Dan Hanson, a Principal in MFR's Tax Service practice, guides us through a comparison of the U.S. tax liability for two different taxpayers under several different legislative options -- the expiration of the Bush tax cuts, the Compromise Plan and the Democratic Plan.  To learn more, contact Dan Hanson at 713.622.1120.

The miser Ebenezer Scrooge is haunted in Charles Dickens’ A Christmas Carol by the “Ghost of Christmas Future” to prompt him into adopt a more caring attitude.  Reflecting on what he had seen, Scrooge asks, “Are these the shadows of the things that Will be, or are they shadows of things that May be, only?”

The Ghost, in response, pointed downward to an inscription on a gravestone.   “Men’s courses will foreshadow certain ends, to which, if persevered in, they must lead,” read Scrooge, “But if the courses be departed from, the ends will change….” 

This is a message that was taken to heart by President Obama and the lame-duck session of Congress – act or let the electorate suffer the tax consequences.

According to Dan Hanson, MFR tax principal, “As a new year begins, we are prompted to think about things that we should change and we make resolutions.  We also think about changes that we made to make things different in the upcoming year.  In 2011, we can be grateful that the Congress’ “lame-duck session” acted to postpone the sunset of the Bush Tax Cuts.  (See: Middle Class Tax Relief Act.)  By looking at several comparisons, we can see how the compromise saved us from a significant, automatic tax increase in 2011 and, instead, resulted in a tax reduction for taxpayers.”

In Early December, the Tax Foundation published Fiscal Fact No. 254, “Obama’s Tax Compromise and its Effects on Low-Income Taxpayers,” which concluded that less affluent taxpayers would benefit in large part from the proposed one-year cut in the payroll tax, a key element of the White House compromise plan. The Tax Foundation also prepared a Tax Calculator  (“MyTaxBurden.org”) that facilitates a comparison anticipated 2011 tax bills under three scenarios:  (1) Congress allows all of the Bush tax cuts to expire; (2) Congress passes the compromise proposal, and (3) Congress passes the Democratic tax plan.  Using that tool, we compared the potential tax consequences for two upper income taxpayers (the controversial minority).

Two Taxpayers

The examples here break down the U.S. tax liability of domestic taxpayers in two different situations, comparing  the tax liability in 2009 (Base Case) with the tax liability under several legislative options: (1) the expiration of the ‘Bush tax cuts’; (2) the Obama/ Republican ‘Compromise’ plan, which was enacted (including the Social Security and Medicare (Payroll Taxed) roll-back from 6.2% to 4.2%; and (3) the Democratic Plan, in which the tax cuts were extended only for taxpayers making less than $250,000.

Taxpayer A:
Married taxpayer, one dependent (under 17, lives at home), earning total gross income of $205,000 ($150,000 in wages, $50,000 in long-term capital gains (LTCG) and $5,000 in dividend income). Gross itemized deductions are $18,000 ($3,000 in state and local taxes, $5,000 in real estate taxes, and $10,000 in charitable contributions).

The Base Case is defined as the hypothetical “Total Tax” in 2009.

None of the options triggered Alternative Minimum Tax (AMT).  Key drivers affecting the various options are the treatment of capital gains and dividends, deduction for state and local taxes (included in the Bush tax cuts) and the payroll tax reduction under the Compromise Plan.

Taxpayer B:
Married taxpayer, two dependents (under 17, at home), earning total gross income of $370,000 (wages of $230,000, spousal wages of $60,000, LTCG of $70,000, and dividends of $10,000).  Gross itemized deductions are $35,000 (state and local taxes of $5,000, real estate taxes of $10,000 real estate taxes, and charitable contributions of $20,000).

In this example, the Compromise Plan triggered AMT of $8,533, increasing tax liability from a regular tax amount of $68,721 to $77,254.  (Under the 2009 Base Case, the taxpayer paid a similar amount of AMT.)  The roll-back in Payroll taxes under the compromise agreement is greater for Taxpayer B than Taxpayer A since Taxpayer B has two wage earners, both of which are eligible for the Payroll tax reduction.  Also note, under the Democratic Plan, taxes would have risen due to earnings in excess of $ 250,000.

Gift and Estate Tax Changes

According to Hanson, “The changes affecting gift, estate, and generation skipping taxes are easier to appreciate, although very few people are satisfied with the resulting short-term fix.  Without legislative action, the rate for these taxes would have increased in 2011 to 55-percent, with an exemption of $1 million (an amount adjusted in future years for inflation).  Effectively, this result was delayed to 2013 unless changed by future legislation.”

As a result of the lame-duck law, the following changes are in place for calendar years 2010, 2011 and 2012:

• For 2010, the estate tax has been retroactively reinstated with an exemption amount of $5 million and a tax rate of 35-percent, but estates can opt out of the tax and be subject to modified carryover basis rules;
• For 2010, the gift tax exemption remains at $1 million with a top rate of 35-percent and the GST exemption is set at $5 million with a tax rate of zero;
• For estates of decedents dying during 2011 and 2012, the executor may elect to carry over any unused estate tax exemption to the surviving spouse; and
• The maximum rate of tax for these transfer taxes is set at 35-percent, with a $5 million exemption amount (adjusted in 2012 and later years for inflation).

Concluding Remarks

“Long-term tax planning for individuals and businesses has become increasingly difficult with a long series of short-term fixes and sun-setting incentives,” this according to Dan Hanson.  Hanson goes on to say,   “Many taxpayers would have suffered if the Bush Tax Cuts were not extended and the Compromise Agreement extended the benefits to all workers by reducing payroll taxes.  The result is that tax policy did not jeopardize our economic recovery.”      

Jeremie VanOeveren, a Tax Associate in MFR’s Tax Services practice, contributed to this article.