MY ANALYSIS OF BUILD BACK BETTER TAX PROVISIONS PASSED ON 11/19/2021
After months of posturing and general government in-fighting, the House of Representatives passed a bill on Friday, November 19 (H.R. 5376, the Build Back Better Act (BBB). There are not nearly as many tax provision changes as I would have expected based on Biden’s agenda prior to being elected and the Democrats holding the Senate after the January runoff elections in Georgia. It is unlikely that the Senate does not make changes to this bill so planning around these actions before year-end will be almost impossible. It has been more than a few years since “tax reform” has been passed outside of late December and this year will likely be no different. What is notable is what isn’t in the bill. Capital gains rates doubling? NOPE. Marginal tax rates higher than 40%? NOPE. Major changes to the estate tax causing you to gift your business in 2021 to your 15-year-old kid 10-20 years too early? NOPE.
SALT
Of significance to higher income taxpayers (despite many lower income taxpayers thinking this is of significance) is the House bill raises the SALT cap (the state and local tax deduction) on Schedule A from $10k to $80k ($40k for married taxpayers filing separate). For higher income taxpayers paying rates about the alternative minimum tax of 28% (Alt Min or AMT), this is a large benefit that could save them almost $26k of federal income tax ($70k add’l SALT times 37% top federal income tax rate). For the middle class, it’s hard to say, but this won’t be a huge benefit to all. Most middle-class taxpayers don’t have $80K of SALT and even if they did, because the AMT adds it back, you likely get stuck in AMT. SALT is the deduction on Schedule A: Itemized Deductions for the greater of state and local income taxes or sales taxes and either option is combined with property taxes. For WA residents, you most likely are using sales taxes because at present, WA has no income tax (even the WA capital gains tax passed for 2022 is “not” an income tax depending on whether you believe Inslee and Olympia).
The increased standard deduction passed in the TCJA of 2017 reduced a large number of itemized deduction filers greatly. According the Tax Foundation, this converted over 36 million itemized deduction filers to standard deduction filers. The increase from $10k to $80k will certainly change this, but the actual benefit received by those in the lower and middle class will be marginal at best. And let’s be honest, do low-income people often pay high state and local income or sales taxes or is that reserved for the upper crust of America. Simply put, this is a benefit to coastal states that have big (D) voting power and often times, even bigger tax regimes (e.g., California, New York).
WASH SALE RULES ON CRYPTO
This one is a big deal for those who buy and sell a lot of cryptoassets. A wash sale occurs when you sell a security at a loss and then purchase that same security or “substantially identical” securities within 30 days (before or after the sale date).If you end up being affected by the wash-sale rule, your loss will be disallowed and added to the cost basis of the securities you repurchased. So, if you are buying that NFT with your ETH and some of that bitcoin is sold at a loss, but you are buying the dip the following day, you won’t get to recognize that loss on the ETH sold until you eventually sell the newer bitcoin which now has a higher cost basis than your purchase price. Wash sale rules are there to prevent people from manufacturing tax losses only to end up in the same economic position and the rules are well intended, but in practice, this will create a lot of complication. I don’t know that I trust brokers at companies like Fidelity and Schwab to calculate wash sales and the basis impacts correctly. Based on the limited crypto tax reporting I’ve seen, I have zero faith in their reporting. I do know Congress wants crypto buying and selling to be more transparent and this should help with that effort. I fear so many crypto HODLRs think their crypto escapes the income tax. It doesn’t. I will write more about crypto in a future installment. The bottom line is that if you receive it for selling something, a good or services, it is ordinary income based on the value of the good or service sold. If you hold it for investment purposes (i.e. growth), it is a capital asset in your hands and eligible for capital gain treatment, which can be good, but isn’t so great when held for less than 1 year and a day.
EXCESS BUSINESS LOSSES
Want to talk about terrible tax policy? I don’t, but I will. Sec. 461(l) of the Internal Revenue Code was enacted as a revenue raiser in the TCJA of 2017 to limit individuals and trusts from taking losses from their partnerships and/or S corporations in excess of $500k for married taxpayers (half that for singles). Adjusted for inflation, this will be $540k for married and $270k for singles. This was law in 2018, then suspended temporarily retroactively based on reaction to COVID-19 and will be back for 2021 tax returns. It was originally enacted to be gone after 2026. The BBB bill will make this permanent. Why is this stupid tax policy? It puts a benefit toward corporations that are not flow throughs. Their losses can benefit them to an unlimited amount, while individual taxpayers can only deduct an arbitrary limit. This law was poorly thought out in the first place and the BBB wants to continue this indefinitely to raise revenue. There has to be a better way.
3.8% SURCHAGE ON ACTIVE FLOW THROUGH INCOME
This is the most impactful change for clients I’ve worked with. The ACA (Obamacare) enacted a 3.8% surcharge on investment income that went into effect in 2013. This applies to interest, dividends, capital gains, and passive income in general. Active income from a business you materially participate in was excluded. Material participation is a difficult subject but most business owners that have a primary role in the company materially participate. The rules on rental real estate get a little weirder from there, but if you are a “real estate professional” your net income from real estate rentals escaped this tax.
