Last week, Sen. Warren reintroduced her “Ultra-Millionaires” wealth tax proposal to the Senate.[i] Query her timing. The measure has the proverbial snowball’s chance in Hell of being enacted by this Congress.[ii] Perhaps the Senator was inspired by the Administration’s Fiscal Year 2025 Budget, which includes its own equally ill-fated – at least for now – version of a wealth tax.[iii]
The more likely explanation for the revival of the Senator’s tax plan is the upcoming contest for the White House, which has begun in earnest,[iv] and the Administration’s focus on what it has described as tax avoidance[v] by the “wealthy”[vi] and especially by the very wealthy.
Does that mean business owners can safely disregard the Senators’ and the Administration’s tax proposals as election year demagoguery?
Hardly. Both Chambers of Congress are up for grabs, as is the White House. The Democrats controlled the legislative process from 2021 through 2022 and, but for two outliers, they came very close to enacting some serious tax increases.[vii] At this point in the election cycle, there is no reason to discount the possibility they will have another opportunity to turn their income tax agenda into law.[viii]
For this reason, it would behoove business owners and their advisers to familiarize themselves with the changes to the federal income tax that have been proposed by the Administration, as set forth in the 2025 budget, to consider the potential consequences thereof and, to the extent feasible, to develop plans that may be implemented in response.
With that possibility in mind, what follows is a summary of several income tax proposals of which the closely held business and its owners should be made aware.[ix]
Individuals’ Ordinary Income
i. The marginal individual income tax rate applicable to the compensation,[x] interest, rents, and other items of ordinary income that are included in an individual’s gross income, would be increased from 37 percent to 39.6%.
a. Actually, the increase would be considerably greater because the new top rate would apply starting at a much lower tax bracket.[xi]
b. Specifically, the current top rate of 37 percent applies to taxable income over $731,200 for a married couple filing jointly. Under the proposal, the same couple would be subject to the top rate of 39.6 percent for taxable income over $450,000.
ii. In the case of a shareholder of an S corporation or an individual partner of a tax partnership, the owner’s share of the entity’s ordinary business income would be subject to the higher rate.
iii. Where the gain from the sale of certain property between certain related persons is treated as ordinary income, the tax on such gain would be more expensive.[xii]
iv. In the context of the sale of a business, the higher rate would apply to the seller’s depreciation recapture, inventory, covenant not to compete, and any stated or imputed interest in respect of any deferred payments of purchase price.
Individuals’ Long-Term Capital Gain
v. Long-term capital gains[xiii] of married taxpayers filing jointly would be taxed at ordinary income rates to the extent their taxable income exceeds $1 million.[xiv]
vi. It appears that the long-term capital gain arising from the sale of a business would also be subject to the increased rate.[xv]
vii. The same would be true for payments received on an installment note received in connection with the sale of property, even if the sale preceded the rate increase.
Net Investment Income Tax (NIIT)
viii. The tax rate for an individual’s net investment income (NII)[xvi] would be increased from 3.8 percent to 5 percent for those individuals with more than $400,000 of income.
ix. The NII base – which now includes (a) interest, dividends, rents, and royalties, other than such income derived in the ordinary course of a trade or business, (b) income derived from a trade or business in which the taxpayer does not materially participate, and (c) net gain from the disposition of property other than property held in a trade or business in which the taxpayer materially participates – would be expanded to ensure that all pass-through business income of high-income taxpayers is subject to either the NIIT or SECA[xvii] tax.
a. Specifically, the amount of trade or business income subject to the NIIT would be determined by adding together (a) the ordinary business income derived from S corporations for which the shareholder materially participates[xviii] in the trade or business, (b) the ordinary business income derived from either limited partnership interests or from interests in LLCs (classified as partnerships) to the extent a limited partner or LLC member materially participates in the partnership’s or LLC’s trade or business, and (c) any other trade or business income to the extent it is not currently subject to NIIT or SECA.[xix]
b. A graduated percentage of this additional income would be subject to the NIIT beginning with married taxpayers filing jointly with adjusted gross income of $400,000 and would reach 100 percent when their adjusted gross income reaches $500,000.
