Editor’s note: The developments discussed in this piece were part of the legislative process leading to enactment of the Inflation Reduction of 2022. Please see our capstone article about that legislation for details about the final changes included in that bill.
On September 15, the House Ways and Means Committee approved the tax provisions of the Build Back Better Act (BBBA), the legislation intended to implement President Biden’s social and education reforms. There are still many steps in the process to become law, but this is a major first step to begin understanding which tax proposals Congress will use to balance revenue and spending priorities as well as the specifics of how those tax proposals will apply.
How did we get here?
Earlier this year, the Biden administration announced plans to pursue two major pieces of legislation. One package would provide significant infrastructure spending, and the second package would involve new social and education spending programs. The Infrastructure Investment and Jobs Act has since passed the Senate and is still pending in the House. For the infrastructure legislation to be passed on a bipartisan basis, compromises made by both parties in the Senate resulted in no major tax changes being included.
The social and education spending plan is now tentatively named the Build Back Better Act and includes major tax changes. The House Ways and Means Committee spent four days marking up its portions of the proposed legislation which, in addition to the major tax proposals, also covers infrastructure financing and community development, green energy, the social safety net, state and local government support, and Medicare drug pricing.
What’s in the proposed legislation?
Here are some of the key tax provisions:
Individual income tax
- Increase in the top marginal individual income tax rate — The top marginal individual income tax rate would increase to 39.6%, the same top marginal rate that existed before the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA). This rate would apply to the taxable income of (1) married couples filing jointly which exceeds $450,000, (2) single filers which exceeds $400,000, (3) married individuals filing separately which exceeds $250,000, and (4) trusts and estates with taxable income over $12,500. An additional surtax of 3% would be applied to modified adjusted gross income exceeding $5,000,000 ($2,500,000 for married taxpayers filing separately). This proposal would be effective for tax years beginning after Dec. 31, 2021.
- Increase in the maximum long-term capital gains rate — The maximum capital gains rate would increase to 25% from the current rate of 20%. The income level that this capital gains rate bracket applies to would be aligned with the new 39.6% rate bracket. These rates would also apply to qualified dividends. This increase is far lower than the Biden administration’s original proposal to increase the capital gains rate to as high as 39.6%. This proposal includes transition rules that will generally apply the increased rate to capital gains and dividends recognized after Sept. 13, 2021, but certain sales subject to a binding contract in effect on that date could still apply the previous rates.
- Net investment income tax application to active business income — Under current law, the net investment income tax applies an additional 3.8% tax to a taxpayer’s net investment income when adjusted gross income exceeds a certain threshold. Net investment income only includes income earned from a business if the taxpayer is passive with respect to that business, but not if a taxpayer is active. The proposal would subject active business income to the net investment income tax as well, but only when adjusted gross income exceeds (1) $500,000 for married couple filing jointly, (2) $250,000 for married couples filing separately, and (3) $400,000 for all other taxpayers. This rule would not apply if the business income was already subject to self-employment tax. When combined with the individual tax rate increases above, this could increase the tax rate applicable to active business income from the maximum marginal rate of 37% under current law to as high as 46.4% (39.6% maximum marginal rate + 3.8% net investment income tax + 3% high income surcharge). This proposal would be effective for tax years beginning after Dec. 31, 2021.
- Section 1202 modifications — Under current law, Section 1202 permits up to a 100% exclusion from the sale of certain C corporation stock. The proposal would cap the exclusion at 50% for taxpayers with adjusted gross income in excess of $400,000 and for all estates and trusts. For taxpayers with income below $400,000, the 75% and 100% exclusions would still be available. Even with a 50% exclusion, this provision could still provide an effective federal tax rate reduction of up to approximately 15%. The proposal is effective for sales occurring after Sept. 13, 2021, but certain sales subject to a binding contract in effect on that date could still apply the previous rules.
- Limitations on contributions to IRAs and increases in required minimum distributions (RMDs) for certain high-income taxpayers with large account balances — Under current law, taxpayers can make contributions to certain retirement accounts regardless of their income level. The bill would prohibit contributions when the total balance of the contributor’s IRAs and other retirement accounts exceeds $10 million (determined as of the close of the previous taxable year) and taxable income exceeds (1) $450,000 in the case of a married couple filing jointly or (2) $400,000 in the case of single or married taxpayers filing separately. Those same taxpayers would have to take a RMD equal to 50% of the value that exceeds $10 million, plus 100% of any amount exceeding $20 million. This provision is effective for tax years beginning after Dec. 31, 2021.
