2021 Tax Proposals
On September 15, the House Ways and Means Committee approved the tax provisions of the Build Back Better Act (BBBA), the legislation intended to implement President Biden’s social and education reforms. There are still many steps in the process to become law, but this is a major first step to begin understanding which tax proposals Congress will use to balance revenue and spending.
What’s in the proposed legislation? Here are some of the key tax provisions:
- Increase in the top marginal individual income tax rate — The top marginal individual income tax rate would increase to 39.6%, the same top marginal rate that existed before the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA). This rate would apply to the taxable income of (1) married couples filing jointly which exceeds $450,000, (2) single filers which exceeds $400,000, (3) married individuals filing separately which exceeds $250,000, and (4) trusts and estates with taxable income over $12,500.
- An additional surtax of 3% would be applied to modified adjusted gross income exceeding $5,000,000 ($2,500,000 for married taxpayers filing separately). This proposal would be effective for tax years beginning after Dec. 31, 2021.
- Increase in the maximum long-term capital gains rate — The maximum capital gains rate would increase to 25% from the current rate of 20%. The income level that this capital gains rate bracket applies to would be aligned with the new 39.6% rate bracket. These rates would also apply to qualified dividends. This increase is far lower than the Biden administration’s original proposal to increase the capital gains rate to as high as 39.6%. This proposal includes transition rules that will generally apply the increased rate to capital gains and dividends recognized after Sept. 13, 2021, but certain sales subject to a binding contract in effect on that date could still apply the previous rates.
- Net investment income tax application to active business income — Under current law, the net investment income tax applies an additional 3.8% tax to a taxpayer’s net investment income when adjusted gross income exceeds a certain threshold. Net investment income only includes income earned from a business if the taxpayer is passive with respect to that business, but not if a taxpayer is active. The proposal would subject active business income to the net investment income tax as well, but only when adjusted gross income exceeds (1) $500,000 for married couple filing jointly, (2) $250,000 for married couples filing separately, and (3) $400,000 for all other taxpayers. This rule would not apply if the business income was already subject to self-employment tax. When combined with the individual tax rate increases above, this could increase the tax rate applicable to active business income from the maximum marginal rate of 37% under current law to as high as 46.4% (39.6% maximum marginal rate + 3.8% net investment income tax + 3% high income surcharge). This proposal would be effective for tax years beginning after Dec. 31, 2021.
- Limitations on contributions to IRAs and increases in required minimum distributions (RMDs) for certain high-income taxpayers with large account balances — Under current law, taxpayers can make contributions to certain retirement accounts regardless of their income level. The bill would prohibit contributions when the total balance of the contributor’s IRAs and other retirement accounts exceeds $10 million (determined as of the close of the previous taxable year) and taxable income exceeds (1) $450,000 in the case of a married couple filing jointly or (2) $400,000 in the case of single or married taxpayers filing separately. Those same taxpayers would have to take a Required Minimum Distributions equal to 50% of the value that exceeds $10 million, plus 100% of any amount exceeding $20 million. This provision is effective for tax years beginning after Dec. 31, 2021.
- Limitations on “back door” Roth IRA conversions — Under current law, while contributions to Roth IRAs may not be made by taxpayers with incomes exceeding certain thresholds, those taxpayers may effectively avoid the limitations by first making a nondeductible contribution to a traditional IRA and then converting it to a Roth IRA. The bill would prohibit this practice for taxpayers with taxable income exceeding (1) $450,000 in the case of married taxpayers filing jointly or (2) $400,000 in the case of single taxpayers and married taxpayers filing separately. The proposal would generally be effective for tax years beginning after Dec. 31, 2021, but certain rollover provisions wouldn’t be effective until tax years after Dec. 31, 2031.
- Extension of additional child tax credits and advance payments — The child tax credit has been expanded over the past several years to increase the amount of the credit, making it fully refundable, and permitting the IRS to make monthly payments of the anticipated credit. These provisions would generally be extended through Dec. 31, 2025 with some modifications to the monthly payment rules and the provisions requiring repayment of excess credits.
