Paying for Building Back Better
I sat in on a webinar yesterday where Karen Miller, tax professor at The University of Alabama, provided insight on the latest on infrastructure and Build Back Better legislation. While you will never get me to utter the words "Roll Tide", Karen does a fantastic job of getting in the weeds of these tax proposals so that we as tax practitioners can spread the word and help our clients navigate the waters.
As quickly as I hit publish on this summary, it is sure to be obsolete - things are moving that quickly. Nonetheless, I thought it might be helpful to offer an update on how certain tax aspects of the legislation are shaping up. One caveat: All of my clients are general and specialty dental service providers, but, even if you do not practice in dentistry, hopefully you will find enough here to make it worth your time.
Employee Retention Credit Early Termination
The Employee Retention Credit (ERC) was a nice tax benefit for dental offices that continued to employ its staff during the pandemic-mandated office shutdowns last year. That credit was subsequently extended into 2021 for businesses that continue to experience economic hardship. However, one element of the infrastructure bill in its current form is to terminate the ERC program effective September 30, 2021 rather than to continue the program through the end of the year. Most dental offices have rebounded from last year and have been ineligible for the ERC this year, so this early termination is no big deal for you guys.
Enhancements to Cryptocurrency Reporting
This is another provision that is no big deal because it was bound to happen anyway. There has been a big surge in cryptocurrency trading over the past several years, and the IRS wants to make sure it has the ability to track and tax gains from crypto trading. Get ready to assemble your crypto records because big brother will soon be watching.
Unrealized Gains on Gifts and Inherited Assets
Here is one that has gotten a lot of attention over the last year. A provision of then-Presidential candidate Joe Biden's tax platform was to levy a tax on the unrealized gains on property received by gift or inheritance. Currently, recipients of gifted appreciated property are not taxed on the gain until they sell the property. Recipients of inherited property get an even better deal in that their tax basis is "written up" to the fair market value of the property as of the donor's date of death. What that means is that a quick sale of inherited property likely escapes income tax altogether.
To say that this unrealized gains tax has received pushback would be an understatement. As a result, this proposed revenue-raiser no longer appears to be on the table for this legislation.
The like-kind exchange (LKE) rules allow businesses and investors to exclude the gain on the sale of property so long as the sale proceeds are fully utilized to purchase similar property. Several years ago, this gain deferral strategy was limited only to real estate transactions, thus closing the popular gain-deferral strategy trading in your fully-depreciated business auto, truck or SUV.
There was an early push to further limit LKE gain deferrals to less than $500,000, which I understand to mean that you could only defer gains less than $500,000. I am not saying a $500,000 gain deferral is not valuable, but, in my opinion, this limitation would significantly depress the investment real estate market at a time where our economy is particularly vulnerable. Thankfully, this revenue-raiser appears to be shelved as well.
The Return of the 39.6% Rate
Not surprisingly, higher income and net worth taxpayers will be asked to pay more. This will be accomplished in a number of ways, the least surprising of which is an increase in the top tax rate to 39.6%. As you can see from the chart below (hat tip, Bradford Tax Institute), the top marginal tax rate has bounced around since the inception of our income tax depending on who controls Congress and occupies The White House. Since 2018, the top tax rate has been 37%, but this will go back up beginning next year.
The bad news does not stop there. The current 37% rate only applies to taxable income over $523,600 for single taxpayers and $628,300 if you are married. The new 39.6% rate applies to taxable income of $400,000 for singles and $450,000 for married couples. If you have ever heard the term "marriage penalty", these rates are a prime example. Two single taxpayers would pay less tax on the same income than if they were married.
If you earn more than $5 million, then, if this provision passes, you will be subject to a new 3% surcharge on the overage. I get it, nobody sheds a tear for the taxpayer earning at this level, but understand that this surcharge (the legislation does not call it a tax) is in addition to regular taxes imposed on the same income. These taxes could possibly include federal income tax (up to 39.6%), federal self-employment tax (call it 3%), the Affordable Care Act Medicare surtax (call it 1%) and state income tax (up to 11%). Adding insult to injury, the surcharge applies to "modified adjusted gross income", which means you cannot reduce the surcharge by being charitably-minded because itemized deductions do not provide an offset.
Consistent earnings above the $5 million threshold are rare for those in the dental profession. Less rare, however, are general dentists and specialists who have sold their practices into DSOs in exchange for equity positions in the roll-up entity. My understanding is that the surcharge applies to all income, meaning that the gain from a highly-lucrative exit from the roll-up entity has the possibility of also being tagged with this add-on.
Capital Gains Rate Increase to 25%
Most of the tax changes summarized here carry an effective date of January 1, 2021, which gives us some time to effectively tax plan for the remainder of this year. As it currently stands, the timing of the capital gain rate increase from 20% to 25% is an exception - the effective date for this increase is September 13, 2020. However, if you have an unexecuted mutually binding contract in effect prior to this date, the 20% rate will still apply even if the closing occurs after the effective date.
