2009 Tax Law in Review

We have long had death and taxes as the two standards of inevitability. But there are those who believe that death is the preferable of the two. "At least," as one man said, "there's one advantage about death; it doesn't get worse every time Congress meets."
-- Erwin N. Griswold

The past 12 months of legislation have significantly affected the tax landscape for WTAS’ clientele. The most significant impact will likely be felt in the new Medicare Contribution Tax on “investment income” imposed by the newly enacted Patient Protection and Affordable Care Act. Additionally, pending legislation with significant tax consequences also looms on the horizon. This article will briefly highlight some of these noteworthy changes.

Medicare Contribution Tax on Investment Income

New Internal Revenue Code (IRC) Section 1411 imposes on individuals a 3.8% tax on the lesser of “net investment income” or the amount by which the taxpayer’s modified adjusted gross income (AGI) exceeds a statutory threshold. “Net investment income” means “investment income” less deductions allocable to that income. “Investment income” includes gross income from interest, dividends, annuities, royalties, rents, capital gain from the disposition of investment property, passive activity income, and trade or business income from trading in financial instruments or commodities.

“Investment income” items flowing through a Limited Liability Company (LLC), partnership, or S corporation will retain their character for the members, partners or shareholders. “Investment income” does not include distributions from qualified retirement plans.

For individuals, the statutory thresholds mentioned above are $250,000 for married couples filing jointly, $125,000 for married couples filing separately and $200,000 for all other filers. Note that these thresholds are not indexed for inflation. For trusts and estates, this same tax is imposed on the lesser of undistributed net investment income or the excess of the adjusted gross income over the amount that triggers the top trust tax rate (approximately $12,000 in 2013). This tax will be effective beginning in 2013.

Tax Rate Expirations

The current top capital gains rate of 15% is set to rise to 20% in 2011. Next January also heralds both the expiration of capital gains treatment for dividends, returning them to ordinary income rates, and the return of a top 39.6% income tax bracket, up from 35%. This means that for 2011, dividend income could be subject to a federal tax rate of 39.6%, and in 2013, 43.4% (top income tax bracket of 39.6% plus 3.8% investment income tax). Likewise, in 2013, capital gains may be taxed at a top rate of 23.8%. There has been movement in Congress to maintain the capital gain and dividend rates at 15% for those with incomes under $250,000 (joint return) and $200,000 (single).

Increase in the Hospital Insurance Portion of the Payroll Tax

Joint filers with AGIs over $250,000 and all other filers with AGIs over $200,000 will see a 0.9% increase in their portion of the Medicare tax on their wages—from 1.45% to 2.35%. Note that the increased tax also applies to self-employment income in excess of the above figures. This tax will be effective for tax years beginning in 2013.

Medical Expense Deduction Limitation

Currently, the medical expense deduction is subject to a 7.5% of AGI floor. Beginning in 2013, this floor will be raised to 10% for everyone under 65. Everyone will be subject to the higher threshold beginning in 2017.

Codification of Economic Substance Doctrine

The “economic substance” doctrine has a long and contentious history, and for the most part has been developed and defined by the courts. New IRC Section 7701(o) gives a statutory, two-pronged definition to “economic substance.” It states the transaction must change the taxpayer’s economic position “in a meaningful way,” and the taxpayer must have a “substantial purpose” for entering into the transaction. Both prongs must be satisfied apart from any federal income tax effects of the transaction. Additionally, a taxpayer may not rely on “potential for profit” to prove either of the above prongs unless “the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected.” The penalty rate is 20% (increased to 40% if the taxpayer does not adequately disclose the relevant facts affecting the tax treatment in the return or a statement attached to the return). This rule is effective for transactions entered into after March 30, 2010.

Estate/Gift Tax and GST Changes

Though the debate over retroactive restoration of the estate and generation skipping taxes (GST) has taken a back seat to the health care overhaul, these two taxes remain repealed for 2010 and will revert back to their 2001 rates in 2011. The gift tax rate in 2010 is 35%, but will increase along with the estate tax and GST rates in 2011 to a top bracket of 55%.

Also keep in mind that, in 2010, recipients of property from a decedent above a $1.3 million threshold do not receive an automatic step up in basis. Rather, they receive basis equal to the lesser of the decedent’s adjusted basis in the property, or the fair market value on the decedent’s date of death, subject to several other complicated wrinkles. For transfers between spouses, the applicable threshold is $4.3 million. In 2011, the full step up in basis on most assets will come back in play, along with the increased tax rates.

Pending Legislation:

GRAT Restrictions and Discounts on Family Limited Partnership

Legislation has been proposed to require that grantor retrained annuity trusts (GRATs) be subject to a minimum 10 year term, with the annuity prohibited from decreasing during that 10 year period. Additionally, grantors will no longer be allowed to “zero-out” a GRAT; instead, they must set up the trust with a remainder greater than zero (though the minimum remainder amount has yet to be clarified). This particular provision looks to be effective upon passage.

Other proposed legislation would prevent appraisers from applying any discounts to “nonbusiness” assets held by partnerships or other entities. Additionally, if a “family” (according to IRC § 2032A’s attribution rules) controls an entity that is not “actively traded,” no discounts would be allowed for lack of control.

Qualified Small Business Stock

Under current law, there is a 50% exclusion for gain from the sale of certain small business stock that is held for more than 5 years. The 2009 American Reinvestment and Recovery Act temporarily increased the exclusion to 75% for qualifying stock acquired in 2009 and 2010. Legislation has been proposed to increase the exclusion to 100% for qualifying stock after March 15, 2010 and before January 1, 2012.