Nutter's Washington

Taxed At Death: How Could the Deceased Owe more Taxes? Isn't Death Enough?

In part one, there was a discussion of how assets are treated upon the death of the taxpayer. Now, it get worse

The centerpiece of the President's tax proposal is much more than an increase in the capital gains rates. The Administration also wants to eliminate the current system by requiring estates to pay capital gains taxes upon death. That is to say, when a person dies, there is a phantom taxable gain on all appreciation in value of a property even though there has been no disposition of the asset.

Part Two: Taxed to death upon death

This is an income tax issue on major consequences and will deeply impact many small businesses, landholders, farmers, ranchers and even those who have owned their homes for many years. It is purely an attempt to raise taxes to enlarge government. It can definitely not be viewed as a deficit reduction measure, particularly the way the Federal government has expanded subsidies, and the welfare state. Deficits will continue to expand for more than the foreseeable future; particularly as interest debt payments and interest rates increase.

Asset appreciation could, in theory, be measured and taxed when the property owner dies and the assets or businesses are transferred to the heirs.

However, a under longstanding provision of US tax law, in place since the Revenue Act of 1921, the transfer of assets at death to an heir does not trigger a capital gains tax. Current tax law allows the heir to increase their basis in the bequeathed assets to fair market value without payment of capital gains tax. This is referred to as a ‘step-up’ of basis. The basis step-up prevents potential past capital gains tax on inherited to be taxed.

The Federal Treasury forgoes-according to some-a substantial amount of revenue by not taxing the gain on assets held until death. In fact, according to the Office of Management and Budget, it is one of the bigger existing “tax expenditures.” which is defined as revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.” 

Tax expenditures have the underlying assumption that the government is allowing taxpayers to keep their own money. It is important to note in the case of stepped up basis, it really not possible to know with any certainty, as data from all people who receive property from a decedent is not verifiable particularly where an estate tax return is not required to be filed.

There have been a few attempts to repeal this 100-year-old established principal of stepped-up basis. There was some fleeting success to a certain extent in Tax Reform Act of 1976, which installed a type of carryover basis regime and eliminated stepped-up basis. However, led by Senator Harry F. Byrd Jr. (I-VA) and Senator Robert J. Dole (R-KS). The provision was suspended and eventually repealed by Congress in short order

The Biden proposal goes beyond the elimination of “stepped-up basis”. It calls for a realization event at death, which means the asset will be deems sold at its fair market value even though it was not, and any untaxed appreciation will be recognized as gain.

So in the previous example, even though the aunt dies and passed on the asset, which is unsold by the beneficiary, there will be substantial income taxes due from the aunt.

Take an even worse example; a family farmer owns agricultural land which been has farmed for 40 years. The price of the land has gone up due to inflation and perhaps other reasons. The farmer wants to pass it on to his son to farm. There is a substantial income tax liability at the farmer’s death but there is no money to pay the tax so the result is the land must be sold, no more family farm.

In order to quell opposition to this very bad idea, the Administration proposal will likely be littered with income levels, carve outs and exceptions but the fact remains a person who dies will have all his property that has appreciated subject to income tax. A pretty horrible and drastic concept and a deviation from long established tax principles. When is enough enough?

These are uncertain times but any big tax expenditure is in jeopardy in a climate of tax increases.  Repeal of stepped-up basis is not necessarily an immediate tax hike that can be felt by everyone but it is a tax increase. Instigating an income tax at death goes far beyond this concept.  

In summary, there have been a number of proposals to repeal the step-up in basis at death to tax gains that were not recognized during the decedent’s lifetime.

The worse by far is to tax gains at death--- that is to deem death to be a “recognition event.” This tax would be in addition to any estate taxes owed, and if no money were available to pay what could be a sizable amount, the asset would have to be disposed. If the heirs take the property, a new fair market value basis would be in place to prevent double taxation in the future.

Promoting income taxes at death is such a terrible idea, destructive, punitive and just shows bad ideas never go away.

Taxed to Death At Death: The Coming Death Taxes

 

The Biden Administration has launched a crusade to increase tax rates to satisfy an insatiable appetite to fund expanded government. It has embraced one of the worse ideas in tax policy by advocating recognition of income tax on unrealized gains at death.

There is considerable confusion concerning tax consequences at death, often referred to as the Death Taxes. In two parts, I am going to explain the different facets and the consequences of such radical changes.

