UPDATE: On November 19, 2021, the House of Representatives passed the Build Back Better Act and sent it on to the Senate. As we expected when we wrote this article in October, there were significant changes to the original bill that was proposed by the Ways and Means Committee. We’ve crossed out the sections in the original article that no longer apply, and here are the provisions in the House version of the bill that are most likely to impact you:
- The limitation on the deduction for state and local taxes (SALT) would be increased from $10,000 to $80,000 ($40,000 for married taxpayers filing separately and trusts and estates). The increase would be in effect for the 2021 tax year through 2031. There is already talk about possibly adding an income limitation on this cap, which could be in the $400-$500,000 level.
- The 3% surtax mentioned in the article below was kept in the bill, but it would only be applied to taxpayers with over $25 million of modified adjusted gross income (MAGI). Estates and Trusts would be subject to the 3% surtax at $500,000 of MAGI.
- In addition to the 3% surtax, there would also be a 5% surtax on taxpayers with MAGI over $10,000,000, or over $200,000 for estates and trusts. Married individuals filing separate returns would be subject to both the 3% and 5% surtax at half these levels.
- Roth conversions would still be eliminated after 2031 and backdoor Roth IRAs would be disallowed beginning in 2022.
- The Qualified Small Business Stock (QSBS) 1202 exclusion would be reduced to 50% for taxpayers with adjusted gross income of $400k or more.
- The 3.8% Net Investment Income Tax (NIIT) would now also be applicable to ordinary business income for joint filers over $500k of MAGI and single filers over $400k. This means you’d have to include income from limited partnerships and S corporations in net investment income even when the S corporate shareholder materially participates in the operations.
- When an “applicable retirement plan” (Defined contribution plan, 403(b), 457 plan, IRA, Roth IRA) exceeds $10 million at the end of the year (starting after 2028), no additional contributions would be allowed to Roth or traditional IRAs and 50% of the amount in excess of the $10 million would be required to be distributed.
The bill requires a 51% majority vote in the Senate to pass, and there are 50 Republican and 50 Democratic Senators. If all 50 Democrats vote for the bill, Vice President Kamala Harris would be the deciding vote, but there are indications some Democratic Senators are unlikely to vote for passage as the bill is currently written. It’s very likely additional changes will be made before the bill is voted on, so as always, stay tuned!
“In this world, nothing is certain but death and taxes”
This quote might need to be changed to “In this world, nothing is certain but death and constant changes to the tax law.“ It was only four years ago when the Tax Cuts and Jobs Act was passed, ushering in a host of tax cuts and new tax calculations. Since then we’ve seen the SECURE Act in 2019, the CARES Act when COVID hit in March 2020, and the Consolidated Appropriations Act at the end of 2020. Over the summer we told you about the proposed SECURE Act 2.0, which has broad bipartisan support but has yet to pass. On top of all this, we’ve known since the election last November that a major piece of tax legislation would eventually be proposed by the new administration.
In September, we finally got a preview of what might be included in this legislation, but there will likely be significant changes as the negotiations in Congress continue. There remain many challenges to getting a bill passed, but here are the main items that might impact you:
Increased Top Tax Bracket - The top ordinary income tax rate would go back up from 37% to 39.6%, which is where it was just four years ago prior to the passage of the TCJA. As can be seen in this chart courtesy of Kitces.com, that top rate would start at a much lower level of income, creating a very narrow 35% tax bracket and pushing much more income into that top bracket. Planning Point: If you can, it may make sense to accelerate income into this year and push deductions into next year
3% Surtax on ultra high-income taxpayers - In addition to the higher rate in the top tax bracket, taxpayers whose modified adjusted gross income (MAGI) exceeds $5,000,000 would be subject to an additional 3% surtax. This would apply to both ordinary and capital gain income and trusts would be subject to the surtax at just $100,000 of MAGI.
