As tax changes brew in Congress, the outlook is grim for pass-through owners
With the festivities starting on Halloween, Congress has chosen to provide tricks rather than treats in their desire to raise taxes and push through significant tax law changes through a process called budget reconciliation. Since Congress holds the federal purse strings, they can focus on spending and revenue policy through the budget reconciliation process, which ultimately impacts the federal tax system. Biparty support can be avoided in the Senate when using the budget reconciliation process, which allows the Senate to pass legislation by simple majority instead of needing the traditional 60 votes. With our current Senate divided into 50 Republicans and essentially 50 Democrats (48 registered Democrats and 2 independents who caucus with Democrats), Vice President Kamala Harris can provide the deciding vote to secure a simple majority and move forward. another substantial modification of the tax code.
As many know, the Tax Cuts and Jobs Act (“TCJA”) passed in December 2017 was a bill that was generally viewed as taxpayer-friendly and included favorable reductions in corporate and personal tax rates, while by offering a pass. through the entity deduction to better align effective federal tax rates for flow-through entities and C corporations. The TCJA was also passed through the budget reconciliation process when the Senate majority was Republican.
As much as tax scholars hoped that the change in political makeup in Congress would not be accompanied by a change in federal tax law, it seems to be true that both sides choose to make significant tax law changes if a majority simple is retained. All the factors seem to point to federal income taxes going up at the start of the new year. However, the impact on the owners of flow-through entities appears to be greater than initially expected. If the proposals are passed as currently drafted, pass-through owners could see their effective tax rate increase up to 9% and a potential increase to 20% in their cash spending for federal tax. on income.
The House Ways and Means Committee has released a tax proposal that is expected to be implemented by the House of Representatives as part of the “Build Back Better” reconciliation legislation. The most disheartening impact for flow-through owners is highlighted below.
Personal income tax rate increases
Following the 2020 election results, I think we all knew that an increase in personal income tax rates was expected. The taxable income base is also not significantly different from 2017. However, many have been caught off guard with the proposed surtax for high income earners. The proposal includes that for tax years beginning after December 31, 2021, married filing spouses, head of household, surviving spouse and single taxpayers will have to pay an additional 3% on taxable income above $ 5,000,000. I would like to point out that in the proposal there is no difference in taxable income for married taxpayers compared to single taxpayers. In other words, if there are two high income spouses, you are hit with a double whammy.
Unfortunately, this is only the beginning. There are also proposals to limit the flow-through entity deduction (199A) and also to increase the tax on net investment income.
Limitation of the deduction for eligible business income under section 199A
Under the proposal of the House Ways and Means Committee, a maximum deduction of 199A will be allowed for taxpayers based on their filing status.
However, even if your current 199A deduction does not approach these limits, your 199A deduction may still be compromised. There is still a lot of negotiation going on, and some suggest that tighter limits could be placed on the 199A deduction.
According to Senator Ron Wyden’s proposal presented in July 2021, the 199A deduction would begin to disappear for taxpayers with taxable income above $ 400,000 and would be completely eliminated if a taxpayer’s taxable income exceeds $ 500,000. Coupled with increasing personal income tax rates, this could cause a flow-through entity’s effective tax rate to skyrocket from around 30% to 39.6%. Yes, you read that right. An increase in an effective tax rate of nearly 10% if the legislation enacted is based on the Wyden 199A proposal combined with the potential increase in personal income tax rates.
Application of the tax on net investment income to commercial or commercial income
The proposal also seeks to extend the current tax on net investment income of 3.8% to be assessed on ordinary business or trading income. This is a significant departure from the current definition which only applies the 3.8% to interest, dividends, capital gains, rental and royalty income, non-qualifying annuities and business income. which are passive activities. The expansion only applies to married spousal taxpayers with taxable income greater than $ 500,000 or single taxpayers with taxable income greater than $ 400,000. There is an exception to the application of net investment income tax if employment taxes are already imposed on income.
While many may find this proposal insignificant, it is another tax that could have a negative impact on flow-through entities.
S companies: Under current law, a 100% shareholder of S corporation does not apply the net investment income tax on ordinary income that arises from S corporation to their individual tax return. According to the proposal, assuming the taxable income threshold is met, ordinary income would not only be subject to an ordinary tax rate of 39.6%, but potentially an additional 3.8%, raising the tax rate at 43.4%.
Partnerships: A similar impact would occur for partnerships with rental income. Under current law, rental income is not subject to self-employment tax. According to the proposal, even if the partner is a real estate professional, the amount of rental income paid in the partner’s individual tax return would be assessed at an additional 3.8% for partners above the taxable income threshold. This would also translate into a potential federal tax rate of 43.4%.
Increase in capital gains rates
The proposal would increase the maximum capital gain and eligible dividend rate from 20% to 25%, with an effective date of September 13, 2021 (the date the proposal was introduced). The lower capital gains rates of 0% and 15% would remain in effect for married spousal taxpayers whose taxable income does not exceed $ 80,800 or $ 501,600 respectively for the 2021 tax year. Congress has intentionally placed the effective date of 2021 to prevent taxpayers from making investment portfolio adjustments to maximize the benefits previously provided.
Adjustment of the deferral period of commercial interest expenses under section 163 (j)
Under the proposal, interest not allowed in a tax year beginning after December 31, 2021 can no longer be carried forward indefinitely, but would be limited to a five year carry forward. The ability to use any unauthorized interest charge would be on a first in, first out basis.
While many taxpayers may not be concerned about this part of the proposal because it does not create a disallowed interest charge under the current limitation rules, taxpayers should be careful. The proposal, coupled with the adjustment to how interest expense limits will be calculated in tax year 2022 under the current law, may come as a surprise to many taxpayers. In general, commercial interest is permitted under applicable law if it does not exceed 30% of adjusted taxable income, which includes an adjustment to add back depreciations and amortizations. For tax years beginning after December 31, 2022, the ability to add back depreciation and amortization is no longer available, causing adjusted taxable income to decrease significantly for many. Such a decrease in adjusted taxable income will broaden the base of taxpayers who fall under the interest expense limitation rules.
It is important to assess these tax proposals as a whole to assess the overall impact. If the above proposals were adopted, some owners of flow-through entities could see their effective tax rate increase by 8% and, for the same amount of income, see their federal tax bill increase by more than 20%.
While some may view an effective federal tax rate of around 44% as excessive, it is also important to consider the state tax implications. Some states create an additional charge on top of federal income tax. For example, New York’s highest personal tax rate was just raised to 10.9% last year. Assuming an effective tax rate in New York of 10%, some individuals in New York State could see an effective tax rate of 54%!
This significant increase in the effective tax rate and cash spending does indeed tax the wealthy, but Congress must also consider a crucial tipping point: when does the amount of taxes impact the decision to an individual to reinvest in our economy and create business growth? While I know there will always be outliers on either end, with some wanting everyone to pay more taxes and some not wanting to pay any, I think most Americans recognize the need to pay. “Their fair share”. The problem for Congress over the next few months will be determining what is indeed a “fair share” while not impacting negatively on an already faltering economy. It’s not a job that I envy.