Legislative Update May 2013 Eaton Vance on Washington Andrew H. Friedman Principal The Washington Update The Upcoming Debt Limit Debate: What Tax and Entitlement Changes are in Store? The United States government has once again hit its borrowing limit. Congress had authorized the federal government to borrow $16.4 trillion and, as of the end of 2012, the government had done so. Congress subsequently extended borrowing authority through May 18, 2013. The federal government can continue to operate without additional borrowing for about four months, perhaps a bit longer, after May 18 by paying bills with current tax receipts and funds in accounts set aside for future expenses. But by fall, Congress will have to raise the debt limit or the United States, unable to borrow to pay interest on its debt outstanding, will default on the national debt. One thing is clear to me: Congress will not allow the United States government to default on its national debt. But the coming months could be anxious ones, as the parties fashion legislation to increase the nation s debt limit. The Budget Debate and Entitlement Changes Notably, the Republican budget seeks to cut not only discretionary government spending (which was the focus of the notorious sequester spending cuts), but entitlement spending as well. The primary demand of the Republicans is to change the rate of growth of Social Security benefits. Under current law, Social Security benefits increase each year based on the consumer price index (CPI). The Republicans seek to replace CPI with chained CPI. Chained CPI acknowledges that when the price of an item gets too high, people do not simply pay that higher price, they substitute something cheaper. If the price of beef gets too high, people buy more chicken. Chained CPI does not grow as quickly as conventional CPI. Thus, using chained CPI would slow the rate of growth of Social Security payments. Republicans also are calling for affluent recipients to pay more for Medicare coverage. President Obama has provisionally accepted these changes to entitlements if the Republicans agree to new taxes. In that regard, the President has proposed a number of tax changes to raise additional revenue. Changes of particular interest to investors are outlined below. Each house of Congress has passed a proposed budget for federal spending in 2014. The two budgets the House (Republican) version and the Senate (Democratic) version are opposite in almost every regard. The Democrats focus their spending cuts on defense and seek to balance their spending cuts with new taxes. The Republicans propose significant cuts in federal spending other than defense and eschew any tax increases.
Eaton Vance on Washington May 2013 2 Income Tax Changes New 28% limitation on tax exemptions and itemized deductions The President proposes limiting the tax benefit of exemptions and itemized deductions to a 28% tax rate. Currently, someone in the 35% tax bracket who makes a $100 contribution to charity saves about $35 in taxes. The President s proposal would limit the tax savings in that case to $28, notwithstanding that income received would continue to be taxed at 35%. The President would impose this cap not only on itemized deductions such as mortgage interest, charitable contributions and state taxes, but on at least two popular tax exemptions: employer-provided health insurance and interest on municipal bonds. Under current law, employer-paid health insurance premiums are not treated as taxable income to the employee. The President would cap this exclusion at a 28% tax rate, so that someone in a 35% tax bracket would pay a 7% tax on employer-provided health insurance. The tax exemption for municipal bond interest would be subject to the same cap, so that taxpayers in the 35% bracket would pay a 7% tax on municipal bond interest received. Taxpayers in higher brackets would pay even more tax. Although it is impossible to predict with certainty, the Hill is unlikely to accept new limitations on deductions and exemptions. Taxing health insurance premiums is contrary to the goal of the health care reform law to have employers provide coverage for their employees. And taxing municipal bond interest would raise the borrowing costs of the states, most of which are not in a position to absorb those higher costs. Imposition of the Buffett rule Taking a cue from Warren Buffett (who notes that he pays tax at a lower rate than does his secretary), the President is proposing a minimum tax rate of 30% on affluent taxpayers. The minimum tax rate would begin to apply to taxpayers with adjusted gross income of $1 million. This tax rate would effectively eliminate for millionaires the benefit of the lower tax rates for dividends and capital gains income. (The minimum tax due under the Buffett rule would be reduced by a portion of any charitable contributions made.) The Republicans controlling the House are almost certain to block any imposition of a minimum tax rate, so the prospects for enactment of the Buffett rule appear dim. Retirement Tax Changes Maximum accumulation in retirement accounts The President is proposing limiting the total amount an individual may hold in retirement accounts to a lump sum that can produce a lifetime annual annuity of about $200,000 at age 62. Under current conditions, this limitation would result in a maximum total retirement account balance of $3.4 million. Under this proposal, at the end of each year, an individual would add up the total amount held in IRAs, Roth IRAs, 401(k)s and qualified pension plans. If the total exceeds $3.4 million, the holder would be required to remove from an account (and pay income tax on) contributions made during that year sufficient to bring the total account value under $3.4 million. The proposal would not require withdrawals from account accumulations that exceed $3.4 million solely due to investment returns on account balances. Similarly, the proposal would not apply to retirement account balances that exceed $3.4 million prior to the 2014 effective date. In both cases, however, the holder could not make additional contributions to the accounts in future years (unless the cap is increased to an amount above the account balance). Finally, as proposed, the limitation would not incorporate amounts held in nonqualified annuity contracts. Because this proposal caught most people by surprise, the Hill has not had sufficient time to react to it. The retirement plan lobby is mounting a vigorous campaign in opposition. On balance, the proposal is unlikely to pass Congress, but it is too soon to say so with any sort of certainty.
