8 Ways Tax Proposals Could Affect Private Business Owners
The Key Wealth Institute is a team of highly experienced professionals from across wealth management, dedicated to delivering commentary and financial advice. From strategies to manage your wealth to the latest political and industry news, the Key Wealth Institute provides proactive insights to help grow your wealth.
United States tax policy was a top priority for the current administration in 2022. However, things have changed as geopolitical challenges, supply-chain concerns and inflation have all elevated the uncertainty of the US economy. With the midterm elections approaching and global tax reform initiatives gaining attention, the viability of passing new tax legislation appears to be in limbo. Nevertheless, it is beneficial to understand how current tax law proposals contained in the 2023 budget proposal (The Green Book) could affect privately held business owners.
1. Increase in Corporate Tax Rate
Under current law, the effective tax rate for C corporations is 21%. Proposed changes would increase the effective tax rate to 28% for tax years beginning after Dec. 31, 2022. For fiscal tax years that begin before Jan. 1, 2023, and end after Dec. 31, 2022, the tax rate would be 21% plus 7% times the portion of the tax year that occurs in 2023.
2. Tax Basis Limitations for Family Partners
Under current law, related-party partners are able to distribute property to a partner and use a Section 754 election to step up the basis of its non-distributed property.
This allows them to shift basis between partners and achieve an immediate tax savings from the partners as a group without any meaningful change in the partners’ economic arrangement.
The Green Book proposes changes to prohibit any partner from benefiting from the partnership’s stepped-up basis until the distributed property is disposed of in a fully taxable transaction. This would be effective for taxable years beginning after Dec. 31, 2022.
3. Carried Interest Treatment
In an investment services partnership, in exchange for services, certain partners receive future partnership profits referred to as “carried interest.” This is subject to current preferential tax rates for long-term capital gains and with an extended holding period requirement from one year to three years. Also, under current law, a limited partner’s distributive share of partnership income is generally excluded from self-employment tax. In essence, service partners receive capital gains treatment on labor income without limit and not subject to self-employment tax.
The proposal would treat a service partner’s share of investment services partnership income as ordinary income, if the partner’s taxable income exceeds $400,000. Such income would not be eligible for the reduced rates that apply to long-term capital gains. Service partners would also be required to pay selfemployment taxes on the partner’s share of taxable income if the partner’s taxable income exceeds $400,000.
4. IRC Section 1031
Currently, owners of appreciated real property used in a trade or business or held for investment purposes can defer the gain on the exchange of the property for real property of a “like-kind” under Section 1031 of the Internal Revenue Code (IRC). As a result, the tax on the gain is deferred until a later recognition event, provided certain requirements are met.
The current proposal would limit this deferral to an aggregate amount of $500,000 per year for each taxpayer and $1 million for married couples filing jointly. Any amount in excess of the limitation would be recognized in the year of the exchange.
5. Depreciation Recapture
Depreciation recapture on IRC Section 1250 allows the IRS to collect taxes on assets that realize a gain from the sale of depreciable capital property. Currently, the maximum tax rate on unrecaptured depreciation gain is 25% and is only taxed as ordinary income to the extent depreciation exceeds the cumulative allowances determined under the straight-line method. Under the new proposal, all gains on Section 1250 property would be treated as ordinary income. This would apply to taxpayers with adjusted gross income (AGI) above $400,000.
6. Individual Minimum Tax
The new individual minimum tax proposal would affect taxpayers with a net wealth over $100 million. The proposal includes a minimum 20% tax on all income and the appreciated value of assets, including unrealized gains from stocks, bonds, and privately held companies. This would require households to pay taxes on unrealized gains each year and, if their effective tax rate fell below 20%, to pay additional taxes designed to meet the 20% minimum threshold. In short, if the underlying asset appreciates in value but is not sold, households owe taxes on the capital gains under this new proposal
7. New Rules for Grantor Trusts and GRATs
The Green Book proposes significant changes to the grantor trust rules. Under current law, no amount paid by the deemed owner of a grantor trust to satisfy the trust’s income tax liability is treated as a gift by the deemed owner to the trust or its beneficiaries for Federal gift tax purposes. The property in the trust grows free of income tax. In addition, transactions between a grantor trust and its deemed owner are disregarded for income tax purposes. When the taxpayer dies, the appreciated asset receives a step-up in basis to fair market value, so that any unrealized appreciation is not subject to capital gains tax. The proposal would prohibit grantors from acquiring, in a sale or an exchange, an asset held in the trust without recognizing gain or loss for income tax purposes. The proposal would no longer permit payment of income taxes of a grantor trust without making a taxable gift.
The proposal also modifies rules for certain grantor- retained annuity trusts (GRATs). A GRAT is an irrevocable trust (meaning it cannot be changed or revoked) and it allows a business owner to transfer ownership of a company in return for an annuity interest for a certain number of years. With recently low Section 7520 interest rates, GRAT assets have accumulated above and beyond the Section 7520 rate, allowing transfers to trust beneficiaries free of any gift or estate tax.
The proposed change to the GRAT rules would eliminate short-term GRATs by requiring a minimum term of 10 years and will not allow a term for more than the life expectancy of the annuitant plus 10 years. Additionally, the GRAT rules proposed changes state that a minimum gift be recognized on transfers to GRATs equal to the greater of 25% of the value of the assets transferred or $500,000. These changes may limit the tax planning benefits provided by grantor trusts and GRATs.
8. The GST Tax Exemption
The generation-skipping transfer (GST) tax is imposed on gifts and bequests by an individual transferor to transferees who are two or more generations younger than the transferor. Each individual possesses a lifetime GST exemption ($12.06 million in 2022) that can be allocated to transfers made, whether directly or in trust, by that individual to a grandchild or other “skip person.” The allocation of GST exemption to a transfer or to a trust excludes from the GST tax not only the amount of assets to which GST exemption is allocated, but also all subsequent appreciation and income on that amount during the existence of the trust.
The proposed changes narrow the class of GST taxexempt beneficiaries by limiting the application of the GST tax exemption only for distributions to beneficiaries who were alive when the trust was created and who are no more than two generations below the donor.
Additionally, the proposals do not permit “grandfathering” – i.e., trusts created before the enactment of the new law are subject to these limitations.
Conclusion: It’s Best to be Prepared
It remains to be seen whether these or any tax changes will be enacted. However, it is always worth the time and effort to incorporate these discussions into tax-planning conversations with your tax advisor in a proactive manner while you have the time to adjust. We also encourage you to consult with your advisor as these are all part of your broader wealth plan.
For more information about strategies and ways to plan ahead, contact your relationship manager, or contact our Business Advisory Services team through key.com/businessadvisory.