Biden Administration Releases Treasury Green Book, Providing Detailed Explanation of Tax Proposals

The Biden administration (the ​“Administration”) last week released the ​“General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals,” commonly called the Treasury Department’s ​“Green Book.”  The Green Book provides more details regarding the Administration’s tax proposals.  This Client Advisory describes some of these proposals.

Individual Tax Provisions

Increase in the Top Marginal Income Tax Rate for High Earners

The Administration has proposed increasing the top marginal individual income tax rate from 37% to 39.6%.  In 2022, this top marginal tax rate would apply to taxable income over $509,300 for married individuals filing a joint return, and $452,700 for unmarried individuals (other than surviving spouses).  These thresholds would be indexed for inflation.

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

Application of Ordinary Income Tax Rates to Capital Gains and Qualified Dividends of High-Income Earner

Long-term capital gains and qualified dividends derived by taxpayers with adjusted gross income of more than $1 million would be taxed at ordinary income rates, but only to the extent that the taxpayer’s income exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2022.  To the extent that the $1 million threshold is exceeded, long-term capital gains would be subject to a 43.4% (i.e., 39.6% + 3.8%) federal tax rate, as opposed to the current 23.8% federal tax rate.

Thus, for example, a taxpayer with $900,000 in compensation income and $200,000 in capital gains income would have $100,000 of capital gains income taxed at the current preferential tax rate and $100,000 taxed at ordinary income tax rates.

The Administration has proposed that this tax increase would be effective for gains recognized after the date ​“of announcement,” presumably April 2021.

Observation:

Although retroactive tax increases are permissible, we would be surprised if the Administration’s proposed retroactive effective date is ultimately adopted.  We believe that the more likely effective date would be (i) January 1, 2022, (ii) the date the tax legislation is ultimately enacted, (iii) the date of Congressional Committee action, or (iv) the date that the House or Senate passes a tax bill incorporating the capital gains tax increase.

Treatment of Transfers of Appreciated Property by Gift or on Death as a Tax Realization Event

Subject to the exceptions described below, the donor or deceased owner of an appreciated asset would generally realize a capital gain at the time of transfer, in an amount equal to the excess of (i) the fair market value of the property over (ii) the decedent’s or donor’s tax basis in the property.

Transfers by a decedent to a U.S. spouse or a charity would not trigger tax.  Transfers of tangible personal property such as household furnishings and personal effects (excluding collectibles) would also not be taxable.  The transfer of a principal residence would similarly not be taxable, subject to a cap of $250,000 of gain per person and $500,000 of gain per couple.

In addition to the exceptions described above, the proposal would also allow a $1 million per person exclusion, and $2 million exclusion per married couple, indexed for inflation after 2022.

Payments of tax with respect to ​“certain family-owned and -operated businesses” would not be required prior to the date the interest in the business is sold or the business ceases to be ​“family-owned and operated.”  No details are provided regarding the type of business that would qualify for tax deferral.  Furthermore, except with respect to liquid assets, such as publicly-traded financial assets, a taxpayer may elect to pay the tax over a 15-year fixed rate payment plan, in which case, the IRS would be authorized to require security in any form which it deems acceptable.

This proposal would be effective for gains on property transferred by gift, and on property owned at death by decedents dying, after December 31, 2021.

If property is held by a trust, partnership or other non-corporate entity and the property has not been subject to a tax recognition event within the prior 90 years, the unrealized appreciation with respect to such property must be recognized.  The first possible recognition event under this provision would be December 31, 2030.

Changes in Self-Employment Taxes

Under current law, 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”), respectively.  SECA and FICA taxes apply at a rate of 12.4% for Social Security tax on employment earnings, subject to a cap of $142,800 in 2021, and at rate of 2.9% for Medicare tax on all employment earnings, not subject to a cap.  An additional 0.9% Medicare tax is imposed on self-employment earnings and wages of high-income taxpayers.

Under current law, limited partners are not subject to SECA tax with respect to their distributive shares of partnership income.  See Internal Revenue Code (“Code”) Section 1402(a)(13).  Furthermore, S corporation shareholders are not subject to SECA tax with respect to their shares of S corporation income, although the tax law requires that owner-employees pay themselves ​“reasonable compensation” for services provided, with respect to which they are obligated to pay FICA tax.

The Administration has proposed that limited partners and LLC members who provide services and ​“materially participate” in their partnerships or LLCs would be subject to SECA tax on their distributive shares of partnership or LLC income to the extent that the income exceeds specified threshold amounts.

Shareholders of an S corporation who ​“materially participate”  in the trade or business would similarly be subject to SECA taxes on their distributive share of the S corporation’s income to the extent the income exceeds specified threshold amounts.

