Still Clear as Mud: The Election's Impact on Tax Policy and Planning After Obama's Win

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Now that the election is over, attention is focused on Congress as it begins its “lame duck” session this week. Many of our clients are wondering how to plan, when to sell, and how to manage their estates with the fiscal cliff looming ahead.

The following is a brief recap of some of the expiring tax provisions and some common planning tips that clients are considering.

Assuming no Congressional action, the following tax changes will occur as of January 1, 2013:

Individual Ordinary Income Tax Rates

The current 10%, 15%, 25%, 28%, 33% and 35% rate brackets will be replaced with 15%, 28%, 31%, 36% and 39.6%.

A Medicare surtax of 3.8% will be levied against all individuals with income of more than $200,000 and married couples with income of more than $250,000. Thus, the highest rate ordinary income tax rate will be 43.4%.

Planning tip:  Individual taxpayers may consider accelerating income transactions to have them occur in 2012.  This will avoid higher taxes if Congress takes no action.

The Dividend Rate

The tax rate of 15% on all dividends expires and dividends will be taxed at ordinary income rates.  This means that as of January 1, 2013, the maximum tax rate on dividends may be 43.4% (the 39.6% plus the Medicare surcharge of 3.8%).

If Congress acts, it may renew the 15% rate but with the Medicare surcharge, the 15% will increase to 18.8% for higher earners.

Planning tip:  Private corporations should consider accelerating a scheduled dividend payment and make the payment before year’s end.  This will help the shareholder and there are no negative tax consequences to the company.

A sole shareholder of a C corporation wants to distribute dividends to herself.  Her current income places her in the highest tax bracket.  Should she distribute $1,000,000 in one lump-sum payment in 2012 or distribute $200,000 per year over five years (2013 – 2017)?

The tax on the lump-sum dividend in 2012 would be $150,000 (15% x $1,000,000).  Assuming Congress takes no action, the aggregate tax on a dividend distribution plan over five years would be $377,200 (39.6% rate plus 3.8% rate x $1,000,000).  The shareholder would save $227,200 by taking the lump-sum dividend in 2012.

Capital Gains Tax

Capital gain rates, currently at 15%, would return to pre-Bush tax rates of 20%.  In addition, the 3.8% Medicare surtax will apply to individuals with income above $200,000 or married couples with income above $250,000.  In total, the 2013 capital gain rate may be as high as 23.8%.

Planning Tip: High income earning taxpayers may want to consider selling appreciated assets in 2012 to capture the lower capital gain rate.

A taxpayer owns investment real property that would yield long-term capital gain of $1,000,000 upon sale.  If the taxpayer sells this real property in 2012, then the federal tax would be $150,000 (15% x $1,000,000).  If the taxpayer sells this real property in 2013, then the federal tax would be $238,000 (20% rate plus 3.8% tax x $1,000,000).  The taxpayer would save $88,000 by selling before 2013.

Estate and Gift Taxes

The $5.12 million per person estate and gift tax exemption will drop to $1 Million on January 1st.  The current 35% rate will change to a graduated rate with the top rate of 55%.

In addition, several proposals have been made to eliminate or curtail the use of extremely effective planning techniques, including:

  1. The imposition of a 10-year minimum term on grantor retained annuity trusts (GRATs).
  2. Elimination of valuation discounts on passive investment businesses; and
  3. Imposition of a 90-year limitation on GST exempt dynasty trusts.

Planning tip:  To take advantage of today’s higher exemptions and the availability of these techniques, many taxpayers are making large gifts of assets.

If you are concerned about the fiscal cliff and have planning questions, please don’t hesitate to contact us.

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