Part One

The difference between estate and income taxes

In order to understand all the nuances it is important to separate the income tax from the estate tax. The federal estate tax does not impact all that many estates even though the estate of every U.S. citizen is subject to tax upon death. Within certain limits, the decedents estate may have to cough up addition dough to the government for dying and having property. However, there is a lurking income tax issue out there that goes along with it and it is a sneaky one.

Many conservatives refer to the estate tax as the ”death” tax and would like to abolish it. Liberals, of course, believe everything belongs to the state and would like to have as high a tax rate and lowest exemption level as possible. There are also a few in the middle, like me. I have no problem with a reasonable tax rate on very large estates.

The dirty secret is that these very large estates through private foundations, charities, generation trusts and other such devices can largely blunt the effect of the estate tax and still more or less control the money from the grave.

The Starting Point is Basis

Every asset has a “basis”, usually its cost. It is the benchmark for future tax consequences, like selling, gifting, asset depreciation and bequeathing.

Property can be disposed during a lifetime like selling, gifting, or abandoning it. For example if my aunt buys a share of stock, which she paid $100 for 10 years ago, the $100 is her basis. If she sells it for $1000, she would incur a taxable gain of $900.

If she gives the stock to me, my basis is $100, and if I sell it for $1000, I have a $900 gain, which would be included in my income taxes. This is called “carryover basis”.

If the aunt dies and leaves the stock to someone, the asset acquired from her estates is “stepped-up.” That is to say, the assets in an estate and the subsequent beneficiaries receive a new income tax basis equal to the fair market value of the assets on the date of the decedent’s death, (or on an alternate valuation date an estate may elect on the six-month anniversary date of a decedent’s death.) Accordingly, a beneficiary will pay income taxes on any received assets subsequently sold based on the difference in value of the assets between the date of death value and the sales price.

In the above example instead of gifting the stock the aunt conveys it at her death, the beneficiary gets a basis of $1000 and upon its sale for $1000, there is no income tax because there is no gain. This is one of the few ways to avoid tax on appreciated property but, of course, someone has to die.

I would argue preserving stepped-up basis is much more important to the average taxpayer than whatever the estate tax rates are on mega-estates. This is an income tax issue after all. Normal taxpayers who inherit property do not always know what the basis is to the property received and why subject the property to the estate tax and then to the income tax?

Part Two will describe the consequences of the Administration embrace of installing a regime that will impose income taxes in all situations when a person dies.

TIME TO GET GOING ON REAL TAX REFORM

 

BY: Jack O. Nutter

Tax Reform. Seems so obvious. For what are we waiting?

There is a dire need to overhaul the Federal income tax system. I do not see any disagreement on this notion. The tax code is a mess and littered with a bunch of garbage and ineffective narrow provisions. It is an unwieldy product of an entrenched political system. I do not know how anyone can defend it.

With the installation of Donald Trump flanked by a Congressional Republican majority it would seem the stars are aligned for tax reform. It is an opportunity that does not come along very often and should not be squandered. However, the issues and the politics are very intricate and success is not assured, but it is time to get moving.

The fundamental role of a tax system should be to raise sufficient revenue to fund the legitimate and democratically agreed upon government functions. Unfortunately, that is not the case for our system.  It has become about picking winners and losers, rewarding friends and trying to punish enemies. It has become a philosophic opportunity to shape government, society and direct individual conduct.  The country can do better.

So, if the system is broken, if there is great support for “reform”, what is the holdup? What is the problem?

Tax reform has been studied for years. I mean real reform. Simplification, Not just simple rate cuts or adding more preferences, but getting the favoritism and distortions out. These are not any real new ideas. It has all been out there for years, studied and re-studied.

Mr. Trump had a sort of campaign plank on taxes and economic policy, which resulted in a one-page summary and outline of a tax proposal released about a month ago. Got to be kidding, right? The House Republicans at least put forth a more detailed plan –the so-called Blueprint but that was a year ago. Chairman Kevin Brady (R-Tax) has been meeting with his colleagues on the Ways and Means Committee and has started to hold some hearings, but really, move on. We have not seen much of any real consideration by their counterparts in the Senate, except to hear what they are against. The Treasury Department is devoting time and effort in trying to flush out a more detailed proposal, but it seems one day they are for this and that, and the next day it changes.

I know in most instances it is better to take your time to get things right. Changes to the tax system will have to survive intense, very intense lobbying pressure. Every deduction, credit, deferral, or special treatment—just fill in the blank- has a champion on the Hill.