A taxpayer would be considered to ​“materially participate” in a business if he or she is involved in the business in a ​“regular, continuous, and substantial way.”

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

Carried (Profits) Interests Taxed as Ordinary Income

The Administration would generally tax as ordinary income a partner’s share of income with respect to an ​“investment services partnership interest,” if the partner’s taxable income from all sources during the year were to exceed $400,000.  In addition, the Administration would require partners in such investment partnerships to pay self-employment taxes with respect to such income.

An ​“investment services partnership interest” is a profits interest in an ​“investment partnership” that is held by a person who provides services to the partnership.  A partnership is an ​“investment partnership” if substantially all of its assets are ​“investment-type assets” (such as securities, real estate, commodities, cash or equivalents or derivative contracts with respect to such assets), but only if more than 50% of the partnership’s contributed capital is from partners in whose hands the interests constitute property not held in connection with a trade of business.

This proposed change in law would be effective for taxable years beginning after December 31, 2021.

Repeal of Deferral of Gain from Like-Kind Exchanges (Section 1031)

Section 1031 would be repealed, subject to the following limited exception:  taxable gain could be deferred 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.

This proposed change in law would be effective for exchanges completed in taxable years beginning after December 31, 2021.

Business Tax Provisions

Corporate Tax Rate Increase

The Administration has proposed increasing the income tax rate for C corporations from 21% to 28%.  The proposed change in law would be effective for taxable years beginning after December 31, 2021.

Observations

• If enacted, C corporations would be incentivized to accelerate income into 2021 and defer deductions to post-2021 taxable years.
• The Administration previously suggested that it may be willing to compromise and accept a lower 25% corporate tax rate.

 

Revision of the Global Minimum Tax Regime

Under the Global Intangible Low-Taxed Income (“GILTI”) tax regime, a U.S. shareholder of a controlled foreign corporation (a ​“CFC”) is taxed annually in the United States.  See Code Section 951A.  The U.S. shareholder’s minimum tax inclusion reflects a reduction for a 10% return on specified tangible foreign property held by the CFC, so-called ​“qualified business asset income” or ​“QBAI.”

Pursuant to Code Section 250, a corporate U.S. shareholder of a CFC is generally allowed a 50% deduction with respect to its GILTI minimum tax inclusion, which results in a 10.5% effective U.S. tax rate.

Certain foreign income taxes paid by a CFC can be credited against a corporate U.S. shareholder’s GILTI tax obligation.  The amount of the credit is limited to 80% of the foreign income taxes allocable to the CFC’s GILTI inclusion.  Under recently-promulgated tax regulations, if gross income is subject to a foreign effective tax rate that exceeds 90% of the U.S. corporate income tax rate, then the U.S. shareholder of the CFC is generally allowed to exclude such gross income from its GILTI.

Under current law, there is a single foreign tax credit limitation that applies with respect to a corporate U.S. shareholder’s GILTI inclusion.  Thus, foreign income taxes paid in a high-tax foreign jurisdiction could be used to reduce the U.S. tax liability with respect to income derived in low-tax jurisdictions.

The Administration has proposed making the following changes to the GILTI tax regime:

• The QBAI exemption would be eliminated;
• The Section 250 deduction would be reduced from 50% to 25%, thus generally increasing the U.S. effective tax rate to 21% (reflecting the newly-proposed 28% corporate tax rate);
• The ​“global averaging” method for calculating GILTI would be replaced with a ​“jurisdiction by jurisdiction” calculation, and as a result, a separate foreign tax credit limitation would be required for each foreign jurisdiction; and
• The high-tax exception would be repealed.

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

Limitations on the Ability of Domestic Corporations to Expatriate

Under current law, Code Section 7874 applies to so-called ​“inversion transactions,” in which a U.S. corporation is acquired by a foreign corporation in a transaction in which (i) substantially all of the assets of the domestic corporation are acquired directly or indirectly by the foreign acquiring corporation, (ii) the former shareholders of the domestic corporation hold at least a 60% ownership interest in the foreign acquiring corporation by reason of having held stock in the domestic corporation, and (iii) the foreign acquiring corporation does not conduct substantial business activities in the country in which the foreign acquiring corporation is organized.

If the former shareholders own at least 80% of the stock in the foreign acquiring corporation (measured by vote or value) by reason of having held stock in the domestic corporation, the foreign acquiring corporation is treated as a domestic corporation for all U.S. tax purposes (the ​“80% Test”).  If the former shareholders of the domestic corporation own at least 60% but less than 80% (measured by vote or value) by reason of having held stock in the domestic corporation, the foreign corporation is treated as a foreign corporation, but U.S. tax must generally be paid with respect to certain income and gain recognized by the expatriated U.S. entity and its affiliates within the ten year period ending after consummation of the inversion transaction (the ​“60% Test”).

