As part of the U.S. FY 2010 budget, President Obama’s Administration has proposed to shift the tax burden on individuals more toward those with higher incomes and greater assets. The budget proposals would restore higher individual income tax brackets, limit certain deductions or exemptions, adopt a permanent estate tax and increase compliance-related reporting requirements.
The increases generally are proposed to take place in 2011, but Congress could accelerate the pace of some changes, depending on the need to fund other Administration priorities, such as health care reform. While these proposals first must be considered by Congress, high net worth individuals would nevertheless be wise to begin thinking through the possible implications of future changes and consult with their tax advisors to plan accordingly.
Individual income tax
Overall, the Administration’s proposals would provide tax cuts to the vast majority of individuals by extending existing tax cuts for low-and middle-income individual taxpayers. But in describing its budget tax proposals, the Administration states its desire “to make the income tax system more progressive and . . . distribute the cost of government more fairly among taxpayers of various income levels.” Thus, it looks to upper income individuals to take on the proposed increases, resulting in the restoration of tax policy positions that were in effect during the 1990s. The Administration generally uses the parameters of singles and married couples with adjusted gross income (AGI) over USD 200,000 and USD 250,000, respectively, to define the group that would face increases. This represents roughly the top 3% of individual income taxpayers, based on recent U.S. Internal Revenue Service (IRS) data.
Tax rates – The largest single revenue generator with respect to individuals would be the Administration’s plan to restore the top two pre-2001 tax brackets. Under the plan, the current top tax rate brackets of 33% and 35% would return to 36% and 39.6%, as they are already scheduled to do after 2010. The budget proposal states the 36% bracket would begin at taxable income in excess of USD 190,650 for singles and USD 231,300 for married taxpayers filing jointly (based on 2009 amounts). While the budget proposal does not specify a breakpoint for the proposed 39.6% bracket, the current threshold of USD 372,950 is believed to be a reasonable indication. The 28% bracket also would be expanded slightly to reflect modifications to the upper limit of that bracket (where the 36% bracket would begin). The lower brackets of 10%, 15% and 25% would remain unchanged, and the tax cuts built into these brackets, such as the 10% bracket and marriage penalty relief, would be made permanent. These lower rate brackets would continue to provide modest benefits to high income individuals, despite the increases in the top two brackets.
The tax rate on capital gains and qualified dividends also would increase after 2010 as scheduled; however, rates for dividends would remain pegged to those for capital gains rather than returning to ordinary income tax rates. The budget proposal would raise the long-term capital gain and qualified dividend rate from 15% to 20%, but only for those taxpayers with income taxed in the 36% and 39.6% brackets. The special reduced rates on property held for more than five years would be repealed.
Phase-outs and limitations – Both the phase-out of personal exemptions and the 3% reduction of itemized deductions (commonly called the PEP and Pease limitations), which affect high income individuals, have been phased out gradually over the past four years. These limitations are scheduled to be eliminated completely for one year in 2010. The Obama Administration proposes to reinstate both the PEP and Pease limitations for upper income individuals after 2010.
The PEP limitation has little effect on individuals with significantly higher income because the amount of the personal exemption is insignificant to overall income. The Pease limitation could limit itemized deductions to only 20% of allowable deductions in cases of high income and more modest itemized deductions. An individual who donates a significant portion of his/her income (e.g. an active philanthropist) or resides in a high income tax state would be less likely to fall into that situation.
Capping itemized deductions benefit – For the same class of taxpayers, the Administration also has proposed placing a cap after 2010 on the benefit provided by the sum of a taxpayer’s itemized deductions. The proposal would operate as follows: while the top income tax rate on ordinary income would be 39.6% (and the marginal tax rate likely slightly higher), the greatest benefit an individual could receive from itemized deductions would be capped as if the highest rate were 28%. Thus, for a taxpayer with USD 1 million of taxable income, the next dollar of ordinary income would be taxed within the 39.6% tax bracket, but an additional dollar of itemized deduction would yield a tax benefit at only 28%. Said differently, for this taxpayer, a USD 10,000 bonus from his/her employer would result in USD 3,960 of additional income tax (without taking into consideration other phase-outs and limitations), but an additional charitable contribution of USD 10,000 would result in a tax savings of only USD 2,800. This proposal has received widespread criticism from lawmakers on Capitol Hill because some argue it would reduce overall aggregate charitable contributions and increase the cost of a personal residence due to the impact on the mortgage deduction, during a time when both activities already have been adversely affected by an ailing economy.
Alternative Minimum Tax (AMT) – For several years, Congress has patched the AMT by temporarily increasing the AMT exemption. Under the Administration’s budget proposal, the increased exemption recently enacted under the American Recovery and Reinvestment Act of 2009 (USD 46,700 for individuals and USD 70,950 for married couples filing jointly) would be made permanent and indexed for inflation. This dual tax system would remain a permanent fixture of the Internal Revenue Code and would not be repealed, as some members of Congress have suggested; instead, the higher exemption would become law going forward. While AMT is a significant issue for some higher income individuals, if the source of their income is primarily tax-favored investments and they reside in states with high income tax rates, the increased exemption amount will provide only modest relief.
