TAX UPDATE: OBAMA ADMINISTRATION S FISCAL YEAR 2017 BUDGET AND GREENBOOK

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1 Insights on... WEALTH PLANNING TAX UPDATE: OBAMA ADMINISTRATION S FISCAL YEAR 2017 BUDGET AND GREENBOOK Explanation of the Administration s FY 2017 budget and revenue proposals Suzanne L. Shier, Wealth Planning Practice Executive and Chief Tax Strategist/Tax Counsel February 2016 On February 9, 2016, the Administration released the Budget of the United States Government, Fiscal Year 2017 ( Budget ), accompanied by the Treasury Department s General Explanations of the Administration s Fiscal Year 2017 Revenue Proposals ( Greenbook ). In this Tax Update, we provide an overview of select proposals from the Administration s FY 2017 Budget and Greenbook that are focused on a simpler and more efficient tax system. Comprehensive tax reform likely will not be sorted out until after the 2016 Presidential Elections. Only time will tell what the effect will be of the Administration s proposals. With the 2016 Presidential election season already well underway, there have been flurries of calls for budget and tax reform by the President, Congress and the 2016 Presidential hopefuls. It was not that long ago December 18, 2015 that Congress passed and the President signed into law the Protecting Americans from Tax Hikes Act of 2015 (commonly referred to as the PATH Act) and spending bills to fund the government for its 2016 fiscal year. The PATH Act permanently extended a number of individual and business tax provisions that were typically extended for one year, every year, known as tax extenders. The FY 2017 Budget continues to build on the investments and reforms proposed in the President s previous seven budgets. The FY 2017 Budget aims to reform and simplify tax incentives that help low- and middle-income families afford child care, pay for college and save for retirement, while expanding tax benefits that support and reward work. These spending proposals come at a significant cost, $4.1 trillion for FY The FY 2017 Budget proposes to pay for this spending by reforming the system of capital gains taxation and by imposing a new fee on certain financial firms. The Budget proposes to reduce the deficit by curbing certain high-income tax benefits. Additionally, the Budget includes proposals and reforms to the business and international tax systems. The tax revenues from these proposed changes would total more than $2.6 trillion for fiscal 2017 through Following is an overview of select tax proposals outlined by the FY 2017 Budget and Greenbook that are of particular interest to taxpayers, including: Upper-income tax benefit reforms; Reforms to capital gains taxation; Modifications to gift, estate and generation-skipping transfer tax provisions; Reforms to the U.S. business and international tax systems; and The introduction of a $10.25 per barrel oil fee. The Administration s FY 2017 Budget, if passed by Congress, would apply for the fiscal year beginning on October 1, Hearings in Washington, D.C., on the proposed budget are ongoing, and we will provide updates as they occur. INDIVIDUAL INCOME TAX PROVISIONS The FY 2017 Greenbook propose a number of middle class and pro-work reforms to the Internal Revenue Code ( Code ). Of the individual revenue proposals in this year s northerntrust.com Insights on...wealth Planning 1 of 7

