The House-Approved Build Back Better Act: Issues Affecting Individuals
President Biden laid out an ambitious agenda in his State of the Union address and FY 2022 budget plan earlier this year, and the Democratic-controlled Congress continues to work to enact that agenda in 2021. After pandemic-relief legislation became law in early spring, Congress then moved on to infrastructure legislation, which was enacted on November 15, 2021.
The major legislation in 2021 with respect to tax issues, however, is the Build Back Better Act (BBBA), which includes many of the key Biden agenda items, including provisions targeting large corporations and high-income individuals, middle-class tax relief, tax incentives and new spending on traditional infrastructure projects and “human” infrastructure initiatives, as well as proposals to address climate change. The BBBA is being considered pursuant to the Fiscal Year 2022 budget resolution that provides for budget reconciliation legislation to be advanced with these tax and spending proposals.
On November 19th, the House approved the BBBA, H.R. 5376, by a vote of 220-213 on party lines with one Democrat voting against the bill. The $1.7 trillion bill includes a package of targeted individual tax relief, clean energy incentives, and increased spending on healthcare, education, childcare, and other programs. The legislation now goes to the Senate for consideration, where changes are expected to be made to many of the bill’s provisions. Some of the provisions that are expected to meet challenges in the Senate include paid family leave, the cap on the deduction for state and local taxes (SALT), immigration reform, and IRS enforcement.
This True Insight provides details of the House-approved version of the BBBA with respect to individual tax issues. Part 2 of our summary of the BBBA provisions will provide details about the business tax and international tax provisions included in the bill. In a future True Insight, we will provide details on the clean energy tax incentives included in the BBBA.
Status and Timeline for the Budget Reconciliation Legislation
The Senate began working on the BBBA on Monday, November 29th, when they returned to Washington from the Thanksgiving recess. Senate Democratic leadership is expected to negotiate modifications to the bill with members of their caucus including Senator Manchin (D-WV) and Senator Sinema (D-AZ), who have been key players in the development of this legislation. The Senate process of revising and debating the bill is not expected to go quickly, but the goal is to gain Senate approval prior to the end of the year.
The BBBA will be considered on the Senate Floor under budget reconciliation instructions that set limits on the overall time for debate. Amendments are expected to be offered on the Senate Floor during debate by Democrats like Senate Manchin in addition to Republicans who nevertheless are expected to oppose the bill. The reconciliation process allows for passage of the legislation by a simple majority vote because it cannot be filibustered on the Senate Floor, in which case it could only be stopped by a 60-vote majority. With a 50-50 split in the Senate, and with the Vice-President breaking a tie, it will be necessary for all Democratic Senators to support the Senate bill since Republican support is unlikely.
TPC Observation: There are a number of issues that the Senate must resolve before the bill reaches the Senate Floor. Senator Manchin opposes the paid family leave proposal, while other Senate Democrats oppose the approach taken to resolve the state and local tax (SALT) deduction cap. SFC Chair Wyden continues to suggest that he may want to add tax increase measures to the bill, such as his mark-to-market “billionaires income tax” proposal.
Some provisions may run afoul of the “Byrd Rule,” which allows Senators to object to specific provisions that they believe are not germane to the budget. Objections are ruled on by the presiding officer, with advice from the Senate Parliamentarian, and a 60-vote majority is required to overturn the ruling. Some changes were made to the House version of the bill before the vote on the House Floor in anticipation of possible challenges under the Byrd Rule based on discussions with the Senate Parliamentarian.
After a Senate version of the legislation has been approved, the House must vote again on the Senate’s version before the final bill can be sent to President Biden for his signature.
With less than one month remaining in 2021, Congress is facing a full schedule of issues that must be dealt with before the end of the year, which could complicate the completion of the BBBA. Those issues include a FY 2022 government funding package, an increase in the debt ceiling limit, and approval of the National Defense Authorization Act legislation.
Failure to complete the BBBA in 2021 will make its approval more challenging. Since 2022 is an election year, politics will become an even greater complicating factor in 2022 than it is now. However, Congress has passed major legislation in an election year before, most recently with Obamacare in 2010. Also, some of the policies included in the BBBA are existing tax laws that are set to expire at the end of 2021, such as the child tax credit. It is also worth noting that many of the effective dates in the BBBA are January 1, 2022, which will need to be revised if enactment occurs after that date.
