Highlights and Surprises in $3.5 Trillion Budget Reconciliation Bill

HOST: Welcome to the Cherry Bekaert Tax Beat, a conversation about tax that matters. Welcome to the Cherry Bekaert Tax Beat podcast. Today is September 15, 2021.

Today's topic is tax highlights and surprises contained in the draft legislation language released earlier this week for the $3.5 trillion infrastructure bill. This includes proposed changes to corporate tax rates, individual tax rates, more international tax changes, and a host of other provisions.

Joining me today are my co-host, Sarah McGregor from Greenville, South Carolina, and Brian Dill, our International Tax Partner in Atlanta, Georgia.

SARAH MCGREGOR: It is exciting to have final legislative language to look at for new tax law.

HOST: Earlier this week, on September 13, Congressman Neal, who is Chairman of the House Ways and Means Committee, released preview language of the Build Back Better Act reconciliation bill. This is informally referred to as the $3.5 trillion infrastructure bill.

Subsequent to that, the Joint Committee on Taxation also released scoring on the estimated budget effects of this proposed legislation. Many provisions in this draft are familiar to us from President Biden's earlier American Jobs Plan and American Families Plan, which were released March 31 and April 28 of this year, respectively.

We also saw these in the Treasury's Green Book, which was released May 28 and provided more detail to the original plans. The proposed language gives us even more details into what we are going to be looking at.

Today, we are going to focus our discussion on a wide range of selected highlights and surprises. We are going to do this in a survey style rather than diving too deep.

We will save detailed analysis by topic for later podcasts, but we will try to provide insights on a broad range of the bigger ticket items. As a familiar caveat, we are not going to be going directly into the spending side of this bill. We are a tax podcast, so that is where we will focus our attention.

Sarah, why don't you give a brief overview of where we are in the legislative process with this bill, as well as the $1.2 trillion infrastructure bill?

SARAH MCGREGOR: The $3.5 trillion reconciliation bill is currently in the House Ways and Means Committee. They are considering this bill and performing markups, which involves making changes, striking items, and adding items to the draft proposed by Representative Neal.

The hope and plan is to have it out of committee and to the House members by the 15th. That is an internally set date, though it is not steadfast.

Then the House will be able to vote on it. Speaker Pelosi has said she would like to have the vote before the end of September, likely around the 27th.

The $1.2 trillion infrastructure bill that has bipartisan support came out of the Senate and is now in the House. They would like to see both bills passed by the House by the end of this month.

Once it is through the House, it goes to the Senate and the Senate Finance Committee. They will either introduce their own bills or take those from the House.

If there is a markup session, they will be adding their proposals and making edits to the version that would then be brought to the Senate floor. If there are differences between the House and Senate versions, there would be a reconciliation of those versions for final approval.

This is set so the Senate can vote on a straight majority of 51 votes, with the Vice President casting the deciding vote if necessary. There is still a lot of negotiation to be done so that this bill can get approval from the Democrats in the Senate.

These are our first real pieces of legislation out of the House to explain how they want to pay for President Biden's plans for green energy and family support.

HOST: Much more horse-trading remains, but there is more knowledge to be gained by seeing the detailed draft legislation. Can we backtrack briefly on the $1.2 trillion plan? What are the major tax consequences contained in that bill?

SARAH MCGREGOR: There were not a significant number of tax increases in that bill, as it was designed more toward spending. One area of focus is virtual currency and increased information reporting.

That has caused some general concern in the industry regarding compliance. It is designed to help provide more information and squeeze the tax gap between what taxpayers should be paying and what they are actually paying.

HOST: Wasn't there also an Employee Retention Credit provision in there?

SARAH MCGREGOR: That's right. The Employee Retention Credit (ERC), brought into being by the CARES Act, would be stopped as of September 30.

Right now, it is set to expire on December 31. However, if the $1.2 trillion infrastructure bill is passed as written, it will terminate the ERC as of September 30.

HOST: Let's go back to the $3.5 trillion infrastructure bill. Corporate tax rate increases are the single largest line item as scored by the Joint Committee on Taxation.

The rates deviate from the prior proposals of a flat rate increase. We are currently at a flat rate, but this proposes moving toward a graduated rate system.

