Tax Planning Guide for Disaster Area Victims

Tax Planning Guide for Disaster Area VictimsThe recent hurricane Ian impacted much of the southeast United States. As a result, it is good to know the general tax rules related to disaster victims. Below, we look at several tax topics for disaster area victims.

1. Tax Returns and Filings

Q: I am a disaster area victim and needed to move from my home. I might not be back for a long time or even at all. Which address should I use on my tax return?

A: A taxpayer should always use their current address in filing a tax return. In the situation where you move after filing your return, you need to update your address with the IRS. You can do this either by filing form 8822 or calling the IRS Disaster Hotline at 866-562-5227.

Q: I filed an extension for my form 1040, giving me until Oct. 15 to file. Are there any further extensions available?

A: Taxpayers who already filed for an extension until Oct. 15 and live in a federally declared disaster area of the recent hurricanes receive an automatic extension due date of Dec. 31.

2. Payments

Q: I have a balance due on my 2021 tax return and am currently accruing interest on it. Is there any relief for disaster victims on interest charges?

A: No, the IRS is not giving any forbearance or cancellation of interest on tax balance liabilities. The IRS is, however, willing to waive late payment penalties when the taxpayer can prove the reason they are late is caused by issues related to the disaster.

3. Property and Casualty Loss

Q: During a recent disaster we lost electricity and all the food in my refrigerator and freezers spoiled and I had to throw it away. My homeowners’ insurance reimbursed me, and it was for more than the food cost me. Do I have to report any income on the amount over my food costs?

A: No. The tax code makes a distinction between scheduled property and general reimbursements. For unscheduled property (general reimbursements), the taxpayer does not need to recognize income for reimbursements on personal property, even if it was more than the cost of the lost property.

Q: I need to prove the reasonable value (FMV) of my home. Am I allowed to use property tax assessments to substantiate the FMV of my home?

A: No, the only way a taxpayer can establish the FMV of a property is either with an appraisal by a credentialed appraiser or using the cost of repairs method.

4. Sale of Home

Q: My primary residence was destroyed and the cause was deemed to be a federally declared disaster. After clearing the lot, I sold the land alone for a gain. Do I have to pay taxes on the gain or is there an exclusion since it is where my primary residence used to be?

A: Selling a vacant lot does not qualify for the exemption on gains from primary residences. The exception to this rule is if the land previously had the taxpayer’s main residence on it. In this case, if the taxpayer would have qualified for the main residence exemption before the disaster, the gain on the sale of the vacant land would be exempt here as well.

5. Expenses

Q: I worked in a federally declared disaster area and had to move for my job at my own expense. Can I deduct my travel and related expenses?

A: The answer depends on whether or not the move is expected to last for more than one year. If you expect the move to be temporary, defined as less than one year, then there is no change in your tax home. In this case, you can deduct travel and related expenses to get you both to and back from your temporary work assignment. If the move is long-term, defined as more than one year, then the expenses are not deductible, regardless of whether your employer reimbursed you.

How to Increase After-Tax Returns on Investments

It is all about how much you keep after taxes – not what you earn from your job, a business or investments. While it is always great to see fabulous investment gains, the only financial metric that really matters is what is in your bank account at the end of the day. One of the ways you can influence this is by minimizing the taxes you pay on your investments.

Unfortunately, many people do not think about how taxes impact their investment returns until near the end of the year; however, you should act all year round. Taking part in investment tax planning throughout the year will give you opportunities to keep more of what you earn. Here are some rules and strategies to keep in mind.

Know When to Take Your Losses

Psychologically, many investors are averse to taking losses, holding out to “make their money back.” Instead of emotion, logic and investment acumen need to be applied here. If an investment does not have a fundamental reason to turn around, then you are better off selling it and taking a tax loss.

Losses reduce taxes on either your capital gains for the year or, when losses exceed gains, up to $3,000 on other income. Excess losses can be carried forward to future years. Plus, you will have the proceeds to reinvest in something more likely to produce a return.

Let Winners Run

Unlike long-term capital gains, short-term capital gains are taxed as ordinary income. This means your marginal income tax rate (the highest rate applied to you) can impact your investment gains.

While you should not let the tax tail wag the investment dog, ideally you want to hold a winning investment for at least a year and a day to benefit from long-term capital gains tax treatment. This means you will pay only a 20 percent maximum tax versus whatever your marginal rate is.

