Major Tax Changes Just Ahead

“This is too difficult for a mathematician. It takes a philosopher.”
– Albert Einstein, on taxes

With the takeover of the House of Representatives by the Republicans in Tuesday’s elections, and the Democratic margin in the Senate growing narrower, the prospect of meaningful Congressional action on a number of fronts has become murkier. Nowhere is the consequence of gridlock in the lame duck 2010 session (and beyond) more dramatic than in federal tax policy. If Congress fails to act soon, American taxpayers – at all income levels – are going to face significant changes in federal income, estate and gift taxes, many of which will become effective in less than sixty days.

Sunset of the Bush tax cuts: The package of tax reforms enacted in 2001 and 2002 which are commonly referred to as the “Bush tax cuts” will expire completely at midnight on December 31, 2010. Taxpayers will wake up on January 1, 2011 to a tax world that looks just like the year 2000. What does that mean? For income taxes, among other things, increases in all rate brackets up to a maximum of 39.6% instead of 35%; reinstitution of the so-called “marriage penalty”; long-term capital gains rates increasing from 15% to 20%; taxes on dividends increasing from 15% to as much as 39.6%; and many other changes whose cumulative effect will be to push a taxpayer currently in the top 35% bracket to an effective marginal rate of about 45%.

For estate and gift taxes the effect will be even more dramatic: Gift tax rates increasing from a maximum of 35% this year to 55% next year; and reinstitution of the federal estate tax at full 2000 levels, which means any estate over $1,000,000 is potentially taxable, and the top rate goes from zero now to 55% next year. An unmarried individual who dies in December with an estate worth $12 million will pay no estate tax; survive until January and the feds will take over $5.6 million of it.

Tax changes embedded in the 2010 health care law and related bills: Most of these won’t take effect as early as January 1, but when they do, they will be important. There are increases in Social Security and self-employment taxes for many taxpayers, limits on medical savings accounts and flexible spending accounts, and many changes in tax credit programs, not to mention the much-discussed health insurance mandates. Perhaps the two most far-reaching tax changes are the new 3.8% tax on unearned income for higher-bracket taxpayers and the enhanced 1099 reporting requirements.

The unearned income tax will apply to virtually all forms of net investment income for taxpayers over the threshold ($250,000 of adjusted gross income for married taxpayers filing jointly), including interest, dividends, royalties, rents, and capital gains from the sale of all non-business assets – including, potentially, the taxpayer’s personal residence!

The new 1099 reporting requirements will require all businesses (including owners of rental investment property) to send a 1099 to every vendor or service provider from whom they buy at least $600 of goods or services during the year. No exemption for purchases from corporate vendors (as in current law), no small business exemptions. Virtually every type of transaction is covered: purchases of inventory, materials, equipment, supplies, and services. If your small business buys a computer from Best Buy, better get Best Buy’s address and tax ID number, because you have to 1099 them or face a penalty.

How should taxpayers cope with the changes?
The cynical answer is to die, and do it before December 31! Assuming that won’t be the preferred tax planning strategy for most taxpayers, there are still a number of other ways to deal with the coming tax changes, some with action time frames that will end in less than two months. Additionally, there are a number of bills in Congress now, and others that are proposed, that would make further changes if passed. We will continue to monitor those bills to help our clients navigate the ever-changing tax landscape.

Please contact us if you have any questions.