As a presidential candidate, Joe Biden campaigned on raising individual and corporate income taxes to fund a variety of social programs.  As president, he unquestionably delivered on his tax-increase promise, releasing his Fiscal Year 2022 (FY2022) budget proposal on May 28, 2021.  President Biden proposed FY2022 budget contains several provisions detrimental to family farms and businesses, including ones that sharply raise taxes and eliminate the step-up in basis on inherited assets.  This blog will explore some of these provisions and suggest steps to avoid or minimize the tax bite.

Tax Rate Increases – C Corps and Individuals

C Corporation Tax Rate Increase

Before delving into President Biden’s budget proposal, it’s worth revisiting the advantages and disadvantages of operating a farm in a C Corp structure.  On the plus side, a C Corp provides a layer of personal liability protection.  In addition, C Corps can provide tax-free meals to employees and spouses/dependents if meals are served on farm premises and provided for the convenience of the employer. (Livestock operations are easier to justify than grain operations, but courts have held that grain farm employees are also eligible for the exclusion.) S Corp employees and partners in farm partnerships are not eligible for meal exclusions, so this is a significant tax-free fringe benefit for C Corp employees.  Also, C Corporations historically have had a low marginal tax rate on the first dollars of taxable income.  2017’s Tax Cuts and Jobs Act (TCJA) raised the corporate tax rate to a flat 21% on all taxable income, eliminating the 15% bracket on the first $50,000 of taxable income. 

A major C Corp disadvantage has always been double taxation, that is paying individual income taxes on dividend income that’s already been subject to corporate income taxes.  Individual tax rates on dividend income vary, but at times the effective double-tax rate on corporate dividends has been nearly 70%.  Currently, the highest effective rate on doubled-taxed income is around 50%.

Another farming C Corp downside is a possible limit on using the cash method accounting.  This affects only corporations with 3-year average annual gross receipts exceeding $25,000,000, so most farming operations are unaffected by this limitation. 

Having revisited C Corp tax advantages and disadvantages, we’ll turn to the proposed C Corp tax rate increase. President Biden’s budget will raise the statutory corporate tax rate over 33% (from 21 percent to 28 percent) in hopes of raising nearly $1 trillion over the next ten years. Remember, C Corp tax rates apply not only to operating income but also gains on sales of capital assets such as farms.  This means the effective double tax rate on farm income or farm sales could be more than 67% when C Corp and Individual tax increases are combined. 

C Corporation Tax Increase Workarounds

Many family farm corporations can elect to be taxed as an S Corporation, which can reduce or eliminate double taxation with effective tax planning.  This could also be an escape valve for sales of highly appreciated farmland, ranches and businesses.  To avoid double taxation, a Corp that elects to be taxed as an S Corporation must wait five years before selling an asset with a built-in gain.  After the 5-year waiting period, appreciated assets can be sold with a single level of tax at individual rates. 

Individual Income Tax Rates

Unlike C Corporations, individuals pay different tax rates on different types of income.  Ordinary income is subject to one set of tax brackets, while long-term capital gains are often subject to lower rates.  We’ll discuss President Biden’s budget proposal’s effect on each. 

Ordinary income tax rates are the ones most frequently mentioned when someone talks about his or her “tax bracket.”  Tax brackets start at a 10% on the first dollar of taxable income (calculated after deducting standard or itemized deductions) and increase six times until reaching a top rate of 37% at taxable income of $523,601 for singles and $628,301 for married couples filing joint returns.  Biden’s budget proposal would raise the top tax rate to 39.6% for singles making $452,700 and joint filers making $509,300. 

Long-Term Capital Gain tax rates apply to sale or exchange transactions involving capital assets, such as farmland, held for more than a year.  Currently capped at 23.8%, President Biden’s budget proposal wants to raise the long-term capital gain tax rate to 43.4% on taxpayers with adjusted gross incomes of more than $1,000,000.  Considering state income taxes (such as Nebraska’s 6.84% tax rate), sellers could find themselves losing over half of their capital gains to taxes!  This combined tax rate would be higher than the highest rate on wage income and highest among countries in the Organization for Economic Co-operation and Development (OECD). 

