Episode 89: The Nitty-Gritty of Biden's Tax Plan with Kyle Pomerleau

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This is The WealthAbility® Show with Tom Wheelwright. Way more money, way less taxes.

Tom Wheelwright:

Welcome to the WealthAbility Show, where we're always discovering how to make way more money and pay way less taxes. Hi, this is Tom Wheelwright, your host, founder, and CEO of WealthAbility. Joe Biden says that his proposal to support a $6 trillion budget is really just aimed at corporations and high earners. So, today we're going to discover whether that's true or not and who it really hits and get into some of the details. I'm really privileged to have a very special guest Kyle Pomerleau on our show today who's an expert in drilling down into not just the tax provisions, but the tax policy behind the provisions.

And this is perhaps in my mind, and I'll get, Kyle I'll get your thoughts on this. But I think the biggest single tax policy shift, if it were to pass, probably since 1913, just because the incredible shift in policy really from benefiting small business and investors to benefiting big business. I actually think this is a big play for big business. But that's my own thought. But let's start with Kyle Pomerleau, who is a resident fellow at the American Enterprise Institute, was previously Chief Economist and Vice-president of economic analysis at the Tax Foundation, and Macroeconomic, and tax modeling. So, I'm just fascinated to have an expert like you, Kyle, on the show. Thank you so much for joining us today.

Kyle Pomerleau:

Thank you very much for having me.

Tom Wheelwright:

So, what are you doing at AEI?

Kyle Pomerleau:

Well, right now I'm following the tax debate as it unfolds. Very recently the Biden Administration just released what's called the Green Book. It's the treasuries detailed overview of the administration's tax and budget proposals that they're going to be putting in front of Congress. So, what that means is looking at how these proposals are going to impact federal revenue. How they're going to impact different tax payers. Really drilling into the details of some of the complex provisions and how they're going to impact a tax taxpayer behavior.

Tom Wheelwright:

Well, awesome. Well, we'll get into that. We'll try to keep it simple for our listeners, so I'll make sure they understand it. You and I could have a detailed discussion and do tax talk for probably a couple of days. But our listeners probably can maybe manage 20 to 30 minutes here of tax talk. And I really want to focus on just a few of the key provisions that particularly affect small business and investors. We know that there's these proposals to extend the child tax credit and a lot of entitlement programs, really. This bill is full of entitlement extensions, which is really interesting after there's been so much discussion over the last two decades about reducing entitlements. And for the first time, I think we have this major idea of a major increase in entitlements, but let's set that aside.

Let's talk about the tax pieces of this, and then a couple of the major tax pieces. Let's begin with a big global piece, which is this corporate minimum tax worldwide. First question I have for you is, and just to recap for everybody, the idea is that there are some countries that charge a much lower tax, some zero. Some like Ireland in the 12% range. And so the idea is, well, if we're going to increase the taxes on corporations in the US we don't want the corporations just moving overseas, which is by the way, what they did prior to 2017 act, which was the intent to bring them back. So, rather than we may be pushing overseas, but if they can't go overseas and get a lower tax, then presumably they're going to stay here. Have I got that right, Kyle, is that kind of the idea behind this?

Kyle Pomerleau:

Yeah. A big part of Biden's tax proposals is a large tax increase on US multinational corporations. So, he's proposed raising the statutory tax rate from 21% to 28%. And then raising the tax burden on the foreign profits of US multinational corporations. So, what he wants to do just very generally is when a US multinational corporation earns income overseas, he wants to bump up the minimum tax that the US would place on that income to 21%. And he would do other types of reforms that would broaden the base of that tax as well so more profits would be taxed. Now you're right there's a big trade off here. Now, what they want to do is reduce the incentive companies have to shift profits into low tax jurisdictions, but the trade-off is, you'd also encourage companies to shift to their headquarters out of the United States because this minimum tax would only apply to companies if they're located in the United States.

Another component of this tax reform is to go to international organizations, go to other countries and negotiate what they're considering a minimum tax throughout the world. So, what they want for other countries to do, and this is consistent with what a lot of the OECD proposals have been in The Organization for Economic Co-operation and Development over the last couple of years. They've been working on, what's been Pillar One and Pillar Two. And I don't have to get into the details of that. But it's roughly just two general proposals to reform the way that countries tax their multinational corporations. And one of those Pillars is a proposal for other countries to enact minimum taxes, like what Biden wants to propose. So, to subject foreign profits to a minimum rate of taxation. And this deal that was just announced is I'd say a baby step towards getting an agreement amongst G7 countries to enact these minimum taxes on foreign profits.

