Estate and Gift Tax Provisions of Pres. Obama’s Fiscal Year 2014 Budget Proposal

On April 10, 2013, Pres. Obama released his budget proposal for the Federal government’s fiscal year running from October 1, 2013 through September 30, 2014.  The budget proposal includes many individual and business income tax provisions, projected to increase taxes by $1.1 trillion over 10 years according to the Tax Policy Center.  This post concerns estate and gift taxes.  Previous blog posts covered the proposals dealing with individual and business income taxes. 

1.     Beginning in 2018, the estate and generation skipping transfer tax exemptions would decrease to $3.5 million and the gift tax exemption to $1.0 million, and the tax rate would increase to 45%.  These are the exemptions and tax rate that existed in 2009.  In addition, the exemption amounts would no longer be indexed for inflation.  Portability of unused estate and gift tax exclusions between spouses would be retained.  These changes are being proposed only three months after the American Taxpayer Relief Act of 2012 had “permanently” increased the exemptions to $5.25 million (as indexed for inflation) and had “permanently” set the tax rate at 40%!  The proposal does not claw back any tax benefits for gifts above the proposed $1 million gift exemption made before 2018.

2.     Effective for transfers on or after the date of enactment, the income tax basis of inherited property could be no greater than the value of property for estate or gift tax purposes.  A new information reporting requirement will cause the estate executor or the donor to provide the necessary valuation and basis information to both the property recipient and the IRS.

3.     For grantor-retained annuity trusts (GRATs) created after the date of enactment, the GRAT term must be no shorter than 10 years or longer than the life expectancy of the annuitant plus ten years.  The remainder interest must have a value greater than zero when the GRAT is established.  In addition, the GRAT annuity may not decrease during the term of the GRAT.  These proposals eliminate the benefits of the so-called short-term, zeroed-out GRAT.

4.     For trusts created after the date of enactment, and for additions made to pre-existing trusts after that date, eliminate any generation skipping transfer tax (GST) exclusion allocated to the trust on the 90^th anniversary of the trust’s creation.  It is unclear how the 90-year limitation applies to an addition to a grandfathered trust.  This proposal effectively eliminates the future use of the dynasty trust strategy.

5.     For property sold to an intentionally defective grantor trust on or after the date of enactment, the portion of the trust attributable to such property (including all retained income, appreciation, and reinvestment) will be included in the gross estate, less any payments received.  In addition, if the trust ceases to be classified as a grantor trust during the grantor’s life, then the amount will be treated as a gift with the gift tax being paid by the trust.  Any distributions out of the trust in excess of the prior taxable gift amount will be treated as additional gifts.

6.     The exclusion from GST tax will be eliminated for health and education exclusion trusts (HEETs) created after the date of introduction of the bill proposing this change, and for transfers to existing HEETs after that date.  A HEET is used to pay providers of medical care and to pay schools for tuition costs of trust beneficiaries, which can include multiple generations.  Direct payments to providers by an individual for another person's medical or tuition costs are gifts that are excludable from GST tax.  The purpose of a HEET is to permit the GST exclusion to apply to such payments made for future trust beneficiaries, even after the death of the trustor.  This proposal eliminates the HEET GST exclusion tax benefit.

Business Income Tax Provisions of Pres. Obama’s Fiscal Year 2014 Budget Proposal

On April 10, 2013, Pres. Obama released his budget proposal for the Federal government’s fiscal year running from October 1, 2013 through September 30, 2014.  The budget proposal includes many individual and business income tax provisions, projected to increase taxes by $1.1 trillion over 10 years according to the Tax Policy Center.  This post concerns business tax proposals.  The previous post dealt with individual income tax and the next post will deal with estate and gift tax proposals. 

1.     Permanently extend the currently high Section 179 business property expensing amount of $500,000 and the currently high phase-out level of $2 million.  These amounts are scheduled to drop to $25,000 and $200,000 in tax years beginning after 2013.  Off-the-shelf computer software would continue to be eligible, but qualifying real property would no longer be eligible for Section 179 expensing.

2.     Increase the alternative simplified research credit rate from 14% to 17% after 2012 and permanently extend the research tax credit which is scheduled to expire in tax years beginning after 2013.

