On-Demand: Navigating Taxes--Putting You in the Driver’s Seat
June 07, 2021
This webinar provided an overview of the recent tax proposals presented by the Biden Administration and how these proposals are being received in Congress.
A lot of the proposals involved funding the IRS more significantly than it's been done in the past, so what can be expected or anticipated with ample resources. Some discussion around the choice of entity in light of tax reform and tax law changes.
We'll talk about some of the SALT cap workarounds that are important part of tax planning in the current environment, as well as just some general individual tax planning strategies that people should consider. For the tax proposals, the Biden administration has released the Green Book, which is a detailed outline of all the revenue proposals that are being put forward. This came out a few weeks ago and it's interesting because in the last administration, they stopped publishing this Green Book, so there wasn't the visibility from the administration on the details and the proposals that was sort of more high level in the last administration. In this administration were getting very detailed proposals that allows us to do more granular planning.
At the headline, the top individual rates, ordinary rates right now are 37% of current law and the proposal is to take it up to 39.6. Long-term capital gain and dividend preferential rate of currently is 20%. The proposal is basically take away the preferential rate for incomes above a $1 million. What's got a lot of attention recently is that in the Biden administration proposal the effective date is actually as of the date, the proposals were submitted, which was back in April/May. If that proposal were to come into law this, these higher capital gains are already in place and there's some of the planning work that we're talking about. It's already happened and so it's made a major concern. Many analysts are saying that this has probably been negotiating for the administration and the ultimate tax law is written by Congress, not by the administration, so it's just part of the whole strands going on.
But it is important to note that it is a proposal that's out there and this is serious. Also the taxing of carriage interests or profits interests at ordinary rates has been in a proposal for many years, that continues to be out there as a revenue raiser. Repealing-like-kind of exchanged deferrals for people with income greater than 500,000 which is a major concern, especially in the real estate industry, as well as oil and gas. A permanent repeal of excess business losses, so under pre Trump tax cuts there was under the TCJA they imposed a $500,000 cap on the amount of loss that was deductible by a flow-through entity. Under the CARES Act last year that cap was suspended and for the next year, and then it comes back and then it sunsets. There's a lot of back and forth. The Biden administration has a proposal for permanently putting in place that $500,000 limit.
Another interesting provision in there is for S Corporations to remove the self-employment tax workaround, so we'll go into that a little bit more detail. There's a lot of green energy tax credits incentives in the rules and in the laws being proposed by the Biden administration. Some of these just a little bit more detailed of the various proposals, so like within the administration to the Biden administration proposals, it's made up of, The Made in America Tax Plan, The Jobs Plan, which is the infrastructure spending and then the American Families Plan, which is for services for low-income taxpayers, and healthcare for seniors, disabled and low income folks. It's a social services plan.
That's from the administration, on the Congressional side, there's a few proposals out there. There's a Senator Bernie Sanders has the 99.5 Percent Act which as you might imagine, is a state tax. In fact, increase in the state tax a reduction of various deductions or strategies that are currently allowed. There's the Ultra-Millionaire Tax, this is the wealth tax taxing the wealth of folks who have above $5 billion of wealth at a 2 or 3% rate which still doesn't exist in our current tax law. It may or may not be constitutional. Then the Sensible Taxation Equity Promotion, the STEP Act. This is a provision which would eliminate the step-up in basis on the passing of someone. That's another proposal floating around right now in the Senate.
The key members in Congress who are influential in this process so in the Senate, the Senate Finance Committee is in charge of tax policy and Senator Ron Wyden of Oregon is the chair of the tax finance committee. He's been in the Senate for many years is a progressive and is no stranger to tax policy matters. The House Ways and Means Chair, Richard Neal from Massachusetts. Again, another seasoned veteran in D.C., so those two are very influential. But a lot of the attention right now is focused on the Senate, which is split 50/50 between Republicans and Democrats with the vice-president Harris would be the tie breaker for the Democrats. The Democrats have effective control of the Senate, but that means in order to pass anything, they need to have all 50 senators on board.
