On April 28, 2021, President Joseph Biden proposed The American Families Plan (the plan) and issued a fact sheet (the fact sheet) outlining what the plan is intended to accomplish and from where revenue will be generated to implement the plan.
The White House release states that “the American Jobs Plan and the American Families Plan are once-in- a-generation investments in our nation’s future...
The American Families Plan is an investment in our children and our families — helping families cover the basic expenses that so many struggle with now, lowering health insurance premiums, and continuing the American Rescue Plan’s historic reductions in child poverty.”
The American Families Plan needs revenue to accomplish its goals. The White House statement characterizes the resulting changes to the income taxation of individuals as “Tax reform that rewards work — not wealth” and describes the proposed changes as follows:
The President’s tax agenda will not only reverse the biggest 2017 tax law giveaways, but reform the tax code so that the wealthy have to play by the same rules as everyone else. It will ensure that high-income Americans pay the tax they owe under the law — ending the unfair system of enforcement that collects almost all taxes due on wages, while regularly collecting a smaller share of business and capital income. The plan will also eliminate long- standing loopholes, including lower taxes on capital gains and dividends for the wealthy, that reward wealth over work. Importantly, these reforms will also rein in the ways that the tax code widens racial disparities in income and wealth.
This article will review some of the proposed changes to the federal personal income tax proposed by the plan and some of the tax benefits the plan hopes to offer. Nevertheless, as the proposals are reviewed, it is necessary to recognize that they are found in a statement released by the White House summarizing President Biden’s public announcement, and that legislation to enact the plan has not yet been submitted to Congress. Additionally, as with all policy proposals, it is far from certain what will ultimately be enacted, if anything. This commentary, therefore, is speculative. As each person’s financial and tax situation is unique, before changing your plans based on administration proposals or proposed legislation, you should talk with your attorney, accountant and other tax and financial advisors.
In the discussion that follows, we assume the plan is enacted as proposed.
Q: How would the plan impact income tax rates?
The plan provides that the top marginal personal income tax rate will be increased to 39.6%. Presently the top marginal personal income tax rate is 37% and applies to the taxable income of taxpayers over a certain amount. For 2021, the top marginal rate applies to:
- married taxpayers filing jointly whose taxable income exceeds $628,300;
- heads of household whose taxable income exceeds $523,600;
- unmarried individuals (other than surviving spouses and heads of households) whose taxable income exceeds $523,600;
- married individuals filing separate returns whose taxable income exceeds $314,150; and
- estates and trusts with taxable income exceeding $13,050.
According to the fact sheet, “[t]he President’s plan restores the top tax bracket to what it was before the 2017 law, returning the rate to 39.6 percent, applying only to those within the top one percent.” During the 2020 presidential campaign and in statements following his election, President Biden and his surrogates indicated that no one having an income under $400,000 would have an income tax increase.
For example, on March 15, 2021, White House Press Secretary Jen Psaki stated, “[t]he president remains committed to his pledge from the campaign that nobody making under $400,000 a year will have their taxes increased.” Looking at the current taxable income amounts subject to the top marginal rate (see above), it seems that the top marginal rate would apply to some taxpayers with “incomes” less than $400,000. Time will tell whether the 39.6% top marginal bracket will replace, or will be added on above, the 37% bracket, so that, in the latter case, the new top marginal rate would only apply to married taxpayers filing jointly with a combined taxable income of at least $800,000 or married taxpayers filing separately each with a taxable income of at least $400,000.
Under the plan, income tax rates on capital gains would also increase for some taxpayers. According to the fact sheet, “[h]ouseholds making over $1 million ... will pay the same 39.6 percent rate on all their income, equalizing the rate paid on investment returns and wages.” Without precise legislative language to review, it is difficult to determine how this would manifest in application. For example, the expression “making over” the threshold amount is ambiguous as to its application in the federal income tax system, not knowing whether the increased rate would apply to the household’s gross income, adjusted gross income or taxable income. Further, it is unclear how this would apply to different types of households. For example, compare a household with married taxpayers who file a joint return against a household with a single person; would each household be afforded the same $1 million threshold for application of the higher rate? To further muddy the waters, one might ask who would be included in the household? Does the household include everyone living in the same home? Does it include income realized by trusts for the benefit of people living in the household? Yet, even with the uncertainties caused by the imprecise language of the fact sheet, the plan’s intent seems to be to increase the income tax rates on capital gains only for relatively wealthy families.
