Congress completes reconciliation bill with key tax changes
The conclusion of a long and winding process
During much of last year, Democratic members of Congress negotiated over ambitious legislative proposals that would pair social and climate-related spending with a wide variety of tax increases and technical changes. Many of those proposals were derived from the 2020 campaign platforms of President Biden and other Democratic leaders. The legislation that evolved, initially called the BBBA, was passed by the House in November 2021 but ran into political headwinds in the Senate. Specifically, an impasse was reached in December 2021 when Senator Manchin announced that he couldn’t support that version of the bill due to concerns both about its contents and broader issues facing the country.
For the first seven months of 2022, it appeared that the BBBA would remain on the sidelines as behind-the-scenes talks continued but with very little public-facing progress. However, a surprise announcement on July 27 gave new life to this legislative package. The negotiations between Senate Majority Leader Schumer and Senator Manchin leading to that announcement made significant changes to both the spending and revenue-raising aspects of the bill, which was rebranded as the IRA. Additional modifications were made on the Senate floor in order to achieve final approval from the Democratic caucus, including Senator Sinema, who orchestrated some of the most significant last-minute changes. The completed version of the IRA passed the Senate during a weekend-long session on August 7 and subsequently passed the House on August 12.
Summary of key tax changes included in the Inflation Reduction Act (IRA)
Fundamental aspects of the IRA are based on prior BBBA proposals, so there are understandable concerns from taxpayers about the magnitude of tax changes. As a threshold matter, it’s notable that the vast majority of BBBA tax changes have been removed. Items specifically excluded are: (1) increases to any stated tax rates including corporate, individual, and capital gains rates; (2) changes to the taxation of carried interests; (3) modifications to the state and local tax deduction cap (SALT cap); (4) changes to the required capitalization of research and experimentation expenses under Section 174; (5) changes to existing estate and gift tax rules, or the taxation of trusts; and (6) any alterations to the international tax rules. The initial version of the IRA released two weeks ago would have limited the availability of long-term capital gain treatment for carried interests, but that was ultimately removed during negotiations. The Senate also approved an extension of the SALT cap by one year, but a subsequent amendment removed that provision.
The tax changes that have been made include a combination of new taxes, enhancements to existing rules, and the creation of new tax credits and incentives. Although the IRA is leaner than last year’s proposed tax package, the changes included in the final bill will still meaningfully impact many taxpayers. However, those impacts will be felt disparately across different industries and types of organizations.
In summary, the tax items included in the IRA can be categorized in the following manner:
- Taxes impacting very large or publicly traded corporations — A headline item is the creation of a new 15% book minimum tax (BMT) that is levied on adjusted financial statement income and operates as an alternative minimum tax for very large corporations with more than $1 billion in average financial statement income. In addition, publicly traded corporations will be subject to a new, nondeductible 1% excise tax on the value of stock redemptions.
- Energy-related credits and incentives — The IRA includes a wide range of tax credits and incentives to support certain aspects of the renewable energy sector as well as businesses that provide inputs into that sector; the credits and incentives also encourage the adoption of certain environmentally friendly technologies by both businesses and individuals.
- Extension of a loss rule impacting pass-through business owners — Application of an existing loss limitation rule, the Sec. 461(l) excess business loss rule, has been extended an additional two years into the future. No technical modifications were made to this rule, but this development confirms expectations that this loss limitation is likely here to stay. For context, each extension year is projected to raise $26 billion in revenue to fund other priorities.
- Increased IRS funding for enforcement and other actions — The IRA includes sizable new funding for the Treasury Department and Internal Revenue Service (IRS) that herald medium- and long-term tax enforcement implications for many taxpayers.
- Other enhancements to tax rules — The IRA also includes an enhancement to the research and development credit for startup businesses, extension of Affordable Care Act premium subsidies, and a new excise tax related to pharmaceutical drugs.
Those tax changes are discussed in greater depth below.
Book minimum tax (BMT) on large corporations
For tax years beginning after Dec. 31, 2022, a new 15% book minimum tax will be applied to large corporations. This is an alternative minimum tax on the worldwide adjusted financial statement income (FSI) of corporations that have average annual FSI exceeding $1 billion over a trailing three-year period. A modified two-part test applies to corporations that are part of a multinational group with a foreign parent corporation. Specifically, the U.S. corporation will be subject to the tax if: (1) the combined FSI of all members of the group exceeds the $1 billion threshold, and (2) the FSI of all U.S. entities, foreign subsidiaries of the U.S. entities, and U.S. business income of foreign parent/sister companies exceeds a $100 million threshold over the same testing window.
