At the end of March, the Biden Administration released its 2023 fiscal year budget, known as the “Green Book.” While there are few public details on these provisions and it is uncertain if any will be enacted, we wanted to discuss the most significant changes that could impact taxes paid by the U.S. agriculture industry.
New Transfer Tax
One of the biggest discussions in the agriculture industry that started last year with the release of the 2022 budget is the establishment of a new “transfer tax.” The proposed tax would be triggered on unrealized gains that exist in property held at death. It would also treat a gift of property as a realization event. A summary of the key items in the new transfer tax follows: (Note: this transfer tax is entirely separate from the existing estate tax regime.)
- The transfer tax is effective for deaths and gifts occurring after December 31, 2022.
- Unrealized gains at death or as of the date of gift are taxed at capital gains rates. This would seem to include all property, such as gains on farm equipment.
- The transfer tax would tax unrealized gains that present in assets. In contrast, the existing estate tax assesses a tax when the net worth of a taxpayer exceeds a certain limit. Therefore, mortgages on property would not serve to reduce this transfer tax, while they would reduce any estate tax owed.
- Transfers to a spouse at death would be excluded. As a result, there is no step-up in basis on property owned by the first spouse to pass.
- Transfers to charities at death are exempt under the existing estate tax regime. The use of charitable remainder trusts appear to be curtailed.
- The transfer tax at death is allowed as a deduction in determining the estate tax.
- There is a $5 million per person gain exemption on the transfer tax.
- Any unused exemption from the first spouse that passes is portable to the surviving spouse. Therefore, a married couple would have a $10 million exclusion.
- Step-up in basis on death is preserved, but it comes at a cost of incurring the transfer tax. In other words, basis in property received at death is still equal to fair market value.
- Gifts of property continue to follow the carryover basis rules unless a transfer tax is paid.
- Example A: land worth $7 million with a basis of $750,000 would receive a basis of $2 million upon gift. The fair market value of the property less the $5 million exemption. The transfer tax would be paid on $1.25 million of gain ($6.25 million gain less $5 million exemption). Essentially, the new basis is the old carryover basis of $750,000 plus $1.25 million of gain incurred under the transfer tax system.
- Example B: land worth $7 million with a basis of $2 million would receive a basis of $2 million upon gift. In this case, the $5 million exemption is used to shield the transfer tax, and since no transfer tax was incurred, there is no change to the basis in the property received by gift.
- A 15-year payment plan is allowed for the transfer tax paid after death, excluding liquid assets, such as publicly traded stock.
- Notably, this 15-year payment plan does not appear to be for transfers by gift.
- For family-owned farms and businesses, the payment of tax is deferred until the business is sold or it ceases to be family-owned and operated.
- More details are needed to determine what constitutes “family.” There is some existing estate tax law (specifically Section 2032A), which allows for a reduced estate tax value if a farm continues to be “family-owned and operated,” but after 10 years, that restriction expires. It is not clear how long of a period would be specified under the transfer tax. This certainly creates some complexity and harsh consequences if the rules are not followed. Guidance will be critical here.
- Valuation rules will be significant, as under the estate tax, this new transfer tax assesses a tax outside of a true liquidation event, which generates cash proceeds in the marketplace.
- Partial interest discounts will not be allowed, except for assets used in the active conduct of a trade or business. This is a change from existing estate and gift tax valuation rules. This presumably means discounts for lack of control and lack of marketability will not be allowed for passive investments. Therefore, for decedents who own a partial interest in a passive business at death, the transfer tax will be based on full pro-rata value of the business.
This new transfer tax adds increased emphasis on determining the tax basis in property held. While depreciation schedules are kept up-to-date for depreciable items, such as tractors and grain bins, farmland may not be shown on the depreciation schedule, as raw land is not depreciable. Make the effort now to determine the basis in your real estate − including whether purchased, inherited or received as a gift. As a reminder, property that was inherited likely received a step-up in basis in the past, so you need to know the value at the date it was inherited. In contrast, if property was gifted to you, the carryover basis from the donor is your tax basis. This may be difficult to determine, so it is important you address this now.