Now I'm not super optimistic that they're going to get very far just yet. It's very complicated, but the first step they've announced is they've agreed that 15% is the minimum tax rate. Now the United States has already proposed higher than that 21%. So, you're already looking at the US negotiating and not really able to get other countries to get the rate as high as they may want it to be. But yeah, this G7 deal is part of this push to encourage other countries to bring the minimum tax rate up, to kind of push back against these incentives that tax havens create.

Tom Wheelwright:

Right. Or actually the disincentives that the non tax haven, high tax countries create, or the tax havens, right? So, there's this constant push there's this fight between the countries that say, “Well, we're willing to do a lower tax to encourage the economic development.” Versus, “We've got economic development already so we want more taxes out of the companies that are already there.” All right. Some of it's kind of mystifying to me that realizing that, boy, companies can move. And at least what the government is saying is we do realize that tax incentives do have an impact on corporate behavior. Here's my only question on this one. Who pays this tax? Do corporations and their executives pay this tax? Or will this funnel down to the average person in America?

Kyle Pomerleau:

Yeah. You see in the media all the time, the shorthand here is that corporations are going to face the tax increase or multinationals are going to face the tax increase. But economists always like to try to track it down to who's actually bearing the burden of the tax. And in the case, it's always people, whether it's shareholders of those corporations, the workers of those corporations, sometimes the consumers that buy products from those corporations. So, that's who is ultimately going to bear the burden. Now it's complicated.

I mean, where the countries are proposing to raise taxes on the foreign profits of US multinationals. And in some ways that's a sympathetic target for a tax increase because it's the US raising taxes on factories that are in Poland or Germany, not in the United States. But it's still eventually going to impact Americans to some degree. I mean, if I'm a shareholder in a corporation that's doing business in Poland, I get returns from that factory that's over there. And I would be impacted by the higher tax burden at the end of the day.

Tom Wheelwright:

And just for our listeners, how much of Fortune 500, for example, stock … How much stock is owned in the public markets by pension plans and profit sharing plans?

Kyle Pomerleau:

It's a large portion. There's been recent research on who owns the stock of US multinational corporations. And I think if you think about it in three groups, taxable shareholders, those that own shares outside of a 401k or IRA, or a pension fund, foreigners. So, foreign individuals that own shares and then pension funds. And the smallest group is actually taxable US shareholders, it's about 25%. And then I think it's around 40% for foreign shareholders. And the rest of that is in pension funds and tax-free accounts. So a good- [crosstalk 00:10:28]

Tom Wheelwright:

You're talking about 35% or roughly a third of all of that money is in your pension plan or your 401k plan. And I think that's something that, there's all this talk about well corporation and when they think corporations, they think Jeff Bezos and Elon Musk, right? Whereas really most of that is not Jeff Bezos and Elon Musk. Most of it is in your pension plan or your 401k plan. So, let's shift a little bit to some of these proposals that are in this Green Book. And as Kyle explained, the Green Book, and I'm sure Kyle has been through it many times, and I've been through it many times. And it's actually a fairly simple document and it was only a hundred pages or so that explains what these proposals are. There are a couple of proposals, some of the proposals in there we were expecting, there's a lot of the international stuff's in there.

We also see proposals to extend the child tax credit, the dependent care credit, some of these things are in there of course. That's where a lot of the money's going. And then there's a huge credits for renewable energy, that's a whole separate topic. I can spend a whole show on that one, probably will. Because I think there's a huge opportunity there from a tax standpoint. But let's talk about, there's really a couple of proposals that I think are so important to the average investor business owner. And let's start with a little one, which is the social security tax on pass-through entities. So, can you just kind of walk us through what that proposal says and really what's the consequence going to be to really the average small business?

Kyle Pomerleau:

Yeah. This is a proposal that's been around for a few years, so it wasn't going anywhere under the Trump Administration, but the Obama Administration had put forth this proposal. And what this proposal is seeking to do very generally is subject more business income to either the Medicare payroll tax, social security payroll tax, or the net investment income tax. If you're not familiar, the net investment income tax was passed as part of the affordable care Act. It's a 3.8% tax on certain investment income and business income of passive business owners of 3.8%. And it's supposed to match up roughly speaking with the medicare payroll tax plus the additional Medicare tax.

Tom Wheelwright:

If I understand, Kyle, this money is all supposed to go to medicare, right?

