“There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — there are things we do not know we don’t know.”
Former United States Secretary of Defense
Donald Rumsfeld — press briefing 2/12/02
How can you advise clients when the Washington legislative tax climate is foggy? And sometimes the fog lifts retroactively.
With Mr. Rumsfeld’s words ringing in my ears, I’ll tell you:
• What is now known about the income, capital gains, gift and estate tax rules for 2012.
• What is now known about the income, capital gains, gift and estate tax rules for 2013, if Congress takes no action this year. (Remember David Brinkley’s admonition: “If you turn on your TV and see nothing is happening, do not call a serviceman. You have tuned in the U.S. Senate.”) Be mindful, Congress can, by midnight Dec. 31, 2013, enact laws that would be retroactively effective as of Jan. 1, 2013.
• About the tax revision proposals for 2013 by the President and the still-standing major candidates for the Republican presidential nomination. Plus, the much-heralded Buffett Rule.
• The known unknowns: who will be the next president and the party that will control the House and the Senate.
• The unknown unknowns: Oh, if I only knew!
KNOWN KNOWNS FOR 2012
Ordinary income tax rates: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent.
Capital gains and dividend rates. For taxpayers in the 25 percent bracket and above, the capital gains and qualified dividend rate is 15 percent. For taxpayers below the 25 percent bracket, the rate is zero.
Exceptions. Gains on sales of artworks (and so-called collectibles) held long term (more than one year) are taxable at 28 percent. Unrecaptured gain on a sale of real property is subject to a 25 percent rate. The gain on sales of capital assets held short term (one year or less) is taxed in the regular income tax brackets — up to 35 percent.
Charitable gifts. No tax incentives for Charitable IRAs, and no enhanced tax incentives for gifts of stock by S Corporations, food inventory gifts, book inventory gifts, corporate gifts of qualified research and computer technology and conservation gifts.
No itemized deduction limitation. Since 1991, the amount of certain itemized deductions (including the charitable deduction) that a taxpayer may claim had been reduced, to the extent the taxpayer’s AGI was above a specified — adjusted for inflation — amount. This limitation is often called the “Pease limitation,” or the “3 percent haircut.” That limitation on itemized deductions is inapplicable in 2012.
No personal exemption phase-out. Personal exemptions allow a certain amount per person to be exempt from tax. Under a personal exemption phase-out (PEP), exemptions are phased out for taxpayers with AGIs above a certain level. The PEP is inapplicable in 2012.
KNOWN KNOWNS FOR 2013 AND BEYOND IF CONGRESS FAILS TO ACT THIS YEAR
Ordinary income tax rates: 15 percent, 25 percent, 28 percent, 31 percent, 36 percent, 39.6 percent.
Capital gains and qualified dividends. Taxed at 20 percent.
Exception. Gains on the sale of artworks (and so-called collectibles) held long-term (more than one year) will continue to be taxed at 28 percent. Unrecaptured gain on a sale of real property will continue to be taxed at 25 percent. The gain on the sale of assets held short term (one year or less) will be taxed at regular income tax rates — up to 39.6 percent.
Charitable gifts. No tax incentives for Charitable IRAs, and no enhanced tax incentives for gifts of stock by S Corps, food inventory gifts, book inventory gifts, corporate gifts of qualified research and computer technology and conservation gifts.
Limitation on itemized deductions for upper-income taxpayers. The charitable and other Itemized deductions (other than medical expenses, investment interest, theft and casualty losses) would be reduced by 3 percent of the amount by which AGI exceeds statutory thresholds, but not by more than 80 percent of the otherwise allowable deductions.
Personal exemption phase-out for upper-income taxpayers. This will apply to taxpayers with AGIs above threshold levels that vary by filing status. The AGI thresholds are indexed for inflation.
2012: ESTATE, GIFT AND GENERATION-SKIPPING TAXES: RATES AND EXEMPTIONS
The unified gift and estate tax exemption in 2012 is $5,120,000 per person, and the tax rate is 35% for estate, gift and generation-skipping transfer taxes. The exemption amount was $5 million in 2011 and was indexed to $5,120,000 for 2012.
The estate tax was retroactively imposed for 2010, but an estate could elect to not have the estate tax rules apply, but ,instead, be subject to the modified carryover basis rules.
The $5,120,000 exemption can be used during life and/or at death. The question has been raised whether using that exemption to make gifts in 2011 and 2012 would completely protect those gifts from tax if the unified exemption is reduced starting in 2013.