It would be 18% for the first $400,000, 21% from there to $5 million, and 26.5% thereafter. At $10 million, you start reaching back to recapture the benefit of the lower brackets. Personal service corporations notably would have the high 26.5% bracket.

SARAH MCGREGOR: This is certainly better than the 28% originally proposed by the American Jobs Plan. It is also better than the 21% for those corporate entities earning less than $400,000 of taxable income.

While it raises the overall tax rate to 26.5%, that is still better than the 35% we saw before the TCJA. It does seem more equitable with this progressive approach for smaller taxpayers.

HOST: Let's move to high-income individuals. This section is aimed toward those in the highest brackets. Together, these proposals are almost double the effect of the corporate tax rate increase.

To no surprise, they are introducing a highest bracket of 39.6%. The levels are $450,000 for joint taxpayers, $400,000 for singles, and $12,500 for estates and trusts, effective in 2022.

SARAH MCGREGOR: This 39.6% rate is applied at a level below where the American Families Plan had proposed. Under Biden's plan, it was going to start around $500,000 for married filing jointly, and this drops it to $450,000.

The other factor is the small gap between single filers and married filers. With only a $50,000 income difference, this brings back what many call a marriage penalty. Married couples may pay at a higher overall rate than two single people would on the same amount of taxable income.

HOST: Let's talk about capital gains. They have proposed raising the rate from 20% to 25% for long-term capital gains, which also captures qualified dividend income.

SARAH MCGREGOR: This is a relief compared to earlier discussions of moving the rate to 39.6%. That is going to be beneficial to taxpayers who have large long-term capital gains.

HOST: Regarding the effective date, what do you see there?

SARAH MCGREGOR: The Green Book suggested that the effective date would be back in April. With this proposed legislation, the 25% rate is effective after the date the legislation was introduced, which appears to be September 13. This effective date has already passed and does not leave space for taxpayers to plan.

HOST: Capital gains rates also have a direct interplay with the carried interest rules. How do you see that happening?

SARAH MCGREGOR: For high-income earners, the required holding period to get long-term capital gains rates is moving from three years to five years. There are a couple of exceptions for real estate businesses and for those in the lower income brackets.

HOST: There was a provision regarding Section 1202 here as well.

SARAH MCGREGOR: For high-income earners, the 75% or 100% gain exclusions will not be available. There will continue to be a 50% gain exclusion for all taxpayers, but higher exclusions are not available for those earning more than $400,000 or $450,000.

HOST: Notably, provisions to limit like-kind exchanges did not appear in this draft. There is no provision in here to limit the availability of like-kind exchanges as we saw in some of the prior proposals.

Let's move on to the net investment income tax. They have expanded that to all business income for those in the high-income category.

SARAH MCGREGOR: For high-income earners with income from pass-through entities, this is significant. For S corporations, it has long been understood that distributions of income are not self-employment income.

If you were active in the S corporation business, you were not subject to the net investment income tax. This proposal is designed to level the playing field so everyone pays either the net investment income tax or the self-employment tax.

There is also a surprise provision allowing S corporations to have a tax-free reorganization into partnerships for a temporary period. It must be a special provision designed for a specific group, though it is not yet clear who.

HOST: Regarding the Section 199A deduction, also called the 20% pass-through income deduction, they are essentially disallowing this for high-income individuals.

SARAH MCGREGOR: This is going to be a real penalty for pass-through businesses that turn out large amounts of income to their owners. When looking at these profitable closely held businesses, the owners are really going to be impacted.

You have an increase in tax rates, limitation on the Section 199A deduction, an increase in the net investment income tax, and a 3% surcharge tax. Owners may need to think about whether to move back to a C corporation setting depending on whether they distribute all income.

HOST: They also included the disallowance of excess business losses for non-corporate taxpayers. As you alluded to, there is a new 3% surcharge on all adjusted gross income over $5 million for joint filers and $2.5 million for single filers.

SARAH MCGREGOR: There were ideas floating around about a wealth tax based on assets. This may be a nod in that direction. It is still an income tax, but it will hit those recognizing significant amounts of wealth on a tax return.

HOST: Regarding the estate and gift tax provisions, the proposal reverses the increased exemption and goes back to $5 million per individual. This moves away from the complicated capital-gains-at-death concepts introduced in prior proposals.

