Taking the new legislative, regulatory and enforcement outlook into account in decision-making ranges in difficulty from merely routine to nearly impossible.
With a new President supported by a Democratic House and a 58-42 margin in the Senate (59-41 if Mr. Franken is seated), "Change we can believe in" has already begun -- and at a break-neck pace. This Alert highlights fundamental changes expected from Congress and from new regulatory and enforcement officials that should be considered when making business decisions.
The American Recovery and Investment Tax Act of 2009
The Obama Administration has named its stimulus plan the "American Recovery and Reinvestment Plan." Initial pieces of the plan are now clearly visible in the form of a draft Bill released by the House Ways and Means Committee. The Senate Finance Committee is expected to hold a markup on the stimulus on January 22nd. Final passage is targeted for mid-February.
The plan is large -- currently standing at approximately $825 billion -- including approximately $275 billion of tax cuts and the rest in increased spending. Approximately one-half of the tax cuts are expected to be in the form of so-called "Make Work Pay" individual payroll tax credits in the amount of $1,000 per family or $500 per individual. Employers may be required to make quick changes to their payroll systems if and when this proposal is enacted. Other tax cuts that are under consideration are an enhancement of the child care credit, a five-year net operating loss carryback (under present law, a two-year carryback is permitted), and extensions of the 50 percent bonus depreciation and the $250,000 capital write-off, the latter being primary benefit to small businesses. A number of energy tax incentives are included, particularly in the areas of renewable energy and energy efficiency, in the range of $25 to $30 billion. In addition, several new state and local government bond enhancements are included to assist with an infrastructure rebuilding effort. Further changes and additions will be made over the next two weeks.
On the spending side, the plan is intended to create or save up to three million jobs, mostly in construction and manufacturing, through the construction or major renovation of lasting infrastructure, including roads, bridges, and schools. Other key projects under consideration are computerizing the healthcare system within five years, doubling renewable energy production within three years, and making 75 percent of public buildings energy efficient. The plan also includes increased Federal aid for increased unemployment benefits, Medicaid enhancement or subsidies for laid-off workers, and food stamps. The spending plan details and monitoring will be put online on a special website and an official oversight board will be created to oversee the spending.
Higher Individual Tax Rates
Federal income tax rates (including hidden income taxes like phase-outs of personal exemptions and limiting itemized deductions) seem certain to increase by approximately five percentage points -- or slightly more -- for individuals earning in excess of $250,000. The Obama Administration appears to favor an increase in these top tax rates on ordinary income when the Bush-era tax cuts of 2001 expire at the beginning of 2011.
Planning considerations include:
- Accelerating income to beat the rate increases
- Avoiding Section 409A traps against acceleration
- Deferral of deductions, including by current AMT taxpayers who may no longer be subject to AMT as regular tax rates increase
Higher Tax Rates on Capital Gains and Dividends
Individual tax rates applicable to capital gains and dividends also will increase, most likely to 20 percent. The Obama Administration appears to favor an increase in these top tax rates on capital gains and dividends when the Bush tax cuts of 2001 and 2003 expire at the beginning of 2011. However, as in the case of rate cuts on ordinary income, some Democrats in Congress would prefer that these rate changes occur sooner.
Planning considerations include:
- Taxpayers intending to sell capital gain property within the next two years should make such sales as soon as practicable.
- Taxable portfolios that generate significant capital gains or dividends should be re-positioned. Tax payers should consider including tax-free bonds and growth stocks held for longer periods to defer taxation.
- Income producing assets in general should be converted to long-term capital growth vehicles. Debt should be increased in appropriate cases to leverage capital growth while taking advantage of current deductions for interest expenses.
- Individual capital losses should be deferred in appropriate cases to offset capital gains subject to higher tax rates.
- Companies should consider accelerating a dividend payment to beat the effective date of the rate change.
Blowing the Cap Off Social Security Earnings
At some point during the Obama Administration, we expect that Social Security taxes on wages exceeding $250,000 may increase by at least two to four percent. The combination of that expected increase with the existing Medicare tax on all wage income will put pressure on high wage-earners to take steps to defer wage income or convert wage income into investment income.
