On May 28, 2021, the government of Biden (the administration) published its budget for the budget year 2022, which serves as the first step each year to initiate the annual budget and approval process of the federal government. While the proposed $ 6 trillion in total spending is budgeted, which includes the transportation / infrastructure portion, the government is proposing countless tax increases and tax law changes that would serve to fund the transportation / infrastructure portion of the budget proposal; However, it currently remains unclear how much of the total cost of the infrastructure component will ultimately be offset in relation to the leveraged costs. The Treasury Department summarized these proposals in its General Explanatory Notes on Government Revenue Proposals for Fiscal Year 2022, commonly referred to as the Green Paper, which were also published on May 28, 2021. The Green Paper outlines many of the proposals that the government is making in its American Jobs Plan, announced March 31, 2021, and American Families Plan, announced April 28, 2021.
This warning outlines the tax law changes proposed in the Green Paper that, if adopted and enacted by Congress, would have a material impact on private investment funds, their sponsors and their portfolio companies and investments.
An important caveat in this discussion is that this is just the government's own illustration of what it would like to see if Congress is passed under budgetary legislation; To date, however, Congress has not submitted a bill for consideration by which it could be analyzed or acted upon, but it is likely to take up many of the proposals made in the Green Paper.
Increase in corporate tax rates
The Green Paper proposes increasing the US federal income tax rate for "C" companies from 21 percent to 28 percent. There would be a phase-in rule for companies that use a tax year other than the calendar year. The Green Paper also proposes a 15 percent minimum pre-tax tax on global book income to apply to companies whose annual book income reaches or exceeds $ 2 billion.
Both proposals would be effective for tax years beginning after December 31, 2021. It should be noted, however, that there is still internal discussion among Congressional tax clerks about including a retrospective date prior to December 31, 2021 and / or the date of enactment.
We note that the government has signaled that it could accept a smaller increase in the federal corporate tax rate (perhaps to just 25 percent), and although some have posited that this is a nod to the Republicans in Congress and the government's attempt at With bipartisanism, there is very little believe that a bipartisan settlement is possible as Republicans are unwilling to support a corporate tax rate hike. In addition, moderate Democrats, including Senator Joe Manchin (D-WV), have raised concerns about corporate tax increases of up to 28 percent. Regardless of the amount, any increase in the federal corporate tax rate could provide an incentive for companies to defer their income until 2021 and defer deductions until 2022 or beyond. Any increase may also encourage taxpayers to use transit companies, especially as the Green Paper does not provide for any change in the § 199A deduction for qualified business income of certain transit companies, but recommends taxpayers to consider the proposed increase as discussed below.
Income tax rates for individuals will rise much sooner than under current law
The Tax Cuts and Jobs Act (TCJA) of 2017 lowered the top tax rate for individuals from 39.6 percent to 37 percent, but that cut should expire for tax years beginning on or after January 1, 2026. The Green Paper suggests that the 39.6 percent rate be restored much sooner, i.e. for tax years beginning on or after January 1, 2022, and that the thresholds for that rate be set at $ 509,300 (for married couples registering together) and US $ 509,300, respectively 452,700 USD (for single parents), which thresholds are then adjusted for inflation.
For taxpayers who detail 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) to $ 10,000 per year. In particular, the Green Paper does not propose lifting this restriction.
Capital gain preference for high income individuals eliminated
Currently, long-term capital gains and qualified dividend income (collectively, LTCG) earned by individual taxpayers are subject to federal income tax at a rate of only 20 percent. The Green Paper's proposal would tax LTCG at normal income tax rates if the person's adjusted gross income exceeds $ 1 million (or $ 500,000 for separate marriages), with that threshold indexed for inflation. For example, under this proposal, for a person with an adjusted gross income of $ 1.2 million, of which $ 500,000 was LTCG, $ 200,000 of their LTCG would be taxed at normal income rates.
A notable aspect of this proposal is that it allows for retroactive entry into force; that is, the proposal would be after the date of the proposal's announcement, ie April 28, 2021 (ie, the date of the American Families Plan announcement) or May 28, 2021 (ie, the date the Green Book was published).
The Green Paper made no proposal regarding the exclusion of certain capital gains under Section 1202 (relating to qualifying small business shares).
Taxable interest as ordinary income
Individuals who organize and manage private investment funds use "carried interests" (ie stakes in a tax partnership that give owners a non-equity share of the profits, also known as an "incentive allocation" or a "grant") to convert whatever the person otherwise received as fee income or compensations (taxed at ordinary income tax rates) in fund-realized allocations from LTCG. The TCJA restricted the ability to recognize LTCG in respect of carried interests by enacting Section 1061 that treats generally recognized gains in respect of certain partnership shares held for less than three years as short-term capital gains (LTCG treatment requires im Generally only a one-time holding period).
The Green Paper's proposal (proposed several times since 2010) would treat all partnership capital gains allocated to certain high-income individuals holding such carried interests as ordinary income (not short-term capital gains). This is especially true for those whose taxable income (from all sources) exceeds $ 400,000. If a person with such carried interest had taxable income of $ 400,000 or less, they would still be subject to Section 1061.
The Green Paper proposal would apply to carried interests held by persons providing services to a partnership that is an "investment company". A partnership would be an investment company if (i) substantially all of its assets are fixed assets and (ii) more than half of the incorporated capital of the partnership comes from partners whose participation in the partnership is an investment (i.e. partners in whose hands the Company shares are not held in connection with any trading or business operation). In general, participation in a company that a service provider acquires for a capital contribution (as opposed to services) would not be the subject of the proposal. The proposal contains a number of anti-abuse rules designed to prevent taxpayers from circumventing these rules through other equalization schemes.
