Reading the tea leaves on tax reform
Diving into the ‘Green Book’ proposals
Paul Neiffer, CPA | August 2021 Footnote
Editor's note: Updated July 29, 2021
Several bills have been proposed in Congress regarding possible major changes to how assets are taxed when transferred from one generation to another. President Joe Biden has also released his “Green Book,” outlining his proposals to raise revenue. Most of these proposals appear not likely to pass (as of this publication), but it is important to understand what is being proposed and how it may affect your clients.
Corporate tax increase
Biden proposes raising the corporate tax rate from 21% to 28%. This would be a 33% rate increase. However, many small corporate taxpayers, especially farmers, would see an even higher rate increase versus the rate they paid in 2017 because most of them paid tax at a 15% rate.
This tax increase, along with proposed capital gains tax changes, would lead to a combined federal tax rate of 59.25% — the corporate tax rate of 28% plus the 43.4% rate on the remaining 72% paid as a dividend. If we add in state taxes, we are likely over a combined 70% rate.
Income and capital gains tax changes
The current top individual income tax rate of 37% would increase to 39.6% and be effective in 2022. The current top capital gains tax rate of 20% would increase to 39.6% for gains incurred after April 28, 2021 — Biden’s proposal — plus the extra 3.8% net investment income tax. This tax would only apply on net gains greater than the $1 million level. If taxable income exceeds $1 million, the lesser of net long-term capital gains and qualified dividend income or income exceeding $1 million would be subject to the higher rate.
The itemized deduction limitation would be accelerated and there is a proposal to limit the “value” of itemized deductions at 28% for higher-income taxpayers. This may also result in retirement plan contributions being allowed as a 28% credit instead of a deduction. This would favor providing benefit to lower-income taxpayers and penalizing taxpayers with higher income. It would likely lead to those taxpayers switching to doing Roth retirement plan contributions.
Tax-deferred 1031 exchanges would be allowed, but the maximum annual gain allowed for deferral would be capped at $500,000 for single filers and $1 million for a married couple.
The excess business loss limitations temporarily placed in effect via the 2017 tax reform would now be permanent.
Self-employment and NIIT tax changes
Biden’s plan calls for applying self-employment (SE) tax to materially participating income of a farm operation that is taxed as a partnership or S Corporation that exceeds $400,000. This creates a “doughnut hole” for SE income. SE tax applies on amounts up to the wage base (currently $142,800); no SE tax between that amount of $400,000; and then SE tax on all materially operating income above that amount.
Almost all farm income including self-rental income or gains on selling self-rental land will now either be subject to the net investment income tax or self-employment tax, assuming the farmer exceeds the pertinent threshold amounts.
If commodity wages remain exempt from payroll taxes, it may push more farmers into creating S Corporations. But will commodity wages retain this tax advantage?
A new transfer tax
The president and many members of Congress believe that not only should an estate or gift apply on transfers, but they also now want to add an additional transfer tax. The transfer tax would be at the applicable capital gains rate on appreciation after a lifetime exemption. Biden proposes a $1 million exemption per person with an additional $250,000 exemption for appreciation in your personal residence.
Family farm operations would owe the tax on nonfarm assets on their final year income tax return. The remaining tax calculated on farm assets would be deferred if the farm continues to be owned and operated by the farm family. However, we don’t know how long this period is, who is considered family and other key details. If the rules are like Section 2302A, then cousins will not be considered family.
Any tax owed on these assets can be paid over a 15-year period with low interest.
Many have referred to this provision as eliminating step-up in basis at death. That is incorrect. All the provisions provide for step-up in basis; however, now you have to pay for it, other than the exemption amounts getting step-up with no tax owed.
Most farm families in Minnesota can deal with estate taxes. However, this transfer tax may create an additional larger tax burden that will forcemany heirs to sell the property and quit farming. Let’s review an example as to how it may impact a farm family.
Ed and Mary Farmer farm 2,000 acres in Minnesota that Ed inherited 50 years ago. At that time, the land was worth $2 million, and it is now worth $20 million. Ed and Mary die in a car wreck, leaving behind farm equipment, a growing crop, prepaid farm expenses and grain inventory worth $4 million with no tax basis. Their personal residence is now worth $1 million and they paid $500,000 for it 10 years ago. Ed and Mary also have savings, IRAs and other assets worth $4 million and have no debt.
Their combined estate is about $29 million. The Minnesota estate tax bill would be about $ 4 million. Total appreciation of $22 million less $2 million exemption results in $20 million of taxable income being reported on their final joint return. A combined 43.4% rate plus the top Minnesota rate of 9.85% (assuming Minnesota couples with federal law) results in about $10.6 million of federal and state income taxes being owed. If the family will not farm the ground and elects to sell the farm, then all the tax is owed immediately. The Minnesota estate tax and income tax are allowed as a deduction against federal taxes resulting in no federal estate tax.
The heirs will inherit — after taxes — about $15 million. Under current law, they would not owe the income tax, but would owe Minnesota estate tax and about $600,000 of federal estate taxes. The new transfer tax cost them $10 million.
Now let’s assume they have debt of $10 million. Their net worth is $19 million. Under current law, they would only owe Minnesota estate tax of about $2 million, dropping the value to the heirs to about $17 million. They still owe the transfer tax of $10.6 million; therefore, instead of $17 million, the inheritance is now less than $7 million.
The proposal also seems to indicate that any transfers out of a trust or partnership now triggers gain. This means that farmland LLCs would be treated like an S Corporation with gain being reported on any transfer of appreciated property out of the LLC or partnership. There is no exemption on these transfers.
Considerations to consider
Remember, these are just proposals from the White House and it’s likely not all of them will pass. However, the pandemic cost the government close to $5 trillion, with more money to be spent now and into the future, and those expenses will need to be paid for. These Green Brook proposals are an attempt to cover some of those costs.
Paul Neiffer, CPA is a principal with CliftonLarsonAllen LLP. He writes a farm blog found at www.farmcpatoday.com and instructs CLA’s Farm Tax Update seminar sponsored by the MNCPA.
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