In light of current circumstances, it is uncertain how much of Biden’s tax platform will be realized, but private equity firms and portfolio companies should still be aware of the areas with the most potential to affect their tax situation.
As the pandemic and its continued challenges are expected to dominate legislative actions in the near term, those in the private equity space should have some time to assess the changes that may be addressed by Congress and plan accordingly, if they haven’t started already.
Another important factor to keep in mind when contemplating whether tax increases will come to pass is the Democrats’ narrow majority in both chambers of Congress; specifically in the Senate, where Democrats and Republicans each have 50 seats, and Vice President Kamala Harris holds the tie-breaking vote. Legislation in the Senate typically requires 60 votes to pass, meaning outside of utilizing the budget reconciliation process, 10 Senate Republicans would need to cross the aisle and vote for significant tax increases, which may be an uphill battle. Even if budget reconciliation is used, which requires only a simple majority to pass a bill, with a one-vote majority, tax proposals can only be as progressive as the Democrats’ most conservative senator.
Biden’s platform called for the top marginal rate to revert back to 39.6%, where it was before the Tax Cuts and Jobs Act of 2017 (TCJA) was enacted, from its present rate of 37% for single filers with taxable income over at $523,600 (over $628,300 for joint filers). While it would not represent a significant percentage increase, it would affect many more taxpayers as it would kick in at a lower income level of $400,000. However, it is currently unclear whether this $400,000 threshold is based on adjusted gross income (AGI) or taxable income, and whether it applies to single or joint filers.
Long-term capital gains and qualified dividend tax rates would see an increase to 39.6%, up from 20%, for taxpayers with income of more than $1 million (again, it is unclear whether this is a reference to AGI or taxable income, or to single or joint filers). This type of increase would obviously have a significant impact on the long-term capital asset sales arena but it would also mean that carried interests would be taxed at ordinary income rates for taxpayers above this income level.
For those who would take advantage of the current lower rates ahead of any potential increases, they should still have time as Congress will likely be more focused on COVID-19 relief in the coming months and, even if something passed this year, tax increases are generally not retroactive. Typically, the earliest date they would be effective is the date a bill is introduced in Congress.
Right now, a benefit for many owners of the operating companies is the 20% deduction for qualified business income (QBI) produced by certain eligible operating businesses, or the 199A deduction. Under Biden’s proposal, the ability to take that deduction would phase out for taxpayers with income of more than $400,000. Limitations for taking that deduction already exist, but this proposal could equate to a loss in the value of deductions that could be significant for some taxpayers. At this point, it is unclear at what income level that would phase out completely.
The TCJA essentially doubled the lifetime estate and gift tax exemption when it passed. In 2020, the exemption for individuals was $11.58 million and, in 2021, adjusting for inflation, will be $11.7 million. This provision would sunset after 2025 to pre-TCJA levels of $5 million, but could be reduced even more and sooner with a Democratic-led Senate. The Biden platform would like to cut the lifetime exemption to $3.5 million.
The platform also calls for increasing the maximum gift and estate tax rate to 45% from 40% and eliminating the step-up to fair market value in the basis of the decedent’s assets upon death.
The new administration proposes limiting the value of itemized deductions to 28% for taxpayers who earn $400,000 or more. Furthermore, it would look to reinstate the Pease limitation, which either reduced the total of certain otherwise allowable itemized deductions by 3% of the amount a taxpayer’s AGI exceeded a specific threshold or limited the deductible amount to 80% of the total expenditures. It had been suspended by the TCJA. This reinstatement would affect those who earn more than $400,000.
Not to take away from the expectations of the Biden platform, but private equity firms, portfolio companies and their respective owners and managers should also keep in mind the taxpayer-friendly changes that were made when the Consolidated Appropriations Act, 2021 (CAA) was signed into law in late December.
The CAA dramatically overhauled the employee retention credit (ERC), a refundable payroll tax credit based on qualified wages paid to employees. Previously only available on wages paid through Dec. 31, 2020, the CAA extended the credit through June 30, 2021, made it much easier to qualify for and increased the credit’s potential dollar value. Before the CAA, one of the qualifications was that a business experienced a 50% loss in gross receipts in any calendar quarter in 2020 relative to the same quarter in the year prior. The CAA prospectively changed that rule so businesses only have to demonstrate a 20% loss in revenue in order to qualify.
Additionally, the CAA prospectively increased the qualified wages per employee limit to $10,000 per quarter from $10,000 per calendar year, the credit calculation ratio to 70% from 50%, and the “large employer” threshold to 500 employees from 100 employees (aggregation rules apply).
The Coronavirus Aid, Relief, and Economic Security (CARES) Act made charitable contributions of cash in 2020 deductible up to 100% of the donor’s AGI. The CAA extended the provision for 2021. Before the CARES Act, those types of cash contributions were limited to 60% of a donor’s AGI.
The CAA allows business meals incurred in 2021 and 2022 to be 100% deductible if provided by a restaurant. Clarification is needed around the exact parameters of “provided by a restaurant,” but the TCJA had only allowed certain meals to be 50% deductible.
For more information about how these issues may affect you, connect with your Baker Tilly private equity professional or contact our team.