The Biden administration’s fiscal year 2023 budget blueprint, released on March 28, consists of a mix of familiar proposals and brand-new initiatives that reflect the President’s policy objectives. The proposals are described in more detail in the General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals, commonly referred to as the “Green Book,” that was released with the budget, and include the President’s now familiar calls for increasing the top corporate tax rate to 28% and the top individual rate to 39.6%.
Among the new proposals, the minimum tax on high-net-worth individuals has garnered considerable press attention.
These proposals, as well as others that have not been closely scrutinized, are described in more detail below.
Corporate Tax Proposals
Raise Corporate Income Tax Rate to 28%
C corporations, unlike an S corporation, the income of which passes through to its shareholders for a single level of tax, pay an entity-level income tax, and their shareholders pay a second level of tax on distributions that come out of either current or accumulated (past) earnings and profits of the corporation.
Before the Tax Cuts and Jobs Act of 2017 (TCJA), a C corporation’s tax was computed on taxable income in the US within a progressive tax system, with the highest rate reaching 35% (before offsetting any available tax credits). The TCJA replaced a graduated tax schedule with a flat tax of 21%, which is applied to all C corporations, before offsetting eligible credits.
The administration’s proposal would increase the tax rate for C corporations from 21% to 28%, roughly halfway between the pre-TCJA and post-TCJA rates. The purpose of the corporate income tax rate increase is intended to raise revenue to help pay for the Biden administration’s initiatives.
Many multinational corporations pay effective tax rates on worldwide income that are far below the statutory rate, due in part to low-taxed foreign income, as discussed below. The proposal would keep the global intangible low-taxed income (GILTI) deduction constant, raising the GILTI rate in proportion to the increase in the corporate rate through the application of the higher rate on the portion not excluded from the deduction. This takes away the incentive to shift profits and activity offshore as the domestic rate is increased with respect to the foreign-source income of foreign subsidiaries owned by U.S. corporations. Thus, the 28% corporate income tax rate would consequently increase the GILTI rate in tandem. The new GILTI effective rate would be 20%, applied on a jurisdiction-by-jurisdiction basis.
This proposal would be effective for taxable years beginning after December 31, 2022. The rate increase would therefore impact calendar year corporate taxpayers for the 2023 calendar year. However, for fiscal year taxpayers with taxable years beginning before January 1, 2023, and ending after December 31, 2022, the corporate income tax rate would be equal to 21% plus 7% times the portion of the taxable year that occurs in 2023.
This proposal may discourage investments in C corporations and might work to provide an increased incentive to fund these corporations through debt rather than equity since the rate of return on equity investments available to shareholders decreases by 7% or the amount of cash that is spent on taxes before excess after-tax earnings are reinvested into the business or are distributed to shareholders.
If enacted, the proposal would also encourage tax planning to manage taxable income between years, that is, to defer deductions to higher-taxed years (e.g., 2023), while accelerating income to lower-taxed years (e.g., 2022).
For financial reporting purposes, companies will need to monitor the legislative process to understand when any pending tax law changes would be enacted. ASC 740, Income Taxes, requires that the tax effect of changes in tax rates and tax laws on both current and deferred taxes be recognized as part of continuing operations in the period in which the law change is enacted. In the U.S., a law change is considered enacted when the President signs a bill into law.
Partnership Tax Provisions
Limitation on Partnership Basis-Shifting Transactions
Under current rules, a partnership is permitted to make an election to step up the basis of partnership assets upon certain transfers of partnership interests or distributions of property to existing partners. With respect to basis adjustments created upon distributions of property, it is possible for related parties to achieve tax savings without a meaningful change in the partners’ economic arrangement. This benefit is obtained by effectively shifting the basis from non-depreciable, non-amortizable property to depreciable or amortizable partnership property.
For example, if Partner A has a tax basis in his or her partnership interest of $100 and receives a distribution of property that has a tax basis of $150, Partner A will be required to take a basis in the distributed asset equal to $100. Additionally, the partnership will be able to record a tax basis step-up of $50 for the remaining partnership property. This $50 tax basis step-up will generate depreciation or amortization deductions allocable to all the partners. Importantly, Partner A will not recognize taxable gain until the distributed property is sold in a taxable transaction. Consequently, absent a disposition of the distributed property, the basis step-up rules have resulted in the creation of $50 of deductions without recognition of gain.