General business provisions and pass-through entities
- Limitation on the qualified business income deduction (QBID) — The QBID would be limited to a maximum deduction of (1) $500,000 for married taxpayers filing jointly, (2) $400,000 for single filers, or (3) $250,000 for married taxpayers filing separately. This means that the deduction would be capped once qualified business income exceeds $2.5 million for married taxpayers filing jointly, $2 million for single filers, $1.25 million for married taxpayers filing separately, and $50,000 for trusts and estates. There is currently no limitation on the deduction, which is otherwise scheduled to expire on Dec. 31, 2025. This proposal is effective for tax years beginning after Dec. 31, 2021.
- Election to make a tax-free S corporation conversion to a partnership — In general, a corporation can’t convert to a partnership without the conversion being a taxable event. The proposal would permit S corporations that have continually maintained an S election since May 14, 1996, to make a tax-free conversion to a partnership during 2022 or 2023.
Corporate income tax
- Modification of corporate income tax rate structure and increase in top rate — The TCJA eliminated the graduated income tax rate structure with a top rate of 35% in favor of a flat rate of 21%. Effective for tax years beginning after Dec. 31, 2021, the BBBA would restore the graduated rate structure and tax income below $400,000 at 18%, maintain the current 21% rate for income between $400,000 and $5 million, and tax any income above $5 million at 26.5%. Personal service corporations and corporations with taxable income above $10 million would be taxed at the flat rate of 26.5%.
- Expansion of deduction limitations on certain compensation – Under current law, publicly held corporations are prohibited from deducting amounts exceeding $1 million paid to covered individuals. Those rules were recently expanded to broaden the pool of covered individuals in tax years beginning after Dec. 31, 2026. The proposal would accelerate this expansion to tax years beginning after Dec. 31, 2021 and make other technical corrections.
Estate and gift tax
- Termination of the temporary increase in unified credit — The bill would accelerate the restoration of the unified credit to 2010 levels of the equivalent of $5,000,000 per individual, indexed for inflation. This was otherwise scheduled to occur in 2026. With retroactive inflation adjustments, the unified credit amount would likely be approximately $6 million. Under current law, only total taxable gifts and taxable estates exceeding $11,700,000 per individual are subject tax in 2021. This is proposed to be effective for decedents dying and gifts made after Dec. 31, 2021.
- Grantor trust changes — Grantor trusts would no longer be excluded from estate tax if the decedent is the deemed owner of the trust. Also, sales between an individual and their grantor trust would be taxable even if they are the deemed owner of the trust. These provisions are proposed to be effective only to contributions made to a trust after the enactment of the BBBA. This provision would greatly affect the use of defective grantor trusts (and asset sales to them), ILIT’s, SLAT’s, GRAT’s…. the list is extensive and these strategies are widely used today.
- Elimination of certain valuation discounts — The bill would eliminate the ability to claim a valuation discount for estate and gift tax purposes on transfers of entities holding nonbusiness assets. This provision is proposed to be effective for transfers made after the enactment of the BBBA.
Other tax provisions
- Infrastructure financing and energy credits — A centerpiece of President Biden’s and the Democrats’ agenda has been infrastructure. The BBBA would significantly expand tax credits in many areas, including housing, clean and green energy, and new markets.
- Increase in funding the Internal Revenue Service – Nearly $80 billion in additional funding would be provided to the IRS over the next 10 years to increase enforcement of federal tax laws with respect to corporations and high-income individuals.
Where do we go from here?
President Biden’s previous proposals during the campaign included a number of concepts that weren’t included in the House Ways and Means Committee proposals, such as capital gains being realized at the death of a decedent or when assets are gifted, changes to the self-employment taxes, and the repeal of like-kind exchanges. Democratic leaders in the House have indicated that they intend to address the state and local tax deduction cap (SALT limitation) and additional information reporting on aggregate inflows and outflows from bank accounts as a part of the debate on the House floor.
As mentioned, there are still many steps to go in this process and many trades and deals will likely come out of this. But the current environment of tax law and the need to fund the stimulus and infrastructure spending should tell us that taxes will likely go up for some people, generally the very high earners. Therefore, action might be taken by taxpayers if they want to take advantage of the current laws.
If you have questions about the above proposals, please contact your legal and tax advisors for further guidance.
The views or opinions in this article are those of the author and do not necessarily represent the views of Washington Trust Bank or senior management. Washington Trust Bank believes that the information used in this blog was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinions expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
About The Author
As Vice President and Senior Wealth Advisor, Greg provides financial analysis to high net worth individuals. He is the author of several articles for various publications and nonprofit organizations on estate and financial planning subjects.