By Robert S. Keebler, CPA, MST, AEP (Distinguished)

On April 13, the Treasury Department issued its annual Revenue Raising Proposals, commonly referred to as the“Green Book”. In this column we will summarize the key income tax proposals and suggest some planning ideas. These proposals include:

(1)  Implementing the Buffett Rule by imposing a new “Fair Share Tax;”

(2)  Reducing the value of certain income tax deductions and exclusions;

(3)  Limiting the total amount a taxpayer can accrue in tax favored retirement plans;

(4)  Shortening the deferral period for inherited IRAs; and

(5)  Taxing carried interests as ordinary income.

INCOME TAX PROPOSALS

Implementing the Buffett Rule by Imposing a New “Fair Share Tax”

This proposal would create a new tax called the Fair Share Tax (FST) that would be phased in as income increased from $1 million to $2 million. The tentative FST would be equal to 30% of AGI less a credit for charitable contributions. The final FST would be the excess, if any, of the tentative FST over the regular income tax, after certain credits, the AMT, the 3.8% Medicare surtax and the employee portion of payroll taxes were taken into account. The Green Book provides the following example of how the tax would be calculated.

Example 1. T has AGI of $1,250,000, tentative FST of $375,000 (.3 x $1,250,000) and a regular tax of $250,000 (.2 x $1,250,000). The FST payable would be:

• (($1,250,000 – $1,000,000)/($2,000,000 – $1,000,000)*($375,000 – $250,000)
• = ($250,000/($1,000,000) * $125,000
• = ¼ * $125,000
• = $31,250

Now let’s look at a more detailed example. Assume the same facts as in the Green Book example except that T makes a $100,000 charitable contribution and all the full $1,250,000 of income is long-term capital gain, taxed at 23.8%.

Example 2. The tentative FST would now be $347,000 ($375,000 – $28,000 charitable deduction credit) and the regular tax would be $297,500 (.238 x $1,250,000). The FST payable would be:

• (($1,250,000 – $1,000,000)/($2,000,000 – $1,000,000)*($347,000 – $297,500)
• = $250,000/($1,000,000 * $49,500)
• = ¼ * $49,500
• = $12,375

The proposal would be effective for tax years beginning after December 31, 2013.

Planning Implications
Note that the tax applies to capital gain as well as to ordinary income. Thus, if it appears that the proposal will become law, affected taxpayers may wish to sell stock or other appreciated capital assets with a long-term holding period before 2014. This may reduce the tax rate on the gain from 30% to 23.8%. In deciding whether to recognize gains in 2013, the opportunity cost of paying the capital gains tax early should be taken into account.

Reducing the Value of Certain Deductions and Exclusions

Under current law, deductions are worth more to high income tax payers than to lower income taxpayers. To address this perceived issue, the second key tax proposal would cap the value of certain above-the-line deductions and all itemized deductions at 28% of the amount deducted. This would presumably mean, for example, that if a taxpayer in the 39.6% ordinary income tax bracket had an itemized deduction of $10,000; the deduction would reduce tax liability by $2,800 instead of $3,960.

The above-the-line deductions this would apply to include (1) contributions to defined contribution retirement plans, (2) contributions to IRAs, (3) moving expenses, (4) interest on education loans, (5) health insurance costs for self-employed individuals, (6) certain trade or business deductions of employees,(7) employer-sponsored health insurance paid for by employers or with before-tax employee dollars, (8) certain higher education expenses, (9) tax-exempt state and local bond interest and  (10) the costs of domestic production activities. The cap would also apply to itemized deductions like mortgage interest, property taxes, medical and dental expenses, state and local taxes and charitable contributions. The proposal would be effective for tax years beginning after December 31, 2013.

Planning Implications
If it appears that this provision will be enacted, taxpayers with income in the higher brackets might consider accelerating applicable deductions and exclusions into 2013. For example, they might wish to increase 2013 charitable contributions, pay extra on their mortgages or undergo medical or dental procedures in 2013 rather than in 2014. Again, the tax benefits would have to be weighed against the opportunity cost of making the payments early.

Limiting the Total Amount in Tax Favored Retirement Plans

This proposal would cap a taxpayer’s total balance in all tax-favored retirement accounts at the amount necessary to make the maximum payout permitted under a defined contribution plan. For 2013, this maximum payout is $205,000 for a joint and survivor annuity beginning at age 62. Given current interest rates, this translates to an account balance of approximately $3.4 million. Tax-favored retirement accounts for this purpose include (1) traditional IRAs, (2) Roth IRAs, (3) stock bonus plans, (4) profit sharing plans, (5) pension plans, (6) section 403(b) plans of non-profit organizations and (7) funded section 457(b) plans of state and local government employers.

The limitation would be determined at the end of each calendar year and would apply to contributions or accruals for the following year. If a taxpayer reached the maximum accumulation, no further contributions or accruals would be allowed, but the taxpayer’s account balance would continue to grow with investment earnings and gains.

If a taxpayer received a contribution or an accrual that would result in an accumulation in excess of the maximum permitted amount, the excess would be treated in a manner similar to the treatment of an excess deferral under current law. The excess amount would be included in current income, but the taxpayer would be given a grace period to remove it from a plan. If the taxpayer did not withdraw the excess contribution or accrual, the excess amounts and earnings attributable to them  would be subject to tax when distributed without any adjustment for basis. This would be true even if the distribution was made from a Roth IRA or from a designated Roth account inside a plan. Thus, the proposal would not force taxpayers to remove (1) excess amounts in the plan when the law went into effect, (2) excess amounts resulting from investment growth after the law went into effect or (3) excess amounts resulting from decreases in the maximum accrual amount due to rising interest rates.

