Earlier this month, the Treasury Department published its explanation of President Biden’s proposed fiscal 2024 budget. We have summarized the tax rate increases, as well as the executive compensation and employee benefits proposals below. These proposals, which are similar to the ones contained in President Biden’s last few budgets, are unlikely to be passed in their current form, especially now given that the House of Representatives is controlled by the GOP. However, we expect that there will be lots of negotiating over the fiscal 2024 budget, so one or more of these proposals may find their way into the final budget. We will publish updates as these proposals evolve.
Individual Tax Rate Increases
Currently, the top marginal individual income tax rate is 37% until after December 31, 2025, when the top marginal tax rate will be increased to 39.6%. For taxable years beginning after December 31, 2022, and before January 1, 2024, the top marginal tax rate applies to taxable income over $693,750 for married individuals filing a joint return and surviving spouses, $578,125 for unmarried individuals (other than surviving spouses), $578,100 for head of household filers, and $346,875 for married individuals filing a separate return.
President Biden has proposed increasing the top marginal tax rate to 39.6%, effective after December 31, 2022 and apply it to taxable income over $450,000 for married individuals filing a joint return, $400,000 for unmarried individuals (other than surviving spouses), $425,000 for head of household filers, and $225,000 for married individuals filing a separate return.
President Biden has also proposed applying ordinary income tax rates to the capital gains and qualified dividends of taxpayers with taxable income of more than $1.0 million. This proposal would be effective for gains required to be recognized and dividends received after the date of enactment.
Finally, President Biden has also proposed a so-called “billionaires tax” of 25% on the total income, included unrealized capital gains, for all taxpayers whose wealth is greater than $100.0 million. The tax for the initial year would be paid over nine years, and over five years for subsequent years. The tax would be treated as a prepayment of taxes for when the unrealized capital gains were realized. This proposal would be effective for taxable years beginning after December 31, 2023.
Carried Interest Taxed as Ordinary Income
President Biden has also proposed taxing carried interest at ordinary income rates for those that make more than $400,000. This proposal is presumably designed to cover situations where capital gains rates don’t actually increase (because of negotiations with Congress), or if they do increase and then are decreased in the future.
Accordingly, regardless of the actual capital gains tax rates, carried interests would be taxed at ordinary income rates if (1) the income is generated by a so-called “High-Taxed Interest” and (2) the investment professional’s income (from all sources) exceeds $400,000. A High Tax Interest is generally any interest in an investment vehicle where a person provides services to that investment vehicle. An investment vehicle is any entity where substantially all of its assets are investment-type assets and more than 50% of the entity’s invested capital is from third-party investors. Capital invested by investment professionals are not generally subject to this provision if certain conditions are met. However, investment professionals would also now be subject to self-employment taxes on the income generated, so at least an additional 2.9% will be paid to the U.S. Treasury. Also, anti-abuse rules are to be included in the provision when finalized.
The three-year extended capital gains holding period that is currently in effect for carried interests would not apply to those investment professionals subject to this new provision. However, for those investment professionals whose income is less than or equal to $400,000, the three-year extended holding period would continue to apply.
President Biden intends to work with Congress to ensure that the sale of goodwill and other assets are not picked up when the High-Taxed Interest is sold, so that only gains from the investment professional’s services are taxed at the higher rate.
President Biden also wants to reform how the net investment income and self-employment taxes apply to individuals that are active in a business that is conducted through a partnership (or LLC) or S-corp. Currently, these rules apply differently depending on the legal form of the entity, with S-corps generally receiving the most favorable treatment. The proposal would remove this preference (as well as lesser preferences for limited partners and LLC members) and will apply to taxable years beginning after December 31, 2022.
IRA and Other Retirement Account Changes
President Biden proposed several changes to the rules applicable to individual retirement accounts (“IRAs”) and certain other retirement accounts.
Required Minimum Distributions. Individuals are not currently required to take a distribution from their retirement accounts (defined below) as a result of their vested account balances meeting or exceeding a particular threshold. Under currently law, taxpayers are generally only required to begin receiving distributions from their retirement accounts (other than their Roth accounts, if any) when they become a certain age.
