The Biden administration released a budget proposal on March 28 with $710 billion in new proposed tax increases, including provisions to tax unrealized capital gains, replace the base erosion and anti-abuse tax (BEAT) with an undertaxed profits rule (UTPR), and restrict basis adjustments between related partners.
The new proposals are part of a $2.5 trillion revenue package that also recycles many of the tax proposals that failed to gain traction last year and were left off the stalled House-passed Build Back Better (BBB) legislation. Many of the new proposals could prove just as controversial. More importantly, the enactment of any tax increases at all hinges on the tenuous efforts of Democrats to resurrect key pieces of BBB in a smaller reconciliation bill. Sen. Joe Manchin, D-W.V., has recently engaged in quiet negotiations with fellow Democrats over a potential slimmed-down version, but many hurdles remain.
The administration’s budget also incorporates the entire tax title of the reconciliation bill that passed the House
last November in its revenue baseline. The $2 trillion in tax increases from that version of BBB brings the total amount of revenue increases envisioned under the budget to $4.5 trillion. Democrats have essentially given up on passing anything at that scale, so the budget proposals that were already cut from BBB last year will likely again struggle for support, including:
- Raising the corporate rate to 28%
- Increasing the top rate on ordinary income to 39.6%
- Taxing capital gains as ordinary income for high-income taxpayers
- Repealing the step-up in basis of inherited assets and requiring tax at death
- Repealing oil and gas incentives
- Repealing like-kind exchanges
- Taxing carried interest as ordinary income
- Changes to grantor trust rules
More modest increases in top rates for corporations, capital gains, and individual ordinary income may have slightly better chances. Manchin has been pushing to resurrect these proposals, but has faced resistance from Sen. Kyrsten Sinema, D-Ariz.
It is not yet clear how much traction any of the new revenue raisers could pick up, and several appear likely to run into administrability concerns and opposition from moderates. It is also important to remember that budget proposals are usually driven at least partially by political messaging.
The largest new tax increase proposal would raise $361 billion by imposing 20% minimum tax on high-income taxpayers. Billed as a “billionaire” tax, it would actually apply to taxpayers with more than $100 million in “wealth.” The 20% tax would be imposed against “total income,” including unrealized capital gains. It appears similar in intent to the mark-to-market capital gains proposal offered by Senate Finance Committee Chair Ron Wyden, D-Ore., last October. Wyden’s proposal was floated as a revenue alternative when Sinema rejected other rate increases, but survived only days before it was discarded in the face of significant opposition. Manchin has already signaled his opposition to the Biden version.
The budget also proposes to raise $239 billion by replacing the BEAT with a UTPR more in line with the Pillar 2 Model Rules
under the global minimum tax agreement the Biden administration helped broker with the Organisation for Economic Cooperation and Development (OECD). Other major new proposals include:
- Restricting basis adjustments between related partners under Section 754 ($61.7 billion)
- Conforming the corporate “control” test under Section 368(c) based only on vote share with the affiliation test under Section 1504(a)(2) to add a value component ($11.1 billion)
- Requiring separate information reporting on Form 5471 under Section 6038 for each taxable unit in each foreign jurisdiction ($1.7 billion)
- Providing Treasury authority to allow late qualified electing fund elections ($39 million)
- Limiting the duration of the generation-skipping transfer tax exemption (no effect in budget window)
- Requiring 100% recapture of depreciation as ordinary income for real property ($6 billion)
- Limiting a partner’s deduction in syndicated conservation easement transactions ($18.6 billion)
- Limiting the use of donor advised funds to avoid private foundation payout requirements ($64 million)
- Extending the statute of limitations for certain qualified opportunity fund investors ($95 million)
- Requiring employers to withhold tax on failed nonqualified deferred compensation plans ($6.8 billion)
- Imposing mark-to-market on digital assets and subject loans to nonrecognition rules ($6.6 billion)
- Expanding the pro rata interest expense disallowance for business-owned life insurance, establishing an untaxed income account regime for certain small insurance companies, and technical corrections of TCJA insurance provisions ($17.1 billion)
The proposals in the House-passed version of BBB were not explicitly listed in the budget, but were assumed as part of the revenue baseline. Many of these tax proposals remain likely to be part of any smaller reconciliation bill Democrats potentially cobble together, including:
- Raising the rate on global intangible low-taxed (GILTI) income to 15%, imposing it on a country-by-country basis, and reducing the exemption from a return on tangible property
- Reducing the deduction for foreign derived intangible income (FDII) and amending the rules
- Implementing other significant international tax reform
- Expanding the 3.8% tax on net investment income (NII)
- Enhancing renewable energy incentives in a $300 billion package
The proposed surtax on adjusted gross income (AGI) and the new Section 163(n) interest deduction limit also remain possible. Proposals to impose an excise tax on stock buybacks and create a minimum tax on financial statement income are more controversial.
The prospects for a reconciliation bill remain fragile. Negotiations have been only intermittent and tentative since Manchin effectively rejected the version of the BBB under consideration before the New Year. Biden and Manchin have recently telegraphed potential alignment over legislation that would pair tax increases and drug pricing savings with a climate package (including tax incentives) and deficit reduction. This has stirred some hope that a deal could still be possible, but skepticism remains. Progressives may be hard-pressed to accept any deal without the child tax credit, which is a major sticking point for Manchin. It also may be difficult for progressives to dedicate revenue to deficit reduction instead of cherished spending priorities. Lawmakers are running out of time, and a deal would realistically need to be reached before the August recess.
