- Expands the net investment income tax (NIIT) for high-income individual taxpayers.
- Makes permanent the section 461(l) limitation on deduction of excess business losses.
- Enacts a surcharge on high income individuals, trusts, and estates beginning 1 January 2022.
- Raises the cap on deductions for state and local taxes to USD 80,000 through 31 December 2030.
- Modifies the definition of “10% shareholder,” whose interest is exempt from tax under the portfolio debt rules.
- Returns section 958(b)(4) to the Code, ending downward attribution in certain circumstances.
Expansion of net investment income tax for high-income individuals, estates, and trusts
Generally, Code Section 1411 subjects individuals, trusts, and estates to a net investment income tax (NIIT) of 3.8% on certain amounts. For individuals, the NIIT applies to the lesser of net investment income (NII) or the excess of modified adjusted gross income (AGI) over a threshold amount: USD 250,000 for joint filers, USD 125,000 for married individuals filing separately, and USD 200,000 for all other individuals. For estates and trusts, the NIIT applies to the lesser of undistributed NII or the excess of AGI over the lower limit of the highest tax bracket for estates and trusts (USD 13,050 for 2021).
Under current law, NII includes traditional investment income, such as interest, dividends, passive rents, and net gain from the disposition of property, but not income from a trade or business that is not a passive activity with respect to the taxpayer and does not consist of trading in financial instruments or commodities. Accordingly, NII generally does not include income or gain from a trade or business, such as a partnership or S corporation, if the taxpayer materially participates in the activities of the business.
The proposed legislation contains a provision (BBBA Sec. 138201) that would expand the NIIT for high-income individuals and all estates and trusts to apply not only to passive investment income, but also to income derived in the ordinary course of any trade or business.
For individuals, the resulting increase in tax would begin to phase in once an individual’s income reaches double the general NIIT threshold: USD 500,000 for joint filers, USD 250,000 for married individuals filing separately, and USD 400,000 for all other individuals. For the first USD 100,000 above the relevant threshold (or the first USD 50,000 in the case of a married individual filing separately), the increase in tax due to this new provision would be multiplied by the fraction of (i) the amount by which the taxpayer’s modified AGI exceeds the relevant threshold over (ii) the USD 100,000 or USD 50,000 phase-in amount. For example, joint filers with a modified AGI of USD 550,000 would be liable for only 50% ((USD 550,000 - USD 500,000) / USD 100,000) of the increase in tax resulting from the expansion of the NIIT. Once an individual reaches USD 600,000, USD 300,000, or USD 500,000, as applicable, the full 3.8% NIIT rate would apply to all net investment income and trade or business income.
In addition to this significant expansion to the scope of the NIIT for high-income taxpayers, estates, and trusts, the proposed legislation includes several clarifications to the calculation of NII generally. First, it would clarify that the NIIT does not apply to wages on which employment taxes (i.e., FICA payroll taxes and SECA self-employment taxes) are already imposed or to wages for services performed outside the US for a foreign employer. Additionally, NII would not be reduced by deductions with respect to net operating losses (NOLs). Furthermore, the proposed legislation would include in the NII of a US shareholder certain income of foreign corporations subject to various anti-deferral rules: namely, inclusions with respect to the stock of a controlled foreign corporation (CFC) under sections 951 (Subpart F) and 951A (GILTI) and certain inclusions with respect to the stock of a passive foreign investment company (PFIC) that has made certain elections.
The proposal would be effective for taxable years beginning after 31 December 2021.
Limitation on excess business losses made permanent
Currently, section 461(l) temporarily limits non-corporate taxpayers’ ability to offset non-business income or gain using business losses for taxable years beginning in 2021 to 2026. Such “excess business losses” are defined as the excess of deductions with respect to all trades or businesses of a taxpayer over the sum of the taxpayer’s gross income or gain with respect to such trades or businesses plus an inflation-indexed threshold amount (in 2021, USD 524,000 for joint filers and USD 262,000 for others). Under current law, disallowed excess business losses are carried forward as NOLs, which are not taken into account when computing excess business losses. Accordingly, one year’s business loss can offset a future year’s non-business income under current law.
