Background and Current Status
In my last blog, in July, I discussed the status of each of the separate elements of the bi-partisan infrastructure proposal, which was passed by the Senate (69-30) in August as a $1 trillion bi-partisan bill. The final bill included a provision requiring “brokers” to report on their customers’ digital assets (crypto-assets). A last minute attempt to narrow the scope of this provision failed. After some negotiations with the House Democratic moderate faction, House leadership agreed to allow a vote on the Senate-passed legislation by September 27, and the bill appears to be on track to become law.
The House and Senate Democrats have also vigorously moved ahead on the Reconciliation budget legislation. The budget was approved in late August at a $3.5 trillion level. Committee mark-ups have been held to advance the Reconciliation legislation on the House side, including with respect to taxes by the Ways and Means Committee on September 13-15. Ways and Means has not yet released its final committee report, but the mark-up tax legislation was estimated to allow $1.2 trillion in tax benefits (over 10 years) for physical infrastructure, green energy and “social safety net” provisions, and to raise $2 trillion in additional taxes. Unless there are additional and substantial non-tax revenues, it is difficult to see at this point how this process translates into a non-deficit producing $3.5 trillion package. Additional revenue, or reduction of spending, will be needed for the budget to be deficit neutral. Senators Manchin and Sinema will gladly oblige on the latter.
Because the Senate is divided 50-50, it will not hold Committee mark-up hearings, but instead the Senate Finance Committee is issuing discussion drafts or frameworks of proposed legislation. These drafts differ somewhat in substance from the House bill provisions and are not as well defined. It is expected that the Senate bill will go directly to the Senate floor for approval once negotiations are concluded amongst Democrats. Once both the House and the Senate have passed their respective bills, a Conference Committee will be organized to come up with a final bill that can be approved by both houses.
Based on past history of reconciliation bills, it appears that the full Democratic Reconciliation budget legislation will be finalized around Thanksgiving or early December. Most tax provisions will be applicable beginning in January 2022 (or for taxable years beginning after December 2021).
House Ways and Means Mark-up Provisions
The House Ways and Means Committee marked up $2 trillion in tax increases – around half of this amount relates to corporate and international tax and half relates to high income individuals. The major provisions are discussed below.
Corporate and international taxes, mostly increases
Corporate tax rates: By far the largest revenue increase in this area would be the increase in the headline corporate tax rate, from 21% to 26.5%. It does not seem (to me) to be coincidence that 26.5% is midway between President Biden’s proposal of 28% and Senator Manchin’s proposal of 25%. There would be some progressive rates of 18% for income below $400,000 and 21% for income above $400,000 and below $5,000,000, and a surtax of 3% on income over $10,000,000. In general, personal service corporations would pay a flat rate of 26.5% on all income.
Section 250 deductions for FDII and GILTI (sec. 951A): Currently, section 250 permits domestic corporations a deduction of 50% of GILTI and 37.5% of FDII. The House bill changes these deductions to 37.5% for GILTI and 21.875% for FDII. This accelerates the expected changes in current law by four years.
Foreign tax credit modifications: The House bill modifies the foreign tax credit rules to apply on a country-by-country basis, as determined using a complex “taxable unit” standard. Cross-crediting between countries would not be permitted. It appears that this slice-and-dice approach would be a subdivision of each of the remaining foreign tax categories - passive, GILTI, and general). The foreign branch category would be eliminated. The credit carryover rules would be changed from 1 year back and 10 years forward to 5 years forward only, but would be permitted for GILTI. In the GILTI basket, the section 250 deduction would be allocable to foreign source income, but other expenses generally would not. Finally, the statutory periods for deducting or crediting foreign taxes would be shortened, in general, to conform with the general refund deadlines.
GILTI inclusion modifications: Under the House bill, GILTI would also be calculated on a country-by-country basis using the same taxable unit standard as in the foreign tax credit area, as applicable to controlled foreign corporations (CFC). The currently exempt portion of income, i.e., 10% of net tangible assets (QBAI), would be reduced to 5% of QBAI (except in the case of U.S. possessions). Foreign oil and gas extraction income (FOGEI) would no longer be exempt from tested income. On the positive side, a CFC’s tested losses could be carried forward for netting against tested income in succeeding years.
Haircut for deemed paid tax credit for foreign taxes attributable to tested income: Under the House bill, the haircut for foreign tax credits would be reduced from 20% to 5%, so more tax credits would be allowed in the GILTI basket.
Limitations on foreign base company sales and services income: Under the House bill, these two types of foreign base company (subpart F) income would be limited to transactions involving a related person that is a taxable unit resident in the United States. Current foreign base company sales and services income that is exempted from subpart F income under this limitation would, therefore, be treated as GILTI.