Portability of unused exemption — in brief. Under earlier law, spouses had to do complicated estate planning to claim their entire exemption ($7 million for a couple in 2009, for example). For 2011 and 2012 the executor of a deceased spouse’s estate can transfer any unused exemption to the surviving spouse obviating the need for a credit shelter trust. But for many estates, portability won’t be the best plan and portability only applies for 2011 and 2012. What happens in 2013 and beyond if the law is not extended? The generation-skipping transfer tax exemption isn’t portable.
2013: ESTATE, GIFT AND GENERATION-SKIPPING TAXES IF CONGRESS TAKES NO ACTION BEFORE 2013
The unified gift and estate tax exemption will be $1 million and the rate will be 55 percent (60 percent on part of a transfer by larger estates). The generation-skipping tax exemption will be $1 million. “Portability” will be inapplicable.
PRESIDENT OBAMA’S BUDGET PROPOSALS — FOR 2013 AND BEYOND
Reinstate the 36 percent and 39.6 percent tax rates for upper income taxpayers. Replace part of the 33 percent and all of the 35 percent tax rate brackets with the prior law tax rate brackets of 36 percent and 39.6 percent.
Tax qualified dividends as ordinary income for upper income taxpayers. The proposal would allow the current 15 percent reduced tax rates on qualified dividends to expire at end of 2012 as scheduled. Thus dividends would be taxed at the ordinary income rates up to the top rate of 39.6 percent.
Tax net long-term capital gains at a 20 percent rate for upper income taxpayers. Allow the current 2012 15 percent tax rate on long-term capital gains to expire as scheduled at the end of 2012.
Exceptions. The special 25 percent rate applying to recapture of depreciation on certain real estate (Internal Revenue Code Section 1250 recapture) and 28 percent on art works (so-called collectibles).
Carried interests (profits). Tax as ordinary income a partner’s share of income on an investment services partnership interest (ISPI) in an investment partnership, regardless of the character of the income at the partnership level. Thus, that income would not be eligible for the reduced rates that apply to long-term capital gains. In addition, require the partner to pay self-employment taxes on that income. In order to prevent income derived from labor services from avoiding taxation at ordinary income rates, this proposal assumes that the gain recognized on the sale of an ISPI would generally be taxed as ordinary income, not as capital gain. This could be called the Anti-Romney Rule (see below for the Buffett Rule).
Reduce the value of certain tax expenditures. A tax provision that excludes income from taxation by way of a deduction, for example, in budget analysis is regarded as analogous to a government expenditure; thus the term “tax expenditures.” It is argued that this theory violates the deeply ingrained principal that income belongs to those who generate it and that only through the democratic process becomes subject to taxation.
Limit the tax value of specified deductions from AGI. This limitation would reduce the value to 28 percent of deductions (including the charitable deduction) that would otherwise reduce taxable income in tax brackets above 28 percent. A similar limitation also would apply under the alternative minimum tax.
Reinstate the limitation on itemized deductions for upper income taxpayers.Itemized deductions (other than medical expenses, investment interest, theft and casualty losses) would be reduced by 3 percent of the amount by which AGI exceeds statutory thresholds, but not by more than 80 percent of the otherwise allowable deductions.
Reinstate the personal exemption phase-out for upper income taxpayers.The proposal would apply to itemized deductions “after they have been reduced by the statutory limitation on certain itemized deductions for higher income taxpayers.” (This refers to the “3 percent AGI” reduction rule described earlier.)
ESTATE AND GIFT TAX PROPOSALS
Make permanent the estate, gift, and generation-skipping transfer tax laws in effect in 2009. The tax rate would be 45 percent, and the exclusion amount would be $3.5 million for estate and GST taxes and $1 million for gift taxes. The portability of any unused estate and gift tax exclusion between spouses would be made permanent.
Other Obama Budget Proposals:
• Limit the duration of dynasty trusts
• Require consistency in value for transfer and income tax purposes
• Modify rules on valuation discounts
• Require a minimum term for Grantor Retained Annuity Trusts
• Coordinate income and transfer tax rules applicable to grantor trusts
• Extend the lien on estate tax deferrals under IRC Section 6166
The Buffet Rule. Although frequently orally stated by the President and his advisers, you won’t find the Buffett Rule spelled out in the President’s 2013 budget proposal or in any other official document. So, it is an Unwritten Buffett Rule — a guideline, says the administration, rather than a tax proposal.
So what is the Buffett Rule — named for Warren E. Buffett, Berkshire Hathaway’s billionaire? Mr. Buffett says that his secretary’s tax rate is higher than his. He pays only 15 percent because his income is from dividends and capital gains, not from salary that is currently taxable up to 35 percent.