The opening to enact tax reform is not all that wide given the complexity of the issue, the political climate and the differing approaches of conservatives and liberals. One side is revenue hungry and the other side loathes new taxes. One side wants to redistribute wealth, punish businesses and upper-income taxpayers and the other side wants to promote growth according to their economic “trickle down” theory.

Interest Rate Time Bomb: Thanks again, Mr. Obama

Financial markets have been focused on recent increases in interest rates and the ones to come. The Federal Reserve after keeping rates near zero during the tenure of Mr. Obama helping to finance massive government borrowing has decide to act. Not necessarily sinister but curious. Overlooked to a certain degree is the impact raising rates will have on the budget deficit and the competition for government spending.

The Wall Street Journal had an interesting editorial on this subject, like it was some new revelation. Surprise, this is not new. Many have-including me- made the point that the incredible increases in national debt will increase government debt service and will squeeze the government fisc even tighter. https://www.wsj.com/articles/obamas-debt-interest-bomb-1491865888

The Congressional Budget Office now pegs the reported the federal budget deficit rose to $522 billion, up some $60 billion from the year before. But the ever worse news is net interest payments rose 30% in March from a year earlier.

Mr. Obama, along with the complacent Congressional collaborators created and left a fiscal mess. The national debt increased $ 10 trillion in the past eight years. Note: it is trillion, with a “T”. Well, so the debt doubled. Big deal. But it doubled from $10 trillion not from $1 trillion.

Do the math—a 2 per cent interest rate from the current rate on $20 trillion is what? Can it be 400,000,000,000? That is a lot of zeros. It is not that simple but the point is made. 

The coming increase in debt service is just one more dark blot on the Obama callous way of governing. Someone-that is us- will bear the consequence.

 

Move over Health Care: Tax Reform and Income Exclusions Examination

Move over Health Care--- It is time for what really matters. Tax Reform. Unlike tax reduction, tax reform means fundamental restructuring of the way the system works and the incidence imposed for the pleasure we all get by contributing our earnings for the greater and lesser good.

It has been a long time since major tax reform was enacted. Long time. It remains to be seen if this will be the time of not. If not, then I say get rid of all the politicians and start completely over with a new crew.

No serious, un-serious person would possible believe the current system is a good one. That is not even open for debate.

So what can be done-?

The usual mantra for tax reformers is to expand the tax base. By expanding the tax base will increase revenues and promote fairness in the tax system.

However, all of this begs the question what exactly is included in income? Where is the starting point to make all the calculations for gross income, to adjusted gross income to net income to taxable income to actual taxes paid?

It is no surprise that the tax code takes a very expansive view on what is income. Gross income in the foundation Section 61 of the Internal Revenue Code states that it includes "all income from whatever source derived”. How is that for legislative drafting! 

Section 61 goes on to define income to include “(but not limited to) the following items:(1) Compensation for services, including fees, commissions, fringe benefits, and similar items; (2) Gross income derived from business; (3) Gains derived from dealings in property; (4) Interest; (5) Rents;(6) Royalties; (7) Dividends; (8) Alimony and separate maintenance payment (9) Annuities; (10) Income from life insurance and endowment contracts; (11) Pensions; (12) Income from discharge of indebtedness; (13) Distributive share of partnership gross income; (14) Income in respect of a decedent; and (15) Income from an interest in an estate or trust.

That is quite a list and courts have consistently given very broad meaning to the definition of income, interpreting it to include all income unless a specific exclusion applies.

So now this is the fun part and the part that does not get much attention. --”Exclusions” from income. It seems that even though you have income, it is not really income because the government says it is not for whatever reason and purpose attached. It is social policy, picking winner and losers, a selective subsidy. The list is long and I think is worth examining. Some of the important exclusions include:

Gifts and Inheritances: A gift, bequest, or inheritance is excluded from gross income.

Life Insurance Proceeds: Life insurance proceeds received by the beneficiary are not included in gross income.

Sale of Residence: Sales of principal residences are eligible for a $500,000 capital gains exclusion.  

Retirement Income: A portion of the Social Security benefits or railroad retirement benefits.

Interest on State Obligations: Interest received on state and local government bonds is generally excludable from gross income.

Fringe Benefits and other employee benefits: Non-taxable benefits include group health insurance, group life insurance for policies up to $50,000, and other certain fringe benefits, including those under a flexible spending or cafeteria plans. (The health insurance exclusion is a major benefit) 

Adoption Expenses: Taxpayers may exclude from gross income certain amount of adoption expenses received.

