Build America Back Better Act

In September the House Ways and Means Committee announced a series of proposed tax changes for integration in Biden’s budget reconciliation bill: “Build America Back Better” act.  

Before delving into the anticipated changes to tax policy, it’s important to understand that revisions, negotiations and targeted implementation of the bill are still very much up in the air.  

In the most general terms, the Build America Back Better act is set up to provide fiscal relief to the working middle class while targeting income earners at the highest tax bracket. A raise in tax rates for both individuals and corporations as well as make numerous changes to the Internal Revenue Code are anticipated with near certainty. Below are the planned changes and how they will impact both individuals and corporations. 

Reduced Estate Tax Exemption 

Current Law – the estate and gift tax exemption amount is $11,700,000 per individual or $23,400,000 for a married couple. This is expected to remain intact through the end of 2021.  

Proposed Change – effective January 1st, 2022, the amount per individual is expected to be reduced to $5,000,000.  

In the past 50 years, this law has fluctuated with the political winds. Expectations are high that the estate tax exemption will be reduced but as to how much is merely conjecture at the moment. It is likely that the 5mm number will be increased to allow for a concession point by Democrats. From a wealthy individual’s perspective, this presents a significant estate planning challenge. $5,000,000 in individual net worth is far more common than the legacy amount. One might argue the irony of reducing the exemption as it only harms the middle class by hampering their ability to bequeath wealth in a time where inheritance is critically important to the financial prosperity of future generations.  

Grantor Trusts 

Current Law – Grantor trusts are utilized to remove assets from one’s estate to reduce the burden of estate taxes and allow assets to appreciate freely without concern for future value.  

Proposed Change – the inclusion of IRS section 1062, which states that sales between grantor trusts and their deemed owner is the same as a sale between the owner and a third party. The amendments to this section pertain to future trusts as well as future transfers or swaps between a taxpayer and a new or previously existing trust.  

The new bill would limit the ability of Grantor Trusts to implement new strategies and leave them with less flexibility to change their course. This is because the bill only has a few steps to go before it becomes law which means that these trusts could become obsolete if not already in place before the bill passes. PPWG strongly encourages anyone who might have an estate planning issue (assets to exceed estate tax exemption) create a Grantor trust thus grandfathering under the current tax code.  

Nonbusiness Assets 

Current Law – section 2031 pertains to the valuation metrics used for certain transfer of non-business assets into trust.  

Proposed Change – the amendment of section 2031. When a taxpayer moves nonbusiness assets, those assets should not be afforded a valuation discount for transfer tax purposes.  

These tend to be passive assets that are used for income and not related to active conduct or trade within the business. Some exceptions are afforded for possessions used as working capital of a business or in hedging transactions.  

This change empowers the government to remove valuation discounts on estate and gift tax trust vehicles. Specifically family limited partnerships, generation skipping and 678 trusts would be impacted.

Tax Rate 

One area that will be affected is the tax rate. The bill would swap the current flat corporate tax rate of 21% to a graduated rate. This would be broken down by income now, starting at 18% for an income of $400,000; a $5 million income would merit a 21% rate; and a rate of 26.5% for any income above $5 million. This graduated rate would phase out corporations that earn more than $10 million. 

Deduction of Qualified Business Income 

This bill would amend section 199A, which was put in place to reduce the income tax on many businesses. This new change would set a maximum allowable deduction of $500,000 in the case of a joint return, $400,000 for an individual, $250,000 for a married individual filing a separate return, and $10,000 for a trust or estate. These changes wouldn’t take effect until after December 31, 2021. 

 Carried Interests and Capital Gains 

These changes would extend the holding period that is needed to gain attributable to an applicable partnership interest to meet the standards for long-term capital gain treatment from three to five years. This would also extend to all eligible assets that qualify for long-term gain rates. 

Exclusion Rates 

The act provides special exclusion rates of 75% and 100% for gains realized from certain qualified small business stock. This would not apply to taxpayers with AGI equal to or exceeding $400,000. The baseline 50% exclusion in Sec 1202(a)(1) would remain available for all taxpayers. 

