BO SOTU PLANS TO INCREASE TAX ON THE “WEALTHY”

Yesterday I told you what tax “reform” for the “middle class” that BO will be proposing in tonight’s State of the Union address.

Today I will tell you how he plans on having the “wealthy” pay for these expanded, and Code-complicating, tax expenditures.

Raise Top Capital Gains and Dividend Rates

BO wants to raise the top “special” tax rate on qualified dividends and long-term capital gains from 20% to 28%.

We are told that the current top tax rate on qualified dividends and long-term capital gains is 23.8% - 20% maximum capital gain tax rate plus the 3.8% Obamacare surtax on net investment income.  This is not true. 

For high income taxpayers who are victims of the dreaded Alternative Minimum Tax, especially those who live in highly taxed states like New Jersey, New York, and California, the effective tax cost of qualified dividends and long-term capital gains can be higher – almost 31%.   

While qualified dividends and long-term capital gains are also taxed separately, at the special capital gain rates, under the dreaded AMT, this income increases “Alternative Minimum Taxable Income”, and can decrease and eventually wipe out the AMT exemption amount – causing more “ordinary income” to be taxed at the AMT rate.

When I first started preparing 1040s, back in the early 1970s, there were no special “capital gains tax rates”.  However there was a 50% capital gain exclusion.  50% of all long-term capital gains disappeared from the tax return.  If your capital gain was $10,000 your Adjusted Gross Income and net taxable income was reduced by $5,000, and you basically paid tax, at regular ordinary income rates, on $5,000.  I think I prefer this concept to a special capital gains tax rate – although I will admit I very much like the current 0% tax rate.

I would gladly support doing away with a special reduced tax rate on dividends if, and only if, a “dividends paid deduction” was permitted for corporations.  I would also gladly support doing away with all special industry-based corporate tax “loopholes” – so that you were taxed on corporate book income less dividends paid. 

{Aside - I also support doing away with the corporate deduction for depreciation of real property – but that is the subject for another post.}

Eliminate Stepped-up Basis on Inherited Property

BO proposes to eliminate stepped up basis at death.  He calls the step-up in basis an “egregious” loophole, and “the single largest capital gains tax loophole”.  

When you inherit investments – stocks, mutual fund shares, real estate – your “tax basis” for reporting capital gain and loss on the sale of the investments inherited is the fair market value of the investments on the date of death of the person from whom you inherit the assets – or the fair market value 6 months after the date of death.  It is the value for the investments that would have been reported on the federal estate tax return if one had been filed.

If your uncle purchased 100 shares of XYZ corporation for $1,000 in the 1970s, and the stock is worth $11,000 when he leaves it to you, your “cost” is $11,000.  If you sell the stock once title has been transferred to your name for, say, $11,500 you have a taxable long-term capital gain of only $500.  If you sell the stock for $10,000 you have a $1,000 long-term capital loss.

{FYI - the sale of inherited property is always treated as long-term by the beneficiary regardless of when the deceased actually purchased the property or how long you held it before selling.}

Nobody pays any capital gains tax on the $10,000 increase in value (the stepped up basis) based on the original $1,000 purchase price.

Why does this happen?  To avoid double-taxation.  The $11,000 value of the stock would have been included on the federal Estate Tax Return of your uncle, and would have been taxed had there been a taxable Estate.

This was a lot more likely when the federal Estate Tax exclusion was $675,000 – but is truly rare today with the current $5+ Million exemption. 

If there was a taxable estate the Estate Tax on the $10,000 increase in value would be a lot more than the capital gains tax of 0%, 15%, 20%, or even 28%.

It appears to me (and correct me if I am wrong) that under BO’s proposal the capital gains tax on the increase in value would be assessed to and paid by the estate at the time of death.  The beneficiaries would still receive a “stepped up” basis (because the tax was already paid by the estate) and not have to pay the capital gains tax when they sell the property.

This would not affect the federal Estate Tax filing.  I expect the gain would be paid on a Form 1041, or perhaps a new 1041-CG, filed by the estate.  And the tax would be paid directly by the estate; the gain would not be passed through to the beneficiaries on a K-1.

It is unclear just how the appropriate capital gains tax rate – 0%, 15%, 20%, or even 28% -would be determined.  Perhaps it will be based on the deceased’s final 1040, or the last 1040 that covered a full calendar tax year.