A couple of the moderate Senate Democrats have made it clear that they're not necessarily going to move in step with the party as a whole. Joe Manchin of West Virginia is the highest profile right now in terms of being a very, very moderate member on the Democrat side and he's using his leverage as a moderate and someone who's looking for consensus and bipartisanship with Republicans, which has given a lot of fits to the more progressive side of the party. John Tester from Montana is another moderate Senator. It was just an article on him this morning and the Wall Street journal for him basically increasing his profile. Angus King of Maine is another independent, but caucuses with the Democrats. One person I didn't put on there is Krysten Sinema of Arizona.
Effectively in order to move through any tax increase for the Democrats are going to have all 50 senators on board and each one of these senators is to join, which is no small feat. Any one of these senators can derail or put it in their provisions and that not just the moderate senators too, the more progressive senators, Bernie Sanders, Elizabeth Warren could get in the way if they don't feel it's going far enough in terms of tax increases. It's interesting point right now, and it'll be important to kind of see as this unfolds the role that these individuals play in the negotiating process.
At a higher level on the business side some of the proposed tax changes being discussed, the corporate tax rate is 21%. There's negotiating going around to what that will be. Minimum tax on book earnings of foreign corporations or multinationals. Over the weekend, there was actually a meeting of the G7 and there was a pretty significant breakthrough or consensus among the G7 led by Janet Yellen from the U.S. to agree to a global rate of 15% for a minimum tax rate, really targeted at large technology companies, the Googles, the Facebooks, et cetera. The G7 is kind of agreed to those terms, but that's ultimately to put that into law is a heavy lift because this actually have a form of a tax treaty, which requires two thirds Senate majority to approve, which is that's probably a long way off, but it is interesting that if the G7 nations are agreeing to sort of a minimum corporate tax rate, that was something that hasn't been agreed to before, at least amongst the G7. Again, things are evolving in real time.
The Section 199A flow-through deduction for high-income taxpayers, that was a provision that came out of the tax reduction in the Trump era, so as some of those deductions and incentives for the job creators are being looked at again, this 199A deduction is being looked at again. The TCJA, so that's the Tax Cuts and Job Act, that's the Trump tax cuts. There are various whole law basically sunsets in 2026, so that's not too far away. Those sunset moving some of those dates around impacts the Congressional scoring process. Bonus depreciation, accelerated appreciation for expensing is something that's being considered. S-Corp earnings and the self-employment tax, historically S Corporations flow-through profits were not subject to self-employment tax. Only the wages paid to the employees, including owner employees were subject to self-employment tax, like a tax on the wages. There are proposals to tax all S-Corp earnings fully with the 3.8 Medicare tax.
Then investment income tax, the same type of tax on investment income for high income earners. Like we talked about before the 1031 like-kind exchanges are being discussed. Repeal of foreign deductions, FDII and BEAT are cross border incentives and various estate and gift tax increases.
Chris Colyer:It's interesting with the proposed corporate rates, initially the Biden administration was proposing something higher, like going from 21 to 28, but it was part of the infrastructure bill. However, the infrastructure bill, like we just start off as a $2.2 trillion request. The Biden administration has paired that down to try and make it bipartisan, trying to get Republican support down to 1 trillion. The Republicans are like around 926 million. If corporate tax reform is tied to the tax rate and tied to the infrastructure spending as an infrastructure bill reduces, the pressure to increase corporate rates to fund that are also reducing. Who knows where we'll end up, but it's all sort of tied together.
All right. Very good. The majority of the audience is correct. It's 21% of the current rate and potentially it'd be something higher next year if Biden the administration gets its way. All right. I'll pass it over to Ben to talk to some of the individual tax provisions. Ben.
Ben Aspir:Thanks, Chris. As Chris mentioned, there's about a half a dozen proposals floating on Congress, all with various creative names. On the individual tax side, what are some of the potential changes? Like Chris said the individual tax rate they're proposing potentially for incomes over $400,000 to increase the top tax rate from 37% to 39%, 39.6%. As Chris mentioned the excess business loss limitation, which came into effect starting in 2018 and then was actually suspended due to COVID through 2020, which denies non-corporate taxpayers excess business losses of $500,000, so there's proposal out there to make the excess business loss limitation permanent. The other really major proposal is essentially almost doubling the top capital gains and qualified dividends rates, which are the top capital gain and qualified dividends rate is now 20%.
