The U.S. House Ways and Means Committee has approved a proposal to increase certain taxes by $2.1 trillion to offset the House Democrats’ $3.5 trillion government spending plan. With a long way to go and a number of possible changes to be made along the way, Jackson Walker tax attorneys Ron Kerridge, Argyrios Saccopoulos, Nate Smithson, and Ashley Withers have divvied up the proposal and provided an overview of some of the key proposals for income tax hikes.
Greg Lambert: Hi, everyone. I’m Greg Lambert, and this is Jackson Walker Fast Takes. Recently, the Democrats in the U.S. House of Representatives outlined a series of tax changes to help pay for the $3.5 trillion spending bill on the social safety net and climate policy. I asked four of our Jackson Walker Tax attorneys to divide out some of the highlights of those changes. So, that’s roughly about $1 trillion each, everyone.
Ashley, let me have you start off with the changes in the corporate and the individual tax rates.
Ashley Withers: Yes. Thank you so much, Greg. My name is Ashley Withers, and I’m a tax attorney out of the Jackson Walker Dallas office. Today, I’m going to be speaking with you about the House Ways and Means Committee tax proposals. Now, importantly, these are only tax proposals at this point. We don’t know what senators are going to be preparing as an example, and so it is draft legislation. There probably will be changes before this is actually enacted into law. Importantly, in the draft legislation, some of these proposals are proposed to go into effect in January 2022, and some of these proposals are to go into effect September 13, 2021.
- In terms of actual increases in tax rates, one of the big proposals is to increase capital gains. Right now, the top long-term capital gains rate is 20%. The proposal is to increase that to 25%, which would be effective September 13, 2021. The same top rate is proposed for qualified dividends. There is a binding contract exception mentioned in the proposed legislation for transactions that close in 2021, but it’s looking like if you have for example a non-binding letter of intent, that that may not quite qualify you under that binding contract exception.
- Another key proposal is a high-income surcharge, which would impose a 3% surcharge on income, both ordinary and capital gains, for taxpayers making about $5 million, and that’s proposed to go into effect in 2022.
- There’s also a proposal for net investment income tax that that would be expanded. Right now, it’s a 3.8% net investment income tax, that is proposed to apply to net investment income derived in the ordinary course of a trade or business. That’s only going to be for high-income taxpayers. So, if you’re married filing jointly with income of $500,000 or more, or if you are a single filer income of $400,000. More importantly, this tax is not assessed on wages on which FICA is already imposed. That is proposed to go into effect next year, 2022.
- For individual tax rates, it is proposed to increase the top ordinary income tax rate to 39.6%. So, that’s about a 2.6% increase from the top rate right now. That also is proposed to go into effect next year.
- For corporations, there’s a proposed corporate tax rate of 18% on the first $400,000 of income, 21% on income of up to $5 million, and then a tax rate of 26.5% on income thereafter. For personal services corporations, they won’t be qualifying for these graduated rates, so they would be under the 26.5% rate.
Overall, most of these tax rate increases will go into effect in 2022, with the exception of that top rate on capital gains and dividends. So, as you’re considering engaging in contracts this year versus next year, keep in mind those affected dates.
Greg Lambert: Thanks, Ashley. So, Nate, what about the proposed 1202 change and the renewable energy extensions?
Nate Smithson: Thanks, Greg. My name is Nate Smithson. I’m a partner in the Dallas office of Jackson Walker. Expanding on Ashley’s capital gains and corporate tax rate comments, one of the unique elements that became popular after the Tax Cuts and Jobs Act was with respect to the sale of qualified small business stock. Under Code Section 1202, individuals might currently exclude 100% of their taxable gains from the sale of qualified small business stock held for more than five years, up to $10 million. As a result of this exclusion, due to the corporate rate reduction to 21% in the Tax Cuts and Jobs Act in 2017, utility of the structuring method was a huge benefit for smaller corporations.
