On May 28, 2021, the Biden Administration (the Administration) released its fiscal year 2022 budget, which serves as the first step each year to initiating the annual, Federal budgeting and appropriations process. While the proposed $6 trillion of spending provided for within the budget in total, which includes the transportation/infrastructure portion, the Administration is proposing myriad tax increases and tax law changes that would serve to fund the transportation/infrastructure portion of the budget proposal; it remains presently unclear however as to how much of the total cost of the infrastructure portion of the cost will ultimately be offset, relative to debt financed. The Department of the Treasury summarized these proposals in its General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals, commonly referred to as the Green Book, which also was released on May 28, 2021. The Green Book expounds many proposals the Administration mentioned in its American Jobs Plan, announced on March 31, 2021, and its American Families Plan, announced on April 28, 2021.
This alert outlines the tax law changes proposed in the Green Book that would, if adopted and enacted by Congress, have material implications for private investment funds, their sponsors, and their portfolio companies and investments.
An important caveat to this discussion is that this is merely the Administration’s own illustration of what they would like to see Congress adopt within budget legislation; however, to date Congress has yet to present any proposed legislative text for consideration from which to analyze or act upon, but are likely to take up many of the proposals presented within the Green Book.
Increase in corporate income tax rates
The Green Book proposes increasing the US federal income tax rate applicable to “C” corporations from 21 percent to 28 percent. There would be a phase-in rule for corporations that use something other than the calendar year as their taxable year. The Green Book also proposes a 15-percent minimum tax on worldwide pre-tax book income, which would be applicable to corporations whose annual book income meets or exceeds $2 billion.
Both proposals would be effective for tax years beginning after December 31, 2021. It is worth noting, however, that there are still internal discussions amongst congressional taxwriters regarding inclusion of retroactive effective date prior to December 31, 2021 and/or prior to the date of enactment.
We note that the Administration has signaled that it could accept a smaller increase in the federal corporate income tax rate (perhaps to only 25 percent), and while some have posited that this is a nod to congressional Republicans and the Administration’s attempt at bipartisanship, there remains very little faith that a bipartisan agreement is possible in light of Republicans being unwilling to support any increase in the corporate rate. Furthermore, moderate Democrats, including Senator Joe Manchin (D-WV) have vocalized their concern with increasing the corporate rate to as high as 28 percent. Regardless of its size, any increase in the Federal corporate income tax rate could incentivize corporations to push income into 2021 and defer deductions until 2022 or beyond. Any increase may also encourage taxpayers to use pass-through entities, particularly since the Green Book does not propose any change to the Section 199A deduction for qualifying business income of certain pass-through entities, but taxpayers would be advised to consider the proposed increase in individual tax rates discussed below.
Individual income tax rates to increase much sooner than under current law
The 2017 Tax Cuts and Jobs Act (the TCJA) reduced the top marginal income tax rate for individuals to 37 percent from 39.6 percent, but this reduction was scheduled to expire for tax years beginning on or after January 1, 2026. The Green Book proposes that the 39.6 percent rate be restored much sooner, ie, for tax years beginning on or after January 1, 2022, and that the thresholds for this rate to apply be lowered to $509,300 (for married couples filing jointly) or $452,700 (for single filers), which thresholds would be thereafter be adjusted for inflation.
For taxpayers who itemize their deductions when filing federal income taxes, the TCJA capped the deduction for state and local taxes (property taxes plus state income or sales taxes, but not both) at $10,000 per year. Notably, the Green Book does not propose to repeal this limitation.
Capital gain preference for high-income individuals eliminated
Currently, long-term capital gains and qualified dividend income (together, LTCG) earned by individual taxpayers are subject to federal income tax at a rate of only 20 percent. The Green Book proposal would tax LTCG at ordinary income tax rates to the extent the individual’s adjusted gross income exceeded $1 million (or $500,000 for married filing separately), which threshold would be indexed for inflation. For example, under this proposal, for an individual with adjusted gross income of $1.2 million, $500,000 of which was LTCG, $200,000 of her LTCG would be taxed at ordinary income rates.
