Deficit Reduction and The Budget Control Act May Change
Lead to Dramatic Tax Changes
By: Martin M. Shenkman, Esq., with input from Steven B. Gorin
Budget Control Act
The Budget Control Act will result in the formation of a bipartisan joint committee
charged to address deficit reduction and present legislation that can be voted upon prior
to year end. They are charged with proposing changes to raise $1.5 trillion over 10 years.
The specific form deficit reduction will take is unknown. That uncertainty alone has
significant planning implications. Unfortunately, many clients will interpret added
uncertainty as another excuse to defer planning. But, more than ever, taking a “wait and
see” approach may result in clients realizing a “wait and pay” result.
Inform Clients Now
Practitioners might wish to consider a quick alert to clients pending more detailed
analysis of the new developments. For example, adding a short legend to emails, or
sending a blast email to clients might be advisable. Consider the following for a quick
reaction:
Client Alert
Congress approved the debt ceiling bill and on August 2, 2011 President Obama signed
the Budget Control Act (Senate Bill 365, as amended). This calls for a new Joint
Committee to weigh year-end tax legislation. If you may benefit from discounts, GRATs,
sale transactions, dynasty trusts or a host of other planning benefits that have been
previously discussed for restriction or elimination, you should consider acting now.
November 2011, not December 31, 2012 might be the new deadline. New changes might
be proposed, not just those in the Budget Control Act. Some might be effective from date
of proposal. If you are considered using any of these tools, consider consulting with their
tax, legal and financial advisers on a regular basis through these fluid, and potentially
dangerous financial times.
The Tax Times are A Changin’
Bob Dylan sang: “For the times they are a-changin'” and from a tax perspective they
certainly seem to be. The tone of the tax discussions has already taken on a decidedly
different nature than only as short time ago. The tax laws are now being labeled a drag on
the economy. If the tax laws can be revised to eliminate a newly identified villain of the
stumbling economy, presumably Congressional tax writers would pursue it in that
context.
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Lower tax rates are being heralded as a spur to economic growth. This might all play out
in fewer deductions and lower rates. But lower rates with fewer deductions will meet
higher actual tax costs for many. Most significantly, slashing of deductions and credits
will have a widely disparate effect on different taxpayers, different industries and
different states. These disruptions may be mollified to some degree by phasing out the tax
benefits over time, but the results may nonetheless create significant hardships for
particular clients. Some of those adversely affected and possible planning strategies are
discussed below. But at this early stage these points are at best speculative. But within
these guesses as to potential tax changes may be lurking a few nuggets of valuable
planning opportunities for the proactive forward thinking adviser and client.
Speculating on Future Tax Changes
All practitioners recognize the futility of predicting future tax change. How many Ouija
boards were tossed out of office windows after failed attempts at predicting the 2010 tax
changes! But there might be some predictive value in reviewing certain tax tea leaves
(although they’re likely as unreliable as the many now shattered Ouija boards).

Some of the many previously proposed tax changes. Legislation requiring grantor
retained annuity trusts (“GRATs”) to use a 10 year minimum term is intorudced
from time to time, with varying proposed effective dates. A requirement that a
GRAT last at least 10 years substantially increases the mortality risk of using the
GRAT technique. Restrictions on the term of dynasty trusts, restriction or
elimination of certain valuation discounts, might all be on the table again. But, in
the horse trading of what might now become an Internal Revenue Code of 2011,
might Congress sacrifice the estate tax as part of a compromise deal and in efforts
to simplify the tax system? Or instead will fiscal demands result in
deduction/technique tightening to raise more revenue without lowering the
exemption or raising rates?

President Obama has continuously recommended tax increases on higher income
tax payers. This might translate into higher ordinary income tax rates, higher
capital gains rates, perhaps even tougher estate taxes on larger estates.

