Author: RVG & Company

The Biden Administration recently proposed the American Families Plan (AFP) which outlines various investments in infrastructure to benefit American families. The AFP provides the costs and spending related to implementing these programs. In addition, the AFP contains various provisions to increase taxes. As part of the tax initiative, the President also proposed a set of compliance measures that will enhance and improve IRS audits.

On May 20, 2021, the Treasury released a proposal titled “ The American Families Plan Tax Compliance Agenda”. The proposal summarizes the challenges faced by the IRS and the investments that must be made in the IRS to ensure that it can do its job of administering a fair and effective tax system. The proposal states that The IRS requires more resources to conduct investigations into underreported income and to pursue high-income taxpayers who evade their tax liability through complex schemes.

According to the proposal, noncompliance is concentrated at the top 1% of taxpayers failing to report 20% of their income and failing to pay approximately $175 billion in taxes owed annually. The Treasury noted that this “tax gap” has many underlying causes, chief among them is insufficient resources because the IRS lacks the capacity, due to budget cuts, to address sophisticated tax evasion efforts. Moreover, audit rates have fallen by almost 80% for taxpayers making over $1 million in income.

Under the proposal, the Treasury outlined four key elements to raise revenue, improve efficiency and build a more equitable tax system. These items are discussed below.

1. Provide the IRS the Resources it Needs to Address Sophisticated Tax Evasion

The first step in the President’s tax administration efforts is a sustained, multi-year commitment to rebuilding the IRS, including nearly $80 billion in additional resources over the next decade. This would allow the IRS to modernize its technology, improving data analytic approaches, and hiring and training agents dedicated to complex enforcement activities. This would make up the ground that the IRS has lost over the last decade. During this time, the IRS budget fell by about 20%, leading to a sustained decline in its workforce particularly among specialized auditors who conduct examinations of high-income and global high net worth individuals and complex structures, like partnerships, multi-tier pass-through entities, and multinational corporations.

2. Provide the IRS with More Complete Information

The IRS would seek to obtain information that financial institutions already have for accounts that they house. Financial institutions would add information about total account outflows and inflows to existing reporting on bank accounts. Importantly, there are no added requirements for taxpayers. The IRS will be able to deploy this new information to better target enforcement activities, increasing scrutiny of wealthy evaders and decreasing the likelihood that fully compliant taxpayers will be subject to costly audits. The Treasury believes that voluntary compliance will rise through deterrence because potential tax evaders will realize that the IRS has an additional lens into previously unreported income streams.

3. Overhaul Outdated Technology to Help the IRS Identify Tax Evasion and Serve Customers

The IRS has systems that date back over 50 years. Additional funding and modernization would allow the IRS to address technology challenges and develop innovative machine learning that can be deployed to better identify suspect tax filings. This would also allow the IRS to employ artificial intelligence to monitor taxpayer returns and reconcile it with third-party information. Further, modernized IT would help improve taxpayer service and ensure that the IRS can effectively deliver tax credits to eligible families and workers, including recent expansions to the Child Tax Credit, the Earned Income Tax Credit, and the Child and Dependent Care Tax Credit proposed in the AFP.

4. Regulating Paid Tax preparers and Increasing Penalties for Those who Commit or Abet Evasion

Taxpayers often make use of unregulated preparers who lack the training to provide accurate tax assistance. These preparers submit more returns than all other preparers combined, and taxpayers rely on their guidance, in part because of challenges in reaching the IRS promptly, when questions arise. In addition to the regulation of paid preparers and service improvements that would simplify tax filing, the President’s proposal includes additional sanctions for so-called “ghost preparers” who fail to identify themselves on the tax returns which they prepare.

The Treasury Office of Tax Analysis estimates that these initiatives would raise $700 billion in additional tax revenue over the next decade.

The Biden administration’s tax proposals are far-reaching and are designed to raise revenue to pay for infrastructure and other spending priorities under the American Jobs Plan and the American Family Plan. The tax revisions would increase the top individual and corporate tax rates, eliminate favorable capital gains rates, overhaul the taxation of U.S. multinationals, increase the imposition of the estate tax, and eliminate perceived “loopholes” that are viewed as primarily benefitting the wealthy.

