Category: Politics and Taxes

How Tax Reform Framework Impacts Traders And Investors

September 29, 2017 | By: Robert A. Green, CPA

shutterstockTaxReforms

On Sept. 27, the Big Six tax writers released an updated Unified Framework for tax reform making concrete steps forward on corporate and individual tax rates. As expected, they left many details and decisions to Congress on which deductions, credits, and industry-specific tax incentives to repeal to offset the massive reduction in tax rates granted to corporations and pass-throughs (PTE). Over the coming months, tax lobbyists will inevitably hover over tax writers like bees. Until we see the final bill, it’s hard to assess its impact on traders and investors.

Capital gains and investment income tax cuts retracted
I searched the nine-page framework document and was surprised not to find any mention of capital gains. I find that odd considering earlier blueprints promised investors lower capital gains rates on “all” capital gains, dividends, and interest income. “All” includes short-term capital gains and non-qualifying dividends. At first, I wondered if it was an oversight, or because they felt it was unworthy of inclusion in the overview. I became concerned they may have scrapped these tax cuts for traders and investors since they have to scale back some tax cuts for budget reconciliation. I confirmed my suspicions when I saw the following tweet after writing this article: Wall Street Journal tax journalist, “Richard Rubin (@RichardRubinDC) 9/28/17, 11:54 AM @SpeakerRyan on lack of capital gains tax cut: You just can’t do everything you want to do.”

Comparing the framework to earlier versions
BNA’s Comparison Chart of Trump Tax Plan and House Republican Blueprint is an excellent resource. According to “Savings and Investment Income” on p. 3:

Current law: “Long-term capital gain and qualified dividends taxed at rates of 0%, 15%, and 20%. (Top rate plus NIIT equals 23.8%.) Short-term capital gain, interest income and non-qualified dividends taxed at ordinary rates.”

Trump campaign tax plan: “Maximum rate of 20%.” (Current law.)

Trump administration tax reform outline: “Not specifically addressed.” (This omission was the first indication they were backtracking.)

House Republican Blueprint: “Deduction for 50% of net capital gains, dividends, and interest income, leading to rates of 6%, 12.5%, and 16.5%.” The House Blueprint A Better Way “provides for reduced tax on investment income. Families and individuals will be able to deduct 50% of their net capital gains, dividends, and interest income, leading to basic rates of 6%, 12.5%, and 16.5% on such investment income depending on the individual’s tax bracket.”

The new framework doesn’t mention any of these provisions. It only states: “The committees also may consider methods to reduce the double taxation of corporate earnings.”

The new framework omits mention of “carried interest” tax breaks for hedge funds and private equity firms. Does omission indicate they are backtracking on a repeal of this tax break? Perhaps not, as it may not have been worthy of mention since the broad statements about closing industry-specific tax breaks may include carried interest. Hedge funds and private equity have significant lobbying efforts in D.C. Carried-interest for hedge fund managers is like sweat-equity for founders of start-ups.

Pass-through vs. corporations
The new framework’s top tax rate for corporations is 20%, PTE 25%, and individuals 35%. Taxpayers and their advisers will want to consider reorganization to maximize tax benefits. It would be nice to know all this before year-end to reorganize by the start of 2018.

The framework narrowed the definition of which businesses may qualify for the PTE rate: “The business income of small and family-owned businesses conducted as sole proprietorships, partnerships and S corporations.” Traders, eligible for trader tax status (TTS), are small, family-owned businesses.

The framework also calls for measures to prevent abuse of the PTE rate: “the committees [i.e., Ways and Means, and the Senate Finance Committee] will adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.” We have to wait for the committees to define “wealthy” in this context. I hope the tax writers don’t consider TTS trading gains as personal income rather than business income.

When the prior framework was released, journalists jumped on the fact that individuals would recast themselves as PTE or corporations to avoid the higher individual rate. Independent contractors are already a significant trend for employers to avoid payroll taxes, unemployment insurance, and employee benefit plans. Employees like the business status to deduct business expenses, reducing income taxes and self-employment taxes.

Treasury Secretary Stephen Mnuchin recently suggested service companies, like accounting, law and financial firms, shouldn’t be eligible for the PTE rate. I disagree. Service companies could recast as software-to-service or house intellectual property in a corporation to collect royalties rather than service revenues. Congress should not be picking winners and losers and penalizing service companies who are stellar performers in the American economy with tremendous job creation. Congress should keep the PTE rules straightforward and easy to enforce in the interests of tax simplification.

Some tax writers floated the idea of a 70/30 split of wage income vs. business income as a way to prevent abuse. For example, if an S-Corp has a net income before officer compensation of $1 million, the IRS would require the owner/officer to have “reasonable compensation” of $700,000, subjected to the individual rate up to 35%. The net income of $300,000 would be business income subjected to the PTE rate up to 25%.

With this labor/capital split, the effective PTE rate would be 32%.

This is calculated as follows: (70% wages x 35% individual rate) + (30% business income x 25% PTE rate) = 32% (only 3% less than the top individual rate of 35%). The Obamacare Medicare surcharge of 3.8% applies on the $700,000 of wages, which could negate much of the PTE tax benefit in an S-Corp. With a 70/30 split, many taxpayers may not find much tax savings using a PTE. If the committees use percentage allocation, I hope it’s more like 50/50. Perhaps, a corporation is better.

