Tax Law Changes in Obama’s Proposed 2012 Budget

Limit the tax rate that certain individuals will get a benefit for their itemized deductions – For investors filing joint returns and having income over $250,000 itemized deductions would only reduce the investor’s tax liability by a maximum of 28%. For those investors who purchase securities on margin this limitation could be very costly. Short-term capital gains and interest income would be taxed at a rate of 35% yet the interest expense would only receive a 28% benefit. If an investor earned $100,000 of interest income and incurred $100,000 of margin interest expense, while the investor would have broken even on a pre-tax basis, he would be liable for $7,000 in tax.

Require a minimum 10 year term for grantor retained annuity trusts (“GRATs”) – Currently, investors are able to contribute property to a trust and retain an annuity interest in the trust. Any excess may be left to anyone the investor desires. The present value of the annuity is subtracted from the contributed amount, and any excess is treated as a gift to the beneficiaries of the trust. The Treasury publishes a discount rate to be used to determine the present value of the annuity. Many investors retain an annuity whose present value equals the fair market value of the property contributed to the trust. In such case, no gift tax is due, and if the trust can earn a rate of return higher than the discount rate, such excess is passed on to the beneficiaries free of gift or estate tax. However, if the grantor dies during the term of the trust, the assets in the trust are included in the grantor’s estate. In order to mitigate that possibility, many of these trusts are set up as two to three year vehicles. The proposal would be to set a minimum term of 10 years for any GRATs established after the date of enactment of the law.

Require ordinary treatment of income from activities for dealers of equity options and commodities – Under current law dealers of equity options, commodities and commodities derivatives treat their income from their dealer activities in Sec. 1256 contracts as 60% long-term and 40% short-term capital gains/losses. Dealers in other types of securities treat all of their income from dealer activities as ordinary income. The proposal would require such dealers to treat all of their income from such securities as ordinary.

Tax carried interests in certain partnerships as ordinary income – Under current law, the character of income flows from a partnership to its partners.  Some partners receive their partnership interests in exchange for services rendered to the partnership. Such interests typically give the partner the right to receive a share of future income from the partnership. At the time the interest is received, the partner would not be entitled to any proceeds if the partnership were liquidated, so there is no taxable income at the time the interest is received. In the future, the partners’ character of the income received from the partnership interest retains the same character that the partnership received. In many cases such income may be either qualified dividends or long term-capital gains, which are taxed at a maximum rate of 15%. The proposal would treat the income on a partnership interest that was not acquired for cash or property as ordinary income, if the partnership is an investment partnership. Gains upon the disposition of such an interest would also be treated as ordinary income. A partnership would be an investment partnership if the majority of its assets are investment type assets, such as securities, real estate, commodities, interests in partnerships, cash or cash equivalents.

Modify rules on valuation discounts – Based on judicial decisions and statutes enacted in many states, valuation discounts are allowed in determining the fair market value of property subject to gift and estate tax even though current tax law states that interests transferred intra-family should not be discounted for “applicable restrictions”.  The proposal would grant the Treasury the authority to write regulations that would define a category of “disregarded restrictions” that would be ignored in valuing property for estate and gift tax purposes.

Require accrual of income from the forward sale of stock by a corporation– Under IRC Section 1032 a corporation does not recognize income or loss from purchases and sales in its own stock. This rule applies when a corporation enters into a contract to issue shares in the future for a sum certain. However, if the corporation issued shares currently and received payment for those shares in the future, a portion of the payment would be treated as taxable interest income. The proposal would impute interest income on the transaction in which the shares are issued in the future. While there are real differences between the two transactions in that there are new shareholders at the time the shares are issued, the Administration believes that the two are economically equivalent and should receive the same tax treatment.

Limit Generation-Skipping Transfer Tax Exemption to 90 Years – GST tax exemption (currently up to $5 million)  allocated to trusts would last for only 90 years, after which it would expire.  This would mean that distributions from the trust after that time would be subject to the 35% GST tax.

Since many states have eliminated or lengthened the rule against perpetuities that limited the time trusts could be in existence, this provision would have a substantial effect on trust creation and administration, severely limiting the use of dynasty trusts.

Make Permanent Portability of Estate Tax Exemption Between Spouses  – For 2011 and 2012, a surviving spouse make make use of the predeceased spouse’s unused $5 million estate tax exemption.  The proposal would make this permanent.

Click here for the Green Book that contains explanations for the proposals.