The administration has proposed limiting the ability of related parties to use a partnership to shift partnership basis amongst themselves. In the case of a distribution of partnership property that results in a tax basis step-up to remaining partnership assets, the proposal would apply a matching rule that would prohibit any partner that is related to the distributee-partner from benefitting from the tax basis step-up until the distributee-partner disposes of the distributed property in a fully taxable transaction.
This proposal would be effective for partnership taxable years beginning after December 31, 2022.
Taxation of Carried Interest Allocations
Following enactment of the TCJA, allocations of long-term capital gain representing so-called “carried interests” have been subject to recharacterization based on the holding period of property generating the gain. To the extent the property generating gain was held for three years or less, the carried interest allocations would be recharacterized as short-term capital gain subject to ordinary income tax rates.
Consistent with the administration’s fiscal year 2022 budget proposal, the administration has proposed treating certain carried interest allocations as ordinary. Specifically, under the proposal, a partner’s share of income from an “investment services partnership interest” (ISPI) would be taxed as ordinary income, provided the partner’s taxable income from all sources exceeds $400,000. Additionally, to the extent income allocated with respect to an ISPI is taxed as ordinary income, the income would also be subject to self-employment taxation.
For purposes of these rules, an ISPI is a profits interest in an investment partnership that is held by a person who provides services to the partnership. A partnership is considered an investment partnership if (1) substantially all of its assets are investment-type assets such as securities, real estate, interests in partnerships, commodities, cash or cash equivalents or derivative contracts with respect to these assets; and (2) over half of the partnership’s contributed capital is from partners holding the interest as an investment rather than in connection with a trade or business.
This proposal would be effective for partnership taxable years beginning after December 31, 2022.
Repeal of Like-Kind Exchange Transactions
Under current rules, taxpayers are able to exchange real property used in a trade or business or held for investment purposes for other real property without triggering taxable income. The administration’s proposal would effectively repeal the ability to defer gain in excess of $500,000 for each taxpayer ($1,000,000 in the case of married taxpayers filing a joint return) per year in connection with the exchange of real property. Any gain above these thresholds would be recognized as taxable gain in the year of the transfer of real property subject to the exchange.
This proposal, which would apply to all taxpayers, would be effective for taxable years beginning after December 31, 2022.
Modify Existing Rules Relating to Amended Partnership Tax Returns
Currently, when a partnership subject to the centralized partnership audit regime amends a return claiming a favorable benefit, e.g., a reduction in partner’s share of taxable income or increase in allocable expense, the adjustment is “pushed out” to the affected partner. The affected partner is then required to recalculate his or her tax liability for the year of the adjustment. To the extent the adjustment results in a lower tax liability, the partner is required to claim the tax reduction as a nonrefundable tax credit in the year in which the amended partnership tax return is filed. Any unused tax credit is permanently lost.
For example, during 2022 AB Partnership amends its 2019 income tax return and reports a reduction in taxable income to Partner A of $1,000. Partner A then recalculates her 2019 tax liability reflecting the reduction in taxable income. Assuming a 37% federal income tax rate, this adjustment will create a $370 tax credit that Partner A may use to reduce her 2022 federal income tax liability. If Partner A calculates a calendar year 2022 pre-credit federal income tax liability of $350, she will reduce this liability to $0 but will then permanently lose the remaining $20 tax credit.
To cure this inequitable result under the existing rules, the administration’s proposal would change the treatment of the $370 tax credit in the above example by treating the $20 excess above the 2022 tax liability as an overpayment that may be refunded.
The proposal would be effective on the date of enactment.
Repeal Corporate Tax Exemption for Certain Publicly Traded Partnerships
Publicly traded partnerships are generally subject to the corporate income tax. Partnerships that derive at least 90% of their gross income from depletable natural resources, real estate or commodities are exempt from the corporate income tax. Instead, they are taxed as partnerships. They pass through all income, gains, losses, deductions and credits to their partners, with the partners then being liable for income tax (or benefitting from the losses) on their distributive shares.
