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Publish Date

Sep 13, 2021

Ways & Means Steps into Limelight with Tax Reform Proposal

A&M Tax Advisor Weekly

This morning, House Democrats on the Ways and Means Committee circulated a discussion draft of legislative text (“W&M Proposal”)  which were the first signs of what they are considering including within their reconciliation package. As of now, it seems that Yoda will need to be called in to use the force to find an agreement amongst the Democrats on the size of the package, as well as proposals that the Democrats in the House and in the Senate can agree upon.  It is highly likely that these proposals will be modified before being included in the final legislative text. However, we thought that discussing the similarities and differences between the various approaches to some of the key provisions can be helpful for taxpayers who should be considering the potential impact on their operations, including modeling.

Fortunately, it currently appears that taxpayers may have a few months before the new provisions would apply so time is of the essence.
Specifically, the following topics are covered in this alert:

Corporate Provisions

  • The corporate tax rate for businesses would be graduated, with the first $400k being subject to 18%, the remaining income up to $5 million being subject to a 21% rate, and any remaining income being subject to a 26.5% rate.

A&M Insight: The proposed increase to 26.5% is less than the Green Book’s proposed increase to 28% and also includes a tax rate reduction for smaller corporations. Additionally, the W&M Proposal does not appear to include the Green Book’s minimum tax based on book income. With that said, it seems increasingly likely that the corporate tax rate will increase for at least some taxpayers and so corporations should consider whether they would want to accelerate income into the current year or defer deductions into future years. The key to successfully evaluating how it would be best to do so is for taxpayers to begin to speak to their trusted advisors immediately.

International Provisions

With respect to potential international provisions, to date, we have seen Green Book proposals; a framework and legislative discussion draft for international tax reform by Senators Wyden, Brown, and Warner (“SFC Proposal,” discussed here); and the W&M Proposal.

  • Modify the Global Intangible Low-Taxed Income (GILTI) regime.

The following chart highlights how the various proposals compare.


A&M Insight: As highlighted in the chart above, we can begin to see some areas where the Democrats may be coalescing. Additionally, the proposed effective GILTI rate of approximately 16.6% is higher than the currently proposed 15% global minimum tax rate that the U.S. has agreed to as part of the OECD. However, there are also areas in which we see divergence (e.g., the SFC Proposal extends the high-tax exclusion to subpart F and foreign branch income, while the W&M Proposal is silent). As noted previously, the imposition of country-by-country calculations can have major implications for the GITLI calculation. Fortunately, at least the W&M Proposal explicitly allows for the carry forward of losses. However, taxpayers would still be encouraged to manage their international affairs to account for the potential complexity associated with a CbC calculation.

  • Retain, but modify, the Foreign-Derived Intangible Income (FDII).

Under current law, domestic corporations are allowed a deduction for 37.5% of its FDII, with the applicable percentage being reduced to 21.875% for taxable years beginning after December 31, 2026. The following table compares the proposed changes to FDII.


A&M Insight: In addition to maintaining the deduction for FDII, the W&M Proposal proposes to delay the applicability of the TCJA changes to section 174 (which will require taxpayers to capitalize and amortize their research and experimentation costs over a five-year period) from its originally scheduled effective date of January 1, 2022 to January 1, 2026.

Retain, but modify, the Base Erosion Anti-Abuse Tax (BEAT).

The approach with respect to the TCJA’s BEAT appears to be similar within the SFC Proposal and the W&M Proposal. Unlike the Green Book, which proposed to repeal the BEAT and replace it with the Stopping Harmful Inversions and Ending Low-Taxed Developments (SHIELD), both the SFC Proposal and the W&M Proposal retain the BEAT. Additionally, both intend to implement aspects of the SHIELD within the BEAT, while also increasing the applicable tax rate and addressing the current disallowance of tax credits.

A&M Insight: The potential of having SHIELD principles being interwoven into the BEAT poses a nightmare situation for both taxpayers and practitioners. While both the BEAT and the SHIELD are intended to address base erosion, their approaches differ vastly and so the complexity of having both apply in some fashion could make the section 163(j) business interest deduction limitation rules for partnerships seem like preschool fodder, which amusingly the W&M Proposal proposes to eliminate, as discussed below. As it seems increasingly likely that the BEAT will remain in existence, as opposed to being replaced, taxpayers are encouraged to evaluate their organizational structures and supply chain analysis for directionality of payments.

  • A foreign parented domestic corporation’s ability to deduct interest will be subject to an additional limitation, similar to the proposal within the Green Book.

A&M Insight: As noted in our previous alert, if this proposal is enacted, it may be beneficial to either increase foreign borrowings to create a higher limitation for U.S. interest expense or shift existing borrowing from the U.S. to foreign group companies. As a result, taxpayers are advised to begin to evaluate whether it would be beneficial to change which entity externally borrows from third-party creditors.

Individual Provisions

 

  • The top individual tax rate would increase to 39.6%, with an additional 3% surtax on individuals with a modified adjusted gross income in excess of $5 million.
  • The top capital gains tax rate would increase to 25% (or 28.8% taking into account the 3.8% net investment income tax (NIIT)).

