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July 06, 2021

Capital Gain Rates and Increase in Marginal Tax Rates Will Impact Our Doctors, Dentists, and Other Closely-Held Business Owners, if It Is up to Biden?

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As a business advisor and tax planning attorney that works with closely-held businesses, including doctors, dentists, and other high-income earning individuals, I am receiving many questions about Biden’s tax proposals, including capital gains rates. I wanted to provide you an update on those tax proposals. Overall, however, it is important to recognize that these are simply proposals. I certainly would not make a business decision or plan a purchase, sale, or restructuring of a business, solely based upon these proposals. Yes, we should consider them. But, they are not currently law. Please note, this summary is based mainly on the General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals issued by the Department of the Treasury—commonly referred to as the: Green Book. Also, it is not a summary of all proposed changes. Rather, I have listed those proposals that I believe are the most impactful on what you do. So, here you go.

28 Percent Corporate Tax Rate

    Current Law

Income of a business entity can be subject to federal income tax in a manner that varies depending upon the classification of the entity for federal income tax purposes. Most small businesses are owned by individuals and taxed as “pass-through” entities, meaning that their income is passed through to their owners who are taxed under the individual income tax system. Most large businesses, including substantially all publicly traded businesses, are classified as “C corporations” because these corporations are subject to the rules of subchapter C of chapter 1 of the Internal Revenue Code (Code) and pay an entity-level income tax.

Additionally, taxable shareholders of such corporations generally pay federal income tax on most distributions attributable to their ownership in the corporation. This is where the concept of double taxation comes into play. If you recall, the Tax Cuts and Jobs Act of 2017 replaced a graduated tax schedule—with most corporate income taxed at a marginal and average rate of 35 percent—with a flat tax of 21 percent applied to all C corporations.

    Proposal

The proposal would increase the income tax rate for C corporations from 21 percent to 28 percent. The proposal would be effective for taxable years beginning after December 31, 2021. For taxable years beginning after January 1, 2021, and before January 1, 2022, the tax rate would be equal to 21 percent plus 7 percent times the portion of the taxable year that occurs in 2022.

Increase the Top Marginal Tax Rate for Individual and Fiduciary Taxpayers

    Current Law 

For taxable years beginning after December 31, 2017, and before January 1, 2026, the top marginal tax rate for the individual income tax is 37 percent. For taxable years beginning after December 31, 2025, the top marginal tax rate for the individual income tax is 39.6 percent.

For 2021, the 37 percent marginal individual income tax rate applies to taxable income over $628,300 for married individuals filing a joint return and surviving spouses, $523,600 for unmarried individuals—other than surviving spouses—and head of household filers, and $314,150 for married individuals filing a separate return.

    Proposal

The proposal would increase the top marginal individual income tax rate to 39.6 percent. This rate would be applied to taxable income in excess of the 2017 top bracket threshold, adjusted for inflation. In taxable year 2022, the top marginal tax rate would apply to taxable income over $509,300 for married individuals filing a joint return, $452,700 for unmarried individuals—other than surviving spouses—$481,000 for head of household filers, and $254,650 for married individuals filing a separate return. After 2022, the thresholds would be indexed for inflation using the C-CPI-U, which is used for all current tax rate thresholds for the individual income tax.

The proposal would be effective for taxable years beginning after December 31, 2021.

Increase Tax Rate on Capital Gains

    Current Law

Most realized long-term capital gains and qualified dividends are taxed at graduated rates under the individual income tax, with 20 percent generally being the highest rate—23.8  percent including the net investment income tax, if applicable, based on the taxpayer’s modified adjusted gross income.

    Proposal

Tax capital income for high-income earners at ordinary rates. Long-term capital gains and qualified dividends of taxpayers with adjusted gross income of more than $1 million would be taxed at ordinary income tax rates, with 37 percent generally being the highest rate—40.8 percent including the net investment income tax—but only to the extent that the taxpayer’s income exceeds $1 million—$500,000 for married filing separately—indexed for inflation after 2022.

This proposal would be effective for gains required to be recognized after the date of announcement. It appears that the "date of announcement" is April 28, 2021, the date that the Administration first detailed this proposal.

Accelerate Capital Gains on Gifts by Treating Transfers of Appreciated Property by Gift or on Death as Realization Events

    Current Law

Capital gains are taxable only upon realization, such as the sale or other disposition of an appreciated asset. When a donor gives an appreciated asset to a donee during the donor’s life, the donee’s basis in the asset is the basis of the donor; in effect, the basis is “carried over” from the donor to the donee. There is no realization of capital gain by the donor at the time of the gift, and there is no recognition of capital gain (or loss) by the donee until the donee later disposes of that asset. When an appreciated asset is held by a decedent at death, the basis of the asset for the decedent’s heir is adjusted (usually “stepped up”) to the fair market value of the asset at the date of the decedent’s death. As a result, the amount of appreciation accruing during the decedent’s life on assets that are still held by the decedent at death completely avoids federal income tax.

    Proposal

Treat transfers of appreciated property by gift or on death as realization events. Under the proposal, the donor or deceased owner of an appreciated asset would realize a capital gain at the time of the transfer. For a donor, the amount of the gain realized would be the excess of the asset’s fair market value on the date of the gift over the donor’s basis in that asset. For a decedent, the amount of gain would be the excess of the asset’s fair market value on the decedent’s date of death over the decedent’s basis in that asset. That gain would be taxable income to the decedent on the Federal gift or estate tax return or on a separate capital gains return. The use of capital losses and carry-forwards from transfers at death would be allowed against capital gains income and up to $3,000 of ordinary income on the decedent’s final income tax return, and the tax imposed on gains deemed realized at death would be deductible on the estate tax return of the decedent’s estate—if any.