Some of the proposals want to increase that rate to 39.6% at the top rate. The gift/estate, and tax exemption/rates, that's obviously one of the most talked about areas. Currently, it's $11.7 million exemption. Some of the proposals out there want to decrease the exemption down to $1 million and we'll talk about some tax planning that could be done at the end of our session today to potentially take the benefit of the current environment for potential changes. Basic step-up upon death, currently investments held at death on are not subject to capital gains rates. One of the proposals would subject any appreciation at the time of death subject to capital gains rates. Carried interests, which now currently the law is, interest is held for three years. It can potentially get capital gains rates. Some of the proposals want to convert that get rid of the capital gain preference and tax at the top ordinary tax rates.
The Ultra-Wealth Tax, which Chris said may not even be constitutional, but Senator Warren and Senator Sanders had proposed this, so basically households in the states with net worth of 50 million to $1 billion would be taxed at 2%, and then households or estates above $1 billion would be taxed at 3% which it would be pretty hard to envision this passing. How would you implement it, is it constitutional? Obviously today's session is just to make our participants aware of some of the proposals that are out there. These are just starting points for negotiation in Congress, and a lot of what's going to change. Then lastly the child tax credit, President Biden has proposed extending it another four years through 2025. It was significantly expanded through 2021, so the Biden administration would like to expand the child tax credit significantly again through 2024.
As far as capital gains, like Chris mentioned that there is a potential that they would like to make the increased capital gains rates retroactive. But I would be surprised if that happened if they do get increased. We'll turn it over to Miri now to about IRS funding and enforcement.
Miri Forster:Thanks so much, Ben. The Biden tax plan emphasizes the importance of multi-year funding so that the IRS can be more successful with moving forward with its initiatives. From 2010 to 2019 the agency was hit really hard. The budget decreased by 20% in those years, and there was also a drop in resources primarily because of the aging workforce and the lack of funds to replace them. Employees actually decreased in that 10 years from 94,000 to 73,000. As a result, there were less IRS exams, there was less money available to train on the new tax laws, here were limited IT enhancements, etcetera. For Fiscals year 2020 to 2021, Congress did approve small budget increases for the agency and Biden wants to build on that. He's proposing more than $13 billion of IRS funding for fiscal year 2022 and that's approximately a 10% increase from the funding that's been enacted for 2021 and nearly 80 billion in funding for the next 10 years.
The funding, if passed, is anticipated to support four areas. First taxpayer services, the IRS simply doesn't have enough customer service representatives to answer the phones, to deal with correspondence sent in by taxpayers, or to even finish processing 2019 paper filed returns where refunds are still due. As an aside, if you're waiting, the IRS is still working on 2019 returns that were filed in the summer and fall of 2020. Certainly funding is critical for taxpayer services to help taxpayers understand their tax obligations so that they can address issues on a timely basis, and to keep the cases from moving forward to collections unnecessarily.
Second, the funding would be used to increase IRS enforcement, so IRS examinations. According to the proposal, the focus would be on high income tax payers with incomes greater than 400,000 a year, and also on corporations. The reason for these two types of taxpayers is that research has shown that that's where there is significant non-compliance. The enforcement funding would also be used to combat identity theft and better address offshore tax evasion, for example with respect to cryptocurrency transactions. We'll talk a little bit more about IRS exam activity shortly.
Third, the funding would be used for operations support and forth, it would be used to modernize the IRS's business systems so that it can accept more electronically filed returns and analyze the data better. Right now a lot of times they pick up taxpayers for examination and those taxpayers are compliant and the examinations end as a no change. If the IRS improves its electronic capabilities, it should be more productive and better focused on those taxpayers that really are non-compliant.
Along with the funding, the Biden administration believes that expanded information reporting is critical to reducing the tax gap. The tax gap is the difference between what should be paid to the IRS and the amount that is actually paid. There've been a lot of estimates about this recently. IRS Commissioner Rettig estimated the tax gap at over $1 trillion.
