Temporary Tax Reform

Posted on January 18, 2011 by Michael Walker

Last month, in a rare moment of bipartisan compromise and with (by Congressional standards) blazing speed, Congress and President Obama came together and passed a sweeping tax package, more formally known as the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. President Obama signed the Act into law on December 17, 2010. The following is a brief summary of the key provisions of the Act:

Current income tax rates will be retained for two years (2011 and 2012), with a top rate of 35%.

Capital gains and qualified dividends will continue to be taxed at a top rate of 15% through 2012.

Social security payroll taxes for employees and self-employed workers (which include partners whose incomes are subject to payroll taxes) will receive a reduction in Social Security payroll taxes in 2011, with the “employee-side” rate being reduced from 6.2% to 4.2%. 

An AMT “patch” for 2010 and 2011 will keep the the alternative minimum tax exemption near current levels.

Itemized deductions of higher-income taxpayers will not be reduced. Without this provision, itemized deductions would have been reduced by 3% of adjusted gross income above an inflation-adjusted figure, but the reduction couldn't exceed 80%.

Tax-free distributions from IRAs to charities are retained for 2011 only. This provision allows taxpayers age 70 1/2 or older to make distributions of up to $100,000 from their Individual Retirement Accounts (IRAs) to charities. In addition, individuals will be allowed to treat IRA transfers to charities during January of 2011 and as if made during 2010).

Businesses expensing equal to 100% will be permitted on the cost of a business’ purchase of equipment and machinery purchases, effective for property placed in service after September 8, 2010 and through December 31, 2011. For property placed in service in 2012, the new law provides for 50% additional first-year depreciation.

Estate taxes are reinstated for 2011 and 2012, with an exemption of $5 million per person and a top rate of 35%. Estates of people who died in 2010 can elect to follow the estate tax rules of either 2010 (no estate tax, but with a “carryover” of a decedent's tax basis) or 2011 (estate tax with a full “step-up” in tax basis to an asset’s fair market value at the decedent’s date of death).

The Gift Tax Exemption was $1 million prior to 2011. With this lower exemption, if a taxpayer’s cumulative lifetime gifts exceeded this $1 million mark, then they would be required to pay gift taxes. Now, the has be “re-unified” with the estate tax, meaning that the current gift tax exemption is the same amount as the estate tax exemption – i.e. $5 million. Like the changes which the Act makes to the estate tax, this change expires at the end of 2012. This means that for 2011 and 2012, taxpayers have an unprecedented opportunity to make larger estate-planning gifts without paying gift taxes.

“Portability” is the latest buzzword for the estate tax.  New provisions in the Act allows surviving spouses to add their deceased spouses unused estate tax exemption to their own, potentially allowing the surviving spouse to ultimately have $10 million of estate tax exemption. However, this new provision may have limited application. First, the provision will only apply if the first spouse dies after January 1, 2011 and the second spouse dies before December 31, 2012. While Congress may extend this provision, that result is far from certain. Second, the exemption will be lost if the surviving spouse remarries and survives his or her next spouse. Ultimately, we suggest that the traditional use of a “bypass trust” continue to be the first line of defense against the estate tax.

While the new tax bill certainly has benefits to taxpayers and does provide some planning opportunities, because of the fleeting nature of many of the provisions in the bill, planning around some of the bill’s provisions will be a somewhat precarious process. 

The new Congress is already discussing additional “tax reform.” Stay tuned! 

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Who are the "Wealthy"? (Really!)

Posted on September 3, 2009 by Michael Walker

At the risk of dating myself, I grew up watching Gilligan’s Island on television. As I did not grow up in a wealthy household, my youthful image of a “rich” person was Thurston J. Howell, III, the extremely wealthy and rather lazy member of the marooned “Gilligan” castaways. 

Demographic statistics (and my own anecdotal experience) tend to show that wealthy individuals in the United States do not resemble Thurston Howell. Rather, many are owners of small and entrepreneurial businesses. This conclusion has certainly been supported by the research of Dr. Thomas J. Stanley, co-author of the bestselling book The Millionaire Next Door. Dr. Stanley’s central finding is that wealthy individuals in America acquire their wealth through hard work, careful savings, and living a lifestyle well below their means. Often these individuals are “self-made” business owners whose hard work and good ideas have brought them economic success.

As I mentioned in my previous post, Congress is currently considering proposals to increase the top two tax brackets from their current 33% and 35% tax rates to 36% and 39.6%, respectively. Congressional leaders have proposed additional surtaxes that will be "layered" on top of the new higher tax rates.  Newly developed data from the Joint Committee on Taxation indicates that 55% of the tax from the higher rates will be borne by small business owners with income over $250,000. These same small businesses create 70% of all new private sector jobs in the United States.

I am neither an economist nor a politician. However, I am concerned that all too often, those seeking to soak ol’ Thurston Howell may really be hurting the owner of the corner store down the street, not to mention the employees that work at that store. Is that the intended consequence of the new tax policy?

I welcome your thoughts and comments!

