The Budget and Accounting Act of 1921 established the requirement that the President submit a budget to Congress for the upcoming fiscal year.[i] Among other things, the proposed federal budget affords the President an opportunity to identify priorities for the next fiscal year, to quantify how much the Administration expects it will cost the government to attain the President’s goals, and to explain how and from what sources the funds needed to cover these expenses will be raised.
Although the President is legislatively required to propose a budget, it is Congress, in the exercise of its Constitutional authority, that ultimately determines which programs the government will fund, how much it will spend on such programs, and how it will finance those outlays.[ii]
Undoubtedly, the $5 trillion in tax increases requested by the President in the FY 2024 Budget submitted last week will evoke not-so-fond memories of Mr. Biden’s ill-fated Build Back Better plan of 2021 in which he requested a “mere” $2 trillion in tax hikes.
Unfortunately for the President, the chances of his proposals being enacted this time around are even more remote than they were two years ago because his Party no longer controls both Chambers as it did then. That said, should Mr. Biden have taken a different approach?
The Administration is certainly aware that Congress, or at least the House, will not be receptive to Mr. Biden’s proposed tax increases. Then again, why should anyone assume that the message conveyed by the Administration via the budget was intended for the divided and dysfunctional Congress?
No Time to Rest
If anything, the budget is in all likelihood directed toward the electorate – the more than 98 percent of the public that does not make more than $400,000 per year – and represents one of the earliest salvos in the 2024 national election campaign.
Thus, instead of treating the President’s budget as “DOA,” it behooves those who advise closely held businesses and their owners to familiarize themselves with the President’s latest tax proposals, and to consider how their clients may be impacted if a version thereof were enacted in the not-too-distant future.[iii]
This is a daunting task because the budget professes to “reform” the taxation of those it describes as “high-income” taxpayers by proposing a veritable smorgasbord of amendments to the Code.
What follows is a necessarily brief description of certain proposals that may be of interest to many business owners.[iv]
- The income tax rate for C corporations would be increased from a flat 21 percent to 28 percent.
- The “boot-within-gain” limitation[v] would be repealed for tax-deferred reorganization transactions[vi] in which the shareholder’s exchange is treated as having the effect of the distribution of a dividend[vii]; the entire amount of dividend “boot” received in the exchange would be taxable.[viii]
- The related party sale rules[ix] would be modified to deny the deduction of losses realized in a complete liquidation of a corporate subsidiary within a controlled group where the assets of the liquidating corporation remain in the controlled group after the liquidation.[x]
- For purposes of the tax-deferred reorganization provisions, “control” would be defined as the ownership of at least 80 percent of the total voting power and at least 80 percent of the total value of stock of a corporation.[xi]
- In the case of a distribution of partnership property that results in a basis step-up for the partnership’s non-distributed property,[xii] any partner in the distributing partnership that is related to the distributee-partner would be prohibited – in an extension of the related party rules – from benefitting from the partnership’s basis step-up until the distributee-partner disposes of the distributed property in a fully taxable transaction.
- The excess business loss limitation, which disallows the deduction by noncorporate taxpayers of current year net business losses over a specified dollar amount, would be made permanent.[xiii] In addition, the use of such losses that are carried forward to later years would be limited by treating them as excess business losses[xiv] instead of as NOL deductions.[xv]
- The trade or business income of an individual subject to the net investment income tax (“NIIT”)[xvi] would be expanded to include all pass-through business income of a taxpayer with adjusted gross income of at least $500,000,[xvii] including income derived from S corporations and partnerships in which the individual owner materially participates.[xviii]
- The Medicare tax rate would be increased by 1.2 percentage points for taxpayers with more than $400,000 of earnings. When combined with current-law tax rates, this would bring the marginal Medicare tax rate up to 5 percent for earnings above the threshold (which would be indexed for inflation).
- The NIIT rate would be increased by 1.2 percentage points for taxpayers with more than $400,000 of income, bringing the marginal NIIT rate from 3.8 percent to 5 percent for investment income above the threshold.