This article will focus on the impact that these proposals may have on the real estate and construction industries. While these proposed measures are subject to negotiation and political horse-trading, the benefit can be gained from awareness of the process and taxpayers can begin to strategize if and how they can mitigate the impact of these potential tax increases.

Elimination of Internal Revenue Code (IRC) § 1031 – Like-Kind Exchanges for Gains Above $500,000

With 1031 exchanges, real estate investors can sell a real estate investment property and exchange that for a like-kind investment and defer the payment of capital gains taxes. IRC § 1030 enables real estate investors to defer capital gain taxes if they invest the profits from one real estate sale into another. These transactions have been used to buy and sell real estate and it has been a source of capital for investors. Investors do not recognize any capital gain until the property is sold without a corresponding purchase of real estate.

Often investors would use these transactions to modernize and update the newly purchased real estate, which led to additional work for the construction industry. Also, many real estate investors continue to exchange properties under IRC § 1031 until their death, at which point the decedent’s tax basis in the replacement property would be stepped up to fair market value and the previously deferred gain was avoided. This strategy will also be affected by the President’s proposal to eliminate the step-up in tax basis at death.

Reducing or Eliminating the Step-Up in Basis at Death

Under IRC § 1014, the tax basis of property that a taxpayer owns is stepped up to its fair market value upon the taxpayer’s death. This step-up allows a beneficiary who then inherits that property to immediately sell it without recognizing any taxable gain.

If the beneficiary instead holds the property for a period, only the portion of the ultimate gain that is attributable to appreciation, which occurred after inheritance, will be subject to income tax.

The American Families Plan proposes to eliminate this step-up in basis for gains of $1 million or more – $2 million or more for married taxpayers filing jointly. The administration has noted that family-owned businesses and farms that continue to be run by heirs will be exempt from this rule, but details regarding this exemption were not provided. As noted above, the elimination of the basis step-up and like-kind exchange rule will have an impact on the real estate sector. Moreover, if this proposal is enacted, it will require improved recordkeeping for the basis of assets held at death to substantiate the basis of the property.

Increasing the Capital Gains Rate

The President has proposed an increase to the tax rate on capital gains and dividends to 39.6% for households making more than $1 million. When combined with the 3.8% Net Investment Income Tax, this would increase the maximum federally imposed rate of taxes on capital gains to 43.4%. The current rate of tax on these items of income is 20% The President indicated in his budget that the effective date of the increase in the capital gains rate would be retroactive to April 28, 2021, the day he announced the American Families Plan. As a result, sales of the property after that date will have no impact on minimizing the tax if this provision is retroactive.

Reduction of Qualified Business Income Benefits

In addition to the changes to the tax rates, the TCJA (Tax Cuts and Jobs Act) made it possible for self-employed taxpayers and small business owners to deduct up to 20% of their qualified business income (QBI) from “qualified trades or businesses,” including real estate ventures. Biden’s tax proposal would phase out the QBI deduction under IRC § 199A for high-income earners making over $400,000.

Elimination of Bonus Depreciation

One of the most impactful things to come out of the TCJA for real estate investors, in particular, was the ability to immediately deduct a large percentage of the purchase price of eligible assets through bonus depreciation, rather than writing them off over the useful life of that asset. This is a form of accelerated depreciation.

For example, when you spend money on improving your property via new appliances, furniture, landscaping, and other real estate property improvements, you can use bonus depreciation to deduct the entire cost in the year you spend the money, or you can deduct them little by little over time. The President’s tax plan has proposed that bonus depreciation be eliminated altogether, something that could drastically impact real estate investors.

Elimination of Carried Interests Benefit

Under IRC § 1061, the gain a partner recognizes related to their ownership of a carried interest (also known as a profits interest) has historically been taxed at favorable long-term capital gains rates. However, an abundance of negative publicity regarding the use of this perceived “loophole” by the private equity and hedge fund industries resulted in the TCJA imposing a three-year holding period for certain carried interests in order to obtain long-term capital gain treatment.