The increase in the income tax rate applied to capital gains would also impact the income tax rate applied to qualified dividends. Qualified dividends are subject to income tax by adding them to net capital gains and are taxed according to the rate limitations applied to capital gains. Accordingly, under the plan, for “[h]ouseholds making over $1 million,” qualified dividends would also be subject to income tax at 39.6%.
The fact sheet states, “[h]ouseholds making over $1 million... will pay the same 39.6 percent rate on all their income, equalizing the rate paid on investment returns and wages.” Although we do not have proposed legislative language, this statement seems to indicate that all income in such households would be subject to federal income tax at ordinary income tax rates, so that the limitations on income tax rates applicable to all types of capital gains would not apply. This raises the question: for “households making over $1 million” would all of the taxpayers’ income (of any type) be subject to tax at the top marginal ordinary income tax rate (similar to a “flat tax”)?
Q: Would any other taxes be impacted?
The plan would expand the 3.8% net investment income tax, sometimes referred to as the Medicare tax (referred to herein as the NII tax), for “those making over $400,000.” The NII tax imposes a 3.8% tax on the lesser of net investment income or the amount of modified gross income that exceeds a threshold amount. The threshold amount is: $250,000 for married individuals filing joint returns; $125,000 for married individuals filing separately; $200,000 for single persons; $200,000 for heads of households; and $200,000 in all other cases. The fact sheet provides no details about this proposal. Perhaps the proposal intends to bring into the definition of net investment income for “those making over $400,000” items presently excluded therefrom, such as income from a non-passive ownership interest in a corporation taxed under subchapter S of the Internal Revenue Code (IRC) or in a limited partnership. In other words, perhaps this is an attempt to tax for Medicare purposes types of income not presently taxed as earned income. Nevertheless, draft legislation will be necessary to see where this proposal is headed.
Q: Under the plan what happens to the basis adjustment (the so-called “step up”) at death?
On the sale or other disposition of property, if the amount realized by the taxpayer exceeds the taxpayer’s adjusted basis in the property, the taxpayer, generally, would recognize a gain. Under current law, generally, the tax basis of an asset transferred by a decedent at death is adjusted to the asset’s fair market value at death. Thus, as a general rule, yet-to-be realized capital gain on a decedent’s assets is eliminated upon the decedent’s death. The plan proposes to eliminate the basis adjustment on death for property with inherent gains in excess of $1 million (or, as stated in the fact sheet, “$2.5 million per couple when combined with existing real estate exemptions”) on a decedent’s death. It seems, however, that the plan may potentially go further than simply eliminating the basis adjustment at death. According to the fact sheet, the plan “mak[es] sure the gains are taxed if the property is not donated to charity.” Without providing elaboration, the fact sheet further states that “family- owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.” While the intent of the plan is clear, that “[w]ithout these changes, billions in capital income would continue to escape taxation entirely,” the timing of when a gain would be recognized under the plan is not. In one interpretation, it is possible to read the language of the fact sheet to indicate that gains would be taxed when the decedent’s heirs later sold the property, that is, when gains are actually realized by the heirs. However, it is also possible to read the fact sheet as requiring gains to be recognized and taxed when a taxpayer dies, regardless of whether the taxpayer’s property is actually sold at that time. Canada, for example, imposes such a tax. Moreover, there is legislation pending in the U.S. House of Representatives and, although not yet introduced, potential legislation is also being discussed by certain U.S. senators that would cause gain to be recognized and subjected to income tax when a taxpayer transfers property either during life by gift or at death.
Perhaps the above-referenced legislative proposals under discussion in the House and Senate will be grafted onto the plan. Nevertheless, until actual legislation that would enact the plan is drafted, it is not possible to determine whether the plan would only end most basis adjustments at death or would also cause inherent capital gain to be taxed at death (or on transfer during lifetime by gift).
Q: What other tax benefits would be reduced by the plan?
Real estate investors would have limited ability to defer gains on the sale of investment real property using so-called “section 1031 like-kind exchanges.” Without going into the many rules to qualify, under current law, a taxpayer who owns real estate that is held for productive use in a trade or business or for investment (and not held primarily for sale) can defer recognition of gain on the sale of such real property (and the income tax that would be imposed on such gain), if such real property is exchanged solely for real property of like-kind which is to be held either for productive use in a trade or business or for investment. The plan would end the ability to defer gains in excess of $500,000. It is not clear from the fact sheet whether the $500,000 limitation would apply to each real property transaction, per year or only once.
