Tax Aspects of the Inflation Reduction Act of 2022

By Mark R. Parthemer

Mark R. Parthemer, Managing Director, is the national Chief Wealth Strategist and Florida Regional Director for Glenmede, an independent private wealth multi-family office and trust company.

Tax Aspects of the Inflation Reduction Act of 2022

On August 16, 2022, President Biden signed into law the Inflation Reduction Act of 2022 (the Act), which focuses on climate investments, clean energy, and deficit reduction. The new legislation is a scaled-down version, albeit renamed, of the administration’s prior efforts, the Build Back Better Act.

Unlike the original Build Back Better Act, which contained numerous tax changes aimed at families of wealth and individuals earning over $400,000 per year, there are only four major tax-related revenue-raisers in the Act. Another key revenue raiser, drug pricing reform, is not a tax provision and therefore not addressed in this article. Before exploring the tax provisions, however, it is important to understand the budget reconciliation process, which was used to pass the Act.

Budget Reconciliation

Reconciliation has been used many times for tax changes, with three recent examples: the 2017 tax act (Pub. L. No. 115-97), often erroneously called the Tax Cuts and Jobs Act; the American Rescue Plan Act of 2021 (Pub. L. No. 117-2); and now the Inflation Reduction Act of 2022.

In fact, since reconciliation was established by the Congressional Budget Act of 1974, Congress has passed 27 reconciliation bills. Of these, 23 were signed into law. Of the 42 fiscal years from the first reconciliation bill in 1981 to fiscal year 2022, reconciliation was used in 24 years. There were two separate reconciliation bills in three of those years. Accounting for the fact that reconciliation was not possible in the 11 years when no budget resolution was passed, reconciliation has been used in 24 of the 31 (77 percent) budget resolutions since 1981 (What Is the Budget Reconciliation Process and Why Is It Important?, USA Facts (Aug. 1, 2022), https://bit.ly/3S1bukJ, as updated by the author to include the Inflation Reduction Act).

Under reconciliation, each chamber drafts its own legislation, then a reconciliation committee merges the two into one. The merged bill then goes back to the House and Senate for “up/down” voting. When the House passed the 2017 tax act, it made an amendment to title it the Tax Cuts and Jobs Act. Thereafter, the Senate passed its version, but the Senate Parliamentarian ruled that the amendment by the House was out of order because it violated the Byrd rule (see Press Release, U.S. Sen. Comm. on the Budget, Parliamentarian Determines Three Provisions in Republican Tax Bill Are Impermissible (Dec. 19, 2017), https://bit.ly/3CGvyDD ). Days later, the House voted again on the bill but without the title. As a result, the official title of the 2017 act is “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.”

As part of the budget process, reconciliation bills are limited in scope and can relate only to changing laws that affect the national budget. So, why the popularity? In a word, filibuster. These bills benefit from a streamlined process in the Senate, and thus potentially are easier to pass than a regular bill.

The Senate may spend only 20 hours debating reconciliation bills. This is in contrast with ordinary bills, which senators can threaten to delay or prevent from reaching a vote through indefinite debate (i.e., filibuster). Even though most bills technically require a 51-vote majority to pass, Senate rules require 60 senators to vote for cloture, meaning to end debate of a bill. Cloture thus stops a filibuster and ripens a bill for a vote by the full Senate.

The practical result is that a reconciliation bill needs only 51 votes to pass in the Senate as opposed to 60 votes to avoid a filibuster. Reconciliation does not have the same benefit in the House, as representatives are always limited on speaking time when debating legislation.

Reconciliation bills also have important safeguards. Limitations were established in the 1980s through what is known as the Byrd rule, named after Senator Robert Byrd (D-WV). The Byrd rule seeks to prevent the expedited reconciliation process from being abused. Here are three examples:

1. Every measure in a reconciliation bill must relate directly to budgetary issues: government spending, revenue or taxes, or the debt limit. This means that measures without any budgetary effect cannot be included in a reconciliation bill. The Senate Parliamentarian decides when the Byrd rule has been violated and can strike provisions from the bill that are in violation of the rule.

2. Reconciliation bills prohibit any measure that would increase the national deficit beyond the budget window. Technically, there is no set budget window, but Congress can establish the length of the budget window. Historically, that window has been 10 years, which is often why we see such laws or certain provisions of those laws “sunset” after 10 years.