- The top marginal income tax rate would be increased to 39.6 percent from 37 percent and would apply to taxable income over $450,000 for married individuals filing a joint return, $400,000 for unmarried individuals, and $225,000 for married individuals filing a separate return.[xix]
- Long-term capital gains (including such gain recognized on the sale of a business) and qualified dividends[xx] of taxpayers with taxable income of more than $1 million would be taxed at ordinary rates.[xxi] The proposal would only apply to the extent that the taxpayer’s taxable income exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2024. For example, a taxpayer with $1.1 million in taxable income of which $200,000 is preferential capital income would have $100,000 of capital income taxed at the preferential rate and $100,000 taxed at ordinary rates.
- The donor of an appreciated asset or the deceased owner of such an asset would realize a capital gain at the time of the lifetime gift or testamentary transfer of the asset. The amount of the gain realized would be the excess of the asset’s fair market value[xxii] on the date of the gift or the decedent’s date of death over the donor’s or decedent’s basis in that asset. That gain would be taxable income to the donor or to the decedent’s estate.[xxiii]
- Every donor would be allowed a $5 million exclusion from recognition of unrealized capital gains on property transferred by gift during life;[xxiv]
- A transferred partial interest generally would be valued at its proportional share of the fair market value of the entire property, provided that this rule would not apply to an interest in a trade or business to the extent that its assets are actively used in the conduct of that trade or business;[xxv]
- Transfers of property into, and distributions in kind from a trust, other than a grantor trust that is deemed to be wholly owned and revocable by the donor, would be recognition events;
- Transfers of property to, and by, a partnership or other non-corporate entity, if the transfers have the effect of a gift to the transferee would also be gain recognition events;
- The deemed owner of a revocable grantor trust would recognize gain on the unrealized appreciation in any asset distributed from the trust to any person other than the deemed owner or the U.S. spouse of the deemed owner;
- All of the unrealized appreciation on assets of a revocable grantor trust would be realized at the deemed owner’s death or at any other time when the trust becomes irrevocable.[xxvi]
- Gain on the unrealized appreciation of property would be recognized by a trust, partnership, or other noncorporate entity that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years.[xxvii]
- Taxpayers with a net worth greater than $100 million would be subject to a minimum tax of 25 percent on taxable income, generally inclusive of unrealized gains
- Taxpayers with wealth greater than the threshold would be required to report to the IRS on an annual basis, separately by asset class, the total basis and total estimated value[xxviii] (as of December 31 of the taxable year) of their assets in each specified asset class, and the total amount of their liabilities.
- A taxpayer who is treated as illiquid (their tradeable assets make up less than 20 percent of their wealth) may elect to include only unrealized gain in tradeable assets in the calculation of their minimum tax liability. However, taxpayers making this election would be subject to a deferral charge upon, and to the extent of, the realization of gains on any non-tradeable assets. The deferral charge would not exceed ten percent of unrealized gains.[xxix]
Estate and Gift Taxation
- The duration of the automatic lien would be extended beyond the current 10-year period to continue during any deferral or installment period for unpaid estate and gift taxes.
- If a gift or bequest uses a “defined value formula clause”[xxx] that determines value based on the result of involvement of the IRS (for example, an audit), then the formula clause will be disregarded and the value of such gift or bequest will be deemed to be the value as reported on the corresponding gift or estate tax return. However, a defined value formula clause would be effective if (a) the unknown value is determinable by something identifiable (other than activity of the IRS), such as an appraisal that occurs within a reasonably short period of time after the date of the transfer (even if after the due date of the return) or (b) the defined value formula clause is used for the purpose of defining a marital or exemption equivalent bequest at death based on the decedent’s remaining transfer tax exclusion amount.
- The “present interest” requirement for gifts that qualify for the gift tax annual exclusion would be eliminated.[xxxi] Instead, there would be an annual limit of $50,000 per donor (indexed for inflation after 2024) on the donor’s transfers of property that would qualify for the gift tax annual exclusion. This new $50,000 limit would not provide an exclusion in addition to the annual per-donee exclusion; rather, it would be a further limit on those amounts that otherwise would qualify for the annual per-donee exclusion. Thus, a donor’s transfers in the new category in a single year in excess of a total amount of $50,000 would be taxable (and would exhaust a portion of their remaining exemption amount[xxxii]), even if the total gifts to each individual donee did not exceed $17,000.