Medicare Tax
x. The additional Medicare tax that is imposed on the self-employment earnings and wages of individuals would be increased from 3.8 percent to 5 percent for individuals with more than $430,000 of earnings.
Individual Shareholders
xi. If a corporation makes a loan to a related corporation for the purpose of enabling the related corporation to make a distribution to its individual shareholders that is treated as a nontaxable return of stock basis, such distribution would be treated instead as a taxable dividend.[xx]
xii. In the case of individuals with taxable income of more than $1 million for a tax year, any qualified dividends qualified dividends[xxi] included in their gross income for such year would be taxed at the top ordinary rate of 39.6 percent.
a. For example, a taxpayer with $1.1 million in taxable income of which $200,000 is qualified dividends and long-term capital gain (“capital income”) would have $100,000 of capital income taxed at the preferential rate of 20 percent and $100,000 taxed at the ordinary rate of 39.6 percent.[xxii]
Minimum Income Tax
xiii. A minimum annual tax of 25 percent would be imposed on the total income[xxiii] of an individual with net wealth[xxiv] greater than $100 million.
a. The minimum tax would be phased in for taxpayers with net wealth in excess of $100 million, and would be fully phased in for taxpayers with wealth greater than $200 million.
b. Taxpayers with wealth greater than the threshold amount would be required to report to the IRS on an annual basis, separately by asset class, the total basis and total estimated value of their assets in each asset class, and the total amount of their liabilities.[xxv]
Basis Shifts in a Partnership
xiv. Members of a partnership who are related to one another would be limited in their ability to use the “inside basis” adjustment election[xxvi] to shift basis between them for the purpose of achieving tax savings.
xv. Specifically, if an in-kind distribution of partnership property results in a step-up for the basis of the partnership’s remaining property,[xxvii] a “matching rule” would be applied that would prohibit any partner that is related to the distributee-partner from benefitting from the partnership’s basis step-up until the distributee-partner disposes of the distributed property in a fully taxable transaction.[xxviii]
Excess Business Loss
xvi. The Code provision that reduces the ability of individual taxpayers to use business losses to offset unrelated income – by capping the net amount of deductible business losses at $305,000 per individual taxpayer per year and disallowing the excess – would be made permanent.[xxix]
xvii. It would also treat the excess business losses carried forward from the prior year as current-year business losses – instead of as NOL deductions, as under current law – which would subject the carryforward to the cap for that year, thereby further limiting the taxpayer’s ability to utilize such excess.
Corporate Tax Rate
xviii. The income tax rate for C corporations, including those that are closely held, would be increased from a flat 21 percent to 28 percent.[xxx]
a. The greater tax liability would leave the corporation with fewer funds to reinvest in its business, and may cause it to borrow money and/or to forego distributions.
b. The increased rate would also make the sale of the corporation’s assets more expensive.
xix. The rate used to compute the tentative minimum tax for a C corporation would be increased from 15 percent to 21 percent.
S Corporations[xxxi]
xx. S corporations would be subject to a flat income tax rate of 28 percent with respect to the net recognized built-in gain for a taxable year that is within the 5-year recognition period,[xxxii] up from the 21 percent[xxxiii] that has applied since 2018.
xxi. Likewise, for any taxable year in which an S corporation has (a) accumulated earnings and profits from C corporation years, and (b) gross receipts more than 25 percent of which are passive investment income, the tax on the S corporation’s excess net passive income[xxxiv] would be imposed at the increased rate of 28 percent.