“Loophole closing” might become the new politically correct moniker for “safe
tax increases.” After all, if it’s merely closing a “loophole” it’s not a tax increase,
it is ending a perceived abuse. So yesterday’s tax incentive might be labeled
tomorrow’s “loophole.” If this concept gets legs some “loopholes’ may start to
resemble those car-swallowing New York potholes. Loophole closing might entail
the wholesale slaughter of time honored deductions in exchange for lower tax
rates. After all, if lower tax rates take the headlines, how can anything else be a
tax increase? So if individual or corporate rates are lowered, but a bevy of
deductions are eliminated, especially more esoteric ones, the media and voting
public might not comprehend readily. Revenue estimates can be raised and the
public might not view the process as really a tax increase.
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
The “Lower Taxes That Raise More Money While Simplifying the Tax System
and Stimulating the Economy Act of 2011” might just suggest where some in
Congress might steer the tax ship. There is much talk of major tax restructuring.
Perhaps if the lower rates and elimination of deductions is extended more broadly,
it can be branded as a “New and Improved Tax Code” as powerful as a new and
improved laundry detergent. If this door opens it could be a floodgate of tax law
changes. Might a Congress smarting (is that a poor choice of words?) from the
recent handling of the deficit ceiling believe that rebranding the Internal Revenue
Code of 1986 as the new and improved and shorter Internal Revenue Code of
2011 might somehow redeem them in the eyes of voters?
Time May Be Shorter than Most Clients Believed
There seemed to be a sense amongst many taxpayers that the 2010 laws would last until
at least December 31, 2012. Many tax practitioners had doubted after the 2010 fiasco that
there would be certainty about the estate tax until well into 2013. Perhaps everyone might
be surprised with what might occur by November 2011. The new joint committee has
been charged with proposing legislation by November 2011 so Congress can act on it
prior to the end of 2011. Bear in mind that some recent tax proposals included effective
dates set at the date of proposal, not the later date of enactment. That tweak of effective
dates itself may translate into bigger revenue estimates. Thus, it is possible that change
may occur much earlier than anyone anticipated, and that the changes may be effective
from the date the envelope is opened, not the date of enactment. The time delay between
the two to close pending deals may not be a luxury afforded to taxpayers or their
advisers.
It is still possible that many changes may be tied to the sunset of the Bush tax cuts, at the
end of 2012.
Speculating on Possible Tax Changes and How They Impact Planning
The crystal ball is rather opaque in general, but as you drill down to specific changes,
reliability wanes. With these caveats, consider the following:

Individual Income Tax Rates:
o Higher income individuals may face higher marginal tax rates. The Obama
administration has defined this as single individuals with incomes above
$200,000, and families with incomes above $250,000. However, at this
juncture it is unclear what higher income tax rates might entail. Will this
be rates higher then current rates? Or if there is a general lowering of
overall tax rates (and that seems to be in the wind) then the higher
marginal rates might in fact be at rates that are not significantly higher
than current nominal rates. The term “nominal” is used because there are
other taxes that might add to whatever the nominal rate is. See below.
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o Some discussion has addressed replacing the current individual marginal
income tax rate schedule with new tax brackets, ranging from: 8-12
percent; 14-22 percent; and 23-29 percent. So if the bean counters can
justify relatively low rates as still generating more revenue as a result of
the elimination of deductions and other benefits, the nominal effective
rates even on high income families may not be that significant by
historical standards. However, factoring in the potential loss of a host of
significant itemized deductions could make this seemingly modest tax rate
quite costly. Further, as discussed below, the costs will vary rather
significantly based on the facts and circumstances of each taxpayer.
o Currently, wages are subject to a 2.9% Medicare payroll tax. Workers and
employers each pay half, or 1.45%. If you’re self-employed you pay it all
but get an income tax write-off for half. This Medicare tax is assessed on
all earnings or wages without a cap. These taxes fund the Medicare
hospital insurance trust fund which pays hospital bills for those 65+ or
disabled. Starting in 2013, a 0.9% Medicare tax will be imposed on wages
and self-employment income over $200,000 for singles and $250,000 for
married couples. IRC Sec. 3101(b)(2). That makes the marginal tax rate
2.35%.
o Under current law, only wages and earnings are subject to the Medicare
tax above, but starting in 2013 the 3.8% Medicare tax will apply to net
investment income if your adjusted gross income ("AGI") is over
$200,000 single ($250,000 joint) threshold amounts. IRC Sec. 1411. More
specifically, the greater of net investment income or the excess of
modified adjusted gross income (MAGI) over the threshold, will be
subject to this new tax. In some circumstances, the 3.8% is effectively in
addition to the Medicare rate of 0.9% above so the surcharge for higher
earning taxpayers is significant. This increased marginal rate will have an
impact on net of tax calculations for budgets, investments, etc.
o The impact of much lower marginal rates will be significant. The income
tax benefit of charitable deductions, to the extent one remains will be
reduced. The calculus of when to purchase tax exempt versus taxable
bonds will change. The asset location decisions as to which asset classes
should be held in tax deferred accounts will change. Those holding
significant municipal bond portfolios may get a double wallop – one from
a reduced tax benefit of holding their tax exempt bonds and the other from
the impact of what might prove higher interest rates. Perhaps taxpayers
who have become overly concentrated on municipal bonds should begin
the weaning process now.