Under this plan, if there is a federally taxable estate, say in the above example your uncle’s estate was worth $10 Million, there would still be a “double-taxation” on the increase in value.  Perhaps there would be an adjustment on the 1041-CG for capital gains that were taxed on the Form 706 (the Estate Tax return). 

As explained in “Obama Proposes New Tax Hikes on Wealthy to Aid Middle Class” by Richard Rubin and Margaret Talev at BLOOMBRG.COM –

“The administration’s proposal on capital gains at death would exempt the first $200,000 in capital gains per couple plus $500,000 for a home {the current exclusion for gain on the sale of a personal residence on a joint return – rdf}, along with all personal property except for valuable art and collectibles. The rest would be treated for income-tax purposes as if it had been sold.”

And the proposal would also exempt inherited small, family-owned businesses from capital gains tax at death unless and until the business was sold. Any closely-held business subject to capital gains tax would have the option pay out over 15 years.

I have always been against totally eliminating the step-up in basis for inherited property.  It is one reason I have been somewhat hesitant to support “killing” the federal “death tax” (aka Estate Tax).  Eliminating the step-up in basis would create a nightmare for tax professionals.  It is hard enough to get clients to keep track of investments purchased during their lifetime, let alone what their parents or other relatives paid for property and investments acquired before they were born!   

This “loophole” benefits lower and middle income individuals just as much as it benefits the wealthy.

However, having the capital gains tax paid by the estate before transferring title to the beneficiaries is a better way of dealing with the taxes lost by stepped-up basis.  There would still be problems determining the cost basis, depending on when and how the investments were originally acquired by the deceased.  But a lot less problems than if we taxed the beneficiaries when they sell the investments.

If there is going to be an elimination of the stepped-up basis tax avoidance this is a better way to implement it.  It shows some actual thought by BO, or whoever actually came up with the plan, a true rarity when it comes to tax legislation.

Of course this is all academic.  BO’s tax proposals, both to help the middle class and punish the wealthy, will never pass in the Republican controlled Congress.

TTFN

BO’S SOTU TAX PROPOSALS

BO has released some of the tax proposals he will be presenting in tomorrow night’s State of the Union Address.

Before I look at his specific proposals let me explain what, in my opinion, the idiots in Congress should, but I expect never will, do (although it has been suggested by several legitimate sources, other than me,  during the Dubya an BO presidencies).

Our current Tax Code should be totally shredded and we should start from scratch.  “Everything is taxable, except.”  And “nothing is deductible, except”.  Only those “excepts” that are appropriate and necessary should be added back.

All “industry-specific” individual and business “loopholes” should be permanently closed.

Government welfare and other benefit programs should no longer be distributed via the 1040, and there should most definitely be no “refundable” tax credits.  And, most definitely, there would be no dreaded Alternative Minimum Tax.

When looking at what “tax expenditures” are appropriate and necessary we should consider only those items that encourage saving, investment, and general economic growth.

That said, let me now take a look at BO’s proposals.  I have used the recent post of Kelly Phillips Erb, FORBES.COM’s TaxGirl, titled “President's New Tax Proposal Would Hit Wealthy, Benefit Middle Class”, and “Obama Proposes New Tax Hikes on Wealthy to Aid Middle Class” by Richard Rubin and Margaret Talev at BLOOMBRG.COM, among other recent blog posts and articles, as my sources.

* Establish a Tax Credit for Two-Income Families 

It’s deja vu all over again.  Or everything old is new again.  This is certainly not new – just a return of the “Schedule W” from the 1970s.  {Aside - as I recall (please correct me if I am wrong) the Schedule W was one of the rare tax benefits that was introduced after the beginning of the tax filing season and made retroactive to the prior year – so we actually had to prepare amended returns for some clients to claim this benefit}.

This is an admirable partial "fix” to the “marriage tax penalty” that currently exists in the Tax Code because of the way the tax tables are written.  As KPE explains, it provides –

“. . . a tax credit of up to $500 for families with two working spouses. The credit would be equal to 5% of the first $10,000 of earnings for the lower-earning spouse in a married couple, and the maximum credit would be available to families with incomes up to $120,000, with a partial credit available up to $210,000.”

My solution to the “marriage tax penalty” is to create one filing status and one tax table – but allowing married couples to file one tax return which separately reports and taxes the individual net taxable income of each spouse.

However anything that reduces the marriage tax penalty is good – and I would not oppose this new credit.  Thankfully it would not be “refundable”.