The proposed legislation would move the exclusion percentage to 50% for taxpayers with adjusted gross income at or over $400,000. So, this is a pretty broad sweep, eliminating a lot of the benefit for many sales of qualified small business stock. The proposed change is one of those September 13 effective dates. Therefore, unless there was a binding contract in place for a sale prior to September 13, then anyone with adjusted gross income over $400,000 would be subject to the reduced income exclusion. As a note, in calculating the $400,000, the proceeds from the sale of stock would count towards the taxpayer’s gross income. Further, any non-excluded gains from the sale of stock are subject to tax at 28% today – not the general 20% rate or even the 25% rate. So, presumably sales of qualified small business stock would also be subject to the 3% surcharge to the extent such proceeds exceed $5 million. Therefore, for example, in the sale of $10 million of qualified small business stock, $5 million of that gain using the 50% exclusion would be subject to tax at a rate of 34.8% including the net investment tax, which is a far cry from $0 in tax that would be due today.
Moving away from that to renewable energy. There have been several extensions of credits. So, the production tax credit would be extended for wind projects completed after January 1, 2022, pushing the current credit phase outs in place until 2032. The PTC would also be revived for solar projects. The investment tax credit would be extended for solar and wind projects, with current phase outs being pushed back to 2032. And the other credit to be extended is for the carbon oxide sequestration facilities that begin construction before 2032. Finally, qualified income for publicly traded partnerships would be expanded to include income derived from green renewable energy.
Greg Lambert: All right. Thanks, Nate. Argy, are there going to be some changes in how private investment funds are taxed? What are we looking at there?
Argy Saccopoulos: Thanks, Greg. I’m Argy Saccopoulos. I’m an attorney in our Austin office, and I do a lot of work with fund sponsors and fund formations. Some of the proposals that leapt out at me had to do with what would impact my clients and fund structuring decisions in that space.
One of the most important changes is the change to how carried interest is taxed. Probably, a lot of people are aware of that in 2017, the new Section 1061 of the Code imposed essentially a three-year holding period for fund sponsors to get long-term capital gains for carried interest. When the Biden Green Book came out back in April, there was a proposal to essentially strip out that half-measure and to go whole hog and tax carried interest as compensation income—the criticism being that it’s derived from services, it should be compensation like any other compensation income. The 2017 Act represented the first successful legislative effort out of many attempts to do something to tax carried interest differently. But the new legislation would essentially retain what’s really a half-measure between giving carry the benefit of the ordinary partnership rules that would let you know long-term capital gains pass through after one year, versus the idea that it’s really compensation and should be taxed as compensation. So, it’s kind of a half-measure.
In 2017, they imposed this three-year holding period. The new legislation would expand that to five years. So, it wouldn’t go as far as the Biden Green Book. It represents a compromise. It would also, importantly, be expanded in scope to include any gains that are taxed as capital gain, which I think has a clear reference to Section 1231 gains—which is of great relevance to real estate fund sponsors who typically get 1231 gains to fill up their carried interest. However, there would be a special three-year holding period rule for real estate funds. So, bad news, they would get swept up in 1061. Good news, they wouldn’t have the five-year period. They would get a special three-year holding period to get their carried interest taxed as capital gains.
The other big point that I thought is worth fund sponsors knowing about, especially if you’re attracting offshore capital and inbound investment structures: The leveraged blocker is a very popular tool for managing the covenants you give inbound capital in terms of not allocating them effectively connected income or making them file U.S. tax returns. A lot of times, you use a leveraged blocker to get capital into the U.S. A couple of the provisions are pretty much direct attacks on the leveraged blocker structure—the portfolio interest exception, which is very important for this structure, in which capital is expatriated from the United States through portfolio interest payments. Those rules have been tightened up so that when you measure who’s able to get the portfolio interest exception, there’s no longer an ability to give very little voting power to offshore capital and thereby allow concentrations of capital to take interest payments out of the U.S. under this portfolio interest exception. So, that that’s been closed effectively. New limitations on interest deductibility that seem to be designed to apply to leveraged blockers means that, I think, a lot of fund sponsors are going to have to re-evaluate those structures going forward. We don’t know whether there will be any grandfather relief in terms of existing structures and existing debt instruments, but it would be customary with such a major change to not overly punish people who relied upon an old set of rules and got caught flat-footed by this kind of change.