As with losses, the fundamentals of the investment are key. Therefore you should not sell a holding if you think the gains are at risk just to save on taxes. If you believe in the investment for the long term, then holding out for preferred capital gains treatment can be a clever idea.

Give the Gift of Appreciation

Making charitable donations you would not otherwise give is generally not a viable tax strategy. However, if you are already charitably inclined then consider donating stock or mutual funds instead of cash.

When you donate property such as stocks, your charitable deduction is based on the fair market value of the asset on the date of the gift. It is much better to do this than donate cash.

For example, if you have a stock you purchased for $35 and it is now worth $135, when you donate it you will receive a charitable deduction of $135. If you were to sell the stock first, you would have to pay tax on the $100 gains and then have only $103 to donate in cash – assuming you are in the 32 percent tax bracket. The only winner in this situation is the IRS; both you and the charity lose. This is because the charity is excluded from paying capital gains taxes on the appreciation that occurred while you owned the asset.

Hold Until You Die

This strategy does not benefit you directly, but rather your heirs. When someone inherits an asset such as real estate, stocks, bonds, mutual funds, etc., the cost basis of the asset is reset to the fair market value at the date of death.

This means that if you have stock in company XYZ that you bought for $50 and now it is worth $500, you would pay tax on the gain of $450 per share. However, your heir would pay $0 if he sold it on the day you died. If your heir continues to hold the stock, the benefit still applies as his cost basis in the stock of XYZ would reset to $500, so he will pay taxes only on gains over that amount.

Conclusion

While you should never cheat on your taxes or do anything unethical, it is foolish to pay any more than legally necessary to the IRS. Engage in investment tax planning year-round and you may see better after-tax returns and more money in your bank account.

Electric Vehicle Tax Credits and the Future of the Automotive Industry

Electric Vehicle Tax CreditsOne highlight of the recently passed Inflation Reduction Act of 2022 (IRA; HR 5376) includes modifications to what is more commonly referred to as EV credits. Specifically, Section 30D of the Act is where the most important modifications are, and where the present tax credit for electric vehicles is spelled out in the U.S. Code. There is also new stimulus for previously owned electric vehicles, industrial vehicles and “alternative fuel refueling property.”

According to the Joint Committee on Taxation’s estimates, in lieu of what was previously known as the credit for plug-in electric vehicles, there is now a new clean vehicle credit. It is expected to be worth $7.5 billion over the next decade. Other noteworthy tax credits include $1.7 billion for “alternative fuel refueling property,” $1.3 billion available for buying a previously owned qualified plug-in EV, and $3.6 billion in tax credits for qualified commercial clean vehicles.

How the IRA Changes Section 30D and EV Tax Credits

For eligible, new clean vehicles, purchasers may receive $7,500 in federal tax credits and $4,000 for similarly used vehicles. It is important to note that taxpayers who purchase such vehicles are eligible for this tax credit if their modified adjusted gross income (MAGI) during the current or preceding tax year is no greater than $300,000 for joint filers; $225,000 for heads of household; and $150,000 for single filers. It is also limited to pickup trucks, vans, and sport utility vehicles up to a MSRP of $80,000. All other vehicles costing up to $55,000 are similarly eligible.

Critical Mineral Standards

Another important qualification for this tax credit is if the vehicle’s battery has a minimum threshold of critical minerals and if it has been processed in the required geographies. Section 30D(e) requires progressively increasing percentages of critical minerals either processed or extracted in the United States or another country the U.S. has an existing free-trade agreement with. If the stated percentages are recycled in North America, a vehicle’s battery components may also qualify for the tax credit.

Once guidance is issued by the U.S. Treasury and before the start of 2024, there must be at least 40 percent of eligible critical minerals to qualify. Vehicles placed in service in 2024 must have at least 50 percent critical minerals in their batteries. Critical minerals must be 60 percent, 70 percent and 80 percent of a battery’s components in 2025, 2026 and after Dec. 31, 2026, respectively. Dependent on future guidelines developed by the Internal Revenue Service, manufacturers will have to sign off on battery component makeup.

Requirements for Battery Manufacturing/Assembly Requirements

According to Section 30D(e)(2), prior to Jan. 1, 2024, at least half of the components of an EV battery must be assembled or manufactured in North America. Starting in 2024 and through 2025, 60 percent of a battery must meet such requirements. Beginning in 2026 through 2028, this requirement will increase by 10 percent annually, eventually requiring 100 percent of a battery’s construction to meet these standards beyond Dec. 31, 2028.

