Issues INSIGHTS AND. Halfway Over the Cliff Taxes Resolved but Debt Ceiling and Spending Cuts Loom

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1 Issues AND INSIGHTS January Halfway Over the Cliff Taxes Resolved but Debt Ceiling and Spending Cuts Loom Carol Kroch, Esq. Managing Director, Wealth and Philanthropic Planning, Wilmington Trust Company Sam Fraundorf, CFA President, Wilmington Trust Investment Advisors, Inc. Donna Barwick, JD, CFP Managing Director, Wealth Planning, Wilmington Trust, N.A. In a stunning game of brinkmanship, on January 1, 2013, Congress finally passed the American Taxpayer Relief Act of 2012 (the Act )* to keep the country from going entirely over the fiscal cliff the combination of tax increases and spending cuts scheduled to occur on January 1, First the good news: the Act ushers in welcome certainty on the estate tax, income tax, and the alternative minimum tax ( AMT ). However, for higher-income taxpayers the Act imposes increased tax rates on ordinary income, capital gains, and dividends, as well as reinstated limitations on itemized deductions and personal exemptions. When coupled with the new 3.8% surtax on net investment income, many taxpayers with incomes above $200,000 (single) or $250,000 (married) will see some tax increases. And wage earners at all levels will see increased payroll taxes, as the Social Security tax holiday came to an end on December 31, For high-net-worth individuals, the Act s wealth transfer tax changes bring the good news of permanence for the $5,000,000 (as indexed for inflation) per person exemption from the estate, gift, and generation-skipping transfer ( GST ) taxes, which had been scheduled to decline to $1 million on December 31, Although the highest wealth transfer tax rate increases from 35% to 40%, the new rate is made permanent, again bringing welcome certainty to wealth transfer planning. And the rate will not rise to the 55% that had been scheduled for January 1, Of course permanence is a term of art when it comes to taxes and Congress, particularly in light of the open issues that Congress has yet to deal with. The bad news is that Congress did not address the other side of the fiscal cliff, deferring for only two months the spending cuts known as sequestration that were scheduled for January 1, Further, the Act does not address the debt ceiling. * President Obama signed the Act on January 2, 2013 page 1 of 7

2 Additionally, the Act provides for some spending increases, including the extension of unemployment benefits and increased Medicare payments, without addressing the revenues for additional costs. Over the next two months, Congress will need to address the spending cuts now scheduled to take effect across the board on March 1, as well as the limits on U.S. government borrowing. This alert will briefly outline the Act s principal changes on income and wealth transfer taxes and their impact on high-income taxpayers and investors. The Act is over 150 pages, and this alert is by no means an exhaustive discussion of each and every change made by the Act. The charts that follow summarize the Act s principal changes to the income and wealth transfer taxes. The Changed Landscape: Wealth Transfer Taxes 2012 versus Estate, Gift, and Generation-Skipping Transfer 35% 40% (GST) Tax Highest Rate Estate, Gift, and GST Tax Exemption $5,120,000 $5,250,000* as indexed for inflation since 2010 as indexed for inflation since 2010 Basis of Inherited Assets Fair Market Value Fair Market Value Portability of Estate and Gift Tax Yes Yes Gift Tax Annual Exclusion $13,000 $14,000 * Source: Leimberg s Estate Planning Newsletter, January 2, The Changed Landscape: Individual Income Taxes 2012 versus Income Tax Highest Rate 35% 39.6% 1 Capital Gains (Long-term) Highest Rate 15% 20.0% 1 Dividends Highest Rate 15% 20.0% 1 Surtax on Net Investment Income N/A 3.8% 2 Surtax on Wages and Self-employment Income N/A 0.9% 2 Payroll Tax 4.2% 6.2% Alternative Minimum Tax Patched (increased exemption $78,750 exemption (married) enacted retroactively) $50,600 (single) permanently indexed for inflation Phaseout of Itemized Deductions and N/A Reinstated 3 Personal Exemptions 1 Applicable to taxpayers with taxable income over $450,000 (married) or $400,000 (single), indexed for inflation from Applicable to taxpayers with modified AGI or wages over $250,000 (married) or $200,000 (single), not indexed for inflation. 3 Applicable to taxpayers with AGI over $300,000 (married) or $250,000 (single), indexed for inflation from page 2 of 7

