Democrats Introduce Tax Proposals

23 September 2021 Legal News: Taxation Publication
Authors: William R. Hughes Emmaline S. Jurgena

The House of Representatives Ways and Means Committee Chairman introduced new tax proposals on Monday that would raise more than $2 trillion in tax revenue as part of the Democrats’ effort to roll back the Trump administration tax cuts.  The tax proposals primarily affect corporations and the wealthy, with provisions changing the corporate tax rate, the estate tax exemption, capital gains tax, and imposing limitations on grantor trusts and valuation discounts for non-business assets.

Tax Changes for Individuals and Corporations

The proposed bill raises the top individual income tax rate from 37% to 39.6% for married individuals filing jointly with taxable income over $450,000, heads of households with taxable income over $425,000, unmarried individuals with taxable income over $400,000, married individuals filing separately with taxable income over $225,000, and estates and trusts with taxable income over $12,500. An additional 3% surcharge is imposed on income in excess of $5 million (or $2.5 million for a married taxpayer filing separately).  The 199A qualified business income deduction would no longer be available for individuals earning over $400,000, or married couples earning over $500,000.  Capital gains tax rates (currently 20%) are raised to 25% for incomes over $400,000.

Other tax increases in the proposed bill include replacing the flat corporate income tax rate of 21% with a graduated rate structure; the proposed top rate would be 26.5% for income exceeding $5 million (and the benefit of the graduated rate would phase out for corporations with more than $10 million in income).

These changes would be effective January 1, 2022 (except for the capital gains increase, which would be effective as of the date of the proposal, September 13, 2021).

Estate Tax Exemption

Under the proposed bill, the estate tax exemption amount, which is currently at $11.7 million per individual, would revert to $5 million (indexed for inflation) effective January 1, 2022.  This reversion was previously scheduled to occur at the end of 2025. However, qualified real property used in a family farm or family business would be entitled to a special valuation reduction of $11.7 million based on its actual use rather than its fair market value.

Changes to Grantor Trusts and Valuation Discounts

The proposed bill would include grantor trusts in a decedent’s taxable estate when the decedent is the deemed owner of the trusts for income tax purposes, taking away a popular tax planning strategy.  Sales between grantor trusts and their deemed owner would be treated as sales between the owner and a third party, rather than their current status being treated as a disregarded transaction.  This would be effective only for future trusts and future transfers made after enactment of this provision.

The bill would also limit valuation discounts on non-business assets.  Presently, a taxpayer can take a valuation discount on an asset, including publicly traded stock, by placing it inside a limited liability company or another entity and then dividing it up among the taxpayer’s heirs, or trusts for the benefit of the taxpayer’s heirs. The new owners do not have full control of the asset, and consequently claim a discount on the value of their interest.  Under the proposal, these discounts would no longer be allowed for “passive” assets, meaning those that are used are only for the production of income.  Discounts for assets used in active businesses (such as farms or family businesses) would still be permitted.

Changes to Retirement Accounts

The proposed bill would impose new contribution limits on retirement accounts (traditional IRAs, Roth IRAs, or defined contribution accounts), essentially prohibiting new retirement account contributions for taxpayers whose aggregate retirement account balance exceeded $10 million in the prior tax year. This applies to married couples with taxable income over $450,000, unmarried individuals with income exceeding $400,000, and heads of households with taxable income over $425,000.  Following any year in which the aggregate account balance in a taxpayer’s retirement account exceeds $10 million, the taxpayer would be required to take a special minimum withdrawal (50% of the amount over $10 million).

For accounts that exceed $20 million, the excess must be distributed up to the lesser of (1) the amount needed to bring the total balance in all accounts down to $20 million; or (2) the aggregate balance in the account.  For purposes of this withdrawal, the account owner must take the special minimum withdrawal from their Roth IRAs or defined contribution plans first.

Under current law, a taxpayer is able to avoid the income limitations for Roth IRA contributions by converting rather than contributing to a Roth IRA.  To close these so-called “back-door” Roth IRA strategies, the proposal eliminates Roth conversions for both IRAs and employer-sponsored plans for single taxpayers (or taxpayers married filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of households with taxable income over $425,000. This provision would apply to distributions, transfers, and contributions made after December 31, 2031.

All conversions of employee after-tax contributions in qualified plans and after-tax IRA contributions to Roth would be prohibited, regardless of income level. This change would take effect January 1, 2022.

Provisions Not Included

Several provisions that had been considered in the months leading up the proposed bill were ultimately not included. The bill would not eliminate the basis “step-up” at death, a mechanism under which the assets of a deceased individual are considered to have been purchased for the fair market value on the person’s date of death.  This eliminates capital gains taxes attributable to appreciation and depreciation taken up through the date of death.

The bill does not impose the “deemed realization” provision considered by President Biden, which would have caused an income tax realization event at the time of the transfer (such as by gift or death) without the basis step-up benefit.  In other words, the taxpayer will be deemed to have sold the transferred asset, resulting in income, but with no corresponding proceeds from the deemed sale to pay the income tax.

Biden’s original proposals also included changes to grantor-retained annuity trusts (“GRATs”) which are fixed-term irrevocable trusts that pay the grantor an annuity over the trust’s term, then distribute the assets to non-charitable beneficiaries (often the grantor’s children).  Biden proposed a required minimum term of at least 10 years, and limiting GRAT terms to no longer than the life expectancy of the grantor plus 10 years.  This was not included in the bill.

A looming concern was that some provisions of the tax bill would be retroactive to January 1, 2021, giving those affected no time to implement responsive tax-planning strategies.  The proposals published by the Ways and Means Committee do not include this retroactive implementation.

Passage of the Proposal

To pass without Republican support, the proposed bill would need the vote of nearly all of the House Democrats and all 50 Senate Democrats.  The House Ways and Means Committee is expected to vote on the proposed tax provisions this week; a majority vote of the committee is required for the bill to advance to the floor of the House.

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