Eaton Vance on Washington May 2013 3 Eliminate stretching of inherited retirement assets Under current law, an individual who inherits an IRA or is a beneficiary on a qualified retirement plan (such as a 401(k) account) can choose to take payments over his or her expected lifetime. Amounts remaining in the IRA or retirement plan continue to accumulate tax deferred. This ability to stretch inherited retirement assets provides significant tax benefits. The President would eliminate a beneficiary s ability to withdraw funds from an IRA or retirement plan over life. Instead, all amounts would have to be withdrawn (and the associated income tax paid) within five years of the death of the IRA holder or plan participant. The rationale for this change is that a retirement account is intended to provide retirement income for the original holder, not for heirs. The proposed rule would not apply to inheritances by a spouse. The rule would apply only to inheritances due to deaths that occur in 2014 or later. As written it would not apply to stretches of nonqualified annuity contracts. The proposed change to stretch IRAs and retirement plans is a loophole closer. The prospects for passage are discussed in the section on loophole closers below. Wealth Transfer Tax Changes The fiscal cliff compromise reached at the end of 2012 permanently adopted the estate, gift and generation-skipping lifetime exemption amounts set in 2010, and indexed those exemptions for inflation. For 2013, the exemptions are set at $5.25 million. (These lifetime exemptions are in addition to the annual gift tax exclusion that in 2013 permits an investor to give away $14,000 to as many recipients as he or she wishes. This $14,000 exclusion, too, is indexed for inflation and will increase in future years.) The compromise also set the tax rate for the gift, estate, and generation-skipping taxes at 40% beginning in 2013. Permanent means that the enacted provision has no explicit sunset date, where old rules automatically come back into effect. Nonetheless, Congress can always choose to change the tax law at a future date. The President s proposal reflects this ephemeral definition of permanent by seeking to return the estate and gift tax rules to those applicable in 2009. Under his proposal, the lifetime estate and generation-skipping tax exemptions would be set at $3.5 million, the lifetime gift tax exemption would be set at $1 million and the tax rates would be set at 45%. These new rules would apply beginning in 2018. Coming so quickly on the heels of the fiscal cliff compromise, the President s proposal is unlikely to pass Congress. The President also is proposing curtailing the availability of certain sophisticated wealth transfer techniques: A. Grantor retained annuity trusts ( GRATs ) A grantor retained annuity trust is a structure that permits an individual to transfer potential asset appreciation to heirs without incurring gift tax. It works as follows: A donor transfers assets to an irrevocable trust with a specified term. During each year of the trust term, the trust pays back to the donor a portion of the amount transferred plus interest at a rate determined by the IRS (which is based on the Treasury rate). At the end of the term, the donor has received back the initial amount transferred plus all interest due. The trust distributes (or retains for later distribution) to the beneficiaries the asset appreciation in excess of the IRS-determined interest rate. Because the donor receives back an amount equivalent to what he initially transferred plus interest, the donor made no net gift and so did not use any portion of his lifetime gift tax exemption. Thus, there is no limit on the asset value that may be transferred to a GRAT. As long as the donor remains alive throughout the trust term, the asset appreciation and any future earnings on that amount is removed from his or her estate. If the donor dies during the GRAT term, however, the trust assets (including any appreciation) are included in the estate for estate tax purposes, defeating the purpose of the GRAT.