A trading S-Corp only wants enough officer compensation to unlock a retirement plan deduction, and IRS rules for reasonable compensation don’t apply since the entity does not have earned income. We don’t know yet how tax reform may impact trading companies. If they must use a 70/30 split, traders might have to report more compensation than they want, which triggers more payroll taxes and the individual rate. We don’t even know if the IRS will allow traders to be eligible for the PTE rate on trading income including Section 475 ordinary income. We also need to confirm that retirement plan and health insurance deductions will still be permissible for trading companies in 2018.

There is another glaring omission in the new framework: the health insurance premium deduction in a PTE. The framework repeals medical itemized deductions, but it does not address health insurance premiums deducted from adjusted gross income (AGI). “The framework retains tax benefits that encourage work, higher education and retirement security.” In prior blueprints, they included health insurance premiums next to retirement deductions.

I don’t expect the final bill to address trading businesses, as current law is shy on these issues, too. The IRS has to codify the legislation and write regulations, and that will take a long time. Traders should consult their CPAs and tax attorneys.

With reasonable compensation rules for a PTE, and perhaps none for a corporation, it could make the corporate structure more attractive. The devil will be in the details of final legislation, and tax writers better carefully think out incentives and “Freakonomics,” how incentives sometimes have the reverse effect. To date, corporations have been a bad choice of entity for a trading business due to double taxation, no pass-through of trading losses and expenses, no lower 60/40 rates in Section 1256, and more. Corporations have been good as management companies.

Budget reconciliation
Congressional tax writers are under enormous pressure to whittle down earlier vows to squeeze trillions of dollars in tax cuts into a 1.5 trillion-deficit placeholder negotiated for the 2018 budget. They scheduled the budget vote for Oct. 5, 2017. The Big Six plan to use “budget reconciliation,” affording them a majority vote procedure for Senate Republicans to pass tax reform and cuts without any support from Democrats.

Senator John McCain (R-AZ), who voted “no” on both health care repeal and replace bills, said the main reason was he wants “regular order” which requires a bi-partisan 60-vote cloture vote, and he recently said the same goes for tax reform. Senator Bob Corker (R-TN) told reporters, “What I can tell you is that I’m not about to vote for any bill that increases our deficit, period.”

In a letter to Republican leaders, 45 of the 48 Democratic senators requested bi-partisan negotiations, stating Republicans should not use budget reconciliation to pass tax reform. Democrats wrote they wouldn’t support tax cuts for the top 1% and they don’t agree on deficit-financing to pay for tax cuts. Despite President Trump’s rhetoric about tax cuts not helping him and his family, and other billionaires in the top 1%, it’s not the case.

The effective tax rate for billionaires is close to the long-term capital gains rate of 20%, 15% before 2013. Long-term capital gains are their primary source of income, as many don’t take much compensation. These billionaires pay AMT because the AMT rate of 28% is higher than the long-term capital gains rate. To limit AMT and avoid estate taxes, many billionaires contribute significant amounts of their net worth to charity. The framework repeals AMT and estate tax, which is a massive tax cut for billionaires, including President Trump and his family. The framework doesn’t mention “step-up in basis” rules where heirs can avoid capital gains taxes. Billionaires and the wealthy own valuable corporations and pass-through entities so they will get lower tax rates on that front, too.

AMT and state and local taxes
If Congress repeals AMT, the second tax regime intended to ensure that wealthy taxpayers pay their fair share, it makes sense to repeal state and local taxes, which are one of the largest AMT preference items. To repeal the deduction alone would unlock much greater deductibility since AMT would no longer put a cap on it. That would wind up being a tax cut, rather than a tax increase, as intended. There’s already been significant blowback from members of Congress in high-tax states. Leadership is bending to that pressure. Will a tax increase turn into a tax cut on this measure? Or, will tax writers retain state and local tax deductions and AMT, too. Closing this deal will be tough.

There are a few other things I don’t like about the new framework. As with previous blueprints, it’s heavy on marketing content to convince working people that tax reform is for them rather than wealthy individuals and companies. I don’t like the double-talk. For example, the framework makes a big deal about lowering the top individual tax rate to 35%, but then it empowers tax writers to add a new higher rate without giving any details. It states it’s converting to a “territorial tax system” from a “worldwide tax system,” no longer taxing American companies abroad, but then it introduces a minimum tax on global income.

Timing and tax planning
The framework’s only retroactive provision is “full expensing,” active on the framework-date of Sept. 27, 2017. Other provisions won’t take effect until 2018. The Big Six is encouraging businesses to purchase equipment and other deductible assets before year-end to spur growth in the economy. It will help them argue growth pays for the tax cuts rather than deficit spending. The budget gives Republicans in both the House and the Senate a deadline of Nov. 13 to release legislative text on tax reform.

I am anxious to read final tax reform legislation so we can start crunching numbers to determine the winners and losers and help clients with tax planning for 2018. There will be surprises in the outcomes, “believe me.”

Taxpayers should commence 2017 year-end tax planning with the assumption that Obamacare taxes remain in place, only tax reform’s “full expensing” may start Sept. 27, 2017, and otherwise, tax reform, if passed, won’t be active until 2018.

Tax Reform Is Uncertain So Reconsider Your Investment Strategy

August 31, 2017 | By: Robert A. Green, CPA

Read Robert’s blog post on Forbes.

Many American taxpayers are tracking developments in tax reform plans, yet it’s uncertain if it will happen. Consider the adage: “Don’t let the tail wag the dog.” The tail is tax reform, and the dog is your investment strategy.

