Checklist: Obama Budget Proposal (Greenbook) - Planning Implications

shenkman martinAs the presidential election is less than six months away it seems highly improbable President Obama’s budget proposals will be enacted. That being said, practitioners are well aware the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, P.L. 114-41 included the new basis consistency and reporting rules under IRC Sections 1014(f) and 6035. This should serve as a reminder that even unlikely legislation may have a tax change appended. Further, the turmoil of the current election process should leave practitioners and clients alike wary of what might be in store. So rather than dismissing President Obama’s proposal as irrelevant practitioners should caution clients as to the possible impact of the proposals and proactive steps that might warrant taking “just in case.” Regardless of the outcome of the election, there appears to have been a change in the “conversation” concerning wealthy taxpayers and many of the provisions may reappear in the future in new proposals. Prudence might suggest taxpayers consider some of these proposed changes in forecasts and projections. Here I explore like-kind exchanges, Roth IRAs and marginal tax rates:

Like-kind or tax deferred code section 1031 exchanges have been a valuable tax deferral technique for wealthy real estate investors and developers for many years. In recent years the technique has taken on a new, different and significant planning role. With the new tax paradigm of estate tax rates closer to income tax rates than ever before, basis step up on death has become a major focus of income and estate tax planning. When planning which assets to retain in the client’s estate to obtain a step up, versus which assets to gift to remove from the client’s estate, the timing of sale is a critical consideration. If, for example, a client has a parcel of real estate that is anticipated to be held for decades, gifting it to remove appreciation from the client’s estate may make sense. The lack of basis step up may be inconsequential on a present value basis. The tax cost in two or more decades is, on a present value basis, likely not to be particularly significant. If the client is uncertain about how long the holding period might be the balance may shift from the prior situation in favor of retaining the asset in the estate for a basis step up. With real estate the planning has assumed a somewhat different analysis. Even if the client is not certain that the particular property will be held for a long period of time, it may be feasible to gift the property at an opportune time when the valuation might be low (e.g., large vacancies depressing current value) and have future appreciation occur outside the estate (e.g., in a grantor trust). If unexpectedly the client (perhaps in his or her role as being an investment trustee of the grantor trust) opts to dispose of the real estate it may be feasible to do so using a tax deferred like kind exchange. Now, however, the planning analysis for real estate investors and developers should contemplate the potential elimination of Code Section 1031 tax deferral. Although the Greenbook proposals recommend a cap on the maximum gain to be deferred in a 1031 like-kind exchange of real estate, if the proposal is sufficiently low it will be insignificant in this estate planning context. The implication of this proposed change is that large real estate investors and developers may be wiser not to assume the availability of a 1031 escape hatch on assets transferred out of their estates. Again, while there may be little likelihood of any legislation in the near term, this proposal seems to recognize that the intent for 1031 when enacted (not to create a tax cost when a taxpayer continues his or her investment, only in a different property) has lost some of its meaning and has with no limit likely favored the wealthiest taxpayers.

There have been many discussions about eliminating stretch IRAs in favor of a mandatory payout over no more than five years. The elimination of stretch IRAs will transform estate planning for inherited IRAs. Again, while practitioners and taxpayers alike may not wish to believe such a provision is likely to be enacted the revenue estimates from this change are significant. Further, if the statistical data as to how long most IRAs remain after the death of the plan holder are considered, the typical IRA is withdrawn rather quickly. It is likely only larger IRAs for wealthier clients that are stretched. The average person’s IRA accounts in 2010 had a total balance of $91,864 and the median value was $25,296. “How Much Do People Really Have In IRAs?” June 6, 2012 • Karen DeMasters. The median value is quite low. The majority of IRA balances are such that the benefits of deferral are not that significant. This may serve to make passage of a restriction on stretch IRAs easier.

Roth conversions are possible to achieve by high income taxpayers through an indirect route. The high income taxpayer can contribute to a non-deductible traditional IRA. Thereafter, he or she can convert that non-deductible IRA to a Roth IRA. The Greenbook proposal would create a chilling effect on high income taxpayers using this indirect approach to create Roth IRAs but limiting a Roth conversion to only the pre-tax portion of a regular IRA. Too often practitioners view the Roth conversion only from an income tax planning lens. But for many taxpayers Roth conversions can and should be primarily about asset protection. If a client has $1 million in a regular IRA, the tax value of assets actually protected may only be about $600,000. However, if a Roth conversion is completed, the total amount can be protected even though funds outside the IRA are used to pay the income tax on the conversion. Leaving aside income tax considerations, the effect of the conversion is for the taxpayer, perhaps an OB-GYN very concerned about malpractice issues, to convert $400,000 of non-protected assets (cash in the bank account used to pay the tax on conversion) into protected assets (the fully protected $1 million Roth IRA). With this change even a possibility perhaps practitioners should review possible conversion opportunities for clients with significant liability worries rather than defer those conversions.

There are a number of proposals to increase the marginal tax rates on the wealthy and to set a minimum tax level the wealthiest taxpayers pay. Whether referred to as the “Buffet Rule” or as a “Fair Share Tax” there are proposals for a minimum 30% tax on very high income individual taxpayers. The goal is to address high income taxpayers using deductions, capital gain characterization and other techniques to reduce significantly their marginal tax burden. There is also a proposal to increase the maximum capital gains rate to 24.2%. When this is coupled with the 3.8% Medicare surtax on net investment income (the “NIIT”) the aggregate capital gains rate before state capital gains tax is close to 30%. While there may be little that can be done to plan ahead for these types of changes, as no one will realize income early to avoid the possibility of a tax increase, practitioners should consider incorporating higher tax rates when completing financial forecasts for client financial plans or investment projections. Perhaps at minimum sensitivity analysis should be done and financial forecasts regenerated with higher marginal tax rates to demonstrate to wealthier clients the possible impact of future changes before they consummate large gift transactions or take other significant financial steps.

For example, a client paying a modest marginal income tax rate today might believe from a financial forecast they can gift their exemption amounts to dynastic trusts for children and future descendants. Perhaps regenerating that forecast substituting a 30% tax rate rather than a much lower rate that is currently paid might suggest to the client that instead of dynastic trusts for heirs some portion or all of the funds might more safely be given to non-reciprocal spousal lifetime access trusts (SLATs) so that each donor/spouse has access to the trust set up by the other spouses should adverse tax changes make that necessary.

The current proposal, as prior year proposals, includes a return to 2009 estate rates and exemption amounts. The possibility of a return to a $3.5 million exemption suggests that physician and other clients with significant malpractice or liability concerns should evaluate consummating estate and asset protection planning before such a reduction makes it more difficult. For example, gifts to non-reciprocal SLATs or to a domestic asset protection trust (DAPT) or both could be consummated to secure the benefits of the current high exemption. This is important for practitioners to realize. Utilizing the current high exemption is not only about estate tax planning but it is vital to asset protection planning for a much broader range of clients. For estate planning, a reduction from the current 2016 $5,450,000 exemption to a $3,500,000 exemption can mean much more than the dollar value reduction. If the planning for a very wealthy client contemplates a note sale to a grantor trust the leverage in the transaction might mean, depending on the interpretation of the law, a tenfold increase in the assets that can be transferred. Thus, a $1,950,000 reduction in the current exemption could mean a reduction of $19,500,000 of assets sold to a trust and for which the value might be frozen.

There are a host of other provisions contained in the latest Greenbook proposal. While few if any are likely to be enacted before the election, practitioners should nonetheless selectively consider the proposals and guide appropriate clients as to steps that might be prudent.