The proposed legislation contains a provision (BBBA Sec. 138202) that would make the limitation on excess business losses permanent. Further, excess business losses would be carried forward to future years as business deductions, not as NOLs, so that they would continue to be counted against the section 461(l) limitation for future years. The legislation provides that excess business loss carryovers of a terminating estate or trust will continue to be allowed as deductions to succeeding beneficiaries, which accords with the treatment of NOLs under section 642(h).
The proposal would be effective for taxable years beginning after 31 December 2020. Because excess business losses were already disallowed for taxable years beginning in 2021 to 2026, the retroactive effective date should be of greatest concern to taxpayers who had planned to carry forward excess business losses to offset non-business income in future years.
Surcharges on high-income individuals, estates, and trusts
The proposed legislation would add a new section 1A imposing a 5% surcharge on a non-corporate taxpayer’s modified adjusted gross income over USD 10,000,000, plus an additional 3% on modified adjusted gross income over USD 25,000,000 (BBBA Sec. 138203). The thresholds are USD 5,000,000 and USD 12,500,000 for married individuals filing separately and USD 200,000 and USD 500,000 for estates and trusts. Thus, for example, joint filers would be subject to 45% tax (37% plus 5% plus 3%) on their income in excess of USD 25,000,0000 (and up to 48.8% if the expanded NIIT applies).
In a prior version of the bill, “modified adjusted gross income” is adjusted gross income, reduced only by any deduction allowed for investment interest and, in the case of an estate or trust, the specific deductions permitted to determine the adjusted gross income of an estate or a trust. The proposed legislation adds to these definition deductions allowed for business interest and, in the case of an estate or trust, deductions for charitable contributions.
The proposal also contains special provisions for specific classes of individuals and entities. Charitable trusts would be exempt from the surcharge. In addition, nonresident aliens (other than residents of US possessions) would be subject to the surcharge only on their net effectively connected income (ECI). However, certain aliens who terminated US residency and then returned, as described in section 7701(b)(10), would be subject to the surcharge during their period of nonresidence on non-ECI which is subject to the expanded definition of US source income under section 877. Additionally, the threshold amounts for US citizens and residents living abroad would be decreased by amounts excluded from gross income for foreign earned income and housing under section 911.
The surcharge would be disregarded for purposes of the alternative minimum tax and in determining any tax credit other than the foreign tax credit.
Other coordinating provisions would take the surcharge into account when applying the maximum tax rate for purposes of calculating various amounts, such as interest on deferred tax of US shareholders of PFICs, the amount to withhold on the ECI of a foreign partner in a partnership that is engaged in a US trade or business, and the amount of an imputed underpayment in a partnership audit.
The proposal would be effective for taxable years beginning after 31 December 2021.
SALT deduction cap increased
Added to the Code by the TCJA, section 164(b)(6) caps the itemized deduction for certain state and local taxes (the SALT deduction) at USD 10,000 (USD 5,000 for married individuals filing separately) for tax years 2018 to 2025.
Under the proposed legislation (BBBA Sec. 137601), a modified section 164(b)(6) would extend the SALT deduction cap through tax year 2031, but would increase the limit to USD 80,000 (USD 40,000 for married individuals filing separately, estates, or trusts) for tax years 2021 to 2030. In tax year 2031, the cap would revert to USD 10,000 (USD 5,000 for married individuals filing separately, estates, or trusts) before expiring in tax year 2032.
Observation: The proposed legislation would subject estates and trusts to the lower limitation, which currently only applies to married individuals filing separately. In addition, this provision is controversial and remains subject to potential changes in the Senate.
The proposal would be effective for taxable years beginning after 31 December 2020.
BBBA’s impact on portfolio debt structures
Generally speaking, the United States imposes a 30% withholding tax on US-sourced payments of interest to foreign persons if such interest income is not effectively connected with a US trade or business of the payee. However, interest paid to foreign persons with respect to certain "portfolio debt instruments" is not subject to US withholding tax.
