Taxes as 2013 Approaches

09/26/2012

Significant tax changes are set to take place on December 31, 2012 (the so-called "Bush Tax Cuts") unless Congress acts before that time to prevent the tax law from automatically changing. In addition, mandatory spending cuts are set to begin on January 1, 2013 which was negotiated as part of the deal struck to increase the debt limit and is a consequense of Congress not being able to agree on specific spending cuts.  Some have referred to this as the upcoming "fiscal cliff."

People are obviously concerned and many don't have faith that Congress will be able to agree on anything, especially given that this is an election year.  Ben Bernanke, the Federal Reserve Chairman Ben Bernanke, recently stated that such a fiscal cliff could harm an already fragile economy.

So what has been Congress' response.  Well, it has listened, but it also recessed ahead of the November election.  Once the November election is over, Congress will have only 54 days to act (not counting recess and holidays which my guess is they will not miss).

Assuming Congress does not act before the end of the year, here is a snapshot of what income and transfer taxes will look like in 2013 (note I have only outlined some, but not all of the changes):

  • Income Tax Rates.  Income tax rates will change from brackets of 10%, 15%, 25%, 28% 33% and 35% to brackets of 15%, 28%, 31%, 36% and 39.6%.
  • Dividends.  Dividend rates will change from 15% (0% for taxpayers under the 25% bracket) to ordinary rates.
  • Long Term Capital Gains.  Long term capital gains rate will change from 15% ()% for taxpayers under the 25% bracket to 20% (or 10% for those under the 25% bracket).
  • Gift Tax Exclusion.  The gift tax exclusion will be reduced from $5,120,000 to $1,000,000.
  • Estate Tax Exclusion.  The estate tax exclusion will be reduced from $5,120,000 to $1,000,000.
  • Generation-Skipping Transfer Tax ("GST") Exemption.  The GST exemption will be reduced from $5,120,000 to $1,000,000.
  • Top Gift, Estate and GST Tax Rate.  The top rate for gift, estate and GST purposes will increase from 35% to 55% with a 5% surcharge for estates over $10,000,000.

For many, this is not a pretty picture.  So what could happen?

It is certainly possible that Congress could once again temporarily extend some or all of the Bush tax cuts – either before December 31, 2012 or sometime next year  It is also possible that Congress will do nothing and the changes outlined above will occur.  Congress could also put tax reform on its agenda and actually do something.  What that something is may very well depend on who wins the November Presidential election.

If President Obama wins re-election and the Congressional majorities go his way, legislation along these lines might be enacted:

  • The Bush tax cuts become permanent for 98% of taxpayers – namely, single taxpayers with incomes under $200,000 and married couples filing jointly with incomes under $250,000.
  • The Bush tax cuts expire for the top 2% of taxpayers (individuals and married couples with incomes over those amounts in the previous bullet point). This would mean a top rate for these taxpayers of 36% to 39.5%, dividends taxed at ordinary income rates, long term capital gains generally taxed at 20%, limitations on itemized deductions and a phase-out for personal exemptions.
  • Tax benefits would be limited for income that is taxed at higher than 28%. This could translate to a surtax on a broad definition of "income" that is generally not currently taxable, including municipal bond interest, employer-provided health care and otherwise deductible contributions to retirement accounts.
  • The so-called "Buffett Rule" becomes law, and generally requires that taxpayers with over $1 million of income become subject to a 30% effective tax rate.
  • Transfer taxes will go back to their 2009 parameters meaning:
    • $3,500,000 estate tax exclusion and generation-skipping transfer tax exemption
    • $1,000,000 gift tax exclusion
    • 45% tax rate on taxable transfers over $1.5 million
    • "Portable" spousal exclusions become permanent (this temporary provision for 2011 and 2012 was not part of the original Bush tax cuts, but President Obama supports it - it allows a surviving spouse to "inherent" the deceased spouse’s unused estate tax exclusion)

On the other hand, if Governor Romney is elected and the Congressional majorities go his way, he would like to fix what his website describes as a "Rube Goldberg contraption of bewildering complexity that leads to undesirable results."  To this end, Mr. Romney has proposed the following for individual taxpayers:

  • permanent, across-the-board 20% cut in marginal rates (that presumably would mean, for example, dropping the current top 35% income tax rate to 28%)
  • Maintain the 2012 tax rates for interest, dividends and capital gains (the rates under the Bush tax cuts)
  • Eliminate taxes on interest, dividends and capital gains for taxpayers with adjusted gross income under $200,000
  • Repeal the "death tax" (i.e., the estate tax)
  • Repeal the alternative minimum tax (AMT)

Mr. Romney has also expressed interest in some of the suggestions made by the Simpson-Bowles Deficit Commission which issued its report in late 2010.  That Commission stated that it was critical to address the nation’s deficit, and advocated reducing tax rates in exchange for modifying (or eliminating) "tax expenditures" – namely, tax benefits that reduce income taxes. Some of suggestions included:

  • Eliminating the preferential rates applicable to dividends and capital gains, and taxing them as ordinary income items or excluding a portion of them from income
  • Eliminating the tax exemption for municipal bond interest (existing bonds would be grandfathered, and only new bonds would be affected)
  • Capping the exclusion for employer-provided health care, and eventually phasing it out
  • Replacing itemized deductions, which include the deduction for charitable giving and home mortgage interest, with a credit
  • Consolidating retirement accounts and capping tax-preferred contributions at the lower of $20,000 or 20% of income

Mr. Romney has declined to specify which tax expenditures he might target, and in fact, some of the Commissions recommendations are inconsistent with what Romney has said he would do.  Mr. Romney has stated, however, that the Commissions recommendations should fall harder on high-income taxpayers (presumably the 2% of taxpayers President Obama has targeted).

So what will happen?

It’s anyone’s guess.