The Current Environment
Excerpted from The 2013 Essential Tax and Wealth Planning Guide
As this publication went to press, Congress had not yet resolved a number of tax issues that are critical to high net worth individuals and will not do so until after the November elections at the earliest.
Individual tax rates — Chief among these unresolved issues is the pending expiration of the 2001 and 2003 tax rate reductions and other individual income tax cuts. Without action, the law will revert to what was in effect in 2000, which would mean:
- The 10% bracket would disappear and rates in all brackets above 15% would increase.
- Marriage penalty relief in the lower brackets would be eliminated.
- The child tax credit would drop from $1,000 per child to $500.
- The top marginal tax rate would return to 39.6%.
- Capital gains would be taxed up to 20%.
- Qualified dividend income would be taxed up to the highest ordinary rate.
- Limits on itemized deductions and personal exemptions would be reinstated.
- The estate tax exemption level would drop to $1 million and the top rate would jump to 55%.
Even if lawmakers reach an agreement to retroactively extend current law sometime in 2013, their failure to have a deal signed by the President before January 1 would effectively result in a tax hike in the form of increased withholding as employers would have to rely on revised withholding tables until an extension is enacted.
Alternative minimum tax — Because the individual alternative minimum tax (AMT) is not indexed for inflation, Congress generally increases the AMT exemption amount each year to limit the reach of the tax to the upper-income taxpayers it was intended to target. In 2011, this tax — which most often applies to families with higher-thanaverage state and local tax burdens, a significant number of dependents, or both — affected 4.4 million taxpayers. The House and Senate have proposed in separate bills to increase the AMT exemption amounts for 2012 to $78,750 for joint filers and $50,600 for singles. If the AMT is not “patched” for 2012, the exemption amounts would fall back to $45,000 for joint filers and $33,750 for singles, resulting in more than 28.5 million additional taxpayers paying the tax for 2012.
Expired and expiring tax provisions — Nearly every year Congress faces a long list of so-called “extenders” provisions — temporary individual and business tax incentives that have expired or are due to expire. Because Congress failed to act on extenders in 2011, lawmakers now face the task of addressing those provisions along with a range of provisions that are set to expire at the end of this year. For individuals, provisions that expired at the end of 2011 included the itemized deduction for state and local general sales taxes, the additional standard deduction for state and local real estate property taxes, and the above-the-line deduction for qualified tuition and related expenses.
For businesses, the research and experimentation tax credit, the New Markets Tax Credit, 15-year straight-line cost recovery for qualified leasehold improvements, the exception for active financing income under subpart F, and look through treatment of payments between related controlled foreign corporations all expired and await legislative action.
Additionally, a number of tax incentives such as bonus depreciation and certain renewable energy credits are set to expire at the end of 2012.
New taxes in 2013 — The following taxes, imposed by the Patient Protection and Affordable Care Act (PPACA) will become effective in 2013:
- Net investment income tax: For upper-income taxpayers, unearned income such as interest, dividends, capital gains, annuities, royalties, and rents, other than such income that is derived in the ordinary course of a trade or business and not treated as a passive activity, will be subject to a 3.8% “net investment income tax” beginning in 2013. The tax applies to the lesser of the individual’s net investment income or modified AGI in excess of specified threshold amounts — $200,000 for singles and $250,000 for joint filers. (For married couples filing separately, the threshold is one-half the amount for joint filers.)
- Medicare HI tax: Also beginning in 2013, an additional 0.9% Medicare HI tax will apply to wages of an employee or earnings of self-employed individuals that exceed specified thresholds. For single filers, this additional tax applies to wages or self-employment income received during the year in excess of $200,000. If an employee or a self-employed individual files a joint return, then the tax applies to all wages and earnings over $250,000 on that return. (For a married couple filing separately, the threshold is one-half the amount for joint filers.) The employer’s HI tax will not change. Selfemployed individuals cannot deduct any portion of the additional tax.
If the reduced current-law tax rates expire at the end of the year as the new 3.8% net investment income tax takes effect, then beginning next year, a high-income taxpayer could expect an effective tax rate on long-term capital ains of 23.8% and an effective tax rate for dividends of 43.4%. Moreover, the reinstatement of the 3% itemized deduction limitation and the phase-out of personal exemptions would further boost the effective tax rate on long-term capital gains and dividends to 25.8% and 45.4%, respectively.
Summary: While it may seem reasonable for our elected officials to agree on a timely path forward to resolve these issues, it is also easy to see how we arrived at this tipping point yet again. We have in Washington, D.C. competing visions of the tax burden that upper-income taxpayers should be expected to bear in today’s society.
The White House and members of Congress in both parties generally agree that the Bush tax cuts should be extended in some form for another year. They disagree, however, over which taxpayers should continue to benefit from the current-law, lower rates. President Obama and congressional Democrats argue that the Bush tax cuts should be extended only for low- and moderate-income taxpayers in order to make the tax code more equitable and to help reduce the federal deficit.
Congressional Republicans, on the other hand, maintain that the tax cuts should be extended for all taxpayers and that allowing current law to expire for upper-income individuals amounts to an unacceptable tax hike on small businesses.