The president’s proposal seeks to “close the carried interest loophole,” which presumably means treating carried interest like ordinary income. Since many real estate partnerships are structured to provide the developer with a carried interest, this change would have a significant impact on the expected economics of many existing deals if the proposal is passed without any grandfather provisions (which is what happened when the holding period for capital gain treatment was increased to three years).

Conclusion

Any potential down-turn in real estate investment will have a corresponding impact on the construction industry. If you have any questions regarding any of these tax proposals, please call RVG & Company at 954.233.1767 to discuss this with one of our tax and accounting advisors in real estate and construction.

Individuals and corporations are anticipating tax rate increases under the Biden Administration’s Tax Proposal. As outlined in the Treasury’s Green Book, released on May 28, 2021, the Administration has proposed that these tax rate increases would be effective for taxable years beginning after December 31, 2021.

Individual Tax Rates

For individuals, the top tax rate would increase to 39.6% (from 37%) for taxable income over $509,300 for married individuals filing a joint return and $254,650 for married individuals filing a separate return.

Corporate Tax Rates

The income tax rate for C Corporations is expected to increase to 28% (from 21%). Under the proposal, for taxable years beginning after January 1, 2021, and before January 1, 2022, only the portion of the taxable year in 2022 would be subject to the increased 28% rate.

Capital Gains and Dividend Tax Rates – Retroactive Effective Date

In addition, the tax rate for long-term capital gains and qualified dividends will be increased to 39.6% (43.4% including the net investment income tax “NIIT”) from 20% (23.8% including the NIIT) to the extent the taxpayer’s income exceeds $1 million, indexed for inflation. This proposal is anticipated to be effective retroactively for gains and income recognized after April 28, 2021.

Planning Strategies

These tax rate increases leave little opportunity for planning, however, a potential plan to minimize the impact of these increases is to consider “reverse” tax planning. The objective behind this strategy is to accelerate income and defer deductions. For companies, this approach may require accounting methods changes and transactional planning. The general concept is to accelerate income recognition to tax year 2021 prior to the potential rate increases of 2022. Likewise, deferring deductions to tax years when rates are higher increases the tax value of the deductions.
Method of accounting changes requires the taxpayer to file Form 3115, Application for Change in Accounting Method. As a result, taxpayers must adhere to the process and procedure related to this form. Below is an overview of some of the items that can be subject to an accounting change that may have a corresponding tax benefit.

Expense Deferrals

Discontinuation of a recurring expense item exception – Defer the deduction until the year of payment for liabilities related to property taxes and other state taxes. Capitalize research expenditures and certain software development costs under IRC § 174(b).

Income Acceleration

Full inclusion of advance payments – Under this change in accounting method, taxpayers are permitted to recognize advance payments in the year they are received as opposed to deferring the advance payment. Long-term contracts – Consider evaluating whether a long-term contract can be accelerated to recognize income.

Elections

In addition to accounting methods changes, taxpayers may consider various elections to defer and capitalize other costs to subsequent tax years when tax rates are expected to increase. Elect to capitalize employee compensation, overhead and de minimis costs – Taxpayers can elect to capitalize these costs not exceeding $5,000 applied on a transaction-by-transaction basis. Elect out of the 12-month rule for prepaid assets – Taxpayers may choose to capitalize and amortize certain prepaid liabilities such as insurance premiums and service contracts rather than deduct such costs under the 12-month rule. Fixed asset depreciation – Taxpayers can elect out of MACRS and bonus depreciation to increase the deduction in subsequent tax years. Capitalize repairs and maintenance expenses to conform with books to recover the repair and maintenance expense over the life of the underlying asset.

Other Items

Other items to consider are the deferral of year-end bonus accruals and the gain exclusion benefit for small corporations under IRC §1202.
Year-end bonus accruals – Taxpayers may defer the deduction for bonus accruals by delaying the payout until more than 2 ½ months after year-end. The terms of the bonus plan must be reviewed or revised to conform to this change.
Exclusion of gain from qualified small business stock – Under IRC § 1202, non-corporate investors may exclude 100% of the gain realized on the disposition of the qualified small business stock. The amount of gain eligible for this exclusion is limited to $10 million or ten times the taxpayer’s basis in the stock. This gain would not be subject to the proposed increase in the capital gain tax rate.