Some invested in the “Trump trade” — a surge in market prices based on perceived corporate tax cuts and deregulation — and they are waiting to sell winning positions after they expect Congress to lower tax rates. Companies are deferring revenues and accelerating expenses to postpone income to 2018 when lower tax rates may apply.

So, what’s an investor to do during this time of uncertainty? If you feel market conditions are right for selling individual securities or other financial instruments, then you should sell. Don’t wait for lower tax rates, which may not be as good as expected, or not come at all.

Long-term vs. short-term capital gains
The 2017 tax rates on long-term capital gains, held 12 months, are reasonable by historical standards. In the 10% and 15% ordinary tax brackets, long-term capital gains rates are 0%. In the 25% through 35% brackets, the long-term rate is 15%, and in the 39.6% bracket, it’s 20%. In Trump’s tax plan, the top long-term capital gains rate is 20%, and in the House plan, it’s 16.5%. If an investor holding a long-term capital gain believes the price may decline soon, they should consider selling that position in 2017 because a 2018 capital gains rate may not generate tax savings. It would create tax deferral for one year.

Conversely, investors holding short-term winning positions under 12 months may prefer to wait and see if tax reform delivers lower capital gains rates on short-term capital gains. The House Republican Blueprint stated: “Deduction for 50% of net capital gains, dividends, and interest income, leading to rates of 6%, 12.5%, and 16.5%.” Current law subjects short-term capital gains, interest income, and non-qualified dividends to ordinary rates. I expect Congress to clarify this issue along with other details in September and October. (See Comparison Chart of Trump Tax Plan and House Republican Blueprint.)

Investors should try to avoid wash sale loss adjustments on securities at year-end. Wash sales can increase capital gains subject to 2017 tax rates and postpone losses to 2018 when lower rates may apply. (A wash sale loss occurs when an investor realizes a capital loss and buys back a substantially identical position 30 days before or after. The loss is added to the replacement position’s cost basis.)

Deferral of capital gains is not possible for investors using Section 1256 MTM on futures, broad-based indexes, and non-equity options. It’s also not possible for traders in securities using Section 475 MTM. (Mark-to-market accounting reports realized and unrealized gains and losses.)

Obamacare net investment tax
It’s uncertain if Congress will repeal the Obamacare 3.8% net investment tax (NIT) for funding Obamacare expenditures. The Obamacare repeal and replace bill included a repeal of NIT, but that bill failed in the Senate. Although tax reform plans include repeal of NIT, it might survive final negotiations in pursuit of making tax reform revenue neutral. Only the wealthy (the upper 2% of Americans) pay NIT. It’s not a business tax cut that Republicans can argue spurs job creation. President Trump doesn’t want Congress to give up on a new Obamacare repeal and replace bill.

Decision-making example
If you sell a security for a $100,000 capital gain in 2017 and owe the top long-term capital gains rate of 20% and the 3.8% NIT, your federal tax liability is $23,800. That leaves you with $76,200 (assuming there is no state tax). If tax reform fails entirely or comes up short of expectation, the Trump trade could reverse course. Investors might then sell positions at lower prices, yet similar tax rates may apply.

Tax reform may be a massive tax cut on short-term capital gains, so investors may want to wait for details including legislative language to clarify this question. Traders in securities include day traders and swing traders, and they are not going to modify their holding periods for tax reasons.

Selling tax reform to the American people
It’s going to be a challenge for the White House and Congress to sell the American public on the need for tax reform including massive tax cuts at a time when many U.S. public companies have high net profits after tax and record-high stock prices. The proposals provide similar tax cuts to wealthy business owners operating through pass-through entities including LLCs, partnerships, and S-Corps.

Supporters say the tax cuts will bring economic growth because companies will invest their tax savings in U.S. job creation and wage hikes. But, opponents say this is wishful thinking: The current productivity trend is for U.S. companies to invest in robots and other automation, replacing human workers. Plus, the offshoring trend continues to make sense, given record low U.S. unemployment rates and considering that the House dropped its controversial border adjustment tax. Both sides will present studies buttressing their position.

President Trump held a pep rally for tax reform in Missouri on Aug. 30. The president argued that tax reform helps businesses, which will surely use the savings to hire workers, raise wages, and increase paychecks. The White House said it wants employees to see bigger paychecks starting in January 2018, which will help when they turn out for the mid-term elections in November 2018.

But, the most significant tax most middle-income employees have on paychecks is payroll taxes, not income taxes. The payroll tax has two components: 12.4% social security up to the SSA base amount, and 2.9% Medicare without any limit. Congress raises the SSA base most years: For 2017, the SSA base is $127,200, up 7% from $118,500 in 2016. That translates to a tax hike of $1,079 for 2017. In 2007, the SSA base was $97,500. If Republicans want to help workers as they say, why don’t they reduce payroll taxes?

President Trump and Treasury Secretary Steven Mnuchin say tax reform with tax cuts will spur growth rates to more than 3% for many years. Many economists disagree, although the government just revised up the Q2 2017 growth rate to 3%, and that’s an outlier over the past decade. When Congress’s independent body, the CBO, scores the tax cut bill, it probably won’t use dynamic scoring with 3% growth rates over a prolonged period. Tax cuts are likely to be scored as revenue negative, which means they incur deficit spending.

If you take away the tax cuts for business and just simplify the tax code by closing many loopholes and deductions, there may not be as much support for the bill. There are lots of winners and losers in tax reform, including voters in high-tax states losing state and local tax deductions.