The calculation of a corporation’s FSI begins with net income or loss stated on the applicable financial statement before several key adjustments are made:
- First, federal income taxes and certain foreign income taxes are added back.
- Second, a series of adjustments are made to coordinate the entities included in the financial statements with the entities included in the federal tax return.
- Lastly, a variety of targeted adjustments are made to account for certain differences between book accounting and tax accounting that Congress didn’t feel should contribute to the BMT.
Most notably, adjustments are made to align pension accounting and fixed-asset depreciation with the relevant tax rules, which prevents distortions due to mark-to-market style accounting on pension plans and accelerated tax depreciation rules. FSI also includes an NOL carryforward concept based on FSI losses incurred in tax years ending after Dec. 31, 2019. Many, but not all, of these adjustments apply in determining both the $1 billion/$100 million thresholds as well as the base upon which that 15% minimum tax is applied.
The BMT incorporates a modified version of the foreign tax credit while also preserving the benefit of general business credits such as the research and experimentation credit. It also permits any BMT paid to be credited against regular tax in subsequent tax years.
The definition of corporations subject to the BMT specifically excludes S corporations, real estate investment trusts (REITs), and regulated investment companies (RICs).
What to do now?
The first step for corporations will be to determine whether they are potentially subject to the BMT based on their FSI and the combined FSI of any foreign-parented multinational groups to which they belong. This tax is effective for tax years beginning after Dec. 31, 2022, so it will apply to the 2023 year for calendar-year taxpayers or to fiscal years ending in 2024. Given the deferred implementation, corporations will have at least four months to complete their preliminary analyses. However, the average FSI for the 2023 tax year will include 2023 FSI, so it may not be possible for some corporations to know whether they will be subject to the BMT until after year-end. Still, for corporations that may be subject to the BMT, consideration will have to be given both to financial reporting considerations and estimated tax payments which could both be relevant in the first quarter of 2023.
Excise tax on stock redemptions by publicly traded corporations
A new excise tax will apply to redemptions of stock by publicly traded corporations that occur after Dec. 31, 2022. This tax is a new, nondeductible 1% excise tax that’s calculated based on the fair market value of stock repurchased by U.S. publicly traded corporations. The tax is assessed against the corporation and not the shareholders whose stock is being redeemed, so it’s economically borne by all shareholders. There is no size threshold, so it will apply to both the smallest and largest public corporations. The tax applies to redemptions of the corporation’s stock or any transaction that the Treasury considers to be economically similar to a redemption.
The excise tax also applies to purchases of the corporation’s stock completed by specified affiliates of the corporation, including corporations or partnerships that are more than 50% owned (directly or indirectly) by the public corporation. A specified affiliate may directly owe this excise tax if it purchases the stock of a foreign parent that’s publicly traded. The value of the redemptions on which the tax applies will be reduced by any stock issuances that occur during the year, including issuances pursuant to the exercise of stock options and issuances made by specified affiliates.
Specific exceptions to this rule are provided for:
- Stock repurchases that occur as part of tax-free reorganizations under Sec. 368.
- Repurchased stock that’s contributed to employer-sponsored retirement plans, employee stock ownership plans, or similar plans.
- Situations where the total value of the stock repurchased by the corporation in a single year is less than $1 million.
- Repurchases where the corporation is a dealer in securities.
- Repurchases made by REITs or RICs.
- Repurchases that are taxed as dividends.
What to do now?
By its terms, this only applies to publicly traded corporations, so all privately held corporations can proceed with their existing plans. For public corporations, the deferred effective date provides a limited window of approximately four months to complete any planned stock redemptions without application of this rule. Once the effective date passes, corporations subject to this rule will need to consider its application prior to the completion of either routine or extraordinary stock repurchases. The significant list of exceptions to this rule does provide a path to completing certain types of repurchases. Otherwise, this will increase the economic cost of all other redemptions by public corporations after the effective date and may incentivize dividends over redemptions in some circumstances.
Extension of the Section 461(l) excess business loss rule
The IRA extends the future expiration date of an existing loss limitation rule that impacts owners of pass-through business entities. The Tax Cuts and Jobs Act (TCJA) originally imposed this limitation on the deductibility of losses from sole proprietorships, partnerships, S corporations, and trusts pursuant to Sec. 461(l). This rule applies after other loss rules, such as the at-risk limitation and passive activity loss rules. At its core, the rule allows an individual, estate, or trust to offset business losses against business income, but limits the annual deductibility of any resulting net business loss to $250,000 (or, $500,000 in the case of married taxpayers filing jointly). The resulting excess business loss (EBL) is then carried forward by the taxpayer as a net operating loss (NOL), subject to the 80% NOL limitation in subsequent years.