President Biden’s proposal would impose additional distribution requirements on certain high-income taxpayers – i.e., those with gross income of more than $400,000 ($425,000 for head of household and $450,000 for joint filers). More specifically, the additional distribution requirements would apply to high-income taxpayers who have an aggregate vested account balance in their “tax-favored retirement arrangements” that exceeds $10.0 million. For purposes of the foregoing, “tax-favored retirement arrangements” include (i) 401(a), 403(a) and 403(b) plans; (ii) 457(b) plans; and (iii) IRAs (collectively referred to herein as “retirement accounts”). Under the proposal, the following distribution requirements would apply to high-income taxpayers:
- For aggregate balances exceeding $10.0 million: 50% of the excess held in the vested retirement accounts; and
- For aggregate balances exceeding $20.0 million: the lesser of (i) the excess over $20.0 million; and (ii) the portion of the individual’s vested retirement account balance held in a Roth IRA or designated Roth account.
Failure to make the foregoing distributions would result in a 25% excise tax (10% if corrected) on the portion of the distribution not taken. Subject to certain limitations, taxpayers may generally choose which of their retirement accounts will make the required distributions. However, distributions from certain retirement accounts may result in additional withholding taxes. Under the proposal, the foregoing distribution requirements would become effective for tax years beginning after December 31, 2023.
Enhanced Reporting for Administrators. The proposal contemplates enhanced reporting requirements for administrators of certain retirement accounts. Administrators of retirement accounts are not currently required to report retirement account balances to the IRS. The proposal would require administrators to report any vested retirement account balances exceeding $2.5 million. This reporting requirement would be effective for plan years beginning after December 31, 2023.
Limitations on Rollovers and Conversions. President Biden’s proposal would prohibit high-income taxpayers (same definition as above) from rolling over, converting or transferring amounts held in non-Roth IRAs to Roth IRAs. This prohibition would be effective for taxable years beginning after December 31, 2023. The proposal would also prohibit taxpayers from rolling over a distribution from an employer’s 401(k) plan into a Roth IRA, unless the distribution was from a designated Roth account within the 401(k) plan. This prohibition would be effective for distributions made after December 31, 2023.
Clarification Regarding the Status of IRA Owner as a Disqualified Person. The proposal clarifies that an IRA owner is always a “disqualified person” for purposes of the “prohibited transaction” rules under Section 4975 of the Code.
IRA Ownership of DISCs and FSCs. The proposal would also prohibit an IRA from owning any interest in domestic international sales corporations (“DISCs”) and/or foreign sales corporation (“FSCs”) that receives any payments from entities owned by such IRA’s owner. A violation of the foregoing prohibition would result in disqualification of the IRA (i.e., the IRA would be deemed to have distributed its assets as of the first day of the taxable year). This prohibition would be effective for DISCs and FSCs acquired or held after December 31, 2023.
Extend statute of limitations for IRAs. The proposal would extend the statute of limitations for asset valuations and prohibited transactions from three to six years and would be effective for taxes for which the three-year window would end after December 31, 2023.
Accelerate Changes to Lost Deduction For Compensation Paid by Public Companies in Excess of $1.0 Million (Section 162(m))
Section 162(m) of the Internal Revenue Code generally disallows a deduction for compensation paid by public companies in excess of $1 million to certain employees — CEO, CFO, and the three next highest-paid non-employees. President Biden’s proposal would accelerate – from December 31, 2026 to December 31, 2023 — the effective date for the expanded coverage so that the next five (as opposed to three) highest-paid employees would be subject to the rule.
Moreover, the proposal would include an entity aggregation rule, which would treat all members of a controlled group as a single employer, so that it would now be clear who is covered and that any compensation paid by a partnership affiliated with the public company would be subject to the rule, for example. The proposal also expands the regulatory authority of the Department of the Treasury to issue anti-abuse rules.
The proposal would be effective for taxable years beginning after December 31, 2023.