Other Considerations for Tax Credit Eligibility

If any critical minerals were extracted, handled or recycled by a “foreign entity of concern,” it is prohibited by the IRA for tax credit eligibility. Similarly, final assembly also must take place within North America to retain eligibility for the tax credit. Being considered a “qualified manufacturer” is another requirement that is necessary to maintain tax credit eligibility. This is any manufacturer that adheres to the EPA’s Title II Clean Air Act rules.

With the push for cleaner and greener energy evolving, this is one of many tax credits for consumers and businesses alike to reduce emissions and navigate the U.S. Tax Code.

Expanding the Net Investment Income Tax

Net Investment Income TaxDespite borrowing massive amounts of money, the government still needs to find ways to raise revenue to pay for new programs and spending. The current democratically controlled Congress is looking to potentially implement new social programs and a climate bill. As a way of funding these initiatives, they are considering an expansion of the Net Investment Income Tax (NIIT).

The NIIT is proposed to raise revenue since it is seen as politically more palatable, given that it typically only impacts a small group of wealthier taxpayers. Critics, however, say the plan in its current form would also hurt small family businesses.

Who Pays NIIT Now?

Under the Affordable Care Act (ACA), the NIIT applied a 3.8 percent tax on investment income. Investment income includes both passive sources like dividends, capital gains, interest, royalties, and rents as well as passive business income. Under the ACA, the NIIT applied only to single taxpayers earning $200k or more and joint filers with $250k or more.

When it comes to the taxability of business income under the NIIT, because the law only captures passive business income, most owners of pass-through entities must pay the NIIT; however, active owners of S-corporations are exempt. Likewise, if someone qualifies as a real estate professional, their income is considered active and so their rental income is also exempt.

Who Would Pay Under the New Proposed Law?

The current version of the House bill makes two major changes. First, the NIIT expands to capture all business income. Essentially, S-corporation shareholders, limited partners, and pass-through entity owners that are currently exempt would be impacted.

Second, when it comes to removing the exemption on this business income, the income threshold rises from $200k to $400k for single filers and from $250k to $500k for taxpayers filing jointly. The effect of this would be to exclude most business owners from the tax, but make filing more complex for those impacted.

Under the new rules, the Tax Policy Center projects that in 2023 the tax hike would fall on those in the top 1 percent of household incomes or those making approximately $885k or more. Further, even among the top 1 percent, more than 50 percent of the tax increase would be borne by the top 0.1 percent for those making $4 million and up.

Impact No Small Businesses

Overall, about 14 percent of taxpayers report some form of business income on their federal tax returns. The amount reported, however, is usually not a material amount for most as a percentage of their income. For example, only approximately 5.5 percent of taxpayers with reported business income had this as the source of 50 percent or more of their total income. As a result, the impact will be mostly on a small percentage of small businesses. At the same time, as business income is far more variable than employment income, someone could easily fall in and out of the tax range.

Conclusion

Overall, the House bill looks to raise the threshold of where the NIIT expansion applies by the type of income it captures. We will have to wait and see if there are changes as the bill makes its way through – if it even passes at all. No matter what happens, there will certainly be tax increases of some kind.

Taxation of Legal Settlements and Fees

Taxation of Legal Settlements and FeesThe taxation of legal settlements and fees is a complex topic. While the mechanics to make a proper claim are now easier, the rules are still complex. Below we look at six rules to consider when it comes to the taxation of legal settlements and the deduction of legal fees on your taxes.

  1. Taxes depend on the origin of the claim; or in plain English, according to why you are seeking recovery. For example, in a case where the plaintiff is suing another business for losing profits, the settlement would be considered lost profits, and therefore would be ordinary business income. If a worker sues for unlawful termination, then the settlement would be considered wages and taxed accordingly. Another example is where a plaintiff sues a negligent builder; here the damages won’t be classified as income, but instead will reduce the purchase price of the real estate.

    The big difference in the above examples is that in the first two cases the settlements are taxable; in the third, they are not. As with many things in tax law, be aware that the rules are full of nuance and exceptions.

  2. Some recoveries are tax free, even if they wouldn’t appear to be on the surface. One example here is cases of personal physical injuries, like a car accident. While you may be suing for lost wages due to the inability to work, the damages should be tax free due to section 104 of the tax code that shields damages for personal physical injuries and physical sickness.

