Proposals For High-Income Taxpayers
In addition to the international tax proposals discussed in the previous article, the FY 2016 Budget has continued certain proposals made in prior budgets, but includes new proposals affecting high-income taxpayers in order to ensure the Administration's view that the wealthiest pay their fair share of taxes.
Increase Capital Gains Tax Rate
The FY 2016 Budget has added a new proposal this year regarding the reforming of capital-gains taxation, which will particularly affect high-income taxpayers. Under current law, long-term capital gains and qualified dividends are taxable at graduated rates, with 20% generally being the highest rate for high-income taxpayers. In most high-income taxpayer cases, the capital gains and qualified dividends also would be subject to an additional 3.8% net-investment income tax causing the aggregate tax rate for long-term capital gains and qualified dividends to reach as high as 23.8%. The proposal would increase the top tax rate on long-term capital gains and qualified dividend tax rate from 20% to 24.2%, which could result in the top tax rate increasing to 28% when including the additional 3.8% net-investment income tax. The proposal would be effective for capital gains and qualified dividends received in taxable years beginning after December 31, 2015.
Elimination of Basis Step-Up on Death
The FY 2016 Budget proposes a significant change to the basis rules for transfers of appreciated property by gift or upon death. Under current law, persons who inherit appreciated property upon death are generally entitled to receive a basis in that asset equal to the asset's fair market value at the time of the decedent's death. As a result of the "stepped-up" basis in the asset, the appreciation accrued during the decedent's lifetime would never be subject to US income tax. With exceptions for surviving spouses, charities, and the middle-class, the proposal would be to treat transfers of appreciated property, both during lifetime by gift and upon death, as taxable sales of the property resulting in such appreciation becoming immediately subject to US income tax in the donor's hands in the year that the transfer was made. The proposal would also have significant tax consequences for those taxpayers resident in US states with a state income tax system, thereby increasing their state income tax exposures. Furthermore, such proposals would be in addition to any applicable US gift or estate tax exposures for the transfer of such appreciated property during lifetime or at the time of death. The proposal would be effective for gains on gifts made, and of decedents dying, after December 31, 2015.
Reduce the Value of Certain Tax Expenditures
The FY 2016 Budget contains a proposal that would limit the tax value of specified deductions or exclusions from adjusted gross income ("AGI") and all itemized deductions. Currently, individual taxpayers may reduce their taxable income by excluding certain types or amounts of income (e.g., interest on State or local bonds), claiming certain deductions in the computation of AGI (e.g., amounts paid for employer-sponsored health coverage, defined contribution retirement plans), and claiming either a standard deduction or itemized deductions (subject to certain thresholds). Under current law, the tax reduction from the last dollar excluded or deducted is $1.00 times the taxpayer’s marginal income tax rate. For instance, if a taxpayer's marginal tax rate is 39.6 percent, then the tax value of the
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last dollar deducted would equal 39.6 cents. The proposed limitation would cap the tax value to 28 percent of the specified exclusions and deductions, thereby reducing taxable income in the 33-percent, 35-percent, or 39.6-percent tax brackets. The proposal would apply to itemized deductions after they have been reduced by the statutory "Pease" limitation. If a deduction or exclusion for contributions to retirement plans or IRAs is limited by this proposal, then the taxpayer's basis will be adjusted to reflect the additional tax imposed. If enacted, the proposal would be effective for taxable years beginning after December 31, 2015.
Implement the Buffet Rule by Imposing a New "Fair Share Tax"
In addition to limiting the tax value of specified deductions, the FY 2016 Budget again proposes a new minimum tax, called the Fair Share Tax ("FST"), on high income taxpayers. The tentative FST would equal 30 percent of AGI less a specified credit for charitable contributions equal to 28 percent of allowable itemized charitable contributions. The final FST would be the excess of the tentative FST over the sum of the taxpayer's (1) regular income tax (after specified credits) including the 3.8-percent net-investment income tax, (2) the alternative minimum tax, and (3) the employee portion of payroll taxes. Finally, the amount of FST payable (i.e., the excess of tentative FST over the regular tax) would be phased in linearly starting at $1 million of AGI for a single taxpayer and fully phased in at $2 million of AGI ($500,000 and $1 million for married filing separately, respectively).
Modify US Estate, Gift and Generation-Skipping Transfer ("GST") Tax Provisions
Restore 2009 US Gift, Estate, and GST Tax Provisions
As proposed in prior budgets, the FY 2016 Budget would make permanent the US estate, gift, and GST tax parameters as they applied during 2009. The top tax rate would be increased from 40% to 45%. The exclusion amount (unified credit) would be decreased from $5 million (adjusted for inflation and currently $5.43 million) to $3.5 million for US estate and GST taxes, and would return to $1 million for US gift taxes, but no US estate tax or gift tax would be incurred by reason of such decrease of the exclusion amount with respect to prior gifts that were excluded under the parameters of current law. There would be no indexing for inflation. Although not discussed, it would seem that the exclusion for non-residents will remain at only $60,000. The proposal would continue to allow portability of unused estate and gift tax exclusions between US citizen spouses. Unlike the prior budget, the proposal would be effective for estates of decedents dying, and for transfers made, after December 31, 2015.
