Planning For The Scheduled 2013 Tax Rate Increases
This year, 2012, marks the end of the low income, estate, and gift tax rates under the existing tax laws. Currently, the maximum federal income tax rate is 35%, but this tax rate is scheduled to rise to 39.6% on January 1, 2013. Additionally, commencing in 2013, there will be a new healthcare tax of 3.8% on passive investment income as well as on capital gains for high income earners. It is unclear whether Congress, after this upcoming November election, will vote to preserve some or all of the current low tax rates. The following planning strategies will assist your clients with these scheduled tax law changes.
1. PLANNING FOR THE 2013 HIGHER CAPITAL GAINS TAXES .
Starting in 2013, taxes on long-term capital gains are scheduled to increase under current tax laws. First , the current maximum 15% federal capital gains rate will rise to 20%. Second , the federal healthcare insurance tax will impose a new 3.8% tax on capital gains for high earners. Third , there remains the maximum 9.3% California income tax rate on all income including capital gains, plus an additional 1% tax for incomes over $1,000,000 under the California Mental Health Services Tax (or a maximum total of 10.3% California tax rate for high earners). California tax rates could increase even further under recent proposed tax ballot measures. Thus, for the highest earning taxpayers, there is a potential aggregate federal and California maximum 34.1% tax rate on long-term capital gains commencing January 1, 2013 (before taking into account the deduction for state income taxes or the effect of the alternative minimum tax). This increased capital gains tax will impose an increased cost if, for example, a client were to sell their business, real estate, or personal residence.
For many California taxpayers, the ability to deduct state income taxes from their federal taxes is effectively limited by the alternative minimum tax. Generally, when a client has a large amount of taxable gain (such as from the sale of a substantial asset), there is a likelihood that this alternative minimum tax will apply.
1.1 WHAT IS THE NEW HEALTHCARE TAX ON CAPITAL GAINS ? Beginning in 2013 the Health Care and Reconciliation Act of 2010 (new Internal Revenue Code Section 1411) imposes a new 3.8% tax on net investment income, which will include net long-term capital gains. The constitutionality of the Health Care and Reconciliation Act of 2010, which may include its tax provisions, is an issue scheduled to be decided by the U.S. Supreme Court in the immediate future. This new healthcare tax applies to taxpayers with modified adjusted gross income (“MAGI”) over $200,000, and to married taxpayers filing jointly with MAGI over $250,000. The tax is calculated as 3.8% multiplied by the lesser of either the net investment income or the amount which the MAGI exceeds these threshold amounts. For estate and trusts this new 3.8% tax applies at the much lower threshold point of when the estate or trust has income in excess of $11,000. Clients could try to minimize this new health care tax by trying to classify income as “active” trade or business income. However, clients must then avoid such “active” income being taxed as self employment income. Additionally, consideration must be given to the possibility that carried interest tax legislation may be enacted in the future which could tax at ordinary income tax rates distributions (even distributions representing proceeds from the sale of a capital asset) to a client from a partnership which they actively manage. One planning strategy permitted by this new health care tax is that the “kiddie tax” concept does not apply to this new health care tax, so that passive investment income can be shifted to a child (who is below the MAGI threshold amounts) and avoid this 3.8% tax, such as by the use of family limited partnerships.
1.2 TAXES ON RECAPTURE INCOME . Assets sold in 2013 may be taxed at even higher tax rates. For example, on the sale of real estate there is a recapture of previously deducted real estate depreciation, taxed at the 25% federal rate, and a tax on the recapture of depreciation on personal property at federal ordinary income tax rates, which increase to a maximum 39.6% rate in 2013 (plus there will be California income taxes and the new healthcare tax).
1.3 WHAT CAN CLIENTS DO TO AVOID THE EFFECT OF THESE TAX INCREASES ?
Close Sale of Asset in 2012. If clients are considering a sale of real estate, a business or other capital asset on which they will be paying taxes, consider trying to close that sale in 2012 in order to take advantage of the lower 2012 income tax rates.
