The current version of the Build Back Better Act offers a combination of surprises, quiet proposals with big impacts, expected developments, and implications for what might be coming next. Our National Tax Office experts discuss.
Biggest surprises of the tax sections in the Build Back Better Act
The following proposals were not previously proposed by the Biden administration:
- Tax surcharge on individuals, estates, and trusts — The majority of discussions about individual income tax rates during 2021 have focused on the top individual income tax rate and the top tax rate on long-term capital gains and qualified dividends. The BBBA adds a new element through the creation of a tax surcharge. This would equal 3% of the modified adjusted gross income (MAGI) in excess of $5 million for most individuals but is reduced to $2.5 million for married taxpayers filing separately. Estates and trusts would be subject to a much more stringent threshold of $100,000 of MAGI.
- Tax-free S corporation conversions — The proposal to allow for a limited tax-free conversion of S corporations to partnerships was a big surprise. Where applicable, this would be a great benefit since it would allow a tax-free escape from the corporate form and take advantage of the flexibility provided to partnerships. S corporations are generally tax-efficient, but they are rigid in terms of ownership, allocations, and distributions. One major limitation is the inability to distribute appreciated property without triggering taxable gain inside the S corporation. Other major limitations are the requirement that all income be allocated in proportion to stock ownership and the fact that shareholders often cannot receive a distribution of borrowed funds without creating a taxable event due to the exclusion of debt in shareholder basis. S corporations are also restricted in the types of shareholders that are eligible to own stock. Converting to a partnership would remove these limitations.
- Section 1202 phaseout — Section 1202 provides for the exclusion of taxable gain from the sale of Qualified Small Business Stock (QSBS). Under current law, the maximum exclusion is 100% of the greater of $10 million or 10 times the tax basis of the taxpayer in the QSBS. The “greater of” threshold means that the $10 million exclusion is the minimum exclusion, but some taxpayers can get a larger exclusion. Section 1202 includes specific rules limiting the application of this exclusion, but this is one of the few tax rules allowing for the elimination of taxable gain that has been realized. The BBBA would reduce the gain exclusion for most taxpayers to 50% of the greater of $10 million or 10 times the tax basis of the taxpayer in the QSBS. This limitation would apply to individual taxpayers with adjusted gross income of $400,000 or more, as well as any estate or trust. Unlike all other recent law changes with Section 1202, this one is proposed to apply to all outstanding QSBS rather than applying only to stock issued after the effective date.
- Rejection of the proposed recognition at death or by gift — The Biden administration proposed a substantial change to the tax treatment of property transfers at death or by gift. Taken together, those proposals would have forced the recognition of capital gains on many assets in order to provide a corresponding tax basis step-up. Exceptions were proposed, but overall, this was a contentious proposal. Based on the current version of the BBBA, it appears that the House intends to reject those proposals. Early indications from Democratic senators suggest that this also faces an uphill battle for inclusion in the final bill in the Senate. However, the exclusion of this from the House bill may all-but-eliminate its inclusion in the final bill. As a tradeoff, the BBBA does include modifications to the estate and gift tax exemption. The Biden administration proposals did not address that exemption, but that type of modification was discussed during the presidential campaign. That proposal would have the effect of increasing estate and gift taxes but would not be as impactful as the Biden administration’s recognition event proposals.
- Exclusion of state and local tax deduction changes — The Tax Cuts and Jobs Act (TCJA) imposed a $10,000 annual limitation on the deductibility of state and local taxes by individuals (the SALT cap). For higher-income taxpayers and those in higher-tax states, this limitation has meaningfully increased their annual taxable income. Democratic members of Congress from higher-tax states have previously pushed for changes to the SALT cap as part of negotiations on the bill overall. Changes that have been discussed include everything from a full repeal of the SALT cap to an increase in the annual limitation. However, the BBBA currently excludes any changes on this topic. A significant factor in that exclusion is likely the cost associated with any modifications. A full repeal is projected to cost several hundred billion dollars. Discussions are ongoing in the House where an amendment may be proposed to provide for an increase or repeal of the SALT cap alongside a revenue-generating proposal to require banks to report the aggregate cash inflow and outflow from bank accounts above a certain balance during the year. Moving forward, we anticipate that modifications to the SALT cap will continue to be discussed, but it is unclear whether any proposals will advance.