Compensation for Injuries and Sickness: Specifically excluded from gross income are payments under workers' compensation, damages received on account of personal injuries or sickness, payments under accident and health insurance for personal injuries or sickness

Meals and Lodging: Employee may exclude the value of meals furnished by the employer in certain circumstances

Educational Assistance Plans: Certain payments of up to received by an employee for tuition, fees, books, and supplies under an employer's assistance program may be excluded from gross income.  

Tuition Reduction Plans: Qualified tuition reductions made available to employees (and their families) of qualified educational institutions are excludable from the employee's gross income.

Dependent Care Assistance Programs: Dependent care assistance benefits paid under an employer plan are excludable from the employee's gross income,

Military Benefits: Qualified military benefits are excluded from gross income.  

Scholarships: Excluded from income.

Foreign earned income:  Exclusion for U.S. citizens or residents for income earned outside the U.S.

And there are more as the above list is for illustrative purposes. Perhaps each one can be justified on some level, perhaps not.

There are dozens more but each one has a cost to the fisk. Several years ago, I put together a list of the “cost” to the Treasury. I am too lazy to update the list but a look at the cost of some of them taken from a few years ago include:

• Capital gains exclusion on personal residences: $35 billio
• Exclusion of Interest on State and local bonds: $26 billion
• Exclusion on Worker’s Compensation benefits:  $6 billion
• Exclusion of reimbursed employee parking benefits: $3 billion
• Exclusion of parsonage allowance: $600 million
• Exclusion of employer transit passes: $500 million
• Exclusion of Railroad retirement benefits: $400 million
• Exclusion of Volunteer EMS and Firefighter benefits: $80 million 

The point being is that reforming the tax laws is a complicated process. These exclusions have big revenue impact. They are often overlooked in the discussion on how to design a better and fairer tax system. Many have been embedded for years but they need re-examining. If the traditional and better known “tax expenditures” are to be served up in tax reform, the exclusions are should be first appetizer. 

Tax Reform: Look to Congress and Ignore Candidate's Plans

 

In watching this car wreck of a Presidential campaign, taxes have become a focal point. We know that Mrs. Clinton has no boundaries in the lust for high income taxes. Since about fifty percent of all taxpayers filers do not pay any income taxes, that means the rest of us smucks are in for a tax increase to be redistributed to those that pay no taxes or for other not so important spending programs.

Mr. Trump says he will cut taxes to spur economic growth. I have seen so many of his plans and revisions thereto; I am not sure exactly what they are in any precise detail and probably neither does he. However, he does seem to grasp the correlation between taxes and economic growth.

These plans-no matter which one a person favors- are portrayed as happening from day one. That is, whatever the candidate says will be the law of the land on Inauguration Day.

Hold on there! The last time I check the Congress enacted the tax statutes in this county. True, the Obama Administration makes up things are they go along (see Section 385 regulations) but by and large, Congress sets the rates, the structure, the preferences, the exemptions, the credits and the exclusions. Always has.

There is no question the “Code” needs an overhaul. Complexed, unfair, unbalanced, burdensome, inefficient, bureaucratic, Byzantine, out-of-date are just a few words to come to mind. The Obama administration never was serious about participating in any tax reform of any consequences. Their annual budget contains the same old tired ideas with the overall manta of raising more taxes. Any taxes. This attitude wasted lots of time, squandered opportunity and has been a disservice to the country.

All that said, it is important to have input from the Treasury Department in enacting major tax reform. There is an expertise there and in some cases, Treasury can balance sometimes over zealous lawmakers. However, it is a real waste to overanalyze the proposals of the candidates and nitpick their so-called “plans”. You already know –Clinton more taxes, Trump probably less taxes. I am more interested in what the Chairmen of the tax writing committee think and say, what the leadership (like Speaker Ryan) has to offer than the fuzzy details from these most unqualified people.

So, keep you eye on the Hill and let the flotsam float away.

Section 385: Debt or Equity or Opportunity to Tax? Proposed Regulations Overstep

Section 385 of the Internal Code enacted in 1969 is a provision that I barely remember from tax school as one of the forgotten and under utilized pieces of the Code. Since passing into law, there has never been any finalized regulations on this provision, (one attempt more than 35 years ago) unlike the thousands and thousands of pages of Regs elsewhere. Up until now, it would seem that there was no need. There are scores and scores of precedent and case law. But as liberals say, never let an opportunity to screw the taxpayer, cause confusion and disrupt business go undone.

