Many say it is DOA, that President Obama’s budget proposal is more a campaign manifesto than it is our next budget. If so it is reminiscent of Dickens’s third spirit in A Christmas Carol: the budget proposal is not necessarily what the future will hold but what the future might hold if he is re-elected and regains control of Congress.
If you doubt that this budget has an eye on the election, just turn to page 134 of the pamphlet to see the “Romney Provision” and why Mitt Romney has more to lose than the election if Obama wins four more years. That provision will tax folks like Romney, hedge fund and private equity partners who now have 15% effective tax rates since their earnings are all from “carried interests” (i.e. the dividends and capital gains derived from their service activities within the partnerships) at 39.6% plus employment taxes. Using the budget document to take a shot across candidate Romney’s bow, it states:
By allowing service partners to receive capital gains treatment on labor income without limit, the current system creates an unfair and inefficient tax preference. The recent explosion of activity among large private equity firms and hedge funds has increased the breadth and cost of this tax preference, with some of the highest-income Americans benefiting from the preferential treatment.
I can only imagine that an early draft actually had Romney’s name typed in this paragraph.
SOME PROVISIONS OF INTEREST TO MY CLIENTS
When viewed in light of tax policy rather than election year politics the latest budget proposal is simply ratcheting up the arms race we call tax planning and tax legislation. We have had the opportunity to learn the law and smart folks among us have developed sophisticated missiles to attack those provisions. Folks equally smart within Treasury then build their version of the Strategic Defense Initiative, only inevitably to have to deal with even smarter missiles. And so on. Here is part of the government’s latest version of Star Wars missile defense, tax law style.
Income Tax Provisions (generally effective for taxable years beginning after December 31, 2012)
· Reinstate the limitation on itemized deductions for upper-income taxpayers. Itemized deductions (other than medical expenses, investment interest, theft and casualty losses, and gambling losses) would be reduced by 3% of the amount by which AGI exceeds statutory thresholds, but not by more than 80% of the otherwise allowable deductions.
· Reinstate the tax rate brackets of 36% and 39.6%.
· Allow the current 0%-15% tax rates on qualified dividends would expire for those at the top rates and such dividends would be taxable in the 36% or 39.6% brackets.
· The maximum long-term capital gains tax rate for upper-income taxpayers would be 20%.
· Even though one might be in a bracket above 28% the proposal would limit the tax value of specified deductions or exclusions from AGI and all itemized deductions to 28%. A similar limitation also would apply under the alternative minimum tax. This would impact tax-exempt state and local bond interest, employer-sponsored health insurance paid for by employers or with before-tax employee dollars, health insurance costs of self-employed individuals, employee contributions to defined contribution retirement plans and individual retirement arrangements, the deduction for income attributable to domestic production activities, certain trade and business deductions of employees, moving expenses, contributions to health savings accounts and Archer MSAs, interest on education loans, and certain higher education expenses. This proposal would apply to itemized deductions after they have been reduced by the statutory limitation on certain itemized deductions for higher income taxpayers.
Estate, GST and Gift tax Provisions (generally effective to transfers after December 31, 2012)
· The proposal would revert to the law in 2009. Thus the top tax rate would be 45% (now 35%) and the exclusion amount would be $3.5 million (now $5,120,000) for estate and GST taxes, and $1 million (now $5,120,000) for gift taxes.
· Portability of unused estate and gift tax exclusion between spouses would be made permanent.
· “Estate freezes” and other techniques designed to reduce the value of the transferor’s taxable estate and discount the value of the taxable transfer to the beneficiaries of the transferor have been important tools for estate planners. These have developed over the years as “judicial decisions and the enactment of new statutes in most states, in effect, have made section 2704(b) inapplicable in many situations by recharacterizing restrictions such that they no longer fall within the definition of an ‘applicable restriction.’ In addition, the Internal Revenue Service has identified other arrangements designed to circumvent the application of section 2704.” This proposal would create an additional category of restrictions (“disregarded restrictions”) that would be ignored in valuing an interest in a family-controlled entity transferred to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor and/or the transferor’s family.