Democrats claim Republican tax reform proposals focus on tax cuts for the wealthy. Senate Minority Leader Chuck Schumer (D-NY) indicated Congressional Democrats and Independents might oppose an increase in the debt ceiling if it’s used to finance tax cuts for the wealthy.

The details are missing, and it’s getting late
Treasury Secretary Mnuchin and National Economic Council Director Gary Cohn promised more information on tax reform in September with passage promised before the end of 2017. Let’s see what legislative language they and the other Big Six tax writers offer in September and October with a crowded legislative calendar including the 2018 budget, increase in the debt ceiling, and several emergency measures including Hurricane Harvey and North Korea.

The expected pathway for tax cuts is Senate budget reconciliation, where Senate rules allow a 51-majority vote, rather than 60 votes needed for cloture (moving forward). Without any Democrats expected to support the Republican bill, the Senate can’t get to 60 votes required for the regular procedure. Using budget reconciliation requires the provision to balance. Otherwise, it’s temporary (sunsets) in 10 years. President Trump has berated Senate Majority Leader Mitch McConnell to change Senate rules, but McConnell won’t budge, so far. Ten-year tax cuts are good for some, but some corporations may not want to build new factories considering that a new Congress and President could repeal and replace these tax cuts.

As we learned with the failure of the majority vote for the Obamacare repeal and replace bill, it only takes three of the 52 Republican senators to vote a bill down if there is no support from Democrats or Independents. Uncertainties and speculation surround the upcoming vote on tax reform, but one thing is sure: We all must be ready for a September and October showdown. Don’t count your tax cut chickens until they hatch and keep an eye out for the Trump trade.

Human Jobs Under Attack By Tax Code Favoring Robots Over People

October 4, 2015 | By: Robert A. Green, CPA

Click for Green’s post on Forbes

Hopefully, a presidential candidate or Congress will consider my tax idea to spur jobs with a new depletion allowance on human labor. Similar in concept to the depletion allowance on oil and gas, it would be an annual tax deduction for a portion of the value of the underlying energy resource. Per Mineral Web, it’s “the using up of a natural resource.” I’m sure many human workers feel used up after a lifetime of hard work, too.

Rise of Robots
In his breathtaking new book on modern economics, “Rise of the Robots: Technology and the Threat of a Jobless Future,” author Martin Ford explains how robots and IT replace human white-collar and blue-collar jobs. This trend is a major contributor to the “new normal,” a frightening low labor participation rate (62%), and a higher U.S. (broad U6) unemployment rate (10%).

Ford points out that robots work faster and longer and more intelligently with fewer errors and with fewer collateral issues than humans. Robots — with artificial intelligence (AI), algorithms and access to big data — are replacing white-collar jobs in law (data mining), finance (high-frequency trading), health care (Dr. Watson IBM), education, science and business. While you may not yet shake hands with a robot that looks like a human, robot systems are working broadly behind the scenes in almost everything we do today.

Ford points out it’s no longer a competitive playing field with robots either winning new jobs or making it possible for virtual immigration of foreign workers, both of which replace U.S.-based jobs.

While the rise of robots is generally a good thing, Ford points out that as a society we should value sustainable jobs for the middle-class, not to slow down advances and adoption of robotics, but to incentivize businesses to hire humans to work side-by-side with robots. Ford argues that income inequality is accelerating with robots since productivity-induced profits go to business owners and investors. Robots don’t buy cars; they are self-driving cars. Robots don’t consume food, medicine and consumer products, and they don’t sustain a consumption-driven economy.

Tax policy favors robots over people
U.S. tax policy favors capital spending on robots, technology and energy over human resources. Businesses benefit from generous Section 179 (100%) depreciation (cash expensing) and bonus depreciation on purchases of technology and tax credits on R&D (research and development) in biotech, software development and more. These tax breaks are among the largest “tax extenders” expected to be renewed again by Congress later this year.

Current fiscal policy for U.S.-based human resources is unattractive. Employers must contribute to Social Security, Medicare, federal and state unemployment insurance, state workers’ compensation, Obamacare health insurance, retirement plans and other employee benefit plans.

In 2011, many people called for a payroll tax holiday and Congress enacted a partial reduction on the employee portion of Social Security contributions. I suggested a full payroll tax holiday on the employer portion, too. But Social Security and Medicare are facing insolvency and a tax holiday accelerates the problem. Consider my idea for a human depletion allowance, instead.

Depletion allowance on human resources
Jobs for Americans are worth more than energy, which is currently in abundance. American workers feel used up just like oil resources. Big oil and gas won and continues to defend its depletion allowance; it’s time to spur American jobs by leveling the fiscal policy playing field back in favor of the American worker.

Energy companies acquire resources and depletion is a mechanism to write off those resources in production. In technology spending, a company writes off the purchase with depreciation. With human resources, companies also write off salaries, payroll taxes and employee benefits. Therefore, depletion on human resources could be construed as double dipping. I argue there is a human resource value above the salary amount and that human resource can have a depletion allowance similar to oil and gas depletion allowances.

The mechanics: Figure the added value of a human resource job over a reasonable period of time and allow the employer to take an annual tax depletion deduction for the annual reduction of that human resource value. I am not suggesting that employers capitalize that value on balance sheets even though intellectual capital becomes structural capital (human capital), which does help businesses win. Google and Facebook have very few human jobs per revenues due to this added human resource value.

Further details can be worked out after Congress accepts the concept.

Robots can also contribute to Social Security and Medicare
Also, consider robots having to pay Social Security, Medicare, workers’ compensation and unemployment insurance. Consider this policy for virtual jobs, too. When a worker in India replaces a U.S.-based white-collar job for a U.S. employer, it would be helpful for the employer to continue paying payroll taxes.

