Budget Control Act
The Budget Control Act will result in the formation of a
bipartisan joint committee charged to address deficit reduction and present
legislation that can be voted upon prior to year end. They are charged with
proposing changes to raise $1.5 trillion over ten years. The
specific form deficit reduction will take is unknown. That uncertainty alone
has significant planning implications. Unfortunately, many clients will
interpret added uncertainty as another excuse to defer planning. But, more than
ever, taking a "wait and see" approach may result in clients realizing a "wait
and pay" result.
Inform Clients Now
Practitioners might wish to consider a quick alert to
clients pending more detailed analysis of the new developments. For example,
adding a short legend to emails, or sending a blast email to clients might be
advisable. Consider the following for a quick reaction:
Congress approved the debt ceiling bill and on August 2,
2011 President Obama signed the Budget Control Act (Senate Bill 365, as
amended). This calls for a new Joint Committee to weigh year-end tax
legislation. If you may benefit from discounts, GRATs, sale transactions,
dynasty trusts or a host of other planning benefits that have been previously
discussed for restriction or elimination, you should consider acting now.
November 2011, not December 31, 2012, may be the new deadline. New changes may
be proposed. Some might be effective from date of proposal. It is strongly
recommended that everyone consult with their tax, legal and financial advisers
on a regular basis through these fluid, and potentially dangerous financial
The Tax Times are A
Bob Dylan sang: "For the times they are a-changin'" and
from a tax perspective, they certainly seem to be. The tone of the tax
discussions has already taken on a decidedly different nature in a short amount of time. The Tax Code is now being labeled a drag on the economy. If the
Tax Code can be revised to eliminate a newly identified villain of the
stumbling economy, Congressional tax writers will undoubtedly pursue it in that
Lower tax rates are being heralded as a spur to economic
growth. This might all play out in fewer deductions and lower rates. But lower
rates with fewer deductions will meet higher actual tax costs for many. Most
significantly, slashing of deductions and credits will have a widely disparate
effect on different taxpayers, different industries and different states. These
disruptions may be mollified to some degree by phasing out the tax benefits
over time, but the results may nonetheless create significant hardships for
particular clients. Some of those adversely affected and possible planning
strategies are discussed below. But at this early stage these points are at
best speculative. But within these guesses concerning potential tax changes may be
lurking a few nuggets of valuable planning opportunities for the proactive
forward thinking adviser and client.
Speculating on Future Tax
All practitioners recognize the futility of predicting
future tax change. How many Ouija boards were tossed out of office windows
after failed attempts at predicting the 2010 tax changes! But there might be
some predictive value in reviewing certain tax tea leaves (although they're
likely as unreliable as the many now shattered Ouija boards).
- Some of the many previously proposed tax changes.
Perhaps restrictions on grantor retained annuity trusts ("GRATs") that
might require a 10 year minimum term may be reconsidered. The
retained annuity interest must have a term not less than 10 years. If a
GRAT has to last at least 10 years it substantially increases the mortality
risk of using the GRAT technique. Restrictions on the term of
dynasty trusts, restriction or elimination of certain valuation discounts,
might all be on the table again. But in the horse trading of what might now
become an Internal Revenue Code of 2011 might Congress sacrifice the estate
tax as part of a compromise deal and in efforts to simplify the tax system?
Or instead will fiscal demands result in deduction/technique tightening to
raise more revenue without lowering the exemption or raising rates?
- President Obama has continuously recommended tax
increases on higher income tax payers. This might translate into higher
ordinary income tax rates, higher capital gains rates, and perhaps even tougher
estate taxes on larger estates.
- "Loophole closing" might become the new politically
correct moniker for "safe tax increases." After all, if it's merely closing
a "loophole" it's not a tax increase, it is ending a perceived abuse. So
yesterday's tax incentive might be labeled tomorrow's "loophole." If this
concept gets legs some "loopholes' may start to resemble those
car-swallowing New York potholes. Loophole closing might entail the
wholesale slaughter of time honored deductions in exchange for lower tax
rates. After all, if lower tax rates take the headlines, how can anything
else be a tax increase? So if individual or corporate rates are lowered,
but a bevy of deductions are eliminated, especially more esoteric ones, the
media and voting public might not comprehend readily. Revenue estimates can
be raised and the public might not view the process as really a tax
- The "Lower Taxes That Raise More Money While
Simplifying the Tax System and Stimulating the Economy Act of 2011" might
just suggest where some in Congress might steer the tax ship. There is much
talk of major tax restructuring. Perhaps, if the lower rates and elimination
of deductions is extended more broadly, it can be branded as a "New and
Improved Tax Code", as powerful as a new and improved laundry detergent. If
this door opens, it could be a floodgate of tax law changes. Might a
Congress smarting (is that a poor choice of words?) from the recent
handling of the deficit ceiling believe that rebranding the Internal
Revenue Code of 1986 as the new and improved and shorter Internal Revenue
Code of 2011 might somehow redeem them in the eyes of voters?