Now, the current information reporting regime only covers certain types of income, for example, your interest, your dividends, your wages, your pensions. Research has shown that about 5% or less of income that's subject to information reporting is unreported. So most income subject to information reporting the IRS hears about. But approximately 55% of the income that's not subject to information reporting, just never gets sent over to the IRS.
The administration is proposing a comprehensive financial account information reporting regime starting in 2023. What does that mean? That regime would expand information reporting to include all inflows and outflows of a financial account. So for example, it would give the IRS more visibility into gross receipts and deductible expenses. The new reporting regime would apply to all business and all personal accounts held with a financial institution, so your bank accounts, your loans, your investment accounts with some exceptions, if you're below a de minimis threshold. The reporting that the financial institutions and others would have to provide is a breakdown of physical cash that's paid or withdrawn, they'd have to provide information on transactions with foreign accounts, as well as transfers to and from another account with the same owner.
The same expanded information reporting rules are going to apply to payments settlement entities like your credit card companies, and it's also going to extend to crypto asset exchanges and custodians. Since we are talking about crypto, the administration is very concerned that U.S. taxpayers are hiding assets and taxable income abroad, with offshore crypto exchanges and wallet providers. The new provision would require brokers of entities that hold crypto asset to provide information on their foreign owners as well.
There's a lot of other parts to the proposal that are on the slides, but another one that I want to highlight before we move on, positively impacts partnerships and their investors. The proposal addresses an existing problem with the centralized partnership audit regime or what we refer to as the BBA. The problem is called the stranded overpayment problem.
Now, by now you probably know under the regime amended K1s have been eliminated and that a partnership that wants to correct a previously filed return does so by filing an Administrative Adjustment Request or an ARR. Very generally speaking, if a partnership corrects a 2019 return today, and they are increasing a deduction on that 2019 return, the partnership would file a 2019 ARR and that adjustment would be reflected on the partners 2021 return. It's sort of similar to a true-up and there's no need for the partner to file an amended return for 2019.
The problem is that under the current language in the regulations, the amount of the refund that a partner is permitted for 2021 is limited to the amount of tax that partner actually paid in 2021. The regime doesn't look to taxes that were overpaid in 2019 or 2020, in our example. If the reduction in income is $100 as a result of the AAR, but you only paid in $75 in taxes in 2021 before the AAR is taken into account, then the partner's going to lose out on a $25 refund, making the partner in a worse position than it would have been had they reported correctly in the first place. Hopefully Congress will change this language in the regulations to address the stranded overpayment problem. The proposed effective date for this is as of the date of enactment.
Miri Forster:I also wonder if the expanded information reporting regime, if it's passed, whether starting these changes in 2023, which seems like a long way off, will iprovide the financial institutions and the others with sufficient time to actually implement these changes and gather all the additional information that is being proposed.
As Chris said at the very beginning; let's talk about how the potential of a fully funded IRS changes the planning landscape over the long-term. We've already seen over the past year, a significant uptick in exam activity, so more funding is just going to continue that trend. With more exams on the horizon, it's critical to document positions, to do it contemporaneously when the transactions are fresh in everyone's mind, and when the teams that are involved in the transactions are still in place, and when the documentation is easy to gather and maintain. Being proactive with documentation is a key strategy for managing risk.
In terms of where the IRS will spend their time and their new dollars if it's passed, the Biden plan emphasizes, like I said before, individual taxpayers with incomes greater than 400,000 and also corporations. But we don't expect it to stop there.
Over the past year, the IRS has had a campaign focused on high-income taxpayers and high wealth taxpayers. High income tax payers are those with income of over $100,000 and the IRS is examining both the individual and at least one related entity, typically a partnership, and for high wealth taxpayers, where the IRS is focused on assets, rather than income, the IRS typically examines the individual taxpayer and up to four related entities. In either case some of those related entities hold crypto assets, and again, crypto is definitely getting heightened scrutiny from the IRS going forward. Some are asset managers, others are real estate. There's a broad range of taxpayers that the IRS has been examining recently.