Therefore, and April 4^th, the U.S. Treasury Department issued proposed Regulations on this non-problem.  

Section 385 authorizes the Secretary of the Treasury to issue regulations "as may be necessary or appropriate to determine whether an interest in a corporation is to be treated... as stock or indebtedness." In addition, the provision suggests various factors to be taken into account in making a debt or equity determination--such as: (a) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money, and to pay a fixed rate of interest;(b) whether there is subordination to or preference over other indebtedness of the corporation;(c) the debt-to-equity ratio of the corporation; (d) whether the purported debt is convertible into stock of the corporation; and the relationship between holdings of stock in the corporation and holdings of the interest in question. A copy of the Law in full is at the end.

I have had a chance to review the proposed Regulations. Whoa.They are quite broad and seem to abandon the long-standing approach in reclassifying instruments as equity that have been denominated as debt. The Regs instead examine the relationship of the parties to the instrument, the context in which it was issued, and the relevant documentation to determine whether there is sufficient support for the claim of debt treatment. In addition, and even more troubling is the Regulations also abandon the practice and authority treating an instrument as either debt or equity in its entirety and introduces the possibility an instrument can be characterized as part debt, part equity, presumably by IRS fiat.

So what difference does it make? Debt or Equity? Plenty. First, understand that tax liberals (defined as those who want to generate more tax money to spend and generally do not understand normal commercial practices.) loathe debt.

Some of the reasons are easy to understand.

• 1nterest payable on debt is fully deductible while distributions on equity interests are not deductible.
• Interest is fully taxable to the non-corporate creditor as ordinary income. Distributions with respect to equity interests held by non-corporate shareholders may also be taxed as ordinary income, but only to the extent of the corporation's earnings and profits.
• Interest is fully taxable as ordinary income, while dividends are either "eliminated" by filing a consolidated return, or are partially taxed due to the dividends received deduction.
• Repayment of debt is a tax-free return of capital to the creditor to the extent of the creditor's tax basis in the debt. Repayment to a shareholder's is usually treated as a dividend.
• Characterization of purported debt as equity might disqualify a corporation's Subchapter S election.

There are other ramifications but I will not dwell on all of them. It boils down, interest deduction against no deduction at all.

Although the Section 385 proposed regulations were issued in conjunction with temporary regulations targeting cross border mergers or what is horribly referred to as “inversion transactions,” they appear to limit the effectiveness of certain types of tax planning by characterizing related party financings as equity, even if they are in form of straight debt instruments and characterize as equity broad categories of related party debt transactions.

This is mean stuff and would seem to me to have a real effect on routine cash management including the use of cash pooling.

I do not believe the Treasury Department rationale that the Regs are intended to limit the earnings stripping benefits of cross border mergers. The proposed Regulations, if adopted without change will apply, and are intended to apply, to a broad range of transactions and would significantly impact many ordinary business transactions and re-structurings of both domestic and foreign corporations.

The issuance of the Regulations is an action trying to solve a problem that did not really exist. It is a ham handed attempt to inject last minute government fiat by a waning Administration.

The rush to get these finalized, change the rules, expand the authority of the tax authorities without any advance notice and a short process of review and comment does not befit sound tax policy.

This is a very complicated, complexed and technical area. There is a coalition business groups working on the issue. Their approach as far as I can determine is timid given the impact but perhaps a combination of Congressional concern and common sense will bring some modifications. I would not hold my breath on that occurring.

 

Remember to Write in Mr. Giant for President--the better alternative

 

 

385. Treatment of certain interests in corporations as stock or indebtedness

(a) Authority to prescribe regulations

The Secretary is authorized to prescribe such regulations as may be necessary or appropriate to determine whether an interest in a corporation is to be treated for purposes of this title as stock or indebtedness (or as in part stock and in part indebtedness).

(b) Factors

The regulations prescribed under this section shall set forth factors, which are to be taken into account in determining with respect to a particular factual situation whether a debtor-creditor relationship exists or a corporation-shareholder relationship exists. The factors so set forth in the regulations may include among other factors:

(1) whether there is a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest,

(2) whether there is subordination to or preference over any indebtedness of the corporation,

(3) the ratio of debt to equity of the corporation,

(4) whether there is convertibility into the stock of the corporation, and

(5) the relationship between holdings of stock in the corporation and holdings of the interest in question.