The plan makes another attempt to end preferential tax treatment for carried interests. A “[c]arried interest is a contractual right that entitles the general partner of an investment fund to share in the fund’s profits.”
A carried interest is generally a partner’s interest in the profits of the partnership that is larger than that partner’s capital interest in the partnership, and which is acquired and held in connection with the performance of services. “Carried interests” work like this:
A private equity fund typically uses carried interest to pass through a share of its net capital gains to its general partner which, in turn, passes the gains on to the investment managers.... With certain exceptions after 2017, [t]he managers pay a federal personal income tax on these gains at [the lower tax rates on capital gains, rather than the higher tax rates on ordinary income].... The general partner receives its carried interest as compensation for its investment management services. (Typically, the general partner also receives a separate annual fee based on the size of the fund’s assets.) The limited partners receive the balance of the fund’s profits in proportion to their capital investment. A typical division for a private equity fund is 20 percent of the profits to the general partner and 80 percent to the limited partners.
Although subject to many exceptions, “[t]he Tax Cuts and Jobs Act slightly curtailed the tax preference for carried interest[s], requiring an investment fund to hold assets for more than three years, rather than one year, to treat any gains allocated to its investment managers as long term. Gains from the sale of assets held three years or less would be short term, taxed at [the higher rates applied to ordinary income.]”
The plan indicates that equalizing the income tax rates on ordinary income and capital gains will “close the carried interest loophole.” According to the fact sheet, “[h]ouseholds making over $1 million will pay the same 39.6 percent rate on all their income, equalizing the rate paid on investment returns and wages.” No special legislation aimed at “carried interests” would be required. Because “all income” in high-earning households would be taxed at ordinary income tax rates, even income from capital gains attributable to the carried interest, the tax benefit for carried interests would be closed.
The plan would also permanently extend the limitation on the deductibility of large excess business losses. For tax years beginning after December 31, 2020, and before January 1, 2027, essentially, a taxpayer may only offset business losses of $250,000 ($500,000 in the case of married taxpayers filing a joint return) against nonbusiness income. The amount of excess business losses is determined without regard to any deductions, gross income or gains attributable to any trade or business of performing services as an employee. The amount of any business loss for which a deduction was denied may be carried forward as a net operating loss to subsequent year.
Q: How will these tax increases be enforced?
The plan would increase funding to the Internal Revenue Service (IRS) and direct those funds to be used to enforce the provisions of the IRC against Americans with “actual income” equal to or greater than $400,000. Additionally, the plan would add resources allowing IRS to scrutinize large corporations, businesses and estates.
Also, the plan would add reporting rules that would require financial institutions to report information about account flows so that earnings from investments and business activities are reported more like wages are today.
Q: Are there any tax benefits proposed under the plan?
The plan would make permanent or extend many of the increases to tax credits provided by the American Rescue Plan Act of 2021 (the ARPA).
Q: The ARPA increased the credits for health insurance purchased through the Affordable Care Act; what would the plan do?
According to the fact sheet, President Biden intends to expand the availability and affordability of health care through a number of means.
President Biden has a plan to build on the Affordable Care Act and lower prescription drug costs for everyone by letting Medicare negotiate prices, reducing health insurance premiums and deductibles for those who buy coverage on their own, creating a public option and the option for people to enroll in Medicare at age 60, and closing the Medicaid coverage gap to help millions of Americans gain health insurance.
“[T]he [ARPA] provided two years of lower health insurance premiums for those who buy coverage on their own.... [the plan] would make those premium reductions permanent.... ”
Q: The ARPA increased the Child Tax Credit, what would the plan do?
The plan would make permanent the fully refundable Child Tax Credit (the CTC) and extend the other expansions though 2025 (the time at which the increases made by the Tax Cuts and Jobs Act [TCJA] expire).