25% Top Capital Gains Rate - The initial proposal was to tax long-term capital gains as ordinary income if your income exceeded $1 million. That would have made the capital gains tax rate as high as 43.4% for some taxpayers. While the reduction to 25% is a welcome relief for some taxpayers, it will start at just $400k for singles and $450k for married filers, that’s about $50k lower than the current top tax bracket for capital gains. Planning Point - The higher capital gains rate as proposed would go into effect for sales on or after September 14, 2021, so it might be too late to recognize gains at the current rates. Still, as this legislation is only proposed, that date could change so if you are considering taking gains soon and might be in the new proposed 25% bracket, you should consider accelerating those gains.
Roth Conversions Limited- A popular strategy now for high-income taxpayers to get around the Roth IRA contribution limitations, called a "back-door Roth conversion", involves making an after-tax IRA contribution, then converting that contribution to a Roth IRA. The proposed legislation would get rid of this strategy completely, including the “mega back-door” Roth conversions that some have been doing. The legislation would also end regular Roth conversions for taxpayers with over $400k/$450k of income starting in 2032.
Planning Point - We might have a window of time over the next ten years when Roth conversions become even more valuable. Now is the time to start considering whether it might make sense to do a Roth conversion this year, or in the coming years.
Estate and Gift Tax Exemption Reduced in 2022 - The TCJA temporarily doubled the estate tax exemption, beginning in 2018, with a sunset at the end of 2025 back to the original $5 million, adjusted for inflation. The proposed legislation would accelerate that sunset to this year, meaning the exemption would be about $6 million starting in 2022. Planning Point - If your assets are over $6 million for a single, or $12 million for a married couple, you should be thinking about using some of that higher exemption amount this year before you lose it.
- The Qualified Small Business Stock (QSBS) exemption would be reduced to 50% if a taxpayer’s adjusted gross income is $400k or greater. Similar to the capital gains tax increase, this would have a retroactive effective date of September 13, 2021.
- The 3.8% Net Investment Income Tax would apply to S-Corporation owners with MAGI over $400k for singles and $500k for married filers. Combined with the increase in the top tax bracket, some taxpayers could see their tax rate increase from 37% to 43.4%.
- There would be a new required minimum distribution for mega retirement accounts if Adjusted Taxable Income is over $400k single/$450k joint and the total retirement accounts are over $10mm. This provision is believed to be in response to the recent story about Peter Thiel’s $5 Billion Roth IRA.
Many estate planning strategies, like using defective grantor trusts and taking valuation discounts on gifts of marketable securities to family limited partnerships, would be eliminated or their effectiveness would be greatly reduced. Section 1061 carried interest rules that apply a 3-year holding period for capital gains to qualify as long-term would be extended to 5 years.
- The recently expanded child tax credit would be extended.
What is NOT in the legislation?
- Elimination of the step-up in basis at death - Back in April, President Biden put forth a proposal to eliminate the step-up in basis at death that would tax unrealized gains that exceeded $1mm per individual or $2.5mm for married couples. The recently released proposal does not include any changes to the step-up rules, though there are indications that Democrats are still considering changes, including a potential basis carryover.
- Increase in the State and Local Tax (SALT) cap, which limits the deduction to $10,000. This is a large point of contention among democrats as many representatives from high tax states want to repeal the SALT cap, but the cost of doing so would wipe out much of the revenue being raised by the other tax increases in the bill. While not included in the original bill, this one is back IN the latest version!
Again, all of these items are simply proposals subject to further negotiation and we don’t know what, if anything will eventually be passed by Congress. Unfortunately, as is typically the case, we might not know for sure what will be passed until it is too late in the year to implement any planning opportunities. If you are worried about how any of the above proposals might impact you and whether you should take action now in case something is passed, please reach out to us NOW so we can discuss your options.
For further reading and more detail on the proposed legislation, we recommend the following articles:
-Chris Benson, CPA, PFS
The views expressed represent the opinions of L.K. Benson & Company and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person.
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