(c) Effect of classification by issuer

(1) In general

The characterization (as of the time of issuance) by the issuer as to whether an interest in a corporation is stock or indebtedness shall be binding on such issuer and on all holders of such interest (but shall not be binding on the Secretary).

(2) Notification of inconsistent treatment

Except as provided in regulations, paragraph (1) shall not apply to any holder of an interest if such holder on his return discloses that he is treating such interest in a manner inconsistent with the characterization referred to in paragraph (1).

(3) Regulations

The Secretary is authorized to require such information as the Secretary determines to be necessary to carry out the provisions of this subsection.

Enacted as part of Tax Reform Act of 1969

Jeb! and "Carried Interest": Tax reform or Tax Increase?

 

Presidential Candidate Jeb! Bush has rattled the taxation of “carried interest “ sabre in his newly release campaign tax reform proposal. As I have said, there are some very good things in his ideas and some not so good one. (Such as expanding the abused earned income tax credit and eliminating so many taxpayers from the income tax so about 50 percent of the public has no skin in the game)

Goodness, what can that be? “Carried” what? Who is “Carrying” whom? Carried interests are a business and financial arrangement that are an essential element of business in almost every section of the U.S. economy (including, real estate, private equity, hedge funds, health care, and oil and gas).

In brief, the tax treatment of carried interests allows managers of hedge funds, private-equity funds, venture-capital funds and others to pay a lower income tax rate applied to investment income as capital gains, rather than higher income tax rates.

Many policymakers believe the carried interest paid to partnership managers is really compensation for their management services, which should be taxed at the higher ordinary income rate. On the other side, supporters of the current tax treatment say the carried interest is only a potential share of partnership profits and should not be considered compensation for services.

It is hard to have crocodile tears for the hedge fund and equity fund managers and the like. They have made and continue to make enormous money partially fueled by favorable tax treatment.  Enormous is maybe even too small a word. Even the word undeserving comes to mind. I can say the same thing about entertainers, professional athletes, football coaches and lobbyists who do not share in the same tax breaks. However, that is part of the used-to-be-freer market system we have.

How do they do that? It is complicated but starts with the taxation of partnerships. If you have an interest in a partnership, you are allocated a share of that partnership's income.  The income to the partner takes on the same character, such as capital gains, that it does in the partnership's hands, and the partner is taxed on it accordingly. The partnership itself does not pay taxes. 

Some investment partnerships, particularly in the private equity industry, earn mostly capital gains by buying and selling shares in other companies.  The managers of these companies thus receive their carried interest in the form of capital gains and pay capital gains tax rather than ordinary income tax. Nifty trick!

There are industries other than the financial sector where the carried interest concept is engrained and useful. Changes in tax policy and treatment is worth examining so let us look at the old whipping boy of oil and gas.

In oil and gas development (and in most extraction industries) the term "carried interest" refers to an arrangement where one co-owner of an operating interest (the " carrying party") incurs an obligation to pay all of the cost to develop and operate a mineral property, in exchange for a right to recoup this investment out of the proceeds from the first production. After the investment is repaid, any subsequent production is divided between the other co-owners. The co-owner, not obligated to pay for the development and operation, holds a “carried interest” in the mineral property until the carrying party's initial investment is repaid. There are many different types of carried interests, the details varying considerably from arrangement to arrangement.

A simple example is as follows:

Jack owns all the working interest in an oil and gas lease and wants to drill a well but cannot afford it. Jack assigns to Big Oil the entire interest in the property, and Big Oil agrees to drill and complete a well bearing all the costs. Big Oil will retain 100 percent of the working interest until it recovers its entire costs (drilling, completing, equipping, and operating the well) from the proceeds (or “runs” as they are called) of the production. After cost recovery, a percentage of the working interest in the property goes back to Jack with each party owning a share.

As far as tax treatment, Jack realizes no gain or loss on the transfer of the property even though drilling a productive well only increases the value of the property interest returned to Jack. Jack has a basis equal to his basis prior to transfer. Jack cannot deduct any of the cost incurred.

Jack can receive his share of production income and report it as such, or he can sell his interest as a capital asset. In this simple example, there is no tax partnership arrangement, which can change the tax treatment. However, the point being, this is a long-standing arrangement that serves a legitimate purpose. Big Oil helped Jack finance the drilling of his well which otherwise would not have occurred. Jack intends to take a well-deserved vacation.

The question being, how will this be changed if the carried interested is changed, decimated or otherwise hammered? Will the policymakers make an exception or is any thing fair game. I can understand the reasoning against the equity firms that are also providing management services to earn their carried interest but I do not see the tax abuse for Jack in our example. 