"Portfolio debt instruments" include registered obligations that do not fall within three important exceptions:
- interest received by a bank;
- interest received by a 10% shareholder; and
- interest received by a controlled foreign corporation (CFC) from a related person.
Section 958(b)(4) returns to end downward attribution
The BBBA proposes to return section 958(b)(4) to the Internal Revenue Code. The Tax Cuts and Jobs Act of 2017 (TCJA) repealed this section to allow "downward" attribution of stock ownership from a foreign person to a US person in the context of determining whether a foreign entity is a CFC. The section 958(b)(4) limitation historically allowed foreign entities to escape CFC status solely on the basis of stock attribution from foreign persons to US persons.
Prior to the repeal of section 958(b)(4) if, for example, a foreign parent company owned a foreign subsidiary and a US subsidiary as brother-sister entities, the foreign parent's interest in the foreign subsidiary would not be attributed to the US subsidiary. Post-TCJA, the foreign parent's interest in the foreign subsidiary is downwardly attributed to the US subsidiary, such that the foreign subsidiary is deemed owned by the US company and is therefore deemed a CFC. This repeal has had far-reaching consequences well beyond its original intent, creating thousands of unintended constructive CFCs.
Notably for portfolio debt, the repeal of section 958(b)(4) had the unintended effect of causing many in-bound loans qualifying as portfolio debt to no longer qualify as portfolio debt because one of the requirements of portfolio debts is the loan cannot be from a related party CFC. The proposed legislation demonstrates Congress' intent to rectify this by reinstating section 958(b)(4). This proposal would solve the "related party CFC" issue for inbound portfolio debt lending.
This proposal would apply for tax years beginning after 31 December 2021.
Note: Other changes proposed in BBBA Sec. 138128 will be discussed in a separate alert.
Modification to Portfolio Interest Exemption Rule
The BBBA includes a proposal (BBBA Sec. 138145) that would effectively eliminate most future inbound portfolio debt planning through a US C-corporation blocker structure due to the altered definition of “10% shareholder.” Currently, under section 871(h)(3)(B), if the obligor is a corporation, interest does not qualify under the exemption if it is received by a foreign lender that directly or indirectly owns 10% or more of the total combined voting power of all classes of the obligor's voting stock. As a result, in-bound portfolio debt structures with corporate borrowers have often employed a so-called "park-the-vote" structure whereby an independent, minority shareholder holds greater than 90% of the vote in the borrower corporation.
However, under this proposal, the definition of "10% shareholder" is revised to also include foreign lenders that own 10% or more of the total value of the corporate borrower's stock. In other words, if the proposal is enacted, any foreign lender that owns 10% or more of the total vote or value of the stock of the corporate borrower will not be eligible for the portfolio interest exemption. If enacted, this change would render park-the-vote structures an ineffective planning tool for portfolio debt.
Notably, if enacted, this revised definition of “10% shareholder” would only apply to obligations issued after the date of enactment, and there is no mention of any changes to the “portfolio interest exemption” rules involving individual or trust obligors.
Observation: Under current portfolio debt rules, there is no "10% shareholder" rule for an individual or trust, which makes an individual or trust borrower an attractive structuring alternative if the individual or trust is prepared to file US federal income tax returns and report and pay tax on underlying investments.
No changes to grantor trust rules or transfer tax exclusion amount
The legislation passed by the House omits a number of proposals from earlier drafts of the bill, such as changes to the treatment of grantor trusts for both income tax and transfer tax purposes, which would have significantly impacted the tax planning of high net worth individuals. The legislation also rejects an earlier proposal to accelerate the timeline for reducing the estate and gift tax exclusion amount from USD 10,000,000, as adjusted for inflation (USD 11,700,000 for tax year 2021). However, the current increased estate and gift tax exclusion amount would still sunset on 31 December 2025 and revert to USD 5,000,000, as adjusted for inflation, under the House bill.