"Green Book" Details President's Tax Reform Proposals

On May 28, 2021, the Treasury Department released the "Green Book," a description of revenue proposals within President Biden’s fiscal year 2022 budget. This document includes a wish list of tax changes the Administration says would “raise revenue, improve tax administration, and make the tax system more equitable and efficient.” The proposals are an opening bid for potential tax reform in the months to come, providing a bit more detail on the President’s Build Back Better agenda, namely the American Jobs Plan and the American Families Plan. We discussed the potential impact of the American Families Plan in a previous post (including some basic examples).  Here we review key provisions detailed in the Green Book, recognizing that any final legislation will likely look quite different from the proposed provisions.

Increase the Top Individual Tax Rate

For tax years beginning in 2022, the proposal would restore the 39.6 percent individual tax rate that was in effect before the Tax Cuts and Jobs Act (TCJA) and lower the income thresholds to which it applies. For tax years beginning in 2018 through 2025, the TCJA lowered the top tax rate from 39.6 percent to 37 percent. It also raised the income thresholds at which the highest rate was triggered. The Green Book explains that “this change would raise revenue while increasing the progressivity of the tax system.”

Under the proposal, joint filers would reach the 39.6 percent top tax rate in 2022 with $509,301 of income. Under current law, joint filers reach the highest tax rate of 37 percent with $628,301 of income. This chart shows how the top rate would change in 2022 under the President’s proposal.

Eliminate the Preferential Capital Gain Tax Rates for Taxpayers with > $1 million in Income

After the date of the announcement (which was April 28, 2021), the proposal would subject long-term capital gain to ordinary income tax rates where overall income (including gain) exceeds $1 million. The highest tax rate would apply to all income (including capital gain) that exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2022. The Green Book explains, “Reforms to the taxation of capital gains and qualified dividends will reduce economic disparities among Americans and raise needed revenue.”  

Currently, long-term capital gain is taxed at the highest rate of 20 percent. Gain subject to the net investment income tax (NIIT) (see below) is taxed at a top federal rate of 23.8 percent. This rate is only reached for joint filers with income of $501,601 or more. Most long-term capital gain is taxed at a 15 percent rate. Under the proposal, all income above a new income cutoff of $1,000,000 would be taxed at the highest rate of 37 percent in 2021 and 39.6 percent in 2022 and beyond.

The Green Book provides the following example:

A taxpayer with $900,000 in labor income and $200,000 in preferential capital income would have $100,000 of capital income taxed at the current preferential tax rate and $100,000 taxed at ordinary income tax rates.

As explained below, the proposal would also impose a 3.8 percent NIIT on this gain, increasing the top 2022 tax rate for long-term capital gain to 43.4 percent.

Extend the Application of the Net Investment Income Tax and SECA

Current Law

Presently, the 3.8 percent NIIT, which was implemented with the Affordable Care Act, applies to net investment income higher than $200,000 for singles and $250,000 for MFJ. Net investment income includes:

• Most interest, dividends, rents, annuities, and royalties
• Income derived from a trade or business in which the taxpayer does not materially participate
• Income from a business of trading in financial instruments or commodities
• Net gain from the disposition of property other than property held in a trade or business in which the taxpayer materially participates

Although called the “Medicare tax,” money generated from the NIIT is paid into the general fund.

Wages and self-employment earnings are subject to employment taxes under either the Federal Insurance Contributions Act (FICA) or the Self-Employment Contributions Act (SECA). FICA and SECA tax applies at a rate of 12.4 percent for social security (capped at $142,800 in 2021) and at a rate of 2.9 percent for Medicare on all employment earnings (no cap). The Affordable Care Act imposed an additional 0.9 percent Medicare tax 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. This ensures that a 3.8 percent Medicare tax applies to earnings as well.

The Green Book explains that while general partners and sole proprietors pay SECA tax on earnings from their businesses, S corporation owner-employees pay employment tax only on their “reasonable compensation” and limited partners pay employment tax only on any employee earnings.  LLC members often pay little or no SECA tax at all.  The Green Book urges that “different treatment is unfair, inefficient, distorts choice of organizational form, and provides tax planning opportunities for business owners, particularly those with high incomes, to avoid paying their fair share of taxes.”