3 INCOME TAX CHANGE THE HIGHLIGHTS The Act brings much needed certainty to the income tax rates, although as noted below, there are some so-called extender provisions, which are only temporary in nature. For all but taxpayers at the highest income levels, the Act permanently adopts the rates for income, capital gains, and dividends that were enacted on a temporary basis in 2001 and The Act reinstates limitations on itemized deductions and personal exemptions previously in effect, again only for high-income taxpayers, but using a different income threshold. Finally, the Act does not change the new 3.8% surtax on net investment income, with the result that there are three different income thresholds relevant to high-income taxpayers. Increased Rates on Ordinary Income, Capital Gains, and Dividends for Higher-Income Taxpayers For taxpayers with taxable incomes over $400,000 (single), $425,000 (head of household), or $450,000 (married filing jointly), as adjusted for inflation, the highest ordinary income tax rate increases from 35% to 39.6%, and the highest income tax rate on capital gains and qualified dividends increases from 15% to 20%. Note that the 3.8% surtax on net investment income, discussed below, will also apply. New Limitations on Itemized Deductions and Personal Exemptions For taxpayers subject to higher tax rates, the good news is that generally the value of a deduction increases when rates are higher. However, the Act has reinstated the expired limitation on itemized deductions for highincome taxpayers, although it provides for a higher income threshold than prior law. Under the phase-out rule, deductions by taxpayers with adjusted gross income above a threshold limit, set at $250,000 (single), $275,000 (head of household), or $300,000 (married filing jointly ), as adjusted for inflation, are reduced by 3% of the income over the threshold, up to 80% of the total deductions. This rule applies to the deductions for home mortgage interest, charitable contributions, and state and local income and property taxes, among others. The Act also reinstates the phase-out of the personal exemption, using the same income thresholds. Permanent Fix to the Alternative Minimum Tax The AMT is a parallel tax system with different rates, permitted deductions and credits, and exemption amounts. Taxpayers are required to calculate both the regular tax and the AMT and pay whichever tax is higher. Prior to the Act, the exemption amount for the AMT had not been indexed for inflation on a permanent basis, so that each year taxpayers had to wait for Congress to enact a patch temporarily increasing the exemption amount, until they could determine whether or not they were subject to the tax. The Act increases the exemption amount for 2012 to $50,600 (single) and $78,750 (married), and indexes those amounts for inflation going forward. This change will give millions of taxpayers the certainty that they are not subject to the AMT. Temporary Changes The Act still provides for a number of so-called extenders for both individuals and businesses, which generally will expire at the end of We highlight a few of potential interest to high-net-worth individuals, noting in particular the time sensitivity to the extension of the IRA charitable rollover for IRA Charitable Rollover Extended: Action May be needed Before February 1 The IRA charitable rollover provision, which had expired at the end of 2011, permits individuals aged 70½ or older to transfer up to $100,000 directly from an IRA to qualified charities without recognizing income or taking a charitable contribution deduction. The Act extends the rollover retroactively for 2012 and for The Act has a special provision only for 2012 permitting a taxpayer to make a rollover distribution to a charity during January 2013 and to elect to have it treated as made in Further, a taxpayer who received an IRA distribution in December 2012 may elect to treat any portion (up to $100,000) of it as a page 3 of 7

