Tax Features of the Inflation Reduction Act of 2022
In August, Congress passed the Inflation Reduction Act of 2022 (the “Act”), sending it to President Biden, who signed it into law. There are several tax-related provisions in the Act, and the purpose of this article is to provide a brief overview and commentary covering a number of them.
The Act has its roots in the president’s Build Back Better plan, with several of its features surviving into this legislation. A couple high-profile changes that fell by the wayside in congressional negotiation include a clamp-down on the favorable tax rate applicable to carried interest, which was dropped very late in the game. (Carried interest is not what its name suggests – a previous BNN article explains that.) A reversal of the so-called SALT limitation (capping itemized deductions at a level that includes no more than $10,000 of state and local taxes) also ended up on the cutting room floor. Also, with the exception of two new corporate taxes that are rather narrow in application; corporate, individual, estate and trust tax rates remain unchanged.
With that background and short list of omissions, we turn our attention to the contents of the legislation.
Clean energy incentives – the focus of another article
Many of the Act’s sections renew or expand “green” energy credits, and those are not covered here only because they will be covered in a stand-alone article delivered with this one, penned by colleague Dan Gayer. The legislation extends and expands a number of existing incentives, and offers several new ones. Green energy commands a significant percentage of the Act’s overall reach (roughly half of its cost), and they warrant a detailed discussion all their own.
Non-tax features of the legislation
Our coverage focuses on the tax-related provisions in the Act, but the legislation is broader than that, in great part due to changes related to healthcare, and specifically prescription drug costs. For instance, for Medicare participants, it caps insulin costs, and it sets an annual out-of-pocket cap on prescription drug costs for those who are enrolled in Medicare drug plans. It allows Medicare to begin negotiating drug costs beginning next year, and it extends some benefits granted under the Affordable Care Act.
Increased IRS funding
Nearly $80 billion of additional funding has been granted to the IRS, to be allocated to a number of specific categories. Approximately $31 billion is intended for operations support, upgrading technology, and funding a study into viability of an IRS-run, direct e-filing system. The remaining $49 billion is set aside for taxpayer-facing aspects of the IRS, including enforcement and its namesake – services. Of this, 93.5% is designated for increased enforcement and 6.5% for provision of services. Much of the $49 billion is intended for increased payroll, with 80,000 or so additional agents – roughly doubling its current headcount.
Observation: The IRS service function has been running woefully behind in recent years, exacerbated by increasingly complex tax laws and Congressional prioritizing of pandemic relief payments. With the allocation of funding skewed as it is with the Act (heavy on enforcement and relatively light on service), it remains to be seen whether IRS personnel (and impacted taxpayers) will be able to catch up anytime soon.
The Act notes that its provision creating the IRS’ increased resources is not intended to increase taxes on taxpayers with income below $400,000, or any taxpayer not in the top 1% (presumably 1% of income). It stops short, though, of prohibiting the funds from targeting those individuals.
Corporate minimum tax
This feature could accelerate some significant tax revenues, but it targets only very large corporations.
The rules related to this provision are complex and voluminous, and this article does not attempt to cover it thoroughly. Greatly oversimplifying, a corporation that generates adjusted financial statement income that averages more than $1 billion in a 3-year period will be subject to a 15% tax on that income. The “adjusted” amount is computed by (1) starting with financial statement income (as distinguished from taxable income), (2) removing the depreciation expense utilized for financial statement purposes, and instead (3) deducting the depreciation expense allowed for tax purposes. A number of other possible modifications on this tax are possible, based on tiered ownership, partial years, certain tax credits, and other influences.
Observation: The lead-up to the creation of this tax was accompanied by some assumptions that companies who will be subject to this tax were somehow manipulating income on a widespread basis to dodge federal taxes. This assumption may be fueled in part by references to multiple types of income measurements and unfamiliarity with the reasons why multiple sets of records are required. Seeing through this haze, and understanding income taxes in general, requires a bit of background.
- “Book income” is a term that describes most companies’ internal financial records. It refers to income computed under GAAP (generally accepted accounting principles). Reports using GAAP are required of publicly-traded companies and by most lenders.
- “Taxable income” is an entirely different animal. Whereas GAAP attempts to spread many expenditures over the life of the asset behind the outlay (using a “matching” principle), Congress has created literally thousands of pages of rules that primarily are designed to delay many deductions, therefore accelerating net revenue and taxes. Congress also routinely uses tax breaks to encourage social goals, by incentivizing certain outlays, often via accelerated deductions (relative to GAAP) and conversion of deductions into much more potent credits, which offset tax dollar for dollar, rather than reduce the income subject to tax.
