Debt Ceiling — Budget Control Act

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 that 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:

Client Alert

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 the 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 times.

The Tax Times are A Changin'

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 context.

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 Changes

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 increase.
• 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 re-branding 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 Believed

There seemed to be a sense among 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 the following:

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 taxpayer.
• 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 ("AMT"):

• 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.

Capital Gains Taxes:

• 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.

Tax Deductions:

• 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 eliminated.
• 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 Changes:

• 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.

Estate Tax:

• The future of the federal estate tax has not yet been the subject of much reported discussion, and the outcomes remain completely uncertain.
• 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 million.
• 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 projections.

Inflation Calculations:

• 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 projection.
• 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 system.
• Personal exemption amount.
• IRA contribution limits.
• 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 overtime.
• 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."

Tax Credits:

• 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.

Corporate 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 Law Changes

The IRS publishes a wealth of statistical data on tax filings. See http://www.irs.gov/taxstats/indtaxstats/article/0,,id=96981,00.html from 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 forming entities.
• 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.

Conclusion

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.