The CTC provides a credit against tax for taxpayers who can claim a child who qualifies as a dependent. The ARPA expanded the CTC by providing special rules for 2021. For 2021, the ARPA increased the CTC for a child under age 6 at the close of the tax year to $3,600 and for a child aged 6 through 17 to $3,000. If the taxpayer has a principal place of abode in the United States for more than half of the year, or is a bona fide resident of Puerto Rico for the year, the full amount of the credit (without inclusion of the partial credit for certain other dependents) shall be treated as a refundable credit.
The increased CTC amount is phased out over certain thresholds. The amount of the increased credit is phased out by $50 for each $1,000 or fraction thereof by which the taxpayer’s modified adjusted gross income (MAGI) exceeds $150,000 for married taxpayers filing a joint return, $112,500 for heads of household and $75,000 for all other taxpayers.
The phase-out is limited to the lesser of (i) the increase in the CTC made by the ARPA and (ii) 5% of the threshold amount (as modified by the TCJA) over the threshold amount determined by the ARPA.
A taxpayer who does not qualify for the increased amount of the CTC may still qualify for the normal amount of CTC. The normal CTC is phased out (but not below zero) by $50 for each $1,000 (or fraction thereof) by which the taxpayer’s MAGI exceeds $400,000 in the case of married persons filing a joint federal income tax return and $200,000 in all other cases.
Q: The ARPA expanded the Child and Dependent Care Credit, what would the plan do?
The plan would make permanent the expansion to the Child and Dependent Care Credit (the CDCTC) enacted as part of the ARPA.
The ARPA expanded the CDCTC for tax year 2021. The CDCTC provides the taxpayer with a credit against federal income tax for certain expenses paid for the care of a qualified individual which are necessary for the taxpayer to be gainfully employed. The ARPA made the CDCTC a refundable credit for 2021 only. The ARPA increased the maximum amount of the CDCTC to $4,000 if there is one qualifying individual with respect to the taxpayer and to $8,000 if there are two or more qualifying individuals with respect to the taxpayer. The CDCTC is calculated by applying a percentage to the allowable amount of qualified expenses (for 2021, $8,000 if there is one qualifying individual with respect to the taxpayer and $16,000 if there are two or more qualifying individuals with respect to the taxpayer). The ARPA increased the percentage amount to 50% (from 35%). However, the percentage amount is reduced (but not below 20%) by 1 percentage point for each $2,000 (or fraction thereof) by which the taxpayer’s Adjusted Gross Income (AGI) for the taxable year exceeds $125,000 (increased from $15,000) but is less than $400,000. The CDCTC begins to phase out when a taxpayer has $400,000 of AGI and is phased out entirely at an AGI of $440,000.
The fact sheet indicates that the CDCTC can be used to offset the cost of full-time care, after-school care or summer care. The fact sheet also indicates that families that receive a partial credit due to the phase out will receive benefits at least as generous as those they are receiving today.
Q: The ARPA expanded the Earned Income Tax Credit; what would the plan do?
The ARPA increased the Earned Income Tax Credit (EITC) for childless workers. The plan would make the increase permanent.
ARPA expanded the EITC for individuals without qualifying children by providing special rules for 2021. The ARPA provides that for 2021, the age thresholds to qualify for the EITC have been reduced from 25 years to (i) age 24 for a specified student, (ii) age 18 for a former foster youth or a qualified homeless youth, and (iii) to age 19 in all other cases. The upper age limit of 65 years has been eliminated. The credit percentage and phase-out percentage are increased (each doubling from 7.65% to 15.3%) as are the earned income amount (increasing from $7,100 to $9,820) and phase-out amount (increasing from $8,880 to $11,610); however, these increases are not adjusted for inflation from the index years. For taxpayers without children the full EITC in 2021 will be $1,502 (increased from $543).
It is not clear from the fact sheet if other expansions to the EITC made by the ARPA will be made permanent, such as the increased limitation for investment income. Before enactment of the ARPA, for 2021, an individual was denied an EITC if such individual had disqualified income (generally, investment income) in excess of $3,650. Pursuant to the ARPA, for 2021, an individual may now have up to $10,000 of disqualified income and still qualify for the EITC.
Q: What happens next?
Proposed legislation necessary to enact the plan has not yet been introduced into Congress. Accordingly, it is possible that the plan will be changed even before Congress has a chance to see it. After proposed legislation has been introduced, no one knows how the proposal will be amended or if Congress will even consider it. With a narrowly divided Congress, the extent to which President Biden’s agenda will be enacted is anybody’s guess.