Ducking Higher Taxes

It’s been about a year since the state of Oregon raised its income tax on wealthy residents by 2%, and now the treasury has admitted they collection significantly less than expected. Not surprising, since most new taxes raise far less revenue than predictions.

The Wall Street Journal reports:

In 2009 the state legislature raised the tax rate to 10.8% on joint-filer income of between $250,000 and $500,000, and to 11% on income above $500,000. Only New York City's rate is higher. Oregon's liberal voters ratified the tax increase on individuals and another on businesses in January of this year, no doubt feeling good about their "shared sacrifice."

Congratulations. Instead of $180 million collected last year from the new tax, the state received $130 million. The Eugene Register-Guard newspaper reports that after the tax was raised "income tax and other revenue collections began plunging so steeply that any gains from the two measures seemed trivial."

One reason revenues are so low is that about one-quarter of the rich tax filers seem to have gone missing. The state expected 38,000 Oregonians to pay the higher tax, but only 28,000 did. Funny how that always happens. These numbers are in line with a Cascade Policy Institute study, based on interstate migration patterns, predicting that the tax surcharge would lead to 80,000 fewer wealthy tax filers in Oregon over the next decade.

The tax wasn't enacted into law until June 2009 but was retroactively applied to January 1, 2009. So for the first half of the year wealthy Oregon residents weren't able to take steps to avoid the tax ambush because they didn't see it coming. This suggests that a bigger revenue loss from tax mitigation strategies will show up on tax return data in 2010 and 2011. The Revenue Office has already downwardly revised tax collection projections for the first three years by one-third.

The biggest loss of revenues came from capital gains receipts. The new 11% top tax rate applies to stock and asset sales, which means that Oregonians now pay virtually the highest capital gains tax in North America. Instead of $3.5 billion of capital gains in 2009, there was only $2 billion to tax—43% less. Successful entrepreneurs like Nike owner Phil Knight don't get rich by being fools with their money. They don't sell tens of millions of dollars of assets when capital gains taxes go up.

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Mad Men and Taxes (No Spoilers!)

From The Tax Foundation:

If you haven't watched last night's season four finale of Mad Men, I won't give anything away other than something you already knew: Don Draper is selling his Ossining, NY house where he's been letting his ex-wife and her new husband live. His accountant helps him figure out the sale, to which Don grouches, "What's the capital gains tax, 48%?"

Not quite, Don, although the comment should make viewers aware of the higher tax rates of 1965 compared to today. Don's probably got income taxes in his head: the federal income tax in 1965 topped out at 70% on income over $100,000, having been reduced from 90% by the Kennedy-Johnson tax cut of 1964. (Today it's 35%, and scheduled to go to 39.6% on January 1, 2011.) Don Draper is probably in that top tax bracket, since he has the cash on hand to lend the firm $150,000 as he just did. (Not a loss, an investment!)

Today, the long-term capital gains tax is 15% (scheduled to go to 20% on January 1, 2011); Don's probably paying about twice that. Since 1997, much of one's capital gain from the sale of a home is excluded from tax. (This change has been suggested as a contributing factor to the home-flipping phenomenon and the housing crash.) Before 1997, the exclusion was much smaller and you had to buy another home within a certain timeframe. This generous provision didn't exist for Don Draper; it didn't come about until 1978.

Back in 1965, figuring out capital gains tax was more complicated. This Congressional Research Service paper (PDF) summarizes the fiddling with capital gains tax, beginning in 1921 when they were taxed at a flat 12.5% rate. In 1938, a big change occurred where you either excluded half of your gain but paid full tax on the other half, or you paid a flat 15% on the whole thing. After 1942 (until 1969), the rule was the same but the flat rate was 25%. So Don could either pay 35% (70% on half of the gain) or 25%. Plus New York taxes of 10%, with some of that deductible. I'm sure that's what his accountant told him after his "48%" line.

Don has good timing, though. In 1969, the alternative flat 25% was eliminated for high-earners, bringing the capital gains rate to 35%. The new alternative minimum tax (AMT) limited the value of deductions, capital losses were limited, and a war surtax was enacted. The long-term capital gains tax began to fall again in the late 1970s and again under Reagan, rose in the 1986 tax reform (as a separate, flat rate), then was cut in 1997 and again as part of the Bush tax cuts. It currently stands at a flat 15% rate.