The concept of a tax surcharge is a new development that would alter the manner in which income taxes are calculated. In essence, taxpayers would complete a separate calculation to determine this tax based on MAGI rather than merely applying the applicable tax rates to the appropriate character of taxable income. Therefore, some taxpayers with significant itemized deductions might have taxable income below $5 million but still owe a surtax because MAGI is above $5 million. The ultimate fate of this proposal is unclear but is likely tied to negotiations over the other income tax rates and the overall revenue required to fund the BBBA. If the Senate rejects this proposal, then the lost revenue might otherwise be found through other income tax rate increases. Conversely, if this proposal is adopted by the Senate, it will increase the effective tax rate on higher-income individuals and many estates and trusts.
The biggest limitation on the use of this proposal is the requirement that the S corporation made its S election prior to May 13, 1996 and has remained an S corporation at all times prior to the conversion. As a threshold matter, this narrows the field of eligible S corporations to those that have been in existence for over 25 years. Eligible S corporations should carefully monitor the status of this proposal. Prior to any future conversions, it will also be important to evaluate the state and local tax impact, the coordination of the net investment income or self-employment tax on partnership income, and any estate and gift tax considerations.
This modification is a surprise given that it had not been previously proposed by the Biden administration or any other members of Congress. In fact, the administration’s Greenbook specifically noted that “the exclusion under current law for capital gain on certain small business stock would also apply” when discussing capital gain changes. But the impact of this proposal will be less onerous than it might otherwise have been due to the limited increase in the maximum long-term capital gain tax rate. When anticipating a potential 43.4% capital gain rate, it was expected that Section 1202 would become a significant tax planning strategy.
Still, a 50% exclusion can reduce the maximum tax rate applicable to QSBS from a maximum rate of 31.8% to 17.4%, a 14.4% rate reduction. For this purpose, the proposed rate of 31.8% for the sale of non-QSBS stock includes the 25.0% long-term capital gain rate, plus the 3.8% NIIT, plus the 3.0% tax surcharge. The 50% gain exclusion under Section 1202 would reduce the gain subject to those taxes, but the remaining gain would also be subject to the 28.0% collectibles tax rate rather than the 25.0% long-term capital gain rate. Combining those rules would provide for the resulting net effective rate of 17.4%. Many states also provide an exclusion for QSBS so the savings can grow above that amount. Thus, while the inclusion of this limitation in the BBBA may be disappointing to many investors, there are still significant tax savings to be realized with QSBS.
Quiet changes in the proposed Build Back Better Act with big impacts
Several other proposals are worth careful consideration because they are unlikely to generate much discussion in the short term but may have significant implications for many taxpayers.
- Modification of common control definitions — A variety of tax rules apply to entities that are under common control based on Section 52. For example, brother-sister and parent-subsidiary groups may exist where there is greater than 50% ownership. These rules are relevant to the aggregation of employee benefit plans, determining available accounting methods (particularly for small taxpayers), determining whether the gross receipts decline test is met for the employee retention credit, and determining whether a business is exempt from the interest expense limitation as a small taxpayer, among others. Under current rules, the common control definitions can only include entities that operate trades or businesses that also meet the requisite ownership thresholds. By limiting the analysis to trades or businesses, the current definitions allow for holding companies that do not operate trades or businesses to be excluded from the analysis. For example, an investment fund that holds a majority interest in several operating companies would often not be viewed as a parent of an aggregated group so that each operating company would stand on its own for any tax determination that looks to these rules.
- Section 163(j) modification for pass-through entities — The TCJA imposed a new limitation on the deductibility of business interest expense pursuant to Section 163(j). For pass-through business entities, that limitation has been applied at the entity level unless such entity qualifies as an exempt small business. The BBBA would change this result by turning off Section 163(j) at the pass-through entity level and instead applying it at the ultimate individual, trust, or C corporation owner level. Moreover, when applying this at the owner level, any interest expense carryforwards would now be subject to a five-year expiration date whereas there is an unlimited carryforward under current law.
- Carried interest modifications — The tax treatment of carried interests have long been targeted by Congress for potential change. After many years of discussion, the TCJA imposed a new limitation on the ability of carried interests to qualify for long-term capital gain treatment. More specifically, Section 1061 applies a three-year holding period in place of a one-year holding period to qualify as long-term capital gains. That limitation applies to gains with respect to applicable partnership interests (APIs), which are generally profits interests in investment fund entities.
