On November 19, 2021, the House of Representatives passed the Build Back Better Act (the “Act”). The Act includes funding for various programs as well as significant new tax provisions intended to help offset the cost. The Act now heads to the Senate, where its passage faces significant obstacles.
While it is uncertain whether the Senate will pass the Act and that the Act will ultimately become law (and, if so, in what form), the enactment of the Act in its current form would raise several issues for taxpayers to consider and plan for in anticipation of future IRS compliance efforts. This bill reflects aspects of the American Jobs Plan that President Biden announced on March 31, 2021 that we wrote about here, the American Families Plan that President Biden announced on April 28, 2021 that we wrote about here and here, and the U.S. Department of Treasury’s 2022 Greenbook that we wrote about here. Some aspects of the Act that may be of particular interest are discussed below.
For additional information regarding other tax provisions of the Act, please see our client update regarding corporate tax (available here).
Additional Funding for the IRS
The Act would appropriate approximately $80 billion in funding to the IRS over the next decade, with approximately $44.9 billion of that earmarked towards enforcement and compliance. This funding is intended to function as one of the revenue-raising aspects of the Act by funding IRS compliance efforts to close the “tax gap” between taxes owed and taxes collected. Taxpayers should therefore anticipate an increase in the number of audits and other compliance efforts if the Act passes the Senate in its current form.
- Baker Botts Note: As we observed in our prior Thought Leadership here and here, based on the focus on high net worth taxpayers and companies that reported to shareholders an annual average of $1 billion in annual profit over the past three years, those groups can expect to face the brunt of increased enforcement actions by the IRS.
Elimination of Written Supervisory Approval of Certain Penalties
Under current law, written supervisory approval must be given before the assessment of certain penalties. The Act would retroactively repeal this requirement.
The written supervisory approval requirement was implemented to ensure that penalties were not asserted as “bargaining chips.” If this proposal is enacted into law, IRS Examination may again subject taxpayers to inappropriate penalties in order to force settlements.
Increased Information Reporting
The Act would require expanded information reporting by “third party settlement organizations” and would make aggregate payments that equal or exceed $600 during a calendar year subject to backup withholding if the taxpayer has not provided the third party settlement organization with certain identifying information.
As we wrote about here, increased information reporting may complicate matters even for compliant taxpayers.
Surcharge on High Income Individuals
The Act would impose a tax equal to 5% of an individual taxpayer’s modified gross income in excess of $10 million (or $5 million if married filing separately) and an additional 3% to the extent the modified gross income exceeds $25 million ($12.5 million if married filing separately). The bill also provides for additional taxes on the income of estates and trusts that exceed certain income levels. This surcharge could increase the stakes for tax planning and controversy – for instance, a disallowed deduction may trigger the surcharge which would increase the cost to the taxpayer more than the same disallowed deduction would under current law. The surcharge would go into effect for tax years beginning after December 31, 2021.
- Baker Botts Note: Tax measures that trigger upon certain amounts of income may increase the desirability of postponing income recognition using options such as installment sales under Section 453 and like-kind exchanges under Section 1031. Consequently, IRS enforcement in these areas may increase.
The Act would increase the state and local tax deduction from $10,000 to $80,000.
In the Infrastructure Investment and Jobs Act (“IIJA”) signed on November 15, 2021, Congress changed the definition of the term “broker” to include “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person” and requires brokers to submit Form 1099-Bs to investors and the IRS. The IIJA also requires businesses to report any payments made in the form of digital assets worth more than $10,000, which is consistent with the requirements for reporting cash transactions on currency transaction reports (Form 8300).
- Baker Botts Note: The definition of broker is broad enough that there is a concern that it could be interpreted as including miners and other participants in the digital asset economy who may not be commonly understood to be “brokers.” While Senators Wyden and Lummis have introduced a bill that seeks to narrow the definition of “broker,” and Treasury is expected to issue similar guidance, taxpayers should seek advice to ensure they are in compliance.
The Act seeks to further increase transparency and enforcement related to virtual currency and digital assets. First, taxpayers should be aware that the language earmarking the $44.9 billion for enforcement (mentioned above) specifically highlights “digital asset monitoring and compliance activities.” Taxpayers should anticipate an increased level of IRS scrutiny with regards to their digital asset transactions.
Second, the Act would modify the wash sale rules and apply them to losses claimed with respect to digital assets. Under the Act, a taxpayer would not be able to recognize a loss if they (or a related party) acquired substantially identical digital assets within a 61-day period starting 30 days before the sale date of the “original” digital assets. The inapplicability of the wash sales rules to cryptocurrency transactions has been widely publicized, but even without those rules the IRS could challenge such transactions under general tax principles such as sham transaction or economic substance doctrine.
Third, the Act would also add digital assets that are marketable securities to the definition of appreciated financial position for purposes analyzing whether a constructive sale has taken place. For instance, a taxpayer may have to recognize gain on the date of the “constructive sale” rather than the actual sale date should they acquire digital assets that are marketable securities to cover a short position. This provision will be important for taxpayers who seek to monetize their crypto asset positions without disposing of them. Unfortunately, the impact of this provision is not clear – for example the Act does not clarify when a digital asset is a “marketable security” and when it is a commodity subject to an exception.
- Baker Botts Note: The application of wash sale and constructive sale rules could operate as traps for the unwary and result in significant tax bills for investors. These changes would be effective upon the bill’s passage.
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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