Congress is working with the Biden administration and the Treasury Department to complete the 2022 budget reconciliation bill. Draft legislation won’t be finalized until later this year, but we expect significant changes in U.S. tax policy.
These changes include tax hikes on corporations, individuals, and capital gains. We also anticipate changes in international and partnership taxation, and estate and gift taxes. These will affect high net worth individuals, corporations, small business owners and upper-income couples filing jointly.
The effective date for these changes is January 1, 2022. Some provisions may be delayed or temporary, to improve the legislation’s scored cost for budget reconciliation. The following are some of the changes we expect:
Higher Corporate Tax Rates
According to The Tax Foundation, an independent tax policy 501(c)(3) nonprofit, the proposed bill would raise approximately $1.7 trillion from C corporations over ten years. Pass-through firms would provide $370 billion over the same period.
The bill proposes replacing the flat corporate income tax with a graduated rate structure. This proposed structure provides for a rate of 18 percent on the first $400,000 of income. The rate on income up to $5 million increases to 21 percent and to 26.5 percent above $5 million. The benefit of the graduated rate phases out for corporations making more than $10 million. Personal service corporations aren’t eligible for graduated rates.
An Increased Top Marginal Individual Income Tax Rate
January 1, 2022 sees the top marginal income tax rate climb from 37 to 39.6 percent. This applies to married individuals filing jointly and reporting income of $450,000. The new top rate affects heads of household who earn more than $425,000 and single individuals earning over $400,000.
Married individuals who earn more than $225,000 and file separately will pay the new higher rate, as will individuals reporting income of $12,500 from estates and trusts.
Higher Capital Gains Rate for Certain High-Income Individuals
2022 sees the capital gains rate rising from 20 to 25 percent. A transition rule provides that the preexisting statutory rate of 20 percent would apply to gains and losses for the portion of the taxable year prior to the date of introduction. Add a 3.8 percent Medicare surcharge on higher earners and the top rate goes to 28.8 percent.
The new higher rate won’t apply to gains recognized later in the same taxable year, from transactions entered into before the date of introduction. These transactions must be pursuant to a written binding contract and would be treated as occurring prior to the date of introduction.
Limitation on Deduction of Qualified Business Income for Certain High-Income Individuals
The Qualified Business Income (QBI) deduction has been useful to sole proprietors, partnerships, S corporation shareholders, and some trusts and estates. Created in 2017, it allowed some individuals to take a 20 percent deduction on business income, REIT dividends or publicly traded partnership income.
The new QBI deduction applies to taxable years after December 31, 2021. It sets the maximum allowable deduction at $500,000 for joint filers and $400,000 for individuals. The QBI deduction for married couples filing separately is $250,000 and $10,000 for trust or estate returns.
Contribution Limits on IRAs for High-Income Taxpayers with Large Account Balances
News that Paypal’s co-founder, Peter Thiel, had accumulated $5 billion in his Roth IRA registered with Congress. According to ProPublica, that account grew from $2,000 in 1999 to $5 billion today. Returns came in part from investments in private securities.
Now Congress plans to eliminate what it sees as an abusive tax shelter. Beginning January 1, 2022, individuals won’t be able to contribute to a Roth or traditional IRA for a taxable year if the total value of their existing IRA and defined contribution retirement accounts exceed $10 million at the end of the prior taxable year. This limitation would apply to single or married filing separately, individuals with taxable income over $400,000, married couples filing jointly over $450,000, and heads of household filers over $425,000. In addition, employer-defined contribution plans would have to report account balances greater than $2.5 million to the IRS and the plan participant.
New Tax Treatment of Rollovers to Roth IRAs and Accounts
There’s more bad news for high earners with Roth IRAs, as Congress moves to eliminate back-door Roth IRA contributions. Individuals with taxable income over certain levels won’t be able to contribute to an IRA or employer-sponsored plan, and then convert their holdings to a Roth IRA, bypassing Roth IRA income limitations.
The change applies to single and married filing separately taxpayers with taxable income over $400,000. The new taxable income limit for married filing jointly couples is $450,000-plus. Heads of households will top out at $425,000. The new restrictions cover distributions, transfers and contributions made in taxable years beginning after December 31, 2031. All employee after-tax contributions to qualified plans and IRAs will be prohibited from converting to Roth, regardless of income level.
