Monday, January 3, 2011

WSJ: Taxing Year Brings a Less-Taxing Year

WSJ reporter Laura Sanders summarizes what happened in tax policy last year--as we came up against a December 31, 2010 "turn into a pumpkin" deadline we'd been anticipating for almost a decade:

In the normally staid world of taxes, 2010 was downright tumultuous. Never was so much done to so many by so few—and for such a short time.

Lawmakers in December finally settled questions on income, capital-gains and other taxes that had been burning for months, lowering rates for nearly all U.S. taxpayers compared with what they were set to be in 2011.

But the legislation amounted to a giant punt: The changes are good only for two years at most, setting up another election-year tax war in 2012. And it will add nearly $1 trillion to the public debt, plus interest.

"The losers of this year's tax battles were those who wanted to face our fiscal issues," says Clint Stretch, an analyst with Deloitte Tax in Washington. "Now tax and debt issues will be at the center of the 2012 presidential campaign."

In short, the "turn into a pumpkin" deadline has been kicked down the road two years, expensively.

Still, the changes do present opportunities for tax planning that wouldn't have been available otherwise. And some certainty, however temporary, is welcome after a year of swirling questions.

This is certainly true--a relief at least for those of us at VITA sites that must figure out how to help our taxpayers comply with the tax laws in as sensible a manner as legally possible--as well as a relief to high-priced tax advisors whose clients have huge amounts of money at stake hanging on many the many decisions for which tax considerations may be make or break.

Here is how Laura Sanders described some of those decisions and concerns:

The controversy began on Jan. 1 of last year, when the estate tax lapsed for the first time since its enactment in 1916, due to Senate inaction in late 2009. All year, as billionaires including George Steinbrenner and others less wealthy died, their anxious heirs and advisers tried to guess what would happen: Would there be a retroactive fix? No tax at all for 2010? Relief for heirs who suffered from the tax lapse because of a corresponding rise in capital-gains taxes?

Others worried about the 2011 return of the estate tax, scheduled to snap back from zero to a low $1 million exemption per individual and high 55% rate. Jokers suggested "throwing Momma from the train" on Dec. 31.

Income-tax turmoil followed, as President Obama and lawmakers sparred over whether to extend the expiring "Bush tax cuts" of 2001-03 to all U.S. taxpayers or only to couples making less than $250,000 ($200,000 for singles). Upper-bracket taxpayers wondered if the top rate would rise to 39.5% from 35%. Investors worried that expiration would spike the top dividend rate to 39.6% from its current historic low of 15%.

Meanwhile, the "patch" adjusting the Alternative Minimum Tax for inflation expired at the beginning of 2010 and threatened to pull an extra 21 million taxpayers onto the rolls of a tax originally meant for the rich and sophisticated. Other popular provisions, such as one for individual-retirement-account donations, also lapsed last January.

The tension built through the year. "My phone started ringing off the hook with panicked business owners who wanted to sell before capital-gains rates went up," says Beatrice Mitchell, a principal at Sperry, Mitchell & Co., a boutique mergers firm in New York that says it has just had the best results in its 25-year history.

Corporate executives and insiders also raced to unload shares at the end of the year, given higher stock prices and looming possible tax increases. According to Trimtabs Investment Research, the value of these shares sold or donated beginning in November topped $23 billion—the highest two-month total since just before the financial crisis began in 2007.

Many private and some public firms, including Progressive Corp., Warner Chilcott Ltd., and Sycamore Networks Inc. also paid higher dividends ahead of the possible tax increase, Other firms, including Kraft Foods Inc. and Altria Group Inc., sent a letter to shareholders urging them to lobby their representatives to vote against the scheduled increase.

And here is what happened:

The drama persisted until an 11th-hour compromise worked out between the White House and Senate Republican leaders. On Dec. 16, the House of Representatives grudgingly passed the Senate's bill, giving payroll managers barely enough time to figure paychecks for this year.

The results were generous beyond what many dared hope: income and investment tax rates maintained at current levels for all; an AMT "patch"; a $5 million-per-individual estate-tax exemption and a 35% rate; most "extenders" extended; and federal unemployment payments for the jobless extended.

The surprise was a one-year, 2-percentage-point cut in the employee portion of Social Security, or Federal Insurance Contributions Act, taxes. Savings will vary according to income, but could be as much as $2,136 for a worker earning more than $106,800, the maximum subject to FICA tax.

The change was the first major payroll tax cut ever. It also was the third time for the year that lawmakers altered payroll taxes, which largely had been exempt from the tinkering the income tax has long been subject to. The March health-care overhaul raised payroll taxes for 2013 for those making more than $250,000, and another temporary change lowered the employer's portion of payroll taxes to encourage some job creation.

So what now?

Many advisers see this year's changes as providing a two-year window to plan for higher taxes that may be coming when lawmakers tackle deficit issues. This is especially true for investors with large capital gains or those who would owe gift and estate taxes, who have far more ability than wage-earners to time their taxes.

Capital gains, gift and estate taxes also are at historic lows, so they could rise more steeply. Already a new 3.8% tax on investment income kicks for those earning over $250,000 in 2013 ($200,000 for singles) to finance the health-care overhaul.

The new estate and gift tax is especially well-suited to those trying to plan around future tax increases. For the first time, one $5 million per-taxpayer exemption applies to estate, gift and generation-skipping taxes. Lawmakers didn't restrict leveraging techniques, such as Grantor-Retained Annuity Trusts, that enable taxpayers to give away many times in real value the nominal amount of a gift.

With proper planning over the next two years, says attorney Joshua Rubenstein of Katten Muchin Rosenman LLP, "Almost no one needs to pay estate tax unless they want to."

Unlike higher-income folks, most low-income working families have little they can do to change their 2010 tax liability at the last minute. They have little discretion over their short-term financial lives.

So we will do our best to help them comply with the 2010 tax law that applies to them, making the best of the circumstances available to them.

But there is a "slot-machine" aspect to the tax code for them. They come in the door of our VITA site, not really sure what to expect. Some will leave with large refunds. Others will get the disappointing news that they owe money, due to the vicissitudes of a withholding system that does not capture the complexity of tax laws and a volatile financial world that makes it hard to predict how many dependents a taxpayer will have until after the year is over.

A simple example: a taxpayer couple might have been expecting to claim a teenage dependent, but perhaps the teenager got a raise or worked more hours at their part-time job in December or used their savings to buy a large amount of "stuff" that counted as self-support. Suddenly, they lose the dependent--who might have been worth thousands of dollars in tax benefits to her parents. The formerly dependent teenager can now claim her own personal exemption--but the benefits she gains from claiming herself are rarely worth as much to her as they would have been to her parents.

As my students will soon see, the marginal tax rates of the poor are far more unpredictable than those of higher income Americans. And although their effective average tax rates may be low (or even negative), their effective marginal rates may be very high, in some cases even higher than those of high income Americans.

We will be talking a lot about the equity and efficiency implications of those average and marginal tax rates this year.

It will probably be a "less taxing year" for many of our VITA site clients, but not for all of them. The vicissitudes of tax law for the poor are surprisingly random.

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