Background: The current capital gain rates are tied to total taxable income. If total taxable income is less than $40,400 ($80,800 if married), then your capital gain rate is 0%. Between $40,401 and $445,850 ($80,801-$501,600 married), the rate is 15%. Over these thresholds, the rate is 20%.
From September 14th through the end of 2021, the 20% rate would be replaced with the 25% rate. After 2021, the 25% rate coupled is with the highest marginal tax rate - remember, those new thresholds will be $400,000 for singles and $450,000 for married couples.
Expanded Net Investment Income Tax
The Net Investment Income Tax (NIIT) is a 3.8% Affordable Care Act-era tax levied on investment income if your overall income is greater than $200,000 (single taxpayers) or $250,000 (married taxpayers). Historically, your passthrough business income has been off-limits for this tax, but that may no longer be the case.
If your taxable income is $400,000 (single) or $500,000 (married), then NIIT would apply to your passthrough income if you are an S corporation owner. If you practice as a sole proprietor or in a partnership/limited liability entity, then you will not be subject to NIIT. That is great news, right? Not really, because you are likely already paying a 3.8% Medicare surtax on your earnings...which is the other Affordable Care Act levy.
Rollback of Estate Tax Exemptions
The lifetime estate and gift exemption is currently $11.7 million per taxpayer, meaning that a married couple can effectively shelter $23.4 million in net assets from estate and gift tax. Under the new legislation, the estate tax would revert back to the 2010 level of $5 million per taxpayer indexed for inflation. That indexing is projected to result in a roughly $6 million exemption ($12 million for married couples).
This rollback will require more taxpayers to dust off their estate plans and possibly consider new strategies to dodge or minimize the tax, which scales up to 40% pretty quickly.
Another wrinkle in the estate planning realm will be a new prohibition on valuation discounts for non-business assets. A deep dive on this topic is beyond the scope of this update, but a common estate planning strategy has been to reduce the value of your estate by placing certain assets (think vacation property) into family limited liability entities (LLEs), gifting those LLE units to various family members and discounting the value of those units for minority ownership and lack of marketability. This is a clever strategy that will soon be prohibited.
Limitations on IRA and Defined Contribution Account Balances
I have long thought that Roth IRAs would eventually find their way into the crosshairs of the IRS, and, thanks to Peter Thiel, we may have finally reached that point. Quick history lesson: Taxpayers have had the ability since 1997 to fund their Roth IRAs (and, later, Roth 401(k)s) with after-tax dollars. In exchange for foregoing a current tax deduction, these retirement savers never pay tax on the asset appreciation that happens inside the account and are never subject to the required minimum distribution requirements of traditional retirement savings vehicles.
Now for some bad news: If you earn over a certain threshold amount ($400,000 singles; $450,000 married couples) and your retirement account(s) exceed $10 million in value, you will be prohibited from making a retirement plan contribution in the following year.
More bad news: If you exceed the income and account value thresholds above, you will be required to withdraw 50% of the excess of your account balance over $10 million. This provision is not age-dependent, meaning that you could possibly be subjected to income tax on your retirement plan well in advance of retirement.
More, more bad news: IRA owners will also be prohibited from making IRA investments in non publicly-traded entities in which the IRA owner owns 10% or more of the company and is an officer or director. Another new prohibited IRA investment is in unregistered/accredited investor securities. There will be a two-year grace period for IRAs to liquidate these newly prohibited investments, after which the penalty for non-compliance will be forfeiture of IRA status.
More, more, more bad news(!): If you hit those income thresholds above (this legislation really does not like you), say goodbye to conversions from traditional retirement savings accounts to Roth accounts and also goodbye to backdoor Roth IRA contributions.
The moral of the story here is that the federal government wants to encourage retirement savings - just don't get too good at it!
For those of you that like to get into the weeds of tax legislation, you know that your itemized deduction for state and local taxes (commonly known as SALT, because we love our acronyms) has been limited to $10,000 for several years. For many taxpayers, especially those in high tax states, this cap was a backdoor tax increase. Ever since the $10,000 cap was enacted, there has been chatter about raising the limitation threshold or repealing it altogether.
As of this writing, there have been no alterations to this cap. However, stay tuned, because the SALT cap is widely believed to be on the table as a bargaining chip to get these various factions of the Democratic party in line for this legislation to pass.
Bless you and thank you for making it to the end of this lengthy post. Once these reconciliation and infrastructure pieces of legislation are finalized, I will either update this post or write a new one. In the meantime, if you have any questions about how any of this may affect your personal tax or financial situation, please feel free to call or email me to schedule a time to chat. I am glad to help!