TPC Observation: Uncertainty about whether the BBBA will be enacted on or before December 31, 2021 makes year-end tax planning extremely difficult, particularly for transactions that would be impacted by provisions in the BBBA that may become effective on January 1, 2022. Taxpayers who are currently planning for non-urgent transactions should consider waiting to solidify plans after the BBBA is enacted in order to make strategic and well-informed decisions.
Taxpayers looking to execute transactions before year end should be working with their tax advisor to determine whether the potential law changes would impact the ideal transaction structure, and if so, quantify the results and craft alternate transaction plans in order to execute the optimal version on or before December 31, 2021, depending on whether the bill is enacted before that date.
TPC Observation: For corporate taxpayers, the question of whether the enactment date of the BBBA occurs in 2021 or 2022 has a significant effect on their accounting for income taxes, which must be reflected in the company’s financial statements in the period containing the enactment date. The impact also depends on whether the company has yet adopted ASU 2019-12.
Revenue Estimates of the Bill: The Congressional Budget Office and the Joint Committee on Taxation
Several members of the House Democratic caucus refused to vote on the legislation until the Congressional Budget Office (CBO) completed its estimate of the revenue effects of the bill over a 10-year period (as required by the budget reconciliation rules). CBO did release their revenue estimate on the bill and projected an overall net cost of $1.7 trillion and an increase in the federal deficit of $367 billion over the 10-year period from 2022 through 2031.
The CBO deficit projection does not include estimated savings of $207 billion from the proposed $80 billion in increased IRS enforcement funding. Accounting for those savings would reduce the deficit increase from $367 billion to $160 billion. The Treasury Department has projected that the increased IRS compliance efforts would raise $480 billion in increased revenue, and thus would decrease the deficit by $113 billion rather than increase it.
The Joint Committee on Taxation (JCT) released their revenue estimate of the BBBA on November 19, 2021, and it states that the bill will have a net effect of raising more than $946 billion from 2022 through 2031. The JCT estimate found that the tax title including the revenue offsets for the bill would raise more than $1.4 trillion during that period.
If the overall cost of the legislation decreases due to Senate amendments, then it is expected that the total package of revenue offsets will also decrease either by dropping or modifying proposals. Under the FY 22 budget resolution’s reconciliation instructions, only provisions that come from the tax-writing committees must be fully offset.
Senator Manchin has questioned some of the revenue estimates for spending provisions that are temporary, such as the one-year extension of the child tax credit through the end of 2022. The White House and Congressional Democrats have stated their intention to extend some of the temporary credits like the child tax credit beyond what is included in the bill, raising the issue of whether those future extensions should be taken into account now.
Overview of the House Bill
In action earlier this fall, the House Committee on Ways & Means approved the tax title of the BBBA, including corporate, individual, and capital gain rate increases, changes to outbound and inbound international tax provisions, and several provisions affecting high-income individuals, pass-through businesses, and estates and trusts. Prior to House Floor action, however, this tax title was significantly modified with many of these proposals dropped altogether in order to meet the demands of Senate Democrats, such as Senators Manchin and Sinema, who threatened to oppose the bill once it reached the Senate.
The House-approved legislation does include several business and international tax increase provisions, including a new 15% corporate book income-based minimum tax on large corporations, a new 1% tax on corporate stock repurchases, limitations on interest deductions of international financial reporting groups, and modifications to inbound and outbound international provisions. The international provisions include changes to global intangible low-taxed income (GILTI), foreign-derived intangible income (FDII), foreign tax credit (FTC) rules, the base erosion and anti-abuse tax (BEAT), and subpart F income. The BBBA also includes extending the immediate deduction of research and experimental costs under Section 174 through the end of 2025, rather than allowing it to expire for tax years after 2021 under current law, which would result in taxpayers having to capitalize and amortize those costs over a 5-year period rather than claim an immediate deduction.
Individual tax increase provisions include a new surtax on high-income individuals and trusts, expansion of the net investment income tax, limitations on qualified small business stock exclusions, wash sale rules on cryptocurrency, and a permanent extension with modifications of the current-law temporary limitation on excess business losses.
The House bill also includes several incentives for clean energy, including an advanced manufacturing investment credit, an advanced manufacturing production credit, clean electricity production and investment credits, and a clean fuel production credit.