* Increase the Child Care Credit 

BO would increase the maximum Child and Dependent Care Credit to $3,000 (half of the first $6,000 of child care costs) per child for children under 5.  The maximum credit could be claimed by families making up to $120,000.  Again, also thankfully, the credit would not be “refundable”.

But he would repeal Flexible Spending Accounts for child care, which let people set aside up to $5,000 a year before taxes.

Again I do not necessarily oppose an increase in the Child and Dependent Care Credit – though I probably would not support doing away with Dependent Care FSAs.

However, if there must be an income limitation, and I do not think there should be one (I generally oppose AGI limitations on deductions and credits) I feel $120,000 is too low.  My clients for the most part live in New Jersey, with some in New York.  In the northeast $120,000 in income is not a lot.  While families in Kansas, or even in parts of my new home state of Pennsylvania, with income of $120,000 may be living large, those with similar incomes in NJ, NY and several other states are just getting by.

* Expand the Earned Income Tax Credit (EITC)

KPE tells us that, “despite heavy criticisms of the EITC (which has become a magnet for tax fraud)” -

“The President’s proposal would double the EITC for workers without qualifying children, increase the income level at which the credit phases out, and make the credit available to workers age 21 and older.”

The increased credit would, I expect, be refundable.

I am the biggest critic of the Earned Income Tax Credit.  The EITC is federal welfare and does not belong in the Tax Code!  Period!  Exclamation Point!

I oppose any expansion or enhancement of the Earned Income Tax Credit – or any “refundable” tax credit.

That is not to say that the government should not assist, encourage, or reward the “working poor”.  But it should be done through the current Aid to Families with Dependent Children program.

Revamp Education Benefits

According to KPE -

“The President’s plan would consolidate existing education tax benefits. . . The move would . . . allow more students up to $2,500 in tax breaks each year over five years.  Specifically, the Lifetime Learning Credit and the tuition and fees deduction would be eliminated and replaced by an expanded American Opportunity Credit (AOC).  The refundable piece of the AOC would also be increased.”

BO would also “eliminate tax on student loan debt forgiveness under Pay-As-You-Earn (PAYE) and other income-based repayment plans” and “repeal of the student loan interest deduction for new borrowers”.

If education benefits must remain in the Code (and I do not believe they should) then consolidating existing education benefits into one expanded AOC is a good idea.  But, obviously, none of the credit should be “refundable”. 

And I would allow the credit to be claimed over six (6) calendar tax years.  Education is measured on a “fiscal” year – a student incurs undergraduate degree costs during five (5) calendar years.

I would not oppose eliminating tax on forgiven student loan debt.  But, while I would certainly prefer direct subsidies for student loan interest, I do not think I would support eliminating the student loan deduction on only some payees.

BO is also proposing “America's College Promise”, which would provide “the first two years of community college free for everybody” who maintains a minimum 2.5 GPA.   

Now this is something I could really support.  However there are no details on how this would be administered, nor how it would be paid for, yet.

This is also nothing new.  Tuition-free community college was first proposed by Harry Truman in 1947.   

Boost, and Limit, IRA Options 

Once again from KPE -

“Every employer with more than 10 employees that does not currently offer a retirement plan would be required to automatically enroll their workers in an IRA – called an ‘auto-IRA’.”

Tax credits would be given to employers to help with the implementation and administration costs.

And

“The proposal would also demand that employers who offer retirement plans permit part-time employees who have worked at least 500 hours per year for 3 years or more to make voluntary contributions to the plan.”

And

“The President’s plan would also bar contributions to and accruals of additional benefits in tax-preferred retirement plans and IRAs once balances have reached $3.4 million.”

I support anything that would encourage retirement savings.  As I said in a post this past December “Everybody Ought to Have an IRA”.  But I would need to know more of the mechanics of these required employer-sponsored IRAs. 

Would contributions come from the employer or the employee?  I doubt very much the government could, or should, require individuals, or employers, to make contributions to an IRA.  At most I think that employers would be required to offer employees the opportunity to make voluntary contributions to an IRA via payroll withholding.

And I would support allowing permanent part-time employees to make voluntary contributions to an employer-sponsored plan, without a required employer match.

But I definitely do not support limiting retirement savings, or any kind of savings, or the accrual of benefits within retirement plans.    

