On September 19, President Obama forwarded his plan for deficit reduction to the Joint Select Committee. The President's plan targets a potential $4 trillion solution. Approximately $1.7 trillion of his proposed plan involves tax increases.
In his proposal, President Obama outlined five "Principles for Tax Reform."
1. Lower Tax Rates – A simple system with lower individual and corporate tax rates.
2. Unfair Tax Breaks – Eliminate those tax reductions that are inefficient, unfair and complicated.
3. Higher Income Tax Increases – Increase taxes for upper income persons, single taxpayers with incomes over $200,000 and married couples over $250,000.
4. Job Creation – Increase incentives to work and invest in the United States.
5. Buffett Rule – Taxpayers with incomes over $1 million annually should pay taxes at a higher rate than middle-class families.
The proposal includes three specific provisions that are designed to raise $1.7 trillion. Over $866 billion is raised by increasing the top tax rates to 39.6% and 36%, and raising capital gains tax to 20%.
Approximately $410 billion is generated through limiting the tax savings on mortgage interests, state and local taxes, medical deductions and charitable deductions. Upper-income taxpayers would receive a deduction limited to the 28% bracket, even though their tax bracket could be substantially higher. Finally, there are about $300 billion in various tax changes for the energy industry and major corporations.
Businessman Warren Buffett testified before Congress that his tax rate is lower than the rate paid by his secretary. In response to the White House proclamation of the "Buffett rule" suggesting that taxes should be higher on those with incomes over $1 million, the House Ways and Means Committee published information provided by the Congressional Budget Office (CBO).
The CBO is a nonpartisan organization that attempts to evaluate various tax rates and the results of legislation. According to the CBO data, middle income earners in America averaged a tax rate of 14.2% in 2010. Those in the top 5% of earners paid an average 29% tax. Finally, the CBO stated that the top 1% paid an average tax rate last year of 31.2%.
Congress Debates White House Plan
Following the publication of the specific parts of the $4 trillion proposal from President Barack Obama, leaders of both parties in Congress responded.
House Ways and Means Committee Ranking Minority Member Sander Levin (D-MI) indicated that the White House proposal is "right on target." He suggested that it is now time for a "Buffett rule" because middle class income has stalled. Levin continued, "We need an approach to deficit reduction that is balanced and a tax system that fairly represents today's reality and begins to get a handle on the dramatic inequality in our nation."
House Speaker John Boehner (R-OH) discussed the White House proposal at his weekly press conference. Speaker Boehner expressed concern about the payroll reductions. The White House proposal includes lowering the normal 6.2% tax for Social Security to 3.1% for 2012. Speaker Boehner indicated that he did not think this reduction would produce a substantial increase in jobs during 2012. His primary concern is that the Social Security reserve is already lower than desired and would be further reduced by a payroll tax cut for next year.
House Majority Leader Eric Cantor (R-VA) noted that former President Bill Clinton had expressed concern about the negative impact of raising taxes. President Clinton said on Meet the Press that the need is "to put Americans back to work, get growth growing and then bring this debt down."
Leader Cantor suggested, "Raising taxes on small business people, job creators and investors is exactly the wrong prescription." He indicated that it is important to focus efforts on creating business growth and new jobs. In his view, tax increases are not helpful for that purpose.
S Corporation Charitable Tax Shelter Fails
In Santa Clara Valley Housing Group, Inc. et al. v. United States; No. 5:08-cv-05097 (20 Sep 2011), a District Court determined that a strategy involving a Subchapter S corporation and a charitable organization would not be approved.
Stephen C. Schott, his wife Patricia and their three adult children created Santa Clara Valley Housing Group, Inc. ("Santa Clara") in May of 2000. They elected Subchapter S corporation status under Sec. 1362(a).
After consultation with accounting firm KPMG, LLP, Schott implemented a strategy to reduce current income taxes. Santa Clara was created with 100 voting shares and 900 nonvoting shares. Each owner of a nonvoting share was granted a warrant that permitted the acquisition of 10 additional shares of nonvoting stock for every share of current stock. The family therefore owned 100 shares of voting stock, 900 shares of nonvoting stock and warrants to purchase 9,000 additional shares of nonvoting stock.
The Schotts collectively "donated" the 900 nonvoting shares to the city of Los Angeles Safety Members Pension Plan ("LAPF"), a qualified charitable organization. The tentative plan was for the Schott family to repurchase the LAPF shares after approximately five years.
During the following four years, Santa Clara reported $114 million in ordinary income, paid tax on $14 million and avoided tax on the $100 million of income attributed to the charitable organization. During this time, the corporation distributed $202,500 to LAPF. Because LAPF was tax-exempt, it paid no tax on the $100 million or the $202,500 in distributions.
In 2006, the IRS audited Santa Clara and determined that the arrangement was an abusive tax shelter. It issued a notice of deficiency for approximately $4 million for years 2000 through 2003.
The IRS determined that the warrants violated the requirements for an S corporation. Therefore, Santa Clara became a C corporation subject to normal tax. Both parties filed pleadings with the District Court and sought summary judgment.
The District Court noted that Reg. 1.1361-1(I)(4)(i) states, "instruments, obligations or arrangements are not treated as a second class of stock."
However, there are two exceptions that are potentially applicable. The warrants could be deemed a second class of stock if they "constitute equity or otherwise result in the owner being treated as the owner of stock" or if there is a "principal purpose" to give the warrant owners preference in liquidation proceeds. The second exception is applicable if a warrant is "substantially certain to be exercised."
The Schotts and Santa Clara contended that the primary provision is a specific description of the warrant and that the secondary exception is a general provision. Because the specific takes precedence over the general, the taxpayer claimed that the exception was not applicable.
The Court noted that the warrants clearly were "instruments" as described under the regulations. In addition, the existence of the warrants enabled the Schott family to claim ownership of 10% of Santa Clara, but effectively to control 90%. Given the great difference in potential liquidation value, the warrants were "substantially certain to be exercised."
Because the warrants were within the exception, the Subchapter S corporation had more than one class of stock. Therefore, the Subchapter S election was revoked. Santa Clara was required to pay the taxes applicable to a C corporation.
The court noted that the Schotts used the warrants as negotiating leverage when seeking to repurchase the nonvoting stock from LAPF. Therefore, it was obvious that the warrants were effectively an equity ownership in Santa Clara.
The Court remanded for trial the charitable deduction of shareholder Kristen Bowes. She had claimed a deduction of $7,657 for a gift of 144 shares of Santa Clara stock to LAPF in 2000. The government denied the deduction on the basis that there was never an intended transfer of actual value. Ms. Bowes is permitted to litigate this issue.
Editor's Note: This is another example of a questionable use of a charitable entity for the purpose of reducing income tax. There was a very minimal benefit to charity in comparison to the loss of revenue to Treasury. As has occurred with other types of transactions where this has been the case, federal courts are very likely to find a rationale to recover the Treasury revenue.
Applicable Federal Rate of 1.4% for October – Rev. Rul. 2011-22; 2011-41 IRB 1 (18 Sept. 2011)
The IRS has announced the Applicable Federal Rate (AFR) for October of 2011. The AFR under Sec. 7520 for the month of October will be 1.4%. The rates for September of 2.0% or August of 2.2% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2011, pooled income funds in existence less than three tax years must use a 2.8% deemed rate of return. Federal rates are available by clicking here.