On April 28, 2021, President Biden announced the American Families Plan to propose funding for education, child care, and the extension of certain tax credits for lower- and middle-income individuals. The White House released a fact sheet describing these proposals, and President Biden discussed them in an address to a joint session of Congress. President Biden’s plan would fund these proposals through increased taxes and other significant tax law changes. These changes would be in addition to the tax law changes proposed in the American Jobs Plan announced by President Biden on March 31, 2021, which we covered here.
While it remains to be seen whether the proposals in the American Families Plan will be enacted into law, they raise a number of issues for taxpayers to consider and plan for in anticipation of future IRS audits.
President Biden’s plan proposes increased funding for enforcement with a focus on “large corporations, businesses, and estates, and higher-income individuals.” A press release issued by the Department of Treasury indicates that this proposal would call for an additional $80 billion over the next decade to fund IRS priorities, including hiring, training and technology improvements. This follows comments made last week by IRS Commissioner Chuck Rettig on the IRS’s plans to reduce the “Tax Gap” between the amount of tax owed by taxpayers for a given year and the amount that is actually timely paid.
Expanded Information Reporting Requirements
The Administration also previewed expanded information reporting requirements by financial institutions on “account flows.” The fact sheet cited a 2019 economics working paper broadly critical of a lack of cross-party reporting with respect to certain items of income, but the text of the proposal refers only to expanded reporting for “financial institutions.” According to the Department of Treasury press release, this proposal “leverages the information that financial institutions already know about account holders, simply requiring that they add to their regular, annual reports information about aggregate account outflows and inflows.”
Increasing the Top Income Tax Rate on Ordinary Income for Individual Taxpayers to 39.6 Percent
President Biden’s plan would increase the top income tax rate on ordinary income for individual taxpayers from 37 percent to 39.6 percent. This proposed increase would restore the rate to what it was prior to the Tax Cuts and Jobs Act of 2017. Under current law, the 37 percent rate applies to individual single taxpayers with incomes greater than $523,600 in 2021 and to married couples filing jointly with incomes greater than $628,300 in 2021. It has been reported that the 39.6 rate proposed in President Biden’s plan would apply to individual single taxpayers with incomes greater than $452,700 and to married couples filing jointly with incomes greater than $509,300. President Biden’s plan does not specifically provide for an increase to rates for lower tax brackets.
Elimination of Lower Tax Rates Applicable to Long-Term Capital Gains of High-Income Individuals
The American Families Plan proposes to increase the top federal income tax rate on long-term capital gains from 20% (plus 3.8% Medicare tax) to 39.6% (plus 3.8% Medicare tax) for households with income greater than $1 million per year. The proposal would also similarly increase the tax rate applicable to qualified dividend income and would tax carried interest at ordinary income rates.
Baker Botts Note: The proposed tax rate increase for long-term capital gains raises important considerations with respect to timing. President Biden’s plan does not specify an effective date. Assuming the effective date is prospective, taxpayers may choose to sell long-term capital assets before the rate increase becomes effective. Taxpayers might also seek to delay the realization of losses until after the effective date when they can be netted against gains that would be subject to the increased tax rate. In some circumstances, such as when a stock or security becomes worthless, there can be significant disputes between the IRS and taxpayers as to when the loss was properly incurred. The substantial increase in tax rate under President Biden’s plan, coupled with increased enforcement budgets, may lead to greater disputes over the proper timing of losses.
Baker Botts Note: For taxpayers who own qualified small business stock (QSBS), the proposed tax rate increase heightens the importance of QSBS considerations. Under current law, taxpayers may be able to defer or permanently exclude some or all of the gain on the sale of QSBS provided that they meet certain requirements. The value of this benefit increases in tandem with the long-term capital gains rate. Taxpayers who may be eligible to claim QSBS treatment will want to take appropriate measures to document that they meet those requirements in preparation for an audit.
Closing the “Stepped-Up Basis Loophole” for Property Upon Death
Current law provides that, when a person who holds appreciated real estate or other appreciated assets dies, heirs who inherit those assets are permitted to step up the tax basis of the assets to their then fair market value. The American Families Plan proposes to “close this loophole, ending the practice of ‘stepping-up’ the basis for gains in excess of $1 million ($2.5 million per couple when combined with existing real estate exemptions [e.g., the primary residence exemption]) and making sure the gains are taxed if the property is not donated to charity.” It is unclear from the fact sheet whether this means that the step-up in basis for such gains would be eliminated or, alternatively, that such gains would be taxed upon death. A press release issued by the Department of Agriculture indicates that the proposal would subject the unrealized capital gains (those that have never been previously taxed) to income tax at death. Under the proposal, there would be protections “so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.”
While there had been speculation that President Biden may propose a change in the estate tax, the American Families Plan does not include any such change.
Other Tax Law Changes
Other tax law changes proposed in President Biden’s plan include:
- Eliminating tax-deferred Section 1031 like-kind exchange treatment for capital gains greater than $500,000
- Extending permanently current limitations restricting deduction of “excess business losses”
- Expanding the 3.8% tax on unearned income (sometimes referred to as Medicare tax) to unspecified categories of income currently not covered
Regulation of Paid Tax Preparers
While CPAs, attorneys, and other individuals who practice before the IRS are already subject to regulation, other paid tax preparers are not. Treasury’s press release indicates that such unregulated tax preparers submit more tax returns than all other preparers combined, but that “they make costly mistakes that subject their customers to painful audits, sometimes even intentionally defrauding taxpayers for their own benefit.” President Biden’s plan calls for giving the IRS the legal authority to provide oversight of paid tax preparers and for stiffer penalties for preparers that fail to identify themselves on tax returns and defraud taxpayers.
We will continue to monitor developments and will provide further updates as more details are released. In the meantime, Baker Botts would be pleased to assist you in your analysis of these proposals.
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