Time May Be Shorter than Most Clients
There seemed to be a sense amongst many taxpayers that the
2010 laws would last until at least December 31, 2011. Many tax practitioners
had doubted after the 2010 fiasco that there would be certainty about the
estate tax until well into 2013. Perhaps everyone might be surprised with what
might occur by November 2011. The new joint committee has been charged with
proposing legislation by November 2011 so Congress can act on it prior to the
end of 2011. Bear in mind, that some recent tax proposals included effective
dates set at the date of proposal, not the later date of enactment. That tweak
of effective dates itself may translate into bigger revenue estimates. Thus, it
is possible that change may occur much earlier than anyone anticipated, and
that the changes may be effective from the date the envelope is opened, not the
date of enactment. The time delay between the two to close pending deals may
not be a luxury afforded to taxpayers or their advisers.
It is still possible that many changes may be tied to the
sunset of the Bush tax cuts, at the end of 2012.
Speculating on Possible Tax Changes and How
They Impact Planning
The crystal ball is rather opaque in general, but as you
drill down to specific changes, reliability wanes. With these caveats, consider
Individual Income Tax Rates:
- Higher income individuals may face higher marginal
tax rates. The Obama administration has defined this as single individuals
with incomes above $200,000, and families with incomes above $250,000.
However, at this juncture it is unclear what higher income tax rates might
entail. Will this be rates higher then current rates? Or if there is a
general lowering of overall tax rates (and that seems to be in the wind),
then the higher marginal rates might in fact be at rates that are not
significantly higher than current nominal rates. The term "nominal" is used
because there are other taxes that might add to whatever the nominal rate
is. See below.
- Some discussion has addressed replacing the current
individual marginal income tax rate schedule with new tax brackets, ranging
from: 8-12 percent; 14-22 percent; and 23-29 percent. So if the bean
counters can justify relatively low rates as still generating more revenue
as a result of the elimination of deductions and other benefits, the
nominal effective rates even on high income families may not be that
significant by historical standards. However, factoring in the potential
loss of a host of significant itemized deductions could make this seemingly
modest tax rate quite costly. Further, as discussed below, the costs will
vary rather significantly based on the facts and circumstances of each
- Currently, wages are subject to a 2.9% Medicare
payroll tax. Workers and employers each pay half, or 1.45%. If you're
self-employed, you pay it all but get an income tax write-off for half. This
Medicare tax is assessed on all earnings or wages without a cap. These
taxes fund the Medicare hospital insurance trust fund which pays hospital
bills for those 65+ or disabled. Starting in 2013 a .9% Medicare tax will
be imposed on wages and self-employment income over $200,000 for singles
and $250,000 for married couples. IRC Sec. 3101(b)(2). That makes the
marginal tax rate 2.35%.
- Under current law, only wages and earnings are
subject to the Medicare tax above, but starting in 2013 the 3.8% Medicare
tax will apply to net investment income if your adjusted gross income
("AGI") is over $200,000 single ($250,000 joint) threshold amounts. IRC
Sec. 1411. More specifically, the greater of net investment income or the
excess of modified adjusted gross income (MAGI) over the threshold, will be
subject to this new tax. The 3.8% is in addition to the Medicare rate of
.9% above, so the surcharge for higher earning taxpayers is significant.
This increased marginal rate will have an impact on net of tax calculations
for budgets, investments, etc.
- The impact of much lower marginal rates will be
significant. The income tax benefit of charitable deductions, to the extent
one remains, will be reduced. The calculus of when to purchase tax exempt
versus taxable bonds will change. The asset location decisions as to which
asset classes should be held in tax deferred accounts will change. Those
holding significant municipal bond portfolios may get a double wallop - one
from a reduced tax benefit of holding their tax exempt bonds and the other
from the impact of what might prove higher interest rates. Perhaps
taxpayers who have become overly concentrated on municipal bonds should
begin the weaning process now.