The IRS is also examining hundreds of limited partnerships that claim their distributive share of income was exempt from self-employment tax. Several of these cases have advanced IRS appeals and some are actually moving towards litigation because the IRS takes the position that limited partners who are active in a business should be subject to self-employment tax on their distributive share. It'll be very interesting to see what happens with the Biden proposal that exempts a limited partner from SECA tax only if the limited partner is not a high income tax payer or doesn't materially participate, and it'll be similarly interesting to see how this fairs for S Corporations. What will it mean for the cases that are existing before the IRS, will a change in the law now mean that all the limited partners were exempt from self-employment tax for prior years. And for S-Corps, will the IRS shift its focus to what is reasonable compensation?
For corporations, the IRS has been prioritizing employment tax compliance, and that makes sense because the service collects over 70% of its revenue from the employment tax area. They're also looking at a number of international tax issues like foreign tax credits, allocations, and the mandatory repatriation tax. If international changes in the Biden plan are approved, we expect that the international focus is just going to increase.
The last thing I want to mention is penalties. Last year, the IRS had said they intended to expand the use of all civil penalties, even those infrequently used in the past and that's exactly what is happening. There are international information return penalties estate and gift tax penalties, excise tax penalties, and the newest wave of notices are for noncompliance with the Affordable CARE Act (ACA) and whether an employee has provided appropriate minimum coverage for its employees. The Employer Shared Responsibility Payments that are being imposed for ACA non-compliance are very steep, so you may be seeing those around the corner at an increased pace as well.
That's it for the IRS update. If you want to know more about current trends, or how to prepare for an exam, or strategize on a notice, please feel free to reach out to any of us or whoever you work with at the firm. Now, I'm going to pass it back over to Ben to talk about choice of entities.
Ben Aspir:Thanks, Miri. I definitely agree with the exploding popularity of a cryptocurrency that the IRS is definitely going to be be a focus area for the revenue service. We talk about all the proposals in Congress, with that, I think it's important to understand the different entity types, the tax entity types, and so we thought it was important to have a choice of entity conversation. Today we'll talk about the three biggest tax entity types, the C Corporation, the S Corporation and the partnership.
What are the pros of a C Corporation? The flat 21% tax rate obviously it's going to be a pro of being a C Corporation, but that may change. Chris mentioned the 28% rate is being floated. But it may end up somewhere in between that. A big hidden benefit of C Corporations that many are not aware of are the Qualified Small Business Stock exclusion under Section 1202. Certain qualified small businesses upon exit upon sale of the C-Corp shares are held for more than five years can potentially exclude $10 million or 10 times or basis. I counter many people that are not aware of this benefit upon exit. If tax rates do increase and this 1202 exclusion, the QSBS Section 1202 exclusion would be even more beneficial if you have a tax free gain at the federal level.
Someone actually had asked in the Q&A if the administration has proposed any changes to 1202 and take the bite out of it. I'm not aware of anything and it hasn't been floated that I'm aware of. It looks like, at least for now section 1202 is safe. The lack of flow-through treatment, so there's no K1s like a partnership or an S-corporation. If you have hundreds of thousands of partners or shareholders, there's less compliance and that end there's a lot of flexibility and ownership structure. Unlike S-corporation, which we'll talk about, which are very rigid, C Corporations are extremely flexible in the structure and the type of owners that are not allowed.
What are some of the downsides of being a C Corporation? Well, the most commonly discussed one is double taxation. C Corporations pay an entity tax at 21%. Then what they mean by double taxation is when if any dividends are distributed to the shareholders, the shareholders then pay the dividends tax on those cash dividends received. If dividends rates go up that would obviously significantly affect investors that are shareholders that received dividends, there's also accumulate earnings or personal holding company tax that is only on C Corporations. Another con of being a C Corporation they do not get benefit of this 20% qualified business deduction, which is also known as 199A.
Lastly, another con of being a C Corporation is that if there's a loss in corporation the losses do not pass through to the shareholders. They there "Stuck," in the entity until they're the corporation generates earnings, whereas on a partnership and an S-Corp, which we'll talk about the losses flow-through to the shareholders and they could claim those losses on their personal taxes.