Significant Exclusions from the House Bill
A number of revenue raisers had been discussed that would have had a significant effect on the taxation of wealth and large corporations in the US, but were ultimately excluded from the House version of the bill. Those proposals included:
Taxation of Individuals
- An increase in the top marginal tax rate on ordinary income
- An increase in the top long-term capital gains rate for taxpayers in the highest ordinary income tax bracket
- Changes to the treatment of carried interest
- An acceleration of the 50% reduction to the estate and gift tax exclusion amount and the generation skipping transfer tax exemption
- Fundamental changes to the grantor trust rules, which would have resulted in gain recognition on previously tax-free transactions and the application of the estate and gift taxes to assets held in and distributed from grantor trusts covered by the post-enactment rules
- Changes to the 20% Section 199A deduction for pass-through income
- The imposition of investment restrictions on IRAs that would prevent retirement accounts from holding certain assets, such as private placement investments and investments in entities in which the account holder owns substantial interests either directly or constructively
Taxation of Business
- An increase in the corporate tax rate
- Bank reporting requirements
TPC Observation: The package of estate tax proposals that was dropped from the Ways and Means Committee-approved bill would have significantly changed long-standing wealth transfer planning techniques, especially through the use of grantor trusts. Note that although the proposal to reduce the estate and gift exemption starting in 2022 was dropped, under current law, the exemption is scheduled to drop back to $5.49 million from the current $11.2 million after 2025.
Although it appears that these proposals are unlikely to be added to the Senate version of the bill due to the opposition of Senator Sinema and possibly other Democrats, taxpayers should take note of the serious consideration that was given to them, which could signal that they will be raised again in future legislation.
TPC Observation: Many of the provisions that were discussed but ultimately excluded from the House bill would have negatively impacted private equity M&A transactions, including the proposals to increase the capital gains rate and change the treatment of carried interest. However, Senator Wyden made similar recommendations in his proposal earlier this year and thus one or more of those revenue-raising provisions may end up in the Senate’s version of the bill.
Imposition of a Surtax on High-Income Taxpayers
The BBBA would impose two surcharges on high-income individuals, estates and trusts effective after December 31, 2021. A new 5% tax would be imposed on a taxpayer’s modified adjusted gross income (AGI) in excess of $10 million ($5 million for a married individual filing separately) and an additional 3% tax on a taxpayer’s modified AGI in excess of $25 million ($12.5 million for a married individual filing separately). The new surtax would be effective in 2022.
Modified AGI does not include below-the-line deductions, including the charitable deduction, mortgage interest deduction, and the state and local tax deduction. It also does not include the 20% Section 199A deduction, since that is an adjustment used to arrive at taxable income.
TPC Observation: This provision might impact partnerships that make tax distributions if their allocation of income to any partner would subject them to the surtax, in which case they may need to increase the payments to each partner to ensure pro rata distributions.
Expansion of the 3.8% Tax on Net Investment Income
The Net Investment Income Tax (NIIT) imposes a 3.8% tax on “net investment income” of individuals, estates, or trusts that have modified adjusted gross income above defined statutory thresholds. Net investment income includes interest, dividends, capital gains, rental and royalty income, nonqualified annuities, and income from businesses that are passive activities to the taxpayer.
For tax years beginning after 2021, the BBBA would subject all trade or business income of individuals earning over $400,000 for single filers, $500,000 for joint filers, and $13,050 for trusts to the 3.8% NIIT, unless that income is subject to self-employment tax. Under current law, active business income earned through pass-through entities is not subject to the NIIT.
The BBBA also provides that net operating losses (NOLs) will no longer be considered as a properly allocable deduction against net investment income. The new definition of net investment income would include certain deemed foreign income items such as subpart F inclusions, GILTI, qualified electing fund inclusions, and mark-to-market income, when they are includable as income for regular tax purposes.
TPC Observation: This change would now subject materially participating partners in entities structured as limited partnerships to the NIIT. Taxpayers may want to consider the fact that the NIIT is not deductible, while the self-employment Medicare tax is 50% deductible.
Limitation on Excess Business Loss Deduction for Noncorporate Taxpayers
The TCJA added Section 461(l) to the Code to limit the deduction of business losses incurred by noncorporate taxpayers with an expiration date at the end of 2025. Section 461(l) disallows a deduction for the amount of business losses in excess of $250,000 ($500,000 for joint filers), indexed for inflation, attributable to a trade or business in which the taxpayer actively participates.
As part of the pandemic-related Coronavirus Aid, Relief, and Economic Security (CARES) Act, this excess business loss limitation was repealed for tax years beginning before 2021, including retroactively for all tax years beginning after 2017.