Modifications of base erosion and anti-abuse tax (BEAT): The House bill makes several changes to the current BEAT rules. The BEAT remains applicable only to corporate taxpayers with average gross receipts over $500 million, so it does not affect smaller businesses.
Other business taxes
There are a number of other business provisions, mostly affecting certain industries or of smaller magnitude or narrower application. The carried interest limitation in section 1061 would require a 5-year holding period, rather than the 3-year holding period of current law.
High income individuals – tax increases
There are several provisions increasing taxes on high-income individuals.
Increase in top marginal rate: The House bill increases the top individual, estate and trust rate from 37% to 39.6% (the top Obama-era rate), and reduces the dollar amounts at which the 39.6% bracket begins. For example, for 2022, the 37% bracket for married filing jointly, currently beginning at $646,151, would become a 39.6% bracket beginning at $450,001. In addition, the 35% bracket would be eliminated beginning 2026. TCJA (2017) rolled back the other brackets and rates to pre-2018 levels after 2025, and the House bill generally does not change that result.
Increase in top rate for capital gains and qualified dividends: The House bill increases the top capital gains and qualified dividend rate from 20% to 25%, and aligns the rate breakpoints for capital gains and qualified dividends with those of ordinary income. In general, the rate increases are effective for gains recognized after September 13, 2021, the date of introduction of the bill.
Application of net investment income tax (NIIT) to all trade or business income of high income individuals: The House bill expands the 3.8% NIIT to cover net investment income derived in the ordinary course of a trade or business, whether passive or active, for taxpayers with greater than $400,000 in taxable income ($500,000 for joint filers).
Limitation on deduction of qualified business income (QBI): The House bill adds a dollar limitation, depending on filing status, for deduction of QBI. For example, the limitation is $500,000 for joint filers.
Limitation on excess business losses of non-corporate taxpayers: Under current law, a deduction for the excess of aggregate business deductions of an individual taxpayer over the gross income of the taxpayer attributable to business income is limited. The amount of the limitation depends on filing status; for example, for 2021 the limitation for joint filers is $524,000. The current rules are scheduled to expire after 2026. The House bill would make this limitation permanent and would treat the limited amount as a separate carry forward rather than as an NOL carryover.
Surcharge on high income individuals, trusts and estates: The House bill includes new IRC section 1A, which would impose a tax equal to 3% of a taxpayer’s modified adjusted gross income (MAGI) in excess of $5 million ($100,000 in the case of estates and trusts). MAGI means AGI, less deductions allowed for investment interest.
Estate and gift tax changes: The House bill would also raise revenue in the estate and gift tax area through a number of key changes. The bill would accelerate the expiration of the temporary increase in the estate and gift tax exemption amount, currently expiring on December 31, 2025. As a result, for decedents dying and gifts made after December 31, 2021, it is expected that the basic exclusion amount would be around $6,020,000 (indexed for inflation after 2022). The bill would also make several changes to the complex grantor trust area. Finally, the bill would alter the valuation rules for farms and nonbusiness assets.
The House bill also includes provisions (concerning smaller estimates) relating to individual retirement plans, funding the IRS, and a number of miscellaneous provisions, including a limitation on deductions for qualified conservation contributions and a large increase in tobacco taxes.
What is Missing from the House Bill and Political Considerations
What appears to be missing from the House bill is approximately $1.5 trillion in new revenue to fund the intended top line of $3.5 trillion in spending (including funding the additional $1.2 trillion in tax benefits). Included in this missing piece are certain proposed information reporting provisions, which focus mostly on high income individuals’ compliance. These legislative holes may be in deference to the Senate, which may either need to shrink the ultimate Reconciliation bill to satisfy their Democratic moderates, or to “find” its own revenue increases to decrease the deficit. This is particularly significant in a Reconciliation bill, which may not extend a deficit outside of the 10-year revenue “window.” Also missing from the House bill are fundamental, long-overdue policy changes to the structure of the tax code and supporting non-statutory rule. The House bill is not a policy-oriented bill, or tax reform in any meaningful sense.
The Senate seems to working on the revenue side of the equation through the additional proposals of Senate Finance Chairman Wyden. His effort consists of a number of parts consisting of various discussion drafts, including a significant “loophole-closing” overhaul of partnership rules that would limit the flexibility of the partnership rules in multiple ways, replacement of FDII with a domestic R&D incentive, and an overhaul of the tax treatment of derivatives. It is also possible that the House is holding in reserve some potential revenue increases.
The biggest problem for the Congressional Democrats right now is its leadership’s need to please both the Senate moderates, who want an early House vote on the bi-partisan infrastructure bill and do not support a $3.5 trillion budget bill, and the House progressives, who strongly support the $3.5 trillion amount and are increasingly insisting that they will not support the bi-partisan infrastructure bill without coordinated Senate passage of the full Reconciliation bill. Obviously, something has got to give here. Will the Democrats thread this needle? Stay tuned for the next episode.