Proposal

The proposal would seek to ensure that anyone earning more than $400,000 would be subject to the 3.8 percent Medicare tax. The $400,000 income limit is a threshold the President has used to define “wealthy.” The imposition of this new tax would be accomplished in several ways.

• Making the application of SECA to partnership and LLC income more consistent for high-income taxpayers
• Applying SECA to the ordinary business income of high-income non-passive S corporation owners
• Ensuring that all trade or business income of high-income taxpayers is subject to the 3.8 percent Medicare tax, either the NIIT or SECA tax
• Redirecting NIIT funds to the Hospital Insurance Trust Fund

Making the application of SECA to partnership and LLC income more consistent for high-income taxpayers

The proposal suggests that limited partners and LLC members who materially participate or provide service to their businesses would be subject to SECA tax on their distributive shares of partnership or LLC income to the extent that their overall business and employee income exceeds $400,000. Material participation standards would apply consistently to these limited partners and LLC members. Exemptions from SECA tax for rents, dividends, capital gains, and certain retired partner income would continue to apply.

Applying SECA to the ordinary business income of high-income non-passive S corporation owners  

Likewise, the proposal states that 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 their overall business and employee income exceeds $400,000. Current exemptions from SECA tax for rents, dividends, and capital gains would continue to apply.

Ensuring that all trade or business income of high-income taxpayers is subject to the 3.8 percent Medicare tax, either the NIIT or SECA tax

For taxpayers with more than $400,000 in adjusted gross income, the proposal would change the definition of net investment income to include “gross income and gain from any trades or businesses that is not otherwise subject to employment taxes.” This would, for example, apply the 3.8 percent Medicare tax to any high earner income missed by the above SECA expansion. This would appear to include IRC § 1231 gain and self-rental income. The 3.8 percent tax would appear to apply to IRC §§ 1245 and 1250 gain as well, whether through a SECA enhancement or a NIIT expansion.

Redirect NIIT funds to the Hospital Insurance Trust Fund

The proposal would redirect the “Medicare tax” from the general fund, as directed by the Affordable Care Act, to the Hospital Insurance Trust Fund, where the SECA and FICA Medicare tax is paid.

Treat Property Transfers at Death or Gift as Realization Events

Beginning in 2022, the AFP would treat the transfer of appreciated property at death or by gift as a sale, meaning that unrealized capital gain would be taxed at the time of death or gift. This would be a new tax, never before imposed in the U.S. As described in the Green Book, dying with or gifting appreciated property would trigger taxable income to the decedent on the federal gift or estate tax return or on a separate capital gains return.

Note: This proposal is in conjunction with provisions that would increase the top tax rate, subject gains to ordinary income tax rates where income is more than $1 million, and apply the NIIT to gain from the sale of business assets, like farmland, if overall adjusted gross income is more than $400,000.

Transfers to Spouses and Charities

Although transfers to a spouse or charity would be exempt from the new tax recognition rules, the proposal states that these transfers would be completed with a carryover basis. Thus, capital gain would be recognized when the surviving spouse disposes of the asset or dies, and appreciated property transferred to charity would no longer result in a charitable deduction based upon fair market value. Likewise, the transfer of appreciated assets to a split-interest trust would generate a taxable capital gain, with an exclusion allowed only for the charity’s share of the gain based on the charity’s share of the value. This means that transfers of appreciated property to charitable remainder trusts would be largely taxable.

Transfers of Tangible Personal Property

The proposal states that it would exclude from recognition any gain on “tangible personal property such as household furnishings and personal effects (excluding collectibles).” It is unclear from this statement whether all tangible personal property, such as depreciated business equipment, would be covered by this exclusion.

