Thanks to Brandon Ketron, CPA, JD, LLM and Ian McClean for their input on this post.
“The Sky Wasn’t Falling”
I thought I was Noah but it turned out I was Chicken Little.
We all know the story of Noah’s Ark. It was Noah who began to build the Ark just before it started to rain. The only difference between Noah and a busy tax lawyer is that busy tax lawyers only handle two-legged animals who need to get onto the Ark, or into lifeboats on the Titanic if you prefer to look at it that way.
On the other hand, Chicken Little was convinced the sky was falling and told everyone about it, they all made big changes in their world, and then the sky didn’t fall and they were disappointed the sky didn’t fall. He was only trying to help, but instead laid an egg.
Whether you are Noah or Chicken Little you still have to deal with clients, what will we say, what will we recommend, and how will we explain?
We can’t be sure what is going to happen but hopefully we know within 40 days and 40 nights.
President Biden appeared to believe that there was a consensus of opinion among Democratic senators and sufficient members of the House of Representatives to pass new tax legislation to support the new infrastructure act.
While there is now some doubt as to whether all 50 Democratic senators will join in this, it is somewhat likely that the following changes, which were released in great detail in a 1,684 page document known as the Build Back Better Act (H.R. 5376) will be enacted.
We have covered the estate tax situation in a Forbes blog post that can be found here.
Instead of an estate tax increase, we have an expansion of the Net Investment Income Tax on high earners who use S corporations and partnership entities to shield themselves from this 3.8% tax, a 5% surtax on those individuals who have income exceeding $10,000,000 and an additional 3% surtax on income exceeding $25,000,000 a year, a reduction in the loopholes available for companies and individuals who use foreign companies to avoid or defer income, and limitations on business loss write offs, to name a few items, which are further discussed below.
Expanding the Definition of “Net Investment Income” for the 3.8% Net Investment Income Tax
The 3.8% Net Investment Income Tax under Internal Revenue Code Section 1411 would be broadened to include any income derived in the ordinary course of business for single filers with more than $400,000 in taxable income ($500,000 for joint filers) and on undistributed income from separately taxed trusts and estates effective January 1, 2022. Under current law, the 3.8% tax generally only applies to passive investment income (interest, dividends, gain on the sale of stock, etc.).
Advisors may consider delaying the filing of Form 2553 S-Elections for newly formed entities until discussions can be had with clients on the impact of the expansion of the 3.8% Net Investment Income Tax, which would apply on all S-Corp income for high earners if the bill is passed. Clients may be better served in entities taxed as partnerships or C-Corporations if S-Corporations can no longer provide the added benefit of sheltering income from the 3.8% Net Investment Income Tax. Please remember, however, that the late filing of a Form 2553 is only permitted if it is inadvertent, so clients need to be communicated with well before the deadline unless the entity can safely be taxed as a partnership or disregarded until a decision is made about whether to make an S election.
The Net Investment Income Tax will also apply to undistributed business income of trust and estates with no threshold limitation. Therefore, most trusts and estates that have ownership of profitable businesses or ownership interests in profitable entities that are taxed as partnerships will be subject to the 3.8% tax, except to the extent that the income received is paid out to beneficiaries. If the income received by the trust or estate is paid out to the beneficiaries, then generally speaking the beneficiaries will be subject to the tax as if they received it directly. S-Corporation income received by a complex trust is taxed at the highest bracket on Schedule K-1 income from the S-Corporation regardless of whether it is distributed, and would also be subject to the 3.8% Net Investment Income Tax if it has made an ESBT (“Electing Small Business Trust”) election. However, many trusts have the ability to sell S-Corporation ownership interests to beneficiaries who are in lower brackets, so this may become a common strategy implemented shortly after the death of a client in order to not incur capital gains tax on such sale. Then the trust owns a note from the beneficiary and the beneficiary owns the S corporation stock, and can use his or her $400,000 or $500,000 (if married filing jointly) exclusion amount on such income, assuming that he or she does not have other income subject to the Section 1411 tax that has already made use of such amounts.
A New 5% Surcharge on High Income Individuals, Trusts and Estates
Beginning January 1, 2022, if the proposed rules become law, a 5% tax will apply to individual taxpayers to the extent that they have Modified Adjusted Gross Income (“MAGI”) in excess of $10,000,000 ($5,000,000 if married but filing separately), and on trust and estate income exceeding $200,000 per trust or estate. Further, an additional 3% tax will apply to individual taxpayers to the extent MAGI exceeds $25,000,000 ($12,500,000 if married but filing separately), and on trust and estate income exceeding $500,000 per trust or estate.
MAGI is defined as adjusted gross income reduced by any deduction (not taken into account in determining adjusted gross income) allowed for investment interest (as defined in section 163(d)). Generally this number appears on line 37 of the 2020 Form 1040.
Because this surcharge applies to MAGI in excess of the applicable threshold, this tax will apply on both ordinary and capital gains, and is not decreased by charitable deductions (or any other itemized deduction). This tax would be imposed for most taxpayers when a business, or other large asset, is sold for a large gain. Experienced planners may consider selling to a related party under the installment method to spread out the gain over multiple tax years, keeping in mind that the related party installment sales would need to be completed more than two years prior to the liquidation event in order to avoid acceleration of the gain upon sale to a third party under the anti-Rushing rule, which has nothing to do with tax fraternities. Planners might also consider transferring interests that could be sold to a charitable remainder trust which can be used to spread income out over a number of years in order to avoid income in excess of the threshold. Running the numbers on these structures can reveal significant tax savings opportunities in the future, in addition to the advantages of tax deferral and helping charities.