The BBBA amends Section 461(l) to permanently disallow excess business losses (i.e., net business deductions in excess of business income above the specified thresholds) for noncorporate taxpayers for tax years after 2025, and it provides that carryforward losses would no longer be considered an NOL. Carryforward losses that are disallowed may be carried forward to future tax years and considered as part of that year’s limitation. The provision is effective for tax years beginning after December 31, 2020.
Expansion of the Wash Sale Rules – Digital Assets
Under current law, Section 1091(a) disallows a deduction for a loss realized from the sale or other disposition of stock or securities (or contracts to buy or sell stock or securities) if, within 30 days, the taxpayer acquires substantially identical stock or securities (or contracts). The BBBA expands the scope of the wash sale rules to include foreign currencies, commodities, digital assets such as cryptocurrencies, and contracts to buy or sell these assets beginning in 2022.
Note that the definition of digital assets is identical to that used in the recently enacted infrastructure bill with changes on reporting requirements. Prior to these bills, the term “digital asset” has not been previously used in the Code or regulations. Treasury is given broad authority to modify the definition.
There is a “business needs exception” that states that the wash sale rules would not apply to foreign currency and commodity trades that are directly related to the taxpayer’s business needs (other than the business of trading currencies or commodities) or are part of certain identified hedging transactions.
TPC Observation: The lack of a business needs exception could be a problem for businesses that receive digital assets like cryptocurrency as payment for goods and services or transact in these assets as part of the normal course of their trade or business, although some experts have suggested that bitcoin and ether are commodities. A planning tip to consider for commodity traders would be to make an election under Section 475 to “mark to market” their assets each year so that any resulting gain or loss is treated as ordinary income, since the wash sale rules do not apply to mark-to-market taxpayers.
There are “related party” rules that state that the wash sale rules would apply when a “related party” acquires substantially identical specified assets within the 30-day wash sale window. For this purpose, related parties generally include (1) the taxpayer’s spouse and dependents, (2) individuals or entities that control or are controlled by the taxpayer or their spouse or dependents, and (3) certain retirement and tax-advantaged accounts of the taxpayer or their spouse or dependents.
The “basis adjustment” rule would preserve any losses disallowed by the wash sales rules on an acquisition by the taxpayer or the taxpayer’s spouse by adding the disallowed losses to the acquirer’s basis in the asset. Losses disallowed as a result of other related party acquisitions, however, would be permanently disallowed.
Expansion of the Constructive Sale Rules – Digital Assets
Under current law, Section 1259 treats a taxpayer as having sold an appreciated position in stock, partnership equity, or certain debt if the taxpayer or a related person enters into certain offsetting transactions. The BBBA expands these rules to cover digital assets beginning after date of enactment of the bill. It also provides that an appreciated short sale, short swap, or short forward or futures contract is constructively sold when the taxpayer enters into a contract to acquire the reference property (not just when the taxpayer actually acquires the reference property as under current law).
Limitation on Gain Exclusion on Sales of Qualified Small Business Stock
Under current law, Section 1202 allows noncorporate taxpayers to exclude up to 75% or 100% (depending on the acquisition date) of their gain on a sale of certain “qualified small business stock” held for more than 5 years. The BBBA would eliminate the 100% (or 75%) exclusion rate for individuals with adjusted gross income equal to or exceeding $400,000 and for all trusts and estates regardless of income, allowing such taxpayers to be eligible for only up to a 50% exclusion. This change would apply for sales occurring on or after September 13, 2021, unless the sale occurs in 2021 pursuant to a binding contract entered into on or before September 13, 2021.
TPC Observation: This proposal may encourage taxpayers to use deferral mechanisms (e.g., installment sales) when selling small business stock in order to stay below the income threshold and maximize their exclusion.
Withholding on Partnership Derivatives
Under current law, Section 871(m) imposes a 30% withholding tax on US-source “dividend equivalent payments” under securities loans, repos, and certain high-delta swaps and other derivatives. The BBBA would expand the withholding tax to “income equivalent payments” under high-delta swaps on publicly traded partnerships and (2) any other partnership as the Secretary by regulation may prescribe. An “income equivalent payment” is any payment that is “determined by reference to income or gain in respect of” the partnership, or any other payment that the IRS determines is “substantially similar.” The BBBA also grants regulatory authority to issue regulations to carry out the purposes of the provision.