Deduction for Compensation
xxii. For purposes of determining its taxable income, a closely held C corporation would not be allowed to claim a deduction for compensation paid in excess of $1 million to any employee.[xxxv]
a. In general, the compensation subject to this rule includes all otherwise-deductible compensation paid to an employee for services rendered, including cash and non-cash compensation, performance-based compensation, and commissions.[xxxvi]
b. Query the interplay between the proposed increase in the tax rate for compensation, especially in connection with the sale of a business, and the proposed denial of a deduction for the payment or accrual of such compensation in that context.
xxiii. All corporate members of a “controlled group” would be treated as a single employer for purposes of applying this disallowance rule, thus making it more difficult for corporations to avoid the limitation by directing payment from another, related entity for which the employee also provides some services.
xxiv. For purposes of determining the amount of compensation paid to an individual, the disallowance rule would consider as compensation any amounts paid to the employee from an affiliated partnership rather than directly from the employer-corporation.
xxv. In addition, the Treasury would be directed to issue regulations to prevent avoidance of the rule, including through the individual’s performance of services other than as an employee.
Losses on Liquidation of Corp
xxvi. A loss recognized either by a corporation or by its shareholder(s) on a liquidating distribution of the corporation’s properties[xxxvii] would be denied where, after the liquidation, the properties of the liquidated corporation remain within the controlled group of corporations of which such corporation was a member.[xxxviii] Where applicable, this would cause losses – both on the stock of the liquidating corporation and the property it holds – to be denied.
a. The proposal would also grant the Treasury the authority to allow for the deferral, rather than the denial, of such losses.[xxxix]
Like Kind Exchanges
xxvii. The amount of gain that an individual taxpayer would be allowed to defer by engaging in a like kind exchange of real property[xl] would be limited to an aggregate amount of $500,000 per year ($1 million in the case of married individuals filing a joint return).
xxviii. Any gains from like-kind exchanges in excess of the applicable threshold in a year would be recognized and included in gross income.
Depreciation Recapture
xxix. Any gain recognized from the sale or exchange of depreciable real property[xli] would be treated as ordinary income subject to tax at the increased 39.6 percent rate to the extent of the cumulative depreciation deductions taken after the effective date of the proposed provision.
a. Gain attributable to depreciation deductions taken on such property prior to such effective date would continue to be recaptured as ordinary income only to the extent that such depreciation exceeds the cumulative allowances determined under the straight-line method.
b. Any unrecaptured gain on such property – the amount of straight-line depreciation claimed – would continue to be taxed to noncorporate taxpayers at a maximum 25 percent rate.
c. Any remaining gain recognized would be treated as capital gain.
xxx. The above-described ordinary income treatment for post-effective date depreciation deductions would not apply to noncorporate taxpayers with adjusted gross income below $400,000 ($200,000 for married individuals filing separate returns).
Slippery Slope
The national deficit is approximately $35 trillion, and it is expected to continue growing as spending continues to outpace revenue by a significant amount.[xlii] The interest payments on the debt may be the fastest growing item of the federal budget.[xliii]
You may recall that in August 2023 Fitch downgraded our long-term debt rating from AA+ to AAA, and last November Moody’s lowered its outlook on our credit rating from stable to negative.
Approximately $7.5 trillion of our national debt – incurred to fund the growing deficit – is held by foreign governments, with the two largest holders being Japan and China.[xliv]
I am neither an economist nor a political scientist, but I would describe the foregoing situation as critical. It also seems that the only way to get out from under such debt and its adverse consequences (both economic and geopolitical) is for the U.S. economy to grow and for American businesses and workers (i.e., taxpayers) to thrive. Such growth should naturally generate more revenue from income taxes, but query whether we can tax our away out of the deficit hole in which we find ourselves without also limiting federal spending.[xlv] Should we even try?
For one thing, can we reasonably expect that increased income taxes will foster such economic growth? By increasing the tax burden on businesses, their owners, and their key employees, will we dampen their enthusiasm to work harder and to invest their capital and efforts in the hope of achieving economic success? My visceral response is yes.
Someone who works 12 to 15 hours every day, risks their savings, and sacrifices their personal life – and often their physical well-being – in order to establish and then grow a business is not doing so as a public service. There is a reasonable expectation that they and their families will be allowed to realize the rewards stemming from whatever economic success they achieve.[xlvi]
Enter the federal government[xlvii] with plans to increase the tax bill for all businesses and their owners by a not-insignificant amount.