Modify Transfer Tax Rules for Grantor Retained Annuity Trusts ("GRATs") and other Grantor Trusts
The FY 2016 Budget combines last year’s GRATs and grantor trust proposals into a single proposal, with some modifications. Under current law, donors use certain types of trusts to hold assets in a way that allows the donor to receive a stream of income from those assets, while transferring expected appreciation to donees, without paying US gift tax, and with minimal US income tax costs. If all goes according to plan, the appreciation in the assets will escape US estate taxation with little downside risk to the taxpayer. The proposal would make overly generous outcomes more difficult to achieve by requiring that donors leave assets in GRATs for a minimum of 10 years plus the grantor's life expectancy, with a new proposal that the remainder interest in the GRAT (i.e., the taxable gift portion)
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must have a minimum value equal to the greater of 25% of the value of the assets contributed to the GRAT or $500,000. This would effectively eliminate the planning to achieve "zeroed-out" GRATs that result in virtually no US gift tax. With the proposal to return to a US gift tax exclusion of only $1 million, such planning would potentially make the use of GRATs more unattractive to taxpayers. In addition, the proposal would prohibit any decrease in the annuity during the GRAT term, and, new this year, would prohibit the grantor from engaging in a tax-free exchange of any asset held in the GRAT under commonly known "swap" provisions.
The proposal would also deter the popular use of sales of appreciated assets to grantor trusts by requiring that the portion of the trust attributable to the property received by the trust in the sale transaction (including all retained income and appreciation) be subject to US gift tax when the grantor is no longer the deemed owner of the trust under US income tax rules or upon a distribution to another person during the life of the deemed owner, or by requiring that such assets be included in the gross estate of the deemed owner and subject to US estate tax at the time of death.
The proposal would be applicable to GRATs created after the date of enactment. The proposal as to transactions with other grantor trusts would be effective with regard to trusts that engage in a transaction on or after the date of enactment.
As in prior budgets, the following proposals are continued in the FY 2016 Budget:
(i) Require consistency in valuation and basis and reporting of valuation and basis by donors and estates to donees, beneficiaries, and the Service;
(ii) Terminate the US GST tax exemption allocated to long-term or perpetual trusts on the 90th anniversary of the creation of the trust so as to cause such trusts to be subject to GST tax thereafter;
(iii) Eliminate the use of certain trusts that make medical expense or tuition payments directly to qualified providers or educational institutions for a grandchild free of US gift or GST tax, by requiring that such payments must be made by a living donor directly to the medical facility or education institution in order for the US GST tax exclusion to apply;
(iv) Extend the US estate-tax lien applicable to estates throughout the entire period that the US estate tax is deferred under Code Section 6166;
(v) Limit a donor’s total annual exclusion gifts to $50,000 per donor for those types of transfers where the donee would not be able to easily liquidate the gifted property;
(vi) Expressly make the US tax code’s definition of "executor" applicable for all tax purposes, and authorize such executor to do anything on behalf of the decedent in connection with the decedent’s pre-death tax liabilities or obligations that the decedent could have done if still living.
Simplify the Tax System
Provide Relief for Certain "Accidental" US Citizens
The FY 2016 Budget unveils a new proposal that would provide relief to individuals who may not learn until later in life that they are US citizens having dual-citizenship since birth and may be citizens of countries where dual citizenship is illegal and have had minimal contact with the United States. As US citizens, these individuals would be subject to US income tax on their worldwide income, regardless of whether they live outside of the United States. The Administration recognizes that some of these individuals upon finding out about their accidental US citizen status would like to relinquish their US citizenship, but doing so may result in paying significant US income tax under Code Section 877A in order to certify under penalties of perjury that he or she has been US tax and reporting compliant for the 5 years preceding the year of expatriation. By being unable to certify US tax compliance, such individuals would meet the definition of a "covered expatriate" under the provisions of section 877A and may be required to pay a mark-to-market "exit tax" on a deemed disposition of their worldwide assets as of the day before their expatriation date. Under the proposal, an individual will not be subject to tax as a US citizen and will not be a covered expatriate subject to the mark-to-market exit tax under section 877A if the individual:
(1) became at birth a citizen of the United States and a citizen of another country,
(2) at all times, up to and including the individual’s expatriation date, has been a citizen of a country other than the United States,
(3) has not been a resident of the United States (as defined in Code Section 7701(b)) since attaining age 18½,
(4) has never held a US passport or has held a US passport for the sole purpose of departing from the United States in compliance with 22 CFR §53.1,
(5) relinquishes his or her US citizenship within two years after the later of January 1, 2016, or the date on which the individual learns that he or she is a US citizen, and
(6) ) certifies under penalty of perjury his or her compliance with all US federal tax obligations that would have applied during the five years preceding the year of expatriation if the individual had been a nonresident alien during that period (i.e., paid all applicable US income tax on income earned from US sources)
The proposal would be effective January 1, 2016.
Tax Carried (Profits) Interests as Ordinary Income
Given the notoriety that the reduced taxability of an individual service partner's "carried interest" in a partnership has drawn in recent years, the FY 2016 Budget contains a proposal that would 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. In order to further prevent income derived from labor services from avoiding taxation at ordinary income rates, the proposal would assume that the gain recognized on the sale of an ISPI would generally be taxed as ordinary income, not as capital gain.
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Tax Gain from the Sale of a Partnership Interest on Look-Through Basis
Also in the area of partnerships, the FY 2016 Budget contains a proposal that would provide that gain or loss from the sale or exchange of a partnership interest is effectively connected with the conduct of a trade of business in the United States to the extent of the partner’s distributive share of unrealized gain or loss of the partnership that is attributable to property used or held for use in the partnership’s trade or business within the United States. In addition, the proposal would require the transferee of a partnership interest to withhold 10 percent of the amount realized on the sale or exchange of a partnership interest unless the transferor certified that the transferee is not a nonresident alien or foreign corporation, or provides a certificate from the IRS that established that the transferor's US federal income tax liability with respect to the transfer was less than 10 percent of the amount realized.