Private equity/investing – With respect to investing, the Administration has proposed that carried interests related to “service partnership interests” would be taxed as ordinary income and generally would be subject to self-employment tax. Also, proceeds from the sale of a carried interest would be considered ordinary income. Certain gains would not be recast as ordinary income if the taxpayer contributes investment capital in the form of money or actual property to the partnership. In this circumstance, the portion of the income related to the invested capital would appear to remain taxed as a capital gain, while the remainder of the income would be taxed at ordinary income rates. Of note, the Obama proposal would have a significantly wider scope with respect to its application than previous carried interest proposals, which focused primarily on investment management activities.
Dealers of marketable securities could see an increase in the tax rate on certain day-to-day dealing activities, effective in 2010 rather than 2011. This proposal presumably would affect not only direct dealers in securities, but also partners in investment partnerships, hedge funds and other flow-through vehicles where a portion of the underlying assets is classified as dealer securities. The budget also proposes to eliminate completely tax on capital gains generated by the sale or exchange of certain small business stock. This change would build upon the change already enacted by the 2009 economic stimulus package, which exempted 75% of the gain.
Planning – With the anticipation of higher tax rates, many will want to consider accelerating income, such as deferred compensation or capital gains transactions. In this context, individuals will want to consult with a trusted tax advisor to examine both the economic and tax considerations. Significant issues to be evaluated could include the availability of attractive alternative investments, economic risk and transaction costs. For example, it might not make sense to accelerate a capital gains transaction to lock in a 15% tax if the transaction costs total 6%. Similarly, if accelerating deferred compensation does not generate cash, the cost of paying the additional tax using alternative cash resources must be considered.
For taxpayers who consistently owe AMT from year to year, the proposed tax rate increases and deduction limitations may not pose as significant a threat. In some cases, these proposed changes may merely reduce the amount of AMT owed without increasing the overall tax burden. However, individuals who primarily owe tax on investment income that is taxed at the lower, more beneficial rates for both regular and AMT purposes may find that the proposed rate changes increase their effective tax rate about five percentage points, increasing their total tax burden by a third. Individuals who own businesses (C corporations, S corporations and partnerships) will want to consider whether their choice of entity continues to make sense. S corporation owners and sole proprietors who pay within higher individual income tax rate brackets may want to determine whether incorporation as a C corporation would be preferable, particularly if Congress reduces the corporate tax rate as some lawmakers have proposed. However, the burden of higher individual taxes must be weighed against the cost of incorporation, state tax issues, other economic factors, business goals and the inherent benefit of S corporation status if the corporation is ultimately liquidated or sold. In many cases, it would not make sense to change to a C corporation unless a dramatic drop in the corporate tax rate were to occur in combination with significant individual income tax hikes.
Estate and gift tax
Under current law, the estate tax rate is 45% on amounts exceeding the USD 3.5 million exemption per individual. The estate tax is scheduled to be repealed for one year in 2010, before returning to a pre-2001 structure in 2011 (a top tax rate of 55% and an exemption of USD 1 million per individual).
No repeal – Neither Congress nor the Obama Administration would like to see the estate tax disappear in 2010 only to reappear in 2011. To avoid this, the budget proposal would make permanent the current 2009 structure (45% rate and USD 3.5 million exemption) effective at the beginning of 2010.
Gifts – Although there is ambiguity on this point, tables accompanying the President’s tax proposals imply that the lifetime gift exemption would remain at its current limit of USD 1 million per individual. Lifetime use of this USD 1 million exemption reduces dollar-for-dollar the amount of the USD 3.5 million estate exemption that a taxpayer can utilize at death. Said differently, the total estate and gift exemption is USD 3.5 million, but only USD 1 million of this exemption can be utilized during an individual’s lifetime. Some in Congress have expressed interest in reunifying the estate and gift tax regime, which would allow for a lifetime gift exemption of USD 3.5 million.
Congressional tax writers also may allow portability of an unused estate tax exemption from one spouse to another. This would allow the surviving spouse to use the preceding deceased spouse’s unused estate tax exemption in addition to his/her own. So, if the first spouse only used USD 2 million of the exemption, the second spouse could use the remaining USD 1.5 million from the first spouse, and his/her own exemption of USD 3.5 million, totaling USD 5 million.
While Congress and the President may move to allow for more gifts and portability, the Administration also would like to address some perceived abuses in the area of estate and gift tax.
Loophole closers – For inheritances and gifts, the Obama Administration proposes to codify the legal doctrine of “duty of consistency,” requiring consistent treatment of asset basis for both income and transfer tax purposes. A reporting requirement also would be imposed under which asset basis and other information would be reported to the IRS.