Clarification of Withholding Liability When an Employer Hires A “Professional Service Organization” (or “PEO”) for its Employees
Generally, an employer is liable for withholding the income and employment taxes from the wages paid to its employees. However, where a PEO is hired to outsource the HR and benefits functions of the employer, and the employer is not the one making the payments, the PEO is often responsible for withholding and remitting these taxes to the Treasury Department and the IRS.
Under current law, it is unclear whether the employer remains ultimately responsible if the employer and the PEO agree that the PEO is liable if the PEO fails to withhold and remit the taxes. In some cases, employers have also been aggressive and claimed tax credits where the obligation to withhold and remit had been shifted to the PEO.
President Biden’s proposal would make clear that the employer cannot avoid liability just because a PEO is engaged and otherwise agrees to pay wages to employees. This proposal would be effective after December 31, 2023, and President Biden’s proposal makes clear companies that have existing agreements with PEOs should not expect to avoid liability even where those agreements shift responsibility for withholding and remitting to the PEO.
Withholding of Excise Taxes on Failed Non-Qualified Deferred Compensation
Ever since the non-qualified deferred compensation rules (Section 409A) were enacted in 2004, there has not been any requirement for an employer to withhold Section 409A’s additional 20% excise tax when an employee’s deferred compensation fails to meet these rules. Employers have been required to collect regular income and employment taxes on the deferred compensation that fails to meet these rules, but nothing more.
As a result, because the employer has no obligation to withhold for these taxes and because identification of these failures is frequently discovered when the IRS audits an employer, the only way for the IRS to receive these taxes would be for it to start an audit of the employee who had the failure. This is costly and time-consuming for the IRS.
To alleviate this burden, President Biden has proposed that employers now start collecting the additional 20% excise tax when an employee’s deferred compensation fails to meet Section 409A. This proposal would be effective after December 31, 2023.
Proposed Changes To Benefits Taxation
Clarify Tax Treatment of Fixed Indemnity Health Policies
Fixed indemnity health policies pay a specified amount of cash to employees upon certain health-related events, such as hospitalization or the diagnosis of a particular disease. Under these policies, the amount paid is not based on the amount of any medical expense incurred, nor are payments coordinated with other health care coverage. Employers that offer this coverage often claim a deduction for the full cost of the fixed indemnity coverage, and do not include the cost of this coverage when calculating an employee’s income or employment taxes, even though the only amounts excluded are limited to an employee’s actual medical expenses. This can lead to an underpayment of taxes.
President Biden has proposed to clarify that the exclusion from an employee’s gross income for payments received under a fixed indemnity health policy only applies to the amounts paid for a specific medical expense, and that all other amounts are subject to income and employment taxes. Amounts paid with an employee’s after-tax dollars would not be subject to the rule. The proposal would be effective for taxable years beginning after December 31, 2023.
Funding for Post-Retirement Medical and Life Insurance Benefits
Currently, an employer is allowed to deduct contributions to a welfare fund for the benefit of its employees, as long as the contribution does not exceed a specified limit. One exception to this limit allows an employer to make additional deductible contributions to fund post-retirement medical and life insurance benefits. Because of this exception, companies can pre-funded the entire liability, claim a deduction, reduce or eliminate the post-retirement medical or life insurance benefits, and then use those funds to provide benefits to current employees.
President Biden seeks to eliminate the potential for this abuse by requiring post-retirement benefits be funded over the longer of (a) the working lives of the covered employees on a level basis and (b) 10 years, unless the employer commits to maintain those benefits over a period of at least 10 years. The proposal would be effective for taxable years beginning after December 31, 2023.
Tax Treatment of On-Demand Pay Arrangements
On-demand pay arrangements allow employees to receive their wages as earned instead of waiting until the next payroll date. Because these arrangements can invoke the “constructive receipt” doctrine — which provides that wages are considered paid to the employee once made available to the employee, regardless whether the employee actually chooses to take the funds – employers offering these arrangement are technically required to withhold income and employment taxes on a daily basis.
Because of the administrative burden, President Biden has proposed that these arrangements be deemed to have a weekly payroll period, even if employees have access to their wages during the applicable week. In addition, special payroll deposit rules would be established and the Internal Revenue Code would be clarified so that these arrangements would not be treated as loans.