    The important distinction here is the physical requirement. The IRS is unclear exactly what constitutes physical harm, but generally requires that you can physically see the injury.

  3. Medical expenses are tax free. Regardless of the type of harm (physical or emotional), payments for medical expenses are tax free. Moreover, the definition of medical expenses is rather broad.
  4. Allocating damages can save on taxes. Most legal disputes involve multiple issues, and as a result the total settlement amount will involve several types of considerations. The parties in suit can agree to the allocation of the settlement according to the issues – and therefore its tax treatment. While these agreements aren’t binding to the IRS, they’re rarely ignored and can provide a good defense for your tax position.
  5. Attorney fees can be a trap. However you pay your attorney – whether hourly or on a contingent fee basis – legal fees will affect your net recovery and your taxes. Plaintiffs who use contingency fee arrangements are typically treated (for tax purposes) as receiving 100 percent of the money recovered. In other words, you’re taxed on the part of the money your attorney takes out of the settlement.

    To understand this a little better, take an example suit for emotional distress where you recover $200,000 in damages, with a 40 percent contingency fee arrangement with your attorney. Here, the plaintiff is going to have $200,000 in taxable income even though they only received $120,000 (with $80,000 going to the attorney). Not all lawyers’ fees face this draconian tax treatment, but this is the general rule in contingency fee cases.

  6. Punitive damages and interest are always taxable. This is true even if the injuries are 100 percent physical. Take a case of a car crash where you get $30,000 in compensatory damages (for the car damage) and $2 million in punitive damages. The $30,000 is tax free, but the $2 million is fully taxable.

Conclusion

These are some of the basic rules surrounding the taxation of legal fees and settlements. There are many nuances and subtleties, but what you should take away from this article is that, in many cases, there are ways to structure both any settlement received and how you pay your attorney to minimize your tax burden.

2022 U.S. Tax Legislation Forecast

2022 U.S. Tax Legislation ForecastNo one knows for sure what 2022 will bring in the form of tax legislation, but there is certain to be some action. Top tax analysts think there are several topics that are likely to come up in 2022. Most predict that a lot of potential changes that were discussed but never made much traction in 2021 will be revisited.

Rolling Back Corporate Tax Rates

Back in 2017, then-President Trump’s Tax Cuts and Jobs Acts (TCJA) reduced corporate tax rates. While a bid raise them again failed in 2021, many believe there is a good chance that Democrats will try again in 2022. Most believe a 2022 proposal would try to raise the current 21 percent corporate tax bracket up to between 25 percent and 28 percent, but opinions vary. While most analysts see a push to raise rates, no one predicts a push to go back to pre-2017 rates, which were as high as 35 percent. Republican opposition to any such measure is expected to be strong.

The Billionaire Tax

New spending proposals in 2021 saw the backing of a billionaire tax as a method to help finance them. While no such tax made its way into law during 2021, many analysts believe that a billionaire tax is likely to resurface once again in 2022.

The name is a bit of a misnomer, as the most recent proposals applied to more than just billionaires; they were set to impact taxpayers with more than $1 billion in assets as well as those with over $100 million of income for three years in a row. Under these thresholds, the tax would only impact approximately 700 to 800 people in the United States.

Proposals from 2021 included a controversial provision that is a major deviation from current tax law: taxing unrealized gains. Currently, with few exceptions for professional traders who can elect to mark-to-market for example, tradable assets such as stocks are taxed only on realized gains once the asset is sold. Iterations of the billionaire tax proposed to change this and require such assets to be valued annually and taxed according to the unrealized portion as well. The rationale is that the ultra-wealthy can take loans against their assets and avoid ever selling or realizing the gains – and therefore avoid taxes as well.

Finally, it’s important to note that this particular form of billionaire tax is not the same as a wealth tax. This tax focuses on unrealized gains only and not the taxpayer’s total wealth.

A True Wealth Tax

Another tax law that made its way into the national spotlight during 2021 and is likely to get another try in 2022 is some form of a wealth tax.

Typically, a wealth tax is a flat tax percentage placed on a taxpayer’s total net worth annually; say one percent, for example. Unlike essentially all forms of taxation in the United States, a wealth tax would see someone owing money year-after-year even if they never made any more money.

One of the biggest non-political problems with a wealth tax is logistics. Taxing net worth means that every asset a taxpayer owns needs to be valued annually, including real estate, cash, investments, business ownership and other assets. This creates a huge administrative burden and leaves a lot of room for interpretation between valuation professionals as well.

