Will You Pay More Taxes in 2007?  A Look Into Our Crystal Ball

With the Democrats now in control of the House of Representatives and the Senate, some of the major issues they and President Bush will face are persistent budget deficits, estate tax reform, the alternative minimum tax, and entitlement spending (Social Security and Medicare). 

Our view, and that of most other commentators, is that the likelihood of significant progress on the big fiscal and tax issues over the next two years is low.  However, the Democrats are, presumably, eager to demonstrate that they can govern effectively, and President Bush is, presumably, eager to add some domestic accomplishments to his final term.  So, just maybe, there are some tax policy areas where meaningful legislation can be passed.  Here are our candidates.  

How Do You Spell AMT Relief

2010 is scheduled to be the mother of all sunset years with one notable exception: AMT.

The AMT change is already upon us.  In 2007, the AMT exemption declines to $33,750 for single filers and $45,000 for married filing jointly.  Without any remedial action by Congress, this reduced exemption, combined with the general impact of even modest inflation on income levels, will cause the AMT to continue to ensnare many more millions of taxpayers (the Congressional Budget Office estimates 30 million by 2010).  No news to many of our clients, who are already paying the AMT because of lost state income and property tax deductions.  What is new is that the Democrats control Congress and the highest incidence of AMT paying taxpayers reside in some of the “bluest” states.  So it’s possible that an AMT fix will draw more congressional sympathy. 

However, a permanent AMT fix is very costly (The Congressional Budget office estimates that “curing” the AMT could cost nearly a trillion dollars).  Simply lowering the AMT tax rates (now 28% and 26%) or increasing, and indexing to inflation, the exemption amount, without any other offsets, will blow an even larger hole in the budget.  So any eventual permanent fix will likely also involve a combination of reducing, or slowing the growth of, domestic spending and increasing regular income tax rates. 

Increasing regular individual income tax rates could “solve” the problem  (whether heightening regular tax exposure should be viewed as a “fix” depends on where one’s tax situation currently falls).  Moreover, it seems virtually unimaginable that President Bush would sign such legislation during the last two years of his Presidency.  A far less likely, but more far reaching solution, could surprise us: wrapping AMT relief into a major tax simplification or flat tax package.  Such a package could even eliminate the AMT or make it moot, but the effect on clients’ overall tax positions would be very dependent on the specifics of the reform. 

The important planning point is that most of the likely eventual fixes to the AMT conundrum and to the overall budget situation will involve higher ordinary income tax rates.  And those higher ordinary rates, of course, would impact many of our clients.  In short, sometime in the future you probably won’t pay the AMT because you will be paying an even higher regular tax.  Be careful what you ask for!

Meanwhile, the cost of a continuation of a short-term AMT fix is not that high.  Muddling along by extending the higher AMT exemption amounts for just another year, the band-aid approach, is estimated to cost “only” $35 billion.  So that is likely to be, for now, the path of least resistance.  We expect legislation along those line sometime fairly early in 2007.

Don’t Forget the Zero Percent Capital Gain Rate in 2008

For the same reason of Presidential legacy, wielded by the veto, we see no increase in capital gains or dividend rates before 2009.  In fact, the rate on capital gains and dividends for the lowest two regular tax brackets (10% and 15%) goes to 0% in 2008!  Clients will thus be able to transfer up to $31,850 in appreciated value (a position worth $50,000, for example, with a basis of $18,150) to single filers.  This includes, of course, children over 17 years of age (to avoid the kiddie-tax).  Of course, gifts in excess of the annual exclusion amount ($12,000 per donor per donee) would be subject to gift tax.

The recipient will pay zero federal capital gains tax if they have no other income.  Many states (including California) will continue to tax the gain, so it’s not completely tax free but the zero percent rate does provide an opportunity that you should not miss in 2008.  Whether this survives a new Administration and continues into 2009 and beyond remains doubtful.

Bottom Line

From this vantage point, we don’t see any general tax reason to accelerate 2008 income into 2007 or not to defer 2007 income into later years.  As next year, 2008, progresses, a different view might prevail as we then look ahead to 2009

More potential good news for our clients:  Estate tax reductions?

The currently scheduled future

Before we look at where the estate tax might go, let’s take a look at the remaining implementation of the existing legislation:

What could happen next?