No Estate Tax Due in 2010 but Beware of Cap Gains

As it gets closer and closer to the end of 2010, experts are beginning to wonder if Congress will make any changes to the estate tax or not. As you probably already know, there is no estate tax for people who pass away this year. Many had expected that Congress would impose a retroactive tax, but with only a few months left in 2010 it is unclear if legislators will tackle the estate tax before the end of the year. However, according to Boston.com that does not mean that large estates get a "free pass" this year.

Things might even be more complicated. That is because a "carryover basis" rule is in effect this year. In previous years, people inheriting property enjoyed a "step up" in basis. That is, the basis of the property they inherited was generally the value of the property when the previous owner died. In 2010 however, people inheriting property also inherit the decedent's tax basis. This means that if you are inheriting property this year, you have to hope the decedent kept very detailed records.

The executor administering the estate can, however, increase the basis of the assets by $1.3M plus any expiring loss carryforwards and the amount by which any asset is worth less than its original cost. The practical implication of this $1.3M is that any estate with untaxed appreciation of up to $1.3M will escape tax free. However, the executor is responsible for designating those assets that will receive the $1.3M. If he or she doesn't pick the assets you inherited, you could find yourself owing taxes upon the sale of the inherited property. However, the good news is that the gains will be taxed at capital gains tax rates.

It is important to note that assets that pass to a surviving spouse are entitled to another $3M in untaxed apprection so it is still possible to shelter as much as $4.3M in appreciation. If you are the executor of an estate for someone who died in 2010, be sure to seek the assistance of a CPA because the rules can be very complicated and you don't want to make a costly error. And if you inherit assets from someone who died in 2010 be sure you know the basis of the asset and if you might owe capital gains taxes be careful to time the sale to minimize any taxes.

Fund manager tax bill could hit House floor Friday

There will be plenty of debate amongst lawmakers tonight regarding increasing taxes on the profits earned by investment fund managers. This measure isn’t a stranger to the House; it’s been brought up for four years now, but it has usually died in the Senate. However, this year might be different; the intense need to increase revenue and the “public anger at the financial industry” right now might just give the measure the momentum it needs this time.

The tax change would impact private equity, venture capital, real estate fund and hedge fund managers. Basically, profits earned by fund managers would be treated as ordinary income subject to a 35 percent rate instead of the current 15 percent rate currently taxed as capital gains. (http://www.reuters.com/article/idUSTRE64C5IU20100513). This fund manager tax increase is supposed to help pay for a broader package of legislation that would extend jobless benefits and renew expired tax breaks.

Read more of the article here.

Changes in Federal Revenues and Tax Rates on Capital Gains

A few days ago, The Congressional Budget Office published a letter on recent changes in federal revenue and the tax rates on capital gains. I have included a small quote from the letter courtesy of the Tax Prof, but you can download the full PDF letter by clicking here.

As a result of the economic downturn, CBO expects revenues from individual and corporate income taxes in 2009 to account for about 50% of total revenue, below the average of about 57% over the past five years. ... CBO expects that when complete information for the year is available, it will show that receipts from corporate income taxes fell substantially in 2009, to about 1.0% of GDP, less than half of the 2.1% of GDP in 2008. The decline stems from a sharp drop in taxable corporate profits.

In answering your questions about how the pending changes in the taxation of capital gains tax will affect revenues and behavior, it is useful to consider how the pending increase compares with previous changes. The top tax rate on most long-term gains was reduced from around 35% to 28% in 1978 and 1979, and was reduced to 20% in 1981. It was raised to 28% in 1987, reduced to 20% again in 1997, and reduced to 15% in 2003. The increase pending in 2011 is to 18% for some gains held over five years and to 20% for most other long-term gains. Thus, the pending tax change is well within the range of changes experienced in the last 30 years, and we have incorporated the impacts from those historical changes into our modeling of the effects of the upcoming law change.

Converting an IRA into a Roth? How's Your Crystal Ball?

Ron Lieber of the New York Times recently published an article discussing the unpredictable future of Roth IRAs. At one point, Lieber even proposes the possibility of taxes on withdrawals from Roth IRAs. Lieber predicts that “at the most extreme end, the federal government might try to tax the earnings on a Roth after all, say through the capital gains tax, which is currently at 15 percent for long-term gains but could go up in the next few years.”

You’ll be hearing a lot in the next six months about Roth Individual Retirement Accounts — but not as much as you should about a long-term threat that hangs over them.