No analyst foresees any wealth tax proposals applying broadly. Instead, most see it being targeted at the ultra-wealthy – those with a net worth over $50 million. This makes it politically palatable as the vast majority of taxpayers are exempt; however, there are many who oppose any such tax either due to ideological reasons or because they feel it represents a slippery slope to eventually capture more and more taxpayers with lower net worth thresholds.

Tougher Regulations on Cryptocurrency

One of the most unclear areas for potential 2022 tax law proposals involve cryptocurrencies. The reality is that most of Congress simply doesn’t understand the market and the IRS itself is mired in technical rules on how to treat various sectors of the emerging financial arena.

While some analysts predict there will be proposals to differentiate the tax treatment from more traditional assets, others believe the moves will be largely regulatory and focus on compliance and minimizing tax avoidance within the asset class.

Conclusion

Many of the above tax provisions are highly partisan in nature. As a result, it is likely that congressional gridlock will ensue and little if anything will get passed through legislative channels. This leaves many analysts predicting that tax changes, to the extent possible under our system, may see more executive actions than usual. Regardless, with the current economic uncertainty, high inflation and geopolitical instability, the topics above may or may not come up this year. One thing is certain however, taxes won’t be going away or getting any simpler.

The Risks of Using Self-Directed IRAs

Self-directed IRAs (SDIRAs) are becoming more and more popular as IRA holders look to enter alternative investments. While SDIRAs can open up a world of investment options, the rules around them are complicated and compliance can be tricky. Below, we’ll look at a couple of relevant court cases that illustrate some of the potential pitfalls.

Self-Directed Equals Higher Fees

A SDIRA can own an investment in pretty much any type of asset except life insurance or collectibles. The downside to accessing investments beyond stocks, mutual funds, ETFs and bonds is that it is more expensive.

The SDIRA custodian usually charges an annual fee as well as per transaction fees. The assets also need to be valued at the end of every year for reporting purposes so there is usually a custodial appraisal or valuation fee. These fees and structures often lead to SDIRA owners taking shortcuts to save money or ease administration.

Side-Stepping Rules is Looking for Trouble

One recent case that went before the tax court involved a taxpayer whose SEP-IRA owned an LLC where he was the only owner and manager, with a national bank as the custodian. The taxpayer opened a checking account for the LLC at the same bank.

The taxpayer took distributions from his SEP-IRA and put the money into the LLC account. He then used the money to fund loans on real estate to third parties. The loans paid back over time and the repayments, including interest, were deposited back into the IRA.

The bank issued a Form 1099-R reporting the distributions as taxable events; however, the taxpayer included this income on his tax return. The IRS taxed distributions, plus the 10 percent penalty because he was under 59½. The case went to tax court with the taxpayer claiming he never actually took distributions because the money went from the IRA custodian to the LLC checking account.

The tax court found in favor if the IRS for several reasons. Most important of which is that the taxpayer held full control of the funds that were distributed. Another mistake was that he owned the LLC, which held his checking account and not the IRA. As a result, the bank as IRA custodian no longer held legal control over the money.

In the end, the taxpayer didn’t want to change custodians from the national bank, which held his SEP-IRA, because he didn’t want to pay the fees associated with setting-up a proper SDIRA. If he had, then he could have structured the investments to be made via the LLC, with the IRA as the owner of the LLC and avoided the taxable distributions completely. In the end, it cost him far more than the fees ever would have.

Collectibles Versus Property and Possession

In another case that went before the tax courts, the taxpayer opened an LLC owned by her IRA where she was the sole managing member. The IRA then purchased American Eagle gold coins, which she took physical delivery of and held in her possession.

IRAs are not allowed to own collectibles, with gold bullion and coins generally considered collectibles. There are exceptions however, with gold American Eagles being one of them – so no issue here.

The problem centered on whether the taxpayer took physical possession of the coins. The tax code says that exempt precious metals can held in physical possession by an IRA custodian. As a result, the taxpayer taking physical possession of the gold was deemed a distribution.

Conclusion

These two cases show that LLCs created to invest through a SDIRA must follow all the IRA rules. This is because the IRA is the entity considered to be engaged in all transactions executed by the LLC. Further, the IRA owner shouldn’t be the managing member of the LLC or take physical possession of the assets. It should always be the IRA custodian who holds the assets and maintains control.

