The Senate Finance Committee held hearings last week to consider the effects of the soon-to-expire “Bush” tax cuts, and those problems could be magnified for tax practitioners and their clients.

At the hearing, ranking member Sen.Chuck Grassley, R-Iowa, cited the harmful effects from the personal exemption phaseout, also known as PEP, as well as the Pease limitation on itemized deductions, and other phase-outs (see Senate Deliberates Fate of Expiring Bush Tax Cuts). They increase the marginal effective tax rate, thus increasing the disincentive to perform productive activity, he noted. They also significantly increase complexity, decrease transparency and have the cumulative effect of increasing the tax gap.

Although PEP and Pease do not exist for 2010, they are both scheduled to spring back with full effect for 2011, Grassley said.

Carol Markman, a partner in the Syosset, N.Y.-based firm Feldman, Meinberg & Co. LLP and a member of the Internal Revenue Service Advisory Council, agreed.

“One of the most serious problems for tax professionals dealing with the phase-outs is that even a very seasoned professional cannot sit down with a married taxpayer and prepare a projection using only a pencil, paper and calculator if the client’s income is above a nominal amount,” she stated.

“The code is so complex and provides for so many phase-outs with different ranges, and different beginning and ending points, that it is impossible to prepare an estimate of projected taxes and marginal tax rates without being armed with a series of worksheets, schedules and charts,” she added. “Some phase-out limits change annually; others do not, so the preparer can never be sure of the applicable limits for specific phase-outs without resorting to numerous reference materials.”

“One of the senators asked me about the need for tax reform,” said Markman, a former president of the National Conference of CPA Practitioners. “I told him that the clear evidence in favor of tax reform is in the annual increase in the number of taxpayers seeking professional advice.”

Ironically, until the Tax Reform Act of 1986, which was meant to simplify the Tax Code, any deduction or credit was available equally to almost every taxpayer, noted Markman. “TRA ’86 changed the tax rates, from 15 brackets ranging from 11 to 50 percent, to two brackets, 15 and 28 percent. The offset to this simple rate structure was the beginning of the phase-ins and phase-outs of exemptions, deductions and credits,” she said.

“The phase-outs have an erosive effect on tax compliance and taxpayer confidence in the fairness of tax laws,” she observed. “Tax practitioners are forced to tell clients that many tax-saving provisions that they read about in the press during tax season each year do not apply to them. They are considered ‘rich,’ yet struggle to make ends meet living an ordinary lifestyle.”

Markman indicated that reinstating PEP and Pease is not the answer. “If they really want to raise taxes, then raise the tax rate but get rid of the phase-out,” she said.

Meanwhile, Bill Rys, tax counsel for the National Federation of Independent Business, urged Congress to act quickly to extend the expiring rates. “This issue is critically important to small business owners since the vast majority of these businesses pay their taxes at the individual rates,” he said. “Uncertainty over tax rates translates into fear and inaction for many small business owners. It’s very difficult to manage a small business when you don’t know what your tax liability will be in the near future.”

Rys cited the NFIB’s latest Small Business Economic Trends survey, which shows that optimism is down, capital expenditures are at 35-year lows, and small businesses are still cutting more jobs than they are adding (see Small Business Owners Feel Less Optimistic).

“Business owners are concerned,” he said. “They don’t know what their tax rates will be, or their health care costs or their energy costs. When you follow a bad economic climate with a lot of policy changes and uncertainty, it makes it harder to plan on how to grow your business.”


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