So, both of those things are something that fund sponsors are going to have to take a closer look at.
Greg Lambert: Thanks, Argy. And finally, Ron, can you summarize all this for us? And let us know what your expectations are going forward.
Ron Kerridge: Thanks, Greg. I’m Ron Kerridge. I’m a partner in the Dallas office. Just a few closing thoughts.
First, we’re only covering income tax in this brief presentation. There are some very significant proposals that will change the estate and gift tax rolls and are worth studying, but that’s outside the scope of what we’re covering today.
In terms of the context, this package in the House Ways and Means Committee is projected to raise a total of about $2.1 trillion. It’s part of a much larger process of budget reconciliation. So, there’s a long way for this to go, and there are a number of ways in which these proposed changes themselves could change and perhaps significantly. The $2.1 trillion number is important, because this is really designed as a process to pay for the reconciliation spending bill. That has to get through the Senate. The Senate, of course, is 50/50 Republicans and Democrats, with Vice President Harris holding the deciding vote. So, for the Democratic initiatives to be passed, all 50 Democrats would have to vote in favor of them. A couple of the Senate Democrats have expressed reservations about the size of the proposed $3.5 trillion spending package. Senator Manchin of West Virginia has said that he doesn’t think it should be any higher than $1.5. If that is in fact where the spending side comes out, then the tax piece would not need to raise $2.1 trillion. Some number of the tax rates and perhaps effective date measures that are in the current Ways and Means bill would presumably change if only $1.5 trillion of revenue is needed, but it’s truly up in the air. The Senate has other tax proposals that are floating around. The Biden Administration has told the House that they’d like to see a number of things that Biden proposed in the Green Book back in April added to the tax package. And finally, Senator Manchin has made some noises that possibly the whole process of a larger spending bill and the accompanying tax fees should be paused until 2022.
We still think it’s fairly likely that there will be reconciliation with significant tax increases passed this year, but the point is that right now, it’s all in flux. We will certainly monitor and provide updates as we’re know more.
Greg Lambert: Well, Ashley, Nate, Argy, and Ron, thank you very much for walking us through some of these proposed tax changes.
The music is by Eve Searls.
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Meet Our Team
Ronald D. Kerridge divides his time between transactional tax matters and tax controversies. On the transactional side, Ron’s practice emphasizes tax structuring of acquisitions and strategic partnerships. In his controversy practice, he represents clients before the IRS on a wide variety of federal income tax issues. For questions related to the current status of the tax proposals, including some potential roadblocks and changes in the proposal as the bill makes its way through the House and onto the Senate, contact Ron at email@example.com.
Argyrios Saccopoulos represents buyers, sellers, and joint venture partners in M&A and real estate transactions, including federal income tax considerations of debt financings, merger agreements, and dealings in stock, partnership interests, and blocker structures. For questions related to tax changes affecting the taxed-carried interest and leveraged blockers for fund sponsors and fund formations, and Section 1231 gains on real estate fund sponsors, contact Argy at firstname.lastname@example.org.
Nathan Smithson is a transactional tax attorney focused on federal income tax planning for corporations, partnerships, and limited liability companies. Nate has worked closely with clients to revisit their tax structures following the enactment of the Tax Cuts and Jobs Act and to revise partnerships and LLC agreements to reflect the newly effective partnership audit rules. For questions related to the sale of qualified small business stock under Code Section 1202 and the extension of renewable energy tax credits, contact Nate at email@example.com.
Ashley P. Withers has a broad-based tax practice that includes representing businesses, family offices, tax-exempt organizations, and individuals on tax strategies, compliance, and tax-efficient organizational structuring. She also represents businesses and individuals in tax controversy matters. For questions related to the proposed increases to capital gains tax rates, high-income surcharges, individual tax rates, and corporate rates hikes, contact Ashley at firstname.lastname@example.org.