On Monday September 13, the House Ways and Means introduced proposed tax changes for debate this week in an initial bill. The tax changes would be significant for many taxpayers and is intended to finance a broader $3.5 Trillion domestic investment plan. The changes proposed in the House bill will almost certainly evolve and deviate to a degree from how they are originally drafted, if it even ever becomes law. At the moment, these are purely provisions as part of the House Ways and Means initial bill proposal and should not be relied on as specific tax law or guidance. Nevertheless, below are some of the initial highlights that could impact high-income individuals, retirement accounts, and some businesses if these provisions advance in the coming weeks.

High-Income Tax Provisions

• Increase in Top Marginal Individual Income Tax Rate
  Under current law, the top marginal individual income tax rate is 37%. The proposed changes increases the top marginal rate to 39.6% which is what it was most recently prior to the TCJA of 2017. This top marginal rate would apply to married individuals filing jointly with taxable income over $450,000 (down from ~$628,000), to heads of households with taxable income over $425,000 (down from ~$524,000), to unmarried individuals with taxable income over $400,000 (down from ~$524,000), to married individuals filing separate returns with taxable income over $225,000 (down from ~$314,000), and to estates and trusts with taxable income over $12,500. The House proposal is more aggressive than the earlier Biden proposal. The income levels at which the top rate of 39.6% would come into play are actually lower than the income levels proposed by President Biden in May. Additionally, the income thresholds are currently NOT set to be indexed for inflation, pushing more taxpayers into higher tax brackets sooner. The amendments made by this section apply to taxable years beginning after December 31, 2021.

• Increase in Capital Gains Rate for Certain High Income Individuals
  The current top long-term capital gain rate is 20%. The proposal increases the highest capital gains rate to 25%. This is a much smaller increase in the top rate than have previously been proposed by President Biden (37%). However, the House proposal sets the new 25% capital gain rate at an income threshold much lower than the Biden proposal’s $1 Million Adjusted Gross Income (AGI) level. The new rate would apply to capital gains and qualified dividends recognized after September 13, 2021. Gains recognized later in 2021 that arise from transactions entered into before September 14, 2021 pursuant to a written binding contract are treated as occurring prior to the date of introduction.

• Surcharge on High Income Individuals, Trusts, and Estates
  A new tax equal to 3% of a taxpayer’s modified adjusted gross income (MAGI) in excess of $5,000,000 (or in excess of $2,500,000 for a married individual filing separately) would be introduced beginning after 2021. This appears to be a relatively small group of taxpayers, however the same surtax will also apply to trusts with “just” $100,000 of income.
  
  For this purpose, modified adjusted gross income means adjusted gross income reduced by any deduction allowed for investment interest. This implies that most typical deductions from AGI will not help high income individuals avoid this surtax. The amendments made by this section apply to taxable years beginning after December 31,2021.

• Application of Net Investment Income Tax to Trade or Business Income of Certain High Income Individuals
  Section 1411 imposes a net investment income tax on certain investment gains and high earners that is 3.8%. Traditionally, certain non-investment income has been exempt from this calculation. The proposed provision amends section 1411 to expand the net investment income tax to cover net investment income derived in the ordinary course of a trade or business for taxpayers with greater than $400,000 in taxable income (single filer) or $500,000 (joint filer), as well as for trusts and estates. The provision clarifies that this tax is not assessed on wages on which FICA is already imposed. Under current law, S Corp profits are not subject to either employment or the net investment tax. This would effectively change that for S Corps. The amendments made by this section would apply to taxable years beginning after December 31, 2021.

• Limitation on Deduction of Qualified Business Income for Certain High Income Individuals
  Section 199A - which was introduced by the TCJA of 2017 - permits certain owners of pass-through businesses to obtain a deduction of up to 20% on their qualified business income. The proposed provision amends section 199A by setting the maximum allowable 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. This does not change the phase-outs applicable to the deduction, but merely limits the amount of deduction available. This will likely only impact very high earning business owners in certain industries. The amendments made by this section apply to taxable years beginning after December 31, 2021.

  
  If enacted, the effects of these proposed changes is dependent on each individual or couples specific facts. Affluent taxpayers will feel a much bigger hit - a higher ordinary income tax rate and a higher capital gains tax rate, both starting at a lower income threshold than they paid before under current law. Compare that to someone with income of $4M that consists of mainly capital gains at only a 25% rate, and this doesn’t seem too bad for these type of high-wealth taxpayers.

