How We’d Pay for the $3.5 Trillion Infrastructure Bill

The House Ways and Means Committee on Monday released legislative text for proposed tax changes as part of the Democrats’ budget reconciliation bill.

Members of the U.S. House of Representatives are currently working on a $3.5 Trillion budget reconciliation bill that would fund a broad range of progressive priorities, from universal pre-K education to forest fire mitigation and clean energy development. By using the budget reconciliation process, they ensure that a filibuster cannot be used to halt the bill, and only the moderate and conservative members of the Democratic party will need to be swayed to secure its passage, with no Republican votes needed.

The reconciliation process, however, has several limits. Chiefly, it must be fully funded – for every expense, there must be an offsetting increase in revenue (tax), or an increase in borrowing. The ambitious spending provisions of the reconciliation bill must therefore be funded in part through an increase in anticipated tax revenue. Such an increase would generally fall into one of three categories: (1) an increase in the tax base, (2) an increase in tax rates, or (3) limiting currently available deductions.

The first category contemplates measures in the bill that would increase actual taxable income being earned by U.S. persons and companies, and thus create more tax revenue. For instance, if a parent is currently not working due to prospective childcare costs exceeding what they could earn in the workplace, government funded child-care could tip this calculus, causing them to enter the workforce and receive a taxable paycheck where previously there was none. Additionally, it is hoped that increased access to low-cost education and better physical infrastructure could lead to less waste and increased productivity across a broad range of economic sectors.

While Democrats anticipate the first category described above to offset some increased spending, they also rely heavily on the second two categories, which are the primary subject of this newsletter. While not exhaustive of all tax law changes contemplated in the House Ways and Means Committee recommendations, we hope that his newsletter will provide useful information on the changes most relevant to our clients.

 

Tax Rate Changes

Individual Tax Rates

The House bill would incorporate several marginal tax rate changes for high earning individuals.

The top marginal rate on ordinary income (which would apply to single individuals earning over $400,000 and married individuals earning over $450,000) would increase from 37% to the pre-2017 rate of 39.6%. It would also essentially create another tax bracket by imposing a 3% “high-income surcharge” on married taxpayers with Modified Adjusted Gross Income (MAGI) over $5 million ($2.5 million for single taxpayers).

The top marginal rate on capital gains would increase from 20% to 25%. Additionally, the high-income surcharge could apply as well, making the effective rate on capital gains 28%.

The 3.8% Net Investment Income Tax would be expanded to cover investment income derived in the course of a trade or business for taxpayers with greater than $400,000 in taxable income ($500,000 if married).

Corporate Tax Rate

Currently, the corporate tax rate is a flat 21%, which was decreased from 35% in 2017. The House bill would introduce a graduated rate (similar to how individuals pay a graduated rate) with brackets ranging from 18% to 26.5%. Corporations with more than $10 million in taxable income, however, would not be subject to the graduated rate, and would only pay the top 26.5% rate.

Additionally, the House bill would modify the Section 1202 rules for certain sales of qualified small business stock, so that the 75% and 100% exclusion rates would not be available for taxpayers with Adjusted Gross Income exceeding $400,000.

 

Estate and Retirement Changes

Unified Credit

Under the House bill, the estate and gift tax unified credit base amount would revert to its pre-2017 level of $5 million, down from $10 million. This would impact the amount of money high net worth individuals would be able to leave their heirs tax free. Notably, the increased amount was set to expire in 2026, and this bill merely moves up the date.

Agricultural Special Valuation

Under the House bill, the special use valuation rules for agricultural property would become significantly more generous. The limitation on special use decrease in valuation would increase from $750,000 to $11,700,000.

Trust Rule Modifications

The House bill would modify the existing grantor trust rules to eliminate situations where property is removed from a grantor’s estate while they retain a high level of control. Additional analysis and guidance are likely needed, but this may have a substantial impact on the use of grantor retained annuity trusts as well as defective grantor trusts in estate planning.

Asset Valuation Modifications

When valuing property for estate tax purposes, an entity is often valued less than its underlying assets when control is divided up between multiple people, the theory being that any prospective buyer would demand a discount for the inconvenience of not being able to use or dispose of the property without the assent of third parties. The House bill would limit the availability of such discounts for passive, non-business assets.

Backdoor Roth Contributions

Under the House bill, Backdoor Roth Contributions would be eliminated by disallowing Traditional IRA to Roth IRA conversions for high income individuals, and all conversions of workplace retirement plans to Roth IRAs.

