What if Congress Does Nothing?

The clock is ticking! If Congress fails to act by the end of 2010, many significant tax provisions passed as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (often informally referred to as “EGTRRA”) will simply expire. This “sunset” feature of EGRRRA was enacted so that the law would comply with the Byrd Rule, a rule that allows Senators to block a piece of legislation if it purports to significantly increase the federal deficit beyond a ten-year term. Now the ten-year clock has almost wound down. 

Here’s a summary of the significant changes to the tax code that will occur if Congress does not act:

 Tax Rates. Currently, the top tax rate is 35%. The following table is comparison of this year’s tax brackets with an estimate of the 2011 post-EGTRRA tax rates, including a reinstated 39.6% tax rate: 

Capital Gains. If you are currently in the 25% or higher tax bracket, your maximum rate on capital gains is 15%. If you are in the 10% or 15% brackets, the maximum rate is 0%! After EGTRRA sunsets, the top capital gains rate increases to 20% (up to 10% for those below the 25% bracket).  

Qualified Dividends. Similar to capital gains, most corporate dividends are currently taxed at a 15% rate. These dividends are known as “qualified dividends.” After 2010, these dividends will be taxed in the same manner as ordinary income, up to the top 39.6% rate.

Phase-out of Itemized Deductions & Personal Exemptions. Prior to the Bush-era tax cuts, itemized deductions (including charitable donations, home mortgage interest, state and local income taxes, and property taxes) were reduced for higher-income individuals under a phase-out rule. Since 2006, this phase-out rule has, itself, been phased out so that by this year, itemized deductions were no longer subject to any limitations. However, in 2011, the phase out rule returns. Specifically, itemized deductions will be reduced by 3% of AGI in excess of the applicable phase-out threshold (approximately $170,000). The maximum reduction is limited to 80% of the affected deduction amounts. Similarly, certain EGTRRA limitations on the personal exemption phase-out rules will expire after 2010, thus further increasing the effective tax burden for high earners.

Estate Tax. At the time of EGTRRA’s enactment, the federal estate tax exemption amount was $675,000 and was scheduled to increase incrementally to $1,000,000 by 2006. EGTRRA increased the exemption amount to $1,000,000 in 2002, $1,500,000 in 2004, $2,000,000 in 2006, and $3,500,000 in 2009. In 2010, the estate tax (as well as the generation-skipping tax) is repealed. Between 2001 and 2009, the top estate tax rate dropped from 55% to 45%. If Congress does nothing prior to year’s end, the estate tax will be reinstated with a $1,000.000 exemption amount and a top rate of 55%.

Many are optimistic that Congress will act this year to make at least some changes to the tax code, particularly for those individuals with adjusted gross incomes of less than $250,000 and estates worth less than $3,500,000. However, in the wake of this year’s cantankerous debates in Congress over health care legislation as well as the election of Senator Scott Brown in Massachusetts (effectively sapping the Democrats filibuster-proof majority in the Senate), it may be difficult for Congress to find common ground over major tax legislation. The best bet for this may be changes in a “lame-duck” session following the fall elections. Stay tuned!