Lower Corporate Tax Rates, At a Cost
There seems to be growing support for reducing the corporate tax rate. Unfortunately, there also is growing support for paying for any rate reduction by eliminating various deductions. Thus, to the extent rate reductions occur at all, there likely will be winners and losers. The most obvious losers may be U.S. companies that take advantage of the manufacturing deduction, as any general rate reduction is likely to result in the elimination of that benefit. Ways and Means Chairman Charles Rangel has a proposal under which deductions that are attributable to unrepatriated foreign income would be deferred until such income is repatriated. Two companion proposals would effectively put an end to high-tax/low-tax foreign tax credit planning and eliminate worldwide interest allocation for foreign tax credit purposes. Corporations that produce products abroad and sell those products into other jurisdictions also would lose any benefits of deferral under Democratic proposals going back many years.
Corporate tax directors need to inform their boards of the potential impact on corporate earnings of these expected changes. Adverse effects of certain proposals may be lessened or eliminated with advance planning.
Revenue Raisers, Including Executive Compensation Tax Changes and So-Called Loophole Closures
Legislation targeting tax benefits associated with executive compensation, carried interests, and tax credits are certain to be considered in the new Congress, and the so-called economic substance doctrine seems certain to be codified. In addition, Congress appears to be poised to aggressively attack the use of tax havens by corporations. Migration of certain holding companies from non-treaty haven states to low-tax treaty jurisdictions may be helpful in certain cases.
Estate Tax Permanence and Co-ordination with the Gift Tax
One thing we can all be certain of is that our new leaders in the White House and the Congress will not allow the estate tax rate to go to zero in 2010 and then spring back to life in 2011 -- which is what will happen under present law. Instead, we expect the estate tax to be made permanent in 2009 at a top tax rate of 45 percent. We believe the exemption amount for 2010 will be retained at least at the 2009 amount of $3.5 million per person or $7 million per couple. We also believe, however, that the new legislation will allow any exemption not used by one spouse to be automatically available to the other spouse. In addition, beginning in 2010, the gift tax exemption amount will be increased to $3.5M (from $1M) to again become uniform with the estate tax exemption amount. Given the recent historic drop in market values of assets of all types and the seeming inevitability of the estate tax for years to come, 2009 will be an ideal time to plan for aggressive gifting in early 2010 using various techniques for those who desire to pass significant assets to their heirs.
Charitable Gifts from IRAs
Charitable gifts of as much as $100,000 may be made from IRAs through the end of 2009 without any income inclusion to the account owner.
Charitable gifts of conservation easements may be deducted up to 50 percent of adjusted gross income for gifts made before the end of 2009. The limitation is removed entirely for farmers and ranchers. The IRS, however, has established a program intended to aggressively challenge any and all such deductions.
With gas prices falling, economic incentives in the marketplace are dissipating for developing alternative, renewable, and environmentally friendly energy sources. Congress seems determined to encourage alternative energy sources and environmentally friendly production and transport, and the Obama Administration is committed to that effort and has even touted massive government investments into eco-friendly research and investments as a type of "public works" project to help end the current economic recession. In addition to the energy component of the stimulus plan, it appears likely that a larger, more comprehensive energy bill may be developed later in 2009 or 2010.
Free Trade Issues
Columbia free trade, along with pending free trade agreements with Panama and South Korea, are stalled for now. Watch for Republicans to press for approval of these agreements in exchange for refraining from filibustering in the Senate various pieces of legislation to be sought by the Democrats.
The overall climate for international trade is deteriorating; both imports and exports are likely to be affected adversely.