Roth IRAs are a popular retirement plan that allow individuals to contribute funds with no current tax deduction, where they will grow tax free and be distributed tax free once the individual reaches retirement age. In contrast, Traditional IRAs offer a current tax deduction when funds are contributed, and while the funds grow tax free, tax must be paid on any distribution, even after the individual reaches retirement age. In both cases, the retirement plans were created by Congress primarily to reduce the tax burden on middle- and low-income individuals saving for retirement, and thus contain limitations applicable to high income earners. In the case of Traditional IRAs, an individual isn’t allowed a deduction if their income exceeds certain limits, and they are covered by a workplace retirement plan such as a 401k (the deduction is fully phased out for single taxpayers with Modified Adjusted Gross Income (MAGI) over $76,000 or married individuals with MAGI over $125,000). While they can still contribute and have their money grow tax free, they don’t get a deduction at the time of contribution. For Roth IRAs, no contribution is allowed at all for single individuals with a MAGI over $140,000 or married individuals with a MAGI over $208,000.

So-called “Backdoor” Roth contributions exploit a long-standing loophole that allow Traditional IRAs to be converted to Roth IRAs, regardless of income level, with tax only imposed to the extent it undoes previously taken deductions and associated growth. What this means is that an individual with income in excess of the limits discussed above could contribute to a regular IRA, receiving no deduction, and then convert such contribution into a Roth contribution with no tax owed (since no deduction was taken and no growth has taken place). Essentially, it allows the wealthy to make Roth contributions, just with extra steps, thereby circumventing Congress’ intent and accessing a retirement savings strategy that was meant for lower income individuals. This is a very common practice in modern wealth planning, which has gained notoriety recently when it was reported that billionaire Peter Thiel holds roughly $5 Billion in a Roth IRA which he will be able to distribute tax free in retirement (though it should be noted that this massive sum was likely the result of buying highly speculative startup assets within a Roth, and that most Roths, whether funded by regular or backdoor contributions, will never grow so large).

The House bill would limit the use of this loophole by disallowing Traditional IRA to Roth IRA conversions for single individuals with taxable income over $400,000 ($450,000 if married) and disallowing the conversion of workplace retirement accounts to Roth IRAs entirely.

Roth 401(k) Contributions

The House bill would additionally disallow any future after-tax (Roth) 401(k) contributions, while still allowing Roth IRAs. Workplace retirement plans would be solely traditional, tax-deductible plans.

No “Special” Investments in Retirement Plans

The House bill would disallow investments within retirement funds which require investors to be accredited, or in which the owner holds a substantial interest.

As mentioned above, billionaire Peter Thiel was likely able to amass a $5 billion fortune within a tax-free retirement plan largely by making speculative investments in start-up companies at the ground level within his Roth account. To give you an idea of how effective this could be, imagine you had invested in Amazon through your Roth IRA before it was public, at $5 per share, and purchased 1,000 shares. That $5,000 investment would now (as of the time of writing this newsletter) be worth more than $41 million and would be completely tax free.

While at first glance this might seem like an impossible thing to regulate, and it may even seem counterintuitive to disallow “good calls” within a retirement plan, a closer look at the rules reveals this strategy as deeply unfair, especially in the context of accounts meant to even the playing field somewhat for middle- and low-income individuals. The reasons for this is that the type of big-risk-big-payout investment that allow individuals like Peter Thiel to gain such huge returns are by law not available to the typical investor. Private equity raising, public offerings, and other such speculative investments may generally only be offered to so-called “accredited investors.” This means investors who the SEC deems to be sufficiently “sophisticated” enough to understand the risks involved. Without going into too much detail, this will generally be limited to institutional investors and the wealthy. That is, the opposite sort of people that tax-advantaged retirement plans were intended to benefit.

Additionally, under current rules, an individual cannot invest in a company through an IRA if they own 50% or greater interest. Under the House bill, this would be decreased to 10% for non-publicly traded investments and would prevent investment in companies in which the individual is an officer.

Account Size Contribution Limits

The House bill would disallow certain IRA contributions after an individual has already accumulated over $10 million in retirement savings.

Retirement plans were intended to help low- and middle-income individuals save enough for a comfortable retirement by easing the tax burden and providing incentives for saving, at the expense of tax revenues. Congress has balanced the goal and the cost by limiting how much you can contribute and limiting the current year deduction based on income level. This is an indirect method that may often allow continued tax-advantaged savings well after an individual has accumulated enough retirement savings to provide themselves with a comfortable income stream for retirement.