- Limitations on “back door” Roth IRA conversions — Under current law, while contributions to Roth IRAs may not be made by taxpayers with incomes exceeding certain thresholds, those taxpayers may effectively avoid the limitations by first making a nondeductible contribution to a traditional IRA and then converting it to a Roth IRA. The bill would prohibit this practice for taxpayers with taxable income exceeding (1) $450,000 in the case of married taxpayers filing jointly or (2) $400,000 in the case of single taxpayers and married taxpayers filing separately. The proposal would generally be effective for tax years beginning after Dec. 31, 2021, but certain rollover provisions wouldn’t be effective until tax years after Dec. 31, 2031.
- Extension of additional child tax credits and advance payments — The child tax credit has been expanded over the past several years to increase the amount of the credit, making it fully refundable, and permitting the IRS to make monthly payments of the anticipated credit. These provisions would generally be extended through Dec. 31, 2025 with some modifications to the monthly payment rules and the provisions requiring repayment of excess credits.
General business provisions and pass-through entities
- Limitation on the qualified business income deduction (QBID) — The QBID would be limited to a maximum deduction of (1) $500,000 for married taxpayers filing jointly, (2) $400,000 for single filers, or (3) $250,000 for married taxpayers filing separately. This means that the deduction would be capped once qualified business income exceeds $2.5 million for married taxpayers filing jointly, $2 million for single filers, $1.25 million for married taxpayers filing separately, and $50,000 for trusts and estates. There is currently no limitation on the deduction, which is otherwise scheduled to expire on Dec. 31, 2025. This proposal is effective for tax years beginning after Dec. 31, 2021.
- Permanent limitations on the ability to deduct excess business losses — The TCJA imposed a $250,000 limit on the deduction for excess business losses (EBL) ($500,000 for married couples filing jointly) for tax years beginning in 2018. The EBL provision prevents business losses from offsetting more than the threshold amount of nonbusiness income of a taxpayer and was originally set to expire at the end of 2025. The proposal would make this provision permanent and would also create a new loss carryforward bucket for EBLs rather than being treated as net operating losses. This separate loss carryover rule is proposed to apply retroactively to tax years beginning after Dec. 31, 2020.
- Section 163(j) changes for pass-through entities — Partnerships and S corporations would no longer be subject to Section 163(j) at the entity level; instead, that provision would always apply to their partners and shareholders directly for tax years beginning after Dec. 31, 2021.
- Amortization of research expenses — Under the TCJA, research expenses incurred in 2022 and later were no longer immediately deductible and would be capitalized and amortized over five years (15 years if they were incurred outside of the United States). The BBBA proposes to defer the effective date of this provision until Jan. 1, 2026.
- Carried interest — The TCJA treated income related to carried interests as short-term capital gain unless the gain was related to property held for at least three years. The BBBA proposes to increase the holding period to five years. However, the three-year holding period would be maintained for real property trades or businesses and for taxpayers with less than $400,000 of adjusted gross income. The carried interest rules would also be expanded to cover all property treated as generating capital gain, which would appear to include Section 1231 gains that weren’t covered by the TCJA rules. The IRS would also have regulatory authority to address carry waivers and other arrangements that are meant to avoid the application of the rules. The proposal is effective for taxable years beginning after Dec. 31, 2021.
- Conservation easement contribution limitation — A charitable contribution deduction for a conservation easement made by a pass-through entity would be disallowed if it exceeds 2.5 times the owner’s investment in the pass-through entity. This limitation would not apply if the property was held for at least three years or was held by a family partnership. The provision would also permit conservation easement deductions that are at-risk because of defects in the deed to be corrected rather than disallowed altogether. The provisions would be applied retroactively to contributions made after Dec. 23, 2016.
- Election to make a tax-free S corporation conversion to a partnership — In general, a corporation can’t convert to a partnership without the conversion being a taxable event. The proposal would permit S corporations that have continually maintained an S election since May 14, 1996, to make a tax-free conversion to a partnership during 2022 or 2023.
Corporate income tax
- Modification of corporate income tax rate structure and increase in top rate — The TCJA eliminated the graduated income tax rate structure with a top rate of 35% in favor of a flat rate of 21%. Effective for tax years beginning after Dec. 31, 2021, the BBBA would restore the graduated rate structure and tax income below $400,000 at 18%, maintain the current 21% rate for income between $400,000 and $5 million, and tax any income above $5 million at 26.5%. Personal service corporations and corporations with taxable income above $10 million would be taxed at the flat rate of 26.5%. Under existing law, a fiscal year corporation would prorate the taxes applicable to it when a rate change is effective in the middle of its tax year. It would appear that this proration would apply to this proposed change so that a fiscal year corporation would apply both rate structures to its taxable income and prorate the resulting tax for the number of days before and after Dec. 31, 2021.