The tax treatment of a carried interest has become a symbol of trying to be for the little guy.  I do not know if Jeb! cares about the little guy or not. I know for liberal Democrats the attack on carried interests is all about social division and raising more money to spend. It is easy to   kick the wealthy because they make sure a great target. Of course, changing the rules to push more income into ordinary income and to erode the treatment of capital gains can lead to other matters, so be careful how hard you kick.

 

 

 

 

Jeb! Wrong on Estate Tax: Eliminating Carryover Basis Protects Rich and Punishes Middle Class

 

Presidential candidate Jeb Bush has put forth a tax reform plan and it contains many good proposals. He wants to be the champion for the middle class. There are also a number of very, very bad ideas.

Mr. Bush proposes to eliminate the estate tax. In return, he proposes to eliminate the “carryover basis” rule. Eliminating the estate will benefit very large estates so the Bill Gates and Warren Buffetts of the world would not have to pay estate tax. Great for their heirs. However, Mr. Middle Class would be subject to an income tax when he disposes of Grandma’s condo when he sells it after her death. Bad idea, very bad idea.

Let’s look at it more closely-----

The federal estate tax does not impact all that many estates even though the estate of every U.S. citizen is subject to tax upon death. Impact in the sense the decedents estate has to cough up addition dough to the government for dying and having property. However, there is a lurking income tax issue out there that goes along with it and it is a sneaky one.

Some background on the estate tax is in order. In 2015, every person may leave or give away up to $5.43 million without owing any estate tax. As a practical matter, that means about 99.5% of all estates will NOT owe any federal gift/estate tax. 

Many conservatives refer to the estate tax as the ”death” tax and would like to abolish it. Liberals, of course, believe everything belongs to the state and would like to have as high a tax rate and lowest exemption level as possible. There are also a few in the middle, like me. I have no problem with a reasonable tax rate on very large estates. The dirty secret is that these very large estates through private foundations, charities and other such devices can largely blunt the effect of the tax and still more or less control the money from the grave.

Every asset has a basis, usually its cost. If I buy a tractor for $100, it has a basis of $100 and I use this amount for depreciation in my business. Under the gift rules, if my aunt gives me a share of stock, which she paid $100 for 10 years ago but now worth $1000, my basis is $100, and if I sell it for $1000, I have a $900 gain which would be included in my income taxes. This is called ‘carryover basis’. Under the estate tax, an asset acquired from the same aunt from her estates is “stepped-up.” That is to say, the assets in an estate and the subsequent beneficiaries receive a new income tax basis equal to the fair market value of the assets on the date of the decedent’s death, (or on an alternate valuation date an estate may elect on the six-month anniversary date of a decedent’s death.) Accordingly, a beneficiary will pay income taxes on any received assets sold based on the difference in value of the assets between the date of death value and the sales price.

In the above example instead of gifting the stock the aunt conveys it at her death, the beneficiary gets a basis of $1000 and upon it sale of $1000, pays no income tax because there is no gain. What a great system. One of the few ways to avoid tax on appreciated property but, of course, someone has to die.

I would argue preserving stepped-up basis is much more important to the average taxpayer than what ever the tax rates are on mega-estates. This is an income tax issue after all. Normal taxpayers who inherit property do not always know what the basis is to the property received and why subject the property to the estate tax and then to the income tax?

So, Jeb!, you got this one wrong. Keeping stepped up basis is for the middle class.

Highway Trust Fund: Spending or Funding?

The Highway Trust Fund, used to finance a variety of transportation projects across the county, is projected to dry up in coming weeks unless reauthorized.

The HTF receives money from the 18.4 cents per gallon tax on gasoline and 24.4 cents per gallon of diesel fuel and other related excise taxes. It was established in 1956 to finance the federal interstate road system. 

The gas and diesel tax rates have not changed since 1993, and account for 90 percent of the fund’s revenue. The remainder comes from taxes on tires, trucks and trailers, and certain kinds of vehicles

The Highway Trust Fund is essentially divided into two accounts. The Highway Account disburses about 85 percent on roadway infrastructure and other projects with the Mass Transit Account expending about 15 percent on such items as rail, buses, and streetcars.

The key word in the Highway Trust Fund is, of course, Highway. The gas tax is paid,  under the theory, by the people who use the roads—classic user fee. You use it, you pay for it. However, the program now subsidizes mass transit and other programs -- like, bike trails and lanes, hiking trails, streetcars, ferries and more. Federal spending on such side projects has increased dramatically in the last few years while actual highway spending has been flat.  