However, they are proposing to eliminate valuation discounts for non-business assets. This takes a strike at common family limited partnership techniques. They are also proposing the inclusion of assets that are in a grantor trust, such as intentionally defective grantor trusts.

SARAH MCGREGOR: For individuals who have not already used their current $11.7 million exemption, they should really think about doing something now. These proposed changes in trusts and valuations warrant taking a look even if you are not at that highest estate value.

HOST: There were also changes regarding retirement plans for high-net-worth individuals.

SARAH MCGREGOR: If you have over $10 million in your retirement plan balances, no further IRA contributions are allowed. There is also a potential for a substantial increase in required minimum distributions each year.

They are also proposing to eliminate "backdoor" Roth conversions for high-income taxpayers. I think they are looking at this more holistically now because there is huge leakage of tax as these Roth accounts continue to build up. There are also provisions limiting the assets you can own in an IRA.

HOST: Sarah, what about other provisions before we get to the international section?

SARAH MCGREGOR: I would highlight a permanent extension and increase in allocation for New Markets Tax Credits, as well as enhancements to the rehab tax credits. In the R&D tax credit space, there is a referral on the requirement to amortize R&D costs.

Another interesting one relates to qualified conservation easements. It is applicable retroactively back to 2016 and 2018. It limits deductions to no more than 2.5 times the investment.

HOST: Now we will move on to the international tax provisions with Brian Dill. International tax provides a lot of the revenue to offset infrastructure costs. Brian, why don't you give a big-picture overview?

BRIAN DILL: International is a big revenue raiser. They are continuing to narrow the ability for companies to earn money offshore in foreign subsidiaries without bringing that money back for US taxation.

They are also limiting your ability to get a foreign tax credit for taxes paid overseas. When you combine rate increases with credit disallowance, global effective rates could jump from 21% to 40% or 45%.

HOST: What about FDII (Foreign-Derived Intangible Income)?

BRIAN DILL: FDII allowed exporters to obtain a special deduction. The House Ways and Means plan would keep it but limit the deduction amount. The effective rate on FDII would be 20.7% instead of the current 13.125%.

HOST: What about GILTI (Global Intangible Low-Taxed Income)?

BRIAN DILL: GILTI is essentially anti-deferral. Currently, you might pay a 10.5% tax rate. Under the House Ways and Means proposal, that would move to 16.5%.

Crucially, the exemption for having tangible property overseas would be reduced from 10% to 5%. Also, GILTI would become a jurisdiction-by-jurisdiction test. If you made money in Thailand but lost money in the UK, you would no longer be able to offset those two.

In addition, they want to impose country-by-country foreign tax credits. You would not be able to offset UK taxes against your Thai taxes.

HOST: Can you touch briefly on BEAT?

BRIAN DILL: The Biden administration looked at replacing BEAT with SHIELD (Stopping Harmful Inversions and Ending Low-Tax Developments). This would make payments to low-tax jurisdictions non-deductible.

The House Ways and Means is taking a different approach by changing the BEAT rules to be tighter. More Middle Market companies would be drawn in as they lower the thresholds. They also want to tighten anti-inversion rules to make it more difficult to achieve foreign parent status.

HOST: Do you have any final comments on the international tax provisions?

BRIAN DILL: Currently, companies with offshore profits can use the dividends received deduction to bring money back tax-free. The Biden administration is looking at eliminating that, and the House version would limit it to controlled foreign corporations.

These proposals are very dramatic in the extent of the changes they will make to tax law. We encourage people to start proactive planning sooner rather than later.

SARAH MCGREGOR: There are many opportunities to consider and a lot of detail in these plans. We will have to wait to see what survives the legislative process.

HOST: It is beneficial to see the legislative language and get more clarity on what is being proposed. We encourage people to look at the bigger ticket items and plan accordingly.

That concludes today's podcast. Thank you for listening to our discussion on the potential provisions contained in the House Ways and Means reconciliation bill.

As a disclaimer, we are not providing tax advice on this podcast. Please consult with your tax advisor, hopefully at Cherry Bekaert, regarding your specific tax issues. Check the firm's website at cbh.com for the latest guidance. Thank you, Sarah and Brian, and thank you to our listeners. Please like, subscribe, and share.