In addition to rate increases, there are two meaningful proposals changing when capital gains would be recognized. First, capital gain recognition on unrealized appreciation in assets would be required in several current nonrecognition scenarios, including the donation of appreciated assets, the death of an owner of appreciated assets and transfers of appreciated assets to a trust other than a grantor trust. There are several exceptions provided, such as transfers to a U.S. spouse or charity. In this case, the recipient would take a carryover basis in the assets transferred.
The second proposal would create a realization event for all trusts, partnerships and other noncorporate entities. Unrealized appreciation on property that has not been subject to a realization event in the prior 90 years would become subject to tax. The first recognition event would be deemed to occur on Dec. 31, 2030, for any property not subject to a recognition event since Dec. 31, 1939.
Partnership tax changes
Tax carried interests as ordinary income
A carried interest is a type of partnership profits interest that is received in exchange for services; carried interests are common in real estate funds, hedge funds and private equity. By utilizing a carried interest, investment managers receive compensation in the form of capital gains as a partner when the fund sells underlying investments (or the partnership interest itself), rather than salary or fees which are taxed at ordinary rates. The Tax Cuts and Jobs Act (TCJA) added Internal Revenue Code section 1061 to address this perceived loophole by recharacterizing certain net long-term capital gain with respect to carried interests. Capital gains that do not meet a three-year holding period are treated as short-term capital gains and, therefore, are taxed at ordinary rates.
The proposal is based on the premise that a service partner’s share of the income of a partnership attributable to a carried interest should be taxed as ordinary income and subject to self-employment tax because such income is derived from the performance of services. For partners with taxable income (from all sources) over $400,000, the proposal generally would tax the partner’s share of income attributable to an “investment services partnership interest” (ISPI) as ordinary income, regardless of the character of the income at the partnership level and regardless of the holding period. In addition, a partner would be required to pay self-employment taxes on ISPI income if the partner’s taxable income (from all sources) exceeds $400,000.
These changes would be effective for taxable years beginning after Dec. 31, 2022.
Prevent basis-shifting by related parties through partnerships
Under current law, certain distributions of partnership property result in a basis increase (i.e., step-up) to the partnership’s remaining assets. While the partner that received the property distribution can defer gain recognition until they sell the distributed property, the remaining partners can receive an immediate tax benefit in the form of depreciation or amortization deductions from the step-up. The proposal introduces a matching rule that would prevent related-party partners from taking advantage of this basis-shifting and timing difference.
The proposal would be effective for partnership taxable years beginning after Dec. 31, 2022.
Changes to the centralized partnership audit regime
Under the centralized partnership audit regime (CPAR), adjustments to a partnership’s income, gain, loss, deductions and the resulting change in tax liability are computed at the partnership level. When this process results in a decrease in tax liability for the reviewed year (i.e., the year under audit), the partners take the decrease in tax liability into account in the year that they receive a statement from the partnership (the reporting year). Partners can apply the adjustment to decrease the tax on their reporting year return to zero, but any excess is not refundable. This is an unduly harsh outcome and may result in the permanent loss of a tax benefit simply because the adjustment was made under CPAR versus outside of CPAR.
In a taxpayer-favorable change, the proposal would amend current law to provide that the amount of the net negative change in tax that exceeds the income tax liability of a partner in the reporting year is considered an overpayment and may be refunded.
The proposal would be effective on the date of enactment.
Trust and estate changes
Use of grantor trusts for estate and gift purposes would be significantly modified under the budget proposal. A minimum value would be required for gift tax purposes, equal to the greater of 25% of the values being transferred into a grantor retained annuity trust (GRAT), or $500,000, but not more than the value of the assets transferred. The GRAT would be required to have a minimum term of 10 years and a maximum of life expectancy of the donor plus 10 years.
The proposal would also provide that payment of income taxes on the income of the grantor trust would be considered a gift unless the deemed owner is reimbursed by the trust during the same year. This would eliminate a popular technique of further reducing the donor’s estate by having the donor fund the income taxes incurred by the grantor trust.
Other proposals would limit the duration of generation-skipping transfer tax exemptions, modify the administration of trusts and estates and require consistent valuation of promissory notes on interfamily sales when the note is later included in a decedent’s estate.