Sec. 461(l) has now been modified and extended several times since it first took effect in 2018. In March 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act retroactively turned off this rule for 2018, 2019, and 2020 while making other technical changes. In March 2021, the American Rescue Plan Act (ARPA) then extended the expiration date from the end of 2025 through 2026. The IRA extension now takes the application of this provision through 2028.
Proposals were also included in the BBBA during 2021 to modify the treatment of the carryforward EBL. However, none of those proposals were included in the IRA.
What to do now?
The Section 461(l) rules were already currently effective, so this will not necessarily require any additional actions by pass-through business owners. However, it would be advisable for such business owners or investors to revisit these rules in order to confirm their expectations about the ability to utilize losses. In some cases, this has proven to be a trap for the unwary with surprising results. Those investors may also want to consider how these rules are incorporated into long-term tax planning models. While the provision does currently have an expiration date, it seems likely that Congress will continue to push that expiration date into the future in order to generate additional revenue that can pay for other priorities causing this temporary provision to be semipermanent.
Energy-related credits and incentives
A significant focus of Democratic leadership during the legislative process was on climate-related programs, including tax credits and incentives for clean, renewable, and other energy sources in order to reduce greenhouse gas emissions on a long-term basis. The programs included in the IRA have a variety of effective dates and apply to many different types of taxpayers. Thus, the initial action item is to review the available programs to determine whether any opportunities exist to claim such benefits based on existing activities or whether additional actions should be taken to qualify for new benefits.
The tax credits in the IRA include the following:
- Expanded and modified credits for electricity from renewable sources — The bill expands, extends, and/or modifies tax credits for electricity generated from renewable sources, the Sec. 48 energy credit, credits for solar and wind facilities in low-income communities, the credit for qualified carbon oxide captured by a taxpayer, the biofuel credit, the credit for nonbusiness energy efficiency improvements, the residential energy efficient property credit, the new energy efficient home credit, and the credit for refueling property for alternative fuel vehicles, among others. These provisions have varying effective dates, but many are retroactive back to Dec. 31, 2021, for those provisions that had previously expired.
- New advanced manufacturing production credit — The bill creates a new credit for businesses that manufacture and sell specified components. All manufacturing must occur within the United States or a possession of the United States. Such components include photovoltaic cells and wafers, solar grade polysilicon, polymeric backsheets, solar modules, wind energy components, torque tubes, structural fasteners, inverters, electrode active materials, battery cells and modules, and critical minerals. This credit is available with respect to components produced and sold after Dec. 31, 2022 through the end of 2032 (the credit phases down in 2030 and 2031).
- New credit for zero-emission nuclear power production — The bill creates a new credit for kilowatt hours of electricity produced by nuclear power facilities that are owned by the taxpayer claiming the credit, were placed into service before the bill was signed, and aren’t advanced nuclear power facilities (as defined in Sec. 45J(d)(1)). The credit applies to electricity produced and sold after Dec. 31, 2023, and included in tax years beginning after Dec. 31, 2023.
- New tax credit for sustainable aviation fuel — The bill creates a new credit for the sale or use of sustainable aviation fuel, which is allowed against income tax or excise tax liabilities for fuel sold or used in calendar years 2023 or 2024.
- New clean hydrogen credit — The bill creates a new credit per kilogram of clean hydrogen produced in a tax year, calculated based on how clean the hydrogen is. The credit applies to hydrogen production occurring after Dec. 31, 2022.
- New clean fuel production credit for transportation fuel — The bill creates a new credit for the production of low-emissions transportation fuel, or fuel that meets the requirements to be suitable for use in a vehicle or aircraft. The credit is calculated by gallon of produced fuel multiplied by an emissions factor. The credit applies to fuel produced after Dec. 31, 2024, and will not apply to fuel sold after Dec. 31, 2027.
- Clean vehicle credits — The bill modifies the electric vehicle credits starting in 2023 and the modified credit doesn’t expire until 2032. One key change is the removal of the cap on the number of vehicles that may qualify for the new clean vehicle credit from any particular manufacturer. The credit amount is capped at $7,500 but would be reduced or eliminated if: (1) the battery contains too many critical minerals mined outside of the United States; (2) the battery contains too many components manufactured or assembled outside of North America; (3) if critical minerals or battery components are manufactured by a foreign entity of concern; (4) the vehicle is assembled outside of the United States; (5) the vehicle price exceeds $80,000 for SUVs and pick-ups or $55,000 for all other vehicles; (6) or the purchaser’s modified adjusted gross income (MAGI) exceeds $150,000 for single taxpayers, $225,000 for heads of household, or $300,000 for married filing jointly taxpayers. The credit is also able to be transferred to the selling auto dealer so that it can directly offset the purchase price of the vehicle for the purchaser. In that case, the dealer is able to receive direct payments from the government for the credits.