Starting Jan. 1, you’ll be able to take a regular IRA, say, one that you have in a brokerage account after having rolled an old 401(k) into it, and turn it into a Roth. You’ll be able to do this no matter how much money you make, though you’ll have to pay income taxes at your current rate on whatever you move. Currently, you can’t make the conversion at all if your household has more than $100,000 in modified adjusted gross income. (That’s a technical Internal Revenue Service term, which it defines in Publication 590, available on its Web site).

Why would you want to make such a swap? Because you think you or your heirs could end up with more money over the long haul by investing in a Roth instead of a regular IRA.

With a Roth IRA, you pay no taxes on your earnings in most instances when you take money out; distributions from regular IRA’s are taxable the same way that income is, though the basic IRA does offer a tax deduction when you first deposit money into the account. The Roth offers no such deduction when you contribute money to it.

So if you think your tax rate will be higher during retirement than it is now, say if you’re fairly young for instance, making the conversion early in 2010 looks sensible.

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Obama Announces Revised Tax Plan

Presidential hopeful, Sen. Barack Obama released a new version of his tax plan. Possibly due to negative media attention, Obama has decreased his ambitions for a large capital gains tax increase. Instead of doubling the capital gains and dividends tax rate, his new plan seeks to only raise it to 20% for families making over $250,000. Below is the summary of his new plan, but you can download the full version at BarackObama.com.

“Barack Obama’s tax plan delivers broad-based tax relief to middle class families and cuts taxes for small businesses and companies that create jobs in America, while restoring fairness to our tax code and returning to fiscal responsibility. Coupled with Obama’s commitment to invest in key areas like health, clean energy, innovation and education, his tax plan will help restore bottom-up economic growth that helps create good jobs in America and empowers all families achieve the American dream.

Obama’s Comprehensive Tax Policy Plan for America will:

• Cut taxes for 95 percent of workers and their families with a tax cut of $500 for workers or $1,000 for working couples.
• Provide generous tax cuts for low- and middle-income seniors, homeowners, the uninsured, and families sending a child to college or looking to save and accumulate wealth.
• Eliminate capital gains taxes for small businesses, cut corporate taxes for firms that invest and create jobs in the United States, and provide tax credits to reduce the cost of healthcare and to reward investments in innovation.
• Dramatically simplify taxes by consolidating existing tax credits, eliminating the need for millions of senior citizens to file tax forms, and enabling as many as 40 million middle-class Americans to do their own taxes in less than five minutes without an accountant.

Under the Obama Plan:

Middle class families will see their taxes cut and no family making less than $250,000 will see their taxes increase. The typical middle class family will receive well over $1,000 in tax relief under the Obama plan, and will pay tax rates that are 20% lower than they faced under President Reagan. According to the Tax Policy Center, the Obama plan provides three times as much tax relief for middle class families as Sen. John McCain’s plan.

Families making more than $250,000 will pay either the same or lower tax rates than they paid in the 1990s. Obama will ask the wealthiest 2% of families to give back a portion of the tax cuts they have received over the past eight years to ensure we are restoring fairness and returning to fiscal responsibility. But no family will pay higher tax rates than they would have paid in the 1990s. In fact, dividend rates would be 39 percent lower than what President Bush proposed in his 2001 tax cut.

Obama’s plan will cut taxes overall, reducing revenues to below the levels that prevailed under Ronald Reagan (less than 18.2 percent of GDP). The Obama tax plan is a net tax cut – his tax relief for middle class families is larger than the revenue raised by his tax changes for families over $250,000. Coupled with his commitment to cut unnecessary spending, Obama will pay for this tax relief while bringing down the budget deficit.”

Study Shows Capital Gains Increase Won’t Impact Investing

A study from Bloomberg has come out claiming that affluent investors are not likely to alter their investments if the capital gains tax rate were increased by a small margin. This study goes against claims from Sen. John McCain who has claimed that it would stop upper income Americans from investing.

According to the Bloomberg and Los Angeles Times investor poll, “69 percent of upper-income investors say a raise in the capital gains tax to 20 percent from 15 percent wouldn't cause them to sell assets they would otherwise hold.”

“The poll of 2,208 adults nationwide included 607 investors with household incomes of at least $100,000 and was conducted May 1 to May 8. The investor group has a margin of sampling error of plus or minus 4 percentage points.”

The nationwide poll has a large sample size, and was conducted by two credible news outlets. However, the poll does not mention how investors would react to Obama’s plan to nearly double the Capital Gains tax rate. I assume that it would be a lot lower then 69 percent.