TPC Observation: This proposal may be challenging for taxpayers to comply with due to the fact that a partnership is not required to provide the Schedule K-1 to investors until the due date for filing the partnership tax return, and the Schedule K-1 is where the partnership discloses the investor’s allocable share of US-source dividends. Thus, it may be difficult to accurately withhold the necessary payments.
Modification of the Rules for Worthless Partnership Interests
The BBBA would modify the current law rules for worthless partnership interests. Under current law, taxpayers are permitted to claim a deduction under Section 165(a) for partnership equity that becomes worthless during the taxable year. Generally, taxpayers treat partnership equity worthlessness deductions as capital losses if they have a share of partnership liabilities, because a shift of partnership liabilities in connection with a partner’s departure results in a deemed sale. In all other cases, taxpayers may claim ordinary losses.
The BBBA would apply deemed sale treatment to all partnership equity worthlessness deductions so that taxpayers would have only capital losses instead or ordinary losses to the extent the deemed sale is attributable to inventory or other “hot assets.” The BBBA would also revise Section 165(g), which applies to worthless corporate securities, to treat partnership debt as “securities” and to treat all worthless securities deductions as arising at the time of the identifiable event establishing worthlessness instead of at the end of the year.
TPC Observation: To the extent that timing matters to a particular taxpayer (e.g., due to changes in ownership at the investor level), this proposal may pose challenges when a partnership becomes worthless due to a series of events since it may be unclear which one was the triggering event.
Individual Retirement Accounts (IRAs)
Under current law, taxpayers are allowed to set up Roth IRAs that allow distributions taken during retirement to be tax-free, including the earnings, as long as certain conditions are met. The BBBA includes several of the IRA provisions that were included in the Ways & Means Committee-approved bill, although it drops the restriction on the types of investments that can be held in an IRA.
The BBBA would prohibit contributions to a Roth or traditional IRA for a tax year if the total value of an individual’s IRA and defined contribution retirement accounts exceeds $10 million as of the end of the prior tax year. The proposal applies to single taxpayers (or married taxpayers filing separately) with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of households with taxable income over $425,000. Under current law, there are no contribution limits based on account balances. There is a new reporting requirement for employer defined contribution plans on aggregate account balances in excess of $2.5 million, both to the IRS and the plan participant whose balance is being reported. This provision is effective for tax years beginning after December 31, 2028, which was a change from the Ways & Means Committee-approved version that had an effective date of 2022.
The BBBA also increases the required minimum distribution (RMD) for taxpayers with aggregate balances exceeding $10 million at the end of a tax year with an effective date of 2029. It also expands the definition of a “disqualified owner” to include IRA owners for purposes of the prohibited transaction rules effective for transactions occurring after 2021.
Under the BBBA, taxpayers with an adjusted gross income over $400,000 ($450,000 for married filing jointly) will be prohibited from completing Roth conversions starting in 2032.
The bill also includes a general prohibition on “backdoor” Roth conversion of amounts held in qualified retirement plans, if any portion of the distribution that is being converted consists of after-tax contributions, which also eliminates the “Mega Roth IRA” technique. The provision is effective beginning in 2022.
State and Local Income Tax (SALT) Limitation Provision
Under current law, the deductibility of personal state and local taxes (SALT) against a taxpayer’s federal tax liability is capped at $10,000 through 2025. One of the key changes that was included in the BBBA in order to gain support of several members of the House Democratic caucus from high income tax states was an increase in the SALT deduction cap from $10,000 to $80,000 (and from $5000 to $40,000 in the case of an estate, trust or married individual filing a separate return) with an extension of the cap through 2030. This would be effective for tax years beginning after 2020. The current law caps of $10,000 and $5000 would be reinstated for 1 year in 2031 with the limitation sunsetting in 2032.
TPC Observation: TCJA included a number of provisions affecting the taxation of individuals that will expire after 2025 unless Congress extends them, including the top marginal tax rate for individuals. This limitation, however, does not sunset until 2032.
Senate Budget Committee Chairman Sanders (I-VT) and SFC member Menendez (D-NJ) have said that they are working on a proposal that differs from the House bill provision by limiting the benefits of a SALT cap increase to taxpayers with incomes no higher than some specific amount, such as $400,000.
With the possibility that this legislation will be enacted by the end of 2021, businesses and high-income individuals are well-advised to monitor reports on the negotiations between Congress and Treasury related to these proposals.
If you have questions about any of the information in this True Insight, please contact a member of your TPC engagement team.