No real surprise from BO with any of his proposals - he does not want “tax reform” or “tax simplification”.  He wants to continue complicating the Tax Code further by expanding “tax expenditures” that do not belong Code in the first place. 

How will BO pay for this “middle class tax relief”?  I’ll tell you tomorrow (which means that the normal Tuesday BUZZ will be pushed to Wednesday).

TTFN

TAXES AND THE STATE OF THE UNION ADDRESS

I did not watch the State of the Union address last night.  Instead I watched the wonderful film GAMBIT with Michael Caine and Shirley MacLaine on TCM.  This morning I “wandered” the web for blogs and articles on the address.

As you might expect, I was interested in BO’s statements on 1040 issues.

In addressing tax reform BO said -

“Both Democrats and Republicans have argued that our tax code is riddled with wasteful, complicated loopholes that punish businesses investing here and reward companies that keep profits abroad.  Let’s flip that equation.  Let’s work together to close those loopholes, end those incentives to ship jobs overseas, and lower tax rates for businesses that create jobs right here at home.”

This is about business tax reform.  The only reference to 1040 tax issues in the address was a call to expand the Earned Income Tax Credit –

“So let’s work together to strengthen the credit. . .”

He referenced Senator Mark Rubio’s concerns with the EITC.  Rubio wants to take the EITC out of the Tax Code and replace it with perhaps a direct wage subsidy.  The President clearly wants to keep the credit as part of the 1040 – where it clearly does not belong.

Rubio had pointed up two of the biggest problems with the EITC –

“One weakness of the EITC compared to the minimum wage, however, is the fact that low-wage workers only see the refundable tax credit once a year in a lump sum, rather than a small increase in their paycheck over a full year.”

And –

“Currently the Earned Income Tax Credit has one of the highest payment error rates of all federal programs that cost between $11.6 and $13.6 billion in 2012. Whether these payment errors are due to intentional fraud and abuse or the program’s staggering complexity is up for debate (it is likely a mixture of the two).”

Apparently the President is not concerned with these serious issues.

It is clear that President Obama does not want serious, substantive tax reform.  He wants to continue to complicate the already mucking fess that is the US Tax Code by expanding refundable credits – which are magnets for tax fraud.  Do not look for any real tax reform in 2014, or probably anytime soon.

The other item of interest in the address was his call for a “myRA” payroll withholding starter retirement account for employees without access to a 401(k) plan. 

It appears the “myRA” would be a kind of US Savings Bond.  Many employees already have the option of purchasing US Savings Bonds via payroll deduction. 

There were no specific details on the “myRA”.  BO spoke of a bond that “guarantees a decent return” – but what is a “decent return”.  Current savings bonds certainly do pay more interest than basic savings accounts – but do not provide what I would call a “decent return”.  Would employers, with or without 401(k) plans, be required to offer this savings opportunity to all employees?  Would employee contributions be tax deductible?  Would there be a ROTH-like option?

I have read that this account would possibly have a maximum lifetime contribution limitation.  When the maximum is reached the account could be rolled-over into an IRA account.

I support anything that encourages and assists Americans to save for retirement, but would obviously need to see more details before giving the “myIRA” a thumbs up.

TTFN

TAXES AND THE STATE OF THE UNION ADDRESS

While I have not yet read it through carefully (nor did I sit through it), there appears to be nothing new on taxes from BO in the State of the Union address.  No mention that I have seen of the need to totally rewrite the mucking fess that is our current Tax Code.  Just more of the same – continue to complicate the Tax Code with more targeted deductions and credits.

The “Buffet Rule” and the general concept of taxing the rich more because they can afford it was one of BO’s themes -

“Tax reform should follow the Buffett rule: If you make more than $1 million a year, you should not pay less than 30 percent in taxes. And my Republican friend Tom Coburn is right: Washington should stop subsidizing millionaires. In fact, if you're earning a million dollars a year, you shouldn't get special tax subsidies or deductions. On the other hand, if you make under $250,000 a year, like 98 percent of American families, your taxes shouldn't go up.”

"Millions of Americans who work hard and play by the rules every day deserve a government and a financial system that do the same. It's time to apply the same rules from top to bottom. No bailouts, no handouts, and no copouts. An America built to last insists on responsibility from everybody."

"Do we want to keep these tax cuts for the wealthiest Americans?  Or do we want to keep our investments in everything else, like education and medical research; a strong military and care for our veterans? Because if we're serious about paying down our debt, we can't do both."