This debate will play out late in 2012 and, while some congressional observers predict that both sides will come to an agreement to extend current law for a short period of time, possibly as a prelude to tax reform, there are a number of uncertainties — including the outcome of the election, the state of the economy, and the willingness of the White House and Congress to agree on a deal — that could result in at least a temporary expiration of those current tax rates for all taxpayers. At a minimum, a review of tax rate planning for 2013 and beyond should take into account the potential for future rate increases and the possible merits of accelerating income such as dividends and capital gains into 2012.
Future environment: Tax reform debate continues
Looking beyond 2012, policy makers continue a tax reform debate that could fundamentally change how individual taxpayers compute their taxes. The approach to tax reform that generates the most interest involves “buying down” tax rates by eliminating many “tax expenditures,” which are provisions of the tax code that provide targeted benefits. Among the largest individual tax expenditures are the exclusion for employer-provided health benefits, the lower rates on capital gains and dividends, the incentives for retirement savings, and the deductions for mortgage interest and for state and local income taxes (see chart below).
|10 Largest individual tax expenditures, 2010|
|Expenditure||Value to the
2010 ($ billion)
|Exclusion of employer health contributions||105.7|
|Mortgage interest deduction||90.8|
|Exclusion of pension plan contributions and earnings||83.8|
|Reduced rates of tax on dividends and long-term capital gains||77.7|
|Making Work Pay Credit||59.7|
|Earned Income Tax Credit||56.2|
|Child Tax Credit||55.1|
|Exclusion of Medicare benefits||54.6|
|Deduction for charitable contributions||36.8|
|Deduction for state and local taxes||30.7|
Note: These 10 items accounted for 70% of all individual income tax expenditures in 2010.
Source: "Tax Expenditures: Compendium of Background Material on Individual Provisions," Senate Budget Committee Report S. 111-58, December 2010.
One of the most prominent examples of this type of reform is the Bowles-Simpson deficit commission report issued in December 2010. For individuals, the commission recommended eliminating all federal tax expenditures (including popular deductions and credits) and then using the savings to reduce the deficit and lower income tax rates. Expenditures that Congress considers necessary could then be added back to the tax code with corresponding rate adjustments.
The report estimates that if all current-law expenditures were eliminated, individual rates could be lowered and compressed into three progressive brackets of 8, 14, and 23%, and the AMT, the personal exemption phaseout, and itemized deduction limitation could be eliminated. The report notes that even if some expenditures are added back — for example, the exclusion for employer-provided health insurance, deductions for mortgage interest and charitable giving, and the child tax credit — individual rates could be pegged at 12, 22, and 28%.
In any discussion of tax reform, a key source of concern for upper-income individuals is the possible change in the treatment of capital gains and qualified dividends. As a group, the highest-income taxpayers receive a higher share of their income as taxable capital gains and receive a disproportionate share of all capital gains income. But fundamental reform that dramatically lowers top rates also could result in capital gains and qualified dividends being taxed at ordinary rates, as recommended by the Bowles-Simpson commission. Such an action would reflect a political desire to maintain relative tax burdens on the highest-income earners.
Alternatively, conservative tax reformers believe that investment income should not be taxed at all. They argue that income is taxed once when earned and that taxing the return when that income is invested amounts to double taxation. If they prevail in a tax reform debate, the capital gains tax could be lowered from existing levels.
Tax planning — Although congressional tax writers have spent much of this year exploring issues related to tax reform, a unified vision around what a reformed tax code should look like and a detailed plan for making tax reform a reality remain elusive. That said, if Congress does act on comprehensive tax reform in 2013 or 2014, it could raise new tax planning issues. For more than a decade, high income taxpayers have planned with an understanding that eventually taxes and tax rates could increase. The tax reform discussion creates two additional possibilities: rates may come down while total burdens increase, or rates may come down without total burdens changing significantly.
To the extent that these tax benefits are at least partially preserved, tax rates will have to be higher than they otherwise would be if all expenditures were eliminated. High-income taxpayers will want to watch for proposals that reduce the cost of tax expenditures to the government by restricting their availability to, or value to, more affluent individuals. For example, President Obama has proposed limiting the tax benefit provided by itemized deductions to that provided by taking the deduction in a 28% tax bracket (rather than 35%). The Bowles-Simpson plan proposed limiting mortgage interest deductions to mortgages of less than $500,000 as well as eliminating the deductions for interest on mortgages on second homes and home equity lines of credit.
If you believe that income tax rates and overall income tax burdens will decline as a result of tax reform, opportunities to defer income or to invest in qualified retirement plans capital gains rates will rise dramatically as a result of reform, you will want to consider appropriate planning as reform moves closer in time.
While the focus of this publication is primarily on individuals and their estates, certain business changes that have been discussed in the context of tax reform could adversely impact individuals who own businesses using passthrough entities. In a worst-case scenario, some large businesses that report as a passthrough entity for tax purposes could be required to report as a corporation. Alternatively, reform could scale back deductions now available to passthrough owners. These changes could result in additional tax burdens on these owners. Again, owners and their businesses will want to closely observe the legislative process and evaluate risks resulting from potential tax changes.