3.     Provide a one-time 10% tax credit for increased wages paid during the 12-month period after the date of enactment, over the amount of wages paid in 2012, whether the increase is driven by new hires, raises, or both.  Eligible businesses are those with less than $20 million of total 2012 wages.  The maximum credit is $500,000.

4.     Require employers who have been in business for at least two years and have over 10 employees, but do not currently offer a retirement plan, to enroll their employees in a 3% payroll-deduction, individual retirement account (IRA), effective for tax years beginning after 2014.  Employees would be able to opt out of the mandatory enrollment or elect to modify the 3% default rate.

5.     Repeal the last-in, first-out (LIFO) inventory costing method for the first tax year beginning after 2013.  When inventory prices rise over time, LIFO reduces income tax by treating the most recently purchased inventory item as having been sold.  The proposal would cause the one-time increase in taxable income to be recognized ratably over 10 years.

6.     Repeal the lower-of-cost or market and subnormal goods methods of inventory tax accounting (applicable to those not using the LIFO method) for tax years beginning after 2013.  The proposal would cause the one-time increase in taxable income to be recognized ratably over four years.

7.     Tax so-called “carried interest” income as ordinary income instead of as long-term capital gains in tax years beginning after 2013.  In addition, such income would be subject to self-employment tax.

8.     Repeal the partnership “technical termination” rules under Section 708(b)(1)(B) for transfers on or after December 31, 2013.  Under current rules, a partnership is considered terminated for income tax purposes if 50% or more of the capital and profits interests are sold or exchanged within any 12-month time period.

9.     Enact a new 20% tax credit for expenses paid or incurred after the date of enactment for costs related to insourcing a line of business into the U.S.  On the other hand, a deduction would be denied for costs of outsourcing a line of business.

10.  Repeal many of the tax benefits for oil and gas and coal exploration and production.  Repealed benefits would include the current expensing of exploration and development costs, percentage depletion, and the domestic manufacturing deduction.  The proposal would be effective for tax years beginning after 2013.

Individual Income Tax Provisions of Pres. Obama’s Fiscal Year 2014 Budget Proposal

On April 10, 2013, Pres. Obama released his budget proposal for the Federal government’s fiscal year running from October 1, 2013 through September 30, 2014.  The budget proposal includes many individual and business income tax provisions, projected to increase taxes by $1.1 trillion over 10 years according to the Tax Policy Center.  While many of the provisions have previously been proposed, there are also new provisions.  It is unlikely that all of these provisions will be enacted, but the following list indicates possible future changes that are worth noting as you contemplate your personal and business financial and tax planning strategies. 

1.     Reduce the tax savings from deductions and exclusions to an effective 28% tax rate for taxpayers in the top three income tax brackets (33%, 35%, & 39.6%), effective for tax years beginning after 2013.  Using 2013 rate brackets as an example, this tax increase would hit single filers and joint filers having taxable income in excess of $183,250 and $223,050 respectively.  The proposal would affect the following deductions and exclusions:

a.      Itemized deductions after all other limitations,

b.     Tax-exempt interest,

c.      Employer-paid health insurance premiums excluded from compensation,

d.     Employee-paid health insurance premiums made with pre-tax dollars,

e.      Self-employed health insurance premium deductions,

f.      Deductible IRA and retirement plan contributions,

g.     Domestic production activity deductions,

h.     Moving expenses,

i.       Contributions to health savings accounts and Archer MSAs,

j.       Interest expense on education loans,

k.     Deduction for college education expenses, and the

2.     Implement the so-called “Buffett” rule requiring taxpayers with over $1 million of adjusted gross income to pay a “fair share tax.”  The fair share tax phases in on a prorata basis so that by $2 million of AGI, the effective over-all tax rate would be no less than 30%.  Any itemized charitable deductions allowed after the overall limitation on itemized deductions would be allowed as a credit of 28% against the fair share tax.  The 30% effective rate is imposed after considering the regular tax, the alternative minimum tax, the 3.8% Obamacare surtax on net investment income, and the employee portion of payroll taxes.  The fair share tax would essentially be another alternative minimum tax, greatly complicating the tax code.  It would also dramatically increase the effective tax rate on long-term capital gains and qualified dividend income.  The fair share tax is proposed to be effective after 2013.

3.     Extend permanently the American Opportunity Tax Credit for college expenses.  The current credit structure is scheduled to expire after 2017.