2 Greenbook, six are entirely new, nine reflect certain policy changes, 15 have been modified or combined from proposals made for FY 2016 and 115 are substantially the same from last year. UPPER-INCOME TAX BENEFIT REFORMS AND CAPITAL GAINS TAXATION Reduce the Value of Certain Tax Expenditures The FY 2017 Greenbook again includes a proposal to limit the tax value of certain expenditures, specific deductions or exclusions from adjusted gross income and all itemized deductions. The proposal seeks to cap the tax value of these items to 28% for taxpayers in the 33%, 35% and 39.6% tax brackets, with a corresponding provision under the alternative minimum tax. Implement the Buffet Rule by Imposing a Fair Share Tax Again this year, the FY 2017 Greenbook includes the Buffett Rule, which would impose a minimum Fair Share Tax on high income taxpayers. This proposal ensures that high-income taxpayers cannot use deductions and preferential tax rates on capital gains and qualified dividends to pay a lower effective rate of tax. The tax is intended to ensure that very high income taxpayers pay tax equivalent to no less than 30% of their income, adjusted for charitable contributions. Tax Carried (Profits) Interests as Ordinary Income Changing the income taxation of carried (profits) interests of partners in investment partnerships is once again suggested in the FY 2017 Greenbook. Under current law, a partner may receive an interest in the future profits of a partnership in exchange for services. Part or all of the associated income may be characterized as capital gain and taxed to the partner accordingly. The proposal would tax as ordinary income a partner s share of income on an investment service partnership interest ( ISPI ) regardless of the character of the income at the partnership level. In addition, the partner would be required to pay self-employment taxes on such income, and the gain recognized on the sale of an ISPI that is not attributable to invested capital would generally be taxed as ordinary income, not as capital gain. Reform the Taxation of Capital Income Under current law, capital gains are taxable only upon the sale or other disposition of an appreciated asset, and are generally taxed at lower income tax rates than earned income, such as wages. In addition, when an appreciated asset is held by a decedent at death, the recipient receives a basis in that asset equal to its fair market value at the date of the decedent s death. As a result, the appreciation accruing during the decedent s life on assets that are still held by the decedent at death is never subjected to income tax (but may be subject to estate tax). The Administration s proposal eliminates the capital gains step-up in basis at death with protections for middle-income taxpayers, surviving spouses, small businesses and charities. Among other provisions, there would be a $100,000 per-person exclusion of gains recognized at death. The proposal also raises the top tax rate on capital gains and qualified dividends from 20% to 24.2%, or 28% including the 3.8% net investment income tax ( NIIT ). Rationalize Net Investment Income and Self-Employment Contributions Act (SECA) Tax and the NIIT Building off of last year s proposal to conform SECA taxes for professional service businesses, this year s proposal further tightens alignment in the SECA tax and the 3.8% northerntrust.com Insights on...wealth Planning 2 of 7

3 NIIT. Under this proposal, all active business income would be subject to either the NIIT or SECA tax, so choice of business entity would not be a strategy for avoiding these taxes. All the revenues from the NIIT would be deposited in the Medicare Trust Fund. This proposal would also rationalize the taxation of professional services businesses by treating individual owners or professional service businesses taxed as S corporations or partnerships as subject to SECA taxes in the same manner and to the same degree. The proposal would ensure that all trade or business income of high-income taxpayers is subject to the additional 3.8% NIIT by amending the definition of net investment income to include gross income and gain from any trades or businesses of an individual that is not otherwise subject to employment taxes. Area of Focus Reduce the value of certain tax expenditures Buffett Rule Fair Share Tax Reform taxation of capital income Tax carried (profits) interests as ordinary income Rationalize NIIT and SECA Tax Current Law Some phase-outs for high-income taxpayers but no cap None Fair market value basis adjustment on property transferred at death; top tax rate on capital gains and qualified dividends is 20%, or 23.8% including the NIIT May be taxed as capital gain and not subject to selfemployment tax Active owners of pass-through businesses are treated differently according to the legal form of their ownership and the legal form of the payment that they receive Greenbook Proposal Cap value at 28% for high-income taxpayers in addition to current phase-outs 30% of adjusted gross income with charitable credit; Fair Share Tax Eliminate the basis adjustment at death; increase the top tax rate on capital gains and qualified dividends to 24.2%, or 28% including the NIIT Tax as ordinary income and subject to self-employment tax Ensure that the 3.8% NIIT is paid by amending the definition of net investment income to include gross income and gain from any trades or businesses of an individual that are not otherwise subject to employment taxes Estimated Revenue Impact FY FY $31.1 $645.5 $7.85 $37.5 $14.8 $235.2 $2.62 $19.3 $16.7 $271.7 northerntrust.com Insights on...wealth Planning 3 of 7