As the economy continues to decline, we expect what seems always to happen, a political inclination to target foreign imports for our problems. During the last eighteen months the trade front has been relatively quiet because typically contentious areas, such as agriculture and steel, had been prospering. That situation is rapidly changing. Domestic manufacturers of goods competing with imports will likely benefit from petitioning for trade relief, even when cases are more difficult to prove, because such petitions invariably disrupt the market in favor of domestic producers. Importers, by contrast, should try to diversify their sources of supply because of such possible disruptions. The Democratic Congress will continue to tilt toward trade protectionism, now supported by an increase in the number of "Blue Dogs" and by clearer majorities.
The Obama Administration, which seemed to uncomfortably lapse into vague protectionist positions during the campaign, is not likely to assign much priority to trade. It may, however, permit the Congress to press forward a protectionist agenda: continued opposition to major trade agreements and continued pressure on China, particularly over alleged currency manipulation.
The export side of our trade relationships could be affected adversely by our own protectionist measures more than at any time since the 1930s. As we enforce our trade laws against foreign subsidies, for example, other countries are going to enforce their laws against our exports. The economic meltdown has led to a sweeping new government involvement that translates, in trade law, to subsidies. We are likely to impose more trade restrictions on goods that we claim are subsidized. Foreign countries are likely to do the same to our exports.
Leaders of Key Committees
The composition of both houses of Congress has shifted. The Democrats have a large majority in the House and have gained several seats in the Senate, but not quite enough to prevent a Republican filibuster. Under standing Senate rules, 60 votes are required to end a filibuster. The Senate now consists of 58 Democrats (59 if Mr. Franken is seated) and 41 Republicans. It will, however, be more difficult for the Republicans to maintain a filibuster in the face of unanimous Democratic opposition. While overall Congressional leadership will remain in place in the new Congress, some key changes have already occurred on the Republican side. Mr. Cantor has replaced Mr. Blunt as House Minority Whip. Mr. Camp has replaced Mr. McCrery as Ranking Member on the Committee of Ways and Means. Several new members have been added on both sides of the aisle to the Senate Finance and Ways and Means Committees.
In other areas, the following key changes have been made: Mr. Kerry has replaced Mr. Biden as chair of the Senate Foreign Relations Committee. Mr. Inouye has replaced Mr. Byrd as chair of the Senate Appropriations Committee. Mr. Waxman has replaced Mr. Dingell as chair of the House Energy and Commerce Committee.
Financial System Regulatory Reform and TARP Implementation
With the meltdown of the financial sector last fall, as well as the unfolding Madoff scandal (where a Baker Hostetler attorney serves as Trustee and the firm serves as Counsel to the Trustee), many fingers are being pointed at the current regulatory structure, which SEC Chairman nominee Mary Schapiro described as "stove-piped" at her recent confirmation hearing.
Massive overhaul of the financial regulatory system is anticipated with various proposals to regulate financial products, participants, and activities previously unregulated (including derivatives, hedge funds, and perhaps even insurance). Congress is contemplating proposals to eliminate or combine one or more agencies such as the SEC and the CFTC, into a single regulator to strengthen enforcement and to better detect overall "systemic risk". Finally, credit rating agency reform is almost a certainty, with both Banking Committee Chairman Christopher Dodd and Ranking Member Richard Shelby citing inaccurate ratings and conflicts in the ratings process as key factors in failing to signal the approach of the current financial crisis. Nearly everything appears to be on the table as a potential target for reform in the financial services arena -- as Schapiro stated during her testimony, there will be "no sacred cows" when she takes the helm at the SEC.
The Obama Administration soon will have access to the remaining TARP Bailout funds. Prior designated uses, including U.S. Treasury matching equity investments in financial services entities, including insurance companies, are on hold for now. The debate over how to best use the remaining TARP funds is ongoing. Interested parties should contact Treasury officials immediately.
