Treasury Department’s “Green Book” Provides Additional Details Regarding Biden’s Proposed Tax Changes
On May 28, 2021, President Joe Biden released his proposed FY2022 budget. In conjunction with the budget release, the U.S. Department of the Treasury released the General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals, or “Green Book.” The Green Book provides additional details regarding the various tax proposals within the Biden administration’s American Jobs Plan and American Families Plan.
At this time, there are no formal legislative actions or bills related to these proposals, and it’s likely that many details of these proposals will change during the legislative process. However, there are several new details within the Green Book that could have a significant impact on a variety of taxpayers. Here’s a closer look at a few of the most talked about proposed income tax changes.
Individual Capital Gains Tax Rate
The proposal is to subject long-term capital gains and qualified dividends to ordinary income tax rates. This increases the income tax rate on such income from 20% to 37% (or 39.6% if the proposal to increase the top individual income tax rate is also enacted). The increased tax rate on capital gain income will only apply to the extent the taxpayer’s adjusted gross income exceeds $1 million ($500,000 for married filing separately).
The Green Book provides this tax increase will apply to gains required to be recognized after the date of announcement. This is generally understood to be April 28, 2021, the date this proposal was first announced as part of the American Families Plan. However, the effective date for this proposal is critical and is likely to be the subject of intense negotiations during the legislative process. We will continue to monitor the effective date as it may change during this process.
S Corporation Shareholders
Currently, S corporation shareholders are only subject to social security taxes to the extent of reasonable compensation for services rendered. S corporation flow-through income is not currently subject to social security taxes. The proposal is to subject the flow-through income of S corporation shareholders who materially participate in the trade or business to self-employment taxes to the extent this income exceeds certain thresholds (generally $400,000). The proposal effectively eliminates a key tax advantage currently enjoyed by many S corporation shareholders.
Expansion of Income Subject to Medicare Tax
The proposal will subject all the trade or business income of high-income taxpayers to the 3.8% Medicare tax through either the net investment income tax or the self-employment tax regimes. In particular, the definition of net investment tax would be amended to include all income from any trade or business that is not otherwise subject to employment taxes, including nonpassive income that is allocated to shareholders and partners that materially participate in the business activity. The proposal will apply to income in excess of $400,000.
Tax Carried (Profits) Interests as Ordinary Income
The proposal creates the concept of an “investment services partnership interest” (ISPI). An ISPI is a profits interest in an “investment partnership” that is held by a person who provides services to the partnership. Under the proposal, a partner’s share of income and gains will be taxed as ordinary income and subject to self-employment taxes if the partner’s taxable income from all sources exceeds $400,000. This proposed treatment is regardless of the character of the income at the partnership level. In other words, this proposal has the potential to recharacterize long-term capital gain income subject to preferential tax rates to ordinary income subject to self-employment taxes.
The Green Book does provide thoughts regarding the definition of an ISPI and the definition of an “investment partnership” for this purpose. However, the details will be critical and are likely to be fluid during the legislative process. The overall goal is to limit the application of this proposal to partnerships that primarily hold investment-type assets, and more than half of the contributed capital is from partners holding the interest as an investment. Investment-type assets include certain securities, real estate, interests in partnerships, cash, commodities, and certain derivative contracts.
The proposal also applies to any person who performs services for any entity and holds a “disqualified interest” in the entity. A disqualified interest is defined as convertible or contingent debt, an option, or any derivative instrument with respect to the entity. The Biden administration views the concept of a disqualified interest as an important anti-abuse rule to prevent the use of compensatory arrangements other than partnership interests. Again, the final details will be critical in being able to identify a disqualified interest.
There are a host of proposals that will change the tax imposed on foreign earnings. The primary proposals previously discussed include a repeal of Foreign-Derived Intangible Income deductions available to corporations, an expansion of the Global Intangible Low-Taxed Income (GILTI) regime, and stronger anti-inversion rules.
The Green Book also includes proposals that will require foreign tax credit calculations attributable to GILTI inclusions and foreign branch income to be done on a country-by-country basis. This will reduce allowable foreign tax credits by preventing low-taxed foreign earnings from increasing the allowable foreign tax credits attributable to high-taxed foreign earnings. The proposal also includes a repeal of the high-tax exemption to Subpart F and GILTI inclusions, provisions that will limit foreign tax credits attributable to gain from the sale of hybrid entities, additional limitations on interest expense deductions attributable to disproportionate borrowing, repealing the BEAT regime and replacing it with the SHIELD rule, and a new credit for onshoring jobs that were previously done overseas.
The Tax Cuts and Jobs Act, passed in December 2017, overhauled the U.S. taxation of international earnings requiring taxpayers and their advisors to spend significant time reviewing international structures and planning for tax efficient international operations. The Biden administration’s proposals for international taxation are just as significant and will start this planning process over anew if these proposals are enacted.
The tax proposals detailed in the Green Book are extensive. The above discussion highlights just a few of the most-talked-about proposals, but it is far from an exhaustive list. Additional proposals include, but are not limited to:
- Increasing the corporate tax rate from 21% to 28%
- Increasing the top marginal individual income tax rate from 37% to 39.6%
- Repealing the deferral of gain from like-kind exchanges for gain in excess of $500,000
- Making limitations on the utilization of business losses permanent
- Forced recognition of capital gain income upon the transfer of appreciated property via gift or inheritance
- Credits directed towards middle-to-low-income families such as an expansion of premium tax credits, a permanent expansion of the earned income tax credit for childless workers, a permanent expansion of the child and dependent care tax credit, and an extension of recent increases to the child tax credit through 2025
- Incentives designed to support housing and infrastructure such as an expansion of the low-income housing tax credit, the creation of a new neighborhood homes investment tax credit, and making the new markets tax credit permanent
- More than a dozen credits and incentives that prioritize clean energy and incentivize investment in energy efficient building improvements
- An increased IRS budget directed towards new enforcement initiatives
We’ll continue to monitor the situation and will provide updates. Please reach out to your KSM advisor with any questions or complete this form.
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