4.     Impose a new lifetime overall limit on savings accumulated in tax-favored retirement accounts such as IRAs, profit sharing plans, 403(b)’s, and 401(k)s.  If the sum of all of the plan balances (including contributions and reinvested earnings) exceeds the amount needed to provide a lifetime annuity equal to the maximum amount permitted under a defined benefit plan (a joint and survivor annuity of $205,000 (for 2013) per year starting at age 62), then no more contributions or benefit accruals can be made, although the account balances may continue to grow with investment earnings and gains.  Currently, this amount is estimated to be $3.4 million.  This amount is susceptible to interest rates swings.  For example, the Wall Street Journal mentions in their article, (Will the Government Shrink Your IRA?) that in 2006 the amount needed to pay the permitted annual benefit would have only required $2.2 million.  If the accumulated retirement savings later fall below the designated level, additional contributions and accruals will be permitted.  The measurement would be made each December 31^st with any limitation on contributions or accruals applying to the following calendar year.  This proposal would be effective for tax years beginning after 2013.

5.     Require non-spouse beneficiaries of IRAs and qualified plans to receive their inherited benefits within five years.  This proposal would eliminate life-time stretch-out distributions of inherited benefits for non-spouse beneficiaries.  This proposal appears to include Roth IRAs, making taxable conversions from traditional IRAs to Roth IRAs for estate planning purposes much less attractive.  Exceptions from the five-year rule would be provided for beneficiaries who are disabled, chronically ill, minor children (but the five-year rule will apply at the age of majority), or those who are not more than 10 years younger than the participant or IRA owner.  This proposal is effective for deaths after 2013.

6.     Permit all inherited IRA balances to be rolled over within 60 days.  Currently, the rollover provision is only permitted to surviving spouses.  Non-spouse beneficiaries currently can only make direct trustee-to-trustee transfers.  This is a trap for the unwary.  A direct transfer is not possible for a distribution from an IRA, whereas a rollover applies to distributions.  This proposal would be effective for distributions after 2013.

7.     Eliminate the requirement to take minimum distributions from IRAs where total IRA and qualified retirement plan balances are $75,000 or less.  Although Roth IRAs are exempt from pre-death RMD rules, amounts held in Roth IRAs would be taken into account in determining whether the $75,000 threshold is met.  The RMD would phase-in between $75,000 and $85,000.  The initial measuring date is January 1^st of the year in which the taxpayer reaches age 70 ½ (or the year of death if earlier).  Subsequent measurement dates would occur on January 1^st of the year following any year in which there are additional contributions, rollovers, or transfers that weren’t previously included in a measurement.  This proposal is effective for taxpayers who attain age 70 ½ on or after December 31, 2013 and for taxpayers who die on or after that date before attaining age 70 ½.

8.     Require the use of the so-called chained Consumer Price Index (CPI) instead of the standard CPI to measure the rate of inflation when indexing tax brackets, exemptions, and other tax benefits after 2014.  The chained CPI produces a lower rate of inflation, thereby increasing taxes because the size of the deductions, exemptions, and tax brackets will correspondingly be lower.  One of the main differences between the two CPI indexes is that the chained CPI assumes that a person will substitute cheaper and perhaps lower quality goods in place of those whose prices have increased.

Tax Tips for Those Still Filing Tax Returns

This tax season got off to a late start because of Congress’ delay in passing new tax legislation until January 1, 2013.  The delay and new tax laws put the IRS behind in programming their computers and revising tax forms and instructions.  Coupled with late-arriving Forms 1099 from investment and brokerage firms, tax preparers have really been crunched this tax season!  Here are a few compliance issues and last-minute tax planning ideas to consider. 

1.     If you or your spouse have earned income and are under age 70 ½, consider contributing to an Individual Retirement Account (IRA) by April 15, 2013 (no extension permitted).  The contribution may or may not be deductible depending upon your specific circumstances.  An IRA allows tax on income and gains to be deferred until distributions are received.

2.     If you have a sole proprietorship, consider making a deductible contribution to a Simplified Employee Pension (SEP) IRA.  Any employees generally must also be covered.  A contribution may be made even if you are over age 70 ½.  The contribution must be made by the due date of your tax return, including extensions.