- The GST exemption[xxxiii] would apply only to: (a) direct skips and taxable distributions to beneficiaries no more than two generations below the transferor, and to younger generation beneficiaries who were alive at the creation of the trust; and (b) taxable terminations occurring while any person described in (a) is a beneficiary of the trust. The generation assignment of trust beneficiaries once GST tax has been imposed, treating younger generations of skip persons as being in the first generation below that of the transferor (and thus as non-skip persons), would not apply in determining the generation assignment of a beneficiary for purposes of testing whether the GST exemption has terminated.[xxxiv]
- Upon the expiration of this limit on the duration of the GST exemption, the trust’s inclusion ratio would be increased to one, thereby rendering no part of the trust exempt from GST tax.[xxxv]
- The remainder interest in a GRAT at the time the interest is created would be required to have a minimum value for gift tax purposes equal to the greater of 25 percent of the value of the assets transferred to the GRAT or $500,000 (but not more than the value of the assets transferred).[xxxvi] In addition, any decrease in the annuity during the GRAT term would be prohibited and the grantor would be prohibited from acquiring in an exchange an asset held in the trust without recognizing gain or loss for income tax purposes. Finally, a GRAT would be required to have a minimum term of ten years and a maximum term of the life expectancy of the annuitant plus ten years.
- For trusts that are not fully revocable by the deemed owner,[xxxvii] the transfer of an asset for consideration (for example, a promissory note) between a grantor trust and its deemed owner would not be disregarded for income tax purposes and would result in the seller recognizing gain on any appreciation in the transferred asset.[xxxviii] Such regarded transfers would include sales as well as the satisfaction of an obligation (such as an annuity or unitrust payment) with appreciated property.
- The grantor-deemed owner’s payment of the income tax on the income of a grantor trust (other than a trust that is fully revocable by the grantor) would be treated as a gift that occurs at the end of the year in which the income tax is paid unless the deemed owner is reimbursed by the trust during that same year.[xxxix]
- The annuity payment made to charitable beneficiaries of a CLAT at least annually must be a level, fixed amount over the term of the CLAT, and the value of the remainder interest at the creation of the CLAT must be at least 10 percent of the value of the property used to fund the CLAT, thereby ensuring a taxable gift on creation of the CLAT.
- Loans made by a trust to a trust beneficiary would be treated as a distribution for income tax purposes, carrying out each loan’s portion of distributable net income to the borrowing beneficiary. In addition, a loan to a trust beneficiary would be treated as a distribution for GST tax purposes, thus constituting either a direct skip or taxable distribution, depending upon the generation assignment of the borrowing beneficiary.[xl]
- If a taxpayer treats any promissory note as having a sufficient rate of interest to avoid the treatment of any foregone interest on the loan as income or any part of the transaction as a gift, that note subsequently must be valued for Federal gift and estate tax purposes by limiting the discount rate to no more than the greater of the actual rate of interest of the note, or the applicable minimum interest rate for the remaining term of the note on the date of death.
- A partner’s share of income on an “investment services partnership interest” (ISPI; basically, a profits interest) in an investment partnership would generally be taxed as ordinary income regardless of the character of the income at the partnership level, if the partner’s taxable income (from all sources) exceeds $400,000. Accordingly, such income would not be eligible for the reduced rates that apply to long-term capital gains. In addition, partners in such investment partnerships would be required to pay self-employment taxes on ISPI income if the partner’s taxable income (from all sources) exceeds $400,000. In order to prevent income derived from services from avoiding taxation at ordinary income rates, the gain recognized on the sale of an ISPI would generally be taxed as ordinary income, not as capital gain, if the partner is above the income threshold.
- A taxpayer would be allowed to defer gain up to an aggregate amount of $500,000 ($1 million in the case of married individuals filing a joint return) each year for real property exchanges that are like-kind. Any gains from like-kind exchanges in excess of $500,000 (or $1 million in the case of married individuals filing a joint return) in a year would be recognized by the taxpayer in the year the taxpayer transfers the real property subject to the exchange.
- Upon disposition, any gain on an item of “Section 1250 property” – i.e., buildings and certain other real property – held for more than one year would be treated as ordinary income to the extent of the cumulative depreciation deductions taken after the effective date of the provision.[xli] The foregoing change would not apply to noncorporate taxpayers with adjusted gross income below $400,000 ($200,000 for married individuals filing separate returns). Partnerships and S corporations would be required to compute the character of gains and losses on business-use property (including section 1250 property) at the entity level and to report to entity owners the relevant amounts for ordinary income (loss), capital gain (loss), and unrecaptured section 1250 gain under both “new law” and “old law”.