Another proposal would disregard, under an existing Code provision, certain factors that generally are held to increase discounts applied to the transfer of minority interests in family-controlled entities, including: (1) limitations on a holder’s right to liquidate his/her interest that are more restrictive than standards to be identified in regulations and (2) any limitation on a transferee’s ability to be admitted as a full partner or holder of an equity interest in that entity. It is difficult to determine from the proposal the extent to which discounts commonly encountered in public transactions would be limited, by analogy, in their applicability to transfers of interests in family-controlled entities. While many fear the worst, it is noteworthy that the legislative history underlying the existing Code section expressly sanctions the continuing applicability of such discounts. In any event, the budget proposal is far less restrictive than a recent congressional proposal that would severely restrict the use of minority discounts.
A third proposal in the estate and gift tax area would require that a Grantor Retained Annuity Trust (GRAT) – a popular and efficient technique for transferring wealth while reducing the gift tax cost – have an annuity term of at least 10 years. The longer term would increase the chance that the grantor’s death occurs during the annuity term, resulting in the inclusion of most, if not all, of the GRAT’s assets in the grantor’s estate. The change would have a significant impact on the demographics of those capable of most efficiently using GRATs for transfer tax planning. This rule would apply to GRATs created after the date of enactment of the legislation.
Additional changes have been proposed in the taxation of certain deemed “for profit” life insurance transactions, such as life or viatical settlements (recent IRS guidance also impacts treatment of these items). Additional information reporting requirements would apply to holders of certain life insurance contracts. However, traditional death benefits received upon the death of the policyholder still would remain exempt from income tax.
Planning – Given the almost virtual certainty that the estate tax will continue through 2010 and that the less favorable transfer tax regime of the 1990s will not return, individuals should examine the effects of the proposed changes with respect to their estate plans.
If Congress moves toward enacting changes that would limit the use of and/or size of discounts on the transfers of minority interests in family-controlled entities, such as family limited partnerships and LLCs, taxpayers may want to talk with their estate planners and tax advisors about whether to accelerate the timing of transfers in existing entities, either by sale or gift. Conversely, if Congress were to reunify the estate and gift tax exemptions at USD 3.5 million, thus permitting gifts of up to USD 3.5 million without tax, some may choose to delay taxable gifts until later.
Proposals to reduce the utility of transfers to GRATs provide an even more compelling reason for taxpayers to review their estate plans. In an environment of depressed asset values and low interest rates – the two factors that together act to enhance the odds of having a successful GRAT – the time to consider transfers to GRATS having annuity terms of less than 10 years is now.
Compliance-related reporting requirements
The Obama budget also proposes new reporting requirements, particularly with respect to tax havens. These would enhance information reporting, increase tax withholding and strengthen penalties to curb offshore tax haven evasion. Individuals would be required to report on their tax returns any transfer of money or property to foreign financial accounts – unless, for example, they are held at qualified intermediaries (QIs) – and receipts from accounts held by U.S. persons at QIs.
Individuals also would be required to file a Foreign Bank Account Report (FBAR) and disclose certain information on a schedule that would be part of their income tax return. In addition, the budget proposal would establish a rebuttable presumption that any financial account held by a U.S. citizen at a financial institution that is not a QI contains enough funds to require the filing of an FBAR. An exception would apply for accounts held through a QI, and the Treasury Department would be given regulatory authority to provide additional exceptions.
Examining the landscape of proposed changes, one should ask about the likelihood of whether they will become law. In the immediate near term, Congress is expected to take little action on these proposals and focus instead on such other priorities as health care reform and climate change legislation. These priorities potentially could pose some near-term risk for tax increases yet unspecified by the Obama budget. For example, Congress may be willing to place a cap on the exclusion available to employer-provided health care benefits. This would almost certainly affect upper income taxpayers. Almost without question, Congress will act to prevent the one-year repeal of the estate tax. An eventual permanent estate tax system likely will include other reforms in this area (such as some of the restrictions suggested by the Administration).
Many of the individual income tax increases for upper income taxpayers could take place without any action from Congress because the tax cuts available during the last decade are scheduled to expire after 2010. In contrast, Congress must act if it wishes to provide permanent relief for low- and middle-income taxpayers.
Overall, the budget proposal shows that the Obama Administration plans to pursue aggressively its tax policy agenda and that wealthier individuals play an important role as a source for tax revenue. More specifically, upper income taxpayers are clearly a target for additional revenue from both the individual and estate and gift tax systems. For now, the proposals remain exactly that – proposals. Some may never be acted on, but others, such as the restoration of the highest tax brackets, are almost certain to occur. Individuals should begin consulting now with their tax advisors to examine the potential implications of these proposals for their tax situations. As the old adage says, an ounce of prevention is worth a pound of cure.
— Julia Cloud (Chicago)
Craig Janes (Washington, D.C.)
Laura Peebles (Washington, D.C.)
Craig DeLucia (Charlotte)
Bart Massey (Washington, D.C.)