3.     Many tax returns claiming college education tax credits were rejected by IRS computers because new boxes on Form 8863 were not checked.  The IRS added new check boxes for lines 23 through 26 to confirm basic qualifications to receive the credit.  Some tax preparation software neglected to check all of the boxes, so be sure that yours are checked.

4.     Electronically filing your tax return and choosing to receive your refund by direct deposit will lower the chance of errors and speed up the receipt of the refund by several weeks.

5.     If you are unable to file your tax return by April 15, 2013, you may file Form 4868 with the IRS by April 15^th and receive an automatic six-month extension to file your tax return.  However, the tax must be properly estimated using available information and indicated on the extension form.  Actual payment isn’t required, but any tax owing and not paid will incur interest and also a late payment penalty of 0.5% per month if at least 90% of the actual tax isn’t paid by the original due date.

6.     The IRS just issued Notice 2013-24 granting relief from the late payment penalty if a filing extension is requested and if the tax return includes one of the many enumerated tax forms (e.g. Form 4562) that were issued late because of the delayed tax law.  The Notice requires that the taxpayer make a good faith effort in calculating the tax and to pay it by the original due date, with any balance owed being paid by the extended due date.

7.     Don’t forget that the first quarter 2013 estimated tax payment due date is also April 15, 2013.  For higher-income individuals, be aware that income tax rates have increased and new taxes are imposed as part of the Affordable Care Act (Obamacare).  These changes should be taken into account when calculating your estimated tax payments to avoid an unpleasant surprise next year.

8.     If you have not yet filed your 2009 tax return and you are owed a tax refund, you will forfeit that refund under the three-year statute of limitations rule if you do not file your 2009 tax return by April 15, 2013.

A Strategy for Savers Dealing with Low Interest Rates

The U.S. government’s intervention causing historically low interest rates has made it very difficult for savers and retirees to earn income on their savings.  Keeping interest rates low is an attempt to help grow the economy.  But the intervention also keeps the current interest cost of the large national debt lower, making the low rates effectively a hidden tax on people who have saved their money.   

Most savers and investors understand that the value of bonds and bond mutual funds will decline when interest rates rise in the future.  Therefore, in an attempt to avoid such losses, many people are keeping their cash in money market funds, short-term bonds and bond mutual funds, and in short-term certificates of deposit (CDs).  However, interest paid at the short-end of the yield curve is miniscule.  By saving and investing at the short-end, savers and investors may be able to avoid a loss in value on their savings when interest rates rise, but this strategy comes at a cost of receiving less interest while waiting for rates to rise. 

Money Magazine recently suggested a strategy using bank CDs to earn extra income during the wait for interest rates to rise.  Look for a bank that charges low early withdrawal penalties, and then purchase a long-term CD instead of a short-term CD.  If interest rates remain low for an extended period, the long-term CD will yield more income than using short-term CDs.  When interest rates rise, cash in the long-term CD early in order to reinvest in new, higher rate CDs.  By cashing in the CD early with the issuing bank you will only lose a portion of the accrued interest and not principal.  This CD strategy enables you to earn extra interest while waiting for interest rates to rise.  The strategy won’t make sense if you have to sell a long-term CD in the marketplace because the rise in interest rates will reduce the sales price.  So purchase long-term CDs directly from the issuing bank.

 
For example, as of February 1, 2013, Ally Bank paid 0.99% on a one-year CD and 1.59% on a five-year CD.  Ally charges an early withdrawal penalty of 60 days’ interest if the CD is cashed in before maturity.  Assume that short-term interest rates rise to 2.00% two years after purchasing the CD.  An investment of $100,000 into a one-year CD that is rolled over for the second year at the same rate would earn $1,989.80 of interest over two years.  On the other hand, if a five-year CD were purchased, it would earn $3,205.28 over two years but suffer a 60-day early withdrawal penalty of about $265.53, netting $2,939.75.  This is $949.95 more than using one-year CDs, or about 48% more income!

UPDATE
Ally Bank has caught wind of this strategy and effective December 7, 2013, their early withdrawal penalty policy changes as described below.  The change doesn't render this strategy ineffective, but it does cut back some of the benefits.  In the example above, the new 150-day early withdrawal penalty would be $663.81, reducing the benefit to $551.67.