The proposal would apply to contributions and accruals for taxable years beginning on or after January 1, 2014.

Planning Implications
The maximum accumulation amount would be highly sensitive to changes in interest rates. The lower the interest rate was, the larger the amount that would be necessary to pay a given annuity amount. As noted above, given the current low interest rates it would take approximately $3.4 million to pay a joint and survivor annuity of $205,000 beginning at age 62. If interest rates increased to 6%, the maximum accumulation would drop to about $2.4 million. This suggests that if the proposal went into effect, taxpayers should try to maximize the amounts they could accrue in tax-favored retirement vehicles before interest rates increase.

The effect of this proposal may be less important than it might appear on the surface. For taxpayers with accruals in excess of the permitted amount, growth in the assets may be far more important than additional contributions.  Suppose, for example that T has $5 million in a 401(k) plan, a 403(b) plan, a 457 plan or a federal government Thrift Savings Plan. The maximum annual contribution for an employee under age 50 for these plans is $17,500 in 2013. Thus, the maximum contribution would represent an increase in the value of the account of only 0.35%.

Taxpayers who are no longer able to invest in tax-favored retirement vehicles will look for other favorable investments. As a result, deferred annuities and permanent life insurance may become more popular.

Shortening the Deferral Period for Inherited IRAs with Non-Spouse Beneficiaries

Under current law, if an IRA owner dies after reaching age 70 ½, and a non-spouse individual is the designated beneficiary, required minimum distributions are made over the beneficiary’s life expectancy. A popular planning strategy for inherited IRAs is to have the youngest possible designated beneficiary to maximize the tax deferral opportunities.

The proposal would limit the tax benefits of deferral by generally requiring non-spouse beneficiaries to take distributions over no more than five years. The reason for the change is that IRAs were intended to provide retirement security for individuals and their spouses, not to provide a tax break for non-spouse beneficiaries.

Planning Implications
Although a planner’s first reaction might be that the requirement could be avoided by converting traditional IRAs to Roth IRAs, this is not the case. Roth IRAs do not have required minimum distributions during the IRA owner’s life, but a non-spouse beneficiary of an inherited Roth IRA is subject to the same payout restrictions as the beneficiary of a traditional IRA.

The proposal would also change IRA beneficiary planning because there would be no need to qualify a beneficiary with a long life expectancy as the designated beneficiary. This would make it more popular to name trusts as beneficiaries, particularly accumulation trusts which could provide much needed asset protection without the loss of potential lifetime stretchout of minimum distributions which may occur under current law. It might also make it more popular to include charities as IRA beneficiaries.

Tax Carried (Profits) Interests as Ordinary Income

A carried interest is a share of profits that general partners of private equity and hedge funds receive as compensation.  Under current law such amounts are treated as capital gains even though they are received in connection with the performance of services rather than as a return on invested capital. The proposal would generally tax carried interests as ordinary income. This would increase the effective tax rate on carried interests in most cases from 23.8% to 43.4%.

Planning Implications
When a bill with similar provisions was introduced by Senator Levin (D. Michigan), it included an exception for a “qualified capital interest.” Such an interest included (1) the portion of a partner’s interest attributable to a contribution of money or other property to the partnership, (2) the inclusion of compensation income under IRC § 83 when the partnership interest was granted and (3) allocation of net partnership income for years after the proposal went into effect.

Commentators have suggested that if the proposal becomes law and includes a similar exception, ordinary income treatment could be avoided in the future by converting a partnership profits interest into a qualified capital interest. Ordinary income would be recognized on the conversion equal to the FMV of the interest, but future income would be capital gain and would not be subject to the payroll tax. A detailed quantitative analysis would be necessary to determine whether such a conversion would be advisable.

Conclusion

It is not clear at this time which, if any, of the Treasury Revenue Proposals discussed above might become law. Because the window of opportunity for limiting their impact might be short, however, planners should start thinking about planning implications now…and keep current with the status of these Proposals!

RELATED TRAINING & EDUCATION
In the past few months, Mr. Keebler has presented a number of timely and  helpful educational programs that may be of interest to you including, but not limited to:

• Understanding the 3.8% Health Care Surtax and Impact on Individuals, Trusts & Estates, and Business Entities
• The Ins and Outs of Correct Form 709 Prep
• Fiscal Cliff Legislation and What it Means for your Clients
• Investment Planning After the New Tax Law

You can download the handout materials and the audio recording to these programs.  Also, take a look at the list of Upcoming Programs to see other related programs we have coming up with Mr. Keebler.

ABOUT THE AUTHOR

Robert S. Keebler is a partner with Keebler & Associates, LLP. He has received the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels and has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States.  Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and has received over 150 favorable private letter rulings. Mr. Keebler is nationally recognized as an expert in family wealth transfer and preservation planning, charitable giving, retirement distribution planning and estate administration and works collaboratively with other professionals on academic reviews and papers, as well as client matters.  He can be reached at (920)593-1701 or at robert.keebler@keeblerandassociates.com.