- Deferral of worthless stock loss on corporate subsidiaries — Under current law, an insolvent corporate subsidiary can be liquidated so that the corporate parent can claim a loss with respect to the subsidiary’s stock. This proposal would defer the recognition of that loss until the subsidiary’s property is ultimately disposed of. This provision is proposed to apply to liquidations that occur after the enactment of the BBBA.
- Expansion of deduction limitations on certain compensation – Under current law, publicly held corporations are prohibited from deducting amounts exceeding $1 million paid to covered individuals. Those rules were recently expanded to broaden the pool of covered individuals in tax years beginning after Dec. 31, 2026. The proposal would accelerate this expansion to tax years beginning after Dec. 31, 2021, and make other technical corrections.
International tax provisions
- Interest limitations on multinational groups — A domestic corporation that is a part of an international financial reporting group would have its interest deductions limited if its share of interest expense is disproportionate to its share of the group’s EBIDTA. Disallowed interest would be carried forward five years, and rules would coordinate this limitation with the Section 163(j) limitations enacted as a part of the TCJA. This limitation would only apply to domestic corporations with a three-year average excess interest expense over $12 million and would not apply to small businesses exempted under current Section 163(j), S corporations, REITs, and RICs.
- Modification of foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) — The Section 250 deduction would be decreased, which, when combined with the increased corporate tax rate, would result in an effective tax rate of 16.5625% for GILTI and 20.7% for FDII. It would also permit Section 250 deductions to create net operating losses. GILTI would also be modified to operate on a country-by-country basis and country-specific tested loss carryovers would be permitted. The QBAI threshold would be reduced from 10 to 5%. The foreign tax credit on GILTI income would be increased from 80 to 95%. These changes are generally proposed to be effective for taxable years beginning after Dec. 31, 2021 with coordination rules where U.S. shareholder and controlled foreign corporation years differ.
- Controlled foreign corporation tax years — The ability of a controlled foreign corporation to elect a tax year that ends one month earlier than the majority U.S. shareholder would be repealed. Controlled foreign corporations with such a year-end would be required to conform to the majority U.S. shareholder’s year-end for tax years beginning after Nov. 30, 2021.
- Foreign tax credit changes — Foreign tax credit determinations would be required to be calculated on a country-by-country basis. This process would combine all of a taxpayer’s activities in a country into a single basket whether conducted directly through a branch or indirectly through a foreign partnership or controlled foreign corporation. As a result, there would no longer be a foreign branch basket and income generated from items of income associated with Subpart F or from branches not under a CFC would be captured in the General and Passive categories. The separate GILTI basket continues to exist; however, allocations of stewardship and interest expense would not be required and only deductions directly attributable to GILTI income, such as Section 250 deductions, would reduce the GILTI foreign source income limitation. Carryforwards of foreign tax credits would be limited to only five years, down from 10 years under current law, and carrybacks would no longer be permitted. These provisions would apply to tax years beginning after Dec. 31, 2021.
- Controlled foreign corporation attribution rule — The determination of whether a foreign corporation is a controlled foreign corporation would be made only if it has direct U.S. shareholders, reversing the attribution rules enacted by the TCJA. This change would apply retroactively to tax years of foreign corporations beginning after Dec. 31, 2017.
- Elective controlled foreign corporation status — This is a binding election that would allow certain U.S. shareholders of a foreign corporation to elect controlled foreign corporation status. The foreign corporation and all U.S. shareholders would be required to join in the election. U.S. persons would then be subject to Section 965, Subpart F, and the GILTI tax regimes but would also enjoy the benefits of the dividends received deduction under updated Section 245A. This election would apply retroactively to tax years of U.S. persons that include the last tax year of foreign corporations beginning before Jan. 1, 2018.
- Foreign dividends received deduction — Currently, the dividends received deduction applies to dividends received from both controlled foreign corporations and foreign corporations that are not controlled by U.S. shareholders. This proposal would limit the foreign dividends received deduction only to dividends received from controlled foreign corporations. This is proposed to apply retroactively to tax years of foreign corporations beginning after Dec. 31, 2017.