4 CAPITAL GAINS TAXATION AND UPPER-INCOME TAX BENEFIT REFORMS The FY 2017 Greenbook includes a number of modifications to the current gift, estate and generation-skipping transfer ( GST ) taxes, most of which have appeared in prior years proposals. Restore the Transfer Tax Parameters in Effect in 2009 Currently, the gift, estate and GST taxes are unified, with the highest marginal transfer tax rate at 40% and the applicable exclusion and exemption amounts for gift, estate and GST tax purposes set at $5 million, adjusted annually for inflation ($5.45 million in 2016). The proposal makes permanent the gift, estate and GST tax parameters as they applied during The top tax rate would be 45% and the exclusion amount would be $3.5 million per person for estate and GST taxes, and $1 million for gift taxes. The proposal, if enacted, would be effective for the estates of decedents dying, and for transfers made, after December 31, Expand Requirement of Consistency in Value for Transfer and Income Tax Purposes New for the FY 2017 Greenbook, the Administration s proposal would expand an estate tax basis consistency provision the Administration offered last year that ultimately was enacted, with changes, in the 2015 Surface Transportation and Veterans Health Care Choice Improvement Act. The law, enacted July 31, 2015, requires generally that, for income tax purposes, the recipient s initial basis in property received from a decedent s estate be consistent with the property values reported on the decedent s estate tax return. The proposal would also subject property qualifying for the marital estate tax deduction to a consistency requirement in the law if an estate is large enough that a return is required to be filed for estate tax purposes even though that property does not increase the estate's federal estate tax liability. The proposal would also apply to property transferred by a gift, provided that the gift is required to be reported on a federal gift tax return. Simplify the Annual Gift Tax Exclusion The Greenbook again includes a proposal to eliminate the present interest requirement for gifts that qualify for the annual gift tax exclusion and to place an aggregate per donor limitation on certain types of annual exclusion gifts. The proposal would eliminate the present interest requirement for gifts to qualify for the annual gift tax exclusion, and would impose an annual limit of $50,000 per donor on gifts in a new category of transfers. Included in the new category are certain transfers in trust, transfers of interests in pass-through entities, transfers of interests subject to a prohibition on sale and other transfers of property that, without regard to withdrawal, put or other such rights in the donee, cannot immediately be liquidated by the donee. Therefore, even if individual gifts do not exceed the annual exclusion amount, a donor s collective gifts within the new category in excess of $50,000 in a single year will be taxable. Modify Transfer Tax Rules for Grantor Retained Annuity Trusts (GRATs) and Other Grantor Trusts GRATs and other grantor trusts are frequently used for transferring wealth while minimizing the gift and income tax cost of transfers. In both cases, the greater the post-transaction appreciation, the greater the transfer tax benefit achieved. The Administration proposes to add the following requirements for GRATs: (1) the GRAT must have a minimum term of ten years and a maximum term of ten years more than the annuitant s life expectancy; (2) the northerntrust.com Insights on...wealth Planning 4 of 7

5 remainder interest in the GRAT at the time of creation must have a minimum value equal to 25% of the value of the assets contributed to the GRAT or $500,000 (but not more than the value of the assets contributed), whichever is greater; (3) there must be no decrease in the annuity during the GRAT term; and (4) no tax-free exchange of any GRAT asset with the grantor is permitted. Coordinate Certain Income and Transfer Tax Rules Applicable to Grantor Trusts The grantor trust income tax rules are separate and independent from the gift, estate and GST tax rules, but may be used under certain conditions to establish what is commonly referred to as an intentionally defective grantor trust or IDGT. An IDGT is treated as owned by the grantor for income tax purposes, but not for transfer tax purposes. Thus, transactions between the grantor and the IDGT are ordinarily ignored and tax-free for income tax purposes. The proposal provides that, if a person who is a deemed owner of all or a portion of a trust engages in a transaction with that trust that constitutes a sale, exchange, or comparable transaction that is disregarded for income tax purposes due to the application of the grantor trust rules, then the portion of the trust attributable to the property received by the trust in that transaction will be: (1) subject to estate tax as part of the deemed owner s gross estate; (2) subject to gift tax at any time during the deemed owner s life when his or her treatment as a deemed owner of the trust is terminated; and (3) treated as a gift by the deemed owner to the extent any distribution is made to another during the deemed owner s life. The transfer taxes would be payable from the trust. Limit the Duration of GST Tax Exemption Many states currently allow trusts created subject to the law of those jurisdictions to continue in perpetuity. As a result, the transfer tax shield provided by the GST exemption effectively has been expanded over the years from trusts funded with $1 million (the exemption at the time of enactment of the GST) and a maximum duration specified by law, to trusts funded with $5.45 million in 2016 and continuing (and growing) in perpetuity. Again this year, the Greenbook proposal would limit the GST exemption and provide that, on the 90th anniversary of the creation of a trust, the GST exclusion allocated to the trust would terminate. The proposal provides an exception intended to permit an incapacitated beneficiary s distribution to continue to be held in trust without incurring GST tax on distributions to the beneficiary as long as the trust is to be used for the sole benefit of the beneficiary and any trust balance remaining on the beneficiary s death will be included in the beneficiary s gross estate for Federal estate tax purposes. The other rules regarding the taxation of multiple skips would continue to apply and would be relevant in determining when a taxable distribution or taxable termination occurs after the 90th anniversary of the trust. northerntrust.com Insights on...wealth Planning 5 of 7