How to think about your future
This publication is intended to help you (1) take stock of the forces that will shape potential changes in federal taxes, and (2) identify underlying realities that will help you plan dispassionately in the context of uncertainty. Effective planning will demand that you develop your own personal view of our economy and the markets, the future of taxes and tax rates that you may experience, and federal spending priorities that may influence your own retirement needs. Although no one can predict the future, a personal assessment of future possibility is a vital step in the planning process. In fact, you may want to test your plans under a range of possibilities. Having framed the debate in Washington, D.C. over the future of tax and fiscal policy, this publication will examine several important areas where effective and appropriate tax planning is paramount.
Planning for 2013: With the extension of lower Bush-era tax rates for individuals and the adoption of a more lenient estate and gift tax regime through 2012, yet another scheduled expiration of tax relief is rapidly approaching. Individuals once again face the same uncertainty over future income tax rates that existed through 2009 and 2010. This section will address planning amidst that uncertainty, with a look toward the three potential outcomes: an extension of current rates, tax reform accompanied by lower rates, or tax reform accompanied by tax increases.
Income tax: Appropriately reducing or postponing the payment of federal, state, and local income taxes is a critical component of assembling the capital from which wealth grows. Although the complexity of income taxes has increased over time, effective tax planning begins with these concerns:
- Understanding and managing the AMT.
- Utilizing the tax benefits accorded capital gains and dividends.
- Planning charitable giving.
- Considering the impact of state taxes.
- Managing the benefits afforded by qualified retirement plans.
Wealth transfer tax: Effective wealth transfer planning is an ongoing process that comprises these five major steps:
- Defining your family wealth transfer and charitable goals and objectives.
- Understanding the available wealth transfer tax exemptions, exclusions, and planning opportunities.
- Creating or updating your family wealth transfer and charitable transfer plan.
- Implementing the plan with due consideration to state and federal transfer taxes.
- Revisiting and fine-tuning your plans and goals as your personal circumstances change.
This process becomes even more important as current estate tax rules are set to expire at the end of 2012, which could result in anything from an extension of current-law rates and exemption amounts, to a return to 2009 rates and exemption amounts, to the reinstatement of pre-2001 law with a 55% top rate and a $1 million exemption.
Planning in uncertain times
In the face of such uncertainty, it is tempting to do nothing on the grounds that it is too hard to know what course of action to follow. Of course, in tax and wealth planning, doing nothing is still a decision and can be a bad one.
Continue to plan; work with what you know — We believe significant tax changes will occur, but until change comes, taxpayers will find that disciplined planning under present law may produce real benefits. This is particularly true as the possibility of tax rates increasing for 2013 becomes more certain; thus, planning for those rate changes becomes more meaningful.
In addition, many of the benefits under existing law are likely to continue. For example, while capital gains tax rates may be increased modestly, the basic structure that results in a significant advantage for long-term capital gains will continue.
Adopt a view of the future and plan accordingly — As this goes to press, we are moving toward an election to determine control of the White House and Congress that presents two competing visions of future taxes. Some in Washington, D.C. would restore the top tax rates that existed before 2001, and others would move toward fundamental reform of the tax system so that top rates could be set in the 25% to 28% range. As a result, as you look ahead to 2013 and beyond, a reasonable assumption could be made that tax rates on ordinary income could range anywhere from 25% to effectively almost 44%. If you believe strongly in the potential for tax reform, planning to appropriately defer tax for several years will be of interest to you. Conversely, if you believe tax rates are bound to increase, then income acceleration will become attractive to consider in late 2012.
Be wary of quick answers and simple advice — Tax legislation never concludes in the manner in which it starts. The U.S. and global economies and our governmental processes are highly complex, as are the structures, instruments, and businesses to which a tax law must apply. Even simple tax proposals change during the legislative process. Before taking action in response to a potential change, taxpayers should completely analyze a proposed transaction and alternative outcomes.
For example, while selling an asset to avoid a higher capital gains tax in the future may make sense in some cases, it may be costly in others. A planning decision will depend on the amount of gain to be recognized relative to the asset’s fair market value, the cost of the initial and anticipated subsequent transactions associated with the plan, the expected return on the asset, and the expected increase in tax rates. There is no simple, quick, or uniform answer.
Watch for opportunities and know your risks — The mere discussion of dramatic tax changes and new taxes can influence markets. Continuing uncertainty over the long-term outlook for the federal budget influences financial markets and the value of the dollar. As a taxpayer and an investor, you should work to be informed about significant tax and nontax reforms and position your portfolio in a manner consistent with your conclusions about how changes will affect investment opportunities.
Although the potentially dramatic level of the changes we see ahead creates unparalleled uncertainty for individual tax and wealth planning, it also can create opportunity for those who address the uncertainty head on.
For more details on tax and wealth planning in our current environment, download The 2013 Essential Tax and Wealth Planning Guide.