- Expansion of wash sale rules — Under existing rules, tax losses from the sale of stock or securities may be disallowed if the taxpayer has engaged in a wash sale transaction. This applies by looking to both the 30-day period prior to the sale and the 30-day period after the loss sale. If the taxpayer acquires substantially identical stock or securities during that combined 60-day window, then the tax loss is disallowed and added to the basis of the newly acquired investment. For this purpose, an acquisition also includes entering into a contract or option to acquire the substantially identical stock or securities.
- Treatment of trusts and estates, generally — Income taxes for trusts and estates are generally determined as if they were individuals. But in some cases, the thresholds applicable to trusts and estates may be lower than what would apply to an individual. The BBBA rules escalate this dynamic by including even more stringent rules for trusts and estates. Examples of more stringent trust rules include:
- The qualified business income deduction (QBID) under Section 199A is capped at $400,000 or $500,000 for most individual taxpayers. Trusts and estates are capped at only $10,000.
- The MAGI threshold for the 3% tax surcharge discussed above is $5 million for individuals. Trusts and estates are subject to the 3% surcharge at only $100,000 of MAGI.
- Section 1202 is limited to a 50% exclusion for individuals with taxable income exceeding $400,000. Individuals with taxable income below that threshold can still get a 75% or 100% exclusion. Trusts and estates are prohibited from ever getting the 50% or 75% exclusion.
- The 3.8% net investment income tax (NIIT) generally does not apply to business income where an individual owner is active in the business. The BBBA would subject this active business income to the NIIT when an individual’s MAGI exceeds $400,000. A trust or estate would be subject to NIIT on its active business income regardless of its income level.
The BBBA would modify the rules under Section 52(b) by clarifying that the term trade or business includes investment activities and any activity involving research and experimentation even if a business has not yet begun. The consequence of this change would be a dramatic increase in the number of entities considered to be under common control. More specifically, entities that are majority owned by holding companies and investment funds would often be considered to be under common control. Since this change could impact every other tax rule that references Section 52, the impact of this change would be pervasive. As this change is proposed to apply as soon as Jan. 1, 2022, impacted businesses may need to start planning now.
Since enactment, the current version of Section 163(j) has reduced the available business interest expense deductions and has also added complexity to multi-tiered structures. The BBBA proposal would offer mixed results depending on the facts of a given taxpayer. For pass-through owners with significant business income, the elimination of entity level testing will allow for more interest expense deductions since business income from one business can absorb interest deductions generated from another business. Conversely, business owners with net business losses (e.g., due to depreciation and amortization) will likely experience limited deductibility of pass-through business interest expense since a loss in one business may prevent the ability to deduct interest expense originating in an unrelated business. Any suspended interest deductions may also become permanently disallowed if sufficient business income is not recognized during the five-year utilization period. Additional guidance may also be required from the Treasury Department on a variety of issues including how interest expense carryforwards and their expiration impact the basis of pass-through entities and how to apply the exceptions for electing real property trades or businesses and electing farming businesses. In any event, this proposal would significantly alter rules that taxpayers have only recently gotten accustomed to applying in pass-through structures. But each taxpayer will need to run the math to determine if this change is favorable or unfavorable.
The BBBA would extend the three-year holding period requirement to five years, except for real estate businesses. However, it would also make several other changes that may have a more significant impact. First, it would expand the sources of income that would be subject to the rule so that all income subject to capital gains tax rates would be included. This would include Section 1231 gains and qualified dividends, both of which are not subject to these rules under current law. Second, the five-year holding period would only begin to run when a partnership acquires substantially all of its assets. While significant additional guidance may be necessary to determine the boundaries of this rule, it would appear to provide that a five-year holding period would only begin when an investment fund has deployed substantially all of its committed capital. That requirement could elongate the five-year holding period by a considerable degree. The same could be true for any partnership subsidiary of an investment fund if that subsidiary is also deploying cash over a period of time. These changes may end up being far more impactful than the change to a five-year holding period.
The BBBA would make several significant changes to the wash sale rules. The first change is an expansion of the assets to which the wash sale rules apply. Under the expanded rule, specified assets would also include foreign currency, commodities, and digital assets (e.g., cryptocurrency). The inclusion of digital assets has been previously discussed, so it is not necessarily surprising.
