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On September 13, 2021, the House Ways and Means Committee released draft legislation proposing various tax increases and cuts, which will undergo markups by the committee over the next few days. While most tax proposals were anticipated, the House introduced a few surprises.
Income Tax Provisions
Section 1202 – Qualified Small Business Stock
Taxpayers are currently eligible for 75% and 100% exclusions for sales of qualified small business stock (QSBS). The proposed legislation would eliminate these exclusions for sales of QSBS acquired after February 17, 2009, and sold after September 13, 2021, unless the sale was made pursuant to a written binding contract already in place and not materially modified thereafter. This provision would apply to taxpayers whose adjusted gross income equals or exceeds $400,000 and to trusts and estates.
Under the current 50% exclusion rules, the remaining 50% QSBS gain is taxed at 28%. The excluded QSBS gain is considered an alternative minimum tax (AMT) preference item, which, when combined with the net investment income tax on the taxable half of the gain, results in an effective rate of 16.88% for QSBS acquired after September 27, 2010, and sold after September 13, 2021.
Capital Gains
The current maximum tax rate on capital gains is 20%. The proposed legislation would increase the capital gains rate to 25% for taxable years ending after September 13, 2021. Transitional rules are proposed for taxable years that include September 13, 2021, taxing net gains realized before that date at 20%. Gains arising from a transaction pursuant to a binding written contract in effect before September 13, 2021, and not materially modified thereafter, would remain eligible for the 20% rate.
Planning opportunity: Consider deferring realization of some capital losses until 2022 to offset capital gains that would otherwise be taxed at 25%.
Top Marginal Individual Income Tax Rate
The top marginal individual income tax rate is currently 37%. The draft legislation would raise it to 39.6% for taxable income over $450,000 for married individuals filing jointly and surviving spouses, $425,000 for heads of households, $400,000 for single individuals, $225,000 for married individuals filing separately, and $12,500 for estates and trusts. This proposal would be effective for taxable years beginning after December 31, 2021.
Planning opportunity: Consider accelerating ordinary income to 2021.
Net Investment Income Tax
Currently, net investment income does not include income derived in the ordinary course of a trade or business or income attributable to the disposition of property earned outside of a passive activity. The proposed legislation would eliminate these carveouts, broadening the type of income subject to the net investment income tax (NIIT). NIIT would apply to the greater of “specified net income” or net investment income for high-income individuals, estates, and trusts. “Specified net income” includes net investment income even if derived in the ordinary course of a trade or business and other gross income and net gains attributable to the disposition of property, even if earned outside of a passive activity or the trade or business of trading financial instruments or commodities. Certain foreign income is includible in the definition of net investment income.
This provision would apply to taxpayers whose modified adjusted gross income exceeds $500,000 for married individuals filing jointly and surviving spouses, $250,000 for married individuals filing separately, $12,500 for estates and trusts, and $400,000 for all other tax filers. It would be effective for taxable years beginning after December 31, 2021.
Carried Interests
The holding period to obtain long-term capital gains treatment for gain allocated to carried interest partners is currently three years. The proposal would extend this to five years. The three-year holding period would remain in effect for income attributable to real property trades or businesses and for taxpayers (other than estates or trusts) with adjusted gross income of less than $400,000. The proposal also includes provisions to encompass all items treated as capital gain (e.g., Section 1231 gain) and prevent avoidance of the holding period rules. This would be effective for taxable years beginning after December 31, 2021.
Qualified Business Income
The qualified business income deduction currently has no maximum allowable deduction. The proposal would introduce a cap, limiting the maximum allowable deduction to $500,000 for married individuals filing jointly and surviving spouses, $250,000 for married individuals filing separately, $10,000 for estates and trusts, and $400,000 for all other taxpayers. This would be effective for taxable years beginning after December 31, 2021.
Excess Business Loss Limitation
Under a temporary provision, excess business losses of non-corporate taxpayers exceeding $500,000 for joint filers ($250,000 for all other taxpayers) are disallowed and treated as net operating losses in the following year; however, this provision is set to expire on December 31, 2025. The proposal would make this provision permanent and modify how a disallowed excess business loss (EBL) is treated. Instead of treating the disallowed loss as a net operating loss in the following year, the EBL would be treated as a deduction attributable to a taxpayer’s trades or businesses when computing the EBL in the subsequent year. This would be effective for taxable years beginning after December 31, 2020.
Surcharge on High-Income Individuals
Currently, there is no surcharge imposed on high-income individuals. The proposal would impose a 3% surcharge on modified adjusted gross income exceeding $2,500,000 for married individuals filing separately, $100,000 for estates and trusts, and $5,000,000 for all other individuals. This would be effective for taxable years beginning after December 31, 2021.