3. No changes can be made to the Social Security trust funds.

For the Act, the Senate Democrats maintained and updated a one-page chart of the revenue and expenditures. The last updated chart was published August 11, 2022 (Chart 1).

Key Tax Provisions

As noted, the Act contains only four major tax items. A fifth, dealing with carried interest, was cut from the final bill and thus is not part of the law. Chart 2 contains some highlights for each item.

15 Percent Minimum Corporate Tax Rate

The Act establishes a minimum corporate income tax rate of 15 percent on applicable C corporations. It does not apply to S corporations, regulated investment companies, and real estate investment trusts. Each year, applicable corporations will pay the greater of (a) the regular corporate tax and (b) an alternative minimum tax of 15 percent of adjusted financial statement income (AFSI) less the foreign tax paid that year. It applies to corporations with financial statement income in excess of $1 billion for any three consecutive tax years preceding the tax year but ending after December 31, 2021 (Act amendments to IRC §§ 55 and 59).

The concept of alternative minimum tax is not new. It was first established in 1969 for individuals and later expanded in 1986 to include corporations. The corporate alternative minimum tax, however, was repealed in 2017. As with the individual alternative minimum tax, it was based on computing regular taxable income and adding back various preferences. What is novel is the Act’s approach of taxing “book income” even if adjusted.

Taxing a corporation based on financial or book income is unusual; however, a key modification from the original bill is that the measured income will be adjusted for certain items.

Specifically, the Act defines AFSI (under the newly added IRC § 56A) as the taxpayer’s net income or loss as reported on the taxpayer’s applicable financial statement (defined in IRC § 451(b)(3) or in future regulations) for the year. Numerous adjustments are to be made to AFSI, including adjustments for statements covering different tax years, related entities, certain items of foreign income, effectively connected income, certain taxes, disregarded entities, and income from partnerships.

Perhaps the most important change in this area from the original bill is that AFSI is reduced by accelerated depreciation deductions and by amortization deductions related to qualified wireless spectrum. The adjustment for accelerated depreciation means depreciation deductions have the same effect on a corporation’s tax base for alternative minimum tax purposes as for regular tax purposes, including any benefit of bonus depreciation under IRC § 168(k). This adjustment is beneficial for each year in which the depreciation deduction for tax purposes is greater than the depreciation deduction for book purposes.

Chart 1: Revenue and Expenditures

Total revenue raised $737 billion

15% corporate minimum tax $222 billion*

Prescription drug pricing reform $265 billion***

IRS tax enforcement $124 billion**

1% stock buyback fee $74 billion*

Loss limitation extension $52 billion*

Total investments $437 billion

Energy security & climate change $369 billion*

Affordable Care Act extension $64 billion**

Western drought resiliency $4 billion***

Total deficit reduction $300+ billion

*Joint Committee on Taxation estimate

**Congressional Budget Office estimate

***Senate estimate, awaiting final CBO score

Chart 2: Major Tax Items in the Act

Minimum corporate income tax

• 15% minimum tax rate

• Applicable to C corporations with AFSI of $1 billion*

• Tax paid will be creditable against future regular tax when greater than the minimum tax calculation

$80 billion of increased IRS funding

• 43% will be dedicated to taxpayer services, administrative and operational support, system modernization, and policy studies

• 57% will be dedicated to enforcement enhancements

• Revenue from increased enforcement efforts is estimated at $204 billion, for a net gain of $124 billion over 10 years

Stock buyback surtax

• 1% surtax on corporate stock buybacks

• 2021 stock buyback volume exceeded $900 billion

Loss limitation extension

• Limits business owners from using more than $250,000 of business losses against other types of nonbusiness income

• Originally part of the 2017 tax act and set to expire after 2025; now extended through 2028

Carried interest provision— DROPPED

• A provision originally limiting the capital gains treatment of a partnership’s profit interest was dropped

• Future discussion of this provision should be expected

*AFSI—Adjusted Financial Statement Income, averaged over the prior three years.