International tax changes
Undertaxed profits rule
A priority of the administration has been to subject multinational entities to a minimum rate of global tax, regardless of where the income is earned or whether the entities are based in the United States or elsewhere. Estimated to raise $239 million over 10 years, the administration proposes to eliminate the base erosion and anti-abuse tax (BEAT) and replace it with an undertaxed profits rule (UTPR) consistent with Organization for Economic Cooperation and Development (OECD) proposals. Effective for tax years beginning after Dec. 31, 2023, the UTPR would, subject to certain de minimis exceptions, generally apply to foreign-parented multinational entities that are members of financial reporting groups with global revenue of $850 million or greater in at least two of the previous four tax years. (The proposal also includes a domestic minimum top-up tax that would protect U.S. revenues from the imposition of UTPR by other countries.) Using a jurisdiction-by-jurisdiction computation based on adjusted financial statement information, the UTPR would disallow certain U.S. tax deductions or require an adjustment to the overall tax liability of the group for member entities not subject to a tax rate of at least 15% in each foreign jurisdiction where the group has a profit.
Additionally, the proposed increase in the corporate tax rate to 28% would raise the global intangible low-taxed income (GILTI) effective tax rate to 20% (from 10.5%). Also in line with OECD proposals, GILTI would be applied on a jurisdiction-by-jurisdiction basis. These changes would be effective for taxable years beginning after Dec. 31, 2022, with a transition rule provided for fiscal-year taxpayers.
Foreign tax credit proposals
Currently, individuals that pay or accrue foreign taxes of not more than $300 ($600 if married filing a joint return) on foreign source passive income reported on a qualified payee statement can elect to be excepted from certain foreign tax limitations and from filing Form 1116, Foreign Tax Credit (Individual, Estate, or Trust). Starting with foreign income taxes paid or accrued in taxable years beginning after Dec. 31, 2022, the threshold for the foreign tax credit limitation exception would increase to $600 ($1,200 in the case of a joint return) and would be indexed for inflation.
Digital asset changes
The Green Book includes a number of provisions that would modernize the tax treatment and reporting of digital assets:
- Actively traded digital assets would be eligible to be marked to market under IRC section 475 by dealers or traders under the proposal.
- Taxpayers holding more than $50,000 in certain foreign digital assets would be required to disclose these investments on Form 8938, Statement of Specified Foreign Financial Assets.
- U.S. brokers would be required to report information regarding “substantial” foreign owners of passive entities holding digital assets in an effort to ensure tax compliance.
As previously mentioned, there is bipartisan legislation currently being negotiated in the Senate to introduce a new regulatory regime for cryptocurrency and other digital assets. It is possible this legislative package could incorporate some or all of the above provisions.
Other tax changes
The budget proposal also includes numerous additional tax changes. The list below summarizes several of the more pervasive provisions:
- Repeal of section 1031 like-kind exchanges: Taxpayers would only be allowed to defer $500,000 of gain ($1 million for married joint filers) per year for like-kind exchanges of real property. Any gains in excess of that amount would be recognized by the taxpayer in the tax year including the transaction date.
- New Markets Tax Credit made permanent: The NMTC was last extended at $5 billion annually through 2025. The administration’s proposal is to make the credit permanent and index the $5 billion annual allocation for inflation beginning after 2026.
- Real property recapture as ordinary income: Upon the sale of real property held for more than one year, taxpayers are required to recapture gain under section 1250 to the extent of depreciation taken on the property. Under the budget proposal, the recaptured gain, previously taxed at a preferential rate, would be taxed as ordinary income. This provision would only impact depreciation taken in 2023 and subsequent years and would only apply to taxpayers with adjusted gross income in excess of $400,000.
- Income exclusion for student debt relief: The American Rescue Plan Act created an exception to the treatment of discharged qualifying student loan debt, ensuring the debt relief is not taxable to recipients. This provision, which currently expires at the end of 2025, would be made permanent.
- Required electronic filing of returns: Taxpayers reporting larger amounts or that are complex business entities would have to electronically file their income tax returns going forward. This includes but is not limited to individual income tax returns with income of $400,000 or more, partnership returns with more than 10 partners or $10 million in assets, and corporate returns with more than 10 shareholders or $10 million or more in assets. Additionally, certain forms would only be available for electronic (not paper) filing.
- Onshoring credit: A new general business credit of up to 10% of eligible expenses paid or incurred in connection with onshoring a U.S. trade or business would be available to the extent it resulted in an increase in U.S. jobs. Correspondingly, there would be a disallowance of deductions for expenses paid or incurred in connection with offshoring a US trade or business to the extent it results in a decrease in U.S. jobs.
- Extended statutes: The IRS’ statute of limitations would be extended from three years to six years for taxpayers who omit more than $100 million on gross income on a tax return and for returns reporting benefits from listed transactions.
We encourage you to connect with your Baker Tilly advisor regarding how any of the above may affect your tax situation.
