As many are aware, the Tax Cuts and Jobs Act (“TCJA”) passed in December of 2017 was a bill that was generally considered taxpayer-friendly and included favorable reductions in both corporate and individual income tax rates, while also providing a pass-through entity deduction to better align the effective federal tax rates of pass-through entities and C corporations. The TCJA was also passed via the budget reconciliation process when the Senate majority was Republican.
As much as tax professionals hoped that the change of the political make-up in Congress would not be married with a change in federal tax law, it seems to be holding true that both parties are choosing to make significant tax law changes if a simple majority is held. All factors seem to indicate that federal income taxes are increasing in the start of the new year. However, the impact on the owners of pass-through entities appears to be more than originally expected. If the proposals go through as they are currently written, pass-through owners could see their effective tax rate increase as much as 9% and a potential increase to 20% for their cash outlay for federal income taxes.
The House Ways and Means Committee issued a tax proposal that is expected to be acted on by the House of Representatives as part of “Build Back Better” reconciliation legislation. The most daunting impact for flow-through owners are highlighted below.
Increase in individual income tax rates
Following the results of the 2020 elections, I think we all knew an increase in individual income tax rates was expected. The taxable income base is also not significantly different from 2017. However, many were caught off guard with the surcharge tax proposed on high income individuals. Included in the proposal, is that for taxable years beginning after December 31, 2021, married filing joint, head of household, surviving spouse, and single taxpayers, will be required to pay an additional 3% on taxable income in excess of $5,000,000. I would like to highlight that in the proposal there is no taxable income deviation for married versus single taxpayers. In other words, if there are two high earning spouses, you are hit with a double whammy.
Unfortunately, this is only the beginning. There are also proposals to limit the pass-through entity (199A) deduction and expand the net investment income tax as well.
Section 199A Qualified Business Income Deduction Limitation
Under the House Ways and Means Committee proposal, there will be a maximum 199A deduction allowed for taxpayers depending on their filing status.
However, even if your current 199A deduction does not come close to those limits, your 199A deduction still may be in jeopardy. There is still a lot of negotiating currently underway, and some are suggesting that more stringent limitations may be placed on the 199A deduction.
Under Senator Ron Wyden’s proposal introduced in July of 2021, the 199A deduction would start to phase out for taxpayers with taxable income above $400,000 and be completely eliminated if a taxpayer’s taxable income exceeds $500,000. Coupled with the individual income tax rates increase this could cause a pass-through entity’s effective tax rate to skyrocket from approximately 30% to 39.6%. Yes, you read that correctly. An increase in an effective tax rate of almost 10% if the enacted legislation is based on the Wyden 199A proposal combined with the potential increase in individual income tax rates.
Application of Net Investment Income Tax to Trade or Business Income
The proposal is also looking to expand the current 3.8% net investment income tax to be assessed on ordinary trade or business income. This is a significant deviation from the current definition which only applies the 3.8% to interest, dividends, capital gains, rental and royalty income, nonqualified annuities, and income from businesses that are passive activities. The expansion only applies to married filing joint taxpayers with taxable income over $500,000 or single taxpayers with taxable income over $400,000. There is an exception from applying the net investment income tax if employment taxes are already imposed on the income.
While many might deem this proposal insignificant, it is another tax that could negatively impact pass-through entities.
S Corporations: Under current law, a 100% S corporation shareholder does not apply the net investment income tax on the ordinary income that flows from the S Corporation to their individual tax return. Under the proposal, assuming the taxable income threshold is met, ordinary income would not only be subject to an ordinary income tax rate of 39.6%, but potentially an additional 3.8%, raising the tax rate to a whopping 43.4%.
Partnerships: A similar impact would occur for partnerships with rental income. Under the current law, rental income is not subject to self-employment tax. Under the proposal, even if the partner is a real estate professional, the amount of rental income that flows to the partner’s individual tax return would be assessed an additional 3.8% for partners exceeding the taxable income threshold. This would also result in a potential federal income tax rate of 43.4%.
Increase in capital gains rates
The proposal would increase the maximum capital gain and qualified dividend rate from 20% to 25%, with an effective date of September 13, 2021 (the date of introduction of the proposal). The lower capital gains rates of 0% and 15% would remain in effect for married filing joint taxpayers with taxable income that does not exceed $80,800 or $501,600 respectively for the 2021 taxable year. Congress intentionally placed the effective date into 2021 to limit taxpayers from making investment portfolio adjustments to maximize the benefit previously provided.
Adjustment to the Section 163(j) business interest expense carryforward period
Under the proposal, interest disallowed in a taxable year beginning after December 31, 2021, can no longer be carried forward indefinitely but would be limited to a five-year carryforward. The ability to use any disallowed interest expense would be conducted on a first-in first-out basis.
While many taxpayers may not be worried about this portion of the proposal as it does not create disallowed interest expense under the current limitation rules, taxpayers should be cautious. The proposal, coupled with the adjustment on how the interest expense limitations will be calculated in the 2022 taxable year under the existing law, may surprise a fair number of taxpayers. In general, business interest is allowed under the existing law if it does not exceed 30% of adjusted taxable income, which includes an adjustment to add back depreciation and amortization. For taxable years beginning after December 31, 2022, the ability to addback depreciation and amortization is no longer available, causing the adjusted taxable income to significantly decrease for many. Such a decrease in adjusted taxable income will expand the base of taxpayers who fall under the interest expense limitation rules.
It is important to evaluate these tax proposals in totality to evaluate the overall impact. If the above proposals were passed, certain pass-through entity owners could see an increase in their effective tax rate of 8%, and for the same amount of income see an increase of their federal tax bill of over 20%.
While some may view an effective federal tax rate of approximately 44% as excessive, it is also important to review state income tax implications. Certain states create an additional amount of burden on top of the federal income tax. For example, New York’s top individual tax rate was just raised to 10.9% this past year. Assuming a New York effective tax rate of 10%, some New York State individuals could see an effective tax rate of 54%!
This meaningful increase in the effective tax rate and cash outlay is indeed taxing the wealthy, but Congress needs to also consider a crucial tipping point: When do the amount of taxes impact an individual’s decision to invest back into our economy and create business growth? While I know there will always be outliers on each end with some wanting everyone to pay more taxes and some wanting to pay no taxes, I do believe that most Americans recognize the need to pay “their fair share”. The problem for Congress over the next few months will be determining what is indeed a “fair share” while not negatively impacting an already teetering economy. Not a job I am envious of.