Basically, the Buffett Rule would be a 30 percent alternative minimum tax for individuals earning over $1 million. In his State of the Union address, Mr. Obama said that the Buffett Rule wouldn’t create disincentives to charitable giving.
How can the administration get a more concrete proposal that sounds as if it comes from 16 Pennsylvania Avenue?
Simple. The Paying-A-Fair-Share Act (S. 2059), introduced by Senator Sheldon Whitehouse (D-RI) does just that. The Whitehouse bill provides that all deductions, except for the charitable deduction, would be eliminated. Then a minimum tax of 30 percent would be imposed. But, there would be a phase-in of the 30 percent tax rate between $1 million and $2 million. The Buffett Rule alternative minimum tax (AMT) would be tied in with the current AMT. That’s tax simplification for you.
REPUBLICAN PRESIDENTIAL NOMINATION CANDIDATES — TAX REVISION PROPOSALS.
In alphabetical order.
• Stop the 2013 tax increases to promote stability in the economy. Job creation improved after Congress extended tax relief for two years in December. We should make the rates permanent.
• Move toward an optional flat tax of 15 percent that would allow Americans the freedom to choose to file their taxes on a postcard, saving hundreds of billions in unnecessary costs each year. This optional flat tax system will preserve deductions on charitable giving and home ownership, and create a new personal deduction [exemption] of $12,000 for every American. This deduction [exemption] is well above the current poverty level, ensuring that this new system does not unfairly target the poor.
• Abolish estate tax.
• The power to tax is the power to destroy, that is why Ron Paul will never support higher taxes.
• Lowering taxes will leave you more money to take care of yourself and your family, and it will allow businesses greater opportunities to hire new workers, increase current salaries, and expand their companies.
• Would support a Liberty Amendment to the Constitution to abolish the income and death [estate] taxes. (Although the gift tax isn’t mentioned, I’ll give you odds that he’s against that too.)
• Capital gains taxes, which punish you for success (and interfere with your efforts to hedge against inflation by purchasing gold and silver coins), should also be immediately repealed.
• Has consistently endorsed legislation to let Americans claim more tax credits and deductions, including on educational costs, alternative energy vehicles, and health care. Also believes it is immoral to tax senior citizens twice by requiring them to include Social Security benefits in their gross income at tax time. A first step to eliminating that requirement would be to repeal the 1993 increase in taxes on Social Security benefits. Then we must abolish that tax entirely.
• While a Flat Tax or a Fair Tax would each be a better alternative to the income tax system, believes that the 16th Amendment should be repealed to avoid having both the income tax and one of these systems as an additional tax.
• Restraining federal spending by enforcing the Constitution’s strict limits on the federal government’s power would help result in a 0 percent income tax rate for Americans.
• Will be proud to be the one who finally turns off the lights at the IRS for good.
Taxes are needed to pay for the operations of government. But they should be collected by a system that is simple,fair and that causes the least possible disruption to the productive economy.
• Would make permanent the Bush-era tax cuts scheduled to expire on December 31.
• Reduce income tax rates for all Americans by 20 percent. That would reduce the current top rate of 35 percent to 28 percent.
• Above proposal would create jobs, boost the economy and would not cost the federal government a dime in lost revenue.
• Eliminate the death [estate] tax. Note. No mention of the gift tax.
• Pursue a conservative overhaul of the tax system over the long term that includes lower, flatter rates on a broader base.
• Cut and simplify personal income taxes by cutting the number of tax rates to just two — 10 percent and 28 percent and return to Reagan era pro-growth tax rates.
• Simplify the tax code and reduce middle income taxes by eliminating the AMT.
• Simplify the tax code, encourage savings and investment, and reduce taxes by eliminating the Death [estate] Tax. Note. No mention of the gift tax.
• Lower the capital gains and dividend tax rates to 12 percent to spur economic growth and investment.
• Reduce taxes for families by tripling the personal deduction [exemption] for each child.
• Reduce and simplify taxes for families by eliminating marriage tax penalties throughout the federal tax code.
• Retain deductions for charitable giving, home mortgage interest, healthcare, retirement savings, and children.
• Eliminate the cap on deductions for losses incurred in the sale of a principal residence.
Roman Tax Holiday Party: IX IX IX
The Relevance Paradox. Former Secretary of Defense Donald Rumsfeld’s “Unknown unknowns” (quoted at the beginning of this article) are related to the relevance paradox.
You think that you have all relevant information, but are unaware that additional relevant information exists because its relevance is not known until you have that information.
© Conrad Teitell 2012. This is not intended as legal, tax, financial or other advice. So, check with your adviser on how the rules apply to you.