Year-End Tax Planning Tips for Individuals and Businesses

Year-End Tax Planning 2021Here we are again, nearing the end of another year. While the tax deadline for 2021 isn’t until April 2022, now is the time to plan and make some strategic moves to optimize your tax situation. Below we’ll look at some tax planning ideas for both small businesses and individuals.

Business Tax Planning

Business owners should consider a few potential planning areas. Below we’ll look at a handful of relevant topics.

Section 163(j) Interest Expense Limitation

Businesses can deduct interest expenses, subject to a limit at 30 percent of adjusted taxable income (ATI). The calculation for determining ATI is changing in 2022, so some planning might be in order.

Currently, ATI is calculated as taxable income with depreciation and amortization added back. Starting in 2022, depreciation and amortization will no longer be an add-back, effectively lowering the amount of deductible interest a business can claim.

Taxpayers should consider their current year forecast and 2022 projections to see if there is opportunity in converting debt financing to equity financing.

COVID-Driven Innovation

Many businesses needed to change and adapt processes and products to survive or thrive during the pandemic. Depending on the nature of the activities, some of the expenses might qualify for R&D tax credits. Now is the time to investigate what will qualify and begin to gather the documentation.

Remote Workers and Nexus

With so many companies allowing remote work in this new normal, consideration should be given to year-end planning for state and local taxes. State laws around nexus are evolving, and remote workers may create new reporting and payment requirements for both income and employment taxes.

Net Operating Loss Carryforward

Net operating loss (NOL) rules are changing. First, NOLs created from activity in 2021 and beyond can only be carried forward; no carry-back is allowed. Also note that NOLs generated in 2017 and can be used to offset 100 percent of current year taxable income, whereas those generated 2018 and after can only offset up to 80 percent of taxable income in any year.

As a result, taxpayers should consider revenue recognition and other tactics to maximize the use of NOLs.

Individual Tax Planning

Start Gathering Your Documents Now

Taxpayers should start gathering their documents now as there are two main benefits to this. First, it will make things more manageable and organized in 2022. Second, it will get them thinking about their financial picture. Gathering documents forces you to give your year-to-date a mental review so you don’t forget about any new or unusual events that could provide planning opportunities.

Retirement Accounts Review

Generally, everyone should consider topping off tax-advantaged retirement accounts such as IRAs or 401(k).

Perhaps more importantly, consider a back-door Roth conversion. This tax savings strategy permits taking deductible or non-deductible IRAs and converting them to a ROTH IRA. There are a lot of nuances to this move depending on the individual’s situation, but it’s very important to consider since 2021 may be the last year this is allowed, depending on legislative developments.

Required Minimum Distributions

In 2020, required minimum distributions (RMDs) from retirement accounts were suspended. RMDs return for 2021 however, so taxpayers who are 72 or older need to remember to make the calculation and withdrawal by Dec. 31.

Conclusion

There is no better time than now to step back and look at the past year, your financial situation, and the changes to tax laws this year and next. Remember, tax planning only works if you act before the end of the tax year. Once we reach 2022, it will be too late to make much of an impact on your 2021 tax situation.

Potential New Tax on Stock Buybacks and What it Could Mean for the Financial Markets

Tax on Stock BuybacksPresident Biden’s latest spending bill could result in a new tax on corporate stock buybacks. In its most recent incarnation, the Senate version of the plan includes a 2 percent excise tax on stock buybacks. Still, this isn’t enough for many critics of stock buybacks, who claim they incentivize short-term behavior in lieu of long-term investment.

Short-Term Incentives

Stock buyback programs have long been criticized for giving a short-term boost to share prices with funds that could have been used for long-term investment instead. Critics, including the current president, believe stock buybacks come at the expense of capital investment in new or updated factories, research, worker training, etc. These critics believe this type of long-term investment is the key to sustainable growth.

Changing Behavior with Taxes

Some critics advocate for an outright ban on stock buybacks, but they are in the minority. Instead, the recent Senate bill proposes a 2 percent tax on stock buybacks. This tax is dual purpose. First, it aims to discourage buybacks and encourage longer-term investment. Second, it’s a revenue generator to help fund the trillions in new spending in the bill.

Will the 2 Percent Tax be Enough to Matter?

While a 2 percent excise tax on buybacks may not be draconian, it appears to be significant enough to drive a change in behavior. In a CNBC poll, more than half of CFOs indicated the 2 percent tax is enough for them to curtail their buyback program. Only 40 percent said they would not change their buyback program plans (CNBC Global CFO Council Survey).