In addition, Congress and the states divert roughly 25 percent of the Highway Trust Fund spending to non-highway projects. The largest of these diversions is the Mass Transit Account, which spent some $8 billion in 2014 on buses, rail, streetcars, and other projects, really local not federal responsibility. Other programs include the Transportation Alternatives Program, which spent almost a billion dollars last year on the critical needs of sidewalks, bike paths, scenic overlooks, vegetation management, and recreational trails.

So what we have here is not a highway spending problem but a program that has overflowed its original banks of its purpose. As usual in government programs, it is the lack of money, not the amount of spending that is important.  

Congress has not passed a long-term transportation-funding bill since 2005 but instead has passed 33 short-term fixes. 

In the past few years, spending shortfalls have been made up of general revenues. However, these short-term fixes are unsatisfactory and some sort of solution has become the “must do legislation de jure”.

The issue, however -- is how will a new transportation bill be funded?  The proceeds from the original three-cent gas tax built the interstate system. Increases in the federal gas tax have paid for expansion and upgrades since. However, better fuel economy, the recession, less driving has not provided the funds for the voracious spending appetite of the expanded program.  

The focus is centered on taxes, not on programmatic issues.  Both parties love to dole out highway money. Liberals get subsidized mass transit, bike paths and plenty of money for their unions buddies. Republicans get roads built and giant projects for all the construction companies.

The House Ways and Means Committee and the Senate Finance Committee have given lots of lip service but not much action. Well, no action. As there has been much talk about broader and long-term "tax reform," both committees are weighing the short-term potential of using "corporate tax changes" or "international" tax changes to fund transportation programs. The idea faces significant hurdles. The simple solution of just raising the gas tax is a nonstarter. Suggestions of charging for miles driven through some sort of big brother monitoring systems are chilling as well as a long way off.  It is a mess.

The honest way would be to scrap the HTF and admit that the HTF is a general transportation program and treat it as such.

If the effort to use a tax overhaul to pay for roadwork fails, lawmakers likely will fall back on a patchwork approach to fund the program for the next six months or whatever from a hodgepodge of sources or perhaps not to offset the cost of some or all the highway spending, as they have in the recent past.

Now, for the most important part.  Why does it take so so long to ever get anything built? I have driven by the same construction zones for years and years. In my area, it took more than a year to build a bridge not much longer than my car and this was after work actually started.

Drive by a construction site and no one is working and if there is some movement, there is still 14 guys holding a shovel doing nothing and another 14 just squatting on the ground. With millions of people not employed, leaving the work force, it would seem you could throw say 5,000 people on a project and get it done in 2 weeks, not 4 years. 

 

The Budget: Creative Writing

 

The Obama Administration has released its budget proposal. It is a great piece of creative writing, certainly to be assigned a Dewey Decimal number in the fiction section in your local library. It proposes taxes increases, a chunk of new government spending, a budget deficit of a bit less than $500 billion, ignores the structural problems of entitlements and well, just bigger and larger government.

I read this morning a comment from a well-known paper that the budget is a blueprint for a better America. Not sure about that, oh, actually I am sure about that, it is not.

In fact, it sheds no new light on the President and his leftist vision. Mr. Obama, is and always has been, a big government, redistribute wealth, less military, tax raiser. This is in addition to piling on more regulations to not to just influence economic decisions but wanting the government to make and control them.  

The Federal Budget submitted by the executive, particularly in this Administration, is often a political document. Mr. Obama knows the suggested tax increases will not be seriously considered by Congress. He knows the “programs of the day” will not be funded. He knows he has notreal intention of negotiating, much less listen to, the suggestions of his political opponents and they know it also. 

The Budget is just a suggestion, the ideas of the President. A wish list. Last time I checked the Constitution (or what remains of its principles), Congress appropriates the money. It has the authority to impose taxes, to raise levies. Guess what? Republicans control Congress.

Mr. Obama has been making threats he is not going to do this, do that. Got to change this or that. I do not think anyone is listening. He says he will veto this and that—Iran sanctions, Keystone XL Pipeline and on and on. Well, so be it.

The best thing the Republicans can do for the country is to stick with the budget deal outlined in the 2011 sequester. It is the only action taken by government in many years to hold down spending, to reduce the deficit. I am not sure Republicans get it but I hope they do.