One noteworthy aspect of this proposal is that it provides for a retroactive effective date; that is, the proposal would be effective for gain recognized after the date of the proposal’s announcement, which is either April 28, 2021 (ie, the date the American Families Plan was announced) or May 28, 2021 (ie, the date the Green Book was released).
The Green Book made no proposal regarding the exclusion from income of certain capital gains under Section 1202 (relating to qualified small business stock).
Tax carried interests as ordinary income
Individuals who organize and manage private investment funds use “carried interests” (ie, ownership interests in a tax partnership that give the owners a share of profits without having to make a proportionate capital contribution, also known as an “incentive allocation” or a “promote”) to convert what the individual would otherwise receive as fee income or compensation (taxed at ordinary income tax rates) into allocations of LTCG realized by the fund. The TCJA limited the ability to recognize LTCG with respect to carried interests by enacting Section 1061, which generally treats gain recognized with respect to certain partnership interests held for less than three years as short-term capital gain (LTCG treatment generally only requires a one-year holding period).
The Green Book proposal (which has been proposed many times since 2010) would treat all partnership capital gains allocated to certain high-income individuals holding such carried interests as ordinary income (not as short-term capital gain). Specifically, this would apply to individuals whose taxable income (from all sources) exceeds $400,000. If an individual with such a carried interest had taxable income of $400,000 or less, she would continue to be subject to Section 1061.
The Green Book proposal would apply to carried interests held by persons who provide services to a partnership that is an “investment partnership.” A partnership would be an investment partnership if (i) substantially all of its assets are investment-type assets and (ii) more than half of the partnership’s contributed capital is from partners whose partnership interest is an investment (ie, partners in whose hands the partnership interest is not held in connection with a trade or business). In general, a partnership interest that a service provider obtained in exchange for a capital contribution (as opposed to services) would not be subject to the proposal. The proposal includes a number of anti-abuse rules designed to prevent taxpayers circumventing these rules through other compensatory arrangements.
This proposal is specifically directed at the private investment fund industry, but would itself not have much material effect on the industry if the proposal on eliminating the capital gain preference were enacted, except on those individuals with adjusted gross income of $1 million or less.
The provision would be effective for taxable years beginning after December 31, 2021.
Transfers of assets on death or by gift to be treated as realization events
In general, under current law, taxpayers do not recognize gain or loss on the value of an asset unless there has been a “realization event” with respect to that asset, which generally means a sale. However, current law also provides that the transfer of an asset by gift or upon death is not treated as a realization event, which allows the recipient to defer tax until the recipient chooses to sell that asset. Transfers of an asset at death enjoy a further benefit, because the recipient of such an asset is permitted to increase its tax basis in the asset to the asset’s fair market value, thereby forever avoiding tax on the appreciation accumulated by the decedent with respect to that asset.
The Green Book would treat transfers of assets by death or by gift as realization events, which would result in a decedent or a donor recognizing capital gain upon such a transfer, based on the asset’s fair market value at the time of transfer. A decedent would be permitted to use capital losses and carryforwards to offset such capital gains, and there would be an election to be taxed over 15 years for certain transfers at death of illiquid assets.
Importantly, this proposal would not apply to transfers of assets to charitable organizations and donor-advised funds. The proposal also provides for certain exclusions, including a $1 million per-person ($2 million per married couple) exclusion, $250,000 per-person exclusion for all residential properties, transfers to a spouse (until the spouse disposes of the property or dies), and transfers of certain small business stock and family businesses.
The proposal generally would be effective for transfers made on or after January 1, 2022.
Expansion of Medicare taxes as applied to high-income individuals
Under current law, the 3.8 percent “net investment income tax” generally applies only to passive income and gains recognized by high-income individuals, including trade or business income earned by taxpayers who do not materially participate in the business. The Green Book would expand this to apply to all business income of taxpayers with income over $400,000, to the extent not otherwise subject to employment taxes.