The Administration has proposed replacing the 80% Test with a greater than 50% Test, thereby eliminating the 60% Test, and thereby expanding the circumstances under which a foreign corporation can be deemed to be a domestic corporation.

The Administration has also proposed that, regardless of the shareholder continuity level, an inversion transaction would be deemed to occur if (i) immediately prior to the acquisition, the fair market value of the domestic entity is greater than the fair market value of the foreign entity, (ii) after the acquisition, the foreign entity’s ​“expanded affiliated group” is managed and controlled in the United States, and (iii) the expanded affiliated group does not conduct substantial business activity in the country in which the foreign acquiring corporation is organized.

This proposal would be effective for transactions completed after the date of enactment.

Repeal of Deduction for Foreign Derived Intangible Income (“FDII”)

Under current law, a domestic corporation is allowed to deduct 37.5% of its FDII for taxable years after December 31, 2017 and 21.875% for taxable years beginning after December 31, 2025.  A domestic corporation’s FDII is equal to the portion of its intangible income derived from export transactions.

The Administration has proposed repealing the FDII deduction effective for taxable years beginning after December 31, 2021.

Fifteen Percent (15%) Minimum Tax on Book Earnings of Large Corporations

The Administration has proposed imposing a 15% minimum tax on worldwide book income of corporations with book income in excess of $2 billion.  In calculating this tax liability, book net operating loss deductions, general business credits, including R&D, clean energy and housing, tax credits, and foreign tax credits, would be allowable.

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

Tax Incentives for Locating Jobs and Business Activity in the United States and Disallowance of Deductions for ​“Offshoring a U.S. Trade of Business”

The Administration has proposed creating a new tax credit equal to 10% of eligible expenses paid in connection with ​“onshoring a U.S. trade or business.”  The technical explanation states that ​“onshoring a U.S. trade or business means reducing or eliminating a trade or business (or line of business) currently conducted outside the United States and starting up, expanding, or otherwise moving the same trade or business to a location within the United States to the extent that this action results in an increase in U.S. jobs.”

Deductions would be disallowed for expenses paid or incurred in connection with ​“offshoring a U.S. trade or business.”  ​“Offshoring a U.S. trade or business” is defined as ​“reducing or eliminating a trade or business or line of business currently conducted in the United States and starting up, expanding, or otherwise moving the same trade or business to a business outside the United States to the extent that this action results in a loss of U.S. jobs.”

Expenses paid or incurred in connection with ​“onshoring” or ​“offshoring” of a U.S. trade or business are limited solely to expenses attributable to the relocation of the trade or business and do not include capital expenditures or costs for severance pay and other assistance to displaced workers.

This proposal would be effective for expenses paid or incurred after the date of enactment.

Limit on Deductions of Interest for Disproportionate Borrowing in the United States

A U.S. corporation’s deduction for interest expense would generally be limited if it has net interest expense for U.S. tax purposes, and its net interest expense for financial reporting purposes (computed on a separate company basis) exceeds its ​“proportionate share” of the net interest expense reported on the group’s consolidated financial statements.  A member’s ​“proportionate share” of the group’s net interest expense would be determined based on the member’s proportionate share of the group’s earnings reflected in the group’s consolidated financial statements.

This proposal would not apply to (i) financial services entities, or (ii) groups that report less than $5 million of net interest expense, in the aggregate, on one or more U.S. tax returns for a taxable year.

Any disallowed interest expense could be carried forward indefinitely.  A taxpayer subject to this proposal would continue to be subject to Code Section 163(j).

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

Replacement of the ​“Base Erosion Anti-Abuse” Tax (“BEAT”) with the ​“Stopping Harmful Inversions and Ending Low-Tax Developments” Rule

The BEAT would be repealed and replaced with a new rule disallowing deductions with respect to payments made to affiliates in low-tax jurisdictions.  Under the ​“Stopping Harmful Inversions and Ending Low-Tax Developments” (“SHIELD”) rule, a deduction would be disallowed to a domestic corporation with respect to payments made to a ​“low-tax member,” which is generally any affiliate whose income is subject to an effective tax rate that is below a designated minimum tax rate.

This rule would apply to financial reporting groups with greater than $500 million in global annual revenues (based on the group’s consolidated financial statement).

This proposal would be effective for taxable years beginning after December 31, 2022.