One of the largest differences between financial and tax income is the treatment of losses. Under tax rules, income is limited to zero, with losses carried forward to offset future income, capped at 80 percent. Under AFSI rules, a financial income loss will be carried forward to offset future financial income similar to the tax treatment and also capped at 80 percent. Financial statement net operating loss (NOL) is defined as the amount of net loss on the corporation’s applicable financial statement, after applying the AFSI adjustments, for tax years ending after December 31, 2019. A financial statement NOL for any tax year may be carried over to each tax year following the tax year of the loss. Thus, AFSI is decreased by the lesser of (1) the aggregate amount of financial statement NOL carryovers to the tax year and (2) 80 percent of AFSI computed without regard to financial statement NOLs.

As with historic alternative minimum taxation, any tax paid under this new alternative minimum tax is creditable against regular tax in future years to the extent the regular tax in a succeeding year exceeds that year’s alternative minimum tax. The impact of the new tax is projected in Exhibit 3, reflecting an impact on approximately 76 companies in the S&P 500 (left panel) and the reduction of earnings per share on the S&P 500 index of a modest .08 percent (and .04 percent for the buyback tax discussed below in Stock Buyback Surtax).

Funding the Internal Revenue Service

A second component is approximately $80 billion of additional funding to the IRS, particularly for purposes of enforcement and collection. The Act summary indicates that by investing this $80 billion over the next 10 years, the IRS will collect $204 billion, for a net gain of $124 billion. Further, the Act proponents declared that none of the appropriated funds are to be used to increase taxes on any taxpayer with taxable income below $400,000.

Specifically, the following would be expended over the 10-year period:

• $3,181,500,000 for taxpayer services.

• $45,637,400,000 for enforcement.

• $25,326,400,000 for operations support.

• $4,750,700,000 for business systems modernization.

• $15,000,000 for the IRS to prepare and deliver a report to Congress on the cost of developing and running a free direct e-file tax return system, and additional funding to the Treasury Inspector General for Tax Administration ($403 million), the Office of Tax Policy ($104,533,803), U.S. Tax Court ($153 million), and Departmental Offices ($50 million) to enforce the Act.

The “No One Under $400,000” Debate

Political debate has ensued regarding whether the Act will raise taxes on individuals earning less than $400,000 per year, something President Biden has pledged not to do. Further to this point, US Secretary of the Treasury Janet Yellen wrote a letter to Speaker of the House Nancy Pelosi about the Act and included this sentence:

Chart 3: Projected Impact of the New Tax

The legislation would either reduce or have no effect on the taxes due or paid by any family with income less than $400,000 and is fully consistent with the President’s pledge.

The letter, dated August 2, 2022, is available online at https://bit. ly/3MAMfok. This article takes no position about whether the legislation will or will not increase taxes for this group but points out two aspects of interest to tax practitioners, both relating to tax audits.

First, the new hires. The Act does not specify the number of new IRS hires; however, a 2021 report by the Treasury Department indicated that the $80 billion additional funding in the proposed-but-never-passed American Families Plan would enable the hiring of 87,000 new employees (about 57 percent in audit and enforcement) over a 10-year period. U.S. Dep’t of the Treasury, The American Families Plan Tax Compliance Agenda, at 16 (May 2021). Further, it has been reported that the Treasury Department projects the attrition rate at the IRS over the next five years will amount to 50,000 current IRS employees who will retire or take another job elsewhere. Megan Loe, The IRS Is Not Increasing Audits on Middle Class by Hiring 87K New Agents, Verify (Aug. 11, 2022), https://bit.ly/3D1F9Gc.

Second, in a carefully worded letter to IRS Commissioner Charles P. Rettig dated August 10, 2022, Secretary Yellen said the enhancement of enforcement resources “shall not be used to increase the share of small business or households below the $400,000 threshold that are audited relative to historical levels.” Understanding it phrased this way, the gross number of audits indeed may increase on these businesses and households, but not disproportionately to the number of audits on those earning more than $400,000. The letter can be found at https://bit.ly/3yHvsug.

Stock Buyback Surtax

The Act creates IRC § 4501, which assesses a 1 percent tax on corporate stock buybacks. It applies to the repurchase of stock by a publicly-traded US corporation. Section 4501 defines a taxable event as a “repurchase” under IRC § 317(b) and any economically similar transaction. The taxable value of a buyback can be offset by the fair market value of any stock issued during the tax year. There is a special rule for stock purchased by a specified affiliate.