Deduction Limitation for Qualified Conservation Contributions Made by Pass-Through Entities
The IRS has moved aggressively against what it sees as abusive conservation easement deductions. Now Congress is moving to reinforce those efforts. Congress was always behind the crackdown on easements but didn’t have the laws on the books to support it, now this will give IRS the legal reinforcement. The current proposal would retroactively deny charitable deductions for contributions of conservation easements by certain partnerships and other pass-through entities. Beginning January 1, 2022, the IRS would disallow deductions when the amount of the contribution exceeds 2.5 times the sum of each partner’s adjusted basis in the partnership relating to the donated property. This general disallowance rule won’t apply to donations of property that meet the requirements of the three-year holding period rule, or contributions by family partnerships.
In addition, various accuracy-related penalties will apply, including a gross valuation misstatement penalty. The IRS can extend the statute of limitations on assessment and collection in case of any disallowance of a deduction by reason of this provision. This section will apply to contributions made after December 23, 2016 (the date of the relevant IRS notice) and after December 31, 2018 for specific contributions made to preserve certified historic structures. This proposal, if it passes, could have a significant effect on numerous returns currently under audit.
GILTI changes and updates target cross-border investment
If you or your business own 10 percent or more of a controlled foreign corporation, expect your tax bill to increase. Proposed changes to the Global Intangible Low-Taxed Income (GILTI) calculation include increasing the tax rate from 10.5 to 16.56 percent. This proposal reduces the Section 250 50 percent deduction to 37.5 percent of taxable GILTI income. Deductions would no longer include the taxable income limitation and Net Operating Loss calculation.
In addition, Congress proposes to calculate GILTI on a Country-by-Country (CbC) basis. The Qualified Business Asset Investment (QBAI) exclusion would drop from 10 to 5 percent, except for QBAI in U.S. possessions, such as Puerto Rico. The draft legislation calls for U.S. shareholders to compute separate GILTI amounts for each country where their companies do business. Losses in one country would no longer reduce the GILTI inclusion for income in another country. In addition, the allowable deemed paid foreign tax credit for GILTI rises from 80 to 95 percent of allocable taxes. For taxes deemed paid to U.S. possessions, the allowable credit goes to 100 percent.
Congress also wants to raise the Foreign Derived International Income (FDII) rate from 10.5 to 20.7 percent. Taxpayers would calculate foreign tax credits on a CbC basis, with no alterations to high-tax exceptions. The FTC carry-forward would drop from ten years to five, with no FTC carry-back of excess credits. We await guidance on pre-CbC carry-forward FTCs.
The Section 245A Dividends Received Deduction (DRD) would be limited to dividends from CFCs only, instead of foreign companies with at least 10 percent U.S. ownership. Congress proposes reinstating Section 958(b)(4), preventing the downward attribution of stock from a foreign individual to a U.S. citizen, for the purposes of determining U.S. shareholder status. This reinstatement would apply to tax years beginning in 2018. This would be a relief to multi-national entities, which have seen significant reporting burdens for entities without at least one U.S. corporation in their structure.
Moving Forward During Short-Term Uncertainty
We won’t have final numbers until November or December, but the intent of Congress is plain. 2022 tax rates on the wealthy and high earners will increase. This leaves the rest of 2021 to re-assess your asset location and minimize tax exposure.
Look at your 401k and IRAs. Are they fully funded? Can you convert a traditional IRA into a Roth IRA? Use this “backdoor Roth” while you can. It may also be advisable to sell certain investments while lower capital gains rates still apply. If you have inefficient tax assets, such as fixed-income investments or REITs, you may consider placing them in tax-deferred or nontaxable accounts.
Are you planning to sell your company? Remember that higher corporate tax rates will decrease cash flow and could affect your company’s valuation. This is particularly true for companies selling to private equity firms. They use cash flow to value transactions and for financial modeling. If you can complete your company’s sale this year, you should consider it.
A grantor retained annuity trust (GRAT) may help you transfer high-growth assets with minimal gift and estate taxes. If you’ve been thinking about funding trusts, now may be the right time, particularly if these trusts need cash for expenses such as life insurance premiums.
The tax landscape is shifting. How you move forward requires in-depth consultation and planning with your CPAs, investment advisors and attorneys. To make sure your tax strategy continues to support your investment objectives, contact Tomika Bullet or Brandi M. Samuel at Windham Brannon.
