Reconciliation Bill’s Tax Provisions Take Shape

On October 28, 2021, the Biden Administration released the revised “framework” for its tax and social spending initiative -- the Build Back Better Act. The product of much political negotiation, this $1.85 trillion “reconciliation” legislation is considerably smaller than the earlier $3.5 trillion version. This framework (and the related statutory language) is significant in what it no longer includes – e.g., corporate and individual tax rate increases (other than the individual surcharges and the corporate alternative minimum tax noted below), capital gain rate increases, restrictions on carried interests, tightened estate and gift tax rules, rules on grantor trusts and restrictions on certain individual retirement accounts (IRAs). A recently discussed so-called “billionaires’ tax,” which would have forced taxpayers with a $1 billion net worth or $100 million of applicable adjusted gross income for each of three years to pay taxes on their unrealized gains every year, was also not included. And, the proposed legislation still does not address changes to the existing $10,000 cap on the deductibility of state and local taxes.

The following is a summary of the highlights of tax provisions of the Build Back Better Act legislation:

Tax Increases for High-Income Individuals

• Tax Rates
  • Under the proposed legislation, there is no increase in personal income tax or capital gain rates for high-income individuals; rather, there are other mechanisms set forth in the legislation that serve to effectively increase the tax rates applied to many high-income individuals.
  • For taxable years beginning after December 31, 2021, a surcharge would be imposed in the case of a taxpayer other than a corporation in the amount of 5% of modified adjusted gross income (AGI) in excess of $10 million ($5 million for a married individual filing separately and $200,000 in the case of an estate or trust). Modified AGI is AGI reduced by any deduction for investment interest.
  • An additional 3% surcharge (bringing the total surcharge to 8%) would be imposed on modified AGI in excess of $25 million ($12.5 million for a married individual filing separately and $500,000 in the case of an estate or trust), effectively bringing the federal income tax rate on such income to 45%, not taking into account any net investment income tax (NIIT).
    Observation: Because the surcharge applies to modified AGI in excess of the applicable thresholds, the surcharge would apply to ordinary income and capital gain without any decrease for itemized deductions, including charitable contributions, which many high earners make during the year.
    Installment sale treatment for certain transactions may become more prevalent as a mechanism to spread out income. Since charitable trusts are not impacted by this surcharge, they may be useful as well in planning.
    Many trustees would be faced with the decision to make distributions to trust or estate beneficiaries in order to minimize or even avoid the entity’s exposure to the surcharge.
    This surcharge would not be treated as a “tax” for purposes of computing any AMT credit.
• Net Investment Income Tax
  The NIIT would be extended to cover net investment income derived in the ordinary course of a trade or business for individuals with taxable income of greater than $400,000 ($500,000 for individuals filing a joint return and $250,000 for a married individual filing separately), as well as for trusts and estates. This would apply to taxable years beginning after December 31, 2021, subject to a transition rule.

Observations: Under current law, the NIIT applies only to passive investment income (interest, dividends, gain on the sale of stock, etc.). In effect, this legislation is taxing more than investment income, causing the first “I” of NIIT to essentially become moot. By taxing active income, the legislation is broadening the reach of this tax to pass-through owners that are active in the business if they are over certain taxable income levels, causing an additional 3.8% tax on this income.

S corporations may lose some of their appeal in certain situations due to the application of the NIIT to S corporation income allocated to high-income shareholders.

• Excess Business Losses
  • The bill would permanently disallow “excess business losses” (i.e., net business deductions in excess of business income above certain thresholds) for non-corporate taxpayers. The provision would allow taxpayers whose losses are disallowed to carry those losses forward to the next succeeding taxable year. This provision would apply to taxable years beginning after December 31, 2020.

Modification of Rules Relating to Retirement Plans

• Individual Retirement Accounts Holding Shares in a DISC or FSC
  • The legislation would close a loophole that allows an IRA to hold an interest in a DISC or a foreign sales corporation (FSC) that receives a commission from an entity whose ownership included the individual for whose benefit the IRA was established. Under current law, the related entity obtains a tax deduction for the commission, while the IRA receives non-taxable income.
  • The proposal would deem the transaction prohibited for purposes of assessing a 15% tax on the amount involved pursuant to IRC Sec. 4975. The provision would apply to stock held or acquired on or after December 31, 2021.