Individual “Income” Definition:
o Currently an employer’s contribution to pay for an employee’s health care
plans is not considered income to the employee. This benefit might be
eliminated or at least restricted. This might be accomplished by creating a
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cap on the maximum amount any employee/taxpayer can exclude from
income each year for employer provided health care.
o This is anticipated to raise nearly $150 billion per year, so the amounts are
rather staggering for employees affected.
o This change will put pressure on employees and businesses to rely on less
costly and less comprehensive health care plans. Employees struggling to
make ends meet when feasible may pressure employers to cover more of
the cost or provide raises.

Alternative Minimum Tax (“AMT”):
o The AMT might in fact be abolished. As nominal marginal tax rates are
lowered, the AMT will be less relevant to the tax system. Eliminating the
AMT will undoubtedly be heralded as a major simplification of the tax
system.
o Tax projections might be a tad simpler; there might be some impact on
municipal bond holdings used to finance private projects.
o However, for several years, Congress has considered permanent changing
or repealing the AMT. So far, Congress has not been able to agree on
revenue offsets enough to permanently change the AMT exemption,
instead settling for last-minute patches. AMT involves more revenue than
estate tax.

Capital Gains Taxes:
o There has been discussion of reducing the tax favored treatment for capital
gains and dividends. This change, if it occurs, might well be phased in
over a number of years to minimize the impact on the markets. It might
take the form of higher rates on those earning over certain thresholds. The
$200,000/$250,000 thresholds that have popped up in a number of
contexts might be the threshold selected here.
o The combination of higher capital gains rates coupled with the Medicaid
tax on unearned income, and other potential changes, could have a
surprising impact on taxpayers. For taxpayers in high tax states that bear a
higher combined capital gains rate, Medicaid tax on investment income
and no federal deduction for state income taxes on the gains realized, the
bottom line result could be quite costly.
o There has even been some discussion of treating capital gains and
dividends as ordinary income. The sales pitch for this is it will simplify the
tax Code and planning and since the marginal tax rates will be relatively
low, perhaps this might be saleable.
o This would have wide ranging impact a host of investment, business and
other transactions. It would level the playing field, but also distort it in
many ways from what taxpayers and advisers alike are presently use to.
Dealer versus investor status, lease versus sale, hedging transactions,
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holding periods, and a host of other planning concepts could become
academic.