Other than the magnitude of the tax hikes included therein, the 2024 Budget submitted to Congress by the President last week should not surprise most observers. As stated earlier, Mr. Biden is seeking to resuscitate his Build Back Better plan.
There may be a key difference, however, between the President’s game plan in 2021 and now. At that time, the Administration was genuinely looking to enact far-reaching tax legislation; after all, the Democrats controlled both Chambers of Congress.
This time around, there is little chance of enactment, at least at present. Instead, Mr. Biden is appealing to and trying to win the support of the electorate – the “98 percent.” Can enough of the voting public be persuaded that the tax increases proposed for the 2 percent, described above, are necessary?
We’ll have to wait and see.
[i] The Feds have a September 30 FYE. The budget submitted last week – the FY 2024 budget – is for the fiscal year beginning October 1, 2023 and ending September 30, 2024.
[ii] Article 1, Sec. 9 of the Constitution grants Congress power over spending decisions, while Article 1, Sec. 8 grants Congress the power to impose taxes and to borrow money.
[iii] A majority of Americans favor increased taxes on those with high incomes. If enough rank-and-file Republicans can be persuaded that this is good for them (as an economic class), members of Congress may go along in order to keep their jobs – reelection at all costs.
[iv] There is so much more in the budget than what is summarized here. The provisions dealing with foreign operations and foreign-source income of U.S. taxpayers alone are a bear.
The endnotes try to explain the reason for the proposed change.
[v] IRC Sec. 356(a)(1) and (2).
[vi] Described in IRC Sec. 368.
[vii] Determined by treating a target shareholder as having received qualifying stock consideration which is then redeemed. The characterization of the deemed redemption as a dividend is determined by applying IRC Sec. 302.
[viii] If, as part of a corporate reorganization, a shareholder receives in exchange for stock of the target corporation both stock and property not permitted to be received without the recognition of gain (often referred to as “boot”; for example, money), the exchanging shareholder is required to recognize gain equal to the lesser of the gain realized in the exchange or the amount of boot received. Thus, it is possible for a shareholder not to be taxed on cash received in excess of the gain realized.
[ix] IRC Sec. 267.
[x] In general, if a corporation distributes its property in complete liquidation, the shareholders of the corporation recognize gain or loss on their stock under IRC Sec. 331, and the corporation recognizes gain or loss on the property distributed to the shareholders under IRC Sec. 336.
Under IRC Sec. 332, however, if the same corporate shareholder owns 80 percent or more (by vote and value) of the distributing corporation’s stock, then the 80 percent corporate shareholder does not recognize gain or loss on the liquidation and, under IRC Sec. 337, the liquidating corporation does not recognize gain or loss on property distributed to the 80 percent shareholder.
There is a concern that a parent corporation may intentionally reduce its ownership of a subsidiary below 80 percent (through a transfer to a related entity) to recognize a loss on liquidation of the subsidiary notwithstanding that the parent hasn’t disposed of its investment.
[xi] IRC Sec. 368(c). At present, “control,” as defined by IRC Sec. 368(c), requires ownership of stock possessing at least 80 percent of the total combined voting power of all classes of voting stock and at least 80 percent ownership of the total number of shares of each class of outstanding nonvoting stock of the corporation.
Because value is not considered, it may be possible to manipulate the presence or absence of control to achieve a desired outcome.
[xii] IRC Sec. 754 and Sec. 734.
A partnership is permitted to make an IRC Sec. 754 election to adjust the basis of its property under Sec. 734 when it makes certain distributions of money or property to a partner.
[xiii] IRC Sec. 461(l). The Inflation Reduction Act of 2022 extended this provision’s expiration date from January 1, 2027 to January 1, 2029.
In 2023, these specified amounts are $578,000 for married couples filing jointly, and $289,000 for all other taxpayers. These specified amounts are adjusted for inflation each year.
[xiv] The deduction of which may be deferred further by the threshold amount in subsequent years.
[xv] IRC Sec. 172.
[xvi] IRC Sec. 1411.
[xvii] This threshold would not be indexed for inflation.
[xviii] At present, such income is not subject to the 3.8 percent NIIT.
[xix] After 2024, the thresholds would be indexed for inflation.
The 37% top marginal rate for 2022 applies to taxable income in excess of $647,850 for a married couple filing jointly.
[xx] IRC Sec. 1(h).