Individual Tax Increase Workarounds

Two strategies spring to mind to deal with the long-term capital gain tax rate increase.  First, consider using the installment sale method to defer income from property sale transactions into future years.  This could result in keeping adjusted gross income below the $1,000,000 level at which President Biden’s proposed long-term capital gain tax rate would apply.  The Installment sale method allows taxpayers to decide when payments will be received and, therefore, taxed. 

Second, business taxpayers have significant control over taxable income through bonus depreciation’s 100% expense deduction.  Depreciable asset purchases, when timed right, could help keep income below $1,000,000.  Judicious use of these tactics could allow taxpayers to escape the proposed confiscatory 50+% tax rate. 

Income Subject to Tax

This next section deals with President Biden’s proposal provisions that would tax more income.  As a reminder, federal income tax is computed on taxable income, that is, gross income less deductions and exclusions.  Gross income is broadly defined as all income from whatever source derived.  Examples of tax-exempt income include life insurance proceeds, municipal bond interest and child support.  Here are two types of income that have consistently been excluded from taxation that would be taxable under President Biden’s proposal.   

Like-kind/Section 1031 Exchange

Recognized gains on a real estate exchange – called a like-kind or Section 1031 exchange, where a seller fully reinvests his or her equity in relinquished property into like kind property – have long been excluded from taxation.  In such a transaction, the seller doesn’t take any sale proceeds in cash, and US tax laws have allowed these gains to be excluded from current taxation.  Under this provision, a taxpayer’s gain that would have been recognized is effectively deferred until the replacement property is sold.  President Biden’s budget proposal limits like kind exchange deferrals to $500,000 or $1million if filing a married-filing-joint return.  Gains more than these amounts will be taxed.

Inherited Property - Step-up in Basis at Death

One other type of income has consistently been excluded from taxes: gains from sales of inherited appreciated property.  Property inherited from a decedent has its cost basis adjusted to fair market value at the date of the decedent’s death, making pre-death gains nontaxable.  This is known as a step-up in basis (though it can work the other way when a property’s value is less than cost at a decedent’s death, in which case a step-down in basis occurs).  Under this rule, inheritors of property owe taxes only on post-death appreciation.

There are many good tax policy reasons for basis step-up, including fairness and simplicity.  Without a step-up in basis, heirs would need to know the cost basis of inherited assets or be forced to pay tax on the entire value of property received. (IRS rules require taxpayers to prove the basis of assets sold.  If you can’t prove an asset’s cost basis, the IRS assumes 100% of sale proceeds are taxable.) This would be a nightmare for heirs who often have no idea of the amount paid for a certain asset. 

Not only would President Biden’s plan repeal the step-up in basis for amounts more than $1 million ($2 million for joint filers), it would also trigger gains on appreciated assets at death, much of which is due simply to inflation, not any real increase in value.  The proposal would exclude from recognition any gains on tangible personal property such as household furnishings and personal effects (which seldom appreciate anyway).  However, it could mean heirs would need to sell investment property to pay this tax if the decedent had insufficient cash to pay it.  It would further require the creation of a new tax form and regulations to implement.  In a stroke of fairness, the existing $250,000/$500,000 exclusion would continue to apply for gains on primary residences. 

Family-owned Farms and Businesses

Payment of tax on the appreciation of certain family-owned and operated businesses would not be due until the business interest is sold or ceases to be family-owned and operated.  While this might provide some relief, it would be difficult for successive generations to operate a family business when tax debts are piling up against it after each sale. 

Tax law changes are coming.  There is still uncertainty on exact proposals and effective dates, but taxpayers who want to minimize taxes might be wise to structure transactions to close in 2021. If you have any questions, please contact us. You can also read related articles on our accounting blog.