Tax Deductions:
o Deductions, referred to in many of the discussions as “tax expenditures”
are slated to be restricted or repealed as the basis or justification for
lowering marginal income tax rates. This will somewhat simplify the tax
system, but it may also drive as many prior efforts at simplification, new
endeavors to benefit under the new tax paradigm.
o Possible tax expenditures up for restriction (often called “reform”) might
include the full laundry list of common tax deductions. Overall these
changes may spur taxpayers to restructure transactions and the manner in
which they handle their affairs. The family limited partnership (“FLP”)
formed to take advantage of discounts presently permitted under the gift
and estate tax valuation rules may morph into a new purpose. If discounts
are restricted or repealed (and for perhaps 99% of taxpayers it’s all
academic if the $5 million exemption remains law) FLPs instead of being
dissolved (which for asset protection reasons alone most should not) may
be the only vehicle left to secure deductions as itemized deductions are
restricted.
o The sacred home mortgage interest deduction appears to be up for
consideration. This could have a huge impact on the cost of home
ownership and the rent versus buy analysis. The impact on the still
recovering housing market may be adverse. Even if the home mortgage
deduction is not significant restricted, lowering marginal income tax rates,
restricting itemized deductions generally, and other broader changes, may
indirectly have a depressing impact on the value of the home mortgage
deduction even if it is retained. For those operating home based
businesses, the calculus of whether a home office deduction should be
claimed may change as that might be of increasing importance. Some may
be driven to form an entity to operate their business in order to try to
increase available deductions as personal home deductions are eliminated.
o There has already been some discussion of generally restricting the tax
treatment household debt. It is not clear whether this will extend beyond
home mortgage deductions to encompass restrictions on investment
interest, etc.
o So far, no mention of restricting property tax deductions has been
mentioned. Of the approximately 46 million income tax returns filed in
2009, nearly 40 million claimed a property tax deduction. If property tax
deductions are not reduced, but the deduction for state and local income
taxes is restricted or eliminated (see below) local governments may tend
towards greater reliance on property tax increases over income tax
increases.
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o Restricting deductions for charitable contributions have been talked about
with increasing frequency. One proposal was to limit the charitable
deduction for individuals to amounts over two percent of adjusted gross
income (“AGI”). However, if medical deductions are restricted and
miscellaneous itemized deductions eliminated there may be less incentive
to peg contributions to a percentage of AGI and instead just provide for a
direct reduction of the amount that can be deducted. A restriction on the
amount of a charitable contribution deduction coupled with reduced tax
rates could have a combined impact of significantly undermining any tax
incentives for donations. With many charities still reeling from the impact
of the recession which affected their portfolios and donations and the
virtual elimination of the estate tax (only 5,600 estates per year pay a
federal estate tax), how will charities fare with yet more restrictions?
Further, as the government will undoubtedly cut programs serving those in
need, the restrictions on charitable deductions will cut fund raising results
for the organizations that will have to pick up the slack from government
programs that are eliminated. None of this bodes well for those in need.
o Deduction for certain medical expenses may be eliminated. Under current
law, you can only deduct, as an itemized deduction, medical expenses to
the extent that they exceed 7.5% of your adjusted gross income (AGI).
This restriction is in addition to the others that limit the tax benefits of
itemized deductions. That never made much sense. But, why stop when
the rules are senseless and unfair. Make ‘em worse. So starting with 2013
you’ll only be able to deduct medical expenses as an itemized deduction if
they exceed 10% of your AGI. IRC Sec. 213. As an attempt to show some
compassion, Congress provided that for folks 65+ the 7.5% rule will
remain in place until the end of 2016. Why does age alone correlate with a
better medical expenses break? What of the millions suffering at young
ages with substantial medical costs? But now it appears that even the little
that is left of the medical expense deduction may be up for reconsideration
and potentially further restriction. As the organizations helping those
living with health issues and disabilities struggle from the economy and
potential restrictions on contribution deductions, those they server will be
further penalized.
o State and local tax deduction for individuals has been talked about as a
target. If this deduction is eliminated the disparate impact on taxpayers
will be significant. See below.
o All miscellaneous itemized deductions for individuals have been proposed
for elimination. As discussed below this might drive many taxpayers to
establish entities for their business endeavors in an effort to retain some
type of deduction offset for earnings.