  Additionally, if this bill were to become law, two high earners with income at or just under $400k could potentially save a considerable amount in taxes by remaining single rather than being married. As single they would have joint incomes close to $800k, avoiding the top tax rate and top capital gains tax rate. As married they would be solidly in the top tax rates.

  Lastly, taxpayers in the highest tax brackets in high-tax states could see their top marginal tax rates reach new heights. For example, a NYC taxpayer would have a top marginal rate of 39.6% (Federal Income Tax) + 3.8% (Net Investment Income Tax) + 3% (High Income Surtax) + 10.9% (New York State Tax) +3.876% (New York City Tax) = 61.176% (!).

Trust, Estate & Gift Tax Provisions

• Termination of Temporary Increase in Unified Credit
  Under current law, the unified credit against estate and gift taxes is $10,000,000 per individual, indexed for inflation ($11,700,000 for 2021) through 2025, before it was set to return to $5,000,000. This provision would terminate the temporary increase in the unified credit against estate and gift taxes, reverting the credit to its 2010 level of $5,000,000 per individual, indexed for inflation. This would mean that individuals passing with a taxable estate in excess of roughly $6,000,000 (when accounting for the inflation adjustment) may be subject to Federal estate tax. The proposal would be effective for estates of decedent’s dying, and gifts made, beginning in 2022.

• Certain Tax Rules Applicable to Grantor Trusts
  This provision adds section 2901, which pulls grantor trusts into a decedent’s taxable estate when the decedent is the deemed owner of the trusts. Prior to this provision, taxpayers were able to use grantor trusts to push assets out of their estate while controlling the trust closely. This could potentially apply to intentionally defective grantor trusts, which are a commonly used estate tax planning vehicle in which value is pushed outside of a taxpayer’s estate (and thus the future appreciation as well), but the taxpayer continues to pay the income taxes on the trust.
  
  The provision also adds a new section 1062, which treats sales between grantor trusts and their deemed owner as equivalent to sales between the owner and a third party. Importantly, the amendments made by this section apply only to future trusts and future transfers.

• Valuation Rules for Certain Transfers of Nonbusiness Assets
  This provision amends section 2031 by clarifying that when a taxpayer transfers nonbusiness assets, those assets should not be afforded a valuation discount for transfer tax purposes. Nonbusiness assets are passive assets that are held for the production of income and not used in the active conduct of a trade or business. Exceptions are provided for assets used in hedging transactions or as working capital of a business. The amendments made by this section apply to transfers after the date of the enactment of this Act.
  
  All-in-all, there may be precious weeks for those with estate tax planning needs to have documents properly drafted and structured to take advantage of current law with respect to certain grantor trust planning and gift valuations.

• No Changes Proposed to Decedent Unrealized Gains
  Notably, at the moment, there is no proposed change to “step-up” in basis law. No taxation of unrealized gains at death is proposed in the House bill. For example, a decedent who owned stock worth $1 Million that they had paid $50,000 for will not have to recognize $950,000 of gain at their death. Instead the heirs/beneficiaries receiving the decedent’s assets will receive a tax-free “step-up” in tax basis to $1 Million. This can still change, but at the moment no modifications to this rule are included in the preliminary bill (unlike in the earlier Biden proposal).

Retirement Plan Provisions

• Contribution Limit for Individual Retirement Plans of High-Income Taxpayers with Large Account Balances
  Under current law, taxpayers may make contributions to IRAs irrespective of how much they already have saved in such accounts. The proposed law in the House bill limits those with large balances from continuing to be eligible to make contributions, starting with tax years after December 31, 2021.

  Specifically, the proposed bill prohibits further contributions to a Roth or traditional IRA for a taxable year if the total value of an individual’s IRA and defined contribution retirement accounts generally exceed $10 million as of the end of the prior taxable year. However, the limit on contributions would only apply to single taxpayers (or taxpayers married 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 (all indexed for inflation).

  This rule doesn’t appear to make a ton of sense considering it only prevents IRA contributions (limited to $6,000/year) but doesn’t prevent those with $10 million or more of retirement assets from contributing to 401ks, SEP IRAs, Pension Plans, and more. We anticipate further clarity on this (and other rules) will emerge as the proposal is debated.

