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Tax planning this year is being made more complex by the Biden administration, which is proposing a number of changes to the tax code. While nothing has been finalized just yet, tax expert Michael J. Tucker explains what the changes could mean for CPAs and their clients.
Many tax practitioners are challenged by what to tell their clients regarding the various tax provisions Congress is currently considering. We, of course, won’t have firm answers until the plan becomes law, but we can educate ourselves about the proposals in order to stay ahead of any major changes. In a recent Surgent webinar, we highlighted the key potential corporate and individual tax code changes most applicable to the clients of general tax practitioners.
To follow is what we know.
Corporate Tax Updates
Currently, the corporate federal income tax rate is 21 percent, as enacted by the Tax Cuts and Jobs Act of 2017 (TCJA). Current legislative proposals would replace the flat corporate income tax with a graduated rate structure for tax years beginning after December 31, 2021. The graduated rate structure would be as follows:
- 18 percent on the first $400,000 of income
- 21 percent on income up to $5 million
- 26.5 percent on income greater than $5 million
The lesser of $287,000 or an additional 3 percent tax would be imposed on corporate income exceeding $10 million until the benefit of the lower brackets is erased. Personal services corporations would not be eligible for the graduated tax rates. Fiscal year taxpayers would be eligible to prorate their applicable tax rate(s) based on the proportion of their fiscal year occurring after December 31, 2021.
Additional legislative changes would affect the dividends received deduction under §243. Currently, dividends received by a C corporation are deductible at a 50 percent rate if the corporation receiving the dividend owns less than 20 percent of the corporation distributing the dividend. In the case of C corporations receiving dividends from a 20 percent or more owned corporation, the deduction rate is 65 percent.
Both the 50 percent and 65 percent deductions are subject to taxable income limitations. The proposed legislation would increase the 50 percent dividends received deduction to 60 percent and the 65 percent deduction to 72.5 percent.
What the Changes Would Mean
By increasing the top corporate tax rate and including an additional 3 percent surtax for certain corporations, it is clear Congress is targeting large corporate profits to fund the human infrastructure agenda. However, as the TCJA hurt smaller, less profitable corporations by removing the lesser graduated rates and legislating a flat 21 percent tax rate, there may be benefits to the C corporation structure that have not been observed since 2017 and earlier. This could be a particular planning point since changes to the §199A Qualified Business Income deduction may adversely impact individual taxpayers owning pass-through entities.
Individual Tax Updates
The highest marginal tax rate applicable to individuals is 37 percent. The legislative proposal, if passed in its current form, would increase the top marginal individual income tax rate in Section 1(j)(2) to 39.6 percent. This increased marginal tax rate would apply as follows:
- Married individuals filing jointly with taxable income over $450,000
- Heads of households with taxable income over $425,000
- Unmarried individuals with taxable income over $400,000
- Married individuals filing separate returns with taxable income over $225,000
- Estates and trusts with taxable income over $12,500
These rates would be applicable to tax years beginning after December 31, 2021. Akin to the corporate surtax, a new 3 percent surtax would be applicable to the extent a taxpayer’s AGI exceeds $5 million ($2.5 million in the case of married taxpayers filing separately).
The legislation proposes, in addition to the rate changes above, an increase in the long-term capital gains and qualified dividends tax rate from 20 percent to 25 percent. These rates would be imposed on the new 39.6 percent bracket.
This 5 percent additional rate increase would generally be effective for taxable years ending after September 13, 2021. Net gains realized before the September 13 effective date would be taxed at the 20 percent rate, and transactions subject to a binding contract in place before September 13, without any material modifications after the effective date, would still be taxed at a top rate of 20 percent. Aside from the 5 percent capital gains rate increase, the 3.8 percent net investment income tax as well as the proposed 3 percent individual surtax noted above would effectively bring the top marginal capital gains rate to 31.8 percent.
In addition to the rate increases noted above, the proposed legislation includes further limitations on the deduction for Qualified Business Income under §199A. Current legislation provides non-corporate taxpayers with a deduction up to 20 percent of their Qualified Business Income, plus a maximum 20 percent deduction for REIT dividends and publicly traded partnership income. The deduction is limited to 20 percent of the taxpayer’s taxable income after subtracting any net capital gain.
Additionally, the deduction is subject to taxable income phase-outs. The proposed legislation would impose a maximum allowable §199A deduction as follows:
$500,000 in the case of married filing joint,
- $400,000 in the case of single taxpayers
- $250,000 in the case of married filing separate
- $10,000 for a trust or estate
The additional limitations to the §199A deduction would also be effective for tax years beginning after December 31, 2021.
What the Changes Would Mean
Just as contemplated for profitable corporate taxpayers, the legislative agenda seeks to fund the human infrastructure changes with additional taxes on individual taxpayers with higher taxable incomes. While §199A brought a sense of parity to the entity selection decision, the potential benefit of the graduated rates at the corporate level and the limitations on the §199A deduction at the individual level may make the entity selection choice -- taxable C corporation versus the pass-through entity structure -- less clear than it was previously.
Certain taxpayers may now consider a check-the-box election or a revocation of an S-election. In planning for a check-the-box election or S-election revocation, it is crucial to remember that these choices are effective for five years, thus limiting an entity’s flexibility to pivot and respond to future guidance.
While our summary outlines some of the key tax legislation issues facing corporations and individuals, they only represent the tip of the iceberg. This legislation promises to be sweeping and far-reaching. Deeper detail is needed to fully advise clients on the relevant issues applicable to them for 2021 and beyond.
Michael J. Tucker, CPA, is V.P., Tax and Advisory Content for Surgent Accounting & Financial Education. As an expert in personal, pass-through, and estate/gift taxation, Mike formerly worked with T.M. Byxbee Co., KPMG Peat Marwick, and Deloitte & Touche. Mike received his J.D. from New York University, his LL.M. from Georgetown...