Question of the Week
I have heard Senator McCain and Senator Obama discussing their positions on whether to “make permanent” or “roll back” certain tax cuts that were enacted during President George W. Bush’s administration. What tax cuts are the senators talking about? Should I consider engaging in any tax planning to take advantage of the current lower tax rates?
Federal income, capital gains, and estate and gift taxes were cut in 2001 and again in 2003. The Federal tax cuts enacted in 2001 and 2003 contained “sunset” provisions that cause the tax cuts to automatically expire after a particular date. Unless extended or made permanent, the following tax cut provisions will expire at the end of 2010 and have the described results in 2011:
1. Ordinary Income Rate Reductions – All the reductions in the marginal tax rates enacted in the 2001 and 2003 tax cuts will expire. The top marginal tax rate, currently 35%, will return to its pre-2001 level of 39.6%.
2. Capital Gains Tax Reduction – The tax rate on long-term capital gains, currently taxed at a maximum rate of 15%, will return to its pre-2001 level of 20%.
3. Qualified Dividends Taxed as Capital Gains – The rule allowing qualified dividends to be taxed as long-term capital gains will expire. Instead of being taxed as long-term capital gains at 15%, dividends will be taxable as ordinary income at a maximum rate of up to 39.6%.
4. Estate Tax – Under current law, estates of decedents dying in 2008 have a $2,000,000 exemption amount and those dying in 2009 have a $3,500,000 exemption amount. In 2008 and 2009, the estate tax rate for estates of decedents above the respective exemption amounts is a flat rate of 45%. Under current law, the estate and generation skipping transfer taxes (but not the gift tax) are repealed for 2010 only. In 2011, the estate and generation skipping transfer taxes come back to their pre-2001 levels, with an exemption amount of $1,000,000 and a graduated rate structure with a top marginal rate of 55%. Many anticipate that there will be some “permanent” change with respect to the estate tax that will keep the estate tax in place with a larger exclusion amount and potentially lower maximum rate before the 2010 one-year repeal is to take effect.
It is unlikely that any of the issues regarding the expiring tax provisions will be resolved before the November election and the outcome of the election will likely greatly impact whether any of the expiring provisions are extended or made permanent. Senator McCain has advocated making all of the 2001 and 2003 tax cuts permanent, while Senator Obama has advocated allowing some or all of the tax cuts to expire and potentially “rolling back” (or repealing) some portion of the tax cuts before they expire under existing law. In addition, Senator Obama has proposed increasing the earnings that would be subject to FICA (social security) taxes, particularly for individuals earning more than $250,000 per year. This would impact both the wage earners and their employers, each of whom are required to pay FICA taxes.
Taxpayers should currently consider the potential for significantly higher tax rates in 2009 and beyond when evaluating whether to engage in certain transactions during the rest of 2008. The most significant change could impact dividends from C corporations because the current tax rate on dividends of 15% could return to ordinary income rates that go as high as 39.6%. Accordingly, a C corporation might be able to significantly benefit its shareholders by making dividend payments in 2008 instead of waiting until later years.
Additionally, taxpayers should evaluate whether traditional strategies of deferring taxable gain until a later year is the best course of action given the potential for higher tax rates. For example, if a taxpayer was certain to have a $1 million gain in either 2008 or 2009 and the capital gains tax rate was certain to remain constant at 15%, the taxpayer would ordinarily choose to recognize the gain in the later tax year and defer the payment of the $150,000 in tax. However, with the potential to have the capital gains tax increase from 15% in 2008 to potentially as high as 28% in 2009 (Senator Obama has stated that he would consider increasing the capital gains tax rate the highest level during the 1990’s), the jump from $150,000 in tax on the gain if recognized in 2008 to potentially $280,000 in tax in 2009 would in most circumstances far outweigh the benefit of deferral.
For more information, please contact Adi Rappoport.