What’s more, the government’s populist arguments that businesses and their owners are cheating the working public[xlviii] is laying the groundwork for the additional “tax reform” that is certain to come once the first round of tax increases fails to adequately address the deficit.
We have a rocky road ahead of us. Stay tuned.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
*How many of you are tired of hearing this? It’s on a par with what many have described as the Veep’s word salads. That said, may the guy from Scranton survive until she can be replaced.
[i] Yes, that old chestnut of questionable constitutionality. It is clearly a direct tax, but it is not an income tax, which means it is not covered by the 16th Amendment and has to satisfy the apportionment requirement under Article I, Sec. 2 of the Constitution. It doesn’t pass this test.
Rep. Jayapal introduced the proposal to the House. (Why is she still in Congress?)
A couple of days later, Senate Finance Committee Chair Wyden proposed a bill that would impose additional requirements on the use of GRATs. IRC Sec. 2702. Just like the White House’s budget.
[ii] Specifically, the Republican-controlled House. But then again, with Mike Gallagher’s departure, we’re looking at 218 Republicans to 213 Dems, at least by my count. The year is still young. (I’ll just note that Gallagher was chair of the select committee investigating the CCP’s activities in the US. That probably includes the many illegally operated CCP police stations in the US, like the one the FBI and DOJ broke up in the Bronx last year.) https://www.justice.gov/opa/pr/two-arrested-operating-illegal-overseas-police-station-chinese-government .
[iii] See https://www.taxslaw.com/2024/03/estate-gift-gst-related-income-tax-proposals-what-is-the-white-house-doing/ . Among the items discussed was the proposal to treat the transfer of assets at death as a sale of such assets at fair market value.
[iv] Election Day is on Tuesday, November 5, 2024. Of course, the date is less meaningful than it once was thanks to early voting and mail in voting.
[v] Not evasion, though that certainly occurs. The vast majority of the taxpayers at which the White House is taking aim plan within the letter of the Code, which of course has been amended time and again by Congress, and interpreted by the IRS through rulings and regulation.
[vi] Judging from the threshold at which many of the tax increases are triggered, this group includes individuals with over $400,000 of adjusted gross income.
[vii] The Republicans took advantage of their control over the White House and the 115th Congress (basically, 2017-2018) to enact the Tax Cuts and Jobs Act.
[viii] At the same time, our nearly comatose commander-in-chief is raking in the campaign contributions as NY’s smug, over-political, and shortsighted AG prepares to seize the assets of the frontrunner.
[ix] Our last post considered the proposed changes to the income and transfer taxation of gifts, estates, and trusts. https://www.taxslaw.com/2024/03/estate-gift-gst-related-income-tax-proposals-what-is-the-white-house-doing/ .
[x] Thus, for example, the following items of compensation would be subject to the higher income tax and Medicare tax: year-end bonuses, change-in-control payments, compensatory stock transfers, the exercise of compensatory options, failed ISOs, stock appreciation rights, and payments pursuant to nonqualified deferred compensation plans (of which there are many forms). In other words, practically every incentive arrangement used by employers to retain, motivate, and reward good employees.
[xi] The current 37% rate applies to taxable income over $731,200 for a married couple filing jointly. Under the proposal, the same taxpayers would be subject to the top rate of 39.6% for taxable income over $450,000.
[xii] See IRC Sec. 1239 with respect to property that is depreciable in the hands of the buyer; see IRC Sec. 707(b) with respect to the sale of property between a partner and their partnership, or between two related partnerships, where the property sold is not a capital asset in the hands of the buyer.
[xiii] For example, gain from the sale of shares of stock and other capital assets (IRC Sec. 1221), and gain from the sale of IRC Sec. 1231 property, including real property used in a trade or business.
[xiv] The highest ordinary income rate would be 39.6%. The NIIT rate (discussed below) would be 5%. Do the math.
[xv] By contrast, the rules that would be applicable to the gain arising from the deemed sale of such assets appear to be more forgiving. See the last post.
