Editor’s note: A shorter version of this commentary appeared in the print version of the Central Valley Business Journal. This is the complete commentary.
President Obama released his 2013 budget proposals on Feb. 13 and, with respect to taxes, there are items of interest in both the income and estate/gift areas.
On the income tax side is President Obama’s desire to see an end to the Bush tax cuts for people with incomes in excess of $250,000. The first item to have an impact on a substantial number of taxpayers is the reinstatement of the limitation on itemized deductions for upper-income taxpayers. This proposal would require itemized deductions – other than medical expenses, investment interest, theft and casualty losses, and gambling losses – be reduced by 3 percent of the amount by which adjusted gross income exceeds statutory thresholds, but not by more than 80 percent of the otherwise allowable deductions. The threshold would be $250,000 for married taxpayers filing joint returns.
The next income tax change to affect a substantial number of taxpayers would be the reinstatement of the personal exemption phase-out for upper-income taxpayers. This proposal would affect taxpayers with adjusted gross incomes above $250,000 for married people filing jointly. Under the proposal, the amount of each personal exemption would be reduced by 2 percent of the exemption amount for that year for each $2,500 or fraction thereof by which adjusted gross income exceeded the threshold.
The next income tax change to affect a substantial number of taxpayers would be the reinstatement of the 36 percent and 39.6 percent tax brackets. This proposal looks to replace part of the 33 percent and all of the 35 percent tax brackets with the prior law tax brackets of 36 percent and 39.6 percent. The 36 percent tax bracket would begin at taxable income levels calculated as the appropriate adjusted gross income threshold minus the appropriate standard deduction and two exemptions for taxpayers that are married and file jointly. The threshold amount would be $250,000 for married taxpayers filing jointly.
Another income tax change would be to tax qualified dividends as ordinary income for upper-income taxpayers. This proposal provides that qualified dividends of taxpayers in the 36 percent and 39.6 percent tax brackets would be taxed as ordinary income at those rates. The reduced rate of 15 percent would not apply to taxpayers in the 36 percent and 39.6 percent bracket. Similarly, capital gains of taxpayers in these tax brackets would be taxed at 20 percent rather than the current 15 percent.
The final income tax change discussed here is the reduction in value of certain tax expenditures. This proposal would limit the tax value of specified deductions or exclusions from adjusted gross income and all itemized deductions. This limitation would reduce the value to 28 percent of the specified exclusions and deductions that would otherwise reduce taxable income in the 36 percent and 39.6 percent brackets. The income exclusions and deductions limited by this provision would include any tax-exempt state and local bond interest, employer-sponsored health insurance paid for by employers or with before-tax employee dollars, health insurance costs of self-employed individuals, employee contributions to defined contribution retirement plans and individual retirement arrangements, the deduction for income attributable to domestic production activities, certain trade and business deductions of employees, moving expenses, contributions to health savings accounts and Archer MSAs, interest on education loans, and certain higher education expenses.
All of the above proposals would be effective for taxable years beginning Dec. 31. Although impossible to ascertain what affect this will have on all taxpayers in these respective tax brackets as a whole because each taxpayer’s income and deductions will be different, the budget does provide in Table S-9 that they anticipate an $83.43 billion increase in tax revenues as a result of these changes to the income tax code.
On the estate and gift tax side of the Internal Revenue Code, President Obama has proposed three items in his 2013 budget proposal that are significant. The first item, and arguably most important, would be the restoration of the estate, gift, and generation skipping transfer tax parameters as in effect in 2009. This means the top tax rate would be 45 percent and the exclusion amount would be $3.5 million for estate and generation skipping taxes, and $1 million for gift taxes. The portability of unused estate and gift tax exclusion between spouses would be made permanent. This proposal would be effective for estates of decedents dying and for transfers made after Dec. 31.