One of the potential changes and risks of being a C Corporation, like I mentioned, an increase in the flat 21% rate to potential 28%. It had been significantly higher prior to the passage of the Tax Cuts and Jobs Act in late 2017, which is effective 2018. Again, the risk of a capital gains or dividend rates increases, that would be a major effect on shareholders. Again, the Qualified Small Business Stock exclusion is definitely a hidden benefit and it will only become more valuable if capital gains rates increase. S-Corp-
Chris Colyer:Ben, one thing I would have mentioned too, that I was thinking about was, so if the C-Corp rates go up, the federal rates go up, the C-Corp can deduct state and local taxes without any type of workaround necessarily. If the federal tax rates going up, the value of the state tax deductions against the corporate income becomes more valuable. That's just sort of another factor, a pro-factor and sort of like a corporate rates going up and more taxes, but the deductions become worth more than as well. So the state tax deduction becomes worth more as other rates go up.
Ben Aspir:Right. Good point. Now, S Corporations, S Corporations are almost as professors described them as C corporations pretending to be partnerships. What happened on the S Corporations, the S Corporations do not pay generally tax. I mean, there's some state level entity tax, but they generally do not pay entity tax. The income flows through to its owners, and then the owners pay the tax personally. There's a single layer of taxation, unlike with the C Corporation with the double with taxation.
Chris mentioned the political loophole on S Corporations. Currently S-corporation earnings to owners are not subject to FICA taxes, and Medicare taxes, whereas partnerships, which I'll talk about the earnings subject to self-employment. There has been proposals which I don't think will pass as far as eliminating that loophole that would effectively kill S Corporations because that's really the main advantage S Corporations have now, is that earnings are not subject to self-employment tax because S Corporations are extremely rigid, they're only allowed 100 shareholders, and they have to be individuals or certain types of trust, so an LLC or a Corp cannot be a shareholder in an S Corporation. Distributions have to be pro-rata. You could only have one class of stock, you are allowed voting and non-voting shares.
Unlike a C Corporation where you could have a very complex structure of ownership and if preferences, you can't have that with S Corporation. The risk obviously with the potential tax changes, is it rate increases because the income flows through to its owners, so if the rates go up to 39.6%, that would affect the owners. Again, if they close that loophole onto self-employment tax and add self-employment tax earnings, that would be, I think the death knell of S-Corps. If they reduce the qualified business deduction, that 20% deduction, that could be another potential area that can make S Corporations less favorable. Lastly-
Chris Colyer:Ben, if they tax all S-Corp earnings subject to self-employment tax, I can't imagine a situation where any new business which is choosing this entity would choose S-Corp, because then LLC, if we could give you a partnership, give you the flow-through benefits or C-Corp, so I think if that were to come through, I think the only S-Corps you'd see are legacy corporations or legacy S-Corps that are already formed that way, which are sort of stuck there from a tax point of view. But any new entity it's a cleaner discussion, either C-Corp or partnership.
Ben Aspir:I agree. Another downside to being a Corp and not that I'm against Corps, but if you distribute property out of a C-Corp or an S-Corp, it triggers a gain. Whereas as I'm going to talk about partnerships now, it generally does not trigger games. That's something to be aware of. Partnerships are somewhat similar to S-Corporation, but there's no limit on the types of partners that need to be in it. You can have extremely flexible ownership structure. You could have profit/loss allocations, you could have multiple classes of equity. It's really, one of my colleagues like to explain partnerships that they're like clay, you can mold them however you want, as long as they don't want to fallow of the IRS treasury regulations. The income again passes through to the partners. They pay taxes on their personal taxes. Partnerships are so flexible they also introduce significant complexity, and that's why the partnership regulations is some of the most complicated parts of federal taxation.
Similar risks to S Corporations, individual tax rate increases. Partnership income is generally subject to self-employment tax, whereas S Corporations currently are not, and if they eliminate the carriage or carry the interest, the profits interest, the preferential capital gains taxation on it, that could be a risk to partnerships as well.
Ben Aspir:It was important to point out when you convert from one tax entity to another, it may be a taxable event, so generally when you convert from a C Corporation to let's say a partnership that could be a taxable event, they usually go in the other way. Generally, if you convert from a partnership to a C Corporation it is generally not a taxable event. Same thing if you convert from C to an S-Corp or a partnership to an S-Corp, it's generally not taxable event. An S-Corp has a special election and may have an election at the state as well it varies state by state.
