Yet Another Congressional Committee Proposal

Take-Away: On November 3, the House Committee added back new tax proposals to the proposed Build Back Better Act that it had removed from the bill in the prior week.

Overview: What is going on in Congress the past few weeks reminds me of what I used to do as a teenager, meaning something that looks really stupid. Remember the old ‘Chinese Fire Drill’ where a car would come to a stop at a red light. All the occupants would exit the car, run around it, and get back into the same seat that they left, just before the light turned green? That seems to be what the House Committee has been doing these past few weeks- running around only to return to where it just left its proposals. That is probably not a fair analogy, but its the feeling I am left with these days.

November 3, 2021 Release: Some of the revenue sources in this week’s version of the Build Back Better Act are the following:

Mega IRAs: Last week the House Committee dropped the proposed tax rule that would preclude Mega IRAs, or more accurately impose a 50% distribution obligation from large IRAs, regardless of the IRA owner’s age. What was out last week’s version came back into this week’s iteration of the revenue sources for the Build Back Better Act. It was in, then out, and now its back in again. [I am humming the Hokey Pokey as I type this summary!]

SALT Deduction: The SALT income tax deduction limit is back, but at a much higher level. Under the Act a married couple could could deduct state and local taxes up to $72,500 for the year (up from $10,000) (a single individual could deduct state and local taxes up to $36,500.)

Share Buy-Back Tax: This 1% tax on a corporation’s buy-back of its issued shares of stock is still part of of the proposed bill.

Corporate Losses: The earlier proposal to limit the amount and carryforward of corporate losses remains in the proposal.

Net Investment Income Tax: The expansion of income covered by this 3.8% tax continues in the this week’s version of the proposed bill. If the taxpayer has modified adjusted gross income. [MAGI- IRC 163(d)] above $400,000 (single) ($500,000 married), then ordinary business income will be subject to the 3.8% net investment income tax. In the past this tax was imposed only on passive investment income like interest, dividends, and gains on the sale of stock.) This change would expose S-distributions to the 3.8% tax.

Omitted Previously Proposed Revenue Sources: Not in the most recent House Committee’s proposal to raise revenues for the Build Back Better Act are the following earlier proposals:

IRC 199A: The effort to curtail the availability of this business deduction (up to 20%) for high earners was removed, so that the IRC 199A small business tax deduction will still be available for many small business owners.

Capital Gains Rate: The capital gain rate will remain at 20%, even though earlier proposals had included an increase to 25%.

Transfer Tax Exemptions: The earlier proposals to reduce the transfer tax exemption from $11.7 million to around $6.0 milllion has been dropped. Recall, though, that the exemption amount is schedule to drop to around $6.0 million in 2026.

Valuation Discounts: The proposal to deny the use of valuation discounts for gift and estate tax purposes of non-business entities has been dropped. Accordingly, valuation discounts can still be used for gifts and transfers at death.

Grantor Trusts: The proposals that would have taxed the sale of appreciated assets to an intentionally defective grantor trust (IDGT), and the taxation of the grantor trust’s assets in the grantor’s estate at death, i.e. the proposed new IRC 2901, have all been dropped. Grantor trusts continue to be alive and well for future wealth transfer purposes (or at least for the balance of this week!)

More On the Surtaxes: Last week, and continuing this week, are the two proposed surtaxes on high income earners.

Individuals: A 5% surtax would be imposed on those whose income exceeds $10.0 million in a year, with an additional 3% surtax imposed for individuals with reported income above $25.0 million.

Trusts and Estates: However, for trusts and estates, these surtaxes will appear at much lower annual income levels. A non-grantor trust that has income in excess of $200,000 for the year would be exposed to the 5% surtax on the excess income. If the trust or estate’s income exceeds $500,000 for the year, the additional 3% surtax would be imposed on the excess.

Mitigating the Surtax for Trusts: As was mentioned previously, one way a non-grantor trust could avoid these surtaxes is with distributions of distributable net income (DNI) to trust beneficiaries, thus exposing the income to the beneficiary’s much lower marginal income tax bracket. Additionally, the trustee could invest in assets that defer income recognition, e.g. life insurance cash surrender values and annuities.

A couple of other thoughts also come to mind if the goal is to avoid these surtaxes on accumulated trust income-

UPIA: The Uniform Principal and Income Act gives a trustee the power to adjust and treat principal (capital gains) as income. However that is a time-consuming process that must be documented each year. More modern trusts simply give the trustee the discretion to treat capital gains as income. Accordingly, a trustee may already possess the authority to treat capital gains as income under the terms of the trust, and thus capital gains could be distributed to the trust beneficiary, even though under conventional trust accounting practices, capital gains are added to principal and not treated as income.

Charitable Distributions: A trust might also be drafted to permit discretionary income distributions to a charity. [IRC 642(c).]The problem is that an existing irrevocable non-grantor trust can neither be amended nor decanted to add a charity as a permissible distributee under the trust. The ability to make distributions of income to a charity must be in the original trust instrument, per the IRS,  in order for the trustee to make a distribution of taxable income from the trust to a charity, such as a donor advised fund with advisory authority over the DAF given to the trust beneficairies.

Backdoor? It has been suggested that there might be a ‘backdoor’ available to existing non-grantor trusts that do not expressly authorize the trustee’s distribution of trust income to charities. The strategy is that the trustee invest trust assets in a partnership. The partnership then makes charitable gifts of its income. The partnership’s charitable income tax deduction is then passed through to the trust, as a partner, with the K-1 issued to the trust, which the trust then uses to reduce its taxable income. This apparently has been approved by the IRS.

Conclusion: These are the some of the proposals before Congress, at least this week. There is a good chance that next week we will see more jockeying to add and exclude revenue generating proposals with those in Congress continuing to dance to the Hokey-Pokey.