If a Client Sells an Asset in 2012 and Receives Back an Installment Promissory Note, They W ill Pay at the Tax Rate in Effect in the Year of the Payment’s Receipt. Thus, if a client receives a promissory note’s payments after 2012, they will be subject to the higher tax rates existing in those years. One planning idea is that if the client sells property in 2012 on an installment promissory note, they may wish to consider accelerating that note’s gain into 2012 (which would be at a lower tax rate) by electing out of installment sale treatment. This election out can be made up to the extended due date of their 2012 tax return (which will give the client until late in 2013 to decide whether or not to make this election out), leaving the client time to see what new tax laws Congress may enact.
If the Client Sells a Business, They Should Consider Utilizing a Tax-Free Sale. As an example, if a client sells their business to a blue chip corporation, they might elect to receive back stock in that buying corporation (rather than cash) in a tax-free reorganization. The stock is received tax free, and the client can then diversify their stock investment through hedging transactions or an exchange fund. The client’s tax can be entirely eliminated if the client holds onto the stock they receive until the death of the first of the client or their spouse (assuming that the stock was community property).
If the Client Sells Real Estate, Consider Utilizing the Tax-Free Exchange Provisions ofSection 1031 to Defer Their Taxes on That Real Estate’s Gain. Section 1031 tax-free exchanges should be considered whenever a client sells real estate.
Use Partnerships to Receive Cash Distributions on a Tax-Free Basis. If the real estate or other assets are owned in partnership (or LLC) form, the client has flexibility through loans and capital contributions to receive cash distributions tax free. The tax rules on partnership disguised sales and the anti-mixing bowl rules of Subchapter K must be followed in this regard.
2. PLANNING FOR THE 2013 CHANGES TO ESTATE AND GIFT TAXES .
December 31, 2012 is scheduled to be the end of the current high unified gift and estate tax exemption amount of $5,120,000 per person and the low 35% estate and gift tax rate. Commencing on January 1, 2013, the unified estate and the gift tax exemption will decline to $1,000,000 per person and the tax rate will increase to 55%. A person who dies in 2012 can leave up to $5,120,000 tax free to their family (less any amount of the exemption that they may have previously utilized). Additionally, in 2012 tax-free gifts up to the $5,120,000 exemption amount can be made (or a combined amount of $10,240,000 in tax-free gifts for a husband and wife). This $5,120,000 exemption amount is in addition to the current annual gift tax exclusions of $13,000 which can be utilized for each donee (or $26,000 per year per donee for a husband and wife). Additionally, each year your clients can pay gift tax free unlimited amounts for their children’s and grandchildren’s school tuition and healthcare needs. In 2012, the generation-skipping tax exemption amount (which exempts from the generation skipping tax transfers of assets to grandchildren) is also $5,120,000, but this exemption is set to be reduced on January 1, 2013 to $1,000,000 plus inflation adjustments.
2012 presents a one-time opportunity to make large amounts of gifts tax free. However, clients first must decide if they want to gift a significant amount of their wealth to their children and grandchildren, and clients need to retain enough liquid assets and cash flow to live comfortably in their chosen lifestyle.
2.1 WILL CONGRESS CHANGE THESE CURRENT ESTATE AND GIFT TAX LAWS ? There is current deadlock between Congress and the President on tax legislation. Some tax observers predict that after the November election some sort of political compromise could occur, such as enacting a compromised estate and gift tax exemption amount of between $3,000,000 and $5,000,000 and a tax rate of around 45%. President Obama has proposed a $3,500,000 estate and gift tax exemption amount. However, it remains uncertain today what tax law changes (if any) will ultimately be enacted.
