Income and Transfer Tax Proposals in Administration s Fiscal Year 2016 Budget

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1 TAX ALERT Income and Transfer Tax Proposals in Administration s Fiscal Year 2016 Budget OVERVIEW On February 2, 2015, the Obama Administration released its fiscal 2016 budget. On that same date, the Treasury Department released its General Explanations of the Administration s Fiscal Year 2016 Revenue Proposals (known as the Green Book), which includes a discussion of the various tax proposals in the President s budget. This Tax Alert summarizes certain of these proposals relating to income and transfer tax. These are only proposals, some of which are new and many of which have been proposed before. Given the Republican control of Congress, there is very little likelihood of these proposals becoming law, but they nevertheless provide insight into the President s plan for tax reform. It is also possible that one or more of these proposals could be incorporated into future compromise legislation. BUSINESS TAX REFORM The budget includes a set of business proposals that purports to close loopholes and provide incentives for growth. The Administration proposes that these policies be enacted as part of business tax reform that is revenue neutral over the long run. As a result, the net savings from these proposals is generally not counted toward meeting the Administration s deficit reduction goals. However, as part of transitioning to a reformed international tax system, the plan would impose a one-time transition charge of 14% on the $1 to $2 trillion of untaxed foreign earnings that U.S. companies have accumulated overseas. The budget proposes to use this onetime savings to pay for investment in transportation infrastructure. 19% Minimum Tax on Foreign Income In general, U.S. multinational companies do not pay U.S. tax on the profits earned by their foreign subsidiaries until these profits are repatriated, at which time a credit for foreign income taxes is allowed. The opportunity to defer U.S. tax provides U.S. multinationals with an incentive to locate production overseas and shift profits abroad. In addition, the current system discourages companies from bringing low-taxed foreign earnings back to the U.S., because they would pay significant U.S. tax. The proposal would impose a per-country minimum tax on the foreign earnings of U.S. corporations and their foreign subsidiaries at a rate of 19% less 85% of the percountry foreign effective tax rate. The minimum tax would be imposed on current foreign earnings regardless of whether they are repatriated to the U.S., and all foreign earnings could then be repatriated without further U.S. tax. Accordingly, U.S. tax would be imposed either immediately or not at all (if the income were subject to sufficient foreign tax). 14% One-time Tax on Previously Untaxed Foreign Income In connection with the transition to the minimum tax, this proposal would impose a one-time 14% tax on earnings accumulated in foreign subsidiaries and not previously subject to U.S. tax. A credit would be allowed for the amount of foreign taxes associated with such earnings, multiplied by the ratio of the one-time tax to the maximum U.S. corporate tax rate for The accumulated income subject to the one-time tax could then be repatriated without any further U.S. tax.

2 Simplification and Tax Relief for Small Business There are a number of proposals relating to small business, including: Expand and permanently extend increased Section 179 expensing for small business Expand simplified accounting for small business Eliminate capital gains taxation on investments in qualified small business stock TAX REFORM FOR FAMILIES AND INDIVIDUALS These proposals include the following: Simplify and better target tax benefits for education The Green Book includes a proposal to make the earnings distributed from a 529 educational savings account taxable to the student beneficiary, but this proposal has since been withdrawn by the Obama Administration. Facilitate annuity portability this would permit a 401(k) plan to allow participants to take a distribution of a lifetime income investment through a direct rollover to an IRA if the annuity investment is no longer authorized to be held under the plan. Simplify minimum required distribution (MRD) rules this would exempt an individual from the MRD rules if the aggregate value of the individual s IRA and tax-favored retirement plan accumulations does not exceed $100,000, indexed for inflation. It would also generally treat Roth IRAs in the same manner as other tax-favored retirement accounts, and require distributions to begin shortly after age 70½. Provide a second-earner tax credit. Extend exclusion from income for cancellation of certain home mortgage debt. REFORMS TO CAPITAL GAINS TAXATION AND UPPER-INCOME TAX BENEFITS Reduce the Value of Certain Tax Deductions and Exclusions The proposal would limit the tax value of specified deductions or exclusions from AGI and all itemized deductions. This limitation would reduce the value to 28% of the specified exclusions and deductions that would otherwise reduce taxable income in the 33%, 35%, or 39.6% tax brackets. A similar limitation also would apply under the alternative minimum tax. Reform the Taxation of Capital Income: Higher Rates and Deemed Sales The proposal would increase the highest long-term capital gains and qualified dividend tax rate from 20% to 24.2%. The 3.8% net investment income tax would continue to apply as under current law, so that the maximum total capital gains and dividend tax rate would be 28%. In addition, non-charitable transfers of appreciated property generally would be treated as a sale of the property, so that the donor or deceased owner would realize a capital gain. There would be an exemption for gain on certain tangible personal property. There would also be a $100,000 per-person exclusion (indexed for inflation) of other capital gains recognized at death, which would be portable to the decedent s surviving spouse. The $250,000 per person exclusion under current law for capital gain on a principal residence would apply to all residences, and would also be portable to the decedent s surviving spouse. This deemed gain upon lifetime transfer or death would be in addition to a potential gift or estate tax. To mitigate full double taxation at death, an estate tax deduction would be permitted for any capital gains tax due at death. However, Federal tax at death could be as high as 57% for zero-basis assets. 2