[xxi] Assuming the ordinary rate is increased to 39.6 percent, and assuming the NIIT rate is increased to 5 percent, a taxpayer could be looking at a combined federal tax rate of 44.6 percent on their long-term capital gain.
Imagine selling one’s business after years of building it, only to see more than half of its value disappear in taxes when you add state and local taxes to this federal rate.
[xxii] A transfer would be defined under the gift and estate tax provisions and would be valued at the value used for gift or estate tax purposes.
[xxiii] The tax imposed on gains deemed realized at death would be deductible on the estate tax return of the decedent’s estate (if any).
The recipient’s basis in property, whether received by gift or by reason of the decedent’s death, would be the property’s fair market value at the time of the gift or the decedent’s death.
[xxiv] This exclusion would apply only to unrealized appreciation on gifts to the extent that the donor’s cumulative total of lifetime gifts exceeds the basic exclusion amount in effect at the time of the gift. In addition, the proposal would allow any remaining portion of the $5 million exclusion that has not been used during life as an exclusion from recognition of other unrealized capital gains on property transferred by reason of death. This exclusion would be portable to the decedent’s surviving spouse under the same rules that apply to portability for estate and gift tax purposes (resulting in a married couple having an aggregate $10 million exclusion) and would be indexed for inflation after 2023.
[xxv] The assets targeted are investment assets.
[xxvi] Certain exclusions would apply. Transfers to a U.S. spouse or to charity would carry over the basis of the donor or decedent. Capital gain would not be realized until the surviving spouse disposes of the asset or dies, and appreciated property transferred to charity would be exempt from capital gains tax. The transfer of appreciated assets to a split-interest trust would be subject to this capital gains tax, with an exclusion from that tax allowed for the charity’s share of the gain based on the charity’s share of the value transferred as determined for gift or estate tax purposes.
[xxvii] This provision would apply to property held on or after January 1, 1942, that is not subject to a recognition event after December 31, 1941, so that the first recognition event would be deemed to occur on December 31, 2032.
[xxviii] Tradable assets (for example, publicly traded stock) would be valued using end-of-year market prices. Taxpayers would not have to obtain annual, market valuations of non-tradable assets. Instead, non-tradable assets would be valued using the greater of the original or adjusted cost basis, the last valuation event from investment, borrowing, or financial Statements, or other methods approved by the Secretary. Valuations of non-tradable assets would not be required annually and would instead increase by a conservative floating annual return (the five-year Treasury rate plus two percentage points) in between valuations.
[xxix] Think along the lines of IRC 453A.
[xxx] Wandry v. Commissioner, T.C. Memo 2012-88.
[xxxi] IRC Sec. 2503(b).
[xxxii] Currently $12.92 million.
[xxxiii] $12.92 million in 2023.
An allocation of GST exemption to a trust has the potential to exclude from GST tax not only the value to which GST exemption was allocated, but also all subsequent appreciation and accrued income on that value during the existence of the trust.
[xxxiv] The result of these proposals is that the benefit of the GST exemption, which shields property from the GST tax, would not last for a trust’s duration. Instead, the GST exemption would only shield the trust assets from GST tax for as long as the life of any trust beneficiary who either is no younger than the transferor’s grandchild or is a member of a younger generation who was alive at the creation of the trust.
[xxxv] The government is rightfully, in my opinion, taking aim at dynasty trusts.
[xxxvi] Good-bye zeroed out GRATs?
[xxxvii] I.e., not includible in the grantor’s gross estate for purposes of the estate tax.
[xxxviii] Good-bye sales to grantor trusts.
[xxxix] Greatly limiting Rev. Rul. 2004-64.
[xl] Within one year after the final payment made on the loan to the trust (whether or not that constitutes full satisfaction of the loan), a refund of the appropriate amount of GST tax (with interest only from the date of the claim for refund) could be requested to be refunded to the payor of the GST tax that was incurred when the loan was made.
[xli] Depreciation deductions taken on section 1250 property prior to the effective date would continue to be subject to current rules and recaptured as ordinary income only to the extent that such depreciation exceeds the cumulative allowances determined under the straight-line method. Any gain recognized on the disposition of section 1250 property in excess of recaptured depreciation would be treated as section 1231 gain. Any unrecaptured gain on section 1250 property would continue to be taxed to noncorporate taxpayers at a maximum 25 percent rate.