The second change would be an inclusion of a related party test when determining whether the taxpayer has acquired substantially identical specified asset. For this purpose, a related party includes the taxpayer’s spouse, dependents, controlled entities and estates and trusts, retirement and savings plans (individual retirement plan, Archer MSA, or health savings plan), Section 529 and Coverdell savings accounts, and other annuity and deferred compensation plans. The related party rule would be a substantial change and could create many traps for the unwary. The expansive listing of related parties would require taxpayers to carefully examine transactions before claiming tax losses on investment assets. It’s often the case that investments of these various related parties are managed by different firms that may not have any transparency into the other holdings, let alone able to coordinate the timing of acquisitions or dispositions. This could create significant headaches for taxpayers.
The rule to determine the basis of an acquired investment in a wash sale would only be adjusted if it’s acquired by the taxpayer or the taxpayer’s spouse, but not if it’s acquired by a related party. This could cause certain wash sale losses to be permanently disallowed.
Lastly, the rules would exempt certain business-related currency and commodity transactions from the wash sale rules. While this is a favorable change, it will significantly increase the level of documentation that businesses dealing in foreign currency or commodities will be required to maintain to ensure that they are eligible for this exception.
Transactions involving grantor trusts have also been specifically targeted by the BBBA. Overall, these changes suggest a future where trusts are much less tax-efficient than under current rules. If all of these changes are enacted, then it might be necessary to evaluate existing trust arrangements to determine whether they continue to make sense given the likelihood for higher incremental tax burdens on trusts.
Generally expected changes from the proposed Build Back Better Act tax sections
- Restoration of the 39.6% top individual income tax rate — Increasing the top individual income tax bracket to 39.6% has been consistently discussed by the Biden administration and Democratic leadership in Congress. The only significant modification from the Greenbook is the threshold at which this would apply. The Biden administration had proposed $509,300 for married individuals filing jointly, $452,700 for unmarried individuals, $481,000 for head of household filers, and $254,650 for married individuals filing separately. The BBBA is more restrictive in that it would apply the top rate beginning at $450,000 for married individuals filing jointly, $400,000 for unmarried individuals, and $250,000 for married individuals filing separately. Moving forward, it’s generally expected that the Senate will also adopt the 39.6% rate, but the applicable income thresholds may be revisited.
- Moderation of the maximum long-term capital gains rate — One of the most controversial aspects of the Biden administration proposals has been the prospect of increasing the maximum tax rate on long-term capital gains and qualified dividends from 23.8% (20.0% plus the 3.8% NIIT) to 43.4% (39.6% plus the 3.8% NIIT). The administration’s proposal would magnify its impact by applying that rate retroactively to April 28, 2021, and to taxpayers with adjusted gross income in excess of $1 million (or $500,000 in the case of a married taxpayer filing separately). That increase generated considerable attention and even questions from some Democratic members of Congress. As such, it was anticipated that Congress would modify some or all aspects of the Biden proposals.
- Application of NIIT to active business income — Under existing rules, an additional 3.8% tax is applied to certain types of income. For investment income, this is imposed through the 3.8% net investment income tax. Conversely, for self-employed taxpayers, a combined 3.8% tax is applied through a 2.9% self-employment tax and an additional 0.9% Medicare tax. However, certain business income for active owners of S corporations and of some partnerships are not subject to these taxes. Accordingly, the Biden administration proposed to “rationalize” these taxes by applying some form of the 3.8% tax to all types of income for taxpayers with MAGI in excess of certain thresholds. This proposal would close what Democratic leadership considers a perceived gap in the rules since some income can currently escape the additional 3.8% tax.
- New limitation on the Qualified Business Income Deduction (QBID) — The 20% QBID has been the target of proposals from both the Biden campaign and Democratic leadership in Congress. The more recent proposals from the Biden administration omitted mention of QBID, but it was expected that some change would be proposed. The BBBA would apply a limit on the maximum deduction based on the taxpayer type, which would apply in addition to existing limitations. The new limitation is $500,000 for married taxpayers filing jointly and surviving spouses, $250,000 for married taxpayers filing separately, $400,000 for single taxpayers and head of household taxpayers, and $10,000 in the case of an estate or trust.
