Senate tax deal brokered; Congress to consider new changes
Editor's note: The developments discussed in this piece were part of the legislative process leading to enactment of the Inflation Reduction of 2022. Please see our capstone article about that legislation for details about the final changes included in that bill.
Key Democratic senators have announced a deal to advance legislation that includes important tax changes. This revitalizes a legislative process that had been dormant for several months. Legislative text has also been released, which outlines a bill with far fewer tax changes than previously considered during the past year. Here are our initial reactions to this announcement, the legislative text, and what’s coming next.
On July 27, Senator Schumer and Senator Manchin announced a deal on updated legislation, the newly named Inflation Reduction Act of 2022 (IRA), to be pursued through the budget reconciliation process. This announcement caught many by surprise and ushered in a new chapter to a legislative story that began in early 2021.
During the first half of 2021, the Biden Administration announced plans for two major legislative packages — the American Families Plan and the American Jobs Plan. Taken together, those packages included ambitious spending programs targeting infrastructure, climate change, and many social programs. The spending would have been offset —at least to some degree — by a wide range of tax increases on businesses, high-income individuals, and estates and trusts. The infrastructure proposals were ultimately isolated into a bipartisan bill, the Infrastructure Investment and Jobs Act, which was enacted in November 2021. The remaining proposals were consolidated into the Build Back Better Act (BBBA), which passed the House in November 2021 before stalling in the Senate in December 2021.
A key factor in the BBBA stalling was Senator Manchin, who expressed concerns about the scale of that bill balanced against economic concerns. In the intervening months, economic challenges, including inflation, have continued, which suggested that tax changes faced substantial headwinds during 2022. However, the announcement of the IRA resurrects legislation with tax provisions, albeit with much more targeted impacts.
What’s included in the IRA bill?
Overall, the IRA is smaller in terms of both overall spending and the number of tax provisions. New spending is found in the form of climate and energy investments and an extension of Affordable Care Act subsidies from the American Rescue Plan Act. It also includes several provisions dealing with Medicare prescription drug pricing. On the tax front, the following items have been included, which were all previously proposed in one form or another last year:
- 15% book minimum tax — A new tax of 15% would be imposed on the financial statement income of corporations with an average annual financial statement income exceeding $1 billion over a three-year period ending in the applicable tax year. Corporations that are members of an international financial reporting group that have a foreign corporate parent will be subject to the tax if the adjusted financial statement income of the corporation and all foreign members of such group exceed $1 billion, and the corporation’s own adjusted financial statement income exceeds $100 million, over a three-year period. This proposal would be effective for tax years beginning after Dec. 31, 2022.
- Carried interest modifications — The existing carried interest rules under Section 1061 would be modified in several ways. First, a new five-year holding period would be used in place of the existing three-year rule. However, exceptions would allow for continued use of the current three-year rule for both gains attributable to real property trades or businesses and individual taxpayers with adjusted gross income of less than $400,000. Second, the holding period of an applicable partnership interest (API) would not begin until the later of: (1) the date that the taxpayer acquires substantially all of the API, or (2) the date that the partnership in which the API is held acquires substantially all of its assets. That rule would generally toll the holding period clock until a fund has invested substantially all its capital. Additional technical modifications would expand the gains subject to Section 1061 and direct the Treasury Department to issue new regulations targeting planning techniques, such as carry waivers. These modifications would be effective for tax years beginning after Dec. 31, 2022.
- Research credit claimed on payroll tax returns — Certain small taxpayers are permitted to claim up to $250,000 of research credits on their payroll tax return. This permits that portion of the credit to be monetized to the extent the company doesn’t currently have any income taxes to claim the credit against. The bill doubles this limitation to $500,000 for tax years beginning after Dec. 31, 2022.
- Energy credits — Subtitle D of the bill is titled “Energy Security” and includes a wide variety of tax credits, including those for energy production, equipment manufacturing, and purchase of electric vehicles.
- Increased IRS enforcement — The bill would also increase IRS funding by $80 billion, with the largest allocation going to enforcement activities. This will have limited short-term impact on taxpayers but is yet another sign of a future involving increased IRS scrutiny and enforcement.
What has been excluded from the Inflation Reduction Act of 2022?
The list of tax provisions excluded from the IRA is expansive and includes many items that taxpayers have been concerned about since early 2021. It also excludes certain tax changes that would have been favorable to taxpayers, such as a modification of the $10,000 state and local tax deduction limitation (the SALT cap). Finally, several technical modifications to existing tax rules included in the BBBA have been excluded. Specific exclusions include:
- Tax rate increases — Changes to the corporate tax rate, ordinary income tax rates, capital gains tax rates, and net investment income tax have all been excluded.
- Tax surcharge on individuals, estates, and trusts — The tax surcharge of 5% on modified adjusted gross income (MAGI) exceeding $10 million and an additional 3% surcharge on MAGI exceeding $25 million has been excluded. The BBBA previously included that surcharge, plus substantially lowered MAGI thresholds for estates and trusts.
- Estate and gift taxes — No changes will be made to the existing rules for estate and gift taxation.
- Trusts — The bill also excludes any changes to the tax treatment of trusts.
- Section 1202 — Previously, the BBBA proposed to reduce the benefit of the qualified small business stock gain exclusion for taxpayers with adjusted gross income in excess of $400,000. Those modifications are not included in the bill, so the existing gain exclusion rules will continue to apply.
- Section 174 research and experimentation expenses (R&E) — The bill excludes any modifications to the required capitalization and amortization of R&E expenses, which first took effect at the beginning of 2022.
- International tax — All of the proposals to modify existing international tax regimes have been excluded.
- Retirement plans — All of the tax changes relating to retirement plans have been excluded.
- Other technical modifications — Proposals to change the Section 163(j) business interest expense limitation, the Section 461(l) excess business loss limitation, the controlled group definition, and the expansion of wash sale and constructive sale rules to digital assets have likewise been excluded.
The Senate parliamentarian is currently reviewing the IRA text for compliance with Senate procedural rules. After that, the Senate is expected to take up this bill within the next week. If the IRA passes in the Senate, then all eyes will turn to the House. At this point, the bill still faces challenges given the narrow Democratic majorities in Congress. The exclusion of the SALT cap modification might also be a particular flashpoint in the House since several Democratic members have voiced the importance of such a provision.
We will certainly learn more over the coming weeks. However, this announcement reignites a focus on tax legislation that had waned for several months.