The Proposed Tax Reform Effects on S-Distributions and Gifts

Preface:“A budget is more than just a series of numbers on a page; it is an embodiment of our values.”
– Barack Obama 

The Proposed Tax Reform Effects on S-Distributions and Gifts

The Department of the Treasury has published the Biden Administration’s proposed plan for raising revenues in 2022 detailing more specifically the tax effects of the new tax reform. In this blog we will highlight two tax items of interest to entrepreneurs and business owners.

SE taxes on S-Corporation Distributions and LLC Distributions

Firstly, the proposed tax reform will revise the tax laws for taxable self-employment earnings. The proposed tax reform would require both materially participating partners who receive guaranteed payments to pay self-employment taxes on their distributive shares of income for pass-through earnings above an AGI of $400,000. S-corporation shareholders while under current tax laws are required to pay a reasonable compensation wage and not taxes for self-employment taxes on distributions.

The tax reform would also subject S-Corporation earnings and distributions beginning in 2022, to the additional income taxes on earnings that would be subject to social security tax as the lesser of (i) the potential social security income, or (ii) the excess over $400,000 of the sum of the potential social security income, wage income subject to FICA under current law, and 92.35 percent of self-employment income subject to social security tax under current law.

This is a possible increase on taxes for business owners including those with an AGI less than $400,000. Of course while not final legislation, this may increase income tax costs for a multitude of small business owners with a pending closure of the social security taxes loophole.

Taxes on Appreciated Gifts

Under the proposed tax reform, a donor or deceased owner of an appreciated asset would realize a capital gain at the time of the transfer. In other words gifts with a built-in gain would tax taxable at transfer.

So for a donor, the amount of the gain realized would be the excess of the asset’s fair market value on the date of the gift over the donor’s basis in that asset. For a decedent, the amount of gain would be the excess of the asset’s fair market value on the decedent’s date of death over the decedent’s basis in that asset. That gain would be taxable income to the decedent on the Federal gift or estate tax return or on a separate capital gains return. Of course assets with gains of $1.0m or greater would be taxed at the 43% rate capital gains rate when including net investment taxes.

The use of capital losses and carry-forwards from transfers at death would be allowed against capital gains income and up to $3,000 of ordinary income on the decedent’s final income tax return, and the tax imposed on gains deemed realized at death would be deductible on the estate tax return of the decedent’s estate.

Interestingly for legacy businesses e.g. say family partnerships or trusts, a gain on unrealized appreciation also would be recognized by a trust, partnership, or other noncorporate entity that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years. The first possible recognition event for any taxpayer under this provision would thus be December 31, 2030. For those graduates looking ahead — New Years Day 2031 has opportunity for valuation experts. A qualifying transfer would be defined under the gift and estate tax provisions and would be valued using the methodologies used for gift or estate tax purposes.

Payment of tax on the appreciation of certain family-owned and -operated businesses would not be due until the interest in the business is sold or the business ceases to be family-owned and operated. Furthermore, the proposal would allow a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, other than liquid assets such as publicly traded financial assets and other than businesses for which the deferral election is made.

The Internal Revenue Service (IRS) would be authorized to require security at any time when there is a reasonable need for security to continue this deferral. That security may be provided from any person, and in any form, deemed acceptable by the IRS.

Summary: With IRS proposed changes from qualified valuation features to securitized collateral with legal documents, the proposed tax reforms will likely bring tax compliance factors to the forefront of business planning and strategy in the year ahead.

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