Importantly, the gain on unrealized appreciation also would be recognized by certain trusts, partnerships, or other non-corporate entities in limited circumstances. There are numerous changes in the law that would be required under this proposal, which would be incorporated by regulations issued by Treasury. There is a more detailed discussion of these anticipated changes in the Treasury’s Green Book.

The proposal would be effective for gains on property transferred by gift, and on property owned at death by decedents dying, after December 31, 2021, and on certain property owned by trusts, partnerships, and other non-corporate entities on January 1, 2022.

Rationalize Net Investment Income (NII) and Self-employment Contributions Act (SECA) Taxes

    Current Law

Individuals with incomes over a threshold amount are subject to a 3.8 percent tax on net investment income. The threshold is $200,000 for single and head of household returns and $250,000 for joint returns. Net investment income generally includes (i) interest, dividends, rents, annuities, and royalties, other than such income derived in the ordinary course of a trade or business; (ii) income derived from a trade or business in which the taxpayer does not materially participate; (iii) income from a business of trading in financial instruments or commodities; and (iv) net gain from the disposition of property other than property held in a trade or business in which the taxpayer materially participates. The net investment income tax (NIIT) does not apply to self-employment earnings.

Self-employment earnings and wages are subject to employment taxes under either the Self-Employment Contributions Act (SECA) or the Federal Insurance Contributions Act (FICA), respectively. Both SECA and FICA taxes apply at a rate of 12.4 percent for social security tax on employment earnings—capped at $142,800 in 2021—and at a rate of 2.9 percent for Medicare tax on all employment earnings—not subject to a cap. An additional 0.9 percent Medicare tax is imposed on self-employment earnings and wages of high-income taxpayers, above the same NIIT thresholds of $200,000 for single and head of household filers and $250,000 for joint filers.

General partners and sole proprietors pay SECA tax on the full amount of their net trade or business income, subject to certain exceptions. Section 1402(a)(13) of the Internal Revenue Code provides that limited partners are statutorily excluded from paying SECA tax with respect to their distributive shares of partnership income or loss, although they are subject to SECA tax on their section 707(c) guaranteed payments from the partnership that are for services they provide to, or on behalf of, the partnership. Because the statutory exclusion only refers to limited partners, questions have arisen as to the meaning of this term and whether the limited partner exclusion might be applicable to limited liability company (LLC) members. According to the Treasury, partners who might more accurately be considered general partners and some LLC members avoid SECA by claiming the treatment of limited partners.

S corporation shareholders are not subject to SECA tax. But, tax law requires that owner-employees pay themselves “reasonable compensation” for services provided, on which they pay FICA tax like any other employee. Nonwage distributions to shareholders of S corporations are not subject to either FICA or SECA taxes.

    Proposal

The proposal would (i) ensure that all pass-through business income of high-income taxpayers are 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 non-passive S corporation owners.

First, the proposal would ensure that all trade or business income of high-income taxpayers is subject to the 3.8-percent Medicare tax, either through the NIIT or SECA tax. In particular, for taxpayers with adjusted gross income in excess of $400,000, the definition of net investment tax would be amended to include gross income and gain from any trade or business that is not otherwise subject to employment taxes.

Second, limited partners and LLC members 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 exemptions from SECA tax provided under current law for certain types of partnership income—e.g., rents, dividends, capital gains, and certain retired partner income—would continue to apply to these types of income.

Third, 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. The exemptions from SECA tax provided under current law for certain types of S corporation income—e.g., rents, dividends, and capital gains—would continue to apply to these types of income.

There is a more detailed discussion of this proposal in the Treasury Green Book, including how to determine the amount of partnership income and S corporation income that would be subject to SECA tax under the proposal.

The proposal would be effective for taxable years beginning after December 31, 2021.

Repeal Deferral of Gain From Like-Kind Exchanges

    Current Law

Currently, owners of appreciated real property used in a trade or business or held for investment can defer gain on the exchange of the property for real property of a “like-kind.” As a result, the tax on the gain is deferred until a later recognition event, provided that certain requirements are met.

    Proposal

The proposal would allow the deferral of gain 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 are like-kind. Any gains from like-kind exchanges in excess of $500,000—or $1 million in the case of married individuals filing a joint return—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.

Permanently Extend Excess Business Loss Limitation of Non-Corporate Taxpayers

    Current Law

Section 461(l) of the Internal Revenue Code limits the extent to which pass-through business losses may be used to offset other income. In particular, for taxable years beginning after December 31, 2020, and before January 1, 2027, non-corporate taxpayers may not deduct an “excess business loss” from taxable income. Instead, these losses are carried forward to subsequent taxable years as net operating losses.

Excess business loss is defined as the excess of losses from business activities over the sum of (a) gains from business activities, and (b) a specified threshold amount. In 2021, these thresholds are $524,000 for married couples filing jointly and $262,000 for all other taxpayers; these amounts are indexed for inflation thereafter. The determination of excess business loss is made at the taxpayer level, aggregating across all business activities. But, gains or losses attributable to any trade or business of performing services as an employee are not considered.

    Proposal

The proposal would make permanent the section 461(l) excess business loss limitation on non-corporate taxpayers.

The proposal would be effective for taxable years beginning after December 31, 2026.

Conclusion

So, what do we do with this? You consider it, but that is it. Recognize that many things will change between now and what the actual tax law change may look like. Do not delay or accelerate a sale or purchase simply because the law may change. It is something to consider. But, there are likely many other business issues and terms that we need to consider as well.

Have a great day!

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July 06, 2021

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