While tax experts are divided on the immediate future of tax rates as we approach the fiscal cliff (the combination of scheduled tax rate increases and spending cuts by the government), the consensus is that rates will indeed rise precipitously.
If nothing is done legislatively before the end of the year, capital gains rates will increase from 15 to 20 percent, and dividends will be taxed at up to 39.6 percent instead of 15 percent. And the $5.12 million ($10.24 million for couples) that can currently be transferred free of gift or estate tax will drop to $1 million, along with a rise in the top estate tax rate to 55 percent.
With a divided Congress, compromise will be difficult, according to Larry Peck, a New York-based tax specialist and estate planner. He sees an advantage for Democrats to go over the fiscal cliff.
“Once the Bush tax cuts have expired, the Democrats would be in a position to draft their own plan to reduce taxes for the middle class and dare the Republicans to refuse to pass it,” he observed.
A number of his clients plan to take advantage of the current more favorable tax scheme before it disappears at the end of the year, Peck indicated. While clients with substantial wealth are concerned about diminishing their liquid assets and cash flow by making large gifts, with proper planning the high exemption benefit can be preserved while satisfying liquid net worth and cash flow concerns.
“This can be done through spousal lifetime access trusts —SLATs—a trust that permits each spouse to create a trust from which the other spouse can receive distributions, and at the same time remove the trust assets from both of their taxable estates,” he said. “Typically, these trusts are set up to run for multiple generations and will shelter the trust assets from transfer taxes at each generation for as long as the trusts are permitted to last under state law.”
Many others will consider selling their business, real estate or stocks before year-end to capitalize on the lower capital gains tax rate, Peck predicted. “Investors with dividend-paying stocks may consider selling them in favor of growth stocks because of the potential tax increase on dividends from 15 percent to 39.6 percent,” he said. “And employees who have the option of receiving their bonuses in 2012 may want to take advantage of that.”
Other items set to expire at year’s end include the payroll tax holiday of 2 percent, which approximated $2,000 a year for an individual making $100,000, noted Jim Daniels, managing director at UHY Advisors NY. “The loss of the payroll tax holiday would affect all individuals by an increase in payroll deductions. There is a good possibility this could be modified or extended given the fragile economy,” he said.
“Given the desire not to derail the economy, there should be some action,” Daniels added. “I believe a compromise will be reached because, at this point, both parties have nothing to gain by seeing the economy derailed again given the recent slight upturn.”
On the corporate side, there has been talk about lowering the federal rate to 25 percent, noted Chuck Sockett, managing director at UHY Advisors. “Such a move would put the federal tax on par with most of the rates in the Westernized world and may be the catalyst needed for companies to invest in the U.S. and not overseas,” he said.
And future estate tax rates are also unknown, observed Joe Falanga, a managing director at UHY Advisors, who believes that the Obama administration’s proposed legislative initiatives to close what it perceives as estate and gift tax loopholes will all be up for negotiation.
The Obama administration has consistently supported a $3,500,000 exemption and 45 percent tax rate, he noted. “Any new exemption and tax rate will have to be negotiated and will likely be overshadowed by the looming fight over income tax rates.”