The Above $200,000 Trust and Estate Income Problem.
Trusts that are separately taxed will face a bigger issue under the proposed rules because the 5% tax would apply to all trust income exceeding $200,000, making distributions of Distributable Net Income (DNI) to reduce a trust’s remaining taxable income an even more critical tool for planners. Stated in overly simplified terms, when a trust makes a distribution of income to a beneficiary, the beneficiary will pay the tax on such income, and the trust will receive a deduction to reduce its taxable income. Fortunately, the 5% surcharge will only apply to the extent that income in excess of $200,000 remains in the trust after taking into account distributions made to the beneficiaries. Drafters of trust documents should be familiar with the applicable Principal and Income Act of the situs of the trust to confirm whether capital gains are treated as principal (and thus not distributable) or income. The majority of states allow trust documents to specify that a fiduciary will have the power to treat capital gains as income that can be distributed to beneficiaries and escape the additional 5% tax.
Often times irrevocable trusts allow for income to be distributed to charities, which will not be taxed thereon. This may therefore cause a significant benefit for many charitable organizations, including family controlled foundations, but if the income generated under the trust would be considered to be Unrelated Business Taxable Income that would be taxed if received by a charity, then the deductibility of amounts paid to charity may be limited to 10% of such Unrelated Business Taxable Income, pursuant to Internal Revenue Code §680.
Other proposed changes, or lack thereof, in the bill that are noteworthy include the following:
- The 100% gain exclusion on the sale of Section 1202 Qualified Small Business Stock that has been held for at least 5 years will be limited to 50% of the gain for taxpayers with AGI exceeding $400,000 unless a binding contract was entered into prior to September 13th, 2021, which would presently translate to a maximum capital gains rate of 10% for qualified sales, if the maximum capital gains rate stays at 20%.
- Crypto currencies (Bitcoin, Ethereum, DOGEcoin, etc.) will be subject to the constructive and wash sale rules as of the date of enactment, so if a taxpayer’s crypto currency went “to the moon” there would be limited or no opportunity to lock in an offsetting position without triggering gain. As the result of this many crypto currency owners will use this technique before year end. Those who were less fortunate and have a loss position in crypto currency have until the date of the bill’s enactment to sell their` coins to harvest the loss and immediately buy back in without being subject to the wash sale rules. Those individuals would be in the same position economically, but with the added benefit of being able to recognize the loss and offset other passive income. This type of planning is prevented for most, if not for all, other marketable securities, but somehow crypto currencies have been excluded from these rules, and would now have to come out from under the rock to be revealed and fully taxed. It is interesting to note that the Tax Code has been encouraging investment in crypto currency by making it more attractive from a tax standpoint than investing in traditional stocks, bonds, mutual funds, and business and investment real estate.
- The new bill includes a 15% minimum tax for large corporations, but the bill does not increase the 21% rate that applies to C corporations that have net income. Many publicly traded and large corporations will therefore pay 21% tax on the income as calculated on the tax return, and then a 15% tax on “reported income” which will be calculated based upon very complex formulas.
- Affluent taxpayers in “blue states” will be disappointed to learn that the proposals to remove the limitation on deductions for State and Local Income Taxes paid (SALT Cap) were not included. Please give us a call when you move to Florida!
- The Best News for Many. The following was not included in the package, and are therefore not expected to be enacted in the near future:
- No increase in personal income tax or capital gains tax rates
- Proposals to reduce the estate tax exemption and do away with the ability to establish and exchange assets with ‘Grantor Trusts”, to sell non-business entity interests at a discount, and to establish Qualified Personal Residence Trusts, Grantor Charitable Lead Annuity Trusts, and Grantor Retained Annuity Trusts, which have all been used in greater volume in the past few months than possibly ever before.
- Proposals to increase individual income tax rates, and slightly compress the rate brackets were not included.
- Proposals to deny a fair market value income tax basis for the estates of individuals who die owning appreciated assets
- Proposals to force liquidation of “Mega IRAs” were not included.
- Proposals to eliminate the step up in basis on death were not included.
- Proposals to curtail or reduce the benefits of the Section 199(A) 20% income tax deduction for qualified business income.
- Proposals to tax people with cats more than people without cats were not included. This didn’t work out because many billionaires own cats. Cat owners were glad that Noah found two cats to put on the Ark, but Congress wasn’t so sure.
For tax advisors, the advantage of this bill is that there will be fewer changes than would otherwise have been the case, and therefore only hundreds as opposed to thousands of pages of legislation to become familiar with. It remains to be seen what will be included in a final bill, or if the bill will pass at all. Nevertheless, taxpayers should be aware of the proposed changes and plan accordingly.
Tax advisors who have had to navigate PPP loans, EIDL loans, mainstream loans, tax law changes that came with the SECURE act, tax law changes that came with the CARES act, and now this round of changes may all wish that they had become dentists or plumbers, but we have the opportunity to help clients understand how these new rules may apply to them, and how to best structure business, investment, trust, and personal arrangements with this handful of changes in mind. Estate tax planners can take a deep breath, but should keep their eyes open in case estate/gift tax changes are brought back into the negotiation table.
The latest version of the Build Back Better Act was released today by the House Rules Committee and all 1,684 pages of it can be viewed be clicking here.
I will be discussing the above situation and other issues in a free live Webinar on Saturday at 11 am EST, and we will answer questions from the audience at that time. You can e-mail to firstname.lastname@example.org for a free invite and replay link.
Just kidding about the cats.