From Washington — Recent Developments, August 2011

VIEW IN PDF: Tax News & Comment — August 2011

A bipartisan deficit-reduction panel is considering ending the preferential tax treatment of capital gains. Although not explicitly mentioned in the plan which is now being considered in the Senate, the proposal would end the tax preference for long term capital gains which has existed since 1986. However, individual and corporate income tax rates would also fall under the proposal.

In a five-page document recently obtained by Bloomberg News, the proposal would create three income tax brackets of between 23 percent and 29 percent, and would end the current preference for long term capital gains, now taxed at 15 percent.

The deduction for home mortgage interest could also be affected.T he mortgage interest deduction costs the Treasury about $100 billion a year. Proposals have been made to either reduce the cap to $500,000 or to eliminate the deduction on second homes.

If Congress fails to pass any new tax legislation in the next 18 months, the Bush tax cuts will expire on December 31, 2012. The Congressional Budget Office has warned that unless the Bush tax cuts are allowed to expire, a sharp increase in spending to fund President Obama’s health care law will result in massive new debt. Grover Norquist, proponent of the “Americans for Tax Reform anti-tax pledge, recently stated that allowing the Bush tax cuts to expire as a means of closing the budget deficit would not constitute a tax increase or violate an anti-tax pledge signed by many Republicans.

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The Joint Committee on Taxation estimates that preferential long term capital gains tax rates cost the Treasury $84.2 billion annually. More than 90 percent of the tax expenditure is enjoyed 20 percent of taxpayers; and half of the tax expenditure is enjoyed by the wealthiest 0.1 percent of taxpayers. For those taxpayers, increasing the long term gains tax rate to 29 percent, (the highest ordinary income tax rate under the proposal) would equate to a 93 percent increase in the current long term gains tax.

An increase in the capital gains tax could adversely affect the performance of the stock market, which has seen a steady climb since the trough in early 2008. In the year to date, despite a lingering recession, a nuclear disaster, high energy prices, and a new European strain of persistently high unemployment, the Dow continues its steady ascent, now up 9.8 percent for the year.

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Former Governor Mitt Romney, a possible rival in 2012 to President Obama for the White House, has in the past advocated eliminating the capital gains tax on all individuals or families with less than $200,000 of annual income. Mr. Romney also expressed support for elimination of the estate tax.

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Federal Reserve Chairman Ben Bernanke stated the central bank is examining several “untested means” to stimulate growth if conditions deteriorate, even though the central bank believes the recent economic downturn is temporary. The Fed recently completed a $600 billion purchase of Treasury bonds completing “QE2.” Addressing the Congress recently, Mr. Bernanke did not rule out further quantitative easing, noting “the possibility remains that the recent weakness may prove more persistent than expected and that deflationary risks might reemerge, implying additional policy support.”

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While many expect the federal estate tax to become extinct in the next five to ten years, in many states not only is the estate tax not an endangered species, but in some states the estate tax has been enacted for the first time, and in other states, the tax has been increased. In New York, the estate tax exemption is firmly entrenched at $1 million, an amount that has not changed since 2003. Illinois recently adopted an estate tax. Connecticut lowered its exemption amount from $3.5 million to $2 million. Fortunately, the rate of estate tax in New York is about 10 percent for estates less than $6 million, and the maximum rate for much larger estates does not exceed 16 percent. It appears unlikely that Albany would increase the rate as that could risk the exodus of its wealthy retired residents.

Although the estate tax is imposed in 22 states, the tax pervades the Northeast and Midwest. Estate tax is imposed in every state in New England and the Mid-Atlantic, with the exception of New Hampshire, and in every state bordering a Great Lake, with the exception of Michigan and Ohio. Other states east of the Mississippi imposing the tax are Tennessee and Kentucky.

No southern state, with the exception of North Carolina, imposes an estate tax. West of the Mississippi, only Minnesota, Iowa, Nebraska, Washington and Oregon have an estate tax. Hawaii and Alaska have none.

The irony of the estate tax being most prevalent in states where few would choose to retire aside, many New Yorkers who divide their time between New York and the south or west are faced with the problem of limiting the time spent in New York to avoid income and estate tax. The Department of Taxation audits the time its subjects spend out of the state to ensure that Albany receives its tribute.

After a recent decision of the Tax Appeal Tribunal, few out of state commuters will now likely purchase a vacation home in New York. (See infra, “From the Courts,” (Matter of Barker.) There does appear to be a real cost associated with the privilege of living — and after Barker not even living  —  but merely working and owning a vacation home, in the Empire State.

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While the federal estate tax exemption has risen substantially in the past few years, the federal gift tax exemption had remained constant for nearly a decade until a spike last year. In its haste to pass a tax bill in December of 2010, Congress unexpectedly increased the gift tax exemption to $5 million from $1 million. That increase is scheduled to “sunset” at the end of 2012. Many believe that there is good chance the gift tax exemption may decrease after sunset. For those who believe that Congress will decrease the $5 million gift tax exemption and are otherwise inclined to make large gifts, now would appear to be a propitious time for doing so.

Not only would a donor be able to “lock in” the higher gift tax exemption amount, but the gift made by a New York resident would also reduce the size of the taxable estate at no tax cost, since New York has no gift tax. Although some have speculated that Congress could retroactively impose gift tax on large gifts if the federal exemption is lowered, this possibility appears remote.

Many had feared that Congress would retroactively install an estate tax for those dying in 2011, at a time when there was no estate tax in place. That fear proved unfounded. So too, it is unlikely that Congress would attempt to remove a benefit imposed on taxpayers merely taking advantage of substantial — even if temporary — gift tax exemption.

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President Obama in his 2012 budget proposal, has called for the repeal of LIFO, a method of computing net profit from sales of inventory. IRC § 472 permits taxpayers, with the approval of the IRS, to consider goods sold during the year to be those most recently acquired. When prices are rising, use of LIFO reduces taxable income. The proposal (which as supported by Senator McCain in 2008) would force taxpayers to convert to FIFO. Under FIFO, inventory is considered to be comprised of those goods which are earliest acquired. Those favoring repeal argue that LIFO allows unwarranted tax deferral and causes controversy between the taxpayer and the IRS. Opponents of LIFO repeal argue that taxing LIFO reserves is unfair since it taxes unrealized inflation-based profit.

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Two Senate democrats have urged the federal government to raise revenue by eliminating offshore “tax havens.” Senator Carl Levin of Michigan and Senator Kent Conrad of North Dakota have introduced a bill that would end current rules allowing hedge funds and corporations to avoid federal tax by opening overseas companies. According to Senator Levin, closing the loopholes could generate $100 billion annually.

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On June 24, Governor Cuomo announced New York’s first property tax cap, which limits property tax levy increases to the lesser of 2 percent or the rate of inflation. The cap will take effect in the 2012 fiscal year for local governments and in 2012-13 for the school budget year. In a press release, Mr. Cuomo remarked: “We are beginning a new era in which New York will no longer be the tax capital of the nation . . . For too long, New Yorkers across the state have been forced to deal with back-breaking property taxes, and this cap will finally bring some relief and help keep families and businesses in New York. This tax cap is a critical step toward New York’s economic recovery, and will set our state on a path to prosperity.”

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