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Two New Income Tax Surcharges Included in Build Back Better Act

An unwelcome tax surprise may await business sellers and non-grantor trusts.

On Nov. 3, 2021, the House Rules Committee released a revised version of H.R. 5376, the Build Back Better Act (the Act), which would impose two new income tax “surcharges” on high-income taxpayers, effective Jan. 1, 2022. For individuals, a surcharge of 5% would apply to modified adjusted gross income (MAGI) of more than $10 million and an additional 3% on MAGI of more than $25 million. For a married individual filing separately, the MAGI thresholds would be $5 million and $12.5 million, respectively.

For trusts and estates, the Act would impose these surcharges at thresholds 98% lower than those for individuals: 5% on MAGI of more than $200,000 and an additional 3% on MAGI of more than $500,000. At present, these surcharges are merely proposed. They’ve yet to be voted on in the House, and even if passed, the Senate may remove them from the final bill.

In effect, these surcharges would create an “intermediate” 31.8% tax bracket on capital gains, about halfway between the current 23.8% maximum long-term capital gains tax rate and the 40.8% maximum ordinary income tax rate. Aside from a handful of highly compensated corporate executives, athletes and entertainers, the proposed surcharges, if enacted, are likely to affect (and may surprise) two primary categories of taxpayers: (1) entrepreneurs who are selling a business, and (2) nongrantor trusts.

So, what now? The most obvious strategy to avoid the proposed surcharges would be to recognize as much income as possible prior to the Jan. 1, 2022 effective date. Aside from accelerating gains and other income, what other strategies are available?


Entrepreneurs seeking to avoid the impact of the proposed surcharges may want to spread gain from the sale of a business among multiple taxable years or several taxpayers. For example, they may:

  • Structure the business sale to recognize gain in stages, by accepting an installment note or retained equity in lieu of cash. This would enable the seller to recognize reduced amounts of gain over time as the purchaser makes note payments or on a later sale of the retained equity.

Transfer business interests to other taxpayers prior to sale and in furtherance of the seller’s larger planning goals. For example, the seller may wish to transfer business interests to family members, nongrantor trusts for their benefit or charities. Each owner will then recognize their ratable share of the gain, thereby decreasing the impact of the sale on any one taxpayer’s MAGI for purposes of the surcharges. Taxpayers seeking to transfer business interests should do so as far in advance of finalizing the business’s sale as possible to avoid having the transfer treated as an impermissible assignment of income, which applies once the taxpayer’s right to receive the income is practically certain. (See Treasury Regulations Section 1.671-1(c); Chrem v. Commissioner, 116 T.C.M. (CCH) 437 (2018)).

  • Transfer business interests to a charitable remainder trust (CRT), which as a nontaxable entity, will avoid immediate recognition of gain on trust-owned interests at the time of sale. (Note: This strategy won’t work with S corporation stock, as a CRT isn’t a permissible S corporation shareholder.) Instead, the seller will recognize this deferred gain on receipt of annual distributions from the CRT generally for the seller’s lifetime or the joint lives of the seller and the seller’s spouse.
  • If the business is a C corporation, use when possible the qualified small business stock exception under Internal Revenue Code Section 1202, which may result in exclusion of up to $10 million of gain from the seller’s MAGI in the year of the transaction.

Nongrantor Trusts

Unlike entrepreneurs, trustees of nongrantor trusts will need long-term or year-by-year solutions to the proposed surcharges, rather than focusing primarily on one large realization event. Indeed, taxpayers may reconsider or restructure nongrantor trusts, especially trusts that have been created primarily to reduce state income taxes, as the proposed federal surcharges may outweigh the state income tax benefits provided by those trusts. For existing nongrantor trusts, or in cases when a nongrantor trust remains appropriate for other reasons, trustees may consider the following strategies:

  • “Toggle on” grantor trust status for a year in which the trust’s MAGI otherwise would trigger a surcharge. IRC Section 675(3) provides that a trust will be treated as a grantor trust for any year during which the grantor borrows from the trust without adequate security and hasn’t repaid the loan prior to year-end. (Note: Taxpayers should be careful to avoid a recognition of gain on a conversion from grantor to nongrantor trust status.) Under this strategy, the grantor potentially could borrow trust assets shortly before the end of the year, repay those assets shortly afterwards and avoid the lower MAGI thresholds for nongrantor trusts that otherwise would apply.
  • Distribute the trust’s distributable net income (DNI) so that responsibility for paying income tax is carried out to individual beneficiaries, rather than retained by the trust. Distributions may be made outright to the beneficiaries, to a pass-through entity that’s owned by the beneficiaries or to creditor-protected trusts that the beneficiaries are deemed to own for income tax purposes. Although DNI generally excludes capital gains income, a trust may be modified to include such income in DNI; liberal distributions to individual beneficiaries under this expanded definition of income would further reduce the trust’s MAG. The trustee may be able to include capital gains in DNI pursuant to the trustee’s power to adjust under the Uniform Principal and Income Act, or as a “reasonable and impartial exercise of discretion” under Treas. Regs. Section 1.643(a)-3(b).
  • Invest some or all of the trust’s cash reserves in private placement life insurance, which if properly structured, should reduce the trust’s MAGI by excluding growth of the policy’s cash value from taxation.

It’s difficult to reduce MAGI by generating deductible expenses. For example, deductible investment interest expenses reduce MAGI, but charitable contributions generally don’t. For the most part, MAGI is adjusted gross income—so shifting income is more likely than profligate spending to reduce the impact of the new surcharges.

There’s no certainty that these surcharges will be enacted at all, much less in their present form. We’ll continue to monitor the Act’s progress and update you with any new developments.

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