Reality Check?
A few days ago, Sen. Wyden, the Ranking Member on the Senate Finance Committee, introduced a bill to tax carried interests as ordinary income on a current basis.[i] A day earlier, Sen. Van Hollen introduced a bill to reduce the federal estate tax exemption to $3.5 million and the gift tax exemption to $1.0 million.[ii]
In fact, Democrats in Congress have been introducing a number of tax bills over the last few weeks that convey a consistent theme: it’s time to tax the wealthy.[iii]
That being said, do they seriously believe that any of their legislative proposals have a realistic chance of making it onto the floor of either Chamber during the present, Republican-controlled Congress?[iv]
Of course not; but then again, that’s not the point.
Reading Tea Leaves?[v]
Political pundits are telling us that Democrats need to gain a net of four seats in the November 2026 general elections to win a majority in the Senate. Meanwhile, Republicans can only lose two seats and retain a majority in that chamber.[vi]
Turning to the House, Democrats need to gain a net of three districts to win a majority, while Republicans can lose no more than two districts to retain a majority in the chamber.[vii]
No one is talking about a veto-proof, Democrat-controlled Congress that can dictate legislation. So why all the activity?
In a sense, the above-referenced bills, and other federal tax proposals that have been introduced by the Party with varying degrees of publicity during the last several weeks,[viii] represent the opening salvos in this year’s Congressional election campaigns and provide a preview of the contest for the Presidency two years hence.[ix]
Beware The Political Pendulum
In effect, the Party is signaling what its tax priorities will be in the event it takes the White House and controls Congress in 2028.[x]
For that reason, those who advise taxpayers within the populations targeted by these proposals – which, in my practice, include the successful closely held business, its owners and their families, and the investments they’ve made thanks to the success of the business – should familiarize themselves, generally, with what may be included on a federal “tax-the-wealthy” agenda and how it may affect their clients.
Close Call
Lest anyone think the foregoing is only so much hyperbole, please recall how close a Democrat-controlled federal government came to bringing a similar agenda to life in November 2021.[xi]
The tax heavy reconciliation bill,[xii] known as the “Build Back Better Plan” – which would have significantly increased the income tax burden on individual taxpayers making more than $400,000 – had already passed the House along strict party lines before running into the opposition of then-Senators Manchin and Sinema (both Democrats), following which it was eviscerated in the evenly-divided Senate.[xiii]
A hard-earned lesson, for sure. Next time around, you can be certain no one’s vote will be taken for granted and there won’t be any dissenting voices from its own side of the aisle to prevent the Party’s tax writers from going to town.
With that admonition in mind, let’s itemize some of the basic measures that have a good chance of being included in a Democrat-directed tax reconciliation bill in the not-too-distant future, and especially those that may be of considerable interest to closely held businesses and their owners.[xiv]
What to Expect
Taxes on Income
- Increase the federal income tax rate for C corporations from a flat rate of 21% to 28%;[xv]
- Increase the top marginal individual income tax rate from 37% to 39.6%, and lower the top bracket threshold[xvi] at which the increased rate would apply;[xvii]
- Tax long-term capital gains and qualified dividends of individual taxpayers with adjusted gross income of more than $1 million at ordinary income tax rates[xviii] (the 3.8% surtax on net investment income would continue to apply);
- Impose a minimum tax of 20% on total income, generally inclusive of unrealized capital gains, for individual taxpayers with net wealth in excess of $100 million;
- Treat an individual donor’s gift of appreciated property as a gain recognition event (i.e., a deemed sale of the gifted property) for purposes of the income tax;
- Treat a transfer of property upon the death of a deceased transferor as a gain recognition event for purposes of the income tax;
- Determine the value of a partial interest in property transferred by gift or at death without applying valuation discounts for lack of control or lack of marketability;
- Apply the 3.8% Medicare tax to all trade or business income of high-income taxpayers, either through the NIIT[xix] – by amending the definition of net investment income to include gross income and gain from any trades or businesses that is not otherwise subject to employment taxes – or the SECA tax;[xx]
- Impose the SECA tax on the distributive shares of ordinary business income of limited partners and LLC members who provide services and materially participate in their partnerships’ and LLCs’ trade or business;[xxi]
- Impose the SECA tax on the distributive shares of ordinary business income of S corporation shareholders who materially participate in the corporations’ trade or business;
- Increase the additional Medicare tax rate by 1.2 percentage points for high-income taxpayers;[xxii]
- In the case of a profits interest in an investment partnership that is held by a person who provides services to the partnership, tax the profits interest holder’s share of partnership income as ordinary income, not as capital gain, and subject it to self-employment taxes, regardless of the character of the income at the partnership level;
