Washington Hotline – October 16 2012

Romney and Schumer Talk Taxes

Members of both parties made speeches on October 9 that focused attention on taxes. While there undoubtedly will be a discussion of tax provisions in the upcoming November congressional session, the focus of the two speeches this week by Presidential Nominee Mitt Romney and Sen. Chuck Schumer (D-NY) was potential major tax reform in 2013.Mr. Romney explained his principal proposal on taxes to reduce the top rate from 35% to 28%. Because the goal is for the plan to be “tax neutral,” the total revenue to be raised should not change from the current amount. The Romney proposal intends to limit itemized deductions to produce a lower top rate and maintain the existing level of tax revenue.

The major itemized deductions are for state and local taxes, home mortgage interest, health insurance and charitable giving. Mr. Romney suggested that a cap of $17,000 on itemized deductions could be one acceptable option.

On a national media news program, Romney was asked whether he would consider reducing the charitable deduction and the home mortgage deduction. He stated, “I can tell you, with regards to the deductions you described – home mortgage interest deduction and charitable contributions – there will, of course, continue to be preferences for those types of expenses.”

In subsequent discussions with news media, aides to the Romney campaign indicated that the cap on deductions could be negotiated to a higher level such as $25,000 or $50,000. All of the final provisions of a tax bill would be subject to negotiation with both parties in Congress.

Romney campaign aides also mentioned other potential options. There could be a percentage cap on itemized deductions similar to the percentage limits for charitable deductions. Another option would be a conversion of some of the itemized deductions to credits.

During the Vice-Presidential debate on October 11, nominee Paul Ryan (R-WI) stated that the tax rate reduction from 35% to 28% could be accomplished without increasing middle-class taxes. He stated that the current levels of taxes paid by upper-income and middle-income Americans could be retained. Vice President Joseph Biden did not agree with this statement and suggested that the current progressivity of the tax system would suffer under the Romney proposal.

Sen. Schumer’s Tax Plan

Senator Chuck Schumer (D-NY) spoke on October 9 and discussed in detail both personal and corporate tax reform.

Schumer stated that the tax reform would be quite different from the last comprehensive tax bill in 1986. That bill was negotiated by House Ways and Means Chair Dan Rostenkowski (D-IL), Speaker of the House Tip O’Neill (D-MA) and President Ronald Reagan. Schumer noted, “Our needs today are different compared to 1986, and we cannot take the same approach we did then.”

He observed that the 1986 bill was revenue neutral. However, because the current national debt is “approximately 73% of GDP” and approximately double the debt level of 1986, Schumer indicated that any tax reform must also lead to higher revenues.

The Schumer plan would start with corporate tax reform. This would be revenue neutral. The rate would be reduced from the current 35% by limiting depreciation and other corporate deductions. A lower overall corporate rate is essential in competing with other nations. All other industrialized nations now have lower corporate rates than the United States. Schumer believes that a lower corporate rate will assist in job creation.

Schumer then discussed three options for personal income tax reform. First, he reviewed the proposals such as a reduction to a 25% top rate accompanied by very limited itemized deductions. He noted that the Joint Economic Committee, a nonpartisan group that assists Congress, estimates that this plan would lead to a tax increase for many taxpayers. Couples with incomes over $100,000 would pay $2,681 in higher taxes.

Second, the Simpson-Bowles plan from the Bipartisan Debt Commission appointed by President Obama suggested reducing the top rate to 28% through changing many of the deductions to credits. This plan would also involve a tax increase for couples with incomes over $100,000 in the amount of $1,000.

Schumer then explored his third approach. He suggested that it is important to protect some tax expenditures, such as those for college education, retirement savings, mortgage interest, charitable deductions, and state and local tax deductions.

In order to protect these tax expenditures, Schumer proposed increasing the top rate to 39.6%. He points to a Congressional Research Service report that states tax cuts “do not appear correlated with economic growth.” If that report is correct, Schumer claims that increasing the rates on upper-income persons will not harm the economy.

A major part of the solution in the view of Schumer is to increase the tax rate on capital gains. A substantial portion of the benefit of the 15% rate on long term capital gains accrues to upper-income persons. Schumer indicates that the capital gain rate should not increase to 39.6%, but should be substantially above the present 15%.

In summary, the Schumer solution involves three elements:

  1. Reduce tax expenditures by limiting itemized deductions.
  2. Increase the top rate to the 39.6% that existed under President Clinton.
  3. Increase the long term capital gain tax rate.

