President Biden’s proposed tax plans contain many provisions that could affect the amount of income tax you pay in the near future. His plans contain provisions to increase taxes for wealthier Americans which will help fund infrastructure spending and proposed tax cuts for lower income Americans. 

The following highlights from Biden’s proposal may increase the amount of tax you owe:

Increase of top tax bracket

Currently, the top tax rate is 37%. Biden proposes to increase that to 39.6%. The 39.6% rate would apply to taxable income over $509,300 for married filing joint filers, $452,700 for single filers, $481,000 for head of household filers, and $254,650 for married filing separate filers beginning in tax year 2022.

Increase in long-term capital gains rate

Currently, long-term capital gains and qualified dividends are taxed at a maximum rate of 20% (or 23.8% including the net investment income tax if applicable). Biden proposes to increase this to 39.6% (43.4% including the net investment income tax) for taxpayers with taxable income over $1 million ($500,000 for married filing separately). If adopted, the increased rate is expected to be retroactive to April 28, 2021. This increase will be particularly painful for large one-time capital gains from selling a business or piece of property. Making matters worse, often long-term gains are purely as a result of inflation, and not really economic income.

Expand self-employment taxes

Under current law, many loopholes exist for pass-through business owners to avoid paying self-employment taxes. Self-employment earnings are taxed at a rate of 12.4% for Social Security tax (limited to $142,800 of earnings in 2021) and 2.9% for Medicare tax (unlimited), plus an additional 0.9% Medicare tax for high income taxpayers. 

Limited partners in a partnership are statutorily exempt from paying self-employment taxes on their share of the partnership income. Some partners claim limited partner status rather than general partner to avoid paying self-employment taxes. Some LLC members avoid paying self-employment taxes by claiming the treatment of a limited partner. While S-corporation shareholders are required to pay themselves a fair wage which is subject to employment taxes, their distributive share of the income is not subject to self-employment taxes. 

Biden plans to impose self-employment taxes on limited partners, LLC members, and S-corporation owners who materially participate in their business to the extent the income exceeds $400,000. This would be effective beginning in 2022. 

Expand net investment income tax (NIIT)

Under current law, taxpayers with income over certain thresholds ($200,000 for single and head of household and $250,000 for joint filers) are subject to a 3.8% tax on net investment income. Net investment income consists of interest, dividends, rents, capital gains, and income from businesses in which the taxpayer does not materially participate. 

The proposal is to make all pass-through business income (even if you actively participate) subject to the 3.8% NIIT for taxpayers with adjusted gross income (AGI) greater than $400,000. If you are an owner in a pass-through business (such as a partnership, LLC, or S-corporation) and your AGI exceeds $400,000, your business income from these sources would be subject to this additional tax.

Increase IRS enforcement efforts

Some experts estimate that the tax gap (the difference between the amount of tax due and the amount of tax paid) is as high as $1 trillion per year. Biden would like to give the IRS an additional $80 billion over ten years to increase IRS enforcement actions. This includes increasing audits, updating outdated technology, and expanding financial reporting requirements for financial institutions. The risk of being audited is expected to increase for taxpayers with taxable income over $400,000.

Limitation on deferred gains from Section 1031 like-kind exchanges

Currently, taxpayers owning real property such as land and buildings, either used in a trade or business or held for investment, can exchange the property for another “like-kind” real property and enjoy the benefit of deferring taxable gain (assuming certain conditions are met). The proposal is to limit the amount of deferred gain up to an aggregate maximum of $500,000 for single taxpayers and $1 million for married filing joint taxpayers.

Making the limitation of excess business losses permanent

The 2017 federal tax reform imposed a limitation on the amount of losses derived from an active trade or business that a taxpayer can use to offset other income such as wages and investment income. The CARES Act repealed this limitation for tax years 2018 through 2020. The limitation goes back into effect for tax year 2021 and is set to expire after tax year 2026. In 2021, excess business losses greater than $524,000 for married filing jointly and $262,000 for all other taxpayers will be suspended and carried forward to the next year. Biden proposes to make this limitation permanent.

While these are all just proposed changes and have not yet been made into law, your advisors at Ketel Thorstenson want to make you aware of potential tax law changes that may affect you and your business. Please contact Ketel Thorstenson with any questions or concerns.