- Increase in the corporate tax rate — The TCJA reduced the maximum corporate rate from 35% to 21%. Since that time, it’s been anticipated that the corporate tax rate could be increased at a future date. Revisiting that rate has been particularly attractive to Democratic members of Congress looking for tax revenue to fund spending programs in the BBBA. Various proposals pointed toward a potential increase to a rate between 24% and 28%. The BBBA would increase the maximum corporate tax rate to 26.5% when income exceeds $5 million but would apply graduated rates to corporations with taxable income below $5 million. A 3% surcharge would be applied when taxable income exceeds $10 million so that a flat 26.5% rate applies when taxable income exceeds $19,566,667. Personal service corporations would be subjected to a flat 26.5% rate.
- Evolution of international tax rules — Many of the international tax changes in the BBBA have been anticipated for several months, based on the proposals from the Biden administration. However, the House bill does include fewer changes overall as some proposals were omitted (e.g., replacing BEAT with a new SHIELD regime). Overall, we have expected that the international rules would continue to evolve based on experience since enactment of the TCJA.
The BBBA would increase the maximum rate on long-term capital gains and qualified dividends to a combined 28.8% (25.0% plus the 3.8% NIIT). That represents an effective increase of 21% (5% increase divided by 23.8%) rather than the increase of 82.3% (19.6% increase divided by 23.8%) under the Biden proposal. The 3% surcharge discussed above can also layer on top of these rates for very high-income taxpayers. The retroactive nature of the proposal has also been muted by proposing a Sept. 13, 2021 effective date. As a final trade-off, the BBBA would apply this rate at a lower income threshold (corresponding with the top individual income tax bracket) than the Biden proposal. This proposal may be further modified in the Senate, but the changes in the House suggest that the proposal from the Biden administration is unlikely to be included in a final bill.
The BBBA proposes a change that tracks closely to the Biden administration’s proposal albeit with higher income thresholds. Namely, this would apply the NIIT to active business income not subject to the self-employment tax for taxpayers with MAGI in excess of $500,000 for married taxpayers filing jointly ($250,000 if married filing separately) or $400,000 for all other individual taxpayers.
Moving forward, it’s likely that QBID will be modified in either this or another form. The chair of the Senate Finance Committee, Senator Wyden, has proposed his own form of amendment that would eliminate QBID for taxpayers within income in excess of $400,000 but remove all other restrictions on QBID for taxpayers below that income threshold. However, the specific form of QBID modification to be proposed by the Senate is not yet clear.
Moving forward, it’s possible that the Senate will revisit the corporate tax rate if additional tax revenue is needed. However, an increase beyond 28% may be unlikely due to the stated positions of key Democratic senators. Conversely, the current proposal could also be reduced to between 24% and 25% depending on negotiations. In any event, it seems clear that a modest increase in the corporate tax rate will almost certainly be included if legislation does advance.
What does this tell us about what’s next?
Enacting broad legislation that includes new spending, social programs, and many types of tax changes is a complicated endeavor under any circumstances. Those challenges are magnified when attempting to pass legislation on a party-line basis with limited room for dissension. The 2020 election cycle provided the Democratic party with majorities in Congress, but there can only be three defections in the House and none in the Senate. This has always pointed toward a legislative process where individual members of the Democratic party would have the opportunity to shape the content and timing of legislation. That process is already evident when reviewing the BBBA from the Ways and Means Committee.
The House has followed many pillars from the Biden administration proposals, but also diverged from those proposals in several key respects. As a threshold matter, the BBBA does follow the core goal of Democratic leadership in increasing taxes on higher-income individuals and corporations. However, the House has chosen to limit the tax rate increases on corporations and capital gains, and instead modified the rules impacting the calculation of taxable income or total tax burden. Another trend includes the complete omission of some Biden administration proposals and the creation of several unexpected rule changes. Taken together, these proposals suggest general alignment between the House Democratic caucus and the White House with several crucial exceptions. Moving forward, it’ll be important to monitor any changes made on the House floor to the BBBA prior to a vote in that chamber.
Once the House completes its work, all attention will shift to the Senate. Democratic leadership in the House and Senate have coordinated to some degree during this process, so certain aspects of the BBBA might already be acceptable to Democratic senators. That said, it’s expected that there will be meaningful changes, including unexpected programs, when the legislative text is unveiled in the Senate. However, the modification of some of the more controversial proposals by the House does suggest that any future bill will have less impact on taxpayers than initially thought.
Continue to follow our Outlook on Tax Rates and Policy Changes for updates as the legislation works its way through Congress.