ALERT - What Should You Do in Light of Uncertain Tax Rates?

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July 27, 2010

The “gordian knot” today is what should a businessman or an investor do in light of the expiration of the Bush income tax cuts and the imposition of new taxes effective in 2013.

Income taxes and the tax rates have at least three important consequences to taxpayers.  First, it affects entity selection: that is, whether the taxpaying entity is an individual, a flow-through organization such as a partnership or Subchapter S corporation, or is a C corporation.  Second, the determination of whether to sell today or defer until a later point is impacted by the tax rate.  Lastly, the taxation choice of income mix to the recipient, whether in the form of wages, dividends, and capital gains, is of increased tax significance.

The 2001 Bush tax cuts will sunset and expire as of December 31, 2010 (1).   How the expiration of these tax cuts will affect tax rates is set forth below:

Tax Rates:  Today and Tomorrow


In addition to the “inlaw” tax increases scheduled for 2011, new taxes were passed in the Health Care Bill in 2010, effective 2013.

Individuals will pay an extra 0.9% Medicare tax on earned income in 2013.  That is, an individual’s tax rate will increase from 1.45% to 2.35% for single taxpayers with earned income of $200,000 and for married filing jointly with earned income of $250,000.  This increase only affects the employee’s portion and not the employer’s.  It will appear as a separate line on Form 1040.

Starting in 2013, individuals will also be required to pay a new Medicare surtax on unearned income of 3.8% on modified adjusted gross income for couples earning more than $250,000 and $200,000 for singles.  The new 3.8% unearned income surtax will be imposed on interest, dividends, annuities, rents, royalties, passive income, capital gains, and financial instrument trading.  It will not include tax-exempt interest, self-employed income, active business income, IRA, or retirement distributions. 

Therefore, in 2013, a capital gain could be taxed at 23.8% ($20% capital gain tax plus 3.8% Medicare surtax). 

Moreover, in 2013, dividends could be taxed at 43.4% (39.6% ordinary income tax plus 3.8% Medicare surtax).

It is also important to remember that dividends, which are payouts from business earnings, are already taxed at the corporate rate of 35%.  The individual dividend tax is a second levy on that same income, and a rate of 43.4% would take the total tax on each dollar paid in dividends to something like 60¢.  These are not unsubstantial tax adjustments.

Further, the individual medical expense deduction threshold will increase from 7.5% to 10% of adjusted gross income through the recent health-care tax changes.

The expiring Bush tax cuts are presently being debated in Congress as to whether they should be modified.  It is important to remember, however, that if Congress does nothing, the tax rates with automatically increase on January 1, 2011.  While predicting what will happen in the political sphere is speculative at best, businesses and individuals need to assess their tax situation and figure out how to best survive in an increasing tax environment.

For example, a businessman who can sell his business in 2010 may want to do so if taxes are a concern.  An illustration will make the point.

The long-term capital gains rate has ranged from 15% to 28% since 1981; and, as indicated above, the current rate is 15%.  Below is a table that represents the percentage increase in the sale price of an asset needed to achieve the same net after-tax proceeds using various capital gains tax rates.

Capital Gain Chart

The new tax environment contains many provisions that will affect you and your business, such as choice of entity, the determination to sell now or defer, and how to arrange your income mix to get the best tax position without sacrificing security and safety (wages, dividends, or capital gains).

While some of the health-care tax provisions do not take effect until 2013, and there is the uncertain specter of what Congress will do in 2010 as to the expiring Bush tax rates, you and your business cannot sit still but need to be planning ahead.

We would be happy to consult on what the new tax rates mean for you and your business today and in the future.  If you have any questions on the new tax rate regime, please contact Jerry Geis or a member of the Tax section or Business Law section.

1) For simplicity, the effect of the expiring clawback on itemized deductions and personal exemptions is not shown on the 2011 rates.  In 2011, the provision that shaves deductions claimed by upper-income taxpayers as well as the phase out of personal exemptions will come back, in effect adding another 1.2% to the 2011 rates.

For a PDF of this alert, click here.

This publication is circulated to bring useful and timely information to our clients and colleagues. The publication is for general information purposes only and is not legal advice. You should not rely on any information or views contained in the publication in evaluating any specific legal issues you may have. Please consult your Briggs and Morgan attorney for specific legal advice. Any U.S. Federal tax advice contained in this communication (whether distributed by mail, email or fax) is not intended or written to be used, and it cannot be used by any person for the purpose of avoiding U.S. Federal tax penalties or for the purpose of promoting, marketing or recommending any entity, investment plan or other transaction. (The foregoing legend has been affixed pursuant to U.S. Treasury Regulations governing tax practice.)