General Business Provisions

• Corporate Alternative Minimum Tax
  • The bill would impose a minimum tax of 15% on any corporation (other than an S corporation, RIC or REIT) which has, over an applicable three-taxable year period, average annual adjusted financial statement income greater than $1 billion, or $100 million in the case of a corporation that is a member of an international financial reporting group the common parent of which is a foreign corporation. The bill would generally permit carryover of financial statement losses for the purposes of the tax and would also generally permit the application of foreign tax credits. The tax would be effective for taxable years beginning after December 31, 2022.

Observation: This provision is consistent with the OECD proposal to implement a global minimum tax rate, which was endorsed at the Rome G20 meeting in October, 2021.

• Excise Tax on Repurchase of Corporate Stock
  • The bill would impose a non-deductible tax on any covered corporation (a corporation the stock of which is traded on an “established securities market,” within the meaning of IRC Sec. 7704(b)(1)), equal to 1% of the fair market value of any stock of the corporation repurchased by the corporation or certain affiliates during the taxable year. The tax would also be imposed in connection with repurchases of stock of foreign corporations in certain circumstances. The tax would apply to repurchases of stock after December 31, 2021.
• IRC Sec. 1202 (Qualified Small Business Stock)
  • The 75% and 100% exclusion rates for gains realized from the sale of certain qualified small business stock would not apply to taxpayers with AGI of $400,000 or more (and in the case of trusts and estates the new rule would be applied without regard to any income threshold). This change would also potentially have the effect of some of the gains on the disposition of qualified small business stock becoming subject to the alternative minimum tax (AMT). This change would be applicable to sales and exchanges after September 13, 2021, subject to a binding contract exception.

Observations: Although the bill reverts back to a 50% exclusion on all qualifying sales after the effective date, the effective benefit of IRC Sec. 1202 would be reduced by approximately two-thirds, further subject to any AMT impacts. This is because (i) pursuant to IRC Sec. 1(h), the taxable portion of the gain is taxed at a 28% rate, and (ii) the 3.8% NIIT would apply on the non-excluded portion.

A similar provision was proposed in the earlier Ways & Means Committee version.

• Worthlessness of Partnership Interests, Partnership and Corporate Securities
  • The bill would change the date when a loss for worthless securities can be claimed under IRC Sec. 165(g) from the last day of the year to the date of the identifiable event that establishes the worthlessness. The bill would also apply similar rules to partnership interests and partnership securities and would extend sale or exchange treatment to worthless partnership interests. The changes would apply to taxable years beginning after December 31, 2021.
    Observation: A similar provision was proposed in the earlier Ways & Means Committee version.
• Taxable Liquidations of Corporate Subsidiaries
  • The bill would amend IRC Sec. 267 (Losses, Expenses, and Interest with Respect to Transactions Between Related Taxpayers) to defer recognition of loss realized by a parent corporation on a taxable liquidation of the subsidiary corporation until the parent corporation disposes of substantially all property received in the liquidation to a third party. The changes would apply to liquidations occurring on or after the date of enactment.
    Observation: A similar provision was proposed in the earlier Ways &Means Committee version.
• Tax-Free Divisive Reorganizations
  • The bill would limit the ability of a distributing corporation to avoid gain in connection with a divisive reorganization where the controlled corporation’s stock or debt securities are transferred to creditors of the distributing corporation. The changes would apply to reorganizations occurring on or after the date of enactment, subject to certain transition rules.
    Observation: A similar provision was proposed in the earlier Ways & Means Committee version.
• Cryptocurrencies
  • The bill would extend the IRC Sec. 1259 constructive sale rules and IRC Sec. 1091 wash sale rules to digital assets, such as cryptocurrencies. In addition, IRC Sec. 1091 would be extended to commodities and currencies and would be modified in certain additional respects. The changes to IRC Sec. 1259 would generally apply to constructive sales after the date of enactment. The changes to IRC Sec. 1091 would generally apply after December 31, 2021.
    Observation: A similar provision was proposed in the earlier Ways & Means Committee version.
• IRC Sec. 52 Common Control
  • The bill would clarify the definition of trade or business for the purpose of IRC Sec. 52, for years beginning after December 31, 2021.
• Credit for Clinical Testing of Orphan Drugs
  • The bill would amend certain credits for clinical testing of orphan drugs, for years beginning after December 31, 2021.
• Treatment of Certain Partnership Interest Derivatives
  • The bill would amend IRC Sec. 871(m) (Treatment of Dividend Equivalent Payments) to provide that any payment made pursuant to a specified notional principal contract with respect to an interest in a publicly traded partnership (and other partnerships as provided in regulations) is to be treated as a dividend equivalent. The provision would apply rules similar to the other paragraphs of IRC Sec. 871(m). The provision would apply to payments made after December 31, 2022.
• Modifications to Limitation on Deduction of Excessive Employee Remuneration (IRC Sec. 162(m))
  • An aggregation rule would be added requiring two or more persons who are treated as a single employer under IRC Sec. 414 to be treated as a single employer for purposes of IRC Sec. 162(m). The brother-sister controlled group and combined group rules of IRC Sec. 1563(a) would not apply.
  • The bill would also expand the IRS regulatory authority, as well as expand the definition of employee remuneration covered under the statute to include performance-based pay, commissions, post-termination compensation and beneficiary payments whether or not paid directly by the publicly traded company. The effective date of the provision would be for tax years beginning after December 31, 2021.
• Research and Experimental Expenditures
  • The Tax Cuts and Jobs Act of 2017 provided for amortization of research and experimental expenditures starting with taxable years beginning after December 31, 2021. Under this provision, amortization of research and experimental expenditures would begin for amounts paid or incurred in taxable years beginning after December 31, 2025.
    Observation: A similar provision was proposed in the earlier Ways & Means Committee version.

