As I approach my third decade in the tax business, never have I seen this much uncertainty over fiscal, budgetary and tax policy. For good reason. We live in challenging times.
Direction of US Income and Estate Tax rates for 2013 and Beyond
Without a change in law, the rates scheduled on January 1st will go into affect. I think it slightly better than a 50 / 50 bet that we will get a compromise on tax rates for the lower 98% of income earners which will then set the stage for tax reform later in 2013 or 2014. I do not believe the 3.8% “Surtax” (which will be implemented on January 1, 2013) will be repealed. The Surtax will again affect “the wealthy” (married taxpayers with income over $250,000 or single over $200,000), and is discussed below.
Hence, my predictions (excluding the 3.8% Surtax) are:
Isn’t it amazing that after $6billion of political ads, all that happened was a few more Democratic Senators and House members. While the Senate gains consolidate the Democratic majorities, it is still 5 short (including the 2 independents who typically vote Democratic) of the 60 needed to stop a filibuster. However, I believe the election has emphasized the need for compromise and see a slight give on both the Republican side (toward higher overall taxation) and the Democratic side (toward lower rates and broader base). Democrats had already avowed the need for spending cuts and, while not championing the idea, there seems no disputing the position outside of the far left of the Democratic Party. Clearly, tax increases alone will not address our fiscal deficits.
Fiscal cliff is the first opportunity for Washington to create a mess. There is neither time, nor talent in DC to tackle the drudgery of true tax reform in a lame duck session, after all, the last major tax reform was 1986 and took 24 months to accomplish in Reagan’s second term. Therefore all I can see is two courses of action:
- We run over the cliff (in which case that rates are as shown above for 2013), or
- The top 2% get run over the cliff, but Republicans get spending cuts they want (rather than the automatic cuts currently scheduled for 1/1/13).
I think we get Option 2. Interestingly, if we get Option 1 and run over the cliff, query whether the political atmosphere will be so poisoned that it becomes 4 years of finger pointing and bickering – I think that is a real possibility. If so, we simply have the 2013 rates shown above. A pox on both of their houses if this turns out to be the case.
However, because I am an optimist, I do think Option 2 sets up the groundwork for bi-partisan tax reform in 2013 & 2014. While the balance of this discussion focuses on tax reform, it is clear that there will be no broad tax reform without a similarly broad approach to entitlement reform.
The simplistic outline of tax reform involves eliminating tax deductions (or tax “expenditures” in budget speak) in exchange for lowering tax rates (or decreasing the amount of tax rate increases). Thus, tax reform will be born out of the ashes created by eliminating significant tax expenditures that individuals and businesses cherish. You can tinker around the edges of tax law, but if you are serious about simplifying the code, broadening the tax bases and keeping rates as low as possible, then you are targeting these tax expenditures. The main ones (as computed by the Congressional Budget Office) are shown below:To begin the topic of tax reform, I thought I’d start the analysis in an unlikely place: corporate taxation.
The growth of international business has put pressure on nations to compete against each other on corporate tax rates. Both Republicans and Democrats (including President Obama in the debates), acknowledge that the current US corporate rate (35%) – the highest in the developed world – is a disincentive to growth in a competitive tax world. Unlike citizenship which imprisons the individual to the tax regime of his country of residency, corporations have greater freedom to direct where they earn income in the world. Further, corporate reform is easier to do because it has less budgetary impact. However, I see no political path to lower the corporate tax rate without chopping out the tax expenditures shown above. Thus I believe many of the subsidies currently in the US Tax code (Manufacturing Deductions, LIFO, Accelerated Depreciation, Energy Preferences) would be sacrificed in an effort to buy the rate down as low as possible. The only major tax expenditure that I think enjoys bi-partisan support is R&D, which I think would survive permanently.
If virtually all of these tax expenditures are cut, corporate rate on business income can be reduced to 25% – 28% and the US Treasury will collect approximately the same amount of tax. Such a corporate reform will in turn put pressure on Congress to address the higher rate pass-through businesses would pay verses their corporate counterparts. Would small businesses stand idly by while their tax rates rise from 35% to (including the Surtax) 43.4% AND all their tax breaks go away? I doubt it. I also find it unlikely the old system of tax expenditures (Manufacturing Deductions, LIFO, Accelerated Depreciation, Energy Preferences) would remain in place for flow through entities after being expunged for corporations. Thus, without pass-through entity reform, the effective tax rate increases on small businesses would be much greater than an increase from 35% to 43.4% due to the loss of business tax breaks under “corporate ONLY” reform. The solution is a new tax rate on pass-through business income. Query: will that new rate be the same as the corporate rate, or higher (to embody at least some element of the concept of “double taxation” of earnings)? I also think that international reform, and the elimination of worldwide taxation (Subpart F) stands a decent chance of making headway as part of broader corporate tax reform.