The BBB will impose this tax on active income for taxpayers with taxable income over $400K for singles and $500k for marrieds (steep marriage penalty here). For taxpayers that are married filing separate the threshold starts at $250k.
RETIREMENT PLANS
Do your IRAs and 401(k) style retirement plans total greater than $10M? If you’re anything like most people, the answer is no. With limits on what can be contributed to these plans annually is around $25k if under 50 years old and closer to $31k when 50 or older, it isn’t easy to get these accounts to those levels. How people get balances above that is a discussion for another post. If you do have balances above $10M, you can’t add to it unless somehow you have income less than $450k (if married). $400k if single, $425k if head of household.
Also, there will be required distributions for taxpayers with balances above $10M which would create more income tax on these folks, and presumably before retirement when their marginal tax rates are higher.
These provisions don’t come into effect until 2029 so you can probably just pretend you didn’t read this as it will change by then even if enacted in the BBB.
Effective for 2022 though would be the complete shutdown of the backdoor Roth. I would have written about this sooner than later, but if enacted, I won’t. I’ve been doing these for years (not bragging, well, maybe a little) and will be disappointed if this gets through as is. My initial understanding was that these would be allowed for incomes under $400k. We will see what happens in the Senate. I don’t think these will permanently die. They do more to benefit the upper middle class in areas like Seattle where incomes are artificially higher than the uber rich. The uber rich contributing an extra $6-7k per year to their IRA is not what caused the wealth gap in this country.
TAX CREDIT EXPANSION
There is an expansion of the child and earned income tax credits in the BBB that I will leave you to google. This is how our government legislates social policy through the IRS, which is not an organization that should be relied on for speed or accuracy. I do know this, the child tax credit can be a max of $3,600 per child if your income is below $150k joint (half for singles) and at $400k of income, you are phased out completely. The earned income tax credit likely does not apply to readers of this, and be thankful it doesn’t.
There will be more “green” incentives in the BBB. Most noteworthy, is the expanded electric vehicle tax credit. This credit is up to $7,500 for qualified EVs, but don’t buy too nice of a vehicle. If a larger vehicle (SUV, van) costs more than $80k – no credit. For smaller cars, it can’t cost more than $55k. The credit will also phase out when your AGI is greater than $500k for marrieds ($250k for singles).
CHANGES TO 1202 STOCK (QUALIFIED SMALL BUSINESS STOCK)
This is a topic I plan to write more about depending on what happens with this in Congress, but for taxpayer’s with AGI above $400k, the 75% and 100% exclusion of gain on 1202 stock will evaporate into thin air and go back to the original 50% exclusion, which sounds good, but really only dropped the rate to 14%. That is still something when you consider the top long term capital gain rate is 20%, but not the 1202 we’ve come to love more recently.
TAX INCREASES THAT PROBABLY DON’T APPLY TO YOU
REALLY HIGH-INCOME SURCHARGE (unless it’s a trust, then it isn’t so high-income)
For individual taxpayers making greater than $10M of adjusted gross income (total of income before itemized deductions and the 20% passthrough deduction) a 5% surcharge will be enacted on income above $10M. An additional 3% surcharge will apply to income above $25M. For married taxpayers filing separate, the income thresholds are cut in half. For trusts, the surcharge starts at $200K and adds the add’l 3% at $500K. This should motivate some trusts to distribute more to beneficiaries to reduce the trust’s income tax rate.
15% MINIMUM TAX ON LARGE CORPORATIONS
The bill proposes a 15% minimum tax on large corporation profits. This is reserved for large companies making over $1B per year ($100M per year if having a foreign parent company) and while this is likely well intended, this is so wrought with problems it gives me agita just thinking about it. First, the income is based on U.S. GAAP principles (financial accounting) rather than income tax principles. This is done because these companies have figured out the U.S. tax code and pay very little income tax. The U.S. tax system is designed to promote investment in assets creating accelerated depreciation deductions and designed to promote U.S. employees performing research and development (R&D income tax credit). Using tools like these, among others, can reduce a profitable company’s tax bill down very low or to zero. The minimum tax will ensure these companies pay their fair share. Will it? I have to admit, I don’t know. I know that I will not be soon working on a client that this applies to and I’m thankful for that.
1% SURCHARGE ON CORPORATE STOCK BUYBACKS
This bill imposes a 1% surcharge on corporate stock buybacks equal to the fair market value (FMV) of any stock the corporation repurchases during the year effective after 12/31/2021. This applies to publicly traded U.S. companies.
There are a handful of international tax changes included that are intended to raise revenue for the Federal government. I’m not going to even pretend to care about them. I know what my lane is and what it isn’t.