- Pre-owned clean vehicle and clean commercial vehicle credits — The bill creates credits for pre-owned clean vehicles and for qualified commercial clean vehicles. These credits apply starting in 2023 and don’t expire until 2032. The pre-owned clean vehicle credit is 30% of the purchase price and capped at $4,000. There are a number of requirements that the vehicle has to meet in order to qualify, and there is a MAGI limit for the purchaser. The commercial clean vehicle credit has a sliding scale based on the type of vehicle and the weight with the maximum amount being 30% of the cost of the vehicle and a $40,000 cap on the credit for each vehicle.
- Extended incentives for biodiesel, renewable diesel, and alternative fuels — The bill extends the expiration of the tax credit for biodiesel and renewable diesel from Dec. 31, 2022 to Dec. 31, 2024. It also expands availability of a claim for refund for use of certain biodiesel and alternative fuels.
The amount of certain tax credits described above are determined by a sliding scale and include unique payment terms that can make them much easier to monetize:
- Enhancement of credits for domestic content, prevailing wage and apprenticeship, and “energy communities” — Many of the energy credits have a sliding scale of benefits. There’s often a base benefit amount or percentage that can then be increased when certain requirements are met. Example requirements include: (1) a facility must be composed of steel, iron, or other products manufactured in the United States, (2) a taxpayer must ensure that laborers on a project are paid prevailing wages during project construction and for further alterations and repairs, and (3) a taxpayer must ensure that a certain percentage of labor hours on a project are performed by qualified apprentices. In some cases, not all of these requirements must be met for increased benefits and the enhanced benefits can be up to 10x the base benefit. Enhancements can also be available for “energy communities,” which include a brownfield site, an area with significant fossil fuel employment, or an area where a coal mine or coal power plant has closed. Meeting these requirements can also impact whether a taxpayer might be permitted to receive a direct payment from the government instead of a tax credit.
- Transferability of elective payments and tax credits — The bill allows taxpayers to transfer certain energy credits to other taxpayers in exchange for cash payments. The taxpayers acquiring such credits may then elect to apply the credit against their taxable income. The transferability provision applies to: (1) credits for alternative fuel vehicle refueling property; (2) renewable electricity production credits attributable to qualified facilities; (3) carbon oxide sequestration credits based on equipment placed in service after 2022; (4) zero emission nuclear power production credits; (5) clean hydrogen production credits attributable to qualified clean hydrogen production facilities; (6) qualified commercial vehicle credits provided to tax-exempt entities; (7) advanced manufacturing credits; (8) clean electricity production credits; (9) clean fuel production credits; (10) energy credits; (11) qualifying advanced energy project credits; and (12) clean electricity investment credits. The transferability provision applies to tax years beginning after Dec. 31, 2022.
- Direct payments of credits — The bill provides for direct payment of credits through an election to offset such credits against a wide variety of income taxes. This election is available to tax-exempt organizations, states or their political subdivisions, the Tennessee Valley Authority, tribal governments, Alaska Native Corporations, and cooperative corporations providing electricity to rural populations. The credits available for this election include the same list as included in the transferability discussion directly above. When an election is made, the applicable entity is treated as making a payment against any applicable income tax imposed by Subtitle A of the Tax Code. This election applies to tax years beginning after Dec. 31, 2022.
Beyond tax credits, the IRA includes the following energy-related tax incentives and modification to certain taxes:
- Accelerated depreciation for commercial energy-efficient building property — The bill expands the property that qualifies for the energy-efficient commercial building property deduction and modifies the calculation to increase the deduction amount. These changes generally take effect for tax years beginning after Dec. 31, 2022.
- Depreciation changes for certain green energy property — The bill creates new categories of green energy property that qualifies as five-year property under the modified accelerated cost recovery system (MACRS) depreciation rules. Specifically, those are qualified facilities, qualified property, and energy storage technology. These changes apply to facilities and property placed in service after Dec. 31, 2024.
- Superfund tax for crude oil and petroleum products — The IRA also reinstates and increases the Superfund tax imposed on crude oil and petroleum products under Sec. 4611 and extends the tax rate under Sec. 4121 to fund the Black Lung Disability Trust Fund. It also imposes a fee on methane emissions of certain petroleum or natural gas facilities emitting more than 25,000 metric tons per year.