Individual tax reform is a similar base broadening exercise. Again, I begin this discussion from an unlikely starting point – the Alternative Minimum Tax. Right now, there is a temporary (and expiring) AMT “Patch” that allows most citizens to escape AMT. However, without the AMT Patch, some 28 million taxpayers would discover they are subject to a tax they knew nothing about. Therefore, ever couple of years, congress “extends” the patch because it lacks the political will to take the budget hit a permanent AMT patch produces. Democratic constituencies (California and New York) are disproportionately impacted by AMT (because state taxes are AMT preference items). However, because an AMT fix is expensive, this will put greater pressure on broadening the tax base to make up the revenue lost by fixing AMT.
There is bi-partisan support for broadening the tax base. Governor Romney proposed capping itemized deductions. I could see the employee health insurance premium income exclusion getting swept up in the broader implementation of Obama Care. There would be a chilling affect on charitable giving and a stampede of assets into self-directed charities prior to the implementation date of the reform. Roth IRA’s, Insurance, Charitable Remainder Trusts and all manner of tax sheltered vehicles will gain popularity. Query whether a middle class rate increase would be acceptable to either party as part of a broader effort to reduce entitlements. I see it as a possibility in a few years.
Lastly, I think there will remain a distinction between Long Term Capital Gains and other categories of income. The current 20 percentage point disparity is scheduled to shrink to just over 15 percentage points (excluding the Surtax) and I think this may shrink further as Republicans try to buy down the dividend tax rate (scheduled at 43.4% including the surtax) against the capital gain rate.
I do not think estate taxes will be addressed in the Fiscal Cliff negotiations and will await tax reform. What is produced from estate tax reform is anyone’s guess as estate taxation is rarely the lead topic of tax reform. I only wish to point out that, the current law in 2013 is so draconian that it is likely Republicans move of off their $0 estate tax plan and accept the Obama proposal in order to get at least some tax relief in place. The key for high net worth people will be two questions 1) does portability of the estate exclusion survive, and 2) does the reform address trust structuring which is the main means by which high net worth individuals escape the estate tax. If you are a high net worth individual, you best be setting up your estates now.
Surtax Increases from Obama Care
Under the Patient Protection and Affordable Care Acts (Obama Care), the existing Medicare tax under Chapter 2 of the Federal code has been strengthened, and there was created new3.8% and .09% Surtaxes under new Chapter 2A to Title 26 of the Federal Code for certain unearned income not taxed under Chapter 2. The new surtaxes on unearned income appear designed to “complement” the 2.9% Medicare payroll tax on earned income under Chapter 2 of the Federal Code. Because the surtax tax statutes were not included in the Chapter 1 of the Federal Code (the Income Tax statutes) it is therefore unclear how the myriad of laws, regulations and court cases governing of Income Tax (i.e. accounting methods, passive activity rules, transfer pricing) will apply to the new surtaxes under Chapter 2A. Because there are no regulations, we can only presume the Chapter 1 rules will apply to the surtaxes in Chapter 2A.
For years there has been a 2.9% Medicare payroll tax (1.45% paid by the employer and 1.45% paid by the employee) under Chapter 2 of the code. Under new Chapter 2A of the code, individuals with earned income over certain thresholds ($250,000 for joint taxpayers) will pay an additional .09% on earned income. Further, it is clear that high income Limited Partners who “materially participate” in the business of the limited partnership will be subject to both the 2.9% tax and the .09% surtax.
Investment income will also be subject to a flat 3.8% federal surtax (if the taxpayer’s joint income is over the $250,000 threshold). Net investment income (unearned income) includes:
- Annuity Distributions
- Income derived from passive activities (i.e. partnerships or S Corporations where the partner does not materially participate).
- Capital Gains
At this juncture it is important to pause and explain an element of “flow through” taxation (i.e. taxation of owners of Partnerships and S Corporations). Flow through entities are not taxpayers. Rather they merely report all the SEPARATE ELEMENTS OF THEIR INCOME to their owners, who in turn pay the tax on this income. For instance, business income, interest income, dividend income are all reported separately to an owner of a partnership, LLC or S corporation and taxed in that owner’s individual income tax return.
Conspicuously exempt from the new surtax are the profits earned by a materially participating Subchapter S Corporation owner. However, any income of the S corporation which is not “property attributable to an active trade or business” (i.e. unearned income) would be subject to the surtax.
The following table summarizes the law for taxpayers above the income threshold:
It is a challenging tax environment for taxpayers in the United States. Globalization is putting pressure on our tax system to “compete” in the marketplace. Budgets are clearly unsustainable, and it is only recently that politicians have begun the unpleasant task of awakening all its citizens to this fact. The current political make up in Washington clearly mirrors the difference of opinion that exists in this country over the social contracts our government has promised against our economy’s ability to provide these benefits via taxation of its constituents. We seemed poised to test the limits of our ability borrow money so as not to break these social contracts. We seem poised to tax up to the breaking point of the US economy. The European malaise has shown us that there are bigger fiscal cliffs than what we currently face. My hope is that our policy makers can craft the compromises necessary to preserve whatever we can of our social contracts while keeping our economy strong. It will be loud and messy. That’s what a Democracy is for, and I for one am not ashamed of the process. It’s the best lousy system there is.