2012 Estate Planning. Martin Inc. Shenkman
for the wealthiest taxpayers.
Income Tax Paradigm Changing
Income tax changes, especially for high-income earners, could be costly. As noted earlier, what changes might eventually be enacted are uncertain. The changes may ultimately not even resemble the sampling of provisions discussed here. However, this discussion is important to highlight some of the considerations that might warrant evaluation while formulating 2012 estate plans.
President Obama has continuously recommended tax increases on higher-income taxpayers ($250,000 might be a threshold). This could translate into higher ordinary income tax rates, reduction or elimination of the favorable tax rates on certain capital gains and dividend income, and perhaps the phase out of certain deductions for those with income above a certain level.
Higher-income individuals will likely face higher marginal tax rates. Whether such a proposal could pass the “no tax increase” GOP objections is unclear. Where the line might be drawn if such a proposal became reality is also unclear. While single individuals with income over $200,000 and married couples filing joint returns with income over $250,000 may face higher tax rates, these changes might only apply to higher-income levels. For these taxpayers, the cost of creating grantor trusts will be greater, but depending on the level of gift and estate taxation they may have a silver lining. The use of family partnerships and LLCs to shift income to lower-bracket taxpayers could become more popular as the spread from highest to lowest tax rates widens (although the new and expanded “Kiddie” tax will make this type of planning challenging). So taxpayers who desire to liquidate existing FLPs and LLCs, suggesting they are no longer needed for estate planning purposes, might defer such decisions until both the income and gift/estate tax laws become clearer. These entities may just be redesigned to focus on shifting income to lower-bracket family members, which was in fact a common application before valuation discounts became so popular.
The taxation of hedge fund managers and others similarly situated has also been the subject of much talk. It might actually be surprising if the current tax benefits afforded these high-income earners are not reduced. For instance, there have been a host of proposals to tax what are called “carried interests” as ordinary income. Carried interests are a right that entitles, for example, the general partner of a private or public investment fund organized as a partnership to a share of profits as compensation for managing the fund’s assets. If the taxpayer were paid management fees, those would be taxed at ordinary income tax rates. But if instead the arrangements are structured as carried interests, the proceeds are taxed at favorable capital gains rates, and are also exempt from employment taxes. Effectively, the general partner managing such an investment fund transmutes income for services rendered into income 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