Tax Rates 

The top marginal income tax rate is set to increase to 39.6%. This would apply differently to individuals based on how they file for their taxes.  

It would apply to any married individuals filing jointly with a taxable income of over $450,000, heads of households whose taxable income is over $425,000, as well as unmarried individuals with a taxable income over $400,000. Changes extend to married couples filing separately with a taxable income over $225,000 and estates and trusts with a taxable income over $12,500 as well.  

Capital Gains 

An incresee on capital gains from 20% to 25%. The current rate would continue to apply for gains and losses for the part of the tax year prior to September 13, 2021.  

Gains recognized later than this date in the same tax year but were entered before the 9/13 date would also get the benefit of the 20% as it would be treated as this event occurring before the change from this act. 

Net Investment Income Tax 

There will also be a change to net investment income tax. The act would add to Sec 1411 net investment income tax to cover net investment income derived from trade or business for taxpayers. This would affect single filers with a taxable income of $400,000 or joint filers with a taxable income of $500,000, as well as for trusts and estates. 

High-income surcharge 

The act would enforce a tax equal to 3% of a taxpayer’s modified AGI (MAGI) in excess of $5 million. This would also apply to any married individuals that file separately that have an excess of $2.5 million. MAGI would refer to AGI minus any deduction allowed for investment interest which is defined in Sec. 163(d). 

Contributions to IRAs 

The proposed act would also restrict further contributions to a Roth or traditional IRA for a tax year if the total amount in the retirement account exceeds $10 million as of the end of the prior tax year. This would only apply to single taxpayers with an income over $400,000 and heads of households with an income over $425,000. 

RMDs 

For individuals with combined assets within a traditional IRA, Roth IRA, and/or a defined contribution retirement account exceeding $10 million at the end of a tax year must elect a minimum distribution prior to the end of year.  

This distribution will usually be 50% of the amount of the individual’s prior year combined traditional IRA, Roth IRA and defined contribution account balance that surpasses the $10 million threshold.  

Roth Conversions 

The act would also eliminate Roth conversions for both IRAs and employer sponsored plans. This would specifically affect single taxpayers with a taxable income over $400,000, married taxpayers that file jointly with an income over $450,000 and heads of households with incomes over $425,000. 

Restriction on IRA Contributions 

Account Holder Status 

The proposal will also restrict IRA investments on the condition of the account holder’s status. The bill will prevent an IRA from holding any security if the issuer of the security requires the IRA owner to have a minimum number or level of assets or income. Or another option is that they have completed a minimum level of education or acquired specific licenses or credentials for it. For example, an IRA can no longer hold investments that are offered to accredited investors as these investments are traditionally securities that have yet to be registered under federal security laws. IRAs holding these types of investments after the bill is enacted would lose their IRA status. This is set to take effect for the tax year beginning after 12/31/21 but there will be a 2-year grace period to transition IRAs already holding these types of investments. 

Significant Interest 

The last major change identified in the act will disallow the investment of IRA assets in entities in which the owner has a significant interest. To prevent self-dealing, the current law restricts a taxpayer with an IRA from investing their IRA assets in a corporation, partnership, trust, or estate in which they have a 50% interest in or greater. For example, under the current law the IRA owner could invest their assets in a company that they own 1/3 of the business.   

The new bill will adjust the mark from 50% to 10% for investments that are not tradable on an established securities market, regardless of if the owner has a direct or indirect interest. The bill also prohibits investing in any entity that the IRA owner is an officer. The bill modifies this as a standard to be an IRA requirement otherwise it will lose its status. This takes effect 12/31/21 but there is a 2-year transition period for IRAs that currently don’t meet these requirements. 

While the final elements of this bill are still in the creation phase, all prudent investors and high incomer earners should pay close attention to the final details of this bill.  

Now is the time to work with your financial advisor or portfolio manager to ensure that these changes will not affect your retirement savings, personal investments, or business interests. If you are unsure on if these changes will affect you, we at Paragon Private Wealth Group welcome the opportunity to produce a financial strategy that benefits you and avoids these taxes and penalties when possible.