Kyle Pomerleau:

This is all supposed to go and fund Medicare. Now the proposal, what it's meant to do is under current law, there are certain business income from partnerships or S corporations that are not subject to the Medicare payroll tax or the net investment income tax. So, from the perspective of the Biden Administration there's a tax gap between certain types of income. And what this proposal is aiming to do is close that gap in their perspective and subject some of the S corporation income, partnership income to either the Medicare payroll taxes or the net investment income taxes.

Tom Wheelwright:

Let me ask you this. So, basically what we're saying is right now, S corporation, most small businesses are formed as S corporations, a few as limited partnerships. And we don't really need to get into the details of limited partnership aspect of this. But let's take the S corporation, which is kind of the heart of the American small business. Right now, if you are an income, that income is subject to income tax. But it's not subject to social security tax, unless you paid out as a salary. This would subject to this Medicare tax, which then opens the door, of course, to down the road, subjecting it to whatever the limits are on social security tax, which is probably to me a lot bigger deal. And I think that's maybe the next ball to drop. But let's say it's just the 3.8%.

Kyle, would this apply whether or not I distribute the income, because of course that income is taxed to me, income tax wise, even if I leave it in the company, because I need that, let's say to grow the business next year. Unlike a corporation, a big corporation, a C corporation that is not subject to that net investment income tax unless it's distributed.

Kyle Pomerleau:

Yep.

Tom Wheelwright:

Right?

Kyle Pomerleau:

That's right. [crosstalk 00:15:07]

Tom Wheelwright:

But in this case is I read this law, the income would be subject to the net investment income tax, effectively, the Medicare tax, whether or not it's distributed. I am I reading it the right way?

Kyle Pomerleau:

That's right. I'm reading proposal that way as well. That a big distinction between traditional C corporations and S corporations partnerships is the ability to defer that second layer of tax and defer the net investment income tax until profits are distributed. S corporations partnerships don't get the benefit of deferral. And that's not going to change here. So, when the income is earned, it's also taxed in that year and it will be subject to tax under the net investment income tax and the Medicare tax.

Tom Wheelwright:

Do you ever think they might, cooler heads might prevail and they might actually just subject distributions to net investment income? Or are they stuck on income?

Kyle Pomerleau:

I don't think that there's a proposal out there to change the timing of tax for pass through businesses or partnerships S corporations. I think if you're going to want to reinvest the money, the company is going to have to pay out a little bit of money to you in order for you to pay the tax each year.

Tom Wheelwright:

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And now let's go to the big one, which is capital gains. I think this is the biggest proposal in here. I think it's the most egregious, and it covers all the way from a state tax to gift tax to basically unrealized capital gains. I'm not talking about the carried interest that's, I actually do have, let me make sure I come back to that. Because I have one technical question for you on that. But on this capital gains tax. So, as I understand, the way it's written. If I took my business and I put it into an S corporation, it's not subject to tax. That 351, that regular transaction non-taxable transaction I put it into a corporation, not subject to tax. On the other hand, if I took the same business and I just put it into a partnership, I'd be subject to taxes if I sold the business. Am I reading that the way you're reading it?

Kyle Pomerleau:

Yeah. This was a question that I got from someone else as well. And I believe that, that's how another tax lawyer interpreted this and that would be a major change. I haven't thought this issue through too much, but you are not the first one to interpret and read it that way.

Tom Wheelwright:

So, why would they do that? I mean, the reality is this is, for those of you don't know this section 721 of the code, which is my specialty area, technically is partnerships. It's been around as long as the corporate, you put something into a partnership that's non-taxable transaction. Why would they do that? What's behind this? Because it seems so anti small business. What are they trying to get at here?

Kyle Pomerleau:

It's potentially an anti-tax avoidance measure, but I'm not sure. They did not have, and your question implies this, they did not have a robust discussion of the purpose of this change.

Tom Wheelwright:

So, let me ask a related question. Let's say that I formed my company and it's in a limited liability company and it's a disregarded entity. Right now I'm on a schedule C. Disregard any. And then somebody comes in and they put money in, in exchange for an interest in that business. It sounds to me like this would actually create a tax to me because they put money into the business because now it's treated as a partnership instead of a disregarded entity. I mean, to me, when I look at something like this, I'm going, whoa, wait a minute. You're telling me that if I raise money from an investor, I'm going to be taxed as if I sold the business.

Kyle Pomerleau:

Yeah. That's interesting. I don't know if they intend to do that or not. I mean, anyone following this, my advice is to really pay close attention to what Congress is thinking, because this of course is just … I mean, the Green Book is meant to be very detailed. But it's not, not all the details are there. I could talk for at length about the missing details in the international provisions. This may be another area where, I don't know if they intended to do that or not. But ultimately Congress is the one that decides, and this may or may not occur.

