2013, The Fiscal Cliff, and Taxes: What do we really know?

By Sherman F. Levey, Esq.

The quick answer to the question posed in the headline is, not much, really.  However, if history is any indicator, there are outlines which are becoming apparent and which can be relied on for some future planning.

First, there is nothing certain in politics, and over the past several years the current crop of politicians has proven that to be truer than ever.  The ideologues from both sides, seemingly unwilling or unable to reach compromise, have made planning in the economic and tax realm ever so more difficult as they hew to their party lines.  However, given that the price of “doing nothing” is the restoration of considerably higher income and estate taxes in 2013, it seems that some compromise will have to occur.  (This article is being written a few days before Christmas, and chaos seems to predominate:  Speaker of the House Boehner has withdrawn his “Plan B” because he cannot get his own party to support it, everyone is leaving Washington, and it appears that nothing will be done until after Christmas, if then.  However, hope springs eternal.)

What is evolving appears to be this: There will very likely be an increase in the highest individual income tax rate in 2013.  However, the “entry level” and the rate are both problematic.  Given President Obama’s pledge to not adversely impact the “middle class,” the first question is, “How do we define middle class?”  The Obama position is that the tax increase is for those with adjusted gross income of over $250,000 (on a joint return).  The Republican position appears to be $1,000,000 of adjusted gross income.  Talk has focused around a $400,000 number.  There are a lot of numbers between $250,000 and $1,000,000, so it is highly likely that the parties will ultimately settle on something closer to the middle – $400,000 – $500,000 seems like a good bet – and move on.  What the top rate (presently 35%) will be is anybody’s guess, but going back to the pre-2001 rate of 39.6% seems to be a reasonable projection.

In addition, again if nothing is done, the rate on long term capital gains goes from 15% to 20%, and the present 15% rate on dividends is eliminated and dividends will be taxed at the highest ordinary income tax rate, which could go to 39.6%.  (On top of all of these might be an additional 3.8% tax from the Affordable Care Act (“Obama Care”) which adds an additional tax burden on investment income for higher income taxpayers.)

Perhaps of more concern is what form “tax reform” will take, and here the “wild cards” will be the reduction or elimination of current deductions or credits.  It seems clear that any compromise not only will be on the rates and entry levels, but will also involve a reduction or elimination of deductions which, after all, favor the wealthier taxpayers.  There are at least three “sacred cows” which are now the subject of discussion.

The first is the deduction for mortgage interest on personal residences.  Presently, within limits, deductions can be taken for interest payments on mortgages on a first or second (vacation) home, as well as on “home equity” loans.  It would not be surprising to see those limits substantially reduced in any future tax legislation.

Secondly are the deductions for charitable donations.  There is an extremely strong lobby opposing any such reduction, and it is likely that charitable donations will not be seriously impacted, but it is possible there will be some limitations at the higher income levels.

Lastly, there is serious talk about eliminating the current tax advantage on state and local indebtedness (“muni bonds”).  Interest income on these bonds has long been exempt from federal taxation, but this exemption is considered a “loophole” by many tax analysts.  Obviously, there is a very strong lobby opposing any change to this, i.e. the many state and local governments who can obtain lower-cost financing because of the tax advantages on their borrowings.  This will open up a considerable political fight, but it may be an idea whose time has come.

In an area where I keep very close watch, there is no certainty as to how the federal estate and gift tax structure will evolve.  Currently, the amount exempt from federal estate and gift taxation is $5,120,000 per person ($5,000,000, plus an inflation adjustment for 2012).  Any amounts over that exemption are taxed at a flat rate of 35%.  If no change is made, in 2013 the exemptions drop to $1,000,000, and the rates escalate to 55%.

The Obama proposal provides an estate tax exemption of $3,500,000, with a flat rate of 45%, but there are strong indicators that the approximately $5,000,000 exemption for estate taxes will hold, and the rate will likely stay at 35% as well.  The “wild card” in this situation is the gift tax exemption: it does not necessarily have to be the same as the estate tax exemption, and for many years was “frozen” at $1,000,000 even though the estate tax exemption was significantly higher.  This is important for estate planning purposes since gift-giving (particularly combined with many valuation discounting techniques still available) is extremely effective.  At this point, all we can do is wait and see what evolves from the political process but I believe some resolution will occur very early in 2013, retroactive to 1/1/13.

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 sflevey@boylancode.com.

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