4 distribution to charity, provided that it is transferred in cash before February 1, These special rules are subject to the other requirements of a qualified rollover, namely that the taxpayer must be at least age 70½, the charity must be a qualified charity, and the amount transferred cannot exceed $100,000. The rollover contribution rule can be helpful for taxpayers who do not itemize deductions, have already maximized their permitted charitable contribution deductions, live in a state that does not provide for a charitable contribution deduction from state income tax, or who can benefit from a lower amount of adjusted gross income, for example to reduce tax on Social Security income. Other Extenders of Interest to High-Net-Worth Taxpayers Election to deduct state and local sales tax rather than income tax Enhanced deduction for contributions of conservation property and of food inventory Research credit Fifteen-year straight-line cost recovery for qualified leasehold improvements Increased expensing limitations under section 179 Exclusion of 100% of the capital gains on the sale of qualified small business stock held for at least five years Reduction in S-Corporation recognition period for built-in gains tax Bonus depreciation on property placed in service after December 31, 2012 Variety of energy tax credits What the Act Did Not Change Payroll tax Increase The Act did not change the payroll tax holiday, which expired on December 31, Accordingly, the payroll tax for wage-earners has increased from 4.2% to 6.2%. 3.8% Surtax on Net Investment Income The new 3.8% surtax on net investment income, effective January 1, 2013, is unchanged by the Act. The surtax provides for lower income thresholds, not adjusted for inflation, than the Act s thresholds for increased income tax rates and deduction limitations, which are inflation adjusted. The surtax applies to taxpayers with modified adjusted gross incomes (MAGI) over $250,000 (married) or $200,000 (single), and taxes net capital gains, dividends, interest (excluding taxexempt interest), rent, royalties, and annuities, reduced by allowable deductions. Note that it includes income from passive activities conducted through a partnership, S Corp, or LLC, but not income from most actively conducted activities, including ordinary trade or business income, qualified plan distributions, IRA or 401(k) distributions, and Social Security benefits. ESTATE TAX CHANGE THE HIGHLIGHTS The surprise in the wealth transfer provisions of the Act is the lack of change. The good news is that most of the 2010 law changes were made permanent, including the $5 million exemption, as indexed for inflation, and the portability of a deceased spouse s unused exemption, discussed below. The Act s most significant wealth transfer tax change was to increase the top rate for all three taxes to 40%, more than the 2012 rate of 35%, but significantly less than the scheduled 55% rate that would have applied had Congress not acted. A Comment on Planning With inflation adjustments, the exemption becomes $5.25 million in Had Congress not acted, the exemption would have reverted to just $1 million on January 1, That possibility created a perceived year-end deadline to make wealth transfers to use the exemption and in fact many transfers were made for that purpose. At Wilmington Trust, we opened an unprecedented number of trust accounts in the last few months of Although that deadline turned out not to be final, large gifts made in 2011 and 2012 nevertheless took advantage of all of the time-honored reasons for making lifetime gifts. Any appreciation on the gifts will be removed from the estate and from the reach of state estate or inheritance taxes. Some transfers were probably not undertaken towards the end of 2012 page 4 of 7

5 simply for lack of time to complete formation of entities and trusts and obtain required appraisals. There is now time to give thought to using the permanently increased exemption, and many of the creative planning techniques discussed in 2012 continue to be useful ways to use that gift tax exemption. If you have not done so, you should review your estate plan carefully to decide whether it makes sense for you to make transfers to take advantage of the $5.25 million exemption. Portability Portability, the ability of a surviving spouse to use any unused exemption of his or her predeceased spouse for either gift or estate tax purposes, first introduced in 2010, is also clarified by the Act and made permanent. (Note that portability of the exemption is not available for the GST.) While portability at first blush seems to make transfers in trust unnecessary from a tax perspective, the benefits of trusts, such as removal of income and appreciation from the estate, long-term management of family wealth for future generations, creditor protection, use of state death tax exemptions, and protection against future decreases in the exemption amount, all still apply. State Death Taxes The Act also made permanent the elimination of the state death tax credit. Because many states have tied state death taxes to this credit, its permanent elimination will avoid increasing many state death taxes. Each state, of course, can impose or amend its estate tax, and there is already considerable variation among the states. With the permanently increased federal exemption, state death taxes, typically imposed on much smaller estates, will continue to be an important part of overall estate planning. What the Act Didn t Do None of the other significant Administration proposals for changes to popular estate planning strategies, such as a minimum 10-year term for GRATs, limiting the duration of the GST exemption allocation, limiting entity valuation discounts, and limiting the benefits of grantor trusts, were part of the Act. Further, the Act did not address the gift tax annual exclusion, which was increased from $13,000 to $14,000 in INVESTMENT CONSIDERATIONS The American Taxpayer Relief Act of 2012 has, for the time being, clarified the investment landscape, as Congress and the White House settled on what they could accomplish, as opposed to what they might like to have changed. Income tax rates, or at least the amount of income taxes themselves, will increase for the top 2% of U.S. taxpayers. This allowed the White House to reiterate that it had met its campaign promise of the fall. Although Republicans allowed rates to rise for some taxpayers, in exchange they were able to protect or improve their position on some key items for investors. The general exemption of municipal bond interest income from federal income taxes was left untouched and rates on dividends rose much less than anticipated. For investors, higher taxes are never a good thing, but the amount of the increases is not so large as to materially change the after-tax relationships among asset classes. The unprecedented amounts of liquidity injected into the financial markets by central banks and central governments have led to historically low inflation-adjusted returns on all asset classes and have narrowed the return differences among the asset classes. Therefore, we continue to believe that investors who ended 2012 with well-constructed portfolios are reasonably positioned to begin Higher taxes do mean, however, that we should once again consider the assumptions or biases we have as investors and make sure that they still hold in light of what investments can deliver after taxes. Asset location, which is the placement of assets in different types of accounts based on their tax treatment, has always been important, and for those in the highest tax brackets is even more so today. To the extent an investor has the ability to locate assets in accounts page 5 of 7

