Small Business Tax Changes Under a Biden Administration: Are You Prepared?
How to prepare for the capital gains changes in the Biden tax plan.
Oct 19, 2021
This article has been updated from its original post in January 2021
One of Joe Biden’s campaign promises was to shrink the expanding gap between the wealthiest individuals and the middle class in America through tax legislation. To this end, he introduced a comprehensive proposal to Congress that would raise taxes for the wealthy and for small business owners. But the tax rules and rates for the lower and middle classes have been left virtually untouched.
However, Biden’s original tax proposal has already undergone several changes since it was introduced in October 2020. Many members of the House of Representatives believe that Biden’s initial plan was too extreme, and so a revised version appeared in September 2021 in an attempt to please both sides of the aisle.
Biden’s Original Proposal
One of the most notable elements of the original Biden tax plan was the potential increase in the capital gains tax for small business owners. Biden’s original plan would have effectively doubled this tax following a business sale. The current long-term capital gains rate stands at 20% for small business owners and corporations. Biden’s original plan sought to raise this rate to 39.6% and also add on a surtax of 3.8% for all income exceeding $400,000. This surtax would have been used to pay for the provisions of the Affordable Care Act along with Medicare.
The original Biden tax plan also intended to revert the inheritance tax on the wealthy back to 2009 levels and repeal the step-up in the cost basis for assets that are passed to heirs. Biden also proposed that the FICA tax be reinstated for income in excess of $400,000. Seeking to raise the corporate income tax rate to 28% and implementing a minimum corporate book income tax was also part of the proposed plan.
These sweeping changes were designed to help pay for America’s underfunded Social Security and Medicare programs along with improvements to the country’s infrastructure as well as financial aid and tax credits for poor and middle-class taxpayers who meet certain requirements.
The Alternate House Tax Proposal
As mentioned previously, the Democrats in the House of Representatives have made major changes to Biden’s original plan. The remainder of this article describes the revised plan in its current form.
Tax Changes for Business Owners
One of the first differences between Biden’s original plan and the current plan in the House pertains to the changes in the corporate tax rate. While Biden originally proposed a flat tax rate of 28% on all corporate income, House Democrats are now advocating for a lower, graduated tax rate:
- The first $400,000 of income will be taxed at 18%
- Income from $400,001 to $5 million will be taxed at 21%
- All income above $5 million will be taxed at 26.5%.
However, the benefit of the graduated rate phases out for corporations with incomes above $10 million.
Although high-earning corporations would see an increase in their corporate tax rate from 21% to 26.5%, those with less than $5M in corporate income would see no change or even a decrease from their current tax rate.
Small Business Tax Credits and Deductions
The original Biden tax plan sought to reduce or remove certain tax deductions, such as the Qualified Business Income Deduction (QBID). This provision has carried over into the modified House proposal, and this deduction could be phased out for business owners who earn more than $400,000. Here’s an example of how this could impact a small business owner:
Eric earns $1.5 million in business income, and he is a sole proprietor. He pays his employees $400,000 a year in total wages, incurs additional expenses of $300,000 per year, and takes in a personal net income of $800,000.
Under the current tax laws, Eric is entitled to a deduction equal to the lesser of half of the wages he paid out ($400,000 x 50% = $200,000) or 20% of his net income ($800,000 x 20% = $160,000). This reduces his taxable income from $800,000 to $640,000. Under the proposed tax changes, he would not receive a QBID, so his taxable income would remain at $800,000.
Biden’s tax plan will likely increase the Child and Dependent Care credit by a substantial margin. This small business tax credit provides relief to those who have children under age 13 or dependent parents to care for. The revised credit could be as much as $8,000 for those who qualify.
The new tax plan may also contain provisions implementing the 12.4% Social Security tax on incremental income above $400,000, split evenly between employers and employees. The current wage cap of $137,700 would remain in place, creating a Social Security tax-free gap on all income between those ranges.
The rules for individual taxpayers are proposed to change as well. While Biden’s initial proposal aimed to limit the amount of the deduction that taxpayers could take for state and local taxes paid, the modified version has effectively eliminated this limitation. But the top marginal tax bracket is still being raised from 37% to 39.6% on a graduated basis for:
- Joint filers on taxable income above $450,000
- Heads of households on income above $425,000
- Single filers on income above $400,000
- Estates and trusts on income over $12,500
There is also a 3% wealth tax for taxpayers and estates with incomes above $5 million (or half that amount for married taxpayers filing separately). For example, a taxpayer with an $8 million income will owe an additional $90,000 ($3,000,000 x 3%) on top of their regular income tax. This tax will also apply to trusts and investment income in excess of $100,000.