Income and Related Tax Changes
The Biden Administration’s proposal includes increasing the C Corporation tax rate to 28% (currently a flat 21%), effective for tax years beginning after December 31, 2022. Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, the first $50,000 of taxable income was taxed at 15%, and the next $25,000 was taxed at 25%. This equates to an 18% rate on the first $75,000 of taxable income. A 28% rate, therefore, would be a significant increase (over 50%) on the taxes that were in effect for smaller corporations before 2018, and a 33% increase for all corporations after 2017.
The current Administration also looks to increase the top individual tax rate from 37% to 39.6% for the 2023 tax year. A threshold of $450,000 (married filing joint taxpayers) would trigger the top rate for 2023. For 2022, the top rate of 37% applies to taxable income of $647,850. Remember, the TCJA tax brackets and tax rates are otherwise set to expire for the 2026 tax year if Congress does not act.
The preferential rate for long-term capital gains is eliminated under the proposed legislation for taxpayers with more than $1 million of taxable income. This means that long-term (assets held over one year) capital gains are taxed at 39.6%. Therefore, if taxable income was $1.1 million, with $700,000 being capital gains, $100,000 is taxed at the top rate of 39.6%. This rate would also apply to qualified dividends, such as those being paid from a C Corporation.
The net investment income tax currently applies to passive income over $250,000 with a rate of 3.8%. The proposal would not change the $250,000 threshold but would instead add an additional threshold to ensure that all income over $400,000 is subject to either self-employment tax or the NIIT. This would make income, such as self-rental income, subject to an additional 3.8% rate. The change would take effect in 2023 tax year.
Currently, S Corporation owners that are “active” in the business do not pay any self-employment tax on their share of the pass-through business income. In contrast, partnership owners are subject to such taxes unless other exceptions apply.
The proposal would attempt to equalize the taxation for active owners in both S Corporations and partnerships. Currently, a 12.4% rate applies to the first $142,800 of wages or self-employment earnings, and a 2.9% Medicare rate applies on top of that. The Affordable Care Act then placed another .9% Medicare tax rate on earnings over $250,000 for married taxpayers. This meant that a 3.8% tax (2.9% plus .9%) applied to wages and self-employment earnings, similar to the 3.8% NIIT.
Example: S Corporation wages being paid to 100% owner of $150,000. Net business income from S Corporation is $600,000. $350,000 ($150,000 + $600,000 – $400,000 threshold) of the business income is subject to the 3.8% tax. This would likely eliminate the need to determine “reasonable compensation” of an S Corporation owner. Note that for S Corporation owners not currently paying themselves at least $147,000 in wages, the rate would be higher than 3.8%.
The ability to defer gains when trading real estate, under this tax proposal, is limited to $500,000 of gains per person, or $1 million of gains for married taxpayers. This applies to trades completed after 2022. Therefore, it appears if the original property was “sold” in 2022 and a new property was not replaced until 2023, the limitation would be in effect. The $500,000 per person exclusion amount is per year, not a one-time situation. It is unclear how these rules would apply to entities, such as partnerships, that want to initiate like-kind exchanges.
For taxpayers with real estate sales that are unable or not interested in a like-kind exchange, the tax law affords some lower tax rates on these sales. Traditionally, for non-corporation taxpayers, depreciation on real estate using the straight-line method is “recaptured” at a maximum tax rate of 25%. This is considered an “unrecaptured Section 1250 gain.” The proposal would eliminate the maximum rate of 25% provision for taxpayers with adjusted gross income in excess of $400,000 (joint and single taxpayers). This would mean that such depreciation recapture could be taxed at the maximum ordinary income tax rate (39.6% under the new proposal). This amounts to nearly a 60% increase in the current 25% rate.
While it’s not yet clear what may or may not pass in Congress, agribusiness leaders can begin to prepare now for potential tax changes. It’s important to evaluate your current tax burden and determine how changes might impact that. To talk to our team of tax professionals with deep experience serving the agriculture industry, please contact us.