How much will you owe?
A look at potential tax changes under the Biden administration
Long before the 2020 presidential elections, Democrats and President Joe Biden have been focused on taxing the rich, defined as those with incomes over $400,000, and getting them to pay their “fair share.” While many small business owners don’t make that much, some do. So, what new tax rules might they face?
One thing is certain, it may take a while to sort things through. We spoke with Steve Grimm, partner at Axley Brynelson LLP, and Rhett Reuter, tax senior manager at SVA, to get their thoughts.
Also featured is Michelle Bertram, advisor/owner of Bertram Financial, who works with certified professional accountants (CPAs) on behalf of clients who may be able to claim Employee Retention Tax Credits (ERCs), a federally funded benefit that might be getting overlooked at tax time.
Tax rate changes
By far, the most discussed change will affect tax rates. The Biden administration is proposing an increase in the marginal income tax rate for high earners, restoring it to where it was prior to former President Donald Trump’s Tax Cuts and Jobs Act
of 2017 (TCJA).
Notes Reuter (SVA): “If you’re a small business like a partnership or an S corporation where that will be reported, income will pass through to the taxpayer and individual rates might go up to what they were pre-TCJA, or 39.6% for people making over $400,000.” Trump’s tax plan lowered the rate to 37%.
In pass-through organizations, which account for about 67% of businesses according to U.S. Census size classification data, income generated by the business passes through to the individual and the individual pays the taxes on their return.
The current corporate tax rate of 21%, which Trump lowered from 28%, could return to 28% under President Biden. At 21%, Trump effectively eliminated benefits of a pass-through structure, according to a CNBC article by Eric Rosenbaum in May, but raising it to 28% has been criticized by small business policy experts concerned it could negatively impact small businesses during the ebbs and flows of a pandemic.
In the same CNBC article, Kevin Kuhlman, vice president of federal government relations at the National Federation of Independent Business, raises concerns about the C corp issue for the smallest corporations because the corporate tax hike is not being discussed in graduated terms that would benefit small companies with lower levels of income.
“The target here is the largest corporations, many listed as paying no corporate tax, but the problem with that is that two-thirds of those companies are small businesses,” he states, adding that most C corps have receipts of less than $1 million.
Reuter says there’s some discussion that the corporate tax rate could settle in at around 25%. “So, at least you’ll see the C corps getting an increase in the rate as well, of at least 4% to 7%.”
The long-term capital gains rate, for gains held longer than one year, may increase for pass-through entities. Historically, capital gains have received preferential rates, says Reuter, but if the Biden proposals are implemented, the highest rate of 20% could be raised to match the ordinary tax rate of 39.6% for those with an adjusted gross income of over $1 million dollars.
“The income tax increase for that highest tax bracket would be for over $400,000 of taxable income,” Reuter adds. It won’t affect everyone. In fact, many small businesses won’t be impacted at all, but business owners should pay attention, he advises.
“President Biden has been quoted saying anyone making less than $400,000 won’t be impacted. I don’t know if that’s necessarily true.”
The Tax Foundation, a Washington, D.C.-based independent tax policy nonprofit, fact-checked the Biden administration’s often-used claim that the president’s agenda will protect 97% of small business owners from income tax rate increases.
In its review, published Aug. 20, 2021, the Foundation was critical of the methodology used. The White House cites a Treasury analysis that examined filers specifically with pass-through income (sole proprietor, partnership, or S corp).
“It appears that they simply calculate how many filers were above the income thresholds where President Biden’s taxes would apply,” the article states. “To assess the economic effect of higher marginal tax rates, it matters how much income or investment will be affected, not how many taxpayers.”
In its own analysis using data from the 2011 Internal Revenue Service Public Use File, the Tax Foundation found that 6% of filers with pass-through net income and adjusted gross incomes above $400,000 were responsible for 52% of all pass-through income reported to the IRS.
A follow-up analysis in 2018 confirmed that a significant share of pass-through businesses would face higher marginal tax rates under the Biden proposals. In that study, taxpayers making above $500,000 (roughly 4% of returns reporting either business net income or losses), accounted for more than half of the resulting net income, implying that taxes targeting this group could have a significant impact on the economy.
Another criticism was that the White House analysis ignores Biden’s corporate tax proposals. While most small businesses are pass-through entities, about 25% of businesses are traditional C corps that also could potentially be impacted by an increase in the corporate tax rate.
