Much has been made of the recent revelation that Governor Romney enjoyed a 14 percent tax rate on “carried interest,” which Congress permits to be reported as capital gain. Investors such as Mr. Romney pay a lower rate of tax because of the favorable capital gains tax rate. Any taxpayer with income over $34,500 per year is by definition taxed at a higher rate than a person the majority of whose income derives from capital gains. Right or wrong, the favorable rate for long term capital gains has long been a part of the tax law.
Perhaps the outcry may be partially attributable to President Obama, who makes no secret of, and clearly bridles at, the “inequity” of wealthy taxpayers paying a lower rate of tax in part because of the lower capital gains tax rate. However, it would be somewhat unfair to blame any such inequity solely on the Republicans. The recent history of the capital gains tax demonstrates that Democrats and Republicans alike have long favored a lower capital gains rate. President Clinton, hardly a Reagan conservative, himself supported a reduction in that tax rate during his presidency. Ironically, President Reagan signed a bill that increased in the capital gains tax rate during his first term.
1986, President Reagan forged a compromise with a Democratic Congress that raised the capital gains rate and lowered the tax rate on earned income so that both were taxed at the same rate. From 1988 through 1990, that rate was between 28 and 33 percent. During the term of President George H. Bush, the maximum rate of tax on ordinary income rose, while that of capital gains remained at 28 percent.
During the first term of President Clinton, the capital gains rate remained at 28 percent. However, during his second term, Mr. Clinton signed a Republican bill that cut the capital gains tax rate to 20 percent. Former Fed Chairman Alan Greenspan, testified before Congress at the time and said “the major impact” of capital gains tax is to “impede entrepreneurial activity and capital formation” and that “[t]he appropriate capital gains tax rate is zero.” Congressional Republicans, including Speaker Newt Gingrich agreed, stating at the time that “[i]f you really wanted the most wealth created over the next 20 years, you would have a zero rate for capital gains tax.”
The capital gains tax rate declined to 15 percent during the first term of President George W. Bush in 2003. The favorable rates for capital gains and ordinary income was to sunset on December 31, 2010. However, Congress and President Obama agreed to extend the Bush tax cuts until December 31, 2012.
If Congress does nothing in 2012, the favorable capital gains rates will expire on December 31, and the long term capital gains rate will revert to 20 percent. A new 3.8 percent Medicare tax on households earning more than $250,000 also goes into effect in 2013. This tax will apply to passive income from dividends, capital gains, interest and other unearned income sources. Thus, for higher income households, the long term capital gains rate will approach 25 percent in 2013. The highest income tax rate for ordinary (nonpassive) income will also rebound to 39.6 percent if the Bush tax cuts are permitted to expire on December 31, 2012.
If President Obama is reelected in November, and history is a guide, the House will remain Republican. No further action would be required by Mr. Obama to effectuate an increase in income tax rates and capital gains rates to the highest level they have been in twenty years. An increase in the capital gains rate past 25 percent or in the ordinary income rate past 39.6 percent appears unlikely since President Obama does not seem to want that and, in any event, a Republican House would not pass such legislation.
Actually, it appears just as likely that President Obama might approve another extension of the Bush tax cuts to stimulate the economy, and to attract voters in Florida, the Midwest, and other swing States. Although Mr. Obama spoke frequently during his earlier campaign of imposing additional income tax on those earning more than $250,000, less has been said on that subject of late, perhaps because Mr. Obama, if reelected, will have the opportunity to get that wish by permitting the Bush tax cuts to expire.
Mr. Gingrich and some Republicans favor eliminating the capital gains tax entirely, as well as the tax on dividends and interest. During a heated exchange in the recent Republican debates, Mr. Romney asked Mr. Gingrich what rate of tax he would impose on capital gains. When Mr. Gingrich responded “zero,” Mr. Romney replied, “then I would have paid no tax.”
Mr. Romney favors making the Bush tax cuts permanent. He also favors reducing the corporate tax rate, which is among the highest in the world, to 25 percent, and eliminating capital gains tax on taxpayers whose income is less than $200,000. Though Mr. Romney is clearly more moderate than Mr. Gingrich, important philosophical differences exist between Mr. Romney and Mr. Obama in how the federal tax system should operate.
With respect to the estate tax, President Obama favors retaining it, presumably at its current levels. Mr. Romney favors eliminating the estate tax. However, even though Mr. Romney supports repeal, it is far from certain that he would actively push for repeal since the revenues generated by gift and estate taxes may be too significant to forego: The Congressional Budget office estimates that estate and gift taxes will generate $197 billion of revenue from 2011 through 2015, which is equal to 11.6 percent of the expected revenue from corporate income tax during the same period.