3 Implement the Buffett Rule by Imposing a New Fair Share Tax The proposal would impose a new minimum tax, called the Fair Share Tax (FST), on high-income taxpayers. The tentative FST would equal 30% of AGI less a certain credit for charitable contributions. The amount of FST payable (the excess of tentative FST over regular tax) would be phased in starting at $1 million of AGI ($500,000 in the case of a married individual filing separately) and would be fully phased in at $2 million of AGI ($1 million in the case of a married individual filing separately). Tax Carried (Profits) Interests as Ordinary Income The proposal would tax as ordinary income a partner s share of income on an investment services partnership interest (ISPI), regardless of the character of the income at the partnership level. An ISPI is a carried interest in an investment partnership that is held by a person who provides services to the partnership. Accordingly, such income would not be eligible for the reduced rates that apply to long-term capital gains. Require Non-Spouse Beneficiaries of Deceased IRA Owners and Retirement Plan Participants to Take Inherited Distributions Over No More Than 5 Years Under the proposal, non-spouse beneficiaries of retirement plans and IRAs (including Roth IRAs) would generally be required to take distributions over no more than 5 years. There would be exceptions for eligible beneficiaries, including a beneficiary who is disabled or chronically ill, or an individual not more than 10 years younger than the participant or IRA owner. Limit the Total Accrual of Tax-Favored Retirement Benefits A taxpayer who has accumulated amounts within the tax-favored retirement system in excess of the amount necessary to provide the maximum annuity permitted for a qualified defined benefit plan (currently an annual benefit of $210,000 payable in a joint and survivor benefit commencing at age 62) would be prohibited from making additional contributions. Currently, the maximum permitted accumulation for an individual age 62 is approximately $3.4 million. Limit Roth Conversions to Pre-Tax Dollars The proposal would permit amounts held in a traditional IRA to be converted to a Roth IRA (or rolled over from a traditional IRA to a Roth IRA) only to the extent a distribution of those amounts would be includable in income if they were not rolled over. Therefore, after-tax amounts held in a traditional IRA could not be converted to Roth amounts. Since after-tax contributions could, in some cases, be made to Roth IRAs tax-free from a 401(k) plan, a similar rule prohibiting tax-free conversions from retirement plans is also being proposed. ESTATE AND GIFT TAX PROVISIONS Restore the Estate, Gift, and Generation-Skipping Transfer (GST) Tax Parameters in Effect in 2009 The proposal would make permanent the estate, gift and GST tax parameters as they existed in The top tax rate would be 45% and the exemption amount would be $3.5 million for estate and GST taxes, and $1 million for gift taxes. There would be no indexing for inflation. The proposal would confirm that in computing estate and gift tax, there would be no tax incurred because of decreases in the exemption amount with respect to a prior gift. Provisions for portability would be included. Require Consistency in Value for Transfer and Income Tax Purposes The proposal would impose both a consistency and a reporting requirement. The basis of property received by reason of death must equal the value of that property for estate tax purposes. The basis of property received by gift during the life of the donor must equal the donor s basis. A reporting requirement would be imposed on the executor and the donor to provide the necessary valuation and basis information to the recipient and the IRS. 3