This proposal is specifically aimed at the private mutual fund industry, but it would not have a major material impact on the industry itself if the proposal to abolish capital-income preference were passed, except for those with adjusted gross income of $ 1 million or less.
The provision would have to be applied for tax years beginning after December 31, 2021.
Asset transfers to be treated as liquidation in the event of death or gift
In general, taxpayers do not recognize a gain or loss from the value of an asset under applicable law unless there is a "realization" in relation to that asset, which generally means a sale. However, current law also provides that the transfer of an asset by gift or death is not treated as a disposal event, which allows the recipient to defer the tax until they decide to sell that asset. The transfer of an asset in the event of death has another benefit because the recipient of such an asset is allowed to increase their tax base in the asset to the market value of the asset, thereby forever avoiding taxation on the increases in value accumulated by the testator in relation to that asset.
The Green Paper would treat transfers of assets by death or donation as liquidation events that would result in a testator or donor in such a transfer recognizing a capital gain based on the market value of the asset at the time of the transfer. A testator would be entitled to use capital losses and carryforwards to offset such capital gains and the option would be to tax certain transfers of illiquid assets after death over a period of 15 years.
Importantly, this proposal does not apply to asset transfers to nonprofits and donor recommended funds. The proposal also provides for certain exclusions, including an exclusion of $ 1 million per person ($ 2 million per couple), an exclusion of $ 250,000 per person for all residential property, transfers to a spouse (until the spouse possesses ownership or dies), and transfers from certain small and family businesses.
The proposal would generally be effective for transfers made on or after January 1, 2022.
Extending Medicare Taxes for High Income People
Under applicable law, the 3.8 percent “net capital gains tax” generally applies only to passive income and gains recognized by high income individuals, including business or business income from taxpayers who do not have a material interest in the business. The Green Paper would extend this to all corporate income from taxpayers with incomes above $ 400,000, unless otherwise subject to wage tax.
Under current law, a separate 3.8 percent "SECA" tax generally applies to self-employed income from high-income taxpayers, but does not apply to the distributing shares of limited partners or S-members (apart from Medicare taxation ). their "fair compensation"). The Green Paper would impose SECA tax on the distributing shares of limited partners, members of limited liability companies that are taxed as partnerships, and S companies that are materially involved in their business and whose income generally exceeds $ 400,000 .
Both proposals would apply to tax years beginning after December 31, 2021.
The excessive loss of business limitation applicable to non-corporate taxpayers is to be made permanent
The TCJA required non-business taxpayers with "excessive business losses" (generally the amount by which losses from a company exceed the sum of profits from business activities) to carry such losses forward as "net operating losses" instead of making an ongoing deduction. however, this provision should expire for tax years beginning after December 31, 2026. The Green Paper would make this provision permanent.
Further restriction of the exchange of the same type
Section 1031 currently provides for the non-crediting of profits from the exchange of real estate for other similar real estate (of a similar type). The Green Paper proposes limiting nonrecognition of profits from similar exchanges to $ 500,000 (or $ 1 million in the case of married people filing a joint declaration) in a tax year. The proposal does not provide for this exclusion amount to be indexed to inflation. This proposal, if passed, would have a major impact on the real estate industry, including private real estate funds.
The proposal would be effective for exchanges beginning in tax years beginning after December 31, 2021.
International tax proposals
The Green Paper outlines certain international government tax proposals in greater detail, as well as some that are also in line with the framework recently presented by Senate Finance Committee Chairman Ron Wyden (D-OR), including proposals to (i) increase the effective tax rate for GILTI to 21 Percent (by reducing the deduction under Section 250 from 50 percent to 25 percent); (ii) revise the anti-inversion regime by treating a foreign acquiring company as a US company based on a reduced threshold of 50 percent (instead of 80 percent) of continuing ownership; (iii) repeal the FDII regulation; and (iv) replace the BEAT rule with the SHIELD rule, which prohibits deductions to domestic companies by reference to the effective tax rate on amounts paid to foreign companies that are members of the same accounting group as the domestic payer. The international tax proposals in the Green Paper are discussed in more detail in our warning titled "Biden’s FY 2022 budget and Treasury Green Book – Additional Details on International Tax Proposals" dated June 2, 2021.
Forward
The Green Paper's proposals, especially those aimed at giving tax privileges to LTCG and carried interests, if passed, would have significant ramifications for private investment funds. We repeat, however, that these proposals are likely to change, especially given the extremely tight majorities in Congress held by the ruling party. We will continue to monitor all further developments and provide warnings if they occur.
Political considerations
The next few weeks are a critical time for government and Democratic leaders in Congress as they prepare to move forward on their next major agenda item, a massive bill for infrastructure spending, partially offset by tax increases for individuals and businesses. Talks between President Biden and Senate Republicans over a bipartisan deal have stalled, and a partisan approach to the budget reconciliation process for fiscal year 2022 (which begins Oct. 1) appears to be the way forward as expectations to a bipartisan compromise are extremely small, if not in place.
Once a final decision has been made on how to approach the passage, the process will move quickly; However, the granular details of the final provisions are fluid, the provisions for cost compensation are not set in stone and are being discussed for adjustment. The 1986, 1993, and 2017 tax bills changed significantly between when they were first introduced and when they were finalized, and that could happen here as well. The provisions described above are, as mentioned, contained in the Ministry of Finance's Green Paper, reflect the President's original proposals and are a starting point.
However, changes remain within reach, but only to the extent that affected stakeholder companies are willing to constructively raise concerns and alternative proposals to both Congress and the administration about the possible negative impact of some of the proposals.
These contacts should be made quickly. From now on, the goal is to complete the infrastructure / tax break package by the first week of August.