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Tax Snowball or Abominable Avalanche? 10 Likely Changes to the Tax Code

Posted on August 28, 2009 by Michael Walker

In a few short months, after the Dog Days of summer have gone and the sweltering humidity of the Washington D.C. begins to subside, Congress will begin to get serious about finishing work on tax legislation that will make substantial changes to our current tax code. I’ll leave to the politicians to discuss the wisdom, or lack thereof, of these changes. However, one thing is certain – tax changes are on the way!

I have no crystal ball. However, as Congress debates health care legislation and begins to embrace the red ink from the fiscal stimulus legislation in the last year, significant changes to the Tax Code are as certain as January snow in Denver. For those whose time has come to pay their “fair share” of taxes, here are the ten changes that we’re most likely to see when the sun rises on New Year’s Day 2010:

1. Tax Rates. The “Greenbook” report released by the Obama Administration in May states that the current 33% and 35% tax rates will increase to 36% and 39.6%, respectively. These rates would affect those individuals with incomes exceeding $200,000 for single persons and $250,000 for married couples. While Congress still needs to make the final decision, the proponents of these increases tend to argue that these “reforms” merely represent a return to the Tax Code of the Clinton Administration.

2. Capital Gains. Currently, the maximum tax rate on recognized capital gains is 15%. Under current law, these changes expire after 2010, with the maximum rate scheduled to increase to 20%.  For the same group of high earners (singles making more than $200,000 and married couples making over $250,000), the 20% bracket would return early, most likely with the 2010 tax year.

3. Qualified Dividends. Certain “qualified” dividends received by individual taxpayers from corporations are currently taxed at a 15% maximum rate. Like the capital gains tax increase referenced above, the maximum tax on these “Q Dividends” would be increased to 20% as well. Interestingly, the Obama Administration did not advocate a return to the Clinton years when dividends were taxed in the same manner as ordinary income. My bottom line on this one – don’t count on it. An increasingly budget-conscience Congress will see it as “low hanging fruit.”  Look for the return of ordinary income tax rates on dividends.

4. Personal Exemptions. Under current law, even the highest earning taxpayers are entitled to claim personal exemptions on their individual tax returns. For example, the highest earning taxpayers can claim $2,433 as a personal exemption. For the same $200,000/$250,000 group referenced above, the personal exemption would be phased out. While a somewhat minor item for high-earning taxpayers, the Administration’s justification for the changes is classic Washington:

“By limiting the tax benefit of higher-income taxpayers’ personal exemptions, the income tax system would be made more progressive, and the cost of government would be shared more fairly by taxpayers in all levels of income.”        

5. Limits on Itemized Deductions (aka the “haircut” limits).  Tax legislation passed during the Bush Administration progressively reduced the prior Clinton-era limitations that the Tax Code placed upon itemized deductions. However, these curbs were scheduled to expire starting in 2011. The Obama proposals would allow these limits to expire “on time” in 2011. In general, these limitations provided that itemized deductions (other than medical expenses, investment interest, theft and casualty losses, and gambling losses) would be reduced by 3% of the amount by which adjusted gross income exceeds statutory floors which are higher than under current law, but not by more than 80% of the otherwise allowable deductions.

6. 28% “Override” Cap on Itemized Deductions. Again, for our $200,000/$250,000 folks, the Obama Administration proposes that in addition to the “haircut” limits on itemized deductions referenced above, itemized deductions would be further reduced by limiting the tax value of those deductions to 28% whenever they would otherwise reduce taxable income in the 36% or 39.6% tax brackets. This proposal has come under attack by many charitable organizations, arguing that the limits would discourage high earners from making tax-advantaged charitable gifts.

7. Extension of Tax Statute of Limitations. Under current law, the IRS generally has 3 years after a return is filed to audit a person’s tax return. Under the Administration’s proposals, this statute of limitations would be extended up to 2 additional years as a result of a change in a taxpayer’s income made by a State taxing authority.

8. Estate Tax Exemption. Under current law, the federal estate tax exemption is $3.5 million for 2009, with estate taxes to be entirely repealed in 2010. These changes “sunset” after 2010, and are replaced with a $1 million estate tax exemption. The Obama Administration budget proposals assume a continuation of the current $3.5 million exemption, with a top estate tax rate equal to 45%.

9. Estate Tax Valuation Discounts. In certain transactions in family-owned entities, the interests that pass to an estate’s heirs are valued at their fair market value. Under traditional valuation principles, the value of such business interests is determined utilizing certain valuation discounts. The Obama Administration would require certain restrictions and other limitations to be disregarded in the process of valuing certain family-owned entities. This proposal will likely increase the overall estate tax burden which is paid by family-owned businesses.

10. “Surtaxes” on High Earners. Separate from Administration proposals, congressional leaders in the House of Representatives have proposed a “surtax” on high-income individuals to pay for health care reform. Presumably in addition to the Obama tax-rate increases discussed above, the new surtaxes would be equal to: 1% for income over $350,000 of adjusted gross income (AGI), 1.5% for AGI over $500,000, and 5.4% for income over $1 million.

The daily popular media tends to focus on the various tax proposals singularly, rarely examining these proposals together. Any one of these proposals, in isolation, can seem rather benign – like a snowball pitched in good fun. However, when the proposals are examined in their mathematical aggregate, the impending avalanche of taxes starts to come into focus -- and it’s not even fall yet.

I welcome your comments and discussion!
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