Will “Tax Extenders” Be Renewed Retroactively For 2014?

October 9, 2014 | By: Robert A. Green, CPA

The IRS commissioner recently told Congress that further delay on anticipated renewal of “tax extenders” will delay the 2014 tax-filing season and 2014 tax refunds. Many taxpayers are hoping Congress renews tax extenders retroactively to all of 2014 so it increases their 2014 tax refunds. I can see a case for non-renewal of tax extenders.

The IRS needs a long lead time
Each year, the IRS and tax publishers need to finalize tax forms and software on a timely basis. Last minute tax law changes often throw a monkey wrench into that process. When Congress passes new tax law, the IRS has to codify those laws with proposed regulations and final regulations. The last step is drafting and finalizing tax forms and related instructions. Factor in government bureaucracy and this entire process can take a lot of time. Congress passed the Affordable Care Act (ObamaCare) in March 2010, yet it took the IRS several years to finalize regulations and 2013 Net Investment Income Tax Form 8960. Form 8960 was released late for the 2013 tax filing season – delaying last year’s tax season. The IRS just released 2014 ObamaCare insurance-mandate tax forms, which is early in this case (see upcoming blog).

Renewal of tax extenders is not certain
Congress allowed the entire list of “tax extenders” to expire at the end of 2013. Unlike in prior years, Congress did not renew the tax extenders during its annual game of political brinksmanship. If Congress permanently passed tax extenders, it would blow a huge hole in the budget deficit forecast and that’s a political problem.

In “A major tax reform bill in 2014 is unlikely, and “tax extenders” may be history, too,” I predicted Republicans might block renewal of tax extenders for leverage in discussing an overhaul of the tax code – otherwise known as “tax reform.” Why pass a bunch of tax breaks separately, without taking the opportunity to also simplify and fix the tax code at the same time?

My latest thoughts about tax extenders and tax reform
Why pass tax extenders just before the major election in November 2014? Congressmen campaign on tax policy raising money from the tax-benefit lobby. Pundits currently predict that Republicans may win narrow control of the Senate, but not filibuster-proof. Republicans could press for their vision of tax reform with the mantle in both houses of Congress. With ongoing public controversy over corporate tax inversions and U.S. companies moving abroad, a Republican Congress can probably exert pressure on the White House to pass corporate tax reform. Most small businesses uses pass-through entities like LLCs and S-Corps, which means they pay their business taxes on individual tax returns. For this reason, Congress should include individual tax reform in the tax reform bill, too. You can’t leave a large gap between individual and corporate tax rates.

The 2015 Congress sits in late January 2015, which means the 2014 lame-duck Congress will deal with year-end calls for renewing tax extenders. It’s highly unlikely the latter will deal with tax reform.

Is the IRS Commissioner weighing in to politics by pressuring Congress on tax extenders before the November election? Tax extenders lapsed at the end of 2013. Shouldn’t the IRS create tax forms based on current tax law? It’s certainly not easy with a last-minute Congress.

I vote for tax reform over just renewing tax extenders. For those that cry wolf, I question if corporations will reduce their research and development, or investments in new technology and equipment simply because the U.S. Treasury won’t subsidize them. American big and small businesses need to innovate and stay technologically advanced or they will lose their worldwide competitive edge.

As we approach the year-end holidays, many lobbyists, corporations and individuals will write letters to their Congressmen crying foul over tax extenders, Congress may cave and renew tax extenders. It’s tough to do tax planning with this routine.

A major tax reform bill in 2014 is unlikely, and “tax extenders” may be history, too

January 9, 2014 | By: Robert A. Green, CPA

Postscript: Jan. 13, 2014 TaxAnalysts “Piecemeal Reform of Financial Products Tax Unlikely, JCT Economist Says.” “Congress is unlikely to pass a stand-alone financial products tax reform bill without enacting broader tax reform legislation, Joint Committee on Taxation economist Karl Russo said January 9 at the Practising Law Institute’s taxation of financial products and transactions seminar in New York.”

Tax-writing Congressional leaders — Rep. Dave Camp (R-MI), chairman of Ways and Means and Sen. Max Baucus (D-MT), chairman of the Senate Committee on Finance — worked on a tax reform bill last year that included closing many tax loopholes and tax expenditures. Due to gridlock over ObamaCare and the government shutdown, they weren’t able to present the bill, so they punted tax reform to 2014.

Budget-writing Congressional leaders – Rep. Paul Ryan (R-WI), chairman of the House Budget Committee and Sen. Patty Murray (D-WA), chair of Senate Budget Committee — forged a last-minute budget deal enacted into law. While it was a small deal — leaving out the extension of expiring unemployment benefits and “tax extenders” — it did break the paralyzing gridlock.

On Jan. 8, TaxAnalysts published “Camp Remains Focused on Comprehensive Tax Reform, Not Extenders.” Camp is pushing forward in 2014 on completing his tax reform bill, and he doesn’t want to undermine it and get side tracked with budget-busting tax extenders in a separate clean bill. If you want tax policy like tax extenders, then include it, and pass the entire tax reform bill. Kudos to Camp. It will be hard to attach tax extenders to a deficit-ceiling vote coming up soon, since tax extenders cost $50 billion per year. Same reason Ryan left it out of his budget vote.

