Tax Snowball or Abominable Avalanche? 10 Likely Changes to the Tax Code

In a few short months, after the Dog Days of summer have gone and the sweltering humidity of the Washington D.C. begins to subside, Congress will begin to get serious about finishing work on tax legislation that will make substantial changes to our current tax code. I’ll leave to the politicians to discuss the wisdom, or lack thereof, of these changes. However, one thing is certain – tax changes are on the way!

I have no crystal ball. However, as Congress debates health care legislation and begins to embrace the red ink from the fiscal stimulus legislation in the last year, significant changes to the Tax Code are as certain as January snow in Denver. For those whose time has come to pay their “fair share” of taxes, here are the ten changes that we’re most likely to see when the sun rises on New Year’s Day 2010:

1. Tax Rates. The “Greenbook” report released by the Obama Administration in May states that the current 33% and 35% tax rates will increase to 36% and 39.6%, respectively. These rates would affect those individuals with incomes exceeding $200,000 for single persons and $250,000 for married couples. While Congress still needs to make the final decision, the proponents of these increases tend to argue that these “reforms” merely represent a return to the Tax Code of the Clinton Administration.

2. Capital Gains. Currently, the maximum tax rate on recognized capital gains is 15%. Under current law, these changes expire after 2010, with the maximum rate scheduled to increase to 20%.  For the same group of high earners (singles making more than $200,000 and married couples making over $250,000), the 20% bracket would return early, most likely with the 2010 tax year.

3. Qualified Dividends. Certain “qualified” dividends received by individual taxpayers from corporations are currently taxed at a 15% maximum rate. Like the capital gains tax increase referenced above, the maximum tax on these “Q Dividends” would be increased to 20% as well. Interestingly, the Obama Administration did not advocate a return to the Clinton years when dividends were taxed in the same manner as ordinary income. My bottom line on this one – don’t count on it. An increasingly budget-conscience Congress will see it as “low hanging fruit.”  Look for the return of ordinary income tax rates on dividends.

4. Personal Exemptions. Under current law, even the highest earning taxpayers are entitled to claim personal exemptions on their individual tax returns. For example, the highest earning taxpayers can claim $2,433 as a personal exemption. For the same $200,000/$250,000 group referenced above, the personal exemption would be phased out. While a somewhat minor item for high-earning taxpayers, the Administration’s justification for the changes is classic Washington:

“By limiting the tax benefit of higher-income taxpayers’ personal exemptions, the income tax system would be made more progressive, and the cost of government would be shared more fairly by taxpayers in all levels of income.”        

5. Limits on Itemized Deductions (aka the “haircut” limits).  Tax legislation passed during the Bush Administration progressively reduced the prior Clinton-era limitations that the Tax Code placed upon itemized deductions. However, these curbs were scheduled to expire starting in 2011. The Obama proposals would allow these limits to expire “on time” in 2011. In general, these limitations provided that itemized deductions (other than medical expenses, investment interest, theft and casualty losses, and gambling losses) would be reduced by 3% of the amount by which adjusted gross income exceeds statutory floors which are higher than under current law, but not by more than 80% of the otherwise allowable deductions.

6. 28% “Override” Cap on Itemized Deductions. Again, for our $200,000/$250,000 folks, the Obama Administration proposes that in addition to the “haircut” limits on itemized deductions referenced above, itemized deductions would be further reduced by limiting the tax value of those deductions to 28% whenever they would otherwise reduce taxable income in the 36% or 39.6% tax brackets. This proposal has come under attack by many charitable organizations, arguing that the limits would discourage high earners from making tax-advantaged charitable gifts.

7. Extension of Tax Statute of Limitations. Under current law, the IRS generally has 3 years after a return is filed to audit a person’s tax return. Under the Administration’s proposals, this statute of limitations would be extended up to 2 additional years as a result of a change in a taxpayer’s income made by a State taxing authority.

8. Estate Tax Exemption. Under current law, the federal estate tax exemption is $3.5 million for 2009, with estate taxes to be entirely repealed in 2010. These changes “sunset” after 2010, and are replaced with a $1 million estate tax exemption. The Obama Administration budget proposals assume a continuation of the current $3.5 million exemption, with a top estate tax rate equal to 45%.

9. Estate Tax Valuation Discounts. In certain transactions in family-owned entities, the interests that pass to an estate’s heirs are valued at their fair market value. Under traditional valuation principles, the value of such business interests is determined utilizing certain valuation discounts. The Obama Administration would require certain restrictions and other limitations to be disregarded in the process of valuing certain family-owned entities. This proposal will likely increase the overall estate tax burden which is paid by family-owned businesses.

10. “Surtaxes” on High Earners. Separate from Administration proposals, congressional leaders in the House of Representatives have proposed a “surtax” on high-income individuals to pay for health care reform. Presumably in addition to the Obama tax-rate increases discussed above, the new surtaxes would be equal to: 1% for income over $350,000 of adjusted gross income (AGI), 1.5% for AGI over $500,000, and 5.4% for income over $1 million.

The daily popular media tends to focus on the various tax proposals singularly, rarely examining these proposals together. Any one of these proposals, in isolation, can seem rather benign – like a snowball pitched in good fun. However, when the proposals are examined in their mathematical aggregate, the impending avalanche of taxes starts to come into focus — and it’s not even fall yet.

I welcome your comments and discussion!

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