Schumer suggests that a “grand bargain” is possible between the two parties. It would include the higher taxes suggested under his plan together with the entitlement reforms that have been proposed by the other party.

Editor’s Note: Your editor and this organization take no position on the Romney and Schumer tax proposals. It is now probable that there will be a major effort towards tax reform in 2013. While there will be discussion of taxes during the November session, the majority of tax changes are likely to be passed by Congress in 2013.

Potential Higher Taxes in 2013

Following the November election, Congress will return for a “lame-duck” legislative session. Major decisions are needed on both taxes and spending. If Congress does not take action, there will be dramatic tax increases on January 1, 2013.

These potential changes include personal income taxes, long term capital gains tax, dividend tax, a new Medicare tax and the estate tax.

Personal Income Taxes

The major change in personal income taxes is that the rates will return to the 2003 schedule. The tax reductions passed in 2001 and 2003 are no longer applicable after 10 years. Therefore, tax rates are scheduled to increase. The table below shows the rates for 2012 and the new increased rates scheduled for 2013.

2012 Rates 2013 Rates
10% 15%
15% 15%
25% 28%
28% 31%
33% 36%
35% 39.6%

Long-Term Capital Gains

The long-term capital gains rate for 2012 is 15%. Most investment property held more than one year qualifies for the 15% rate. In 2013, long-term capital gains will be taxed at 20%. However, the new 3.8% Medicare tax will apply to capital gains for higher-income persons. Their top rate will be 23.8%.

Dividend Taxes

Dividend taxes in 2012 are at a reduced level for payments from U.S. corporations and some foreign corporations. In 2012, most dividends are taxed at the 15% long-term capital gain rate. If the law is not changed, in 2013 they will be taxed as ordinary income. The top rate for dividends could be 39.6%. In addition, the 3.8% Medicare tax applies to dividends, producing a potential tax on dividends of 43.4% for higher-income taxpayers.

New Medicare Tax

The Patient Protection and Affordable Care Act (PPACA) creates a new Medicare tax in 2013. The tax is 3.8% on the amount of income that exceeds $200,000 for a single person and $250,000 for a married couple. The tax is generally applicable on interest, dividends, passive income from a business, sales of property and other income from financial instruments.

Fortunately, IRA and other pension income are not subject to the increased Medicare tax. However, this retirement income may increase your total income levels. If total income exceeds the $250,000 or $200,000 levels, then your IRA distributions may cause other investment and capital gain income to be subject to the Medicare tax.

Other Personal Tax Changes

There are other changes that will affect individuals. Under PPACA, individuals with incomes over $200,000 (single) or $250,000 (married couples), will pay an additional payroll tax of 0.9% on the excess amount. The personal exemption phase out and limitations on itemized deductions will be reinstated.

Finally, the medical expense deduction floor increases from 7.5% to 10% for most taxpayers. It is retained at 7.5% for persons age 65 and older. Only qualified medical expenses in excess of the floor are deductible.

Estate Tax

In 2012, the applicable exclusion amount for gift and estate taxes is $5.12 million. In addition, a spouse may pass away and transfer his or her available exemption to a surviving spouse. The surviving spouse therefore could have an estate exemption up to double the standard amount.

If there is no tax bill, the exemption reverts to $1 million plus indexed increases over the past decade. In addition, the current 35% estate tax rate will increase to a top rate of 55%, starting at a $3 million estate. Estates from the $1 million plus indexed amount to $3 million will pay tax at a reduced rate. The marital portability, or option to transfer your exemption to a surviving spouse, will not apply unless extended by Congress.

Editor’s Note: It is probable that there will be significant tax changes on January 1, 2013. Because the November legislative session is very short, Congress may change some provisions, but is not likely to change all of these tax rates. It will be important for all Americans to be in contact with their tax advisor to take appropriate action to reduce taxes in December of 2012.

Applicable Federal Rate of 1.2% for October — Rev. Rul. 2012-28; 2012-42 IRB 1 (17 September 2012)

The IRS has announced the Applicable Federal Rate (AFR) for October of 2012. The AFR under Section 7520 for the month of October will be 1.2%. The rates for September of 1.0% or August of 1.0% 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 2012, pooled income funds in existence less than three tax years must use a 1.8% deemed rate of return. Federal rates are available by clicking here.

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