Chris Colyer:At least people who selected that they were sole proprietorship. Well, we will discuss the advice to possibly add another member or partner to your organization for certain state tax benefits on the next topic.
All right. Last year like less, sorry. It's actually two years ago. The IRS came out with surprising ruling. To set the stage back, part of the TCJA, the Trump tax cuts to help fund those cuts there was imposed a $10,000 limitation on state and local income taxes, and the states started getting busy especially in the Northeast and trying to figure out ways to provide a deduction for the residents, constituents for those losses, say local tax deduction. Municipalities were saying, okay, rather than paying us real estate taxes, donate to this charity who in turns will give fund us, others shut that down. Then they've kind of moved on to saying, okay, well, for businesses that are flow-through, if the entity withholds the tax, then they can deduct the tax against the business income and it's not really a state income tax payment by the taxpayer that should work around and get the business owners that deduction.
At the time talking to other colleagues, we all thought, okay, there's no way that's going to happen to us. We can shut that down, and we were all surprised when the IRS during the Trump administration actually approved it through a revenue procedure. New Jersey among other states, Connecticut, and there's a handful of states here on the list, is a longer list than it's on the screen. The states are now adopting, now that the IRS has blessed us, most states are kind of working towards this in the larger states, providing an entity level deduction for the level taxes payable by the partners or shareholders at the entity election.
This is a pretty significant factor and a major deduction and a major reduction in the effective tax rate of businesses, but it requires some fancy footwork. Relies on the state or the individual state to provide for a structure that allows the entity to elect, to pay the shareholders, or partners tax at the entity level. New Jersey as of this past year and kind of get some other states have had it. We've had one for the 2020 tax year. We've taken our clients through that, so it's a major factor. It's been a major boon. Last year there was some uncertainty, like specifically in New Jersey, whether New York resident or non New Jersey residents, New York residents would qualify or get a benefit. As an example based in New Jersey with New Jersey owners it was a no brainer.
It was New Jersey business with owners in other states where it was unclear whether those other states would to give a credit for taxes paid to New Jersey. It was not a no brainer. But as this body of law has been evolving, the states are starting to come more on board and give credit for each other's state tax. This is a significant portion of discussion, a planning discussion for all of our clients around this opportunity to claim this SALT deduction workaround. There's been a significant factor in M&A planning as well, which we'll come to, I think in the next slide. Tax planning opportunities. All right. Ben, if you want to walk them through here.
Ben Aspir:Sure. What can we do now? We know that there's changes on the horizon. Tax rates are only going to go in one direction and we don't know where they're going to land, but they're certainly not going to go down. What can we do now? If a company sells or you sell anything and cash, you see that after year end is considered an installment sale which you're automatically in unless you elect out of it and recognize the entire gain in the year of sale. One potential possibility is if let's say tax changes don't take into effect until 2022. If there is a sale or an exit in 2021 considering potentially electing out of the installment sale and recognizing the entire gain in 2021 to lock in the '21 tax rate before they go up. If potentially capital gains rates double, if you can save 20% and recognize the entire gain in '21, that could be a possibility, it's something that should certainly be evaluated if the company is thinking about exiting.
An interesting one is with S Corporation, an S-corporation, if it was a prior C Corporation and the earnings is in profits and they convert to an S Corporation from a C to an S, the earnings of profits need to be tracked to the extent that an S Corporation still has earnings and profits. There's an election that can be made to basically strip out the earnings and profits and recognize you basically pay dividends rates in the year that you remove all the EMP from the S-Corp. Why would you want to do that? Let's say again, if dividends rates don't increase until 2022, if you can strip out all the E&P from the S Corporation and pay 20% instead of 39.6% in 2021, that should be evaluated for S Corporation with current EMP.
Chris, what have you seen as far as M&A structuring and tax planning and around the potential changes?