Millionaires don’t get the Child Tax Credit, for example, or any of the tuition tax benefits.  Many tax benefits are wiped out based on Adjusted Gross Income (AGI) or Modified Adjusted Gross Income MAGI) well below the $1 Million mark.  Millionaires are taxed on 100% of net capital gains in successful years, but are limited to a deduction of $3,000 in net capital losses in unsuccessful years. 

Millionaires with excessive dividend income pay a lower tax rate on corporate dividends, but only because, due to unfair double-taxation, this income has already been taxed by the federal government on the corporate level as high as 35%.

Does insisting on “responsibility from everybody” mean that almost half of Americans do not have to pay any federal income tax?

And BO calls for the extension of the payroll tax reduction

“Right now, our most immediate priority is stopping a tax hike on 160 million working Americans while the recovery is still fragile. People cannot afford losing $40 out of each paycheck this year. There are plenty of ways to get this done. So let's agree right here, right now: No side issues. No drama. Pass the payroll tax cut without delay.”

To be sure, extending this for only 2 months was totally ridiculous, and, as long as it is in place for part of 2012 it should be all or nothing.  But we should also address whether or not this kind of political trick is good tax or financial policy in the first place.

To give BO credit, he does make one good suggestion that I noticed -

“Put Americans to work today building the infrastructure of tomorrow.”

And he talks about corporate tax reform – but that is not my interest at this point nor is that the focus of this blog.

TTFN

TAX ISSUES IN THE STATE OF THE UNION ADDRESS

For those of you who missed the State of the Union Address Kelly Phillips Erb posts the text of the speech at TAX GIRL (click here).

So what did BO have to say in terms of taxes last night?

"I've proposed a fee on the biggest banks. Now, I know Wall Street isn't keen on this idea. But if these firms can afford to hand out big bonuses again, they can afford a modest fee to pay back the taxpayers who rescued them in their time of need."

Any fee will most likely be just passed along to bank customers. How about making bonuses in excess of a certain reasonable amount, or not paid out of current earnings and profits, non-deductible?

“I'm also proposing a new small business tax credit -- one that will go to over one million small businesses who hire new workers or raise wages. While we're at it, let's also eliminate all capital gains taxes on small business investment, and provide a tax incentive for all large businesses and all small businesses to invest in new plants and equipment."

I have no objection to a “jobs credit”.

As for the comment “eliminate all capital gains taxes on small business investment” – this certainly raises a lot of questions. Do I understand BO correctly? Does he want to make the capital gains tax rate “0” regardless of level of income? Will this apply only to capital gains from “small business investment”? How will “small business investment” be defined? I thought BO wanted to increase the capital gains tax rate.

.

I certainly support lower rates for capital gains for all. As for eliminating the ta on certain capital gains - I actually have never given this idea any thought before.

“To make college more affordable, this bill will finally end the unwarranted taxpayer subsidies that go to banks for student loans. Instead, let's take that money and give families a $10,000 tax credit for four years of college and increase Pell Grants. And let's tell another one million students that when they graduate, they will be required to pay only 10 percent of their income on student loans, and all of their debt will be forgiven after 20 years -- and forgiven after 10 years if they choose a career in public service, because in the United States of America, no one should go broke because they chose to go to college."

Doesn’t the American Opportunity Credit already give taxpayers a $10,000 credit for four years of college (within AGI income limitations, of course)? The maximum credit it $2,500 and it is available for four years of college. I suppose he is talking about making it permanent.

I am against any debt forgiveness for student loan borrowings. Don’t charge any interest on the debt for the first 10 years if you want – but don’t forgive the debt altogether. Although I would consider some kind of debt forgiveness or other special treatment for those who enter “public service” and stay there for a required number of years.

“To help working families, we will extend our middle-class tax cuts. But at a time of record deficits, we will not continue tax cuts for oil companies, investment fund managers, and those making over $250,000 a year. We just can’t afford it.”

So it appears that BO will support extending, or making permanent, the “Bush tax cuts” for those with income (AGI?) of less than $250,001, but will not do so for those with income (AGI?) of over $250,000. I am not against extending the “Bush tax cuts” for those under $250,001, or over $250,000 for that fact. Of course I would certainly prefer a total overhaul of the tax system to simplify the mucking fess – but I expect this is not to be - at least until the economy has been stabilized.

TTFN