Tom Wheelwright:

Let me ask you another question. So, part of this is the gifting provision. So, the idea is that if you gift, so that you can't get away from this, the capital gains on death by gifting that if you make this gift, then that gift is subject to not gift tax, but income tax on capital gains. As you read the Green Book, how would this apply? We've got this million dollar limit. Is this a million dollar lifetime?

Because I couldn't follow that in the Green Book, frankly, Kyle. It would seem to me, it would have to be a lifetime limit that once you got over that million dollars, everything over that would be taxable. Is that the way you read that? It has nothing to do with the level of your income, it's not like the capital gains tax over a million dollars of income. This is rather a capital gains tax based on, I think, a lifetime giving over a million dollars.

Kyle Pomerleau:

Yeah. This provision is somewhat confusing. I mean, frankly, a lot of the Biden proposal is somewhat confusing, because they use many different thresholds, they use many different definitions of income. So, just for maybe some context here. And their capital gains proposal has two general changes. The first change is that capital gains realized the treatment of long-term capital gains will change for anyone with taxable income over a million dollars. That income would be taxed at the top ordinary tax rate, whatever that ends up being under Biden's proposal. He's proposing 39.6 plus the net investment income tax. But we don't know what Congress is going to do. And that's taxable income million dollar plus. Then there's a second provision, which is the taxation at death of unrealized gains. And that is a different threshold.

And I think you're right. But that's more based on the lifetime limit rather than any threshold of taxable income or adjusted gross income. And I think it has to be that way. Some other details here too, is that the taxation of death will also have exemptions, not well specified yet, but exemptions for primary residences that will remain in there. And they also will have an exemption for certain businesses. So, I think their intention and I don't know, they'd have to work out the details, is that if the stock is passed to say a family member and that family member continues to actively run the business, there would be an exemption there too. But we'll wait and see, this is like you said, as Congress is discussing this more, some members are becoming uncomfortable with it. And I mean, it's too bad for Biden because this is where he gets a lot of his revenue. And we don't know if this is actually going to happen at all. There are some democratic lawmakers that state that this may be too much of a tax increase for them.

Tom Wheelwright:

Right. So, one of the things that I think is important to note though, is that while the capital gains increase, the income tax on selling an investment that is basically retroactive to April, right?

Kyle Pomerleau:

Yep, yes.

Tom Wheelwright:

The other proposals don't come into play until next year. What that means is, is that we have a window right now where we ought to be doing some planning. If you want to do some planning, you've got a window between now and December 31st, presumably. Assuming that they hold to that timeline to get ready. And what I always suggest is get all the planning done. You don't have to sign it until December 31st, but you'd better get the planning ready ahead of time because we do have this window. Which is actually a nice window to know that you've got seven months to prepare for this.

Kyle Pomerleau:

Yeah. The administration did have two dates built into this. And yeah, there is a window, a prospective window for the taxation of death provision. But the window for the tax on realizations at ordinary income tax rates, that's effectively closed. And they meant to put that retroactive to April 28th as an anti-avoidance measure. Now, we don't know if that's the actual date, because again, Congress decides. But it's worth paying attention to that at least the Administration is really paying attention to the effective date provisions as a means to avoid too many people planning around this. Because they do actually want to raise revenue from it.

Tom Wheelwright:

But apparently they don't want to raise revenue this year. They want to raise revenue down the road, because historically the best way to raise revenue in the current year is to actually give people time because then they all sell their stock and they get everything sold so that they've got this huge cash influx in the current year. Obviously at the cost of the longer term rate increase.

But let me come back to the carried interest if I can. And we're going to have to wrap up. I wish we could go on for another hour. Kyle, this has been great. Thank you so much. Okay. Carried interest right now, we have this three-year rule and basically says that if you have certain carried interest, which is basically somebody puts in services in exchange for the appreciation on the investment and that appreciation on the investment historically has been taxed at long-term capital gains rates. But under this three year rule, now you have to hold it for three years.

One of the things that was really interesting in the, because this came in 2017 in the Trump tax Act. One of the things that was very interesting is, is that they very much specifically left out real estate investment in the 2017 law. And the IRS confirmed that in their rulings and their regulations. So, my question to you is, do you think that they will maintain that exemption? A lot of our listeners are real estate investors. They're very interested in this, they're syndicators, they raise capital all the time and most of their money is made on the carried interest. So, do you think that they will continue that exemption or you think they'll bring real estate back in?