2.2 WHAT CAN CLIENTS DO TO PLAN FOR THIS INCREASED 2013 ESTATE AND GIFT TAX RATE AND LOWER EXEMPTION AMOUNT ? 2012 could be a “use it or lose it” year. In other words, clients need to make gifts in 2012 to take advantage of the $5,120,000 per person exemption amount (or $10,240,000 combined amount for a husband and wife). If a client does not make gifts this year, they could lose the benefits of this large exemption amount and the lower gift tax rates. For example, in 2012 clients can make gifts of the family business, can forgive loans that they may have previously made to their children, and can make substantial gifts of other assets to their children and grandchildren. These low 2012 gift tax rates, combined with the current low AFR interest rates, allow clients to gift and sell assets to family members (or trusts for their benefit) at no gift tax cost. Clients can retain cash flow from assets by selling the assets to a grantor trust (also known as a “defective income trust”) in exchange for a promissory note, thereby transferring the sold assets’ future appreciation to children and grandchildren. Clients can also gift assets to a “Grantor Retained Annuity Trust” (or a “GRAT”) and retain an annuity amount from the gifted assets for a specific term. When that GRAT’s term expires, the GRAT’s assets then pass gift tax free to the children. The current low federal interest rates make GRATs and grantor trusts effective tax planning strategies.
2.3 SHOULD CLIENTS MAKE TAXABLE GIFTS IN 2012 AND PAY A GIFT TAX BASED UPON THE 35% GIFT TAX RATE ? Gift and estate tax rates may never be as low as 35% again. Thus, clients should consider paying a gift tax at the current low 35% rate by making gifts in 2012 in excess of the $5,120,000 exemption amount. In 2013 the gift and estate tax rate is scheduled to increase to 55%.
2.4 WHAT ARE SOME OF THE ADVANTAGES OF MAKING LIFETIME GIFTS ? Valuation discounts on lifetime gifts allow clients to gift to their children and grandchildren the family business, real estate holdings, and even large liquid asset holdings (such as stock and bond portfolios) at a low, or no, gift tax cost. Clients could fund an irrevocable life insurance trust with existing life insurance policies having a cash value by using a portion of their $5,120,000 gift tax exemption. Lifetime gifts often generate larger valuation discounts (such as minority and lack of marketability valuation discounts) than if clients wait and bequeath those same assets at their death. Also, lifetime gifts transfer future appreciation on gifted assets to children and grandchildren. Clients should try to gift high income tax basis assets and those assets that are likely to appreciate in value in the future. Finally, if clients do elect to pay a gift tax this year (at 2012’s 35% tax rate), a lifetime gift can remove the paid gift tax amount from the client’s taxable estate so that there is no “tax-on-tax” affect that occurs for estate taxes at death. This ability to remove the paid gift tax amount from a client’s taxable estate requires that the client live at least three years after they complete the gift.
2.5 COULD THERE BE A “CLAWBACK” OF THE CLIENT’S HIGH 2012 GIFT TAX EXEMPTION IF THE CLIENT UTILIZES THAT GIFT TAX EXEMPTION IN 2012 ? If Congress allows the exemption to be reduced after December 31, 2012 to $1,000,000 then Congress could require the recapture or “clawback” of the emption amount used over this $1,000,000 amount. For example, it is possible that Congress could require that prior gifts made during lifetime be added back into a decedent’s taxable estate at death, and then have the estate tax applied on both the decedent’s estate and any prior gifts made by that decedent, using a lower exemption amount. The result would be that on the decedent’s estate tax return, the higher $5,120,000 exemption amount which may have been used to make gifts in 2012 would effectively be reduced. Congress has not taken a position on having such a “clawback” of the gift tax exemption amount, and many tax professionals feel it is unlikely that Congress would attempt such a “clawback” of the 2012 higher gift tax exemption. Even if Congress were to enact such a “clawback,” the income and appreciation from a client’s 2012 gifts would still inure to the benefit of the client’s children and grandchildren to whom they made those gifts.
This Newsletter contains general information on tax issues. Because each client’s tax and factual situation is unique, nothing in this Newsletter should be deemed advice on a specific transaction or to a specific person. Please contact Robert A. Briskin at 310-201-0507 or by e-mail at [email protected] to obtain legal and tax advice.