“By focusing on the number of people, the Biden administration is misleadingly claiming their tax proposals would have a small effect. The actual statistics show more than half of pass-through business income could face tax increases,” the organization concluded.
Reuter says tax codes will impact almost all businesses based on where their income comes in at the end of the year. “C-corp rates have the highest increase in terms of percentages, but the ending percentage is still lower than the highest individual tax rate.”
He suggests small business owners with plans to make a capital purchase in 2021 may want to talk to their tax advisors. “Putting a capital purchase off to the first quarter of 2022 may make more financial sense because the write-off on a piece of equipment may be worth more if the rates are higher.”
Also up for debate is the stepped-up basis when it comes to capital gains taxes.
Steve Grimm (Axley Brynelson) offers the following scenario:
“Let’s say you invested in a piece of real estate or business 50 years ago, bought it for $100, and now it’s worth substantially more in capital appreciation. You haven’t sold the asset, so you haven’t paid any capital gains tax yet.”
Current estate tax law provides that when someone passes away, the tax basis (original purchase price) gets reset at the date-of-death value, which is normally much more than the original purchase price.
“Using simple numbers, I buy something for $100 and over time it appreciates to $1,000. I pass away, leave it to my daughter, and she inherits and sells it. If I would have sold it the day before I died, there would have been a $900 capital gain. If I hold onto it until after death and my daughter sells it, her basis is my date-of death value, meaning she could sell it for $1,000 and owe no tax. That’s how a lot of people pass on wealth.”
The Biden administration argues that a lot of appreciation goes untaxed because people hold assets until death, which is called the step-up law. “Some people would call that a loophole,” Grimm says.
One proposal on the table is to use the tax-at-death rate and do away with the step up in basis. “So, if someone owned $5 million worth of property and only had $1 million of cost/purchase-price basis, upon death the estate would owe the same capital gains rate (say, 20%) times the $4 million inherent gain that under current laws would not be taxed. That’s a big deal if someone has a closely held business that they’ve grown and grown over decades. It could be a big gain.”
If that plan comes to fruition, Grimm says there likely would be exceptions. In fact, he notes, there’s talk of having a $1 million exemption, meaning $1 million would be exempt at death, but anything over that would be subject to tax. “It’s hard to predict at this point, but that is the concept.”
1031 exchanges, or “like-kind” exchanges, are commonly used in real estate to defer gains in real property. These deals are being looked at as well.
Real estate developers typically buy land, hold it, take depreciation and expenses, and hope the parcel increases in value. When the developer finally decides to sell, they can use their gain to purchase a larger, similar property without paying tax on that gain, Grimm explains.
“If I buy a stock and it goes from $100 to $200 and I sell it, I pay tax (say, 20% again) on that $100 gain, and I use the remaining $180 to purchase another stock.”
In real estate, gains aren’t recognized if the proceeds are rolled over into a new property that’s worth at least as much as the old property.
“Then you avoid gain, so that’s how a lot of real estate developers never pay tax because they keep buying larger properties,” Grimm explains, and it applies to all real estate, whether vacant land, improved properties, or buildings.
“This also is a loophole” he adds.
Without the like-kind exchange, developers would be taxed when they sell and could invest the remaining money in a new building, for example. The Biden administration is studying the issue.
“It would raise a lot of revenue,” Grimm says, “but my cynical view is that the real estate lobby will be way too strong to get rid of a law that’s been on the books for many, many years. Most real estate developers live by it. It’s part of their business plan.”
Estate tax is a very hot topic, because of its impact on succession planning for owners thinking about transitioning their businesses.
“What is their plan for their business 20 years from now?” Reuter asks. “It may be smart to execute those documents now to maximize the tax benefits.”
Currently, estate tax exemptions are at historical highs, Grimm notes. In 1997, a single individual could pass down as much as $600,000 without owing taxes upon their death. That amount has ballooned over the years to a whopping $11.7 million, and when there’s a spouse, it doubles
to $23.4 million.
“Some people thought $600,000 was too low, but now a lot of people say $11.7 million is way too high,” Grimm states.
Under President Barack Obama, it was $3.5 million, and there’s talk of lowering the estate-tax exemption to bring it back around the $3.5 million/$7 million level.
Grimm says the $11.7 million exemption sunsets (expires) on Dec. 31, 2025, as part of the Trump tax laws affecting projected revenues and expenses. That means that if nothing was changed in Congress, the estate tax exemption would revert to $3.5 million on Jan. 1, 2026. “Indexed for inflation, it would come back around $5.5 million.”
