Income taxes. It seems inevitable that taxes will soon be higher on a number of fronts. If Congress does not take any action on income taxes this year, beginning in 2011, the tax reductions enacted in 2001 and 2003 will expire and the rates will revert to their previous levels. In the case of long term capital gain income, the rate will go from its current 15% to 20%. The maximum rate on ordinary income will increase from 35% to 39.6%. This will include dividend income for which the tax rate will increase dramatically from 15% today to 39.6%. The President’s 2011 budget proposal would hold the line on dividend taxation at 20%, but that will only happen if Congress acts. Recently, Congress has been having difficulty acting.
The original Senate healthcare bill, H.R. 3590, “Patient Protection and Affordable Care Act,” was passed by the House of Representatives on March 21 and was signed by the President on March 23. Beginning in 2013, this legislation will increase the Medicare tax imposed on an individual’s wages or earned income from 1.45% to 2.35% on wages or earned income in excess of $250,000 for married taxpayers or $200,000 for single taxpayers. For purposes of this additional tax, wages and earned income of married taxpayers are combined to determine when the $250,000 threshold is exceeded.
The healthcare legislation does provide some limited tax benefits including a tax credit for small employers (25 employees or less) who make contributions for the purchase of health insurance for their employees. For most of our readers, it appears that increases under the legislation will be far more significant than any of the incidental tax benefits that may be available.
The additional reconciliation bill, H.R. 4872, “Health Care and Education Affordability Reconciliation Act of 2010,” was also passed by the House on March 21. The Senate passed the bill on March 25, and the President signed it on March 30. This bill imposes a new 3.8% Medicare tax on investment income (including interest, dividends, royalties, rents, annuities and capital gains) for married taxpayers with modified adjusted gross income in excess of $250,000 and single taxpayers with modified adjusted gross income in excess of $200,000. This new tax also begins in 2013. As a theoretical worst case, dividends could end up being taxed at a federal rate as high as 43.4% (39.6% + 3.8%) and long term capital gains at 23.8% (20.0% + 3.8%) before you consider state income taxes. The committee reports for this legislation confirm that this tax will not apply to income that is not subject to regular income tax such as interest on state and municipal bonds or the portion of gain from the sale of your residence that is not subject to tax.
Estate Taxes. On the estate and gift tax front, inaction continues to describe the state of affairs. The much anticipated “patch” to preserve 2009 law through 2010 has not been enacted. If Congress takes no action, on January 1, 2011, the estate and gift tax rate will go back up to 55% with the exemption limited to $1,000,000. We continue to hear that there is a desire to enact legislation preserving the 45% maximum rate and $3,500,000 exemption, but so far nothing has happened. As more time passes, it will be more difficult to enact legislation that is retroactive to January 1, 2010. There have recently been reports from Washington that Congress may consider allowing estates of persons who die in 2010 to elect to apply either 2009 law or 2010 law. While 2010 law means no estate tax, there is also only a limited increase permitted to the income tax basis of the decedent’s assets. Also, do not forget that there is still a gift tax in 2010 on gifts over the lifetime exemption amount of $1,000,000. For 2010 only, the maximum gift tax rate is reduced to 35%.
For many estates, the 2009 regime which imposed estate tax at a maximum rate of 45% with a $3,500,000 exemption, would be preferable because the law also permitted the income tax basis of all of the decedent’s assets to be increased to fair market value. Estates would benefit from the 2009 regime where the estate is not larger than the $3,500,000 exemption amount or where the decedent left a surviving spouse and took advantage of the marital deduction for all of his assets that were in excess of his $3,500,000 exemption. These “first death” estates would not have owed any estate tax anyway due to the exemption and marital deduction but could have received considerable benefit from the income tax basis increase. We will continue to keep you apprised on any developments.
Grantor Retained Annuity Trusts. Congress has considered for some time now the possibility of legislation that would impose a ten year minimum term for Grantor Retained Annuity Trusts (“GRAT”). That legislation has now been introduced as a provision in H.R. 4849, “The Small Business and Infrastructure Jobs Tax Act of 2010,” and would also make two other changes to the rules for GRATs. A “zeroed out” GRAT, i.e., one where there is no element of gift upon the creation and funding of the GRAT, would no longer be permitted. However, the current version of the legislation does not impose any minimum gift amount so perhaps a gift of $1 will suffice. Finally, the amount of the annual payment to the creator of the GRAT could not decline during the first ten-years of the GRAT term. The changes would be effective from the date of enactment. If you have been contemplating a shorter term GRAT (two years has been popular), time is of the essence in completing it.
The ten-year term is problematic for two principal reasons. First, the GRAT will not produce any estate tax savings unless its creator survives to the end of the term. This will make GRATs less useful for people of advanced age or marginal health. Second, over a ten-year term, it will be far more challenging to invest the assets of the GRAT to generate a return that is in excess of the mandated hurdle rate.