Overall Impact of Individual Changes:
o Consider the possible impact of several of the above changes. A 50
something socialite-executive in New York earning big bucks may lose a
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substantial charitable contribution deduction for the myriad of wonderful
local charities he or she supports, a significant state and local tax
deduction, and have to add to income a large amount for his or her health
insurance plan if a new cap on what can be excluded is provided for. The
new Medicare tax on earnings and investment income may be triggered.
Contrast this with a retiree living in Florida with a comparable income, but
no income tax. This taxpayer might face a lower marginal income tax rate,
even if the Medicare Tax on investment income is added. The bottom line
difference on these two taxpayers could be dramatic.
o High tax state fence sitters may well be pushed by the net cost of
eliminating a state income tax deduction to finally get off the fence and
move to a no/low tax state. Residency and domicile issues will become
significant planning factors.
o Use of C corporation entities to trap income, similar to the personal
holding companies (“PHCs”) of not so many years ago, may again become
popular, at the cost of huge taxes when the entities are unwound later.

Estate Tax:
o The future of the federal estate tax has not yet been the subject of much
reported discussion and the outcomes remain completely uncertain.
o The 2010 Tax Relief Act provided higher exemption amounts and lower
tax rates, but its relief is temporary and is scheduled to expire after 2012
so the issues of the estate tax have to be addressed. Many believe it is
unlikely that Congress will permit the currently scheduled return to a 55%
estate tax rate and reduction in the maximum estate tax exemption from $5
million to $1 million, but can anyone really predict what Congress will
do?
o Perhaps the Republicans will bargain the elimination of the hated AMT
and estate tax for a few points higher on the income tax to offset the
revenues and then proclaim a victory for tax simplification and new found
tax encouragement for economic growth. Gee a swap meet!
o If the estate tax is eliminated, what of the gift tax assuming its role for
most of 2010 as a backstop to the income tax? Perhaps in that role
Congress will be willing to reduce the gift tax exemption back to its prior
level of $1 million. There never seemed to be much of a constituency
fighting the gift tax. That would provide a backstop for the income tax and
may be necessary to support some of the income tax revenue projections.

Inflation Calculations:
o The “feeling” is that Congress might strive to reduce rates and deductions
so they can herald a new economic period of growth with a new simplified
tax system. But lower rates won’t necessarily raise the revenue needed to
make the numbers work. So stealth changes may become common. These
could take many forms but share the common theme that they don’t
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increase the nominal or advertised tax rates. Inflation adjustments, or
more aptly the lack thereof, might be an effective technique to permit the
government to project revenue growth while telling the taxpaying public
they’ve lowered rates.
o Many provisions in the tax Code are adjusted annually for inflation so
tinkering with the inflation calculations can slowly generate more revenue
over time as numerous tax calculations change. Technical changes with
inflation indexing are unlikely to hold much media attention or be
understood by most taxpayers, so that this might be a safe bet as Congress
seeks out every positive increment in revenue projection.
o One proposal has been discussed to use a chained-Consumer Price Index
(with the wonderful abbreviation “C-CPI-U”) for calculation purposes.
See http://www.bls.gov/cpi/super_paris.pdf. This Bureau of Labor
Statistics (“BLS”) index utilizes expenditure data in adjacent time periods
in order to reflect the effect of any substitution that consumers make
across item categories in response to changes in relative prices. The
objective of this CPI in contrast the general CPI is to provide a closer
approximation to a "cost-of- living" index. Expenditure data required for
the calculation of the C-CPI-U are available only with a time lag. That lag
might tend to reflect a lower inflation rate than the general CPI
calculation. The change in inflation indices would lower a host of tax
hurdles thereby increasing taxes, including:

Income tax brackets Congress establishes.

Standard deduction amounts and itemized deduction phase-outs if
these concepts survives the re-engineering of the tax system.

Personal exemption amount.