Capital Gains and Investment Income Changes
Many of Biden’s original tenets regarding retirement and investment income were modified, at least to some extent. Biden’s plan to double the capital gains tax for some high-income individuals was reduced to raising the long-term capital gains rate in the top tier from 20% to 25%.
Here is an example scenario of how this could play out:
Eric invested $1 million into building up his manufacturing business. He grew the business for many years and found a buyer willing to pay $5 million for it. Under current tax laws, Eric would only pay $800,000 (20%) in capital gains tax on his $4 million of profit.
The proposed small business tax changes could raise Eric’s long-term capital gains tax rate from 20% to 25%. Under the revised plan, Eric could wind up owing $1,000,000 ($4 million x 25%)—an increase of about $200,000—on the sale of his business.
The capital gains tax rate for high-income individuals is effectively a flat rate that is not graduated, meaning you would immediately become liable for the 25% tax rate upon reaching the highest tax bracket. As the example above shows, this could mean hundreds of thousands or even millions of dollars in additional taxes that you might need to pay when you sell your business.
The 3.8% surtax on all investment income above certain levels has survived into the modified tax plan. This tax is used to pay for the provisions of the Affordable Care Act, and it applies to all investment income above $200,000 for single filers and $250,000 for joint filers.
For example, if you are single, earn $150,000, and reap a capital gain of $100,000, then $50,000 of your income will be subject to this tax. Earned income is always counted first, then investment income is added on top of that.
The types of investments that are subject to the wash sale rules have been expanded to include all forms of digital currency such as Bitcoin, commodities futures contracts, and currencies. This law previously only applied to stocks and other publicly traded securities. Digital assets must now also follow the rules governing constructive sales, where offsetting positions to a sale of digital currency must be treated as a capital gain. Thus, investors cannot lock in a gain without declaring it on their taxes.
Under current tax laws, taxpayers can make IRA contributions regardless of how much money they already have in their traditional and/or Roth IRAs and employer-sponsored retirement plans. The House proposal mandates that those who have a combined balance of $10 million or more can no longer contribute to their IRAs. But this only applies to individual taxpayers with incomes above $400,000, heads of household making at least $425,000, and joint filers with incomes over $450,000.
Furthermore, this limitation does not apply to qualified, SEP, or SIMPLE plans of any kind. Therefore, a married small business owner who makes $500,000 a year and has over $10 million saved in IRAs and qualified plans could still contribute to a 401(k) plan—but not IRAs.
Required Minimum Distribution (RMD) Rules
Another segment of the revised tax plan applies to taxpayers in the income brackets listed above who have more than $10 million aggregated between their IRAs and qualified plans. The revised plan mandates that those who fall into this category must take a taxable distribution of 50% of the amount that they have saved that exceeds $10 million.
So, if the married small business owner mentioned in the previous example has $12 million saved in her retirement plans at the end of the previous year, she will have to take a distribution of $1 million ($12 million – $10 million x 50%) the following year and pay taxes on it (excluding the Roth portion). This distribution must be taken by all qualifying taxpayers, regardless of their age. If they are under the age of 59 ½, then the standard 10% early withdrawal penalty will be waived.
Furthermore, to the extent that the combined balances of a taxpayer’s traditional IRAs, Roth IRAs, and defined contribution plans exceed $20 million, that excess is required to be distributed from Roth IRAs and designated Roth accounts in defined contribution plans up to the lesser of:
- The amount needed to lower the combined balance in all accounts down to $20 million; or
- The aggregate balance in the Roth IRAs and designated Roth accounts in defined contribution plans.
Once the individual satisfies the RMD for balances over $20 million, they are allowed to determine the accounts from which to take the distributions to also satisfy the 50% RMD rule described above.
The revised tax law also closes up a loophole in the tax code that currently allows taxpayers with incomes above certain thresholds to permit direct Roth contributions to make a nondeductible contribution to a traditional IRA and then convert it to a Roth IRA. The new provisions prohibit any type of after-tax retirement plan contributions from being converted to a Roth IRA regardless of the taxpayer’s level of income. The new proposal also prevents any type of Roth conversion under any circumstances for single filers with incomes over $400,000, heads of households with incomes over $425,000, and joint filers with incomes over $450,000.