The new House bill would create an additional limit based on account size, so that individuals who have already accumulated $10M within retirement accounts (at the end of the prior year), and who exceed certain taxable income limits for the current year ($450,000 married, $400,000 unmarried), could not make further contributions to IRAs or Roth IRAs. Note that they could still contribute to their 401(k)s.

RMDs on High Value Accounts

Retired individuals are generally required to take a certain minimum amount from their retirement plan each year, known as a required minimum distribution (RMD), which is determined based on their account values and the remaining life expectancy for a person of their age. The House bill would build on the RMD rules so that while high value accounts wouldn’t be forfeited, they would have to be spent down in a shorter time to limit the future (but not past) upside of previously allowable transactions that we now view as abusive.

For individuals already subject to RMDs, and whose retirement accounts and current income fall within the amounts discussed above under contribution limits, an additional RMD would be required equal to 50% of the amount of the excess value of the retirement account over $10 million.

The House bill also creates another RMD-type rule, whereby if the value of an individual’s retirement plans exceeds $20M, then the excess is required to be entirely distributed from Roth accounts until the balance is below $20M or no Roth amounts exist. While this wouldn’t create a tax burden on distribution (as Roth distributions are non-taxable), it would stop currently “abusive” Roth accounts (such as the Peter Thiel account discussed previously) from continuing to grow in retirement.

 

Small Business Changes

QBI Deduction Limit

The Qualified Business Income Deduction (a deduction claimed by low- and high-earning small business owners alike) would be limited to $400,000 for single individuals and $500,000 for married individuals).

This deduction generally allows a 20% deduction for owners of pass-through entities, subject to certain limitations based on the type of the business, the amount income generated by the business or otherwise earned by the owner, the amount of property the business owns, and the amount of people the business employs. The modification contemplated by the House bill would largely only affect large business, as a married business owner not limited by any of the limitations that already exist, would not be affected until they reached $2.5 million in yearly net profit ($2 million for an unmarried taxpayer).

Excess Business Losses

The House bill would make permanent the temporary suspension of excess business losses created by the 2017 Tax Cuts and Jobs Act. Essentially, it would extend the current rule that losses from a pass-through entity (such as a Schedule C small business) cannot offset income from other sources (such as wages) and must instead be treated as NOLs to offset business gains in other years.

 

International Tax Changes

Modification of Foreign Tax Credit

Under current law, excess foreign tax credits can generally be carried back one year or carried forward up to 10 years. Under the House bill, the carryback would be eliminated, and the carryforward would be limited to five years.

Reduction of GILTI/FDI Credit

The 2017 Tax Cuts and Jobs Act created a new type of so-called Subpart-F income, Global Intangible Low Tax Income, for companies with foreign subsidiaries, and then created a GILTI deduction to reduce the tax rate that would apply to such income. It also created the Foreign Derived Income (FDI) deduction to create a similar rate on companies not operating through foreign subsidiaries. The House bill would modify these deductions to result in higher rates of tax on GILTI and FDI income.

Miscellaneous Provisions

Several other changes would affect businesses with international operations. For instance, certain interest expenses would be limited for domestic corporations which are part of international financial reporting groups. Additionally, foreign oil related income would include oil shale and tar sand operations. This list is not exhaustive and special care should be taken by any taxpayer with international concerns.

 

Other Modifications

This newsletter provides information on only a portion of the many tax changes contemplated by the House bill. Some provisions, such as extension of the wash sale rule to digital assets, the exclusion of prison rents from REIT qualified income, or the disallowance of conservation credits for partnerships with insufficient partner basis might seem relatively niche but could impact taxpayers in unexpected ways through their retirement portfolio. If the Way and Means committee proposals are adopted, we recommend that anyone with non-traditional investments, any business owner, or anyone with international exposure consult with their tax professional to see what if any impact these new rules will have on their situation.

 

Additional IRS Budget

For some time, the Internal Revenue Service has been operating on somewhat of a starvation budget, both in terms of staffing and technology. The House bill provides almost $79 billion in additional funding for increased tax compliance enforcement. While it states that such funds are not intended to be used to increase enforcement on anyone with taxable income below $400,000, such provision seems almost impossible to enforce and increased enforcement should be anticipated across the board. Additionally, $410 million is provided to the Treasury Inspector General for oversight of the IRS, and $157 million is provided to the Tax Court.