- Limit to $500,000 per individual taxpayer the amount of gain, per year, from the sale of qualifying real property that may be deferred in a like kind exchange;[xxiii]
- Treat as ordinary income all of the gain from the disposition of Section 1250 property[xxiv] held for more than one year to the extent of the cumulative depreciation deductions taken;[xxv]
- Reduce the ability of related parties to use a partnership distribution to shift partnership basis among themselves by applying a matching rule that would prohibit any partner in the distributing partnership that is related to the distributee-partner from benefitting from any resulting partnership basis step-up until the distributee-partner disposes of the distributed property in a fully taxable transaction;[xxvi]
- Require a high-income taxpayer with an aggregate vested account balance under a tax-favored defined contribution plan that exceeds $10 million as of the last day of the preceding calendar year to distribute a minimum of 50% of that excess;
- Direct additional resources, including enhanced information technology, toward the enforcement of the tax laws against those with the highest incomes;[xxvii]
Transfer Taxes - Require that the remainder interest in a GRAT[xxviii] at the time the interest is created have a minimum value for gift tax purposes equal to the greater of 25% of the value of the assets transferred to the GRAT or $500,000, require that a GRAT have a minimum term of ten years and a maximum term of the life expectancy of the annuitant plus ten years, and prohibit the grantor from acquiring in an exchange an asset held in the GRAT without recognizing gain or loss for income tax purposes;[xxix]
- In the case of an irrevocable grantor trust, treat the transfer of an appreciated asset for consideration (including the satisfaction of an obligation) between the trust and its deemed owner as one that is regarded for income tax purposes, which would result in the recognition of gain by the seller;[xxx]
- Treat as a taxable gift the grantor’s payment of the income tax on the income of a grantor trust;[xxxi]
- In the case of an individual taxpayer who treats a promissory note as having a sufficient rate of interest to avoid the treatment of any part of the transaction as a gift,[xxxii] such note must subsequently be valued for federal gift and estate tax purposes by limiting the discount rate to the greater of the actual rate of interest of the note, or the applicable minimum interest rate for the remaining term of the note;
- Restrict the use of dynasty trusts to remove assets from the transfer tax system by limiting application of the GST exemption[xxxiii] to: (a) direct skips and taxable distributions[xxxiv] to beneficiaries who are 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, thereby;[xxxv]
- Provide an automatic 10-year lien (extended to continue for any deferral or installment period) on all gifts made by a donor, and on all property included in a decedent’s gross estate, to enforce the collection of gift and estate tax liabilities from the donor or the decedent’s estate, as applicable;
- The value of property that is the subject of a gift or testamentary transfer that uses a defined value formula clause to determine the value of the property based on the result of involvement of the IRS, will be deemed to be valued as reported on the corresponding gift or estate tax return;[xxxvi]
- Change the annual exclusion rules to impose an annual limit of $50,000 per donor (not donee) in the aggregate, such that a donor’s transfers in a single year in excess of a total amount of $50,000 would be taxable;
- Treat a loan made by a trust to a trust beneficiary as a distribution for income tax purposes (carrying out an appropriate portion of distributable net income to the borrowing beneficiary), and for GST tax purposes (constituting either a direct skip or taxable distribution);
- Treat the value of a partial interest in a closely held trade or business that is transferred to or for the benefit of a family member of the transferor as equal to the interest’s pro-rata share of the collective fair market value of all interests in that property held by the transferor and the transferor’s family members, with that collective value being determined as if held by one individual;[xxxvii]
- In the case of an irrevocable grantor trust, treat the trust’s purchase of assets from a trust that is subject to GST tax as a change in trust principal that would require the redetermination of the purchasing trust’s inclusion ratio when those assets are purchased;
- Require that the annuity payments made to charitable beneficiaries of a CLAT at least annually must be a level, fixed amount over the term of the CLAT, and that the value of the remainder interest at the creation of the CLAT must be at least 10% of the value of the property used to fund the CLAT;
Other - Provide that a distribution by a private foundation to a donor advised fund (DAF) is not a qualifying distribution[xxxviii] unless the funds are expended by the DAF as a qualifying distribution by the end of the following taxable year;
- The payment of compensation, or the reimbursement of expenses, by a private foundation to a disqualified person (other than certain foundation managers) would not be a qualifying distribution that satisfies the payout requirement.
What’s Next
If the foregoing proposals were enacted, it is doubtful they would have much of an impact on the federal deficit or on the government’s ability to service its outstanding indebtedness.
They would, however, have a significantly adverse effect on the owners of many closely held businesses.