Under current law, a separate 3.8 percent “SECA” tax generally applies to self-employment earnings of high-income taxpayers, but is viewed as not applicable to the distributive shares of limited partners or to S corporation shareholders (apart from the Medicare taxed on their “reasonable compensation”). The Green Book would impose the SECA tax on the distributive shares of limited partners, members of limited liability companies taxed as partnerships, and S corporation owners that materially participate in their businesses and whose income generally exceeds $400,000.
Both proposals would be effective for tax years beginning after December 31, 2021.
Excess business loss limitation applicable to noncorporate taxpayers to be made permanent
The TCJA required noncorporate taxpayers with “excess business losses” (in general, the amount by which losses from a business exceeds the sum of gains from business activities) to carry forward such losses as “net operating losses” instead of taking a current deduction, but this provision was scheduled to expire for tax years beginning after December 31, 2026. The Green Book would make this provision permanent.
Further limitation on like-kind exchanges
Section 1031 currently provides for non-recognition of gain on exchanges of real property for other like-kind real property (like-kind exchanges). The Green Book proposes to limit nonrecognition of gain on like-kind exchanges to $500,000 (or $1 million in the case of married individuals filing a joint return) in a taxable year. The proposal does not provide for indexing this exclusion amount to inflation. This proposal would, if enacted, have large reverberations in the real estate industry, including private real estate funds.
The proposal would be effective for exchanges completed in taxable years beginning after December 31, 2021.
International tax proposals
The Green Book outlines in more detail certain international tax proposals made by the Administration, as well as some that are also aligned with the recent framework put forth by Senate Finance Committee Chairman Ron Wyden (D-OR) including proposals to (i) increase the effective tax rate on GILTI to 21 percent (by reducing the Section 250 deduction from 50 percent to 25 percent); (ii) overhaul the anti-inversion regime by treating a foreign-acquiring corporation as a US corporation based on a reduced 50 percent (rather than 80 percent) continuing ownership threshold; (iii) repeal the FDII regime; and (iv) replace the BEAT regime with the SHIELD regime, which would disallow deductions to domestic corporations by reference to the effective tax rate on amounts paid to foreign entities that are members of the same financial reporting group as the domestic payor. The Green Book’s international tax proposals are discussed more fully in our alert entitled “Biden's FY 2022 budget and Treasury Green Book–additional details on international tax proposals,” dated June 2, 2021.
The Green Book proposals, particularly those targeting the tax preference for LTCG and carried interests, would, if enacted, have significant consequences for private investment funds. We iterate, however, that these proposals are likely to change, particularly given the extremely narrow congressional majorities held by the Administration’s party. We will continue to monitor any additional developments and provide alerts as they arise.
The next several weeks are a critical period for the Administration and Congressional Democratic leaders as they prepare to move forward on their next major agenda item, a massive infrastructure spending bill partially offset by individual and business tax increases. Discussions between President Biden and Senate Republicans toward a bipartisan deal have stalled and a partisan approach through the budget reconciliation process for fiscal year 2022 (which starts October 1) appears to be the path forward, as expectations for a bipartisan compromise are extremely low, if not non-existent.
Once a final decision is made on the approach to passage the process will move quickly; however, the granular details of the final provisions are fluid, the cost offset provisions are not set in stone and remain under discussion for adjustment. The 1986, 1993, and 2017 tax bills changed significantly between initial introduction and final passage and that could happen here as well. The provisions described above are in the Treasury Department’s Green Book, as noted, reflecting the President’s initial proposals and are a starting point.
But modifications remain within reach, but only to the extent that affected stakeholder businesses are willing to raise concerns and alternative suggestions in constructive fashion with both the Congress and the Administration regarding the potential for negative impact of some of the proposals.
These contacts should happen quickly. As of the now the goal is to complete the infrastructure/tax offsets package by the first week of August.