Individual "Income" Definition:
- Currently an employer's contribution to pay for an
employee's health care plans is not considered income to the employee. This
benefit might be eliminated, or at least, restricted. This might be
accomplished by creating a cap on the maximum amount any employee/taxpayer
can exclude from income each year for employer provided health care.
- This is anticipated to raise nearly $150 billion per
year, so the amounts are rather staggering for employees affected.
- This change will put pressure on employees and
businesses to rely on less costly and less comprehensive health care plans.
Employees struggling to make ends meet when feasible may pressure employers
to cover more of the cost or provide raises.
Alternative Minimum Tax
- The AMT might in fact be abolished. As deductions are
eliminated and nominal marginal tax rates are lowered, the AMT will be less
relevant to the tax system. Eliminating the AMT will undoubtedly be
heralded as a major simplification of the tax system.
- Tax projections might be a tad simpler, there might
be some impact on municipal bond holdings.
- There have been discussions of reducing the tax favored
treatment for capital gains and dividends. This change, if it occurs, might
well be phased in over a number of years to minimize the impact on the
markets. It might take the form of higher rates on those earning over
certain thresholds. The $200,000/$250,000 thresholds that have popped up in
a number of contexts might be the threshold selected here.
- The combination of higher capital gains rates coupled
with the Medicaid tax on unearned income, and other potential changes,
could have a surprising impact on taxpayers. For taxpayers in high tax
states that bear a higher combined capital gains rate, Medicaid tax on
investment income and no federal deduction for state income taxes on the
gains realized, the bottom line result could be quite costly.
- There have even been some discussions of treating
capital gains and dividends as ordinary income. The sales pitch for this is
it will simplify the Tax Code and planning, and since the marginal tax rates
will be relatively low, perhaps this might be saleable.
- This would have wide ranging impact a host of
investment, business and other transactions. It would level the playing
field, but also distort it in many ways from what taxpayers and advisers
alike are presently use to. Dealer versus investor status, lease versus
sale, hedging transactions, holding periods, and a host of other planning
concepts could become academic.
- Deductions, referred to in many of the discussions as
"tax expenditures", are slated to be restricted or repealed as the basis or
justification for lowering marginal income tax rates. This will somewhat
simplify the tax system, but it may also drive as many prior efforts at
simplification, new endeavors to benefit under the new tax paradigm.
- Possible tax expenditures up for restriction (often
called "reform") might include the full laundry list of common tax
deductions. Overall these changes may spur taxpayers to restructure
transactions and the manner in which they handle their affairs. The family
limited partnership ("FLP") formed to take advantage of discounts presently
permitted under the gift and estate tax valuation rules may morph into a
new purpose. If discounts are restricted or repealed (and for perhaps 99%
of taxpayers it's all academic if the $5 million exemption remains law),
FLPs, instead of being dissolved, (which, for asset protection reasons alone,
most should not) may be the only vehicle left to secure deductions as
itemized deductions are restricted.
- The sacred home mortgage interest deduction appears
to be up for consideration. This could have a huge impact on the cost of
home ownership and the rent versus buy analysis. The impact on the still
recovering housing market may be adverse. Even if the home mortgage
deduction is not significantly restricted, lowering marginal income tax
rates, restricting itemized deductions generally, and other broader
changes, may indirectly have a depressing impact on the value of the home
mortgage deduction, even if it is retained. For those operating home based
businesses, the calculus of whether a home office deduction should be
claimed may change as that might be of increasing importance. Some may be
driven to form an entity to operate their business in order to try to
increase available deductions as personal home deductions are
- There has already been some discussion of generally
restricting the tax treatment household debt. It is not clear whether this
will extend beyond home mortgage deductions to encompass restrictions on
investment interest, etc.
- So far, no mention of restricting property tax
deductions has occurred. Of the approximately $46 million income tax
returns filed in 2009, nearly 40 million claimed a property tax deduction.
If property tax deductions are not reduced, but the deduction for state and
local income taxes is restricted, or eliminated (see below) local
governments may tend towards greater reliance on property tax increases
over income tax increases.
