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Tax Reform in the American Families Plan

April 30, 2021

The Biden-Harris administration on April 28 introduced the American Families Plan (AFP), a $1.8 trillion legislative framework including provisions to “grow the middle class, expand the benefits of economic growth to all Americans, and leave the United States more competitive.”[1] The AFP would expand access to education, reduce the cost of child care, create a national comprehensive paid family and medical leave program, and extend or make permanent certain tax credits for families with children and low and middle-income households, such as the Child Tax Credit and the Child and Dependent Care Tax Credit.

To fund and offset the cost of these proposals, the AFP includes various tax proposals that, in general, would increase taxes on high-income and wealthy taxpayers. The AFP is meant to work in tandem with the American Jobs Plan, an infrastructure reform plan proposed by President Joseph Biden in late March that is funded in part by an increase to the federal corporate tax rate to 28% from its current 21% level and various other corporate and international tax reforms, discussed in our prior LawFlash. This LawFlash summarizes key components of the tax proposals in the AFP that may be relevant to our clients.

Proposal to Eliminate Carried Interest

Under current federal tax rules, a carried interest is a partnership interest that is received in exchange for services to a partnership that entitles the holder to share in future partnership profits and not existing capital value. In general, carried interest recipients do not recognize compensation income taxed at ordinary individual federal income tax rates, the highest of which is currently 37%, upon grant of a carried interest. Instead, carried interest recipients are entitled to receive a distributive share of future partnership profits, which for many partnerships in the private equity context generally consist of long-term capital gains taxed at a rate of 15% or 20% (depending on the carried interest recipient’s taxable income and filing status). Legislation effective for taxable years beginning after December 31, 2017 imposes a special three-year holding period requirement for certain carried interest recipients’ gain to earn long-term capital gains qualification, although there are various exceptions to this holding period requirement.

The carried interest rules have long been the subject of tax policy debate. Some view carried interest as a “loophole” that allows what should be compensation income taxed at ordinary individual federal income tax rates to be taxed at the lower long-term capital gains rate. Others argue that carried interest is a payment similar to investment income, such as an economic return on goodwill, and should remain taxed at capital gains rates when otherwise applicable. As we reported in our prior LawFlash many tax proposals have been considered to reform the carried interest rules.

Specifically in the AFP, President Biden calls on Congress to permanently eliminate the carried interest rules, which would result in the taxation of what is currently carried interest as compensation income. This AFP proposal is intended to “close the carried interest loophole so that hedge fund partners will pay ordinary income rates on their income just like every other worker.”[2]

As discussed further below, President Biden and his administration also propose to raise the top capital gains tax rate to 39.6%, which would effectively eliminate the preferential tax rate on carried interest for many taxpayers who might otherwise benefit from a reduced tax rate under current law. Thus, these carried interest proposals would serve as a backstop in the event that the top tax rate does not increase or is increased and later decreased.

The elimination of carried interest would largely impact professionals in the private equity and hedge fund contexts and may potentially prompt changes to how such professionals are compensated. It may also make the recent legislation discussed above imposing a special three-year holding period for certain gain derived from carried interest largely irrelevant. As such, we will be closely monitoring for any updates and alert our clients on any material developments.

Limitations on Like-Kind Exchanges

Taxpayers must generally recognize gain or loss upon the sale of real property. However, Section 1031 of the Internal Revenue Code of 1986, as amended, provides an exception to this general rule by allowing no gain or loss to be recognized if real property held for productive use in a trade or business or for investment is exchanged solely for real property of a “like kind” to be held either for productive use in a trade or business or for investment. Such “like-kind exchanges” allow taxpayers to defer the recognition of gain until the property that is received in the exchange is sold in a later transaction. Taken to its extreme, the taxation on deferred gain may be potentially avoided in its entirety if the property that is received in the exchange is passed through an estate and its basis is “stepped-up” to fair market value as of the date of death.

The AFP proposes eliminating like-kind exchanges for gains exceeding $500,000. This limitation would exclusively affect larger-scale investors in real property, as like-kind exchanges are applicable only to real property exchanges and the proposal would still allow like-kind exchanges for gains below $500,000.

Increased Tax Rate on Long-Term Capital Gains

The AFP proposes increasing the long-term capital gains and qualified dividend rate from 20% to 39.6% for taxpayers earning $1 million or more. Combined with the existing 3.8% surcharge tax on net investment income, the top capital gains rate may reach 43.4% (not including any state or local taxes). According to the Biden-Harris administration, this proposal would affect only 0.3% of households, where investment income is concentrated. While unclear, this proposal appears to mean that such households would pay such higher rates of tax on their capital gains and qualified dividend income but it does not appear to mean that all of such households’ income would be necessarily subject to the higher rate. It is further unclear whether all capital gain and qualified dividend income of such households would be subject to the higher rate, as the AFP does not discuss any phase-in for this new top rate.