6 with different tax treatments, he or she should look to maximize that opportunity. That could even mean realizing a gain to reposition assets, since there remains a material difference between ordinary and capital gains rates. Investors have shown an increased preference for current income since the market unraveled in 2008, both in terms of their overall allocation to fixed income securities and their holdings in dividendpaying stocks. With the increase in rates, a bias toward income may be more expensive on an after-tax basis. Certainly, to the extent one concentrates on municipal bonds, there is little change from a tax standpoint. But income can be expensive today, and investors should consider the alternatives within their portfolios. Investors initially reacted positively to the news of a resolution to the fiscal cliff, but many commentators have been quick to point out that the Act only begins to address the United States fiscal challenges. Far from the grand bargain many had hoped for, the Act may generate just $620 billion of additional revenue over the next ten years, which is far less than even one year s federal budget deficit. Absent from the Act were any material spending cuts. It certainly appears that Republicans and Democrats have positioned themselves for yet another donnybrook in the next six to eight weeks as the debt ceiling becomes the next issue. Markets may gyrate widely as the give-and-take of the political process dominates the news scene. In the end, though, we expect an agreement an increase in the debt ceiling, additional spending cuts, perhaps some more revenue increases, and hopefully greater clarity for the remainder of the year. If so, we would tend to expect equities to do better than bonds, with positive economic growth and enhanced fiscal stability possibly ushering in some long-predicted interest rate increases. But before that, we have more drama yet to unfold. KEY PLANNING POINTS Income Tax Planning: Before February 1: consider whether you wish to make a rollover distribution to charity in January that can be treated as made in If you took an IRA distribution in December 2012, consider whether you want to make an election to treat any portion of it as a direct distribution to charity under the new IRA rollover provision For taxpayers with incomes over $200,000, it is important to determine which of the new provisions based on an income threshold apply to you Investment Planning: With income tax rates increasing for higher-income taxpayers, now is a good time for investors to review their portfolios Wealth Transfer Planning: With wealth transfer taxes more certain than they have been for a decade, now is a great time to review your plan and make sure it works for you and your family If you have not already used the full exemption, you can consider doing so now Remember that state estate tax rules have not changed Trusts serve a variety of needs and can be appropriate even if not needed for exemption purposes With a large exemption and increased income tax rates, considering what will be the basis of transferred assets received by gift versus at death is more important than ever It may be even more important in 2013 than it has been in the past to exercise care in selecting tax-advantaged versus taxable accounts as holding places for investments If your investment plan is solid today, quick changes intended solely to avoid potentially higher future tax rates may be counter-productive page 6 of 7

7 PLANNING FOR THE FUTURE The recent tax law changes are the start of a Congressional solution to the fiscal cliff. With the income tax and estate tax rates and exemptions now permanent, it is much easier for individuals and families to make long-term plans for their income, wealth transfer plans, and investments. Even though we recognize that nothing in the tax law is unchangeable, the current changes are far preferable to the sunset provisions under which we have been living for more than a decade. As always, we are happy to work with you and your other advisors to effectuate effective wealth plans. Please do not hesitate to contact your relationship manager if you have any questions. This article is for information purposes only and is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. This article is not designed or intended as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will succeed. Past performance is no guarantee of future results. This article focuses on federal income and wealth transfer tax planning strategies. While some of these strategies may have favorable state tax benefits, those are beyond the scope of this publication. Wilmington Trust is a registered service mark of Wilmington Trust Corporation, a wholly owned subsidiary of M&T Bank Corporation. Investment management and fiduciary services are provided by Wilmington Trust Company, a Delaware trust company, and Wilmington Trust, N.A., a national bank. Loans, retail and business deposits, private banking services, and other personal and business banking services and products are offered by M&T Bank, member FDIC. Wilmington Trust Investment Advisors, Inc. is an SEC-registered investment adviser providing investment management services to Wilmington Trust and M&T affiliates and clients. Brokerage services, mutual funds, and other securities are offered by M&T Securities, Inc., a registered broker/dealer, wholly owned subsidiary of M&T Bank, and member of the FINRA and SIPC. page 7 of 7