One striking difference between the position of President Obama and Mr. Romney appears to center around the taxation of investment income of wealthy individuals. While Mr. Romney, himself a beneficiary of a lower tax rate on carried interest, might not object to eliminating the current rule that allows carried interest to be reported as capital gain, he certainly does not favor increasing the capital gains tax.
Mr. Obama has not expressed a interest in increasing the capital gains tax rate past 25 percent, or the ordinary income tax rate past 39.6 percent, which is where they will be if the Bush tax cuts expire. However, Mr. Obama appears resolute in his determination to prevent wealthy persons with large amounts of investment income from being taxed at lower effective rates than most taxpayers. Without raising the capital gains rate, this objective could only be achieved by imposing a new tax on the affluent.
The Obama administration recently advanced a proposal whereby the alternative minimum tax would apply only to those with adjudged gross income exceeding $1 million. Those taxpayers would first calculate their income tax based upon the current tax rules. If their effective rate were less than 30 percent, an additional tax equal to the difference between 30 percent and the calculated tax would be payable. If their effective rate were higher than 30 percent, the taxpayer would pay the higher rate.
Mr. Obama also favors reducing or eliminating the mortgage interest deduction and the child tax credit for the top 2 percent of earners. The deduction for charitable gifts would remain unchanged. Both Mr. Obama and Mr. Romney have stated a desire to simplify the tax law. Mr. Obama speaks of eliminating loopholes that favor wealthy corporations and individuals. Eliminating inappropriate tax expenditures (loopholes) is of course a worthwhile objective. The complexity of the Internal Revenue Code is arguably necessary to ensure that tax policy is carried out effectively. While the observation that only a tax lawyer or accountant can comprehend the Internal Revenue Code may be true, it does not necessarily follow that making the Code more simple to understand would further sound federal tax policy.
With the lifetime exemption now $5 million, or $10 million for a married couple, lifetime gifts may be an important part of estate planning in 2012. The Generation Skipping Tax (GST) exemption parallels the gift and estate tax exemption in 2012. Therefore, the $5 million GST exemption can be applied to gifts made in trusts to “skip” persons.
Use of the $5 million gift tax exclusion can be leveraged in a variety of ways, including (i) making installment sales to grantor trusts; (ii) GRATs and QPRTS; or (iii) fractionalizing family entities. Careful planning is necessary in order to ensure that discounts taken for family entities will not backfire, as the IRS has taken an aggressive stance toward these discounts in recent years. The IRS has enjoyed considerable success in challenging discounts where the taxpayer has retained too much control over the assets gifted to the entity.
The transferee of a lifetime gift takes a carryover basis in the assets, while the beneficiary of an estate takes a stepped up basis. This means that the sale by the donee of a gift will generate capital gains tax, while the sale by a beneficiary of an estate will generate estate tax to the estate. When estate tax rates were 45 percent and capital gains rates were 15 percent, this disparity tended to favor the gifting of assets likely to be sold compared to estate inclusion. However, with gift and estate tax rates now 35 percent, and capital gains rates scheduled to increase to 20 percent at the end of 2012, the attraction of making lifetime gifts to avoid estate tax has declined.
Nevertheless, a countervailing factor favors lifetime gifts in New York: Such gifts will reduce the size of the estate for New York state estate tax purposes without triggering a gift tax, because New York has no gift tax. For federal transfer tax purposes, the gift will have no effect, since the gift and estate tax regime has been reunified — the $5 million exclusion applies first to lifetime gifts and the remaining portion to the decedent’s gross estate.
If donor makes a $5 million gift 2012, what will be the result if Congress reduces the applicable exclusion amount to $3.5 million for both gifts and estates in 2013 and decedent dies in that year? In calculating the decedent’s estate tax, would the estate be required to “give back”” $1.5 million in previously used exclusion? On the one hand, it would seem unfair to impose estate tax on the estate of the decedent when, at the time the gift was made, the gift was fully covered by the exclusion amount. On the other hand, the estate of similarly situated decedent who had made no lifetime gifts would be allowed only the $3.5 million exclusion amount. Congress has not addressed the issue.
Although the estate of the decedent will have achieved somewhat of a windfall by a gift of $5 million at the time when the exclusion amount was also $5 million, it seems unfair to retroactively impose a tax on the decedent’s estate. Since it could appear unseemly for Congress to attempt to ““recapture” the previously used exemption amount at a time when that amount was higher, 2012 seems like a prudent for persons with large estates to consider making such gifts.