Funding the Internal Revenue Service and Improving Taxpayer Compliance

• Increases to IRS Funding – The bill would appropriate nearly $80 billion to the IRS over the next ten years as follows:
  • $1.9 billion for taxpayer services
  • $44 billion for IRS enforcement, including funding to support litigation, criminal investigations and cryptocurrency monitoring and compliance
  • $27 billion for operations support
  • $4.75 billion for business systems modernization including development of call-back technology
  • $15 million for a task force to determine how to create an IRS-run free “direct efile” tax return system
  • $403 million for the Treasury Inspector General for Tax Administration
  • $104 million for the Office of Tax Policy to promulgate regulations under the Internal Revenue Code
  • $153 million for the United States Tax Court

The proposed funding is not intended to increase the tax of a taxpayer with a taxable income below $400,000.

The bill would require the IRS Commissioner to submit a plan to Congress within six months after enactment on how the appropriated funds will be spent, followed by quarterly updates on progress and challenges. Failure to submit the plan or required quarterly reports would result in a $100,000 per day reduction in appropriated amounts.

Observation: The IRS has also begun to expand its workforce and technical expertise, hiring more specialized resources for its enforcement function. With the approval of additional funding, a significant rise in IRS enforcement activity can be expected.

• Back-up Withholding on Third-Party Network Transactions
  • The bill would expand the definition of “reportable payments” subject to withholding to include payments in settlement of third party network transactions where the aggregate payment during the calendar year is $600 or more. The proposal would apply to calendar years beginning after December 31, 2021, subject to a transitional rule for 2022.
• Modification of Procedural Requirements Relating to Assessment of Penalties
  • The bill addresses the highly litigated issue of managerial approval for penalty assessment and would replace the requirement with quarterly certifications of compliance by appropriate supervisors of employees, effective beginning after the date of enactment.
    Observation: The requirement for supervisory approval of penalties was put in place to ensure that penalties are properly assessed and not used to encourage taxpayers to resolve an issue. The proposal appears to go against the provision’s original intent.