"Early Withdrawal Penalty for CDs

We will be changing our early withdrawal penalty for longer term Ally Certificates of Deposit (CDs) and Individual Retirement Account (IRA) CDs. Any CD or IRA CD with a term of three (3) years or longer that is opened or renewed on or after 12/07/2013 will have the following early withdrawal penalty structure:

• 3-Year CD – loss of 90 days interest
• 4-Year CD – loss of 120 days interest
• 5-Year CD – loss of 150 days interest

Many of our CD's are unaffected by this change:

• Any CD or IRA CD with a term of three (3) years or longer that was opened before 12/07/2013 will continue to have an early withdrawal penalty of 60 days' loss of interest until it matures. The withdrawal penalties shown above will apply if the CD is renewed for another term.
• No Penalty CDs will continue to have no early withdrawal penalty after the first six (6) days after funding.
• There is no change to CDs or IRA CDs with terms of less than three (3) years. They will continue to have an early withdrawal penalty of 60 days' loss of interest."

New Supplemental Wage Withholding Rates

Supplemental wages include bonuses, commissions, stock option income, and other income earned outside of the normal payroll amounts.  Federal income tax withholding on supplemental wages is computed under one of three methods:

1.     Mandatory flat-rate method.  When supplemental wages exceed $1 million during a calendar year, federal income tax withholding must be at the highest ordinary income tax rate.  In 2012, this rate was 35%.  In 2013, the flat-rate rises to 39.6%.

2.     Optional flat-rate method.  For supplemental wages (paid separately from regular wages) of $1 million or less during a calendar year, federal income tax withholding must be at the third lowest ordinary income tax rate.  This rate is 25% for both 2012 and 2013.

3.     Aggregation method.  For supplemental wages of $1 million or less during a calendar year, the supplemental wages can simply be added to regular wages to determine the amount of federal income withholding for that payroll period.

In addition, back-up income tax withholding is required on payments to a person that had either a missing or an incorrect taxpayer identification number on a required information return filing (e.g., Form 1099).  The back-up withholding rate must be at the fourth lowest ordinary income tax rate.  This rate is 28% for both 2012 and 2013.

Some taxpayers with supplemental wages fall into the trap of thinking that the optional flat-rate withholding pays all of the federal income tax due on those wages.  For example, employees with nonqualified stock option income or bonus income may have had 25% in federal income tax withholdings, but much or all of those supplemental wages may be subject to higher ordinary income tax rates (e.g. 28%, 33%, 35%, or 39.6%).  Therefore, it is important that such individuals estimate what the total income tax will be on those supplemental wages and set aside any shortfall in order to have the cash needed to fully pay the total income tax when the tax return is filed.

Form 1099-K Reporting Issues

The Form 1099 series is used by the IRS to match income reported by payers to the income tax returns of taxpayers in an effort to combat under reporting.  There are 17 different types of 1099s, plus other information reporting forms such as W-2s, K-1s, 1098s, 5498s, etc.  For example, Form 1099-INT is used to report interest income and Form 1099-MISC is used to report payments to non-employees.  The IRS developed new Form 1099-K to be used for the first time in 2011.  Form 1099-K was developed to require merchant card companies (issuers of credit and debit cards) and third party e-commerce facilitators (e.g. PayPal) to report the gross receipts received by businesses from customers paying with credit or debit cards or engaging in e-commerce transactions.  The 2011 business income tax forms included a special line for businesses to report the portion of their receipts coming from credit or debit card charges.  Small businesses complained to the IRS about the heavy burden they would experience if they had to reconcile their gross receipts with Forms 1099-K.  In response, the IRS announced that the special reconciliation line on the 2011 income tax return forms for Forms 1099-K should be left blank, and that the IRS did not intend to require reconciliation on future income tax returns.

Nevertheless, Form 1099-K is still required to be completed by merchant card companies and e-commerce facilitators.  Form 1099-K does not need to be filed on a business if the total gross amount of payments during the calendar year to the business is $20,000 or less and if the total number of transactions is 200 or less.  Despite its assurances above, the IRS announced plans to establish a small compliance program in which it will send notices to some businesses to determine whether taxpayers are properly reporting all of their income.  Businesses should expect IRS scrutiny if total Form 1099-K receipts are higher or represent a high percentage of reported gross receipts.  Absent receiving a notice from the IRS, businesses do not need to reconcile the Forms 1099-K on their 2012 income tax returns.