- Restricting deductions for charitable contributions
have been talked about with increasing frequency. One proposal was to limit
the charitable deduction for individuals to amounts over two percent of
adjusted gross income ("AGI"). However, if medical deductions are
restricted and miscellaneous itemized deductions eliminated, there may be
less incentive to peg contributions to a percentage of AGI and instead just
provide for a direct reduction of the amount that can be deducted. A
restriction on the amount of a charitable contribution deduction coupled
with reduced tax rates could have a combined impact of significantly
undermining any tax incentives for donations. With many charities still
reeling from the impact of the recession, which affected their portfolios
and donations, the virtual elimination of the estate tax (only 5,600
estates per year pay a federal estate tax) how will charities fare with yet
more restrictions? Further, as the government will undoubtedly cut programs
serving those in need, the restrictions on charitable deductions will cut
fund raising results for the organizations that will have to pick up the
slack from government programs that are eliminated. None of this bodes well
for those in need.
- Deduction for certain medical expenses may be
eliminated. Under current law, you can only deduct, as an itemized
deduction, medical expenses to the extent that they exceed 7.5% of your
adjusted gross income (AGI). This restriction is in addition to the others
that limit the tax benefits of itemized deductions. That never made much
sense. But, why stop when the rules are senseless and unfair. Make 'em
worse. So starting with 2013 you'll only be able to deduct medical expenses
as an itemized deduction if they exceed 10% of your AGI. IRC Sec. 213.
As an attempt to show some compassion, Congress provided that
for folks 65+ the 7.5% rule will remain in place until the end of 2016. Why
does age alone correlate with a better medical expenses break? What of the
millions suffering at young ages with substantial medical costs? But now it
appears that even the little that is left of the medical expense deduction
may be up for reconsideration and potentially further restriction. As the
organizations helping those living with health issues and disabilities
struggle from the economy and potential restrictions on contribution
deductions, those they serve will be further penalized.
- State and local tax deduction for individuals has
been talked about as a target. If this deduction is eliminated, the
disparate impact on taxpayers will be significant. See below.
- All miscellaneous itemized deductions for individuals
have been proposed for elimination. As discussed below, this might drive
many taxpayers to establish entities for their business endeavors in an
effort to retain some type of deduction offset for earnings.
Overall Impact of Individual
- Consider the possible impact of several of the above
changes. A 50 something socialite-executive in New York earning big bucks
may lose a substantial charitable contribution deduction for the myriad of
wonderful local charities he or she supports, a significant state and local
tax deduction, and have to add to income a large amount for his or her
health insurance plan if a new cap on what can be excluded is provided for.
The new Medicare tax on earnings and investment income may be triggered.
Contrast this with a retiree living in Florida with a comparable income,
but no income tax. This taxpayer might face a lower marginal income tax
rate, even if the Medicare Tax on investment income is added. The bottom
line difference on these two taxpayers could be dramatic.
- High tax state fence sitters may well be pushed by
the net cost of eliminating a state income tax deduction to finally get off
the fence and move to a no/low tax state. Residency and domicile issues
will become significant planning factors.
- Use of C corporation entities to trap income, similar
to the personal holding companies ("PHCs") of not so many years ago, may
again become popular.
- The future of the federal estate tax has not yet been
the subject of much reported discussion, and the outcomes remain completely
- The 2010 Tax Relief Act provided higher exemption
amounts and lower tax rates, but its relief is temporary and is scheduled
to expire after 2012, so the issues of the estate tax have to be addressed.
It is unlikely that Congress will permit a return to a 55% estate tax rate
and a reduction in the maximum estate tax exemption from $5 million to $1
- Perhaps the Republicans will bargain the elimination
of the hated AMT and estate tax for a few points higher on the income tax
to offset the revenues and then proclaim a victory for tax simplification
and new found tax encouragement for economic growth. Gee, a swap meet!
- If the estate tax is eliminated, what of the gift tax
assuming its role for most of 2010 as a backstop to the income tax? Perhaps
in that role, Congress will be willing to reduce the gift tax exemption back
to its prior level of $1 million. There never seemed to be much of a
constituency fighting the gift tax. That would provide a backstop for the
income tax and may be necessary to support some of the income tax revenue
- The "feeling" is that Congress might strive to reduce
rates and deductions so they can herald a new economic period of growth
with a new simplified tax system. But lower rates won't necessarily raise
the revenue needed to make the numbers work. So, stealth changes may become
common. These could take many forms, but share the common theme that they
don't increase the nominal or advertised tax rates. Inflation
adjustments, or more aptly the lack thereof, might be an effective
technique to permit the government to project revenue growth while telling
the taxpaying public they've lowered rates.