[xvi] IRC Sec. 1411.
[xvii] Employment taxes under the Self-Employment Contributions Act (SECA).
[xviii] Material participation standards would apply to individuals who participate in a business in which they have a direct or indirect ownership interest. Taxpayers are usually considered to materially participate in a business if they are involved in it in a regular, continuous, and substantial way. Often this means they work for the business for at least 500 hours per year. The statutory exception to SECA tax for limited partners would not exempt a limited partner from the NIIT if the limited partner otherwise materially participated.
[xix] In short, the material participation exception to the NIIT would be eliminated.
[xx] Typically, the loan flows from a corporation in which the shareholders have low basis stock to a related corporation in which the shareholders have high basis stock.
[xxi] IRC Sec. 1(h). In general, a qualified dividend is one that is paid with respect to the share of stock of a domestic corporation with respect to which the shareholder has satisfied 121-day holding period.
[xxii] In either case, don’t forget to add the 5% NIIT.
[xxiii] Including unrealized gains.
[xxiv] Assets minus liabilities.
[xxv] Taxpayers who are treated as “illiquid” would be allowed to defer the tax on their nontradeable assets, but would be subject to a deferral charge when such assets were sold. Think IRC Sec. 453A or IRC Sec. 1291.
[xxvi] IRC Sec. 754.
[xxvii] Under IRC Sec. 734. Say a partnership makes a current distribution of property to a partner, and the partnership’s basis for such property exceeds the distributee-partner’s basis for the property. In that case, the partnership would increase the adjusted basis of the remaining partnership property by the amount of such excess. IRC Sec. 754, Sec. 734(b) and Sec. 732(a)(2).
[xxviii] Think IRC Sec. 267(d).
[xxix] IRC 461(l). It is currently set to expire after 2028.
[xxx] The top rate before 2018 was 35%.
[xxxi] This addresses two scenarios that may apply to an S corporation that was previously a C corporation or that acquired a C corporation on a tax-free basis.
[xxxii] IRC Sec. 1374.
[xxxiii] IRC Sec. 11.
[xxxiv] IRC Sec. 1375.
[xxxv] Until now, this limitation on deduction applied only to publicly held corporations and only with respect to payments made to certain individual employees.
[xxxvi] Certain types of compensation are not subject to the deduction disallowance and are not taken into account in determining whether other compensation exceeds $1 million, including (a) payments made to a tax-favored retirement plan, and (b) amounts that are excludable from the employee’s gross income, such as employer-provided health benefits and miscellaneous fringe benefits.
[xxxvii] The corporation would recognize the loss on the deemed sale of the distributed properties under IRC Sec. 336, and the shareholder would recognize loss in respect of its shares of stock in the liquidating corporation under IRC Sec. 331.
[xxxviii] For the meaning of a “controlled group,” see IRC Sec. 1563(a) but apply a 50% ownership threshold.
[xxxix] See IRC Sec. 267(f) by analogy.
[xl] You may recall that, after 2017, only exchanges of real property could qualify for tax deferral under IRC Sec. 1031.
[xli] Basically, Section 1250 property.
[xlii] We’re expected to run a $1.6 trillion deficit for the 2024 fiscal year, ending September 30, 2024. https://www.crfb.org/papers/analysis-cbos-march-2024-long-term-budget-outlook .
[xliii] By some accounts, it is expected that interest payments will soon exceed defense spending.
[xliv] China being the principal threat to our security and one of our largest trading “partners.” Each of these countries holds approximately $1 trillion of U.S. debt.
[xlv] For example, why are we paying to fly illegal aliens all over the country? Why are we housing and feeding them?
[xlvi] This is not intended as a criticism. It is merely an observation or recognition of human nature – people are naturally selfish, and some are more so than others.
[xlvii] State and local governments are doing the same, but in those cases the business and its owners have the ability to move to a different jurisdiction.
[xlviii] Another example of how they view the world as comprised of oppressors and the oppressed. It’s neither helpful nor productive. It’s actually selfish.