• Increase in Minimum Required Distributions for High-Income Taxpayers with Large Retirement Account Balances
  Under current law, required minimum distributions (RMDs) are typically only required of owners of certain retirement accounts that have reached a certain age or if the account has a certain type of beneficiary. Under the proposed provisions, if an individual’s combined traditional IRA, Roth IRA and defined contribution retirement account balances generally exceed $10 million at the end of a taxable year, a minimum distribution would be required for the following year. This minimum distribution is only required if the taxpayer’s taxable income is also above the thresholds described in the section above (e.g., $450,000 for a joint return). The minimum distribution would be 50 percent of the amount by which the individual’s prior year aggregate traditional IRA, Roth IRA and defined contribution account balance exceeds the $10 million limit.

  If the combined balance amount in traditional IRAs, Roth IRAs and defined contribution plans exceeds $20 million, that excess would be required to be distributed from Roth IRAs and Roth designated accounts in defined contribution plans up to the lesser of (1) the amount needed to bring the total balance in all accounts down to $20 million or (2) the aggregate balance in the Roth IRAs and designated Roth accounts in defined contribution plans. Once the individual distributes the amount of any excess required under this 100 percent distribution rule, then the individual is allowed to determine the accounts from which to distribute to satisfy the 50 percent distribution rule above.

  This provision would be effective for tax years beginning after December 31, 2021.

• Tax Treatment of Rollovers to Roth IRAs and Accounts
  Under current law, contributions to Roth IRAs have income limitations. For example, the income range for single taxpayers for making contributions to Roth IRAs for 2021 is $125,000 to $140,000. Those single taxpayers with income above $140,000 generally are not permitted to make Roth IRA contributions.

  However, in 2010, the similar income limitations for Roth IRA conversions were repealed, which allowed anyone to contribute to a Roth IRA through a conversion. irrespective of the still- in-force income limitations for Roth IRA contributions. As an example, if a person exceeds the income limitation for contributions to a Roth IRA, he or she can make a nondeductible contribution to a traditional IRA – and then shortly thereafter convert the nondeductible contribution from the traditional IRA to a Roth IRA.

  In order to close these so-called “back-door” Roth IRA strategies, the bill eliminates Roth conversions for both IRAs and employer-sponsored plans for single taxpayers (or taxpayers married 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 (all indexed for inflation). This provision applies to distributions, transfers, and contributions made in taxable years beginning after December 31, 2031.

  Important to note, this section also prohibits all employee after-tax contributions in qualified plans and prohibits after-tax IRA contributions from being converted to Roth regardless of income level, effective for distributions, transfers, and contributions made after December 31, 2021. This may mean that both normal back-door Roth IRAs AND if your current 401(k) plan allows for “Mega Back-door Roth” conversions, may no longer be permitted after this tax year - with back=door Roth IRA strategies not being available to high-earners and after-tax back-door 401(k) conversions becoming unavailable to all.

• Prohibition of IRA Investments Conditioned on Account Holder’s Status
  The bill prohibits an IRA from holding any security if the issuer of the security requires the IRA owner to have certain minimum level of assets or income, or have completed a minimum level of education or obtained a specific license or credential. For example, the legislation prohibits IRAs from holding investments which are offered to accredited investors because those investments are securities that have not been registered under federal securities laws. IRAs holding such investments would lose their IRA status. This section generally takes effect for tax years beginning after December 31, 2021, but there is a 2-year transition period for IRAs already holding these investments. This will force more of these investments to not be held in retirement accounts, where they have traditionally enjoyed tax-free treatment.

• Statute of Limitations with Respect to IRA Noncompliance
  The bill expands the statute of limitations for IRA noncompliance related to valuation-related misreporting and prohibited transactions from 3 years to 6 years to help IRS pursue these violations that may have originated outside the current statute’s 3-year window. This provision applies to taxes to which the current 3-year period ends after December 31, 2021.

• Prohibition of Investment of IRA Assets in Entities in Which the Owner Has a Substantial Interest
  To prevent self-dealing, under current law prohibited transaction rules, an IRA owner cannot invest his or her IRA assets in a corporation, partnership, trust, or estate in which he or she has a 50 percent or greater interest. However, an IRA owner can invest IRA assets in a business in which he or she owns, for example, one-third of the business while also acting as the CEO. The bill adjusts the 50 percent threshold to 10 percent for investments that are not tradable on an established securities market, regardless of whether the IRA owner has a direct or indirect interest. This section generally takes effect for tax years beginning after December 31, 2021, but there is a 2-year transition period for IRAs already holding these investments.