It would be a lot easier for Democrats to leave this tax alone, he adds, because it will expire at the end of in 2025 and afford Democrats the desired result without having to take a hard vote.
What happens now?
Congress could pass new tax legislation that would take effect on Jan. 1, 2022, or rule the laws be retroactive. Notes Grimm: “There’s a lot of posturing going on, but no legislation or votes are scheduled. “We’re still in a wait-and-see mode.”
Reuter concurs. “Every time there’s a new president, there are all kinds of proposals and dreams, but to get something passed into law requires a lot of bartering and negotiating. Some things will get cut, some things will stay, but the goal is to find some middle ground.”
Business owners typically expect to make enough money to support their standard of living, notes Grimm. If tax rates drop, as they did during the Trump administration, they can pocket the profits or divvy it up as a reward for employees.
When tax rates increase, owners earn lower profits, which can impact raises, slow hiring, force layoffs, or increase product prices.
Grimm offers his own projections: “If I were a betting man, which I’m not, I’d bet on increased capital gains on high earners and increased top marginal income rates for high earners. I’d bet against the tax on capital gains at death being passed; the 1031 like-kind exchanges being repealed; and I’d bet they punt on the estate tax exemption and just allow it to reset itself in 2026.”
Clarifications are forthcoming, notes Reuter. “Every year there’s something! We just received clarification on changes that took place with the TCJA in December 2017 — three years after the new law was enacted! That’s just how things go.”
Grimm agrees tax attorneys, CPAs, and accountants are often in limbo when it comes to governmental changes. “We’d rather be doing actual planning to help businesses succeed rather than dealing with the whims of Congress every year!”
The ABCs of ERCs
Business owners, don’t overlook this tax credit.
By now, it’s likely every business owner is familiar with PPP, the Small Business Administation-backed Paycheck Protection Program loan that saved thousands of small businesses in 2020. Less known, perhaps, is the Employee Reduction Tax Credit (ERC), a government-funded program designed to help small companies in tax years 2020 and 2021.
Michelle Bertram, advisor/owner of Bertram Financial, is working with GMG Growth to spread the word about ERCs. The goal is to ensure small businesses can utilize available tax credits for the 2020 and 2021 tax years. They work with CPAs and accountants to help clients wade through details that some CPAs may not have the time or staff to research.
“CPAs and accountants have an extremely tough job,” Bertram says, noting ever-changing tax codes that span thousands of pages. “Nobody can know it all.”
ERC was a part of the CARES Act for declared disaster areas across the country until it was assimilated into a relief package specifically for COVID-19. The American Rescue Plan Act, signed into law in March, expanded the credit through 2021. To date, 30,000 businesses have claimed more than $1 billion in ERC, but that’s just a small fraction of eligible businesses.
“In 2020, you could either do the PPP or the ERC,” Bertram states, “but in 2021, you can do both.” While the pot of money set aside for ERC is larger than that set aside for PPP, “PPP got all the attention.”
To receive the 2020 tax credits, businesses must either have had a full or partial shutdown of operations due to COVID-19 or had a 50% or more decline in gross receipts in any quarter. In 2021, businesses must either have experienced a full or partial shutdown or a more than 20% decline in gross receipts in any quarter.
“Almost all businesses experienced some sort of shutdown,” Bertram says, “which is why most can at least apply.”
ERC provides a refundable tax credit of 50% of up to $10,000 in qualified wages paid per employee for the year. Eligible businesses can still claim up to $5,000 per employee for 2020.
In 2021, the refundable tax credit improves to 70% of up to $10,000 in qualified wages per employee for the year, bringing the total annual amount of the credit to $28,000 per employee, more than five times the credit.
Credits are applied against a business’ employment taxes, offsetting most if not all liability in employment tax, and if a business’ credit is more than what it owes in employment taxes, the Internal Revenue Service will send a check back for the difference.
“ERC benefits give a little infusion into cash flow to help employers keep employees,” explains Bertram. “Also, if they hire employees, they may get hiring credits too. Employees are expensive, so this can help owners offset employee costs to keep the business going.”
Bertram advises companies use an online calculator to estimate their tax savings. It uses national algorithms to determine what they might receive, and there’s no restriction on the number of employees.
“In my experience,” Bertram says, “it’s been the mid-size to larger companies that get this. As a small business owner myself, I’m going to look at any tax credits available to my business!”
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