The use of a buyback is a common way to provide funds to increase per-share value as well as provide shareholders a tax-advantageous source of cash versus a dividend. Buybacks are relatively common and can be valued at billions per year on the S&P 500 alone.

For 2021, the total value of buybacks exceeded $911 billion, and earlier this year it was reported that one firm predicts the volume in 2022 will exceed $1 trillion in value. Natasha Dailey, Companies Are on Pace to Buy Back a Record $1 Trillion in Stock This Year as Russia’s War in Ukraine and the Fed’s Planned Rate Hikes Rattle Markets, Bus. Insider India (Mar. 16, 2022), https://bit.ly/3S4LRQi.

Chart 3 also shows the projected impact of this buyback tax on earnings per share of the S&P 500 at approximately one dollar.

Loss Limitation Extension

Taxpayer-unfriendly, the excess business loss limitation has been subject to much political adjustment, especially in light of its relative newness. Enacted in the 2017 tax act as IRC § 461(l), business owners were prohibited from using losses to offset more than $250,000 of their nonbusiness income (or $500,000 of nonbusiness income in the case of married couples). The dollar threshold amounts are indexed for inflation after 2018. The loss limitation applies to noncorporate taxpayers, or, in other words, to individuals and entities treated like individuals (i.e., passthrough structures).

The stated goal was to prevent highincome taxpayers from deducting business losses (which perhaps may be “on paper” only) to reduce other taxable income. The limit on pass-through losses was established for tax years beginning after December 31, 2017, and before January 1, 2026 (thus, for 2018–2025 filings). The Coronavirus Aid, Relief, and Economic Security Act, also known as the CARES Act, suspended the loss limitation for tax years 2018 and 2019 (permitting amended filings to claim the full loss), with a new effective date of tax years beginning after December 31, 2020. The American Rescue Plan Act extended the loss limitation for one year, through 2026. The Inflation Reduction Act now extends the application for another two years, capturing tax years through 2028 by having the loss limitation expire on January 1, 2029.

Carried Interest Provision Dropped

Based on much-reported political machinations, the Act does not contain a change to the taxation of carried interest. Because this has become a hot topic, some tax practitioners would not be surprised to see it reappear at some point. As a result, a brief review may be in order.

Carried interest is a share of profits earned by general partners of private equity, venture capital, and hedge funds as a performance fee. It aligns the general partner’s compensation with the fund’s returns. Typically, carried interest is paid only if the fund achieves a minimum return, known as the hurdle rate.

For example, a limited partner invests $10,000 in a fund that charges 20-percent carried interest. The fund is successful (exceeds the hurdle rate) and the distribution to the limited partner is worth $100,000. The general partner receives as carried interest 20 percent of the amount the investor earned after the principal is paid back. The math would work as follows:

• General partner earns $18,000 (($100,000 – $10,000) x 20%)

• Limited partner receives $82,000 ($10,000 initial investment plus the $72,000 remainder after paying the general partner)

Carried interest appears to be compensation for services, but, under current tax law, it instead can receive more favorable tax treatment as longterm capital gains (maximum rate of 20 percent, with a potential additional net investment income tax of 3.8 percent) versus the highest federal marginal rate on ordinary income (37 percent).

Generally, short-term gain is taxed as ordinary income, where “short-term” is defined as held for a year or less. Property held longer than one-year benefits from the reduced long-term capital gain rate. In 2017, the shortterm gain holding period for purposes of carried interest was extended to three years. Recent efforts (the original proposed Inflation Reduction Act and the original Build Back Better Act) have sought to extend the holding period for long-term capital gain treatment to five years. Others have advocated recharacterizing carried interest from a profits interest to a capital interest, which would result in taxation as ordinary income.

Conclusion

Most of the expenditure provisions of the Inflation Reduction Act of 2022 will not be triggered immediately but ratcheted in over the 10-year budget window. In contrast, the tax changes will be effective starting in 2023. We may see guidance from the IRS, perhaps in the form of regulations. Further, we may see future legislative attempts to amend these tax provisions, perhaps driven by midterm election results.

The author takes sole responsibility for the views expressed herein and these views do not necessarily reflect the views of the author’s employer.

Published in Probate & Property, Volume 37, No 1 © 2023 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.