There is another path to retroactive renewal of “tax extenders”
After Ryan and Murray omitted tax extenders from their year-end budget bill — probably because they would have broken their bank — Senate Majority Leader Harry Reid (D-NV) sponsored a “clean bill” to continue all tax extenders for another year. Perhaps Reid will push it soon on the Senate floor.

While it’s hard to imagine Republican leaders balking at a clean bill for tax breaks, in my view, it would interrupt all tax and budget leaders work toward budget and tax reform. Republicans voted against extending expiring payroll tax cuts a few years back to make a bigger political point. In my opinion, extending tax loopholes and corporate welfare like R&D tax credits undermines concrete efforts underway toward meaningful tax reform. Are separate “clean bills” for extending unemployment insurance benefits and tax extenders meant to embarrass the other party or are they for realistic enactment?

One tax extender that may affect traders and investment managers the most is a significant reduction in Section 179 expensing. For 2014 the maximum Section 179 expense deduction for equipment purchases decreases to $25,000 of the first $200,000 of business property placed in service during 2014. The bonus depreciation of 50 percent is gone, as is the accelerated deduction, where businesses can expense the entire cost of qualified real property in the year of purchase.

Tax reform is unlikely in 2014
Tax reform as contemplated by Camp and Baucus will continue to be highly contested by many lobbyists in Washington campaigning to retain valuable tax breaks for their clients and industries. That’s just the half of it. Even more controversial is the partisan divide over the underlying goals of tax reform. Democrats want to raise revenue and Republicans want it to be revenue neutral.

Will Congress pass tax reform in pieces in 2014? President Obama has continued to campaign on closing the carried interest tax break for investment managers of hedge funds. It’s hard to envision hedge fund managers being sacrificed alone, with Wall Street’s Sen. Charles Schumer (D-NY) representing their interests and Chicago exchange’s Sen. Dick Durbin (D-IL) also in leadership — second and third behind Reid.

While Baucus is expected to leave his chair soon – President Obama nominated him for the next U.S. ambassador to China – Camp has expressed interest to finish his year as chairmain, and run for another one year term. Camp remains dedicated to completing his hard work on tax reform pushing for passage in 2014, no matter the political headwinds.

Camp’s proposals on investments
It is interesting to consider some of the tax reform changes promoted by Camp in connection with investments. He proposed using mark-to-market accounting more than it’s used now — in Section 1256 contracts and with business traders who elect 475 MTM and dealers. This would do away with complex provisions and opportunities for income deferral and tax rate arbitrage.

Camp also proposed connecting entities with their owners for wash-sale loss calculations, and he confirmed that is not the case under existing tax law. IRS Pub. 550 mentions individuals and their controlled entities are connected for wash-sale purposes. We agree with Camp that separate tax filing entities are not connected with individuals under current tax law for purposes of wash sale calculations. It’s important to note that IRS publications are not authoritative tax law.

Bowles-Simpson goes further than Camp
The Bowles-Simpson 2010 Plan (National Commission on Fiscal Responsibility and Reform) suggested one tax rate to do away with a material difference between ordinary income and long-term capital gains tax rates. While that change would surely simplify the tax code in a huge way, Republicans won’t agree to it unless Democrats agree to lower that individual tax rate to around 23% to 25%, which is highly unlikely.

Business traders seem on safe ground
There are no current indications that business traders should fear losing their current trader tax breaks. Of course, business traders are regular individual taxpayers, too, and Congress may further limit their itemized deductions. Trader tax status is more valuable than ever, turning investment expenses into business expenses, which are unlimited.

We have not heard of proposals to repeal Section 475 MTM ordinary gain or loss treatment for business traders, and again we feel it’s positive that Camp favors MTM.

Some progressive Democrats want to repeal lower 60/40 tax rates on futures and other Section 1256 contracts. In a July 11, 2011 New York Times article (An Addition to the List of Tax Loopholes), I defended 60/40 while Warren Buffett argued for its repeal. Will Durbin stand by to watch 60/40 be repealed by Congress? Infamous Rep. Dan Rostenkowski (D-IL) won 60/40 treatment for Chicago futures exchanges. President Obama was a Senator from Illinois, too.

Tax reform goals will certainly be political campaign fodder and platforms for the 2014 midterm election in November and perhaps for the 2016 Presidential election. With continued political infighting over ObamaCare, it’s hard for me to envision Congress enacting a meaningful tax reform in 2014. The November election doesn’t have consequence until the new Congress takes office in January 2015.

ObamaCare tax on investment income
Not all tax change has been favorable to traders and investment managers. The Affordable Care Act’s 3.8% Medicare tax on unearned income — otherwise called the net investment tax (NIT) on net investment income (NII) — takes its first bite out of your apple on 2013 tax returns. New IRS Form 8960 for the NIT will be a nasty surprise for taxpayers with AGIs over $250,000 joint and $200,000 single, providing they have NII. The IRS published instructions for Form 8960 in early January. We are satisfied that the IRS repaired some glaring problems in their proposed NII regulations, making it much more favorable for business traders and investment managers that it otherwise would have been in the proposed regulations. See our Dec. 4, 2013 blog “IRS final regulations for Net Investment Tax help traders.”

Bottom line
Tax breaks for business traders and investment managers are still alive and well.

Bill de Blasio’s tax-the-rich plan

September 15, 2013 | By: Robert A. Green, CPA

New York City mayoral front-runner Bill de Blasio invoked “tale of two cities” rhetoric — including a tax-the-rich plan — to win the Democratic primary. That almost assures him of winning the election in the heavily Democratic city.