Increased funding for the IRS
Considerable discussions about the IRS have occurred in Congress in recent years. Those discussions have involved a variety of topics, including concerns about processing times at IRS Service Centers as well as the volume and scope of tax enforcement in the context of tax revenue expectations. The IRA responds to many of those concerns through the deployment of the following new funding primarily consisting of:
- $45.64 billion for tax enforcement
- $25.33 billion for IRS operations support
- $4.75 billion for system modernization
- $3.18 billion for taxpayer services
The focus on increased tax enforcement is punctuated by the allocation of over 57% of the total funding to such activities. Some of this funding will be made immediately available, but the Treasury Department and IRS will have up to 10 years to fully utilize such funds. This signals a future of increased audits and enforcement actions in the years to come. To address certain public concerns, Treasury Secretary Yellen sent a letter to the IRS Commissioner Rettig on August 11 directing that none of the additional funding shall be used to increase audit rates beyond historic levels for any small businesses or households making less than $400,000 annually.
What to do now?
The new funding isn’t expected to immediately impact taxpayers. However, now is a great time to plan for the audits of the future by revisiting current tax positions and related documentation.
Enhanced research credit claims on payroll tax returns
For tax years beginning after Dec. 31, 2022, certain small taxpayers will have an enhanced ability to monetize the research and development (R&D) tax credit. Under existing rules, small taxpayers are eligible to claim up to $250,000 of the R&D credit on their payroll tax returns, allowing them to take advantage of the credit even if they don’t have sufficient tax to utilize the credit. The IRA enhances this rule by doubling, to $500,000, the amount that may be claimed against payroll taxes. Eligible small taxpayers are those that have less than $5 million in gross receipts in the current year, and who did not have gross receipts in any year prior to the five-year period ending with the tax year at issue (e.g., for 2023 the taxpayer would need less than $5 million of gross receipts in 2023 and can’t have had any gross receipts prior to Jan. 1, 2019). The IRA enhances this rule by doubling, to $500,000, the amount that may be claimed against payroll taxes.
What to do now?
This rule generally provides a targeted benefit to businesses that are in the very early stages of their life cycle. By doubling the limitation, the IRA has enhanced the maximum benefit of this rule while retaining the same eligibility criteria. Businesses that are conducting R&D activities, especially those in the service, technology, medical, biotechnology, or pharmaceutical industries, should evaluate the available opportunities.
Other tax changes
- ACA premium subsidies — The ARPA previously expanded Affordable Care Act (ACA) health insurance premium subsidies for 2021 and 2022. These take the form of refundable tax credits provided to eligible individuals to assist with the cost of paying for health insurance purchased through the Health Insurance Marketplace. Qualified taxpayers include low-income individuals that meet specified income tests. The IRA extends the core aspects of these subsidies through 2025. Individuals who have received ACA premium subsidies in 2021 or 2022 should revisit these rules to determine the availability of continued benefits in the coming years. Lower income taxpayers that have not previously claimed such subsidies should also reconsider their eligibility.
- Excise tax on noncompliant drug manufacturers — The IRA imposes a new, nondeductible excise tax on certain importers, manufacturers, or producers of specified drugs. This tax is triggered by a list of noncompliance situations, including failure by the business to enter into drug pricing agreements with Medicare as required by the bill and failure to timely submit required information to the Secretary of Health and Human Services. The excise tax applies to sales made by the noncompliant taxpayer only during the taxpayer’s noncompliance period. The excise tax applies to sales occurring after the date the bill is signed into law, but the noncompliance period can begin no earlier than Oct. 2, 2026.
Final thoughts on the IRA
The IRA includes impactful tax changes, albeit on a much more modest scale than previously proposed in the BBBA. The delayed effective dates for most changes also provide taxpayers with at least four months to evaluate these rules and determine appropriate next steps. In many cases, the new provisions will not impact a taxpayer and no further action will be required. However, for those that will fall within certain new rules, those few months are a crucial opportunity to consider what, if anything, can be done to mitigate any detrimental effects or maximize any benefits.
Enactment of the IRA completes a process that we have discussed for 18 months or more. This is also expected to foreclose the possibility that any further significant tax increases will be passed during the remainder of the year. Although there is still a chance that limited tax changes will be completed during the short legislative session that follows the upcoming midterm elections. Changes to required capitalization under Sec. 174 could potentially be modified as part of a tax extender package focused on the few remaining provisions that expired in 2021 or will expire in 2022 that were not addressed by the CARES Act, ARPA, or the IRA. But the likelihood of such changes is far from certain.