If you’ve had your head buried in the sand, or just decided you were not going to follow all the potential federal tax law changes, you’ve chosen wisely. Between the Biden Green Book proposal, the House Ways and Means Committee proposal, and the most recent Budget Reconciliation Bill released by the House Democrats this past week, the potential tax law changes have been all over the board. The deviations between the proposals seem to indicate there is still enough discontent amongst the Democratic party in D.C. to require significant changes. Unfortunately, when you follow the money, the picture starts to reveal that the taxpayers bearing the burden for the revenue are disproportionately pass-through entity owners, and not the large multinational companies and estates as many believed. The best way to understand the most recent tax proposals is to review the progression of the changes and follow the money train.
A sigh of relief was felt by investors, as the increase in capital gains from 20% to 25% does not appear in the most recent proposal for married filing joint taxpayers earning taxable income over $450,000, or $400,000 of taxable income for single filers. However, there still will be an increase to 25% and 28% for individual taxpayers with AGI over $10,000,000 and $25,000,000 respectively due to the surcharge tax.
Some of you may be wondering where the billionaire tax proposal was included. It was never included in either the Biden or the House Ways and Means Committee proposals. The billionaire tax would have targeted approximately 700 persons with more than $100 million of annual income or more than $1 billion in assets for three consecutive years. The calculation would include the taxation of unrealized gain (or losses) incurred by these select group of people based on a mark-to-market approach. It was the buzz in all news media for the past week but was nowhere to be seen in the proposals. To me, the main reason was the difficulty in its implementation. First, the targeted persons have the most resources to challenge the very constitutionality of the tax. Second, it could have resulted in economic turmoil as it is possible the targeted persons would reduce investments in publicly traded companies. After all, the only way to tax tradable assets is if there is a clear ascertainable value. If assets are moved to the private sector, the billionaire tax no longer applies. Lastly, the targeted audience has access to some of the most talented accountants and attorneys in the world. There was already planning discussions to find opportunities to avoid the tax, including the utilization of trusts in order to decrease the asset valuation to a level below the $1 billion threshold.
Other major proposals regarding the estate and gift tax seem to have been dropped all together in the most recent proposal. The Budget Reconciliation Bill published by House Democrats is silent to significant estate tax changes, including lowering the estate and gift lifetime exemption from $11,700,000 to $5,000,000 (which would be indexed for inflation) and significant changes to grantor trusts that were both introduced in the House Ways and Means Committee proposal. Even Biden had made estate planning professionals nervous with his proposal to create additional taxes that would apply when assets were transferred to trusts and on certain unrealized gains at death. Professionals then were stunned to see no amendments relating to the estate and gift tax system in the most recent bill. After all, the platforms in many democrats’ campaigns included the reduction of the gift and lifetime exemption. There seemed to be consensus that a shift in the estate tax arena might be one of the more systematic ways to raise revenue.
While reviewing the list of what remains in the tax proposals versus what was removed, some may conclude the highlights above are fair to both corporations, pass-through entities, and individuals. Everyone got a bit of the “compromise”. But to understand the weight of some of these proposals, and the type of taxpayers being affected, you must follow the money. The preliminary estimated revenue effects of selected provisions provided by White House and the University of Pennsylvania in the Penn Wharton Budget Model (PWBM) can be found below.
If you add the federal revenue creation from both the net investment income tax expansion and permanently establishing the excess business loss limitation, both directly impacting pass-through entity owners, the revenue being raised under the White House Estimate is $420 billion or $400 billion, respectively, under the PWBM estimate. The total Build Back America proposal is now estimated to be $1.75 trillion, resulting in 23% being born on the backs of pass-through entity owners. Reviewing the same PWBM revenue estimates for the corporate minimum tax and modifications to GILTI, which generally impacts large multinational C Corporations, will only create $447 billion or roughly 25% of the proposal.
Are you thinking the differences between the revenue raisers between pass-through entities and C Corporations are negligible? While both pass-through entity owners and C corporations are seeing tax increases, keep in mind the type of businesses that are being impacted. In order for the corporate minimum tax to apply, book earnings must exceed $1 billion for a three-year period and the GILTI provisions generally apply to large multinational corporations. On the other hand, the proposal to extend the net investment income tax will impact S Corporations shareholders and select partners with an adjusted gross income over $500,000 and the permanence of the excess business loss limitation rule can apply to individuals operating trades or businesses, no matter their AGI. Even though the C Corporation and pass-through entity proposals will create similar revenue streams, the burden of the pass-through entity proposals will impact a much broader base of small businesses with AGI as little as $500,000 while the C Corporation impact primarily targets large multinational companies with more than $ 1 billion in book earnings, estimated to be less than 12o companies.
As far as the Internal Revenue Service being able to recoup $400 billion over the next ten years with increased funding, many tax professionals are leery. It is unclear how the White House is estimating that number, and the PWBM estimates it could raise as little as $190 billion, or less than half of what is being projected by the White House.
While it appears that negotiations are still to be had, the most recent proposed legislation places a heavy burden on pass-through entities owners and is assessed at a much lower income threshold than C Corporations. The ability to raise revenue for the federal government while focusing on pass-through owners make sense. After all, prior to the COVID pandemic, over 90 percent of businesses in the United States were pass-through businesses. However, for the time being, it appears that large multinational C corporations and wealthy estates escaped higher tax rates yet again, and most likely are breathing a sigh of relief.