Exemptions

Each person would be allowed to exclude up to $1 million (indexed for inflation) in gain from recognition at death or at the time of gift. Spouses would each get their own exemption, which would be portable, meaning that a couple could exempt $2 million in gain from tax. Additionally, the proposal would exempt $250,000 in gain from the sale of a personal residence ($500,000 for married filing jointly). The current exclusion for capital gain on certain small business stock would also apply.

Basis

The proposal states that if property is transferred at death, the recipient’s basis in the property would be the FMV of that property at the decedent’s death.

Example: Decedent transfers a $5 million parcel of land with $3 million in appreciation ($2 million basis) at death. The heir receives the land with a $5 million basis. Tax is due on $2 million of gain after the $1 million exemption.

If property is transferred by gift, the recipient would receive a carryover basis, to the extent that the $1 million exclusion applies. In other words, if a gift triggers a transfer tax, the basis would adjust to FMV only for that portion of the property subject to the tax.

Example: Donor gifts a $5 million parcel of land with $3 million in appreciation ($2 million basis). Here the donee receives the land with a $4 million basis. Tax is due on $2 million of gain.

Interaction with the Estate Tax

Note that this tax is not an estate tax based upon the value of the estate. It is a tax on unrealized gain. The current estate tax would continue to apply if the value of the estate exceeds the basic exclusion amount (currently $11.7 million). The proposal states, however, that the new tax would be deductible from the estate value. The Green Book does not contain any estate tax proposals, but current law would reduce the current basic exclusion by 50 percent in 2026.

Special Provisions for Trusts, Partnerships and Other Non-Corporate Entities

The proposal also states that gain on unrealized appreciation would be recognized by a trust, partnership, or other non-corporate entity (presumably an LLC) that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years, with such testing period beginning on January 1, 1940. Under this proposal, the first possible recognition event for any taxpayer would be December 31, 2030 (90 years from January 1, 1940).

No Valuation Discounts for Minority Interests

The proposal states that transfers would be defined under the gift and estate tax provisions and would be valued using the methodologies used for gift or estate tax purposes. A transferred partial interest would be its proportional share of the fair market value of the entire property. This means that the proposal would disallow valuation discounts for minority interests.

Transfers into and out of Trusts, Partnerships, and Non-Corporate Entities Would Be Recognition Events

The proposal states that transferring property into and receiving distributions in kind from, a trust, partnership, or other non-corporate entity (LLC)—other than a grantor trust that is deemed to be wholly owned and revocable by the donor—would be recognition events. While this provision is likely intended to prevent recognition avoidance schemes, this proposal would fundamentally transform partnership taxation.

Deferral of Tax for Family-Owned and Operated Businesses

The proposal states that payment of tax on the appreciation of certain family owned and operated businesses would not be due until the interest in the business is sold or the business ceases to be family owned and operated. No further details are provided on this key, yet difficult, exception. It is likely that in conjunction with deferral liens would be imposed on the property to secure the unpaid tax.

15-Year Payment Plan

The proposal provides a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, except for liquid assets, such as publicly traded stock, and family owned and operated businesses that elect a tax deferral.

Other Provisions

The proposal includes several other details:

• The full cost of appraisals of appreciated assets would be deductible.
• Liens could be imposed for unpaid tax.
• Underpayment of an estimated tax penalty would be waived if underpayment is due to death.
• New rules would seek consistency in valuation for transfer and income tax purposes.
• New rules and safe harbors for determining the basis of assets in cases where complete records are unavailable would be created.
• New reporting requirements for all transfers of appreciated property including value and basis information would be imposed.

Limit the Section 1031 Exchange

The proposal would limit the IRC § 1031 like-kind exchange deferral to $500,000 in gain ($1 million for a married couple) per year. The Green Book states that this proposal would raise revenue while increasing the progressivity of the tax system. This provision would apply to exchanges completed after the 2021 tax year.

Increase the Corporate Tax Rate

The proposal would raise the corporate tax rate from 21 percent to 28 percent, for tax years beginning in 2022. Before 2018, the corporate tax rate was 35 percent. It is not clear whether any increased corporate tax rate would be graduated (like the pre-2018 rate).