A&M Insight: It is noteworthy that this provision is one of the few that would be retroactive. The proposed change would apply to sales or exchanges after September 13, 2021, subject to a binding contract exception.

  • TCJA’s carried interest provision would become stricter, requiring taxpayers to have a holding period of 5 years (as opposed to just 3 years) in order to recognize long-term capital gains in connection with “applicable partnership interests.” The 3-year holding period requirement would still apply to taxpayers with an adjusted gross income of at least $400k or for income that is attributable to a real property trade or business. Additionally, the scope of the carried interest provision would be expanded to capture all income that is treated as capital gains or subject to tax at the capital gain rate (which would capture section 1231 gains and qualified dividend income). Lastly, any transfer of an applicable partnership interest would be a taxable event.

A&M Insight: After Senator Wyden released draft legislation on Friday that would drastically alter the treatment of partnerships, many, including those in the private equity space, should be relieved that this is generally the only partnership provision within the W&M Proposal. That is not to say that further changes would not be made within the partnership realm, but complying with a 5-year holding period seems more reasonable and much less disruptive to business activity than all of the changes within Wyden’s draft legislation.

  • For taxpayers with adjusted gross income of at least $400k, the ability to exclude gain on the sale of small business stock, under section 1202, is limited to 50%.

A&M Insight: It is noteworthy that this provision is also retroactive, similar to the capital gains rate, so that it would apply to sales or exchanges after September 13, 2021, subject to a binding contract exception.

  • For taxpayers with taxable income greater than $400k (or $500k for joint filers), impose the 3.8% NIIT on earnings from passthrough businesses that are not wages or already subject to NIIT.
  • Amend section 199A to limit the deduction to $400k for an individual return (or $500k for joint filers).

A&M Insight: Section 199A was added by TCJA and was highly criticized by the President while he was on the campaign trail. However, the Green Book did not have a proposal to modify the provision to the surprise of many. Senator Wyden has proposed modifying it, along with the W&M Proposal, so it is likely that the section 199A deduction will be modified. This is significant for taxpayers that are evaluating all of the proposed changes and the effects it has on their potential choice of entity (i.e., partnership or corporation).

  • Permanently extend the section 461(l) limitation to disallow the use of business losses to offset non-business income.

Estate and Gift Provisions

  • Revert the estate exemption back to pre-TCJA levels (approximately $5.5 million) beginning in 2022.
  • Modify the tax treatment of grantor trusts so that they are included in the grantor’s estate at death and treats sales between grantor trusts and the grantor as a recognized transaction between unrelated third parties.
  • Modify the estate valuation rules to ignore partial ownership and lack of control discounts.

A&M Insight: While not taxpayer friendly, many were anticipating estate and gift changes similar to those within the W&M Proposal. While the actual legislative text will be important, what is most noteworthy is that it appears the effective date for these changes begins next year. Therefore, taxpayers can still implement estate and family wealth transfer plans this year, however, time is of the essence.

Other Provisions

  • Modify the section 163(j) business interest deduction limitation so that it applies at the partner or S-corporation shareholder level, as opposed to at the entity (partnership or S-corporation) level. Additionally, the section 163(j) disallowed business interest expense carryforward is limited to five taxable years (rather than indefinitely) for a carryforward arising in a taxable year beginning after December 31, 2021.

A&M Insight: The proposed modification to apply section 163(j) at the owner, as opposed to the entity level, is a welcome change that will eliminate complexity. However, the limitation on the duration of the carryforward could be problematic for startup companies and those that are anticipated to generate losses for the next several years.

  • Prohibit contributions to IRAs whose balances exceed $10 million and require mandatory distributions once they reach a specified threshold.
  • Subject cryptocurrency transactions to wash sale and disguised sale rules.
  • Accelerate the timing of the American Rescue Plan’s changes to section 162(m) so that beginning in 2022, the limitation applies to the top 5 compensated employees (instead of 2027).

A&M Tax Says: 
The W&M Proposal is just one step in the process as the Democrats are seeking to pass a partisan infrastructure bill. Whether the partisan bill will be finalized by September 27th is yet to be seen, but over the weekend, Senator Manchin threatened to block a $3.5T partisan package, while suggesting that he could support a package that is around $1.5T. Obviously, the size of the package would in turn drastically impact which tax changes will be included as the revenue demands would be less. If we harken back to our elementary school days and draw a Venn diagram of the various proposals, there does appear to be some areas where the White House and both the House and the Senate may be agreeing. It is within those areas that taxpayers should be particularly focused on, although no area is truly safe from broad tax reform. It continues to be imperative for clients to collaborate with their trusted advisors to navigate the landscape during this uncertain time. A&M will continue to monitor the tax reform process and will provide timely updates on new developments. If you would like to discuss your particular situation or the potential tax reform changes, including potentially modeling scenarios or identifying planning opportunities, please feel free to contact Kevin M. Jacobs.

https://www.alvarezandmarsal.com/insights/ma-trends-private-equity-market-activities-germany