Conclusion

Taxpayers must carefully consider the factual, procedural, and tax impact of each of these potential minimization strategies before implementation. As noted above, accounting method changes require the filing of appropriate forms with the IRS, and procedures must be followed.

If you would like to discuss any of these items, please contact one of our tax experts at RVG & Company!

Under IRC § 1202, if a taxpayer other than a C corporation sells or exchanges qualified small business stock (QSB stock) that has been held for more than five years, 100% of the gain from the disposition may be excluded from the taxpayer’s gross income. The 100% exclusion applies to QSB stock acquired after September 27, 2010. QSB stock acquired before that date has a reduced exclusion amount. This benefit applies if the stock meets all the criteria of IRC § 1202. IRC § 1202 allows eligible taxpayers to exclude gain that is greater than $10 million or 10 times the taxpayer’s basis in the QSB stock sold.

In general, here are the significant requirements that must be met to qualify for the 100% gain exclusion:

· Only stock of C corporations qualifies for the gain exclusion.
· QSB stock must be originally issued by the C corporation.
· Qualified small business requirement – The aggregate gross assets of the C corporation did not exceed $50M at the date of issuance.
· The C corporation must be engaged in a qualified trade or business.
· 80% of the assets of the C corporation must be used in an active qualified trade or business.
· 5 year holding requirement by shareholders.

The IRS recently released Private Letter Ruling 202114002 (PLR) regarding the application of the “qualified trade or business” requirement under IRC § 1202. This PLR is significant because the IRS has not issued much guidance on this provision since it was enacted in 1993. While the PLR supports the taxpayer’s capital gain exclusion, more importantly, it provides insight into the factors that the IRS may consider in determining whether a corporation is engaged in a “qualified trade or business” for purposes of the gain exclusion.

In short, IRC § 1202(e)(3)(A) provides that a company engaged in brokerage services would not be a qualified trade or business under the QSB stock rules. Consequently, the shareholders would not be able to exclude from gross income the capital gain generated by the sale of the company’s stock.

It should be noted that the term “brokerage services” is not defined in IRC § 1202 or the legislative history. As a result, the IRS relied upon a dictionary definition of the term to determine if the company engaged in brokerage services. To perform this analysis the IRS reviewed the day-to-day operations of the company.

In the Merriam-Webster dictionary, a broker is defined as “one who acts as an intermediary: such as an agent who negotiates contracts of purchase and sale (such as of real estate, commodities, or securities).” The IRS found that the company’s role in its insurance business is not that of a mere intermediary. Contracts with insurance companies and customers require the company to perform several administrative services beyond those that would be performed by a mere intermediary facilitating a transaction between two parties. Once an insurance policy or contract is put into place, the business has an ongoing relationship with the insurance company and its customer – the purchaser of the policy.

For example, the company must promptly report all known incidents, claims, suits, and notices of loss to the insurance company or its designated claims adjuster and cooperate fully to facilitate any investigation, adjustment, settlement, and payment of any claim. It also must keep records of all transactions and correspondence with the insureds at its principal office. These records and insurance accounts must be open to examination, inspection, and audit by the insurance company upon reasonable notice.

The importance of this PLR is two-fold. First, the PLR provides insurance agents and brokers with a reasonable basis to assert that they are engaged in a qualified trade or business under IRC § 1202 if their facts resemble this ruling. In this regard, the PLR illustrates that the IRS would examine the facts and circumstances of a business to determine whether it is a qualified business under the QSB stock rules and not merely rely upon titles and broad categories to arrive at a conclusion.

Second, in light of President Biden’s proposed increase to the capital gains tax rate from 20% to 39.6%, the gain exclusion under IRC § 1202 may get more attention from taxpayers and the IRS as it becomes a means to minimize taxes.

If you have any questions regarding the application of IRC § 1202 to your business and/or the impact of the potential capital gains tax increase, please contact a tax expert at RVG & Company at 954.233.1767, to discuss this matter.