- Historical “AMT” (alternative minimum tax) was created by Congress in 1986, because it felt that the concessions it created to compute taxable income were allowing certain taxpayers to delay paying taxes for too long, even while following the rules. With AMT, taxpayers now had to maintain a third set of records (a second set of tax records), and taxpayers would pay the higher of “regular” tax or AMT. The historical AMT was more or less dissolved in 2017.
- The 2022 Act’s new 15% “corporate minimum tax” is really nothing more than a second generation AMT, created for the same reasons that the historical AMT was rolled out. Whereas the earlier iteration started with taxable income and used certain adjustments to arrive at AMT income, 2022’s version starts with book income and adjusts from there.
With a few exceptions for permanent differences (treatment of entertainment expenses and penalties, for instance), the differences between book, taxable, and AMT income are negligible – over time. The differences relate primarily to timing of the same deductions.
In any case, corporations have for many decades legitimately utilized multiple sets of books (book income, taxable income, and AMT income) as required by the rules. There is nothing nefarious about simultaneously computing income under these multiple methods just because someone doesn’t like the outcome. Often the rules will produce income under one method but a loss under another. Sooner or later, the timing differences that can create gaps between book, tax, and AMT income flip around, and the new minimum tax simply moves that needle closer to the “sooner” end of the dial for large corporations.
Corporate stock buy-back tax
Applicable to transactions occurring after 2022, corporate redemptions of a company’s own stock are subject to a 1% excise tax, assessed on the value of the redeemed shares. The tax applies primarily to publicly-traded corporations.
There are a number of exceptions that allow a company to avoid this tax. Those exceptions include certain reorganizations, stock repurchased but then contributed to an ESOP, transactions that are structured as redemptions but for tax purposes are treated as dividends, and redemptions of less than $1 million.
Excess business losses
This feature merely monkeys with the expiration date of an existing limitation on the use of losses.
Specifically, the Act extends the expiration date of an existing cap on an individual’s use of “excess business losses” (EBLs). A previous BNN article explains how this loss works and how it fits into other loss limitations, such as “net operating losses.”
In a nutshell, only $250,000 of business losses ($500,000 for married taxpayers filing jointly) may offset other types of income on a taxpayer’s 1040. The balance is converted to a net operating loss and must be used in a later year. This can cause a taxpayer who generated an overall loss for the year to end up paying taxes anyway, because part of the losses are ignored in computing taxable income in that year, and instead are suspended and carried forward for analysis and potential use beginning the following year. This restriction was first created in 2017 and scheduled to expire after 2025, but was extended in later legislation through 2026. The 2022 Act extends it two more years through 2028.
Research credit applies to payroll tax
The Act doubles the amount of R&D credit that can offset payroll taxes (rather than income taxes), from $250,000 to $500,000.
For many years, the R&D credit could only offset income tax. Any unused credit could be carried over to future years. But recently, to accommodate small entities without sufficient income taxes (such as those suffering losses), the credit was expanded to allow certain taxpayers to elect to offset payroll taxes (specifically, the employer’s share of Social Security taxes). Entities eligible for the payroll option are those that (1) produce less than $5 million in revenue in the year of the election, and that also (2) produced no revenue in the 5th year preceding the year of the election, or any earlier year. (In other words, a company’s lifespan can predate that 5 year period, but its revenue cannot.) Entities that flunk this test cannot offset payroll taxes with the R&D credit, but they are not precluded from offsetting income taxes, if otherwise qualified.
The Act doubles the amount of R&D credit that can offset payroll tax by allowing the first $250,000 to continue to offset the employer’s share of Social Security taxes, and allowing another $250,000 to offset the employer’s share of Medicare taxes.
If the overall R&D credit exceeds $500,000, the balance continues to be available for use offsetting income taxes, and it is eligible for carryover to later years if not useable in the current period. Also, any credit amounts allocated to Social Security or Medicare that are unused in a particular period (because the credit exceeds the payroll taxes otherwise due) can be carried forward to offset future payroll taxes.
The Inflation Reduction Act of 2022 is a tax-rich piece of legislation, although many of its features either are adjustments to existing rules or roll out changes applicable only to large corporations. A group of changes that will have both deep and broad appeal are the green energy incentives included in the Act. As noted above, those features are significant enough to command its own article, which is written by colleague Dan Gayer.
For more information, please contact Stanley Rose or your BNN tax advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.