The administration’s proposal would repeal the exemption from the corporate income tax for publicly traded partnerships with qualifying income and gains from activities relating to fossil fuels.
The proposal would be effective for taxable years beginning after December 31, 2027.
The budget proposal includes several measures addressing the tax treatment of digital assets, including proposals to modernize certain tax rules relating to securities, including nonrecognition rules applicable to certain securities lending transactions and the mark-to-market rules under Section 475, to extend them to cryptocurrencies and other digital assets. The proposals would also expand certain reporting requirements to digital assets.
Individual, Estate, and Gift Taxes
The administration’s proposals affecting individuals, estates and gift taxes in its second budget look quite similar to the proposals in the first budget. High-net-worth individuals continue to be the focus of many of these proposals, which encompass raising individual tax rates, raising capital gain and qualified dividend rates, taxing exchanges between grantors and grantor trusts, imposing restrictions on grantor retained annuity trusts and taxing dispositions of appreciated property at death. A summary of the income and transfer tax proposed changes most likely to be of interest to high-net-worth individuals follows.
Individual Income Tax Rate
The administration proposes to increase the top marginal individual income tax rate from 37% to 39.6%. For taxable year 2023, the rate would apply to taxable income over $450,000 for married individuals filing jointly ($225,000 for married individuals filing separately), $425,000 for head of household filers and $400,000 for single filers.
The proposal would be effective for taxable years beginning after December 31, 2022.
The proposal to increase the top marginal individual income rate merely accelerates the increase of the top individual tax rate to 39.6% that is currently scheduled to occur beginning in 2026, which is after most of the TCJA provisions are set to expire. However, this proposal also would lower the taxable income bracket subject to the top marginal income tax rate. As a result, the proposal would impose the top marginal tax rate on filers currently below the existing top marginal income tax rate of 37%. Thus, in 2022 the top marginal tax rate is 37% for joint filers with more than $647,850 of taxable income ($539,900 for single filers and heads of household, $323,925 for married filing separately). By comparison, the proposed 39.6% tax rate is proposed to be on taxable income over $450,000 for joint filers.
Minimum Tax Liability
The administration also proposes a minimum tax of 20% on taxable income, inclusive of unrealized capital gains, for taxpayers with a net worth in excess of $100 million. Payments of the minimum tax would be treated as a prepayment available to be credited against taxes on future realized capital gains. The minimum tax liability in subsequent years would equal 20% of (1) the taxpayer’s taxable income and unrealized gains reduced by (2) the taxpayer’s unrefunded, uncredited prepayments and regular tax. The tax due for the first year could be paid in nine equal annual installments. For subsequent years, the minimum tax could be paid in five equal annual installments.
The proposal also provides guidelines and limitations on how uncredited prepayments would be applied against future realized capital gains, in addition to providing a cap whereby a taxpayer would be fully phased into the minimum tax liability. As a result, taxpayers with a minimum tax liability and uncredited prepayments exceeding $40 million would be fully phased in.
Notably, the proposal does not require annual valuations of non-tradeable assets. Rather, non-tradeable assets would be valued using the greater of the original or adjusted cost basis, the last valuation event from investment, borrowing, or financial statement purposes, or other methods approved by the Secretary, increased annually by the sum of the five-year Treasury rate plus two percentage points. Taxpayers deemed to be illiquid because tradeable assets are less than 20% of their wealth may elect to include only unrealized gain in tradeable assets in the calculation of their minimum tax liability. However, the eventual realization of gains on such non-tradeable assets would be subject to a deferral charge not to exceed 10% of unrealized gains.
Estimated tax payments would not be required for the minimum tax liability.
For unmarried taxpayers, net uncredited prepayments in excess of any tax liability from gains at death would be refunded to the estate and includable in the decedent’s gross estate for federal estate tax purposes. For married taxpayers, net uncredited prepayments remaining at death would be transferred to the surviving spouse.
The proposal would be effective for taxable years beginning after December 31, 2022.
