Reconciliation: Tax Pay-Fors

September 16, 2021

On Sept. 13, House Ways and Means Committee Chairman Richard Neal (D-Mass.) released his ‘chairman’s mark’ of tax increase and tax relief proposals that the committee approved on September 15 as part of “Build Back Better” reconciliation legislation. Chairman Neal’s tax increase proposals are projected to raise federal revenues by more than $2 trillion over 10 years, according to estimates by Joint Committee on Taxation (JCT). The proposal would raise tax rates for corporations and individuals and make many other changes to the Internal Revenue Code.

A section-by-section summary of these provisions is available from the Ways and Means Committee. Below is a breakdown of some of the provisions most impactful on small businesses.

Tax Rates: The proposal would increase the top marginal individual income tax rate to 39.6 percent from the current 37 percent. This marginal rate would apply to married individuals filing jointly with taxable income over $450,000; to heads of household with taxable income over $425,000; to unmarried individuals with taxable income over $400,000; to married individuals filing separate returns with taxable income over $225,000; and to estates and trusts with taxable income over $12,500.

The proposal would replace the current flat 21 percent corporate tax rate with a graduated rate, starting at 18 percent on the first $400,000 of income; 21 percent on income up to $5 million; and 26.5 percent on income above $5 million. However, the graduated rate would phase out for corporations making more than $10 million.

Qualified Business Income Deduction: The proposal would set the maximum allowable deduction under Sec. 199A 20 percent pass-through deduction at $500,000 in the case of a joint return, $400,000 for an individual return, $250,000 for a married individual filing a separate return, and $10,000 for a trust or estate.

Capital Gains: The proposal would increase the 20 percent tax rate on capital gains to 25 percent. A transition rule would provide that the current statutory rate of 20 percent would continue to apply to gains and losses for the portion of the tax year prior to the date of introduction. Gains recognized later in the same tax year that arise from transactions entered into before the date of introduction pursuant to a written binding contract would be treated as occurring prior to the date of introduction.

Net Investment Income Tax: The House proposes to expand the net investment income tax to include all net income from pass-through businesses for taxpayers with income greater than $500,000 for joint filers, trusts, and estates, and $400,000 for single filers. The House proposed effective date is for tax years beginning after Dec. 31, 2021. Specifically, the definition of net investment income would include gross income and gain “from any trades or businesses that are not otherwise subject to employment taxes”; further, certain partnership income and S corporation income would be subject to employment taxes (and therefore to the Medicare tax).

High-income Surcharge: The proposal would impose a tax equal to 3 percent of a taxpayer’s Modified Adjusted Gross Income (MAGI) in excess of $5 million (or in excess of $2.5 million for a married individual filing separately).

Estate and Gift Tax: The estate tax and lifetime gift tax exemption (which was temporarily doubled through 2025) is currently $11.7 million per person ($23.4 million for married couples). In addition, there is a $15,000 per donee gift tax exclusion ($30,000 if spouses agree). The current estate tax rate on amounts in excess of the exemption amounts is a flat 40 percent, and the tax basis in inherited assets is “stepped up” to the fair market value upon the death of the decedent. The proposal accelerates to the end of 2021 the end of the temporary doubling of the estate and gift tax exemption—moving the date from Dec. 31, 2025 to Dec. 31, 2021. Specifically, this provision would cut the current lifetime estate, gift, and generation skipping tax exemptions in half from the current $11.7 million level down to roughly $6 million per individual. For businesses, that means the amount they can currently protect from estate and gift taxes would be cut in half starting in roughly 3 months.

Grantor Trusts: The proposal changes the estate and gift tax rules that apply to grantor trusts so that they are similar to the income tax rules for grantor trusts (for example, pulling grantor trusts into a person’s taxable estate when that person is deemed to own the trust assets), causing many such trusts to be included for estate tax purposes. These rules would apply to future trusts and to future transfers to existing trusts. It also proposes to tax sales between grantors and grantor trusts the same way a normal sale of assets is taxed. These proposals could make it much more difficult and expensive, if not impossible, for many small businesses to keep control of those businesses in the family.

Estate Tax Valuation Rules: This provision changes the valuation rules to ignore discounts from partial ownership or lack of control of an asset in determining its value. This rule applies only to assets that are not used in a business. This provision is limited to passive assets, so these discounts are still permitted for family farms and businesses in the same way as current law.

In the Senate, Democratic members of the Senate Finance Committee have begun informal discussions of corporate, international, and individual revenue-raising options for inclusion in budget reconciliation legislation. The Senate Finance Committee is not expected to hold a formal markup on budget reconciliation legislation but is developing draft legislation for inclusion in budget reconciliation legislation that will go directly to the Senate floor for consideration. Senate rules allow Senate leaders to take legislation directly to the Senate floor for consideration and bypass a formal vote by the Senate Finance Committee and other committees. However, differences between the House tax proposals and Senate tax proposals that are expected to be considered in coming weeks will have to be resolved before final legislation can be put to a vote in both chambers.

NSBA has long called on Congress to simplify the tax code for small businesses, create stability and predictability in our tax laws, and move toward greater parity in the tax treatment of various business forms. Unfortunately, the released tax provisions from the Ways and Means Committee do not succeed in achieving these goals. Instead, they would add further complexity, decrease rate parity between corporate and pass-through entities, and potentially harm the already fragile small business recovery from the pandemic. If small business owners pay taxes as individuals, they could be hit by a steeply higher marginal tax rate, and some may even lose an existing 20 percent deduction on qualified business income. Also, an expansion of the 3.8 percent net investment income tax could impact more small businesses. Finally small-business owners will have a harder time passing their business along to an heir, given that the estate tax exemption will be sliced in half to $5.5 million. These tax increases could have a disproportionate impact on small businesses, slow economic growth and harm the entrepreneurs who adapted and worked so hard to keep their businesses afloat during the pandemic.