When taken in context with the reduction of the unified credit limit (see below), it may benefit wealthy taxpayers to convert their traditional IRA and qualified plan balances to Roth IRAs before the end of the year. This could have the double benefit of exempting the account from income taxation and reducing their taxable estates by the amount of tax that was paid.
For example, a taxpayer with a $10 million traditional IRA could convert it to a Roth in 2021 and pay $3.7 million in taxes on the conversion. If he pays the tax out of the assets in the account, then he has effectively reduced his taxable estate by that amount. This prevents the taxpayer from having to pay tax twice on that amount. If he leaves the IRA as it is, he will pay income tax on the distributions plus estate tax on the amount he bequeaths to his heirs that is in excess of the unified credit limit.
The revised proposal in the House also prohibits IRAs from holding investments that require the IRA owner to be an accredited investor as defined by the SEC. Any IRA that holds this type of investment will automatically lose its tax-advantaged status. Those who currently hold this type of investment in their IRA would have a two-year transition period before this penalty is levied.
IRA owners will also be prohibited from investing in any type of business or other entity in which they are an officer or hold a substantial interest. The interest cannot be more than 50% for a publicly traded entity or more than 10% for a closely-held business or entity.
The House’s revised proposal differs substantially from the Biden tax plan in regards to inheritance taxes. While Biden originally proposed to levy a substantial death tax on heirs of large estates, the House version eliminated this provision.
Biden’s original program also included the repeal of the step-up in cost basis of assets that are passed to heirs after the death of the taxpayer. The House version also excluded this provision, maintaining the step-up in basis under current tax law. Biden’s original version of the tax bill called for assets bequeathed at the death of the taxpayer to be treated as sales, with a $1 million exemption for single filers and a $2.5 million exemption for joint filers. But House Democrats were reportedly concerned that this provision could adversely impact family-owned businesses and farms. At this point, it looks unlikely that consensus will be reached to repeal the step-up in basis any time soon.
Under current tax law, owners of grantor trusts were able to place the trusts outside their taxable estates and still control the actions of the trust very closely. The House provision states that any grantor trust that is closely controlled by the owner must be pulled back into the estate of the owner. Trust owners must therefore look to irrevocable trusts to place assets outside their estates.
Another key tenet of the House proposal is the reduction of the unified credit limit from its current level of $11.7 million back to its 2010 limit of $5 million per individual, indexed for inflation. This will cause many more large estates to become subject to estate taxes and, thus, increasing tax revenue.
The new rules also stipulate that any sales between a grantor trust and the trust owner must be treated as a sale between the owner and a disinterested third party. However, these provisions only apply to future trusts going forward, not to grantor trusts that have already been established.
This provision raises the special valuation reduction that is available for qualified real property used in a family farm or family business. This reduction permits heirs who own these types of real property to establish the property value for estate tax purposes based on its actual use instead of its fair market value.
This provision increases the allowable reduction from $750,000 to $11,700,000. This rule was intended to give tax breaks to family-owned farms, although other types of businesses can also benefit from it.
How to Prepare for the New Tax Plan
Tax changes should be a single factor among many when deciding to sell your business. It’s vital to consider your future goals, like retirement and estate planning, as well as the overall lifecycle of your business and even proper diversification of your net worth. If you’re thinking about selling your business, know that there are various structures available that offer liquidity while also potentially providing the benefit of reduced taxes:
- Exit – Some business owners who may have been contemplating a sale in the near future will undoubtedly decide to sell their businesses immediately to take advantage of the current capital gains and small business federal tax rate.
- Earnout or Installment Plan – Business owners who are willing to monetize the sale of their business over a period of time may realize tax benefits that are unavailable when receiving all the funds at closing. This carries additional risk, as the seller must rely on the new buyer’s operational success to receive the full sales proceeds.
- Deferred Sales Trust – This allows the cost basis of the business to step up, and the owner can invest the money that would otherwise be paid in taxes in annuities, life insurance, or managed money. This is generally done in conjunction with an installment sale, but the business owner comes out substantially ahead over time. The taxes on the sale can be deferred for an indefinite period of time.
- Minority Stake, Joint Venture, or Partial Sale – Selling a minority stake of your business or entering into a JV brings in new capital and ideas for growth. Some owners may opt to sell a minority portion of their business to avoid ending up in the highest tax bracket while simultaneously achieving wealth diversification. The owner can arrange to buy back the minority stake or sell the remaining share of the business in the future.
If you are a small business owner who is looking to explore options for tax savings and selling your business, now is the time to take action. Consult a professional advisor who can provide you with additional ideas and explore all avenues available to achieve your desired goals.