The recently released U.S. Treasury Department’s Green Book (the Green Book or the proposals) provides information on the Biden Administration’s tax proposals. This article is part of a series examining the Green Book’s explanations and focuses on many of the items aiming to increase taxes on income of high-income taxpayers (generally those with incomes in excess of $400,000).
The proposed effective implementation date is generally for tax years beginning after 12/31/2021 unless otherwise indicated.
Increase in Top Marginal Tax Rates
The highest tax bracket rate will be increased to 39.6% up from 37%. The highest tax rate bracket kicks in at lower income levels than under existing law.
Note that there is no separate analysis in the Green Book related to the income tax brackets for taxable trusts and estates. Currently, the highest rate for those types of taxpayers begins at $13,050.
Increase in Capital Gain and Dividend Tax Rates for High Income Taxpayers
The tax rate on long-term capital gains and qualifying dividend income is proposed to be increased to 37% up from 20% under existing law (excluding the tax on net investment income of 3.8%). These rates will be assessed on individuals with adjusted gross income that exceeds $500,000 for single taxpayers and $1,000,000 for married taxpayers filing jointly. Including the separate 3.8% tax on net investment income, the combined federal income tax rate on long-term capital gains and dividends will be 40.8%
OBSERVATION: Section 199A qualified business income deduction is not a deduction in arriving at adjusted gross income. Further, in 2022, the Section 461(l) $500,000 excess business loss limitation will again be in place. Net operating losses will be limited to 80% of taxable income. These types of loss limitation provisions have the impact of increasing adjusted gross income and therefore increasing the likelihood of the higher rate applying to gains and dividends.
The Green Book indicates the higher tax rate will apply to “gains” beginning on the date of President’ Biden’s announcement; this is presumably on or around April 28, 2021 (the date of President Biden’s first address to Congress). The Green Book does not separately address when the increased rate will apply to dividend income, but the specific use of the word “gains” may imply that the effective date for dividend taxation will not be until after 12/31/2021 (but again more details are needed).
Effectively Eliminates Deferral of Gain from Like-Kind Exchanges
The proposal would continue to allow the deferral of gain on like-kind exchanges but only up to an aggregate amount of $500,000 for each “taxpayer” ($1 million in the case of married individuals filing a joint return) each year for real property exchanges that qualify as like-kind. Any gains from like-kind exchanges exceeding the maximum deferral during a taxable year would be recognized by the taxpayer in the year the taxpayer transfers the real property subject to the exchange. The proposal would be effective for exchanges completed in taxable years beginning after December 31, 2021.
OBSERVATION: This seems to imply that replacement property received in deferred like-kind exchange transactions would need to be closed by the end of the year. Taxpayers contemplating like-kind exchanges in 2021 should plan accordingly and continue to monitor legislative developments.
There is no discussion in the Green Book of how this rule would be implemented and applied to flow-through entities such as partnerships or S Corporations with multiple owners; additional details would be needed.
Broadens the Scope of Net Investment Income Tax (NII) and Self-Employment Tax (SECA) To Include Certain Limited Partners and S Corporation Shareholders
The proposal would (i) ensure that all pass-through business income of high-income taxpayers is subject to either the NIIT or SECA tax, (ii) make the application of SECA to partnership and LLC income more consistent for high-income taxpayers, and (iii) apply SECA to the ordinary business income of high-income nonpassive S corporation owners.
In other words, the proposal is designed to ensure that all trade or business income of high-income taxpayers will be subject to a total of 3.8% tax that is dedicated to the Medicare trust fund either through the NII tax regime or SECA tax regime (combined with the additional Medicare tax).
First, for taxpayers with adjusted gross income in excess of $400,000, the definition of net investment income would be amended to include gross income and gain from any trades or businesses that is not otherwise subject to employment taxes.This would pull-in income that currently is exempt from the NII tax such as the distributive share of S corporation income of shareholder-employee as well as those claiming exemption from the tax as limited partners.
The net investment income tax would be applied to all trade or business income that is not otherwise subject to employment taxes.
Next, limited partners and LLC members treated as limited partners who provide services and materially participate in their partnerships and LLCs would be subject to SECA tax on their distributive shares of partnership or LLC income to the extent that this income exceeds certain threshold amounts (the explanation of which will be saved for a future time).
Finally, S corporation owners who materially participate in the trade or business would be subject to SECA taxes on their distributive shares of the business’s income to the extent that this income exceeds certain threshold amounts.
Material participation standards would apply to individuals who participate in a business in which they have a direct or indirect ownership interest. Taxpayers are usually considered to materially participate in a business if they are involved in it in a regular, continuous, and substantial way (often meaning work for at least 500 hours per year). The statutory exception to SECA tax for limited partners would not exempt a limited partner from SECA tax if the limited partner otherwise materially participated.
Carried Interests Will Be Subject to Ordinary Income Taxation
The proposal would repeal IRC Section 1061 for taxpayers with taxable income (from all sources) in excess of $400,000 and would generally tax as ordinary income a partner’s share of income from an “investment services partnership interest” (ISPI) in an investment partnership, regardless of the character of the income at the partnership level. In addition, the proposal would require partners in such investment partnerships to pay self-employment taxes on such income.
An ISPI means a profits interest held by a person who provides services to an investment partnership (substantially all of its assets are certain securities, real estate, interests in other partnerships, commodities, cash or equivalents, and derivative contracts with respect to those assets).
While there are exceptions, the proposal assumes that gain recognized on the sale of an ISPI would generally be taxed as ordinary income and not as capital gain. This area will require additional guidance and explanation and the Green Book notes that anti-abuse rules may be necessary.
Losses on Working Interests in Oil and Natural Gas Properties Becomes Passive
The exception to passive loss limitations provided for working interests in oil and natural gas properties would be repealed.
Capital Gain Treatment for Coal Royalties Repealed
The treatment of royalties received on the disposition of coal or lignite and that generally qualifies as long-term capital gain under existing law would be repealed. This type of income would be taxed at ordinary income tax rates.
If you have any question on the above topics, please don’t hesitate to reach out to your Schneider Downs tax advisor or contact us at [email protected].
This article is part of a series discussing the Treasury Department’s Green Book Explanation of President Biden’s Tax Proposals.
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