Chris Colyer:There's a flurry of activity right now in the M&A world, not lost on business owners that tax rates are going to be going up at some point, hopefully not effective till 1/1/22. That retroactive thing if that comes into law, like it's kind of too late to do anything. But again, like most people think that's unlikely, but it's possible. It's been proposed. The most action is kind of a game change in terms of in general, from a tax point of view, if you're looking to sell your business, you have a choice between structuring as an asset sale or a sale of stock. Typically a sale of stock is a better tax deal for sellers. However, with the new SALT workaround, with the New York PTET and the various other states, that analysis has kind of flipped on its head and it's become not necessarily if you could consider an asset sale, could actually get a better result from a tax point of view for the sellers, which wasn't typically the case in the past before this rule changed.
That structure, there's a lot of activity in the M&A field. There's a lot of evolving rules around the state workaround. New York just put those out like a month ago, that was one of the statute. There's still guidance to become, but there's deals being done now and anticipating these structures being available. It's added a significant potential boon to sellers and it's significantly complicated that the tax structuring, so it's kept us very busy working with the M&A attorneys to structure these deals. That's been a lot of time the last few weeks, it's been an exciting time to be a tax planner for sure.
Ben Aspir:It's very interesting. Moving on to entity conversion. If S Corporation earnings are subject to a self-employment tax, S Corporations may want to consider, and obviously we would have to do a full analysis of maybe terminating their S election becoming C Corporation, or depending on where rates land, it may be worth it to convert from one entity type to another, but obviously consult tax professional to determine if there's tax effects from that actual conversion. As far as just estate and gifting, obviously that's the hot topic conversation accelerating gifting before year end, seeing how much of your exemption you have used prior to any potential changes. Roth conversions, if tax rates are going to be going up, potentially considering converting pre-tax IRAs, converting them to Roth IRAs, obviously that's a taxable event, but you get the benefit of current tax rates, or maybe only partially converting just to up to a certain tax bracket. That should be something that should be evaluated.
Like Chris spoke about the SALT deduction, some of them are mandatory, some of them are elective. That could be a key area to plan around. It is interesting that with all these proposals, I mean, I don't know if you've seen anything, Chris, of anyone talk about repealing the SALT cap.
Chris Colyer:That's certainly been mentioned in late. I mean, Chuck Schumer, Head of the Senate, Majority Leader, Nancy Pelosi, that's New York and California, they've been advocates for it. However, it hasn't really come up. It's certainly not in the Biden administration proposal, and in terms of what gets worked out in the Senate. If you go back to this slide, we don't have to go back to it, but the senators who are kind of controlling this are in West Virginia, in Montana, in Maine, we don't really care about the SALT limitation. Ultimately, I think the balance of power shifts to the Democrat senators in more rural states. I'm not sure the SALT cap, either it gets eliminated or increased. Maybe it does. You never know. But based on the wave of the land right now, I'm not anticipating that it would.
To go back on that and it's sort of tying in with the trust and estate planning. We will also been looking at a lot of structures where if getting a plan in place so that if a tax increases happening and we're not able to execute the sale to a third party in time, because of delays, setting up certain structures to trigger gains within a family or within a group before third-party control comes out so that you can lock in the lower rates before the task goes up. But you'd only want to do that really, if you can either finance the tax or you're very certain you will be assigned to a third party. There is planning that we're working to put in place for clients who are going through M&A processes that are aimed to close before the end of the fourth quarter, but may not. That's of the planning where we're modeling that for clients as well right now.
Ben Aspir:I think that rounds out the topics. Were there any questions that we have time to get to? Let's see.
Miri Forster:Chris, I'll take one. Someone asked about the self-employment tax changes, and when if enacted when they would be effective. Right now, the effective date is starting in 2022.
Ben Aspir:Many of the proposals that Miri and Chris and I spoke about today are really just starting points for negotiation and they're likely to change. We just want the today’s participants to be aware of the potential changes and to plan around for the future.
Chris Colyer:In D.C. right now, the focus is really on the infrastructure spending and trying to get bipartisanship there. I think chances are like, we're not going to have probably not kind of tax certainty until probably late in the year. But I think it's going to get done. It's something we'll get done before the end of the year, because 2022 is a midterm election year, so unlikely anything is going to move that and especially if Republicans see a chance in the midterms to pick up there the house and impossibly flip the Senate. Even though Democrats control things, there's still a lot of gridlock to get through.
Ben Aspir:Well, thank you everybody for attending today, and we'll turn it over to Lexi.