Transfers Between Deemed Owner and Irrevocable Grantor Trust
Transfers between a deemed owner and their irrevocable grantor trust are currently nontaxable events. The proposal would disregard grantor trust status when determining whether a transfer between a deemed owner and their grantor trust is a sale or an exchange, possibly resulting in a taxable event. Additionally, the proposal would expand the definition of related party under Internal Revenue Code Section 267(b) to include grantor trusts and their deemed owners. This would apply to trusts created on or after the enactment date and to any portion of a trust established before the enactment date that is attributable to a contribution made on or after such date.
Planning opportunity: Consider sales to intentionally defective grantor trusts.
Estate and Gift Tax Provisions
Estate Tax Basic Exclusion Amount
The estate tax basic exclusion amount is $11,700,000 for 2021. The proposal would terminate the temporary increase in the basic exclusion amount, returning it to $5,000,000, indexed for inflation. Under this proposal, the basic exclusion amount in 2022 is anticipated to be $6,030,000. This would apply to estates of decedents dying and gifts made after December 31, 2021.
Planning opportunity: Consider making gifts up to the 2021 estate tax basic exclusion amount of $11,700,000.
Grantor Trusts
When a deemed owner of a grantor trust dies, the assets of that grantor trust (other than a fully revocable trust) are generally not included in the deemed owner’s estate. The proposal would require that assets in a grantor trust be included in the gross estate of the deceased deemed owner. Additionally, the proposal would treat distributions (other than to the deemed owner or spouse) during the life of the deemed owner and the termination of grantor trust status during the life of the deemed owner as completed gifts.
This would apply to trusts created on or after the enactment date and to any portion of a trust established before the enactment date that is attributable to a contribution made on or after such date.
Planning opportunity: Consider terminating grantor trust status or making a gift to a grantor retained annuity trust (GRAT) or spousal lifetime access trust (SLAT).
Valuation Discounts
Valuation discounts, such as marketability discounts and minority interest discounts, are currently allowed for transfers of nonbusiness assets for estate and gift tax purposes. The proposal would eliminate valuation discounts for certain transfers of nonbusiness assets. Nonbusiness assets are defined as passive assets held for the production or collection of income and not used in the active conduct of a trade or business. This would apply to transfers after the enactment date.
Planning opportunity: Consider making gifts that will be eligible for valuation discounts.
Retirement Plans
Annual Contributions to Plans
Annual contributions to retirement plans are not currently limited by the value of the retirement plans owned by a taxpayer. The proposal would prohibit annual contributions by “applicable taxpayers” to “applicable retirement plans” (including tax-qualified defined contribution plans, IRC Section 403(b) and 457(b) plans, and traditional and Roth IRAs) if the total value of all the taxpayer’s applicable retirement accounts exceeds $10 million as of the end of the prior year. Applicable taxpayers are head of household filers with adjusted taxable income over $425,000, married individuals filing jointly and surviving spouses over $450,000, and all other taxpayers over $400,000. Both the $10 million cap and income limitations are indexed for inflation beginning after 2022. This would be effective for taxable years beginning after December 31, 2021.
Minimum Required Distributions from Plans
Taxpayers are not currently required to take additional distributions if the total value of their retirement plan accounts exceeds $10 million. The proposal would require applicable taxpayers (as defined above) of any age to take a minimum required distribution equal to 50% of the aggregate vested balances in applicable retirement plans exceeding $10 million. If an applicable taxpayer’s combined retirement plan account balances exceed $20 million, the taxpayer would be required to take distributions equal to the lesser of (i) the aggregate plan balances in excess of $20 million or (ii) the aggregate balances in Roth IRAs and designated Roth accounts in defined contribution plans. Once the taxpayer distributes the amount of any excess required under this rule, they would then be allowed to determine the retirement accounts from which to make distributions in satisfaction of the 50% distribution rule.
This would be effective for tax years beginning after December 31, 2021.
Roth Rollovers and Conversions
Currently, the definition of a qualified rollover or conversion does not exclude any portion of the rollover or contribution that is not includible in gross income. The proposed legislation would amend the definition of qualified rollovers and conversions to Roth IRAs to include only amounts that would be includible in gross income and subject to tax. This would be effective for rollovers and conversions made after December 31, 2021.
“Back Door” Roth IRAs
“Back door” Roth IRA strategies currently allow taxpayers who exceed existing Roth income limits to make nondeductible contributions to a traditional IRA and shortly thereafter