Moreover, the proposals described above are just a sampling of the federal tax obstacles[xxxix] these owners and their advisers may have to confront in a couple of years, assuming a Democrat trifecta in 2028. There will certainly be others.[xl]
Until then, it would behoove these taxpayers to take advantage, as much as practicable, of the rules that are currently in place, to stay informed of proposed changes to the tax laws, and to position themselves, their businesses, and their investment interests in such a way that will afford them the most flexibility and greatest number of options for responding to adverse changes in the tax laws.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i] Think along the lines of the imputed interest rules under IRC Sec. 7872.
[ii] We haven’t seen these levels since 2009.
[iii] It’s a theme that many states have been pursuing aggressively over the last couple of years.
[iv] In case you’re wondering, we’re in the 119th Congress; its 2-year term ends January 3, 2027.
[v] In the Eastern Mediterranean and Middle East, the thick sediment that remains at the bottom of a cup of coffee is sometimes turned upside down onto a saucer and one reads, or interprets, the shapes formed to “predict” the future.
[vi] https://ballotpedia.org/United_States_Congress_elections,_2026. There are also two special elections for the unfinished terms of V.P. Vance and Sec. Rubio.
[vii] This calculus is complicated by the legal status of redistricting laws and the many resignations and retirements.
[viii] Senator Booker made sure that his plan to reduce taxes on low- and middle-income taxpayers while raising them on the wealthy received the coverage it “deserved” when it was introduced last month.
[ix] November 7, 2028.
[x] Hardly far-fetched. Moreover, several Blue States have been especially active in pursuing their wealthier residents. For example, Washington, Maine, Minnesota, Massachusetts, California, and others have enacted or are considering millionaire taxes and/or wealth taxes. New York appears to be leaning toward an increased corporate income tax rate, but the possibility of a rate hike on wealthy individuals cannot be ruled out, notwithstanding Hochul’s protestations against such a measure. Foreshadow?
[xi] I should also remind you that a Democratic Socialist was recently elected Mayor of New York City. His former colleagues in Albany have been flexing their muscles ever since.
[xii] A reminder: the reconciliation process, pursuant to which bills may be passed on a simple majority vote, is useful when the same party controls the White House, the Senate and the House, but lacks the 60-vote majority needed to overcome a filibuster in the Senate.
[xiii] Then-V.P. Harris would have broken the expected tie.
[xiv] These are culled from proposals made during the Biden administration (some of which harken back to the Obama and Clinton years) and from more recent proposals.
[xv] IRC Sec. 11.
[xvi] Which in itself constitutes an additional rate increase.
[xvii] IRC Sec. 1.
[xviii] IRC Sec. 1(h).
[xix] IRC Sec. 1411.
[xx] IRC Sec. 1401.
[xxi] This issue is being fought in the courts, where the government has been having a difficult time.
[xxii] IRC Sec. 3101(b)(2) for wages and Sec. 1401(b)(2) for self-employment income.
[xxiii] IRC Sec. 1031.
[xxiv] Depreciable real property.
[xxv] Under current rules, such gain is recaptured as ordinary income only to the extent such depreciation exceeds the cumulative allowances determined under the straight-line method.
[xxvi] As where the distribution is undertaken by a partnership with an IRC Sec. 754/Sec.734 election in effect for the purpose of creating advantageous tax results with no meaningful economic consequences.
[xxvii] This would encompass the vehicles through which such individuals engage in business or hold their investments, including partnerships.
[xxviii] Grantor retained annuity trust. IRC Sec. 2702.
[xxix] In other words, prevent the grantor’s use of IRC Sec. 675(4) to acquire property from the trust by substituting other property of equal value. This right of substitution is already denied to the grantor of a QPRT. Reg. Sec. 25.2702-5(c)(9).
[xxx] In other words, revoke Rev. Rul. 85-13, which is the foundation for so much estate planning.
[xxxi] Basically, revoke Rev. Rul. 2004-64.
[xxxii] IRC Sec.7872.
[xxxiii] IRC Sec. 2631.
[xxxiv] IRC Sec. 2612.
[xxxv] As a result, the benefit of the GST exemption that shields property from the GST tax would not last as long as the trust. Instead, it would shield the trust assets from GST tax only 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 but who was alive at the creation of the trust. At the appropriate time, the inclusion ratio of the trust would become one, thereby rendering no part of the trust exempt from GST tax.
[xxxvi] In other words, the re-valuation cannot be based upon an audit adjustment.
[xxxvii] The value of its passive assets would not be included; their FMV would be determined as if they were held directly by the one individual. In other words, discounting would be available as to these.
[xxxviii] IRC Sec. 4942.
[xxxix] As already indicated, the states are well ahead of the federal government in pursuing wealthier taxpayers.
[xl] For example, a scaling back of bonus depreciation.