April 7, 2022
The Office of Management and Budget last week released the Biden Administration’s budget proposal for the 2023 fiscal year, which commences on October 1, 2022. In parallel, the Department of the Treasury released General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals, commonly known as the Green Book. As executive compensation advisors, we found the following tax proposals to be particularly applicable to our clients, should they ultimately take effect:
1. Minimum Income Tax on Billionaires Hundred-Millionaires
Expected to apply to the top 0.01% of American households, this proposal causes anxiety particularly among people whose wealth arises from illiquid assets, such as private-company founders.
Most Americans work for their income and must remit a substantial portion of it annually in the form of ordinary income taxes (top rate for 2022: 37%, plus 3.8% Medicare tax). For the ultra-wealthy, however, earned income is usually a tiny portion of net worth, the vast majority of which is tied up in investments taxable at capital gains rates (top rate for 2022: 20%, plus 3.8% net investment income tax). Moreover, tax on growth typically comes due only when the investments are exited – not based on year-over-year appreciation on paper.
To compensate for this disparity, the Biden Administration has proposed a minimum income tax on persons with extreme wealth. The media has referred to this proposal as a “billionaire tax,” but it actually applies to individuals with net worth (assets less liabilities) in excess of $100,000,000, subject to a phase-in through $200,000,000. This tax would be imposed annually at a 20% rate and would cover not only “traditional” income but also unrealized appreciation in asset value. But don’t feel too sorry for these hundred-millionaires; the tax they would pay under this proposal would be credited against capital gains actually realized in future years – so it’s more like pre-paying future taxes than paying an extra tax.
2. Tax Certain Profits Interests at Ordinary Rates
If this proposal sounds familiar, it may be because the White House introduced it last year as well – and has been a Democratic talking point for years. It would particularly impact employees at real estate, private equity and hedge funds, where profits interests are a common form of compensation.
At present, service providers (employees, consultants, advisors, directors, etc.) can be issued a special category of partnership interests that entitle them to share in the subsequent appreciation of the partnership’s value. Labeled “profits interests” for tax purposes, they are also commonly referred to as “carried interest,” “incentive allocation” or “promote.” They are an appealing form of equity-based incentive because the holder is immediately eligible for pass-through tax treatment on income from the profits interests. As a result, profits interests generally give rise to capital gain (subject to an extended three-year holding period for long-term capital gain in some cases).
Under the Biden proposal, income relating to a profits interest will be taxable at ordinary rates, and will be subject to self-employment tax, if—
The service provider’s total taxable income (from all sources) exceeds $400,000; and
The profits interest is an “investment services partnership interest”– that is, a profits interest in an “investment partnership,” meaning a partnership (a) substantially all of whose assets are investment-type assets and (b) over half of whose contributed capital is from partners whose investment is not in connection with a trade or business.
To prevent end runs, the administration has also proposed that parallel treatment apply in some circumstances in relation to both disqualified interests (e.g., convertible or contingent debt, options and derivative instruments) and certain capital interests held by service providers in investment partnerships.
3. Obligation to Disclose Position Contrary to a Treasury Regulation
Mandatory confession.
A taxpayer who takes a position on a tax return that is contrary to tax regulation may, under current law, choose to disclose the contrary position in order to avoid imposition of an accuracy-related penalty should the IRS identify the contrary position. However, the taxpayer is not currently required to inform the IRS of the contrary position. The Green Book states that increasingly, taxpayers – especially large multinational entities – are taking contrary positions but not disclosing them. This means that such a taxpayer’s position is not subject to scrutiny, and its reduced tax liability is protected, unless the IRS manages to independently deduce the taxpayer’s contrary position.
To discourage aggressive position-taking and ease the IRS’s review burden, the Biden administration has proposed that if a taxpayer takes a position on a tax return that is contrary to a tax regulation, the taxpayer must disclose the position to the IRS in writing. Otherwise, the taxpayer may face a penalty of 75% of the decrease in tax resulting from the contrary position, subject to a minimum of $10,000 and a maximum of $200,000, adjusted for inflation. The taxpayer is not eligible for a refund even if the taxpayer’s interpretation of the tax regulation is ultimately upheld(!).
4. Withholding Requirement for Noncompliant Deferred Compensation Plans
Relevant to employers who otherwise have a W-2 filing requirement.
If an employer commits to pay an employee compensation, but not necessarily in the current tax year, the arrangement must satisfy certain nonqualified deferred compensation (“NQDC”) requirements set out under the tax code, or it will be subject to a 20% excise tax and an interest charge plus, potentially, penalties and interest – all on top of the ordinary income and employment taxes that normally apply. While the employer is obligated to report noncompliant NQDC, generally in the year that it vests, there is no corresponding withholding requirement with respect to the 20% excise tax and interest charge. And the tax burden of NQDC noncompliance falls on the employee. As a result, if the employee does not voluntarily fund the incremental noncompliant NQDC tax, it falls entirely to the IRS to enforce collection.
The Biden administration therefore proposes that employers be required to withhold the full amount of taxes and interest resulting from employees’ NQDC compliance failures.
(The NQDC rules can also apply to other service relationships, such as those of directors and consultants; however, the service recipient would not normally have a withholding obligation for non-employees as a general matter.)
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While the final Congressional appropriations and related legislation may vary substantially from the President’s starting position, the process is worth monitoring from this early stage to avoid an unhappy tax surprise down the road. And even the Green Book proposals that don’t survive the 2023 approval process may be revived in a subsequent year.
Zahava Blumenthal, Esq. is an executive compensation attorney who advises regularly on compensation tax planning and compliance. She can be reached at zahava@cohenbuckmann.com.