Tax News & Comment — August 2014
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I.   From Albany: Perils of Being a Rich State in the Federal System

If the United States were the European Union, New York, Connecticut and New Jersey could be compared to Germany and France, which subsidize less wealthy E.U. members. Of course, the U.S. is not Europe, and wealthier states must bear a larger tax burden if federal programs are to benefit all taxpayers. Yet, intense competition for tax revenues should also not cause New York and Washington to become unseemly dueling principalities. Although not decorous, at some point one must ask whether tax equity is furthered when New York taxpayers are subject to what is effectively a double tax regime consisting of high federal tax and high New York State tax, while some states impose no resident income tax, and still other states, though imposing an income tax, contribute far less to the Treasury.

In effect, wealthier states are subsidizing poorer states and wealthier states imposing income tax are subsidizing other affluent states imposing no income tax.
Few would dispute that under our system of Federalism, Congress appropriately decides the allocation of federal revenues, contracts and grants. It would be unfair to blame the existing federal tax disparity — where New York receives many fewer revenues than it contributes — on elected representatives. Nevertheless, a tax fissure has developed between New York and Washington. Witness New York legislation that obviates the federal grantor trust rules in order to re-impose tax on New York residents who settled trusts in Nevada in response to a favorable IRS ruling. Or New Yorkers who flee to Florida or Texas to avoid high taxes.

The dilemma, though evidencing itself as a tax disparity, is not at its core simply an issue involving an allocation of federal tax revenues. Rather, the predicament raises fundamental questions of tax equity and tax fairness in a federal system, flashing across many strata and planes en route to their just determination, if there be one. For it is unfortunately axiomatic that if New York and Connecticut receive more federal tax revenues, then poorer states such as Mississippi, New Mexico and Alabama, as well as more affluent states with no income tax, such as Texas and Florida, will receive fewer revenues.

Historical Legacy of Taxation of New Yorkers

One evening in April 1664, the colony of New Amsterdam, organized by the Dutch West India Company, and then composed of New York City and parts of New Jersey, Long Island and Connecticut, was surrounded by a large British fleet. Without struggle, the Dutch Governor Peter Stuyvesant surrendered, and the flag of Britain was raised. Unlike other Colonies formed for religious reasons, New Amsterdam was founded upon principles of tolerance and capitalism. Under the terms of the Dutch capitulation, commerce continued to thrive under British rule in New York. The practical difference to most New Yorkers was that taxes became payable to the British Crown instead of to the Dutch. In 1862, New Yorkers began paying income tax to fund the Civil War. To replace lost revenue from Prohibition, New York imposed an income tax in 1920. Sales tax was imposed by Governor Rockefeller in 1965; and New York City imposed income tax in 1966 under Mayor Lindsay. In 2014, while New Yorkers continue to endure high living costs and high taxes, Mayor DeBlasio proposed raising the top combined New York City and New York State income tax rates to 13.23 percent, besting even California by nearly one percent.

New York continues to possess an embarrassment of wealth, talent and resources. The philosophy of Governor Cuomo, in sharp contrast to that of Mr. DeBlasio, appears to be that ameliorating the tax burden imposed on New Yorkers will attract new investment and increase revenues. Hopefully, the Legislature will concur and continue on the path to tax reform. The outlook for New York is less sanguine at the Federal level. Washington remains a quaint southern city where disparate voices are muted and the nation is governed. Congress appears likely to continue to demand a disproportionate tribute from New York. Always stoic, New Yorkers might nevertheless take solace in the fact that the doctrine of Federalism, upon which our nation was founded, appears to lead inexorably to this tax result.

II.  From Washington; 2015 Fiscal Year Tax Proposals of President Obama

The 2015 fiscal year budget of President Obama contains the following proposals of note:

Like Kind Exchange Proposals

President Obama proposes limiting deferred gain in like kind exchanges to $1 million per taxpayer per year. Treasury would also repeal portions of the 1984 Act, which codified Starker v. U.S., 602 F.2d 1341 (1979), a case which the IRS lost, but had never acquiesced to. Starker blessed multi-party deferred exchanges. Arguments in favor of curtailing exchanges are flawed, as they implicitly assume that deferred exchanges will become taxable exchanges. However, if gain on real estate sales may no longer be deferred, many transactions now resulting in deferred gain will never transpire. Instead, taxpayers will hold property longer — perhaps until death where gain will be vanquished by a basis step up.

Moreover, many deferred exchanges involve property previously exchanged. Like any depletable resource, once realized gain is tapped, it will forever disappear. To illustrate, assume successive exchanges where the replacement property in the first exchange becomes the relinquished property in the second. If the property fails to appreciate between exchanges, total deferred gain equals $20x dollars. Yet realized gain lost to Treasury equals only $10x dollars. Statistics referring only to deferred gain lost through exchanges may therefore be inaccurate and misleading. The rationale for allowing deferred exchanges is no less compelling than a century ago: It is inappropriate to impose tax where the taxpayer has not “cashed in” an investment, but has continued the investment in a different form. The non-tax benefits of exchanges are legion. Proposals to curtail exchanges are counterproductive.

Gift and Estate Tax Proposals

Mr. Obama proposes lowering the estate and gift exemption amount to $3.5 million after 2017 from its present $5.34 million, and raising the transfer tax rate to 45 percent from 40 percent. The annual exclusion amount would be increased to $50,000 from $14,000, but would cap annual gifts at $50,000. Currently, the donor may gifts of only $14,000, but to any number of donees. Thus, the proposal sharply curtails the annual exclusion. Mr. Obama would also (i) impose a 10 year limit on GRATs; (ii) attempt to make consistent grantor trust rules for income and transfer tax purposes; and (iii) require consistency in values for transfer and income tax purposes.

Business Proposals

The President would (i) allow new businesses to expense up to $20,000 of start-up expenses; (ii) increase the Section 179 investment expense limitation to $500,000; and (iii)would require small business owners to offer employees the opportunity to enroll in an employer-sponsored IRA. Employers with more than 10 employees would be required to contribute three percent of an employee’s compensation to the IRA. The Administration also favors (i) limiting itemized deductions that benefit taxpayers in the 33 percent or higher tax bracket; (ii) imposing self employment tax on the distributive share of income earned by professionals materially participating in professional service businesses operating as S corporations and LLCs; (iii) eliminating tax incentives for fossil fuels, reducing federal excise tax on natural gas and encouraging biofuels; and (vi) allowing credits for electricity produced from alternative sources.

Retirement Proposals

The Administration proposes (i) eliminating the complex minimum distribution rules for individuals with less than $100,000 in IRA and other retirement plans; (ii) requiring beneficiaries of retirement plans to liquidate plans within five years; (iii) allowing non-spouses a 60-day grace period in which to effectuate a rollover from an inherited IRS; and (iv) curtailing the amount of tax-favored retirement benefits that may be accumulated per year by providing that once a $210,000 annuity limit was reached, no further contributions could be made to any retirement account. Currently, the $210,000 limit may be applied to multiple retirement accounts.

Buffet Rule

President Obama favors imposing a minimum 30 percent tax on the taxpayers whose adjusted gross income (modified downward for charitable deductions) exceeds $1 million.

Expansion of New York Subsidies

President Obama favors tax credits from 2015 through 2024 for the creation of transportation infrastructure occasioned by 9/11.