We last saw a proposal to impose additional taxes on high-income individuals, estates and trusts in the Build Back Better Act, which proposed a surcharge on modified adjusted gross income in excess of $10 million for joint filers and $200,000 for trusts. The Build Back Better Act was approved by the House of Representatives on November 19, 2021, yet remains stalled in the Senate. This proposal would apply to a smaller taxpayer base than the Build Back Better Act, though it would apply to more than just “billionaires,” a term not used in the budget or Green Book, but frequently mentioned in press coverage.
Capital Gain and Qualified Dividend Income
Long-term capital gains and qualified dividend income of taxpayers with taxable income over $1 million would be taxed at ordinary income tax rates to the extent the taxpayer’s income exceeds $1 million ($500,000 for married individuals filing separately).
The proposal would be effective for gain required to be recognized and for dividends received on or after the date of enactment.
If the proposal for raising the ordinary income tax rate to 39.6 % becomes law, then the maximum tax rate on capital gains would effectively be 43.4% (39.6% plus net investment income tax rate of 3.8%).
Transfers of Appreciated Property
The administration proposed to tax unrealized capital gains on transferred appreciated property upon the occurrence of certain realization events, which would include:
- Transfers of appreciated property by gift
- Transfers of appreciated property on death
- Transfers of property to, or distributions of property from, trusts (other than wholly revocable trusts)
- Distributions of property from a revocable grantor trust to any person other than the deemed owner or U.S. spouse of the deemed owner (other than distributions made in discharge of an obligation of the deemed owner)
- Terminations of a grantor’s ability to revoke a trust – at death or during life
- Transfers of property to, and distributions of property from, partnerships or other non-corporate entities if the transfer is a gift to the transferee
- Recognition of gain on the unrealized appreciation of property held by trusts, partnerships or other non-corporate entities, if the property has not had a recognition event within the prior 90 years. The first recognition event under this 90-year rule would occur December 31, 2030, for property not subject to a recognition event since December 31, 1939.
The proposal allows for some exclusions. Transfers by a donor or decedent to a U.S. spouse would not be a taxable event, and the surviving spouse would receive the decedent’s carryover basis. The surviving spouse would recognize the gain upon disposition or death. Similarly, transfers to charity would not generate a taxable capital gain. Transfers to a split interest trust, such as a charitable remainder trust, would generate a gain with an exclusion allowed for the charity’s share of the gain. Transfers of tangible personal property, such as household furnishings and personal effects (excluding collectibles), are excluded.
Once a donor has exhausted his or her lifetime gift exemption, the proposal would allow a $5 million per donor exclusion from recognition of additional unrealized capital gain on property transferred by gift or held at death. Any unused exemption by a deceased spouse would be portable to the surviving spouse, effectively making the exclusion $10 million per couple. This additional exclusion amount would be indexed for inflation after 2022. The transferee’s basis in the property shielded by this exemption would be the fair market value of the property at the time of the gift or the decedent’s death.
Payment of the tax on the appreciation of certain family-owned and operated businesses may be deferred until the business is sold or ceases to be family-owned and operated. The capital gains tax on appreciated property transferred at death would be eligible for a 15-year fixed rate payment plan. However, publicly traded financial assets will not be eligible for the payment plan. Furthermore, family businesses electing the deferral will not be eligible for the payment plan.
The proposal generally would be effective for transfers by gift, and on property owned at death by decedents dying after December 31, 2022, and on property owned by trusts, partnerships and other non-corporate entities on January 1, 2023.
Contributions of appreciated property to split-interest trusts, such as charitable remainder trusts, will no longer have the favorable treatment afforded under current law – likely making that planning strategy less attractive as a deferral planning technique. Transfers to S corporations and C corporations do not appear to generate gain, assuming those transfers qualify for the deferral provisions of Section 351.
Notably, this proposal does not eliminate the $500,000 exclusion currently available to joint filers ($250,000 for unmarried filers) upon the sale of their principal residence, nor does this proposal eliminate the current exclusion on the sale of qualified small business stock.
This proposal radically alters the rules for recognition of income when it comes to capital assets. Under current law, there generally must be a sale or exchange of property to generate a capital gain. Because the proposal would “deem” a sale when in fact there was no sale, the taxpayer will not necessarily have the cash to pay the capital gains tax. Thus, the utmost care would need to be exercised to avoid the liquidity issues created by a “deemed” sale.
