The Federal government has proposed legislation and the state of Minnesota has enacted legislation that may affect your tax situation. Below are highlights of four hot-topic tax items to keep an eye on.
State and Local Tax Deduction
One tax law under debate right now is referred to as the SALT cap. The SALT cap is the amount of State and Local Taxes that an itemizing taxpayer can deduct on their federal income tax return. A taxpayer that uses the standard deduction will take that in place of the SALT (and other itemized) deductions. Currently, the SALT cap is stuck at $10,000.
The recently passed House of Representatives version of the Build Back Better bill includes provisions that raise the SALT cap to $80,000. As the Bill moves to the Senate, the Senate appears to have different thoughts concerning the cap. The Senate Budget Committee calls for an unlimited SALT deduction for households that make less than $400,000. Households that make more than $400,000 would be subject to a phase-out range with a minimum deduction of $10,000. Other proposals have included raising the $400,000 income limit for the full deduction to $500,000.
While raising the SALT cap is most beneficial for taxpayers who live in states with high-income tax rates, many members of Congress see raising the SALT cap as another unnecessary boon to the wealthy. The Senate plans to counteract this by bolstering the provisions of the Alternative Minimum Tax (AMT).
Changes to the SALT cap may affect the availability and effectiveness of the pass-through entity tax credit laws that states have been passing in a way to circumvent the existing SALT cap. Currently, 19 states have passed a variant of a pass-through credit. This credit allows pass-through entities such as partnerships or S-corporations, which do not limit the amount of state and local taxes they can deduct on the federal return, to bear the burden of state taxes instead of the individual taxpayer.
Minnesota Passthrough Entity Tax (PTE)
Minnesota has enacted a Passthrough Entity (PTE) tax as part of the tax bill signed into law this summer. This new system is designed to thwart the State and Local Tax (SALT) deduction limit imposed by the 2017 Tax Cuts and Jobs Act and could produce significant Federal tax savings for Minnesota business owners.
The mechanics of the tax are straightforward – qualifying PTEs elect to calculate and pay the Minnesota tax liability due on the entity’s income instead of passing it through to be taxed at the individual owner level. This tax liability is a Federal deduction reducing the net business income of the entity, not a separately stated itemized deduction, and is not subject to the SALT cap. Finally, the business owners are granted a Minnesota tax credit equal to their share of the PTE tax to avoid double-taxation of the income.
Further specifics on the structure are as follows:
- Tax is effective for tax year 2021 and future years until the SALT cap expires or is repealed
- Entities must choose to be subject to the PTE tax no later than the extended due date of the entity’s tax return; the decision can be made year-to-year, but once made, is irrevocable for that year
- S corporations and entities taxed as partnerships (traditional partnerships/LLCs) are eligible to utilize the tax
- C corporations and pass-through entities with C corporations or other pass-through owners are disqualified
- Per MN DOR, an entity must qualify for its entire tax year to utilize the PTE tax – mid-year restructures will be eligible for the following tax year
- Grantor trusts are qualifying owners for both S corporation and partnership structures
- Non-grantor trusts are qualifying owners for S corporations, disqualifying for partnership structures
- At least 51% of an entity’s ownership group must sign off on the decision, which is then binding on all owners
- PTE tax is levied at a flat 9.85% (equal to the top Minnesota individual rate)
- PTE taxable income is based on the entity’s income apportioned to MN
- Payment of the PTE tax satisfies the entity’s nonresident withholding requirements and relieves nonresident owners of any MN filing requirement (if applicable)
- Entities will be required to make estimated tax payments against their PTE tax liability
- IRS has indicated they will not challenge this or similar tax structures
- Per IRS Notice 2020-75, PTE tax payments will be Federally deductible in the year paid
Impact of Infrastructure Bill on Cryptocurrency
The recently signed Infrastructure Bill (PL 117-58) includes several provisions that will affect crypto investors. First, the provisions define cryptocurrency as a “digital asset.” A “digital asset” is defined as “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.” While this includes cryptocurrency, it is ambiguous what else is included in the definition, such as NFTs.
The provision also changes the definition of a specified security to include “digital assets.” The applicable date for this change is January 1, 2023.
The Bill also changed the definition of Brokers to include “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” This means brokers, mostly exchanges like Coinbase, would be required to report gains to the IRS. It is crucial that the investor track the basis accurately as these exchanges may not know your actual basis in the asset due to transfers from other wallets. This could result in overstated gains reported to the IRS. Treasury officials have said the reporting requirements will only extend to those who can comply with it. The Treasury Department will be conducting studies up to the effective date (listed below) of the amendments to establish who can comply with the requirements.
Changes were also made when using “digital assets” for transactions in a trade or business. Businesses that receive more than $10,000 in cash or cash equivalents must report the transaction to the IRS. The definition for cash equivalents has been expanded to include “digital assets” for purposes of Code section 6050I. The reporting requires the recipient to report all the payor’s personal information to the IRS.
The Effective Date for all the amendments included in Section 80603 of the Infrastructure Bill (PL 117-58) is after December 31, 2023 (effectively January 1, 2024).
More changes to “digital assets” reporting/ taxation have been proposed in the Build Back Better Bill, but as of this date, the Bill has not yet been signed into law.
Build Back Better Act – Estate, Trust, Gift Provisions
The House passed Build Back Better Act mainly contained none of the gift, estate, or trust tax provisions that had been previously proposed back in September. However, below we outline the income tax provisions that were included in the Bill. In addition, as the Bill moves to the Senate, we have outlined the previously proposed provisions that should be watched in case they were to creep back into a tax bill before anything becomes law.
Surcharge on High-Income Taxpayers – Trusts and Estates (INCLUDED IN BILL)
- Trusts and estates would be subject to a 5% surcharge on Modified Adjusted Gross Income (MAGI) over $200,000. An additional 3% surcharge would be assessed on Trust and Estates with MAGI of more than $500,000.
Lower Gift and Estate Exemptions
- Previously proposed changes would reduce the Federal Lifetime Gift and Estate Tax exemption from $11,700,000 to $6,020,000 effective January 1, 2022, instead of January 1, 2026.
Changes to Intentionally Defective Grantor Trusts (IDGT), Spousal Lifetime Access Trust (SLAT), Irrevocable Life Insurance Trust (ILIT), Grantor Retained Annuity Trust (GRAT), and Qualified Personal Residence Trust (QPRT)
- All trusts are designed to be free from the grantor’s estate but taxable to the grantor for income tax purposes during life. Taxes paid on the asset’s earnings are designed to be free from gift tax and seen as a good planning tool to reduce a grantor’s estate.
- Previously proposed changes would end this mismatch (income taxation to the grantor but free from the grantor’s estate) – from now on, distributions from the grantor trusts would be considered gifts, and assets of any grantor trust would be includible in the grantor’s gross estate for estate tax purposes.
- Additionally, sales between the trust and the grantor would become fully taxable. Currently, sales between the grantor and the grantor trust (for income tax purposes) are tax-free as the grantor and the trust are considered the same taxpayer.
Disallowance of Valuation Discounts on Passive Entities
- Previously proposed changes would eliminate the discounts for lack of marketability and minority interest for nonbusiness assets (marketable securities and real estate unless the donor or decedent actively managed the real estate) when valuing closely held entities for gift and estate tax purposes.
For the federal and state changes highlighted above, some are pending legislation and others have already been enacted. A consultation with your tax professional is advised.