On a practical level, the current lay of the estate tax land is annoying and makes confident, long term estate planning difficult.  More importantly, it’s a fairly high profile political topic.  Most taxpayers hate the estate tax; but some (even very rich people) view it as an engine of social justice; and the revenue is a non-trivial component to the government’s budget.  With a Republican remaining in the White House for the next two years and a newly Democratic Congress beginning its work in 2007, what might unfold?

Do nothing?  This is not a very likely outcome.  Momentum is already building, as evidenced by several proposals that have come out of Congress in the recent past.  Both the Republicans and the Democrats face the threat of losing the ability to each claim victory in this area, if they don’t act fairly soon. 

Make the 2010 repeal permanent? We don’t really expect the government to go this far in the next two years…or ever.  If the Republican White House and Republican Congress weren’t able to achieve this result in the last six years, there’s little chance that we’ll see repeal during the next two.

Pass structural reforms?  Our fingers are crossed!   There is real political popularity to be gained by simplifying the estate tax rules. 

The most likely element would be the lifetime exemption amount.  We can easily envision Congress and the President agreeing on some higher, but fixed (maybe even indexed for inflation), lifetime estate tax exemption, maybe in the $5 million per person range.  With the benefit of both spouses’ lifetime exemptions, this would mean that, for married couples, the estate would have to exceed $10 million to attract any estate tax exposure.  This would dramatically decrease the total number of taxable estates, while still sheltering a large absolute dollar amount of even bigger estates from tax. A larger and fixed lifetime exemption also avoids the cost basis record keeping mess that would likely unfold if total estate tax repeal actually occurs with the trade-off of only limited income tax basis step-up.

Modification of the estate tax rates is a wild card and may be the stumbling block to a quick bipartisan agreement; the fiscal impacts could be damaging to the budget balancing act.  

Doing both: Raising the exemption and reducing rates would result in charging the estate tax to many fewer wealthy Americans and at effective tax rates that may not be worth the bother of administering and enforcing the estate tax system.  The pragmatic limitation of this complex tax system would meet, at some impasse, the resistance of those for whom the tax is a matter of social justice, so we’re not counting on a major rate reduction.   

Another factor that could be changed is the $1 million lifetime gift tax exemption amount.  Since 1976, the lifetime estate and gift exemptions had been synchronized until the tax law of 2001.  In 2002, the gift tax exemption became fixed at $1 million while the estate tax exemption began to increase.  Since this gift tax free limitation doesn’t get much attention and since, to most people, $1 million is a large sum of money to be able to give away tax-free on top of the per donor per donee annual exclusion, we don’t see much political impetus to enlarge this opportunity. 

Sadly, it’s possible that the government could move opposite to our expectations and prolong the confusion by passing band-aid laws that would serve to continue some version of the current annual changes in estate tax exemption and tax rate amounts for a series of future years.   Still, we think a likely outcome, before 2010, would be some balancing act between changes to the estate tax exemption and to the estate tax rates that would allow almost all Americans to avoid the tax entirely.

What does this mean for clients’ estate plans?

Remember that it’s not mostly about taxes.  The main purpose of an estate plan is to efficiently transfer assets at your death to beneficiaries that you’ve designated, while minimizing confusion and emotional strain on those beneficiaries.   Minimizing estate taxes is usually a secondary objective.  Regardless of what changes are…or are not…made to the estate tax system over the next several years, estate plans (with their wills, trusts, and other agreements and directives) will remain an important and valuable means of accomplishing clients’ goals and be a crucial component of clients’ overall financial plans. 

Consequently, you will continue to benefit by having a flexible estate plan in place that is designed to deal with a changing tax law landscape, including mechanisms in the plans that could be turned on or off to optimize tax treatments as appropriate. 

What about Social Security taxes?

For legacy purposes and to avoid the rap as the two-term president who promised much but then failed to deliver on Social Security, we expect the President to again focus his attention on improving the Social Security financial situation during his remaining 2 years in office.  While we’re not sure that that’s enough time for the President to successfully realize his dream of private Social Security accounts, he may convince Congress to pass some reforms that would make the system more financially viable.  See the article from our 1st Quarterly 2005 Wealth Management Commentary for a discussion of what was last on the table. 

Sadly, we don’t expect anybody in Washington to be willing, soon, to tackle the even larger problem looming in Medicare…a conversation for another day.

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While no one can know what lies ahead for personal income, estate, and Social Security tax legislation, we’ll continue to pay very close attention to developments.  As always, we stand ready to help clients optimize their personal financial situations as changes appear on the horizon.

Tom Tracy and Sandi Bragar