Currently, sales between a grantor and his or her intentionally defective grantor trust are nontaxable events. The proposal would recognize such sales and require the seller to recognize gain on the sale of appreciated assets. Taxable transfers also would include the satisfaction of an obligation (i.e., annuity or unitrust payments) with appreciated property. The provision would apply to all transactions between a grantor trust and its deemed owner occurring on or after the date of enactment.
The proposal also would treat the payment of a grantor trust’s income taxes by the deemed owner as a taxable gift occurring on December 31 of the year in which the tax is paid, except to the extent the deemed owner is reimbursed by the trust during that same year. The provision would apply to all trusts created on or after the date of enactment.
This proposal would overturn the IRS’s prior ruling in Rev. Rul. 85-13, which disregarded transactions between a grantor and his or her grantor trust for income tax purposes.
Grantor Retained Annuity Trusts (GRATs)
Grantor retained annuity trusts (GRATs) currently do not have term restrictions or remainder interest restrictions. The proposal, however, would require a minimum term of 10 years and a maximum term equal to the annuitant’s life expectancy plus 10 years for all GRATs. In addition, a GRAT’s remainder interest would be required to have a minimum value (for gift tax purposes) equal to the greater of (1) 25% of the value of the assets transferred to the GRAT or (2) $500,000 (but not more than the value of the assets transferred). The GRAT annuity may not decrease during the GRAT term. Further, the grantor would not be allowed to engage in tax-free exchanges of assets held in the GRAT.
The provisions would apply to all trusts created on or after the date of enactment.
This provision would effectively eliminate short-term GRATs that are commonly used in a rolling GRAT strategy to reduce the risk of a grantor dying during the GRAT term (and thereby the resulting inclusion of the GRAT’s assets in the grantor’s estate). This provision also would prohibit the use of zeroed-out GRATs.
Generation-Skipping Transfer (GST) Tax Exemption
The administration proposes to limit the benefit of the generation-skipping transfer (GST) tax exemption to certain generations. GST tax exemption would apply only to direct skips and taxable distributions to beneficiaries who are no more than two generations below the donor, and to younger-generation beneficiaries who were alive when the trust was created. Also, GST tax exemption would apply only to taxable terminations occurring while any of the aforementioned persons are beneficiaries of the trust.
These proposals would apply on and after the date of enactment to all trusts subject to the GST tax, regardless of the trust’s inclusion ratio. For purposes of determining beneficiaries who were alive when the trust was created, trusts created prior to the date of enactment would be deemed to have been created on the date of enactment. Further, decanted trusts and pour-over trusts would be deemed to have been created on the same date of creation as the initial trust.
This proposal eliminates the ability to shield trust assets from GST tax in perpetuity, dramatically reducing the allure of dynasty trusts as a tax savings tool.
Generally, an intrafamily note carries an interest rate equal to the applicable federal rates (AFR), which have been historically low, to ensure the loan is not treated as a below-market loan or a gift. After the note holder’s death, the valuation of the note for estate tax purposes often includes a discount because the note’s interest rate is well below the market rate. The administration proposes to remedy this inconsistency in valuation by limiting the discount rate to the greater of the actual interest rate of the note or the AFR for the remaining term of the note on the note holder’s date of death. The note would be treated as a short-term note or valued as a demand loan if there is a reasonable likelihood that the note will be satisfied sooner than the specified payment date. The proposal would apply to valuations as of a valuation date on or after the date legislation is introduced.
This proposal would seemingly align the valuation of notes for both income and estate tax purposes.
This second version of the Biden administration’s Green Book does not discuss eliminating the $10,000 limit on the deduction of state and local income taxes, repealing or modifying the qualified business income deduction, reducing the lifetime estate tax exemption, or increasing the estate tax rate. These items were proposed during President Biden’s election campaign, in the American Families Plan, or in other proposals; however, the mere absence of these items does not mean that they are not still in play. They may become important bargaining chips as the Green Book proposals are discussed in Congress.