What does the re-election of President Obama mean for you? Well, it depends. There is a great deal of confusion out there, most of which finds its genesis in over-simplified scare tactics and lack of knowledge by those who are supposed to be “in the know.” What is certain is that regardless of who won yesterday, an epic game of “Chicken” would ensue. Congress and the President are facing the “fiscal cliff.” With that, they will face the sunset of every Bush-era tax decrease. Many may believe that President Obama would be happy with a sunset of the Bush Tax Cuts. However, if the sunset occurs, it will raise taxes on almost every American. On the other hand, the sunset achieves most of what the President wants. The Republicans believe strongly that the qualified dividends rate, a low capital gains rate, and a lower corporate rate all serve as positive economic drivers.
The President, and Congress for that matter, must recognize that the poker playing of the past two years cannot continue and that blaming all policy errors on the other party is no longer an option. What does this mean for us? It means that the President, the Senate and the House will play a three way game of chicken that none can lose. For instance, if the sunset does occur, then the President, who has the mandate to lead, would have failed in his promise to not raise taxes on the middle class. If the sunset occurs, the House will prove itself to be only a body of opposers and not reformers. If the Sunset occurs, the Senate will leave the impression that it is not an independent body, but instead a tool of the executive branch. Accordingly, all three have a vested interest in dropping the polarizing principles of the past two years and working on real negotiations for tax and budgetary reforms.
With this in mind, what are the things that the respective parties cannot allow to occur? The Democrats cannot allow the sunset to occur. However, they can use it as a major club against their rivals. The American people seem to have bought the Republican argument that it was the opposition party. That was great two years ago. However, now the stakes are higher, and if a deal is not reached, the opposition will take the blame. This gives the President a tremendous amount of leverage and actually gives the Republicans more to lose. The Republicans may focus on the qualified dividends rate, a low capital gains rate, and a lower corporate rate. If this occurs, other taxes, such as the estate and gift taxes, will see reform, but somewhat hollow. Although the estate tax is projected to bring in between $100 billion and $500 billion over the next decade, it affects a very small minority of Americans. It is my prediction, that most clients need to be more concerned with income tax planning.
With regard to income taxes, the current top rate is 35%. If the sunset occurs, this will rise to 39.6%. Obama generally supports the sunset rate of 39.6%. He also supports doing away with the qualified dividends tax rates of 15%. The “Obamacare” tax on investment income (3.8%) would raise the qualified dividend tax rate from 15% to 43.4%. That affects wealthy seniors quite harshly given their investments support their lifestyle with investment income. In addition, Obama has proposed to increase the capital gains rate from 15% to 20%. This means that you would be wise to harvest gains this year, and to consider accelerating income, especially investment income, in 2012.
On to estate and gift taxes. If the sunset occurs, the estate and gift tax exemptions will fall to $1 million (actually over $1.3 million when indexed to inflation) and the highest marginal rates rise to 55%. This is a huge increase from the current estate and gift exemption of $5.12 million and the current highest marginal rate of 35%. President Obama has proposed an exemption of $3.5 million and a highest marginal tax rate of 45%. He has also proposed to ban many types of planning that are commonly used to leverage these exemptions. On the President’s hit list include: Grantor Trust Transactions, Discounts for Lack of Marketability and Control, Fractional Interest Discounts, Qualified Personal Residence Trusts, and “Zeroed Out” Grantor Retained Annuity Trusts. Negotiation on the estate and gift tax is sure to be one thing on the surface and another in reality. For instance, most Americans are not focused on this tax. Some estimate that only 1 out of 15,000 estates pay the estate tax. Therefore, there is not a lot of focus on this tax by the public. However, most members of Congress are affected by the tax. All in all, it is doubtful that any Republican (other than those in the super-red states) is willing to “die in the estate tax ditch” when most of what is at stake is not understood by the average American. With a high exemption for almost a decade, the Republicans can’t rely on Mom and Pop fighting against the “Death Tax.” Therefore, there is a strong probability that as long as the estate tax exemption is high enough, the President may win on this tax, even if it looks on the surface as if the Republicans won the battle.
So, what should clients do now to plan for the estate tax? Well, a very general rule of thumb is that if you are not willing to give away over $1 million in assets (each spouse) then you probably need not lose sleep between now and December 31, 2012. Also, if you are not willing to give away $5 million ($10 million combined for husband and wife), or at least have $5 million “disappear” from your grasp and pass to the kids at the first spouse’s death, then there is not much you can do to get the benefit of the current high exemptions. Remember, using the full $5 million exemption this year most likely means only that you can shelter future appreciation and income on those assets from inclusion in your estate for estate tax purposes. If you are willing to make a large gift (say, over $1 million), then you are prudent to consider acting now to attempt some discounted transfers. This is also a fantastic time to make gifts to generation skipping trusts because that exemption is set to be cut along with the gift and estate tax exemptions. However, the time is running short, and as we have warned for months, these things cannot be done at the last minute.
For some, the end of 2012 brings serious possibilities and opportunities, but for most, it is a good time to take a long hard look at your income tax planning.