By Christopher Davis, CPA
To date, President Biden’s American Rescue Plan has been enacted and has changed various tax credits, including the child tax credit, earned income credit and the child and dependent credit. The American Jobs Plan and The American Families Plan (not yet law) contain several proposed changes including:
- The increase of the corporate tax rate from 21 percent to 28 percent
- The increase of the top federal income tax rate from 37 percent to 39.6 percent
- The increase of the capital gains tax rate to 43.4 percent for taxpayers with adjusted gross income over $1 million
- The removal of the step-up in basis rule for estates
- Creating new limits for 1031 “like-kind” exchanges
- The expansion of the 3.8 percent net investment income tax (NIIT)
- Making the excess business loss limitation permanent ($250,000 for single filers and $500,000 for joint filers)
Increased Tax Rates
As with any proposal, the final form and application of the tax increases is to be determined. The increased the top federal tax rate to 39.6 percent, which is a return to the Obama administration top rate, would apply to income over $452,700 for single filers and $509,300 for joint filers. The Biden administration continues to preserve its pledge not to raise taxes on taxpayers with total income of $400,000 or less.
With regard to the capital gains rate increase, it is unclear as to how the $1 million income threshold will be calculated or if this threshold applies to single filers, joint filers or both. There is also some concern that this rate increase could be applied retroactively to April 28 (when it was first proposed).
The American Families Plan includes a proposal to repeal the step-up in basis rule for inherited assets on gains in excess of $1 million for a single filer or $2 million for a joint filers. There is much uncertainty as to the practical application of this rule. The step-up in basis rule is an integral part of estate planning and, if removed, may expose heirs of appreciated property to income tax at all income levels, not just the wealthiest Americans. Additionally, as outlined in tax reform legislation proposed by Senator Bernie Sanders on March 25, the current $11.7 million estate exemption would be reduced to $3.5 million per person effective January 1, 2022.
The current proposal calls for a repeal of “like-kind” exchanges under IRC Section 1031 for gains greater than $500,000. There is currently no limitation on the amount of gain that can be deferred using a like-kind exchange. The Tax Cuts and Job Acts passed during the Trump administration previously limited these types of exchanges to real property only. This change would be a major blow to the real estate industry.
Expansion of the 3.8% Net Investment Income Tax
Under current rules, this tax is assessed on unearned income (interest, dividend, capital gain, passive rental income) and passive pass-through income from partnerships and S-Corporations when a taxpayer’s modified adjusted gross income exceeds $200,000 for single filers and $250,000 for joint filers. In general, income from a pass-through entity in which the taxpayer actively participates is not subject to this additional tax even when income exceeds the applicable thresholds. As proposed, the NIIT would be expanded to include a taxpayer’s share of income from pass-through entities on income above $400,000 regardless of their involvement in the business. Many medical practices are structured as a pass-through entity, meaning physician owner/employees could be facing a top tax rate of 43.4 percent (39.6 percent + 3.8 percent).
Also included with the American Families Plan is a significant increase of $80 billion to the Internal Revenue Service’s (IRS) annual budget over the next 10 years, with the intent to increase the enforcement of tax law by increasing audits of high-income individuals and corporations.
Noticeably absent from any of the current proposals are items that then candidate Biden discussed on the campaign trail such as the phase out of the qualified business income deduction, the expansion of the social security wage base for wages above $400,000 and limitations on the itemized deductions for high-income taxpayers. Technically speaking, the Biden administration has not proposed a change to the gift and estate tax rate nor a reduction of the estate exemption but is expected to do so.
The final form and timing of these changes remain to be seen, but we know with certainty that change is headed our way.