Impact on the Capital Markets      

Stock buybacks have had a significant impact on the markets. Not only are companies using excess cash to buy back shares, but with interest rates so low for so long, many companies have even taken on debt to buy back shares. Still, excess cash that can’t just sit on the corporate balance sheet is the main driver of the largest buyback programs. Established, cash-flush tech companies such as Apple, Alphabet and Microsoft are the dominant players, accounting for nearly one-third of all buyback activity in the first half of 2021.

Given the recent run-up in the markets, buyback programs have not kept up. Couple this with the proposed increases in corporate tax rates from 21 percent to 25 percent, and there’s even less cash to fund buyback programs. Generally, most experts believe these macro-economic factors combined with the new 2 percent tax will cause a shift toward dividend payouts as they will be more favorable to shareholders.

Conclusion

The main idea behind the proposed 2 percent excise tax on stock buybacks is to both raise revenue and encourage corporate investment. Critics of stock buyback programs believe this is better for the economy and workers, whereas buybacks favor corporate shareholders at their expense. While a 2 percent tax might not be enough to create wholesale change, it appears to have enough teeth combined with corporate tax rate changes to change most public company CFOs.

New Proposed Tax Laws

New Proposed Tax Laws 2022The House recently released a nearly 900-page proposed bill that would make major changes to current tax laws. The bill is intended in large part to help pay for both the Biden Administration’s budget and infrastructure stimulus bill.

It’s important to keep in mind that the provisions and changes outlined below are by no means settled. Changes can (and likely will) still be made as the Senate ratifies the bill; however, the remainder of this article should give readers a good idea of the most significant provisions.

Income Tax Rates are Rising

The increase in the top income tax rate is probably the most talked about proposed change in the bill, bringing it up from 37 percent to 39.6 percent. The top marginal rate would apply to single filers with taxable income over $400,000, heads of household over $425,000 and married filing jointly taxpayers making over $450,000. The impact starts with income earned on Jan. 1, 2022, and after.

Capital Gains

The highest capital gains rate would increase from 20 percent to 25 percent and apply to qualified dividends. The increase is effective on gains made from sales that happen on or after Sept. 13, 2021, but any gains from sales incurred before or that result from binding contracts executed before this date fall under the old rate. For example, gains received post-Sept. 13, 2021, under an installment sale entered on Aug. 31, 2021, would be subject to the old 20 percent rate.

Expansion of the Net Investment Income Tax

The bill also would redefine net investment income (NIIT) to include any income earned in the ordinary course of business. Currently, the 3.8 percent NIIT surcharge applies only to passive income. The NIIT is applied to single taxpayers with more than $400,000 in taxable income and joint filers with over $500,000, and would start Jan. 1, 2022.

New 3 Percent Surcharge on High Income Individuals

Starting after Dec. 31, 2021, a new 3 percent tax will be placed on Adjusted Gross Incomes (AGI) over $5 million ($2.5 million if married filing separately).

Small Business Tax Increases

Under the bill, the current 21 percent flat corporate (C-Corporation) tax rate would change to a three-tiered system. The structure would tax net income at 18 percent up to $400,000; 21 percent from $401,000 to $5 million; and 26 percent on net income over $5 million.

Other Miscellaneous Changes

As you can imagine in an 881-page bill, there are only so many changes that can be covered in this article, but here is a smattering of miscellaneous provisions.

  • Crypto currencies would become subject to the constructive and wash sale rules (like most marketable securities such as stocks) starting Jan. 1, 2022. This means that if you are holding a position at a loss, you have until the end of 2021 to harvest the loss and immediately buy back in.
  • IRAs will no longer be allowed to invest in an entity where the IRA owner has a 10 percent or greater ownership interest (down from the current 50 percent threshold) or if the IRA owner is an officer of the entity.
  • $80 million is earmarked for the IRS to step up enforcement and audit more taxpayers.
  • Smokers will feel the pain as the bill also doubles the excise taxes on cigarettes, small cigars and roll-your-own tobacco.

Conclusion

Remember that this is only the House version of the bill, and nothing is final. Also remember that Democrats control the House, and the Senate is split 50/50 with the Democratic VP as the tiebreaker. As a result, while there will be changes, the major provisions outlined above will likely be in the final law in some form or another.