- Base Erosion and Anti-Abuse Tax (BEAT) — The BEAT rate would be increased to 15% by 2026 (a 10% rate would apply in 2022 and 2023 while a 12.5% rate would apply in 2024 and 2025). It would also permit most tax credits to offset the BEAT liability. Base erosion payments would include those included in cost of goods sold and other changes to the determination of modified taxable income would be made. It would also provide an exception for payments subject to U.S. tax and for payments made to foreign parties if the taxpayer establishes that such amount was subject to an effective rate of foreign tax not less than the applicable BEAT rate. The 3% base erosion payment threshold would only apply to years through 2023. These provisions are proposed to be effective for tax years beginning after Dec. 31, 2021.
- Elimination of Roth IRA-owned DISCs — Commissions paid to an IC-DISC owned by a Roth IRA would be treated as prohibited transactions. This would result in an additional tax of 15% and, if the transaction is not “corrected,” the tax increases to 100%. This change would eliminate any benefits derived through a Roth IRA-owned IC-DISC and impose significant punitive taxes on structures left in place. The provision would apply to stock held by Roth IRAs after Dec. 31, 2021.
- Limitations on foreign-owned DISC — Distributions from an IC-DISC to a foreign owner would be treated as income effectively connected with a U.S. trade or business conducted through a permanent establishment in the U.S. This will eliminate the ability for non-U.S. shareholders to claim preferential rates on IC-DISC distributions under the dividend clause of a U.S. tax treaty. This provision would apply to distributions made by an IC-DISC after Dec. 31, 2021.
Estate and gift tax
- Termination of temporary increase in unified credit — The bill would accelerate the restoration of the unified credit to 2010 levels of the equivalent of $5,000,000 per individual, indexed for inflation. This was otherwise scheduled to occur in 2026. With retroactive inflation adjustments, the unified credit amount would likely be approximately $6 million. Under current law, only total taxable gifts and taxable estates exceeding $11,700,000 per individual are subject tax in 2021. This is proposed to be effective for decedents dying and gifts made after Dec. 31, 2021.
- Grantor trust changes — Grantor trusts would no longer be excluded from estate tax if the decedent is the deemed owner of the trust. Also, sales between an individual and their grantor trust would be taxable even if they are the deemed owner of the trust. These provisions are proposed to be effective only to contributions made to a trust after the enactment of the BBBA.
- Elimination of certain valuation discounts — The bill would eliminate the ability to claim a valuation discount for estate and gift tax purposes on transfers of entities holding nonbusiness assets. This provision is proposed to be effective for transfers made after the enactment of the BBBA.
Other tax provisions
- Infrastructure financing and energy credits — A centerpiece of President Biden’s and the Democrats’ agenda has been infrastructure. The BBBA would significantly expand tax credits in many areas, including housing, clean and green energy, and new markets.
- Increase in funding the Internal Revenue Service – Nearly $80 billion in additional funding would be provided to the IRS over the next 10 years to increase enforcement of federal tax laws with respect to corporations and high-income individuals.
What’s next?
President Biden’s previous proposals included a number of concepts that weren’t included in the House Ways and Means Committee proposals such as capital gains being realized at the death of a decedent of when assets are gifted, changes to the self-employment taxes, and the repeal of like-kind exchanges. Democratic leaders in the House have also indicated that they intend to address the state and local tax deduction cap and additional information reporting on aggregate inflows and outflows from bank accounts as a part of the debate on the House floor. As discussed below, there are many steps remaining in the legislative process, so it’s possible that these ideas can still be incorporated at a later date.
The final tax proposals from the Ways and Means Committee will be combined with proposals on the other elements of the BBBA currently being marked up in other committees, and the full package will move to the House floor as a single piece of legislation. Further amendments can be made to the legislation during this process. The leadership in the House has tentatively agreed to bring the BBBA to a vote by September 27 alongside the Infrastructure Investment and Jobs Act, which has already passed the Senate. It’s possible that the timeline slips beyond September 27 because not all Democrats in the House are fully aligned on each component of the legislation, and the Democrats can only afford to lose three out of 220 potential votes without losing their majority.
The BBBA will undergo a similar process in the Senate. It’s possible that committee markups will be bypassed in the Senate to speed up the process. However, the precise procedural path and the timeline as to when that will occur has not yet been set. To pass the Senate, it will take all 50 Democratic senators to approve, meaning that any one senator could demand changes or otherwise delay the process. Currently, several Democratic senators have voiced significant opposition to certain elements of the BBBA and have stated that the legislation should be much smaller and the timeline should be slowed considerably. However, this is very early in the process and things can change quickly.
Continue to monitor our Outlook on Tax Rates and Policy Changes for updates as the legislation works its way through Congress.