Some high-income NYC residents are considering an exodus. Everything is already very expensive, including rents, condos, private schools, services and especially taxes. But before you rush to rebalance your work and lifestyle to tweak your days spent in NYC, understand there are many myths about quick fixes and most fail in practice. Learn the NYC residency rules and respect the might of tax authorities in interpreting the rules in their own favor.

NYC is the highest taxed city in America already!
As the biggest U.S. city with quite a security-budget requirement, you can imagine it costs plenty of money to run, even with Mayor Bloomberg at the controls. A recent report indicated that 50% of the residents are under the poverty line. But NYC is no Detroit and there are Wall Street multi-millionaires living in towers all over Manhattan and Brooklyn. In 1975 NYC also faced bankruptcy, before Wall Street’s ascension to fame and fortune.

For NYC residents making over $500,000 per year, the top marginal income tax rate is 3.876%. Bill de Blasio’s tax plan is to raise that rate to 4.41%. A married couple making around $500,000 may not have any savings left at year-end after paying for expensive private schools for their children and other high-priced services.

If you own a business in NYC, there’s an additional “unincorporated business tax” (UBT) of 4% on pass-through entities and sole proprietorships. Corporations are assessed a “general corporation tax” of 8.85%. New York state’s “flat tax rate” on corporations is 7.1%. (A trading business is exempt from UBT, as that is portfolio income.)

Very few U.S. cities assess individual income taxes and/or business income taxes. (Pennsylvania and Ohio have local school taxes on earned income but the rates are fairly low, except in Philadelphia.) Most cities and towns collect tax revenue from property taxes, real estate taxes and sales and use tax.

Gov. Cuomo already passed a “tale of two cities” plan in 2011
New York’s Gov. Andrew Cuomo said he was “not thrilled” with de Blasio’s tax plan. I’m skeptical because in 2011, Cuomo raised rates on the wealthiest residents to 8.82% — temporarily through 2014 — while cutting taxes on married couples earning less than $300,000 a year. Technically, that’s a tale of two cities tax plan. First, candidate Cuomo campaigned on allowing the temporary “millionaires tax” to expire as scheduled, but he later flip flopped as governor to extend the millionaires tax.

NYS/C’s combined top tax rate after these tax hikes is 13.23%; factoring in the 4% UBT tax on business puts the rate at 17.23%. An investment manager relocating to Florida saves all these NYS/C taxes. Many investment advisers and professionals moved their residences and businesses to Connecticut where the top tax rate is 6.5%, saving 10% of their highest-marginal income.

President Obama passed a similar plan
In the hotly debated fiscal cliff deal forged at the last minute of 2012, President Obama passed a “tale of two cities” tax-the-rich plan. President Obama didn’t sacrifice his long-held position to stop Bush-era tax cuts for the upper 2% of taxpayers making over $300,000 married and $250,000 single. The top tax rate returned to the Clinton-era 39.6%, plus the agreement phased-out itemized deductions and personal exemptions, effectively raising the rates even higher. Bush-era tax cuts continued for 98% of American taxpayers. President Obama passed other middle-class and small-business tax cuts, too.

“Progressivity” is widening with these tax-the-rich plans
Even without Occupy Wall Street succeeding in its mission, it’s pretty evident now that there’s a trend among Democrats for invoking “tale of two cities” rhetoric, including tax-the-rich plans. It’s good politics (and they believe more fair) to advocate tax hikes for the rich, tax cuts for the middle class and transfer payments and subsidies like ObamaCare for the poor. This is not a political statement but a new reality on the ground.

What’s an upper-income family in a high tax area to do? Embrace income tax hikes coming to your state and/or city soon, pay them with a smile and enjoy your city’s great lifestyle, diversity and culture. Or, consider rebalancing your affairs to successfully become a non-resident of your high-tax state and city.

How easy is it to change your tax residence?
Don’t fool yourself; it isn’t easy. Unless you pack your bags and move your possessions out of NYC, give up a “permanent place of abode” and stop coming on most days, you will probably remain “domiciled.”

Many other high-tax states have similar rules and concepts on residency, so read them carefully online. The days of fooling states are over — they’re much more sophisticated now and the burden of proof is on you.

Exiting a state or city is easier than exiting the U.S.
Simply “move out” of NYS/C and you are a non-resident as of the date of your move. You may have some leftover NYS source income such as from the sale of real property. Non-residents of NYS owe state taxes on NYS source trade or business income, not portfolio income.

It’s far harder to escape the IRS, as it has you bound as a tax indentured servant for 10 years. You can surrender your green card at your foreign consulate and move out of the U.S. entirely. But the IRS “exit tax” or “expatriation tax” applies for 10 years after you leave on long-term residents and citizens.

State rules to avoid double taxation
Just because you can show you are domiciled in another state, doesn’t mean NYS/C can’t argue that you are really a NYS/C “domiciled resident” or qualify as a “statutory resident.”

Most states have a system to get tax relief for double state taxation. For example, NYS residents can deduct state income taxes paid in another state and they usually get full relief since NYS tax rates are higher than most states. Conversely, a Florida resident has zero income taxes and they won’t get any relief for taxes paid to NYS.

There is no double taxation relief for NYC taxes paid.

NYS/C “domicile residency”
NYS Tax Department’s definition states “Your domicile is: the place you intend to have as your permanent home; where your permanent home is located; the place you intend to return to after being away (as on vacation, business assignments, educational leave, or military assignment). You can only have one domicile. Your New York domicile does not change until you can demonstrate that you have abandoned your New York domicile and established a new domicile outside New York State…”

It’s where your roots are in the ground on all fronts, including economic, financial, family and community.