The Employee Free Choice Act (EFCA) will be a major focus of the Congressional agenda in 2009. EFCA would amend the National Labor Relations Act (NLRA) by substituting card check recognition for the secret ballot election as the means for employees to choose union representation. EFCA will also require binding arbitration of first contracts 120 days after a union is certified as the employees' representative. That means that an arbitrator (not the employer) will have the power to set employees' wages and benefits for the first two years of the bargaining relationship. Finally, EFCA would impose stronger penalties for employer violations of the NLRA during organizing drives or the negotiation of first time labor contracts. Passage of EFCA is assured in the House, however, it is unclear whether the Act's proponents will be able the muster the 60 votes necessary to end debate given opposition of certain Senate Democrats and a likely Republican filibuster in the Senate. President Obama has promised to sign any such legislation into law. Watch for efforts by Congressional Democrats to attempt to negotiate a compromise version of the Act.
We expect that the Obama Administration will increase enforcement of environment regulations, which will cause both an overall increase in environmental litigation and a shift to some degree from lawsuits initiated by environmental interest groups to lawsuits initiated by the Administration itself. Early indications of the Obama Administration's enforcement priorities will become clearer as the Environmental Protection Agency begins sending investigatory letters to key industry sectors.
The new Administration also will begin to implement some of Obama's environment-related campaign promises, most notably those associated with climate change legislation. The new chairman of the House Committee on Energy & Commerce, Rep. Henry Waxman (D-CA) has announced his goal of moving a climate change bill to the floor of the House by Memorial Day. Support by some in industry for a carbon tax rather than a cap-and-trade system, along with the current economic crisis, likely will delay passage and affect components of the leading proposals.
During the campaign, President Obama focused upon healthcare reform and indicated it would be a major initiative of his administration. Although the financial sector of our economy has taken precedence at the moment, the appointment of Tom Daschle both as Secretary of Health and Human Services, and the creation of a new White House healthcare reform team signals that the administration will soon address major healthcare reforms. The mounting deficit may play a major role in major expansion initiatives, including the expansion of entitlement programs. The Children's Health Insurance Program (CHIP) reauthorization bill, however, has already been approved by the House and is making its way through Congress to the President's desk. Expansion of CHIP was one of Obama's stated goals. In addition, Daschle's longstanding study and writings about healthcare reform portend the potential creation of a Federal Health Board, similar to the Federal Reserve. In Congress, we understand that entitlement program funding cuts are being discussed. If history plays out again, we can expect major healthcare funding cuts, similar to those felt in the Balanced Budget Act of 1997.
Subprime Lending Litigation
As the subprime mortgage crisis has evolved into far broader economic challenges for the United States, the subprime litigation aftershock continues through U.S. courts. Court filings lag behind the triggering subprime events, but the wave of securities-related lawsuits reflects the magnitude of the subprime crisis. More than 600 lawsuits were filed by the end of the second quarter of 2008 alone, exceeding the total associated with the savings and loan crisis of the 1980s. Plaintiffs have employed many theories of liability, generally focusing on claims of fraud and inadequate disclosure and oversight. Recent developments in the law restricting the ability to recover in securities lawsuits create additional uncertainty for litigants. A relatively thin body of precedent exists regarding many securitized lending issues because of major changes in the applicable law. The Private Securities Litigation Reform Act enacted in 1995, changed pleading standards to restrict securities class action lawsuits, and in 2008, the Supreme Court disallowed lawsuits against secondary violators like credit rating agencies and mortgage consultants for fraud. As financial disputes unrelated to subprime mortgages increase in the year ahead, subprime litigation will provide risks and opportunities for financial institutions and investors, and related regulatory investigations will surely continue.
White Collar Defense and Corporate Investigations
Over the last five years, the Department of Justice (DOJ) under the Bush Administration has experienced a significant decrease in corporate fraud cases. While certain Foreign Corrupt Practices Act (FCPA) cases made headlines in recent years, the priorities of the new president and turbulent global economic environment suggest that white collar criminal prosecutions generally, and FCPA investigations in particular, will be given an enhanced prosecutorial emphasis by the new Administration. Specifically, President Obama's strong messaging on transparency in government and multilateralism, together with his attorney general appointee's experience with corruption investigations in public and private practice, strongly suggest that FCPA enforcement -- with its promise of substantial fines and publicity -- will be an even greater Justice Department priority under the new Administration.