If you watch the news, you might get the impression Americans can’t agree on much of anything these days. One thing I think we can all agree on, however, is that it’s been a long and eventful couple of years. I for one would like nothing better than to sip on a tasty beverage, enjoy the cooling weather, watch the leaves change color, and count down the days to a tasty turkey dinner for Thanksgiving. However, Congress has other plans for tax practitioners this fall, starting with the House Ways and Means Committee’s initial draft of major tax legislation. The draft legislation proposes far-reaching changes to existing tax laws, though not quite as far-reaching as the Biden administration may have hoped. This article explores some of the major provisions contained in the draft legislation.
1. Corporate Income Tax Rate
Under current law, the corporate income tax rate is a flat 21%. In its General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals (commonly referred to as the “Green Book”), the Biden administration had proposed increasing this rate to a flat 28%.
Rather than a flat 28% rate, however, the House Ways and Means Committee’s provision would replace the current 21% rate with a graduated rate structure, effective for tax years beginning after December 31, 2021. The rate would be 18% for income up to $400,000, 21% for income above $400,000 and up to $5,000,000, and 26.5% on all income over $5,000,000. Quick math shows the benefit of the graduated rate structure to corporations with income in excess of $5,000,000 is $287,000, but this benefit is phased out for corporations with income in excess of $10,000,000. Additionally, personal services corporations are not eligible for the graduated rate structure (sorry lawyers).
2. Individual Income Tax Rate
This provision would increase the top marginal income tax rate on individuals to 39.6%, effective for tax years beginning after December 31, 2021. The 39.6% rate would apply to single taxpayers on income in excess of $400,000, married filing jointly taxpayers on income in excess of $450,000, head of household taxpayers on income in excess of $425,000, and married filing separately taxpayers on income in excess of $225,000.
Interestingly, the 39.6% rate would start at lower income thresholds than the Biden administration had proposed in the Green Book. The Green Book imposed the 39.6% tax rate on single taxpayers on income in excess of $452,700, married filing jointly taxpayers on income in excess of $509,300, head of household taxpayers on income in excess of $481,000, and married filing separately taxpayers on income in excess of $254,650.
3. 3% Surcharge
This provision would impose a 3% tax on an individual’s modified adjusted gross income (“AGI”) in excess of $5,000,000 ($2,500,000 for married filing separately taxpayers), effective for tax years beginning after December 31, 2021. For this purpose, a taxpayer’s “modified adjusted gross income” is its AGI reduced by any deduction for investment interest.
4. Long-Term Capital Gains Tax Rate
Under current law, long-term capital gains and qualified dividends are generally subject to tax at rates of 0%, 15%, or 20% (depending on income level and filing status), plus a 3.8% tax on net investment income for taxpayers with modified AGI in excess of $200,000 ($250,000 for married filing jointly taxpayers).
The Green Book had proposed to tax long-term capital gains and qualified dividends at ordinary income rates for any taxpayer with AGI in excess of $1,000,000, but only to the extent that the taxpayer’s income exceeds $1,000,000 ($500,000 for married filing separately taxpayers). In a departure from the Green Book, the House Ways and Means Committee’s provision would increase the 20% long-term capital gains rate to 25%. The 25% rate would apply only to taxpayers who are in the highest marginal ordinary income tax bracket.
The increased 25% rate applies to all long-term capital gains and qualified dividends realized after September 13, 2021, except gains realized during the current taxable year pursuant to a binding written agreement entered into on or before September 13, 2021 (and which is not materially modified thereafter). The upshot is that if you were thinking about selling your business in 2021 to avoid increased long-term capital gains tax rates on the sale, you may be too late.
5. Qualified Small Business Stock
Under current law, noncorporate taxpayers can exclude all or a portion of their gain on certain sales of qualified small business stock (“QSBS”). A full discussion of these rules is beyond the scope of this article, but in general they allow taxpayers to exclude 50%, 75%, or 100% of gains realized on sales of QSBS held for more than 5 years (subject to various limitations). The 50% exclusion applies to QSBS acquired before February 18, 2009; the 75% exclusion applies to QSBS acquired from February 18, 2009 through September 27, 2010; and the 100% exclusion applies to QSBS acquired on or after September 28, 2010.
The House Ways and Means Committee’s provision would apply the 50% exclusion to the sale of QSBS (regardless of the date the QSBS was acquired) by any individual with AGI equal to or exceeding $400,000. Importantly, this provision would be effective for all sales or exchanges occurring on or after September 13, 2021 (other than sales or exchanges made pursuant to a binding written contract in effect before such date and not materially modified thereafter).
This proposal is surprising (at least to this tax practitioner) because the increased 75% and 100% exclusions were intended to incentivize investors to put their capital at risk in smaller, less proven businesses (rather than investing in something relatively low-risk, like an index fund). Many taxpayers have made investment decisions based in significant part on the availability of the 75% and 100% QSBS exclusions, and pulling the rug out on these exclusions seems unnecessarily harsh and unfair. I think Congress would be better served to apply this provision only to QSBS acquired on or after September 13, 2021.
6. Net Investment Income Tax
Current law imposes a 3.8% tax on the “net investment income” of taxpayers with modified AGI in excess of $200,000 ($250,000 for married filing jointly taxpayers). Net investment income generally does not include income generated in the ordinary course of a taxpayer’s trade or business.
Effective for tax years beginning after December 31, 2021, this provision would expand the definition of “net investment income” for taxpayers with modified AGI greater than $400,000 ($500,000 for married filing jointly taxpayers). The expanded definition would include income derived in the ordinary course of a taxpayer’s trade or business, except wages on which FICA is already imposed.
7. Section 199A
Under current law, taxpayers can (subject to limitations beyond the scope of this article) deduct up to 20% of their qualified business income. The House Ways and Means Committee’s provision would cap the allowable deduction for qualified business income at $500,000 for married filing jointly taxpayers, $400,000 for single taxpayers, and $250,000 for married filing separately taxpayers.
The House Ways and Means Committee’s proposals would significantly alter the current tax landscape and can all be passed through the budget reconciliation process with only Democratic support. It will be fascinating to watch which of these proposals—or others not currently included, such as SALT cap relief—ultimately make their way to President Biden’s desk for signature.