It is said that the future is not yet written. But the Biden administration has a draft ready for Congress. Our Federal Tax Group is researching the Made in America Tax Plan to find the many questions waiting for you in it.
- The uncertainty of retrospective or anticipated effective dates
- Deferring income realization and hastening the deduction may not be the best plan
- Prepare to review traditional tax planning strategies
In April, President Biden unveiled the American Jobs Plan, a comprehensive proposal to increase investment in US infrastructure. At the same time, President Biden also announced his “Made in America” tax plan – the aim of which is to finance the substantial costs of this investment in US infrastructure. Although no legislation has yet been put in place, the proposed tax plan includes significant changes to the US federal income tax system, such as the capital gains tax rate for certain high-income individuals.
Given the tension between and within political parties, it is unclear whether President Biden’s Made in America tax plan will be implemented in its proposed form, in a scaled-down version, or at all. It is also unclear whether changes will take effect retrospectively or prospectively. For taxpayers who transact in the third and fourth quarters of 2021, this uncertainty can make tax planning more difficult than if there were certainty about tax rates.
In general, it is common knowledge that a taxpayer wants to postpone income recognition and expedite deductions. However, given some suggestions from the Made in America Tax Plan, a taxpayer may consider tax planning that contradicts this rationale.
For illustration, assume that a high-income taxpayer sells shares in a corporation for cash in the third quarter of 2021, and that a portion of the taxpayer’s cash proceeds are held in trust for one year after the closing date to protect the buyer against potential risks in future claims . Traditionally, the taxpayer is advised to use the installment sales method under Section 453 of the Code, with the profit from cash proceeds from the sale in 2021 and the profit from cash proceeds in escrow (or earned out) whether and when they will finally be paid out to the taxpayer in 2022 (or in later years). However, one of the proposals in the Made in America Tax Plan is to increase the capital gains tax rate applicable to high-income individual taxpayers to the highest marginal income tax rate. The taxpayer may need to consider ending treatment of the installment sale and recognizing the full amount of cash proceeds, including any amount held in trust (or earned through an earnout) in 2021.
Unfortunately, such a decision is not without risk. If the Made in America Tax Plan is not implemented in its currently proposed form, capital gains tax rates may not increase for high-income individuals. Therefore, the taxpayer’s decision to choose the hire purchase treatment could create a liquidity problem. The choice could unnecessarily expedite income recognition and taxation of the full cash proceeds before the taxpayer actually receives the full cash amount. Fortunately, until a 2021 federal income tax return (including renewals) is filed, taxpayers should have time to decide whether to opt for the installment method, unless enacted legislation precludes such a wait-and-see approach.
To illustrate how the current uncertainty can affect both the economics of the business and tax considerations, let’s assume that on December 31, 2021, shareholders sell 100% of a company’s shares in exchange for cash being paid to certain employees of the company .
Traditionally, the selling shareholders want the company to accumulate these change of control payments on or before December 31, 2021 in order to take advantage of the corporation tax deduction associated with the change of control payments in the pre-tax period. However, if the corporate income tax rate increases as proposed in the Made in America Tax Plan and is expected to take effect January 1, 2022, the selling shareholders should consider deferring the accrual of change of control payments until after the closing. Achieving this postponement can be complex and may require changes to contracts, plans, or other agreements currently in force. But the benefits of letting the buyer benefit from the increased tax deduction can be worth the effort if it gives the selling shareholders more leeway in the transaction or allows them to participate in the additional corporation tax deduction through a purchase price increase.
Finally, suppose that in the previous example, instead of receiving all of the cash for their shares, the selling shareholders receive part of their consideration in the form of rollover equity from the buyer. Traditionally, the selling shareholders want to structure their rollover equity to take advantage of the Section 351 or Section 721 tax deferral. Given the proposed increase in the capital gains tax rate for high-income individuals in the Made in America Tax Plan, selling shareholders may be able to avoid a tax deferral and instead tax the rollover equity at a lower capital gains tax rate upon completion of the transaction in 2021. The same can also apply to tax-free renovations. In certain situations, for transactions taking place in 2021, it may make sense to avoid tax-free reorganizations and trigger an integrated corporate profit now at a potentially lower corporate tax rate.
These are just some of the issues taxpayers are facing right now given the current uncertainty in the US tax system. Until final tax rules are enacted, taxpayers and their advisors must re-examine certain traditional tax planning strategies in terms of their assessment of the likelihood of a waiver and, in essence, venture a leap of faith before definitive tax rules and their entry into force are known.
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