Senate Extenders Compromise on Hedge Fund Taxes

The Senate continues to move forward on the American Jobs and Closing Tax Loopholes Act of 2010 (H.R. 4213). Following passage of the bill by the House on May 28, 2010, the Senate has taken up the legislation.

The House bill’s principal offset is a tax increase on hedge fund managers. Under existing law, their “carried interests” are taxed at the 15% capital gain rate. The House bill would tax 75% of carried interests at ordinary income rates and 25% at the capital gain rate. Because the capital gains rate is scheduled to increase from 15% to 20% next January, the combined rate under the House bill will be 34.9%. This is more than double the current tax rate for hedge fund managers.

The Senate this week released its version of the extenders bill. The Senate proposes taxing income of most hedge fund managers’ carried interests as 65% ordinary income and 35% capital gain. However, if the hedge fund holds the asset for seven years, then the ordinary rate portion is 55% and the capital gain part is 45%.

The Senate bill also increases the oil-spill-cleanup tax. While the House would increase the tax from eight cents to 33 cents per barrel, the Senate plan is to increase the “oil spill” tax from eight cents to 41 cents per barrel. The existing oil spill fund of $1.5 billion is now inadequate to clean up the Deepwater Horizon spill that has done great damage in the Gulf of Mexico.

Sen. David Vitter (R-LA) expressed concern about the oil spill tax. He suggested that this tax is an obvious effort to use the outrage over the Gulf of Mexico oil spill as a “gimmick” to raise taxes on the oil industry.

The Senate bill also includes the House provision on Subchapter S corporation payroll taxes. The House bill does not permit the current practice by many Subchapter S corporations to pay nominal salaries. These Sub S corporations still pay the same income to owners, but avoid payroll taxes on the majority of income by classifying it as dividends. For individuals who are in most service partnerships, the full amount of future Subchapter S earnings will be subject to payroll taxes.

The American Institute of Architects sent a letter this week to Senate Majority Leader Harry Reid (D-NV) and opposed the Subchapter S payroll tax increase. The architects and engineers indicated that the bill will “sweep in many legitimate and tax compliant small architectural and engineering firms” into the new tax. It will increase payroll taxes and reduce potential ability to hire unemployed workers.

Sen. Reid indicated that he plans to start voting on the new bill and potential amendments within the next few days.

Editor’s Note: The House and Senate are nearing agreement on the tax increases for the extenders bill. The ongoing debate shows how difficult it is to come to agreement on tax increases. As the Federal Fiscal Commission continues to prepare for the report due December 1, 2010, it is becoming quite evident that the tax increases they are certain to propose will be quite controversial.
Independent Sector Supports IRA Rollover in Extenders Bill

Diana Aviv, President of Independent Sector, sent a letter this week to Chairman Sander Levin (D-MI). She expressed “strong support” for many of the provisions in the tax extenders bill. She was “particularly pleased that this legislation would extend the IRA rollover provision.”

Ms. Aviv notes that the rollover provision during the past four years has “generated millions of dollars in new contributions” that have enabled charities to “build cancer centers, develop programs for counseling at-risk youth, support housing for homeless families, conserve wilderness areas and provide art therapy for people with developmental disabilities.”

The other provision in the bill that Independent Sector noted is the enhanced deduction for gifts of “apparently wholesome” food inventory. This is particularly important because of the number of people in economic need during the downturn.

Editor’s Note: Both the House and Senate tax extenders bills include the IRA charitable rollover effective from January 1, 2010 to December 31, 2010. After the compromise on offsets is finalized, the bill should pass by the end of June.
Bernanke Predicts 3.5% Growth for USA

Federal Reserve Chairman Ben Bernanke spoke on June 9, 2010 to the House Budget Committee. He gave a fairly complete briefing on the economy. Chairman Bernanke indicated that he expects real gross domestic product (GDP) growth this year and next of 3.5%.

There was both good news and bad news in his briefing. The good news was that business profits are up and corporations have record levels of cash accumulation. This cash is likely to be invested in new equipment and software during the next year. In addition, inflation has been very low for the past year. Because the world economy is still quite slow, Chairman Bernanke anticipates low inflation rates for the foreseeable future.

However, there also was bad news. Housing continues to be in recession. There is a “large inventory of distressed or vacant existing homes” that continues to depress prices. The unsold homes also reduce incentives for contractors to build new homes.

Unemployment remains just below 10%. The U.S. economy lost 8.5 million jobs during the past two years. While an average of 140,000 new private sector jobs are being added per month, it may take three to five years to replace the lost jobs.

There is also concern over the problems in Greece and other nations in Europe. As a result of large government debt and massive budget deficits, Greece and several other European nations have been forced to take dramatic austerity measures. They have substantially reduced budgets and increased taxes in the middle of a major recession. These actions will lead to a sustained period of below-normal economic growth.

The U.S. fiscal position has “deteriorated appreciably” since the 2008 financial crises. Chairman Bernanke considers the current budget trend “unsustainable” and urged Congress to address the structural budget deficit.

Editor’s Note: While Chairman Bernanke did not explicitly make this statement, it is clear that his presentation is intended to pave the way for the 2011 tax increases. Even with the recovering economy, the need to address the budget deficit makes very likely the increase in the top income tax rate to 39.6% and the capital gain rate from 15% to 20%.
Small Business Bill Offset by 10 Year GRAT

The House is preparing to vote on the Small Business Jobs Tax Relief Act of 2010 (H.R. 5486). The major tax provision of this bill is a forgiveness of capital gains tax on sales of stock for qualifying small businesses that issue new stock between March 15, 2010 and January 1, 2012.

The White House supported the bill provisions and recognized the importance of new jobs created by small businesses. Information from the Small Business Administration (SBA) indicates that between 1995 and 2010, 64% of net new jobs were created by small business.

President Obama praised the bill and stated, “Insuring that small businesses can thrive is about more than our economic success. It’s about who we are as a people. It’s about a nation where anybody with a good idea and a willingness to work can succeed. That’s the promise of America.”

Because under the “pay-go” rules a reduction in taxes requires an offsetting tax increase, the House bill necessarily includes several tax increases. One proposed tax increase is to change the minimum term for grantor retained annuity trusts (GRATs) to a minimum of 10 years. This concept was included earlier this year in the proposed White House Budget for 2011.

Editor’s Note: A GRAT is frequently created for a term of two years under current law. With a very high two-year payment back to the grantor, the assets transferred to the GRAT are frequently returned. However, if the assets appreciate during the two years, then the appreciation may be transferred to family with little or no gift taxation. If the minimum GRAT term is 10 years rather than the current two years, it still will be possible to create a GRAT. However, the attractiveness will be substantially reduced with a ten-year term. The Congressional estimate is that the increase in the GRAT term would save $5.3 billion in taxes over the next decade.

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