Congress extends debt ceiling as all eyes turn toward tax legislation

On October 14, President Biden signed into law a short-term extension of the federal debt ceiling. That follows the enactment of a continuing resolution to fund the government through December 3. Those actions temporarily resolve two matters Congress is facing and set the stage for further negotiations over other matters. Of particular interest are the major tax proposals from the Biden administration and Democratic leadership that continue to be debated in Congress. Here are our initial reactions to what these developments mean and what’s expected to come next.

What happened?

Recently, Congress has considered legislation involving the following matters:

• Government funding and debt ceiling – The federal government’s fiscal year ended on September 30, so Congress needed to take action to avert a government shutdown. Potential actions could have involved either funding for the entire fiscal year beginning on October 1 or a short-term extension of current funding through a continuing resolution. Congress chose the latter, so future action will be required to continue government funding beyond December 3. In addition, Congress needed to act to raise the limitation on government borrowings to prevent a default on its debt. The Treasury Department indicated that such a default could occur in mid-October. Negotiations among members of Congress have concluded with a short-term extension of the debt ceiling. The timeline for exhausting this new debt ceiling will depend on government revenues, but initial indications imply that this will last until at least early December.
• Infrastructure Act and the Build Back Better Act – The Senate previously passed the bipartisan Infrastructure Investment and Jobs Act (Infrastructure Act) on August 10. A vote on that bill in the House has been delayed as part of negotiations over the Build Back Better Act (BBBA). Democratic leadership initially planned to bring the Infrastructure Act to the House floor for a vote by September 27, but that vote has been delayed indefinitely. It’s now expected that the Infrastructure Act will not be enacted until the BBBA is either completed or a deal is reached on the vast majority of issues.

The BBBA has progressed on a much slower path. The tax proposals in the BBBA were approved by the House Ways and Means Committee on September 15. However, that bill has not yet been brought to the House floor for a vote, as negotiations among Democratic members of the House and Senate continue. The delay in the vote on the Infrastructure Act was caused by some members of the House wanting to have a more definitive framework for the BBBA agreed upon prior to voting. That framework has yet to be agreed upon or announced, so many key questions persist. We previously discussed the current House version of the BBBA in an alert describing the tax key proposals and a follow-up alert addressing the top surprises, quiet proposals with big impacts, and the expected proposals.

What’s next for tax legislation?

With the government funding and debt ceiling out of the way for the moment, Congress will now focus its full attention on the BBBA. Difficult negotiations among members of the Democratic Party over the substance of the BBBA are currently ongoing. The current draft of that bill in the House includes various changes from the original proposals advanced by the Biden administration, and it’s expected that the bill will continue to evolve. There doesn’t appear to be consensus within the Democratic Party over the amount of spending in the BBBA or the tax increases that would fund such spending. In the coming weeks, those disagreements will need to be resolved if the BBBA is going to advance. Here are the key questions that are expected to shape the resulting tax aspects of the bill:

• How much tax revenue will be needed to offset spending? — A central feature of negotiations involves the extent of spending programs to be included in the BBBA and the corresponding tax revenue required to offset that spending. The current House version is projected to include approximately $3.5 trillion in spending programs. However, moderate members of the Democratic Party, especially those in the Senate, have pushed to reduce the overall spending. The final target is still being determined, but it’s expected that the spending will be reduced to approximately $2.0 trillion. Difficult negotiations over which programs to remove to achieve this are ongoing. However, a reduction in spending will reduce the overall tax revenue required.
• Will the expected tax increases be modified? — There appears to be consensus within the Democratic Party around some of the proposed tax increases. Those include:
  • Raising the corporate tax rate to between 25 and 28%.
  • Restoring the top ordinary income tax bracket to 39.6%.
  • Increasing the top rate on long-term capital gains and qualified dividends to approximately 25%.
  • Expanding the 3.8% net investment income tax to cover items currently excluded.
  • Modifying the international tax rules that were enacted by the Tax Cuts and Jobs Act.

Certain aspects of those items still need to be determined, including effective dates and the income thresholds at which increased rates would apply. However, it’s highly likely that those will be the core tax changes in the version of the BBBA that’s ultimately enacted.

• What will happen with estate and gift taxes and the treatment of trusts? — The Biden administration previously proposed taxing the appreciation in certain assets transferred by gift, at death, or upon certain transfers to or distributions from noncorporate entities. However, the administration didn’t specifically propose other changes to estate and gift taxes. The House has taken a much different approach by rejecting the recognition at death or gift concept. Instead, the current BBBA draft would reduce the estate and gift tax exemption, fundamentally alter the tax treatment of grantor trusts, and disallow certain valuation discounts for gifting transactions. It’s likely that these proposals will continue to evolve during negotiations, with the final settlement difficult to project. 
• Will technical enhancements to existing rules be implemented? — Several proposals currently under consideration would enhance existing rules. Those are found in the current House version of the BBBA as well as proposals from members of Congress, including Senator Wyden, the Chair of the Senate Finance Committee. Some of those proposals would tighten existing rules and lead to increased taxes. Examples include the phase-out of the 20% qualified business income deduction, modification of the carried interest rules, alteration of Section 1202, and the many adjustments to partnership tax rules proposed by Sen. Wyden. Others would modify existing rules in ways that could impact taxpayers either favorably or unfavorably depending on their specific facts. Examples of those proposals include the change in common control definition and modification of the business interest expense limitation for pass-through businesses. The proposals under the technical enhancement category would impact many different types of taxpayers, but most would generate only modest amounts of tax revenue. Thus, their inclusion may be less about raising a specified amount of revenue and more about reshaping the tax code.
• Are any surprises coming? — As we addressed in a prior article, the current House version of the BBBA includes some big surprises. While it was anticipated that Democratic leadership would look to increase taxes on businesses and higher-income individuals, the form of those tax increases wasn’t expected in certain cases. Moving forward, it’s possible that certain provisions will be excluded or modified. For example, the 3% tax surcharge could be eliminated if less tax revenue is needed to fund lowered spending. However, it’s certainly possible for new tax proposals to emerge from negotiations.
• What is the timeline for completion of tax legislation? — There is currently a limited window of time for Congress to advance tax legislation without additional complexities. That window will begin to close by early to mid-November. As previously noted, the continuing resolution funding the federal government only lasts until December 3, and the debt ceiling extension only lasts into December. In addition, Congress has other legislation to complete prior to year-end, including the annual National Defense Authorization Act and, potentially, a bill extending any expiring tax provisions. Thus, it’s expected that Democratic leadership will work in earnest to complete the BBBA by mid-November. Missing that target would not necessarily be fatal to the BBBA. However, the legislative path for the BBBA will become significantly more complicated with each passing day as the end of the calendar year approaches.

Continue to monitor our Outlook on tax rates and policy changes for updates as the BBBA works its way through Congress.