Business Owner Tax Provisions

• Changes to Carried Interest Rules
  Under current law, carried interest permits certain fund manages to treat their gains and profits on investment through their employment as capital gains in nature rather than as ordinary income (as employees would in other industries that don’t manage capital assets). Normally, a taxpayer must hold a capital asset for greater than 1-year to potentially qualify for the preferred rate that capital gains can afford and which makes them appealing from a tax perspective. Carried Interest rules for these fund managers require a 3-year holding period to obtain the preferential capital gain rates (rather than 1), but is still a way to enjoy a lower overall tax rate for their work. The proposed changes by the House Ways and Means Committee would increase this to a 5-year holding period instead. So while the carried interest “loophole” would still exist, it would become increasingly restrictive. Some smaller funds may be able to qualify to use the 3-year period.

• Limitation on Certain Special Rules for Section 1202 Gains.
  Section 1202 is the primary code section which governs the rules around Qualified Small Business Stock (QSBS). QSBS permits certain original shareholders of qualifying C Corporations to exclude some, or all, of their capital gain on the disposition of their original shares. The proposed change amends section 1202(a) to provide that the special 75% and 100% exclusion rates for gains realized from certain qualified small business stock will not apply to taxpayers with adjusted gross income equal or exceeding $400,000. Certain 50% exclusions would still continue to apply as before. This change would severely impact many founders and original shareholders that were planning on tax-free exits as part of their business planning and perhaps was the very reason why they organized as a C Corporation to begin with. This change would apply to any applicable sales after September 13, 2021.

• Rules Relating to Common Control
  The tax code aggregates certain business entities in order to apply various limitations (e.g., the gross receipts limitation in the use of the cash method of accounting, the exemption from interest deductibility limitations). The provision would provide that a taxpayer engaged in any activity in connection with a trade or business or any for-profit activity is subject to the aggregation rules under section 52(b). Section 52(b) refers to “trades or business (whether or not incorporated)” and the treatment of certain for-profit activity is unclear. The provision would be effective on the date of enactment.

• Limitations on Excess Business Losses of Noncorporate Taxpayers
  This provision amends the code to permanently disallow excess business losses (i.e., net business deductions in excess of business income) for non-corporate taxpayers. The provision allows taxpayers whose losses are disallowed to carry those losses forward to the next succeeding taxable year. The amendments made by this section apply to taxable years beginning after December 31, 2021.

Cryptocurrency & Digital Asset Provisions

• Constructive Sales
  This provision includes digital assets in the constructive sale rules, anti-abuse rules previously applicable to other financial assets. The constructive sale rules in section 1259 treat the adoption of certain offsetting positions to previously owned positions as sales of the previously owned position. This is commonly considered in situations when a taxpayer is using options strategies to hedge positions. These rules prevent taxpayers from locking in investment gains without realizing taxable gain. The amendments made by this section would apply to taxable years beginning after December 31, 2021.

• Wash Sales
  This section includes commodities, currencies, and digital assets in the wash sale rule for the first time. As a reminder, a wash sale is when a taxpayer sells a security (think stock for example) at a loss and buys the same (or substantially the same) investment back within a 30 day window before or after that sale. It effectively DISALLOWS the loss and adds it to the COST of the purchased stock. This basically defers the tax loss (a benefit for tax purposes) until the purchased stock is ultimately sold. The rule was previously an anti- abuse rule previously only applicable to stock and other securities. The amendments made by this section would apply to taxable years beginning after December 31, 2021.

closing

The coming days and weeks will afford us a better idea as to the likelihood that each of these proposed changes (as well as many others) may become law. Handicapping the likelihood of enactment is difficult at best. However, following the initial proposals from earlier this year, this House bill gives us an even clearer idea on what areas of tax reform Congress is most motivated to accomplish. We anticipate changes from what has been drafted in this House bill, but some variety of these changes (and more) will likely become law if tax reform does make it’s way through Congress this year. Taxpayers and their advisors should begin preparing as these potential changes become more evident in the coming days and weeks.

Any U.S. tax advice contained in the body of this message was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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