taxed at more favorable capital gain rates. The proposals would tax proceeds from carried interests at more expensive ordinary income rates, regardless of how the income or interest was characterized at the hedge fund partnership level. These earnings might also be made subject to self-employment taxes. Even if the Bush tax cuts are extended for all taxpayers, the favorable treatment afforded hedge fund managers may still disappear.
Taxpayers who own business interests, in particular S corporations, have often taken dividend distributions that are not subject to employment taxes. Differentiating what should really be a salary, versus what can appropriately be treated as a dividend (i.e., a distribution of business earnings), is often murky at best. The lost payroll taxes on these S corporation distributions is substantial and future legislation might establish rules to assure that a greater proportion of closely held S corporation earnings are subject to employment taxes. This type of change might generate substantial revenues, close what some perceive as an unfair loophole, and have a rather significant impact on taxpayers affected. It is not clear that there would be much of a groundswell against such a change.
The rate of taxation of dividend income may be increased to the ordinary income tax rates. The fact that Warren Buffett has voiced public objection to his paying a lower tax rate, while earning substantial dividends on investments, while his personal secretary bears a higher tax burden as a wage earner working full time, may have some sway in encouraging Congress to address this dichotomy.
If a change in the relative tax rates of various assets occurs, wealth managers might decide to juggle existing asset location (not allocation) decisions to take better advantage of the new paradigm. For example, it might prove beneficial to hold dividend paying stocks in more tax-efficient buckets, like retirement plans, instead of in taxable accounts. Within your various taxable investment buckets, what might have been favoritism shown to holding tax-favored investments, such as dividend paying stocks, inside irrevocable non-grantor trusts, might also be reevaluated. Investment policy statements, funding decisions, and other investment considerations for some family entities and trusts might be affected if the income tax law changes. Since estate planning often involves shifting ownership of various “pots” of assets (e.g., gifting interests in an FLP but not in an IRA which cannot be given), changes in asset location decisions will have an impact on estate planning.
Another possibility is that, in lieu of a tax rate increase, the income base on which tax is calculated will be expanded. This might raise more revenue without the need to raise rates. One example of the types of changes that might occur is that an employer’s contribution toward employees’ health care may be treated as income to the employee receiving the benefit. This stricture may only apply above a certain level of benefit or may only apply to taxpayers earning above a stated wage level. So whatever the tax rates are set at, that may only be a small part of the planning story.
What planning steps might you consider to address potentially higher future income tax costs? Accelerating deductions and deferring income has historically been the year-end tax approach. But in 2012, the opposite may be true. However, if deductions for high-income taxpayers are capped to have a maximum benefit of 28 percent in later years, or are restricted or even eliminated, then one in the hand is worth more than two in the bush. This would again favor taking the deduction now. This would mean accelerating deductions into 2012 that are likely to face restrictions. For example, there has been talk of applying a reduction or threshold for charitable contributions so that no charitable deduction could be claimed until charitable contributions exceed 2 percent of adjusted gross income. So for some taxpayers, bunching charitable contributions into 2012 could prove superior to making them in later years with no deduction. If you cannot identify appropriate charities today, consider making the donation to a donor advised fund to lock in the deduction in 2012 and then distribute funds in later years. Review the ability to prepay a month of your home mortgage and possibly property taxes. On the other hand, it may be best to delay incurring deductions this year because income tax rates may be higher next year. The possible inconsistencies in many cases make planning difficult, if not impossible.
What about recognizing income? Traditionally, taxpayers have endeavored to defer income (and thus resulting income taxes) into later years to take advantage of the time value of money. For many taxpayers, that strategy might still make sense but only so long as the cost of the planning is insignificant, in light of today’s low interest rates. However, for wealthier taxpayers, the opposite might be true. With the time value of money being insignificant, and the specter of higher tax rates in the future, 2012 might be a good year in which to recognize income. Instead of deferring income to later years as historically has been done, wealthy taxpayers might actually benefit from accelerating income into 2012. If the tax rates in 2012 prove to be lower than those in 2013, then accelerating income into 2012 might be worthwhile. If no changes are made to the income tax system, it could still be advantageous to accelerate income into 2012 if ordinary income tax rates will increase to their pre-2001 levels in 2013. While it seems unlikely that the tax system will remain unchanged through 2013 or that the Bush tax cuts will completely disappear for all taxpayers, those do remain possibilities.
How can you accelerate income? Sell bonds that have accrued interest and thereby trigger that gain. Exercise non-qualified stock options now. Have your CPA complete projections before exercising stock options to monitor the tax impact. Review annuity contracts to determine if there is a means to accelerate any portion of the annuity payments into income. Distributions from traditional IRAs (or a Roth IRA conversion) might serve to increase current income at lower rates. (See Chapter 9.) Select highly appreciated securities or other appreciated property and sell them before year end to assure favorable long-term capital gain treatment. Similarly, appreciated assets held in grantor trusts might be sold to trigger current gain to the grantor.
For all this planning, be certain to have your CPA consider the so-called alternative minimum tax (AMT). Revisit any estimated tax payments to avoid penalties, especially if you pursue any of the above planning. It may change the required estimated taxes.
When pursuing income tax planning, don’t let the tax tail wag the economic dog. If you have, for example, concentrated stock positions or other non-diversified assets, focus on the economic issues and decisions first, then maximize the tax benefits in light of the broader economic decisions.
Capital Gains Rates
The 2001 Act (EGTRRA) created low capital gains tax rates of 0 percent for taxpayers in the 10 percent and 15 percent income tax brackets, and 15 percent for others. These rates continue through the end of 2012 but, unless Congress acts, will expire in 2013. If you anticipate higher capital gains rates, look into diversifying concentrated positions now by selling in 2012 before rates are increased in 2013. Obviously, those strategies are not assured to be successful given the political uncertainty. If you don’t act in 2012, and capital gains rates do rise in 2013, then the use of a charitable remainder trust (CRT) to soften the income tax blow on diversification of a concentrated stock position could be considered.
There has also been discussion of reducing the tax-favored treatment for capital gains over a number of years to minimize the impact on the markets. This might take the form of higher rates on those earning over certain income thresholds. The $200,000/$250,000 thresholds that have popped up in a number of contexts might be the threshold selected for such changes.
The combination of higher capital gains rates coupled with the Medicare tax on unearned income (see the discussion that follows), and other potential changes, could have a surprising impact on taxpayers. For taxpayers in high-tax states who face a higher combined capital gains rate, coupled with Medicare tax on investment income and no federal deduction for state income taxes on the gains realized, the bottom line result could be quite costly.
There has even been some discussion of treating capital gains and qualified dividends as ordinary income. The sales pitch for this is it will simplify the tax code and planning. Since the marginal tax rates will be relatively