· GRATs have proven to be a popular and efficient technique for transferring wealth while minimizing the gift tax cost of transfers, providing that the grantor survives the GRAT term and the trust assets do not depreciate in value. This includes the ability to zero out the gift value by effective use of the annuity. Also among the tools employed have been two-year rolling GRATs. This proposal would require, in effect, some downside risk in the use of GRATs by imposing the requirement that a GRAT have a minimum term of ten years and a maximum term of the life expectancy of the annuitant plus ten years. The proposal also would include a requirement that the remainder interest have a value greater than zero ($1?) at the time the interest is created and would prohibit any decrease in the annuity during the GRAT term. Although a minimum term would not prevent “zeroing-out” the gift tax value of the remainder interest, it would increase the risk that the grantor fails to outlive the GRAT term (seems like valid tax policy to me) and the resulting loss of any anticipated transfer tax benefit.
· With the exemption for the generation skipping transfer tax cost at $5,120,000, a properly structured trust, particularly one in a state that permits trusts to go on perpetually (or virtually perpetually), will never have a GST, estate or gift tax—NEVER. Even for a trust that pays the GST, as costly as that might be, it is a one-time toll charge. This proposal would generally provide that the GST exclusion allocated to the trust would terminate on its 90th anniversary. Because contributions to a trust from a different grantor are deemed to be held in a separate trust under section 2654(b), each such separate trust would be subject to the same 90-year rule, measured from the date of the first contribution by the grantor of that separate trust. The special rule for pour-over trusts under section 2653(b)(2) would continue to apply to pour-over trusts and to trusts created under a decanting authority, and for purposes of this rule, such trusts will be deemed to have the same date of creation as the initial trust, with an exception.
· Another major estate planning tool has been the intentionally defective grantor trust (“IDGT”) and, recently, its cousin, sometimes called the Beneficiary Defective Trust (“BDIT”). These work because the rules that make a trust a grantor trust for income tax purposes differs slightly from the rules that make a trust a grantor trust for transfer tax purposes. And that slight difference is enough to create great opportunities for clients. To the extent that the income tax rules treat a grantor of a trust as an owner of the trust (that today would be an IDGT and excluded from the estate, among other benefits), the proposal would (1) include the assets of that trust in the gross estate of that grantor for estate tax purposes, (2) subject to gift tax any distribution from the trust to one or more beneficiaries during the grantor’s life, and (3) subject to gift tax the remaining trust assets at any time during the grantor’s life if the grantor ceases to be treated as an owner of the trust for income tax purposes. In addition, the proposal would apply to any non-grantor who is deemed to be an owner of the trust (the BDIT) and who engages in a sale, exchange, or comparable transaction with the trust that would have been subject to capital gains tax if the person had not been a deemed owner of the trust. In such a case, the proposal would subject to transfer tax the portion of the trust attributable to the property received by the trust in that transaction, including all retained income therefrom, appreciation thereon, and reinvestments thereof, net of the amount of the consideration received by the person in that transaction. The proposal would be effective with regard to trusts created on or after the date of enactment and with regard to any portion of a pre-enactment trust attributable to a contribution made on or after the date of enactment. (NOTE: there has been some debate as to whether a BDIT works; apparently, if this document is any gauge, the government seems to think it does).
· The proposal would require a person or entity who purchases an interest in an existing life insurance contract with a death benefit equal to or exceeding $500,000 to report the purchase price, the buyer's and seller's taxpayer identification numbers (TINs), and the issuer and policy number to the IRS, to the insurance company that issued the policy, and to the seller. Upon the payment of any policy benefits to the buyer, the insurance company would be required to report the gross benefit payment, the buyer's TIN, and the insurance company's estimate of the buyer's basis to the IRS and to the payee.
· The proposal also would modify the transfer-for-value rule to ensure that exceptions to that rule would not apply to buyers of policies.
· The proposal would apply to sales or assignment of interests in life insurance policies and payments of death benefits in taxable years beginning after December 31, 2012.