Another significant change in the estate and gift tax area would be the modification of rules on valuation discounts. This proposal would create an additional category of restrictions (“disregarded restrictions”) that would be ignored in valuing an interest in a family controlled entity transferred to a member of the family, if after the transfer the restriction will lapse or may be removed by the transferor and/or the transferor’s family. Specifically, the transferred interest would be valued by substituting for the disregarded restrictions certain assumptions to be specified in regulations. Disregarded restrictions would include limitations on a holder’s right to liquidate that holder’s interest that are more restrictive than a standard to be identified in regulations.
A disregarded restriction also would include any limitation on a transferee’s ability to be admitted as a full partner or to hold an equity interest in the entity. For purposes of determining whether a restriction may be removed by member(s) of the family after the transfer, certain interests (to be identified in regulations) held by charities or others who are not family members of the transferor would be deemed to be held by the family. Regulatory authority would be granted, including the ability to create safe harbors to permit taxpayers to draft the governing documents of a family controlled entity so as to avoid the application of Section 2704 if certain standards are met. This proposal would make conforming clarifications with regard to the interaction of this proposal with the transfer tax marital and charitable deductions. This proposal would apply to transfers after the date of enactment of property subject to restrictions created after Oct. 8, 1990.
The last proposal to be discussed here is the coordination of certain income and transfer tax rules applicable to grantor trusts. This proposal is meant to attack the estate planning technique that involves the use of intentionally defective grantor trusts, or IDGT.
Currently, estate planners use the IDGT to transfer property out of an estate, while the transferor retains the income tax burden associated with the transfer. The typical technique will involve the gift of money to the IDGT to fund the IDGT. Typically, the donor’s children will be the beneficiaries of the IDGT. The IDGT will enter into a transaction to purchase the stock or a portion of the stock of a family-owned business using the cash gift to secure a promissory note at a rate of interest equal to the applicable federal rate, which is currently 2.58 percent. Even though the stock has appreciated in value the grantor does not pay income tax on the sale, because for income tax purposes the sale is deemed to have been made to the grantor themselves. The income from the stock sold will go to the IDGT, but will be taxed to the grantor/transferor as if he had not sold the stock for income tax purposes. The amount paid on the promissory note by the IDGT will be used by the grantor to pay the current income tax on the income going to the IDGT. For estate tax purposes, the transferred stock is excluded from the grantor/transferor’s estate because the IDGT is an irrevocable trust. This type of transaction is sophisticated and requires the advice of a tax attorney to properly structure.
President Obama’s proposal would be to the extent the income tax rules treat a grantor of a trust as an owner of the trust, the proposal would include the assets of that trust in the gross estate of that grantor for estate tax purposes, subject to gift tax any distribution from the trust to one or more beneficiaries during the grantor’s life, and subject to gift tax the remaining trust assets at any time during the grantor’s life if the grantor ceases to be treated as an owner of the trust for income tax purposes. This proposal would be effective with regard to trusts created on or after the date of enactment and with regard to any portion of a pre-enactment trust attributable to a contribution made on or after the date of enactment. Regulatory authority would be granted, including the ability to create transition relief for certain types of automatic, periodic contributions to existing grantor trusts.
Although the above proposals will require Congress to pass new legislation, some of the proposals could essentially come back into play by inaction. If new legislation is not enacted by Dec. 31, all of the Bush tax cuts will expire. This means that current estate and gift tax exemption amounts of $5 million dollars will revert back to $1 million dollars. Accordingly, the window is starting to close to transfer wealth under favorable tax scenarios. Transactions involving valuation discounts and the use of IDGT take time to properly plan and obtain the necessary substantiation documents. Thus, if you are contemplating such transactions, you should act quickly.
Pursuant to requirements related to practice before the Internal Revenue Service, Circular 230, any tax advice contained in this article is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the U.S. Internal Revenue Code. If you are contemplating any transactions relating to any of the topics contained in this article, you are strongly advised to seek the advice of a qualified tax attorney.
The author is a partner at Calone & Harrel Law Group LLP who concentrates his practice in all manners of taxation, real estate transactions, corporate, partnership, and limited liability company law matters. He is a certified specialist in taxation. He may be reached at 209-952-4545 or This email address is being protected from spambots. You need JavaScript enabled to view it. .