- Many provisions in the Tax Code are adjusted annually
for inflation, so tinkering with the inflation calculations can slowly
generate more revenue over time as numerous tax calculations change.
Technical changes with inflation indexing are unlikely to hold much media
attention or be understood by most taxpayers, so that this might be a safe
bet as Congress seeks out every positive increment in revenue
- One proposal has been discussed to use a
chained-Consumer Price Index (with the wonderful abbreviation "C-CPI-U")
for calculation purposes. See
http://www.bls.gov/cpi/super_paris.pdf. This Bureau of
Labor Statistics ("BLS") index utilizes expenditure data in adjacent time
periods in order to reflect the effect of any substitution that consumers
make across item categories in response to changes in relative prices. The
objective of this CPI, in contrast to the general CPI, is to provide a closer
approximation to a "cost-of- living" index. Expenditure data required for
the calculation of the C-CPI-U are available only with a time lag. That lag
might tend to reflect a lower inflation rate than the general CPI
calculation. The change in inflation indices would lower a host of tax
hurdles thereby increasing taxes, including:
- Income tax brackets Congress establishes.
- Standard deduction amounts and itemized deduction
phase-out if these concepts survive the re-engineering of the tax
- Personal exemption amount.
- The ways to pay for the large deficit are to raise
taxes, lower spending and inflation. Inflation will enable the government
to repay current debt in lower real dollar terms in the future. So the
potential of increased inflation in future years could make this innocuous
technical change a powerful revenue raiser.
- The 3.8% Medicare tax is scheduled to apply to
net investment income applies only if the taxpayer's adjusted gross income
("AGI") is over $200,000 single ($250,000 joint) threshold amounts but
these threshold amounts are not inflation indexed at all, so that over time
this could result in a much broader reach affecting a large swath of
taxpayers in a manner similar to how the reach of the AMT grew
- Inflation may provide a significant sub-rosa
tax increase that will grow over time. Like the "The gift that keeps on
giving", inflation adjustments (or the lack thereof) might prove to be "The
tax that keeps on taxing."
- The child tax credit and the earned income credit
("EIC") are up for consideration as well. These might be retained, retained
at reduced rates, or otherwise modified. Perhaps some of these breaks for
those on the lower end of the wealth and income spectrum will be bargained
for in exchange for the repeal of AMT and estate tax.
- A single, lower corporate tax rate of somewhere
between 23 percent and 29 percent while promising to raise as much revenue
as under the current corporate tax system as a result of restrictions of
deductions and preferential tax provisions.
- The relative rates for corporate versus individual
tax rates (with consideration to the Medicare tax on investment income),
might lead to renewed consideration to holding companies to accumulate
income, the use of FLPs to shift income to lower bracket family members,
and so forth. Might advisers begin forming limited liability companies that
elect to be taxed as C corporations?
Tax Filing Statistics and the Possible Tax
The IRS publishes a wealth of statistical data on tax
which the following 2009 data was taken. Considering the number of returns
affected by some of the proposed changes gives valuable insight into the impact
of some of the tax laws that might be considered.
In 2009, there were approximately 46 million individual
income tax returns filed. Consider:
- About 28 million returns, more than half, had
miscellaneous itemized deductions that exceeded 2% of AGI. The elimination
of these deductions will affect a host of taxpayers. These taxpayers will
have to evaluate with their advisers whether the amount of potentially lost
deductions, and their facts and circumstances, would justify establishing
an entity to receive income and pay expenses. The purported simplification
of individual returns by eliminating miscellaneous itemized deductions will
see a likely increase in Schedule C business deductions and taxpayers
- Nearly 9 million returns reported business or
professional income and about 5.5 million returns reflected pass through
income or loss from partnerships or S corporations. All these filings may
increase as personal deductions are eliminated. Perhaps more taxpayers will
formalize home based and small businesses. The formation of these new
entities to garner tax benefits that would otherwise become unavailable
might be perceived as an increase in formation of businesses, rather than
the tax play it might be.
- Of the approximately 46 million returns filed in 2009,
nearly 34 million reflected a deduction for cash contributions to
charities. The restriction of contribution deductions may affect a
substantial portion of taxpayers.
The formation of a new Joint Committee to identify tax
changes might result in modest revisions to the tax system and a perpetuation
of the estate tax in its present form. There is also the possibility for
wholesale and massive change to the tax system that, as with all significant
tax law changes, will have a wide and varying impact on different clients and
the advisers that serve them.