If Democrats cannot enact a reconciliation bill, bipartisan legislation to extend popular expired and expiring provisions would still be possible. There is bipartisan support for retroactively postponing the amortization of R&E expenses under Section 174 and enacting legislation enhancing retirement incentives. The timing for these priorities remains unclear, and they may need to wait for a lame-duck session after the November election.
More information on several of the administration’s new tax proposals is offered below.
The proposal would create a new 20% minimum on taxpayers with more than $100 million in “wealth.” The administration defines wealth only as “subtracting liabilities from assets.” The 20% tax would be levied against “total income,” which is not defined, but would include (and appears specifically aimed at) unrealized gains.
Taxpayers would be required to annually report the total basis and estimated value of all assets by class. Tradeable assets would be valued by end-of-year market prices, with non-tradeable assets valued using the greater of original or adjusted cost basis and the last valuation event from investment, borrowing, or financial statements. Taxpayers would be considered illiquid if tradeable assets made up less than 20% of their wealth, and could elect to pay minimum tax only on unrealized gain from tradeable assets.
Liability in the first year of implementation could be paid in installments over nine years, while liability in other years could be spread over five years. Payments of minimum tax would be credited against taxes on future realized capital gains. The proposal declines to define “taxpayer,” though a separate fact sheet says the thresholds are imposed by “household.” The tax would also phase in from $100 million to $200 million in wealth, and is proposed to be effective beginning in 2023.
Grant Thornton Insight: The proposal is clearly targeting unrealized gains in a similar way as Wyden’s failed mark-to-market proposal. The administration leaked the provision to the press early and seems to view it as a valuable political issue. But it is unclear whether it has any realistic chance at enactment, as Manchin has already signaled opposition to the proposal. Though the general idea of taxing unrealized gain in Wyden’s proposal was popular among many Democrats, it was dropped quickly because it was deemed unadministrable. This version appears potentially more complex. Wyden’s version was aimed only at gains without a broader minimum tax concept layered in. Wyden’s proposal also would not have required immediate tax on non-tradeable assets. Finally, Wyden’s version only affected taxpayers with $1 billion in covered assets and $100 million AGI over the prior three years.
The proposal would repeal the BEAT in 2024 and replace it with a UTPR more in line with the OECD’s Pillar 2 Model Rules
The UTPR would apply only to financial reporting groups that have global annual revenue of $850 million or more in at least two of the prior four years. Under the UTPR, domestic corporations or branches would be denied deductions in order to collect the hypothetical amount of “top-up” tax required for the financial reporting group to pay an effective tax rate of at least 15% in each foreign jurisdiction in which the group has profits. The computation of profit and the effective tax rate for a jurisdiction is based on the group’s consolidated financial statements, with adjustments to address temporary and permanent differences between the financial accounting and tax bases. Profit in a jurisdiction would be reduced by 5% of the book value of tangible assets and payroll.
The deduction disallowance applies pro rata with respect to all otherwise allowable deductions. There are coordination rules with other countries that impose a top-up tax under a qualified UTPR and a mechanism to ensure U.S. taxpayers would benefit from U.S. tax credits and other tax incentives.
Grant Thornton Insight: The proposal would be a fairly radical departure from BEAT. In last year’s budget, the administration also proposed an aggressive replacement for BEAT, dubbed the Stopping Harmful Inversions and Ending Low-tax Developments (SHIELD). Congressional Democrats rejected this wholesale shift, but did make changes to BEAT to align it more closely to SHIELD in the reconciliation bill that passed the House. This new version may garner more support given the need for the United States to the adjust tax rules for Pillar 2 implementation.
Partnership basis shifts
The proposal would limit the ability of related-party partners to benefit from an election under Section 754 to adjust basis when the partnership makes a distribution. Under the proposal, if a distribution of property results in a step-up in basis of the partnership’s non-distributed property, a matching rule would prohibit any related partners from benefiting from the basis step-up until the partner who received the distribution disposes of the property. The proposal would be effective beginning in 2023.
Grant Thornton Insight: This proposal takes a very different approach to partnership basis shifts than the Wyden discussion draft on partnership proposals. Wyden would require partnerships to use the remedial method with mandatory revaluations and basis adjustments. The Biden proposal is much more modest in scope.
Ordinary income recapture of real property
The proposal would generally amend Section 1250 to require ordinary income recapture on all depreciation on real property for taxpayer with AGI exceeding $400,000. Current rules under Section 1250 generally limit recapture on real property to the amount that depreciation deductions exceed the straight-line depreciation method. Because real property generally must use straight-line depreciation, there is typically no ordinary income recapture under current law. The proposal would repeal this limit and require ordinary income recapture on all real property depreciation under Section 1250.
The proposal would be effective for depreciation deductions taken on Section 1250 property in tax years beginning after Dec. 31, 2022, and sales, exchanges, involuntary conversions, or other dispositions of Section 1250 property completed in tax years beginning after Dec. 31, 2022. Depreciation deductions taken on Section 1250 property prior to the effective date would continue to be subject to current rules and recaptured as ordinary income only to the extent such depreciation exceeds the straight-line method.
The outlook for significant tax legislation remains very uncertain. Momentum has been scarce, and significant challenges must still be overcome for any reconciliation bill to be enacted. But there are viable scenarios to passage. Taxpayers should continue to monitor legislative developments closely and assess how the proposals would affect them. The proposed effective dates are largely prospective and could give taxpayers significant runway for planning if enacted.
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