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 may have significant effects on partners in tax partnerships, and on the relative benefits of conducting business through an entity treated as a partnership for tax purposes (tax partnership) vs. a C corporation, particularly when combined with revenue raisers in the American Jobs Plan.
Proposed Revenue Raisers Potentially Affecting Tax Partnerships and Their Partners
Proposed revenue raisers in the American Families Plan of particular interest to tax partnerships and their partners include:
- Increasing the top federal income tax rate on ordinary income to 39.6% for high-earning individuals—it has been reported that this rate would apply to individual single taxpayers with taxable incomes greater than $452,700 and to married couples filing jointly with incomes greater than $509,300
- Increasing the top federal income tax rate on capital gains and dividends to 39.6% (plus 3.8% Medicare tax) for households with income greater than $1 million per year
- Closing “the carried interest loophole” so that “hedge fund” partners will pay ordinary income rates on their income “just like every other worker”
- 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
- Requiring “financial institutions to report information on account flows so that earnings from investments and business activity are subject to reporting more like wages already are”
The plan also calls for increased IRS enforcement discussed in more detail here.
These proposed changes would presumably be combined with the American Jobs Plan’s proposed increase in the top federal income tax rate on C corporations to 28%, discussed here.
Choice of Entity: Tax Partnership vs. C Corporation
The proposed increase in the top corporate tax rate (to 28% from the current level of 21%) and the top dividend and capital gain tax rate (to 39.6% from the current level of 20%) would substantially increase the tax benefits of owning businesses through a tax partnership rather than a C corporation, particularly in the case of businesses eligible for the 20% deduction under section 199A that currently distribute their cash flows to their owners. Click here to view a table comparing effective tax rates under current law and under the Biden Administration proposals.
Under current law, the effective tax rate advantage of tax partnerships fully eligible for the 20% section 199A deduction is 6.4% - this is the excess of a 39.80% effective tax rate on income earned and distributed by a C corporation over a 33.40% effective tax rate on income earned and distributed by a tax partnership, in both cases taking into account the effect of the 3.8% Medicare tax.
Under the Biden proposals, the effective tax rate advantage for investors with income over one million dollars would rise to 15.85% even before taking into account any additional benefits available under section 199A – this is the excess of a 59.25% effective rate on income earned and distributed by a C corporation over a 43.40% effective tax rate on income earned and distributed by a tax partnership, in both cases taking into account the effect of the 3.8% Medicare tax.
Simplified illustration of effective tax rate calculation for a C corporation. Assume a corporation earns $100, pays tax of $28 (28% of $100) and pays a taxable dividend of $72 ($100 minus $28). Assume the shareholder pays income tax of $28.51 (39.6% of $72) and Medicare tax of $2.74 (3.8% of $72) on the dividend. The total tax payments with respect to the original $100 would be $59.25 ($28 paid by the corporation and $31.25 paid by the shareholder), for an effective tax rate of roughly 59.25%.
It remains to be seen exactly how the effective tax rate advantage for a passthrough structure will be affected for investors with income below $1 million per year.
These tax rate changes would significantly increase, for example, the tax benefits of master limited partnerships (MLPs) over publicly traded C corporations that distribute their income. However, click here to view a discussion of other possible Biden Administration revenue raisers directed at the fossil fuels industry that may prevent businesses primarily handling fossil fuels and their derivatives from benefitting from the MLP structure.
The American Families Plan proposes to “close the carried interest loophole” so that “hedge fund” partners will pay ordinary income rates on their income “just like every other worker.” This presumably refers to the ability of a service provider to pay tax at capital gain rates, rather than ordinary income rates, on disposition of a profits interest. The scope of the proposal is uncertain and, in particular, it is unclear whether the proposal would extend to eliminate or curtail the other principal advantage of the treatment of carried interests—the deferral of tax resulting from carried interests not being taxed upon grant or vesting. It is also unclear whether the proposal would extend beyond “hedge fund” partners and whether it would supplant the new holding period requirements imposed by the 2017 Tax Cuts and Jobs Act on certain carried interests.
Excess Business Losses
The American Families Plan would make permanent the current rule disallowing excess business losses of non-corporate taxpayers. This rule was enacted as part of the 2017 Tax Cuts and Jobs Act and generally disallows certain business losses (including losses allocated from partnerships) in excess of specified thresholds. The provision is currently set to expire at the end of 2025, but the Administration is proposing to make it permanent.
Expanded Base for 3.8% Medicare Tax
The Administration is also encouraging Congress to close what it sees as loopholes in the 3.8% net investment income tax. The fact sheet asserts that this tax is “inconsistent across taxpayers due to holes in the law,” and the proposal would target those with income in excess $400,000 per year. The details of this proposal have not been released, although it may include imposition of the 3.8% Medicare tax on certain types of business income that is not subject to self-employment tax.
Expanded Information Reporting RequirementsThe 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 underreporting by partnerships, but the text of the proposal refers only to expanded reporting for “financial institutions.” According to a press release issued by the Department of the Treasury, 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.” 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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