IRA contribution limits.
o The ways to pay for the large deficit are to raise taxes, lower spending and
inflation. Inflation will enable the government to repay current debt in
lower real dollar terms in the future. So the potential of increased inflation
in future years could make this innocuous technical change a powerful
revenue raiser.
o The 3.8% Medicare tax is scheduled to apply to net investment income
applies only if the taxpayer’s adjusted gross income (“AGI”) is over
$200,000 single ($250,000 joint) threshold amounts, but these threshold
amounts are not inflation indexed at all. Thus, over time this could result
in a much broader reach affecting a large swath of taxpayers in a manner
similar to how the reach of the AMT grew over time.
o Inflation may provide a significant sub-rosa tax increase that will grow
over time. Like the "The gift that keeps on giving," inflation adjustments
(or the lack thereof) might prove to be “The tax that keeps on taxing.”
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
Tax Credits:
o The child tax credit and the earned income credit (“EIC”) are up for
consideration as well. These might be retained, retained at reduced rates,
or otherwise modified. Perhaps some of these breaks for those on the
lower end of the wealth and income spectrum will be bargained for in
exchange for the repeal of AMT and estate tax.

Corporate Tax:
o A single, lower corporate tax rate of somewhere between 23 percent and
29 percent while promising to raise as much revenue as under the current
corporate tax system might occur as a result of restrictions of deductions
and preferential tax provisions.
o The relative rates for corporate versus individual tax rates (with
consideration to the Medicare tax on investment income), might lead to
renewed consideration to holding companies to accumulate income, the
use of FLPs to shift income to lower bracket family members, and so
forth. Might advisers begin forming limited liability companies that elect
to be taxed as C corporations?
Tax Filing Statistics and the Possible Tax Law Changes
The IRS publishes a wealth of statistical data on tax filings. See
http://www.irs.gov/taxstats/indtaxstats/article/0,,id=96981,00.html from which the
following 2009 data was taken. Considering the number of returns affected by some of
the proposed changes gives valuable insight into the impact of some of the tax laws that
might be considered.
In 2009, there were approximately 46 million individual income tax returns filed.
Consider:

About 28 million returns, more than half, had miscellaneous itemized deductions
that exceeded 2% of AGI. The elimination of these deductions will affect a host
of taxpayers. These taxpayers will have to evaluate with their advisers whether
the amount of potentially lost deductions, and their facts and circumstances,
would justify establishing an entity to receive income and pay expenses. The
purported simplification of individual returns by eliminating miscellaneous
itemized deductions will see a likely increase in Schedule C business deductions
and taxpayers forming entities.

Nearly 9 million returns reported business or professional income and about 5.5
million returns reflected pass through income or loss from partnerships or S
corporations. All these filings may increase as personal deductions are eliminated.
Perhaps more taxpayers will formalize home based and small businesses. The
formation of these new entities to garner tax benefits that would otherwise
become unavailable might be perceived as an increase in formation of businesses,
rather than the tax play it might be.
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
Of the approximately 46 million returns filed in 2009 nearly 34 million reflected a
deduction for cash contributions to charities. The restriction of contribution
deductions may affect a substantial portion of taxpayers.
Will History Repeat Itself?
Although this newsletter reflects a number of possible changes that have been bandied
about, one should keep these in perspective. President Reagan tried earnestly to disallow
many deductions and simplify our tax laws, but lobbying by many people who would
have been adversely affected by disallowing deductions succeeded in enhancing a
parallel flat tax system, the alternative minimum tax, which is despised by many for
taking away those same deductions. Attempts to simplify the system somehow always
seem just to complicate matters. One really cannot predict what Congress will do.
Conclusion
The formation of a new Joint Committee to identify tax changes might result in modest
revisions to the tax system and a perpetuation of the estate tax in its present form. There
is also the possibility for wholesale and massive change to the tax system that, as with all
significant tax law changes, will have a wide and varying impact on different clients and
the advisers who serve them. All we can do is plan with what we know and try to secure
benefits before they might be repealed.
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