In this column published on Friday, December 28, 2012 I suggested that there were a number of “outlines” evolving in the tax field as we approached the dreaded “fiscal cliff.” Since then the White House and Congress struck a series of compromises on tax matters, so we’ll take a quick look at how close the predictions were to reality, and what makes sense for current tax planning. In quick order, the predictions were…
1. There would be an increase in the highest individual income tax rate, and that while the White House wanted that to take effect for adjusted gross income of over $250,000 (on a joint income tax return), and the Republicans urged $1,000,000, it was likely that the parties would ultimately settle on something in the range of $400,000 – $500,000. In fact, the top rate jumped from 35% to 39.6%, and the “number” turned out to be precisely in the middle of the prediction range, or $450,000.
2. As predicted, the rate on long-term capital gains went from 15% to 20%. Although there was some talk that the tax rate on dividends would go from 15% to perhaps the highest marginal rate, as anticipated the rate went to a maximum of 20%.
3. However, the Affordable Care Act (“Obamacare”) creates an additional 3.8% tax on investment income (generally, capital gains, interest, dividends, royalties, and some rental income), on joint returns with adjusted gross income over $250,000, so that for “high earners” the rate on long-term capital gain and dividends can easily be 23.8%.
4. The previous article also suggested that there could be a “back door” or “stealth” increase in taxes (in addition to raising the rates) by eliminating or reducing deductions. It was suggested that 3 categories might be in play, the deduction for mortgage interest on personal residences, charitable donations, and the exemption for state and local indebtedness (municipal bonds). In fact, the compromise resulted in a “stealth” increase that impacts all itemized deductions, as well as personal exemptions, because the amount of those deductions is “phased out” for high earners, here defined as adjusted gross income on a joint return of over $300,000. The phase-out impacts all itemized deductions except for medical expenses, investment interest, and casualty losses. The math is unduly complicated since the personal exemptions and deductions are “phased-out” under different schedules, but it has been projected that the cutbacks to exemptions and itemized deductions will each add over a percentage point to the effective tax rate. By any standard, however, it represents a “one way street” in favor of the tax collector which won’t be fully realized until the 2013 tax returns are prepared. (Tax exempt interest on municipal bonds has escaped change, at least for now.)
5. Two changes that were not discussed in the article bear quick noting. First, the “payroll tax holiday” was not extended, so that there will be a 2% increase in the employee’s share of social security withholding. (The same 2% “bump” applies to self-employed persons.) That has already had an impact as withholding on paychecks has increased by that 2% amount. Another change is the provision extending tax-free distributions from Individual Retirement Accounts (IRAs) to public charities by individuals aged 70 ½ or older to December 31, 2013. Further, there is a special “transition” rule which permits any transfers to charities made in January 2013 to be treated as if made in 2012. This can still be helpful to some taxpayers, particularly if they have not taken their minimum required distribution by the end of 2012.
6. (a) In the estate and gift tax arena, in 2012 the amount exempt for federal and estate gift taxation was $5.12 million per person, and any amounts over the exemption were taxed at a flat rate of 35%. If no compromise was struck, the exemptions were to drop to $1 million, and the rates escalate to as high as 55%. The White House was arguing for an estate tax exemption of $3.5 million with a flat rate of 45%, but the article predicted that the approximately $5 million exemption for estate taxes would survive, and that the rate would likely stay at about 35%. A serious question existed as to whether the gift tax exemption would revert to only $1 million as it was before 2011, or whether that would continue to be the same as the estate tax exemption.
(b) In fact, the estate and gift tax exemption was not only kept at the $5 million mark, but by reason of indexing for inflation it is now $5.25 million per person. The rate, however, jumped from 35% to 40%. Also, “portability” – the ability for the estate of a surviving spouse to apply the “unused” exemption from the estate of the predeceased spouse – has now been made permanent, and, although it has some technical requirements, makes it easier for a married couple to be sure to take advantage of the combined exemptions in passing property on to the next generation. (Note, however, that the exemption from the New York State estate tax apparently remains frozen at $1 million; you might want to remind your friendly State legislator of that, and note that even if you are not thinking of moving to Florida or some other “tax haven” state, a lot of your well-to-do customers and clients seem to be doing just that, and maybe its time for the Empire State to think about revisiting its estate tax policy which appears to be designed to provide incentives for well-to-do people to leave, rather than stay.)
Now, what to do with this set of facts?
7. Recent press reports suggest that star golfer Phil Mickelson is seriously considering leaving the country, and even more likely the high-tax state of California, as a result of his concern over the high tax rates. Since most of us may not have the same flexibility, some other ideas might work better. First, it would seem that looking for “tax shelters” is generally not rewarding. Clearly, there are some tax-favored investments, such as real estate, and oil and gas, but as always, they should be viewed from an investment prospective, and the tax advantages are merely one factor in making that decision. It’s been my experience that to acquire those principally for their tax advantages is usually not productive.
8. From a tax perspective, tax exempt interest on municipal bonds continues to be favorable. Whether the economic climate and interest rates make these favorable investments is always subject to question, but from a tax standpoint it is highly likely that they will continue to receive favored treatment and escape the tax burden.
9. However, as Mitt Romney has clearly demonstrated – and this has always been true for virtually the hundred years that we have had an income tax – if one can convert what is otherwise ordinary income into either long-term capital gain or dividends, the tax savings can be extraordinary. If a taxpayer can “cap” the tax rate at 20%, in the real world it’s hard to do better. However, for those who derive most of their income from personal services – by means of salary, wages, bonus, fees, commissions, etc. – escaping the burden of these higher taxes will be very difficult. This is particularly true for those of us living in one of the “blue states,” i.e. states like New York with high personal income tax and property taxes; the deductibility of these state and local taxes will not only be severely reduced, but since many high earners are subject to the dreaded alternative minimum tax (AMT), the benefit of those deductions may be lost entirely. Avoiding the impact of the AMT is itself a complicated issue, but may be worth investigating with one’s tax return preparer.
10. On the estate and gift tax side, however, there remain a number of interesting opportunities. The continuation of the gift tax exemption at the $5.25 million figure provides maximum opportunities for estate tax avoidance. This is particularly true now since the many “discounting” mechanisms are still widely available. It is likely that Congress – urged by the Treasury Department – will address those discounting techniques with any coming tax reform movement, but right now a number of these favorable procedures are still available and predictable, and persons with significant net worth should continue to explore significant gift planning, whether in trust or otherwise, with these larger exemptions. Further, the “annual exclusion” from gift taxes – that is the amount that can be given to any person each year – has now been raised to $14,000 annually. This can be doubled for a married couple, so that with a little proper planning a couple can give $28,000 per donee per year.
11. There are also a number of other fairly sophisticated techniques which are worth looking into in our new higher tax environment. Clearly, the larger estate and gift tax exemptions, combined with the current availability of significant discounting techniques, continue to make aggressive estate and gift tax planning a priority for high net worth individuals.
Sherman F. Levey is Of Counsel to Boylan Code LLP, concentrating his practice on Tax Law and Estate Planning, including Tax Controversies. For more information, please contact Sherm at (585) 232-5300 or by email at email@example.com.