International Tax Provisions

• Interest Expense Limitations
  • The bill would limit interest deductibility for domestic corporations that are members of an international financial reporting group. The proposal would limit the deductible interest expense of a multinational group’s U.S. operations and would generally take into account the ratio of the domestic corporation’s earnings before interest, taxes, depreciation, depletion and amortization (EBIDTA) to the worldwide group’s EBIDTA.
  • The proposal would modify the existing IRC Sec. 163(j) limitation to apply at the partner, rather than partnership, level. Additionally, the bill would limit the carryover period for amounts disallowed under IRC Sec. 163(n) or 163(j) to five years. For these purposes, interest would be allowed as a deduction on a first-in, first-out basis. It would apply to taxable years beginning after December 31, 2022. There is a special transition rule for partnerships.
• Rate Changes
  • The bill would reduce the IRC Sec. 250 deduction for foreign-derived intangible income (FDII) to 24.8% (from 37.5%), resulting in an effective rate of 15.8% on FDII, and the IRC Sec. 250 deduction for GILTI (and the associated IRC Sec. 78 gross-up amount) to 18.5% (from 50%). Combined with a 5% haircut on GILTI foreign tax credits (reduced from 20% under current law), this deduction would produce an effective tax rate on GILTI income of 15.8%. These changes to the IRC Sec. 250 rates would be effective for tax years beginning after December 31, 2022. However, the bill includes a transition rule for tax years that include December 31, 2022. Like the Ways & Means Committee version, the bill would remove the existing taxable income limitation on the IRC Sec. 250 deduction and instead permit the IRC Sec. 250 deduction to be taken into account in determining a taxpayer’s net operating losses.
• GILTI
  • The proposal would require a U.S. shareholder to compute its GILTI inclusion on a country-by-country basis by aggregating the items (e.g., net CFC tested income, qualified business asset investment (QBAI), etc.) of taxable units within a single foreign country and computing a separate GILTI amount for each country.
• Foreign Tax Credit (FTC) Limitation
  • The proposal would determine a U.S. shareholder’s FTC limitation for all baskets on a country-by-country basis.
    Observation: This would prevent excess FTCs from high-tax jurisdictions from being credited against income from low-tax jurisdictions.
• Covered Asset Dispositions
  • The proposal would extend the principles of IRC Sec. 338(h)(16) to transactions treated as an asset disposition for U.S. tax purposes but as a stock disposition (or disregarded) for foreign tax purposes. Consequently, the source and character of any item resulting from a covered asset disposition would be determined for FTC purposes as if the seller had sold or exchanged stock (determined without regard to IRC Sec. 1248). This could result in a loss of FTCs because the source of the gain would be considered U.S. This would apply to taxable years beginning after December 31, 2021.
• Dividends from Foreign Corporations
  • The proposal would limit the IRC Sec. 245A deduction to dividends received from CFCs, whereas current law allows the deduction for dividends received from “specified 10%-owned foreign corporations.” The proposal would apply to distributions made after enactment. U.S shareholders of a foreign corporation could jointly elect, however, to treat a foreign corporation as a CFC for purposes of this rule (and for the purposes of GILTI and subpart F).
• BEAT
  • The proposal would significantly modify IRC Sec. 59A while retaining its general framework. The bill would amend the BEAT rate to 10% for tax years beginning after December 31, 2021, and before January 1, 2023; 12.5% for tax years beginning after December 31, 2022, and before January 1, 2024; 15% for tax years beginning after December 31, 2023, and before January 1, 2025; and 18% for tax years beginning after December 31, 2024. Special rules would apply to certain taxpayers.
• Reinstate Prohibition on Downward Attribution
  • The proposal would reinstate IRC Sec. 958(b)(4) to prohibit downward attribution from a foreign corporation and add new IRC Sec. 951B to more narrowly allow downward attribution only to foreign-controlled U.S. corporations.
  • The literal language in the bill, unlike the earlier Ways & Means Committee version, does not appear to be retroactive to December 31, 2017, but prospective only. It is not clear if this was intended.
• Limitation to the Portfolio Interest Exemption
  • For purposes of disallowing the portfolio interest exemption for interest received by a “10-percent shareholder,” the bill would modify the definition of “10-percent shareholder” with respect to corporations under IRC Sec. 871(h)(3)(B)(i) to include ownership by value. The provision would apply to obligations issued after the date of enactment.
• Certain Dividends from CFCs to U.S. Shareholders Treated as Extraordinary Dividends
  • The bill would add a new IRC Sec. 1059(g), providing that any disqualified CFC dividend is treated as an extraordinary dividend without regard to the period the taxpayer held the stock to which such dividend relates. The rule would apply to any dividend paid by a CFC if such dividend is attributable to earnings and profits that were earned while such foreign corporation was not a CFC or attributable to disqualified CFC dividends received by a CFC from another CFC. This provision would apply to dividends paid (or amounts treated as dividends) after the date of enactment.
• Extension of Supplemental Security Income to Certain U.S. Territories
  • The bill would extend the Supplemental Security Income program to Puerto Rico, the United States Virgin Islands, Guam and American Samoa.

EisnerAmper will continue to keep you informed of this important tax legislation as developments warrant.

Contributors to this article include Harold Adrion, Stanley Barsky, Miri Forster, Jeffrey Kelson.