The AFP does not include a mark-to-market taxation regime proposal for capital gains, an idea that has been championed by Senator Ron Wyden (D-OR), chair of the Senate Committee on Finance.

Net Investment Income Tax

Under current law, taxpayers are assessed a 3.8% Medicare tax on net investment income above $200,000 for single filers and $250,000 for joint filers. Stating that the “application is inconsistent across taxpayers due to holes in the law,” the AFP proposes applying the tax consistently to those making over $400,000 per year.[3] The implications of this proposal are unclear at this time, as a specific framework has not yet been set forth.

Increase in Individual Tax Rate

The highest marginal federal income tax rate is currently set at 37% and applies to taxable income above $523,600 for single filers and $628,300 for married filers. The AFP proposes increasing the top marginal rate to 39.6%, which would restore the top marginal rate to what it was before the 2017 Tax Cuts and Jobs Act (PL 115-97) and what it was when George W. Bush became president. According to the Biden-Harris administration, this increase would affect only the “wealthiest 1% of taxpayers.” [4]

Permanent Limitation to Excess Business Losses

Noncorporate taxpayers are disallowed from taking a deduction for “excess business losses” in taxable years beginning after December 31, 2020 and prior to January 1, 2026 (with some modifications made under the CARES Act, which we discussed in a prior LawFlash). With some modifications, a business loss is (1) the sum of all otherwise allowable deductions for the taxable year that are “attributable to trades or businesses” of the taxpayer, less (2) all “gross income or gain” for the year that is attributable to these trades or businesses. A business loss is an excess business loss to the extent it exceeds $250,000 ($500,000 in the case of a joint return). The AFP seeks to make this limitation permanent.

Internal Revenue Service Enforcement

The AFP would increase investment (a reported $80 billion, though the AFP is silent on the specific amount) in the Internal Revenue Service (IRS) budget over the next decade and would give the IRS stronger enforcement power to increase audits of corporations and wealthy and high-income taxpayers. In conjunction, the proposal also requires banks to provide the government with more information about the inflows and outflows from bank accounts, which the IRS could use to determine who it audits. The Treasury Department in a press release outlined a series of proposals that may improve tax administration and be implemented if such investment is made. President Biden and his administration estimates these changes would increase revenue by $700 billion over 10 years.

Capital Gains Taxation at Death

Currently, taxpayers are not subject to capital gains taxes upon death and their heirs receive a basis step-up to fair market value. The AFP would repeal the basis step-up for gains in excess of $1 million per person (or in excess of $2.5 million per couple when combined with real estate exemptions), assuming the property is not donated to charity. The repeal of the basis step-up does not apply to heirs of small businesses and farms that continue to run those businesses. This proposal is similar to a proposal by Senator Chris Van Hollen (D-MD) and other Democratic senators released in March 2021. The AFP provides scant technical explanation as to how these objectives would be accomplished.

The modification of the basis step-up rule is potentially critical in conjunction with increased tax rate on long-term capital gains discussed above. An April 2021 Penn Wharton budget model[5] estimated that raising the long-term capital gains rate without also modifying the basis step-up rule would not only fail to raise tax revenue but would likely decrease revenue by $33 billion over 10 years as a result of taxpayers holding capital gain assets until death and using methods such as the basis step-up on death to avoid the increased tax rates. By contrast, the Penn Wharton model estimates that raising capital gains in combination with the modification of the basis step-up rule would increase tax revenue of $113 billion over 10 years.

Observations

The AFP outlines tax proposals that would generally increase taxes on high-income and wealthy taxpayers meant to fund and offset the costs of the various spending programs outlined in the AFP. However, it is notable that some of President Biden’s prior tax proposals have not been included. For example, the AFP does not include the proposal to impose a Social Security payroll tax on those earning more than $400,000, which we reported on in our prior LawFlash. In addition, the AFP does not mention any provision to increase the estate tax, a platform on which President Biden campaigned.

The Biden-Harris administration’s proposals set forth in the AFP represent the early stages of a much longer conversation with Congress. It remains to be seen whether the House and Senate will engage with the president’s proposals or go in one or more entirely different directions. Even if a majority of the House and all of the Senate Democrats support the AFP—itself a tall order—it is unclear whether the bill could be enacted in its present form under the Senate rules for budget reconciliation. Specific details of the tax proposals in the AFP and other tax reforms proposals are continuing to emerge, and we anticipate movement in the coming weeks. We will continue to monitor for potential tax reform and provide further information on any material developments.

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Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Boston
Daniel A. Nelson

Chicago
Jeffrey Funston

New York
Richard S. Zarin
Ester Lee

Philadelphia
Paul A. Gordon

San Francisco
Sarah-Jane Morin

Washington, DC
Alex E. Sadler



[1] See “Fact Sheet: The American Families Plan.”

[2] Id.

[3] Id.

[4] See Remarks as Prepared for Delivery by President Biden – Address to a Joint Session of Congress”.

[5] See Revenue Effects of President Biden’s Capital Gains Tax Increase.