4 Modify Transfer Tax Rules for Grantor Retained Annuity Trusts (GRATs) and Other Grantor Trusts The proposal would require that a GRAT have a minimum term of 10 years and a maximum term of the grantor s life expectancy plus 10 years. It would also include a requirement that the remainder interest have a minimum value equal to the greater of 25% of the value of the assets contributed to the GRAT or $500,000 (but not more than the value of the assets contributed). In addition, the proposal would prohibit any decrease in the annuity during the GRAT term, and would prohibit the grantor from engaging in a tax-free exchange of any asset held in the trust. If a person who is a deemed owner under the grantor trust rules of a trust engages in a transaction with the trust that constitutes a sale or exchange that is disregarded for income tax purposes, then the portion of the trust attributable to the property received by the trust (including all income, appreciation and reinvestments), net of the amount of consideration received by the person, will be subject to (1) estate tax as part of the gross estate of the deemed owner, (2) gift tax at any time during the owner s life when grantor trust treatment is terminated, or (3) gift tax to the extent any distribution is made to another person. The proposal would not change the treatment of any trust that is already includable in the grantor s gross estate. Limit Duration of Generation-Skipping Transfer (GST) Tax Exemption The proposal would provide that on the 90 th anniversary of the creation of a trust, the GST exemption allocated to the trust would terminate. Since contributions to a trust from different grantors are deemed to be held in separate trusts, each separate trust would be subject to the 90-year rule, measured from the date of the first contribution by the grantor of that separate trust. Pour-over trusts and trusts created by decanting will generally be deemed to have the same date of creation as the initial trust. Modify GST Tax Treatment of Health and Education Exclusion Trusts (HEETs) Current law excludes any transfer from GST tax which, if made during life by an individual, would be eligible for the gift tax tuition or medical exclusion. The proposal would provide that the exclusion applies only to a payment by a donor directly, and not to trust distributions, even if for those same purposes. Simplify Gift Tax Exclusion for Annual Gifts The proposal would eliminate the present interest requirement for gifts that qualify for the gift tax annual exclusion. Instead, there would be a new category of transfers (without regard to the existence of any withdrawal rights), and would impose an annual limit of $50,000 (indexed for inflation) per donor on the donor s transfers of property within this new category that would qualify. This new $50,000 per-donor limit would not provide an exclusion in addition to the annual per-donee exclusion; rather, it would be a further limit on those amounts that otherwise would qualify for the annual per-donee exclusion. Therefore, a donor s transfers in the new category in a single year in excess of a total amount of $50,000 would be taxable, even if the total gifts to each individual donee did not exceed $14,000. OTHER In total, the Green Book contains hundreds of tax proposals, some intended to provide tax relief, some to generate additional revenue and others to ease administrative burdens. Below are several other proposals worthy of simply noting: Change the due date for calendar year partnerships from April 15 to March 15 Simplify the contribution base for charitable deductions and extend the carryover of excess contributions from 5 years to 15 years 4

5 Provide tax relief for certain accidental dual citizens Require the cost of any stock held long-term that is sold or otherwise disposed of to be determined under an average cost method Repeal special income tax exclusion for appreciation on company stock held in certain retirement plans for those under age 50 at the end of 2015 the so-called Net Unrealized Appreciation exclusion. CONCLUSION As noted, the income and transfer tax items discussed in this Alert are only proposals. Although it does not appear likely that these will become law, it is possible that one or more of these proposals might be incorporated in future legislation. It is therefore important to follow these developments in order to be able to make an informed decision whether any action may be advisable. -- National Wealth Planning Strategies Group Any examples are hypothetical and are for illustrative purposes only. This is not a solicitation, or an offer to buy or sell any security or investment product, nor does it consider individual investment objectives or financial situations. Neither U.S. Trust nor any of its affiliates or advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decision. While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. U.S. Trust operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC Bank of America Corporation. All rights reserved. NWPSTA