6 Area of Focus Restore the transfer tax parameters in effect in 2009 Expand requirement of consistency in value for transfer and income tax purposes Simplify annual gift tax exclusion Modify certain income tax and transfer tax rules for GRATs and other grantor trusts Limit duration of GST tax exemption Current Law $5 million gift, estate and GST tax exclusion/exemption, indexed for inflation with portability ($5.45 million in 2016); Gifts, estates and GSTs taxed at maximum tax rate of 40% The value of property a beneficiary receives from an estate must be consistent with the property values reported on the estate tax return No current limitation regarding a donor's ability to make annual exclusion gifts ($14,000 per donee in 2016) No minimum or maximum annuity term; (perceived) lack of coordination between income and transfer tax consequences of certain grantor trusts Determined under applicable state law Greenbook Proposal $3.5 million lifetime exclusion for estate and GST taxes; $1 million lifetime exclusion for gift tax; Gift, estate and GSTs taxed at 45% maximum rate Consistency requirement expanded to apply to property qualifying for the estate tax marital deduction and to property transferred by gift, provided the gift is required to be reported on a federal gift tax return Limit a donor's ability to make annual exclusion gifts to $50,000 within a new category of transfers Minimum 10-year annuity term; maximum term of the life expectancy of annuitant plus 10 years; subject certain grantor trusts and transactions to gift and estate tax For federal estate tax purposes, limit to 90 years Estimated Revenue Impact FY FY $0 $201.8 $0 $1.7 $0 $3.7 $0 $19.2 Negligible effect northerntrust.com Insights on...wealth Planning 6 of 7

7 SELECT ADDITIONAL REVENUE PROVISIONS One of the few new additions, the Administration s FY 2017 Greenbook proposes to impose a $10.25 fee on a per barrel equivalent of crude oil. The fee would be collected on domestically produced as well as imported petroleum products. Exported petroleum products would not be subject to the fee and home heating oil would be temporarily exempted. The $10.25 per barrel fee (adjusted for inflation from 2016) would be phased in evenly over a five year period beginning with FY The FY 2017 Greenbook address a number of tax provisions aiming to reform and modernize the U.S. business and international tax systems. Included are a proposed 19% minimum tax on foreign income of multinational corporations and a 14% one-time tax on previously untaxed foreign income. The 14% tax would be payable ratably over five years. These provisions are expected to generate an additional $60 in FY 2017, $649 from FY 2017 to FY The Greenbook also addresses the issue of tax-related identity theft. The incidence of identity thieves using stolen Social Security numbers to file false or fraudulent income tax returns and claims for refund has increased markedly in recent years. The proposal would increase the criminal sanctions and civil penalties imposed for tax fraud. The FY 2017 Budget and Greenbook noticeably omit mention of one topic that has been in the Administration s proposals from FY 2010 to FY 2016 Social Security. Although previously recognizing that Social Security is indispensable to workers, the disabled, seniors and survivors, this year s Budget and Greenbook make no specific proposals to ensure that Social Security funds are not depleted, as they are forecasted to be in 2033 if no changes are made to the tax or benefit provisions before then. However, the FY 2017 Budget and Greenbook propose to fund the Medicare Hospital Insurance Trust Fund with the revenue generated by the 3.8% NIIT. Tax reform and simplification have been topics of ongoing discussion in Washington for years. Depending on the outcome of the 2016 Presidential election, we may finally see some reformation, simplification and modernization of the U.S. tax code in FOR MORE INFORMATION As a premier financial firm, Northern Trust specializes in life-driven wealth management backed by innovative technology and a strong fiduciary heritage. For more than 125 years we have remained true to the same key principles service, expertise and integrity that continue to guide us today. Our Wealth Planning Advisory Services team leverages our collective experience to provide financial planning, family education and governance, philanthropic advisory services, business owner services, tax strategy and wealth transfer services to our clients. It is our privilege to put our expertise and resources to work for you. If you d like to learn more, contact a Northern Trust professional at a location near you or visit us at northerntrust.com. Special thanks to Ben Lavin, Associate Wealth Planning and Tax Strategy at The Northern Trust Company, for his contributions to this piece. (c) 2016, Northern Trust Corporation. All rights reserved. Legal, Investment and Tax Notice: This information is not intended to be and should not be treated as legal advice, investment advice or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. northerntrust.com Insights on...wealth Planning 7 of 7