There are plenty of good resources on the Internet on NYS/C residency, like this one from the NYS Society of CPAs.

NYS/C “statutory residency”
The NYS Tax Department also defines a “statutory resident” as follows: “Your domicile is not New York State but you maintain a permanent place of abode in New York State for more than 11 months of the year and spend 184 days or more in New York State during the tax year.”

If you work in NYC, you will probably spend 184 or more days in the city. Renting an apartment for two years will subject you to NYC resident taxes, whereas short-term stays in a hotel or furnished apartment for only a few months will not. Non-resident commuters get off scott free. That nice pied-a-terre you have in mind just won’t fit the family budget after you factor in another 4% income tax and perhaps more if business taxes apply.

There are countless cases you can read online about taxpayers trying every angle to avoid domicile or statutory resident designation. For example, you can’t rent an apartment in your child’s name, since you will have “key access” and have to “maintain” it, which are the rules that count.

The 184 day rule feels more like 100 days
Don’t just figure 184 days is half a year; it’s not easy staying under 184 days, as you need to count partial days.

For example, visiting your NYC apartment for just one night counts as two days. Try to maximize your day count by spending longer blocks of time. Be prepared to be stingy with your days in NYC, and carefully plan what you devote them to in terms of seeing people, clients and coming to events. It can be a pain and hindrance.

Are you really going to save much?
Don’t forget to factor in the cost of maintaining your new domicile and travel costs, too. Don’t make this move on principle alone — run pro-forma tax returns to see the actual concrete tax savings vs. other costs incurred. You should factor in the risk of NYS/C audit and disagreement, including back taxes, penalties and interest. States rarely abate penalties.

The burden of proof of residency is on the taxpayer
Don’t even dream of fudging the numbers. You have to prove your residency and you need to cobble together an assortment of different methods to do it, including: Easy Pass records for driving over toll roads, bridges and tunnels; credit card and ATM transactions; cell phone tower records if you can get them; and internet access through IP tracking to your server if you can get this complex information; landline phone records. Also, some smartphone apps track your daily GPS whereabouts, but they often crash or have cessation of service.

One famous hedge fund manager fought with NYC over just one day, as it would tip the balance to cause residency and trigger a NYC tax bill of tens of millions of dollars.

Example
Consider an example of a married couple interested in exiting from the NYC tax regime. The wife has a long-term job making around $250,000 per year on a W-2. The husband recently converted from being an employee to an independent contractor reporting 1099-Misc. non-employee compensation of $300,000 on a Schedule C. They trigger the top NYC marginal tax rate of close to 4% and the husband also owes NYC UBT tax of an additional 4% on his net Schedule C income.

For several years, the couple traveled to their country home outside of NYC on weekends. They raised their family in NYC in a large condo which they purchased decades ago. They have been domiciled residents of NYS/C for decades and they have averaged well over 200 days per year in the city.

How can they rebalance their lives to exit the NYC tax structure? This couple may be tempted to tweak their work and lifestyle a bit, spending more nights in their country home vs. their NYC apartment. But, that’s highly unlikely to convince NYC they “abandoned” their NYS/C domicile, even if they vote in the country and move car registrations and more technicalities as well.

To safely accomplish abandoning domicile in NYS/C, this couple should sell their condo and not have any place of abode in NYC for a few years, while they establish a replacement domicile outside of NYC. Downsizing to a small NYC apartment is not enough, especially since these are still very high priced and the couple is maintaining significant economic and personal connections in NYC. (This couple can benefit from the $500,000 exclusion of income on the sale of their primary residence.)

After moving to Florida for a few years, this couple can get a place of abode in NYC again. At that juncture, they can probably safely claim a domicile change to Florida. Then, only “statutory residence” should be a consideration. It now becomes a question of counting days and they need to stay under 184 days in NYC per year. Each year is assessed separately.

For statutory residency calculations, a husband and wife should count their days in NYS/C separately, as they can file a joint federal return and separate NYS/C returns.

Will NYS/C let them go? No one likes to lose a good customer, especially high-tax states. NYS and NYC have huge tax departments and they spend the majority of their resources on residency audits. Many residents try to game the tax system and once audited, many are busted with back taxes, interest and penalties. They try all sorts of failed angles. You shouldn’t bother with those.

Consult a state and city tax expert
Don’t rely on a tax advisor in the low-tax state that wants your business; make sure you get advice from a CPA or tax attorney with excellent experience and practice in the state you seek to exit from.

State residency rules and nexus are complex, nuanced and often vague. States increasingly are looking at economic nexus and intangibles, rather than just focusing on technical facts like where you register to vote, register your cars and get your driver’s license. States look at where your family conducts its affairs like attending school, seeing friends, community activities and much more.

States are hungry for tax revenues and they don’t like losing their tax base, especially when in fact they haven’t lost them, but rather the taxpayer in question feigns non-residence.

Bottom line
The next mayor of NYC may raise taxes in a material fashion on the upper income. Many of these taxpayers don’t appreciate that and they are in a position where they can move out of the city. They can still enjoy the NYC lifestyle and do some business using temporary hotel stays, which is not a place of abode. In a year or two, they can get a pied-a-terre in NYC, and only pay sales and property taxes, not income and business taxes.

Maybe lowering NYC taxes would invite more rich residents to call the city their home and it could then benefit from huge growth in business and overall tax revenues.