Kyle Pomerleau:

Yeah, not sure. So, if we look back to the Biden campaign proposal, they did suggest that they would go after unspecified, what they would call real estate tax breaks. We didn't really know what those were, whether those were accelerated depreciation for real estate investments or carried interest. We didn't really know. Now that at least suggests to me that it's that's in the back of the mind of the Administration, but we haven't seen yet what Congress thinks about what they do at that provision. So, right now we're kind of in a middle ground where we kind of know what they want the rates to be and some of these thresholds. But we don't really know what they want to do with the base with respect to real estate. But that is something to keep an eye out for in the next couple of months.

Tom Wheelwright:

No, absolutely. All right. So, let me ask you one final question, Kyle. Biden has maintained from day one of his campaign that none of his proposals would have a negative impact on anybody making less than 400,000. Do you agree that, that would be the consequence of these current proposals?

Kyle Pomerleau:

There are a couple of problems with that threshold. First, it leads to very complicated tax policy. We're just talking about the carried interest provision. So, it's one thing to get rid of the carried interest provision altogether. But what they're doing is getting rid of it with a income threshold, which adds additional complications to a provision. That's problem number one. Problem number two is that the Biden Administration has arbitrarily enforced this limitation. So, clearly the $400,000 threshold that they're working with doesn't apply to the corporate tax, because if it did apply to the corporate tax, they'd already been violating it. Because the corporate tax eventually does fall on people earning less than $400,000, whether you're a retiree that owns stock and you live on interest in dividends and make only $40,000 a year. Or the worker of that corporation.

But the Biden Administration said it doesn't apply to the corporate tax. That's their way out of it there. Now the individual provisions, there may be some small places in which people earning less than $400,000 could be impacted by the provision, by any of these provisions. The capital gains provision, for example. Taxation at death, who is ultimately going to bear the burden of that tax increase. Well, the person who passed away isn't because they're not alive. You can't bear the burden of a tax if you're not alive anymore. If you're passing on that asset, you could be passing it on to someone whose annual income is below the threshold. So, there is potential for mismatches.

Tom Wheelwright:

On top of that, Kyle. I mean, consider that you could have a business that makes $300,000 a year. That when you sell it, you sell it for more than million dollars. That's a tax to me, that's a tax on somebody making $300,000 a year. And the reason it is because it's really no different for a business owner if you have this tax, this high capital gains tax, when you sell your business. It's no different than if you took your 401k and the day you're retired, you are taxed as if that entire amount was distributed.

It's exactly the same consequence. And yet that's never going to happen, right? That's clearly never going to happen. So, you really are, it seems to me taxing those higher. The other question I have is, is this 400,000 per person or 400,000 per couple? Because even if you look just at the increase in the rate, the 39.6%, he's talking about couples making more than 500, $10,000 roughly. Well, that's only 250,000 a piece or $255,000 a piece. So, that's way less then 400,000. How do you reconcile all that?

Kyle Pomerleau:

Yeah. I mean, it's somewhat arbitrary, right? I mean, at the end of the day, it's mostly political. He's really trying to signal that not a lot of people are going to face this tax increase and roughly speaking most of them are going to be very high income. Because right, it is just not possible to design a tax plan that holds harmless every single solitary person that may be earning less than $400,000 a year.

Tom Wheelwright:

Got it. Thank you, Kyle. Really appreciate it. aei.org is that right?

Kyle Pomerleau:

aei.org is where you can find my work.

Tom Wheelwright:

Great. Well, very much appreciated, Kyle. As this stuff keeps developing can we get you back to talk about the actual legislation?

Kyle Pomerleau:

Absolutely. I'd be happy to continue the conversation.

Tom Wheelwright:

That be awesome. So, thank you very much. Here's the real takeaways today. We'd need to be A, as Kyle says, “Following the legislation.” Let's follow what's going on. Second of all, we can always write our congressmen if we don't like write our congressperson, if we don't like what's going on. Remember there's a very slim majority in both the House and the Senate. So, they are paying attention to their constituents right now. I think that's very clear that they are getting nervous because their constituents. So, if you want to make them more nervous, then send them a letter.

And the third thing is, of course, is that we have a window of opportunity for planning. So, we can't wait to plan until we know what the answer is. We have to plan based on what we think the answer might be, spend a little money for the planning, knowing that we don't have to sign that final plan until December 31st. I think with that, I think we've got some flexibility going on here because what happens is, is we do all those three things. We're going to always make way more money and pay way less tax. See you next time. Thanks.

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