the top capital gains rate from 20 percent to 25 percent for gains incurred on or after September 13, 2021. This provision does not apply to a sale that closes after September 13, 2021, provided the sale transaction was under a written binding agreement prior to that date. All gains incurred up to September 12, 2021 will be taxed at a rate no higher than 20 percent. Note: President Biden had originally proposed a 39.6 percent rate on gains for taxpayers with adjusted gross income in excess of $1 million.
- Carried interests: Increases the holding period to receive long-term capital gain treatment for carried interests from three to five years effective January 1, 2022.
- Surtax on high earners: Imposes a three percent surtax on individuals with modified adjusted gross income exceeding $5 million ($2.5 million for a married individual filing separately) effective January 1, 2022. Note: The top income tax rate for taxpayers earning more than $5 million could be 46.4 percent (39.6% + 3.8% NIT + 3% surtax) and the top capital gains rate would be 31.8 percent for those same taxpayers.
- Net investment tax: Expands the application to include net investment income derived from a trade or business for taxpayers with taxable income greater than $400,000 for individuals or $500,000 for married filing jointly.
- Pass-through deduction: Limits the maximum Section 199A deduction to $500,000 for married filing jointly taxpayers; $400,000 for individual taxpayers; $250,000 for married filing separately taxpayers; and $10,000 for a trust or estate.
- Business losses: Permanently disallows excess business losses for non-corporate taxpayers.
- S Corporation reorganization: Temporarily allows certain S Corporations to reorganize as partnerships without triggering taxable gain.
- What’s missing…for now: Changes to the State and Local Tax (SALT) deduction cap, which is currently set at $10,000, but it is expected that some changes will occur before the legislation is finalized.
Draft Proposals: Estate Tax
- Estate tax: Reduces the estate tax exemption to $5 million per individual adjusted for inflation (anticipated to be around $5.5 million for 2022) effective January 1, 2022. There are no changes to estate tax rates. Note: President Biden did not propose this; however, he expressed support for lowering exemptions to $3.5 million.
- Grantor trusts: Requires grantor trusts to be includable in the decedent’s taxable estate when the decedent is deemed to be the owner of the trust for income tax purposes. This provision also treats sales between grantor trusts and the deemed owner as between the trust and a third party thereby causing such transactions to be fully taxable for federal income tax purposes. Note: Changes to grantor trust rules were not proposed by President Biden, but they were previously included in Obama administration budget proposals and U.S. Treasury Greenbook and in proposed legislation from Senator Bernie Sanders.
Planning tip: Grantor trusts created and funded prior to the date of enactment, which is anticipated to occur sometime in October or November 2021, are grandfathered. Thus, there is still time to create and fund a grantor trust, which is a commonly used and powerful tool for estate tax mitigation. However, this window is closing rapidly with proposed changes set to take effect on the date of enactment. Contact your RKL advisor to maximize this opportunity.
- Valuation discounts: Eliminates valuation discounts for non-business assets (i.e. passive investments).
- What’s missing: The elimination of the step-up in basis as proposed by the Biden administration. At this time, there does not seem to be sufficient support from Congress for this proposal to become law.
Draft Proposals: Corporate Tax
- Graduated corporate rate: Replaces the flat corporate structure with a graduated rate structure of 18 percent rate up to $400,000 of income; 21 percent rate up to $5 million of income; and 26.5 percent rate for income over $5 million. Corporations with more than $10 million of income will be prevented from benefiting from the lower marginal rates. Note: President Biden had originally proposed a flat 28 percent tax rate on all income.
- Section 250 deduction: Increases taxation of international activities of companies by reducing the eligible Section 250 deduction for both Foreign-Derived Intangible Income (FDII) and Global Intangible Low Tax Income (GILTI).
- Section 1202 exclusion: Limits the Section 1202 small business stock exclusion for taxpayers with AGI of $400,000 or more. This would be effective September 13, 2021.
Draft Proposals: Retirement Plans
- Contribution limits and RMDs: Imposes new contribution limits and increases minimum required distributions when the total of a taxpayer’s IRAs and defined contribution retirement accounts exceed $10 million effective January 1, 2022.
- Roth conversions: Eliminates Roth conversions (sometimes referred to as “backdoor” contributions) for both IRAs and employer-sponsored plans for:
- Single taxpayers 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.
Draft Proposals: Miscellaneous
- Increased IRS funding: Provides for $78.9 billion over 10 years to expand IRS enforcement and audit capabilities.
The RKL team continues to monitor developments in Washington, D.C., as the legislative process plays out. Contact your advisor with specific questions within the context of your personal circumstances. For continuing coverage, stay tuned to our blog and make sure you’re signed up to receive our newsletter and webinar invites.