Eaton Vance on Washington May 2013 4 The President proposes requiring a GRAT to have a minimum term of ten years and a maximum term of the life expectancy of the annuitant plus ten years. Imposing a minimum term increases the risk that the donor fails to outlive the GRAT term, resulting in the loss of the anticipated estate tax benefit. The President also would require that the remainder interest have a value greater than zero at the time the interest is created, and would prohibit any decrease in the annuity during the GRAT term. B. Intentionally defective grantor trusts ( IDGTs ) An intentionally defective grantor trust is an irrevocable trust whose assets are outside the donor s estate but the donor rather than the trust itself pays tax on the income earned on the trust assets. Because the donor pays the income tax on trust earnings, income taxes do not deplete the trust assets, permitting more value to be transferred to the beneficiaries. Moreover, because individuals often pay income tax at lower rates than trusts do, income tax paid may be less with an IDGT. An IDGT structure is often combined with an installment sale arrangement. Under this arrangement, a donor sells property to the IDGT in exchange for an installment note payable over a specified term. The installment note bears interest at a rate determined by the IRS (which is based on the Treasury rate). The donor reports on his tax return income generated by the trust assets. However, because the donor is treated as owning the IDGT assets for income tax purposes, the donor does not pay income tax on the initial sale or on the installment note payments received (it s as if he sold the property to himself). Asset appreciation in excess of the installment note interest rate is removed from the donor s estate and passes to heirs free of estate tax. (The IDGT assumes the donor s original cost basis in the trust assets, and so heirs may pay capital gains tax when the assets are later sold.) The President would eliminate many of the tax advantages of this installment sale arrangement. Under his proposal, if a person who engages in a sales transaction with a trust is required to pay income tax on that trust s earnings, then the assets of the trust are included in that person s estate. C. Dynasty trusts To avoid estate tax through multiple generations, estate planners have used dynasty trusts. These trusts remain in place through many future generations, typically distributing income to each generation but retaining principal. In many states, a rule against perpetuities limits the number of future generations that a trust may remain in existence. But some states have repealed the rule against perpetuities and permit dynasty trusts to go on for very long periods. The President proposes limiting to ninety years the tax benefits provided to dynasty trusts. After ninety years, the generation-skipping tax (which is imposed at a rate equivalent to the estate tax) would be imposed on the value of the trust assets. D. Family limited partnerships ( FLPs ) Use of a family limited partnership can allow a donor to claim a lower value for gifted assets, thus reducing the gift tax due on the transfer. With an FLP structure, a donor transfers assets to a (often newly formed) partnership rather than to the recipient directly. The donor then gifts a minority interest in the partnership to the recipient. Where the minority interest holder in an entity is unable to control the actions of the entity, most economists believe that the value of the minority interest is less than the value of the equivalent percentage of the entity s underlying assets. This minority discount applies, for instance, where the holder of the retained majority interest can make decisions unilaterally for the partnership. Application of a minority discount reduces the value of the gift for purposes of applying the gift tax.
Eaton Vance on Washington May 2013 5 In past years, the President has proposed limiting the use of minority discounts to assets that are not readily traded and, thus, not easily valued, such as real estate or interests in a closely held business. Under those proposals the minority discount would not be available for publicly traded securities, such as equities or mutual fund shares. This proposal is notably absent from the list of tax changes the President is now seeking. Some commentators believe that the absence reflects the fact that the IRS is about to issue long-awaited regulations that would accomplish these restrictions without additional legislation. See, e.g., Schaller & Harshman: The Death Knell for Family Discounts?, Steve Leimberg s Estate Planning Email Newsletter (April 2013). This path would be consistent with the President s stated aim to act by regulation where possible rather than wait for a recalcitrant Congress. Loophole Closers The proposed changes to gifting techniques as well as the proposal to eliminate stretch IRAs fall under the category of loophole closers, provisions in the tax code that provide, at least in the eyes of the Democrats, unintended tax benefits. Republicans are not against loophole closers in concept. However, Republicans believe that revenue generated from closing loopholes should not be used to reduce the deficit. Rather, deficit reduction should be undertaken solely through spending cuts, and any revenue raised from closing loopholes should be used to reduce the tax rate in a process of comprehensive tax reform. Nonetheless, loophole closers remain one area of possible agreement as Congress approaches the need to increase the debt limit. The proposed curtailments to sophisticated gifting techniques would apply to gifts made after the date legislation is enacted (or, in the case of minority discounts, after the date regulations are issued). These effective dates put a premium on individuals acting now to take advantage of these techniques to augment their gifting programs, before any changes (if enacted) become effective.
Eaton Vance on Washington May 2013 6 About Eaton Vance Eaton Vance Corp. (NYSE: EV) is one of the oldest investment management firms in the United States, with a history dating to 1924. Eaton Vance and its affiliates offer individuals and institutions a broad array of investment strategies and wealth management solutions. The Company s long record of exemplary service, timely innovation and attractive returns through a variety of market conditions has made Eaton Vance the investment manager of choice for many of today s most discerning investors. Andrew H. Friedman is the Principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He speaks regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products. He may be reached at www.thewashingtonupdate.com. Neither the author of this paper, nor any law firm with which the author may be associated, is providing legal or tax advice as to the matters discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. It is not intended as legal or tax advice and individuals may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement or insurance arrangement. Copyright Andrew H. Friedman 2013. Reprinted by permission. All rights reserved. Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor. Prospective investors should read the prospectus carefully before investing. 2013 Eaton Vance Distributors, Inc. Member FINRA/SIPC Two International Place, Boston, MA 02110 800.225.6265 eatonvance.com 6867-5/13 EVOWDLOTCLF