Year-End Tax Planning and 2011 Tax Rate Changes

Historical perspective: It’s always interesting to look back at tax rates when we are in the middle of a Congressional battle over preserving current rates or reverting to higher rates. Here are the top tax rates dating back to 1913 when the U.S. adopted an income tax.

Top Income Tax %

Year	Top % Rate		Year	Top % Rate
1913– 1915	7		1946-1951	91
1916	15		1952-1960	92
1917	67		1961-1964	77
1918	77		1965-1980	70
1919-1921	73		1981-1986	50
1922-1923	58		1987	35
1924	46		1988-1990	28
1925- 1931	25		1991- 1992	31
1932-1935	63		1993 - 2000	39.6
1936–1940	79		2001	39.1
1941	81		2002	38.6
1942	88		2003-2010	35
1944-1945	94		2011	39.5 (projected)

(1) Tax Foundation - see full rate tables at

http://www.taxfoundation.org/files/fed_individual_rate_history-june2010.pdf

For 2011, Federal tax rates will most likely increase as the tax cuts enacted in 2001 and 2003 under the Bush Administration will expire. There is, however, a political see-saw between now and the end of the year so it's still a guessing game. The worsening of the employment picture and economic news in general provides leverage for the critics of the tax increase and with mid term elections coming up in November, it’s possible that the scheduled increases will be delayed.

At this point, the momentum appears to be with the Obama Administration. New business incentives were proposed this week. That should buffer complaints that higher rates will be a drag on the economy. Tax cuts for the middle class with incomes below $200,000 for individuals or $250,000 for a married couple will also help the Obama Administration sell the higher rates on "the wealthy".

The following changes will likely occur for 2011:

Ordinary Income

·   35% bracket  will increase to 39.6%

·   33% bracket  will increase to 36%

·   28% bracket will increase to 31%

·   25% bracket will increase to 28%

·   10% and 15% will condense to 15%

·   The top tax rate on dividends will increase from

    15% to 39.6%

Capital Gains

·   Tax rate will increase from 15% to 20% (1)

Estate and Gift

                                                  2009                   2010                      2011
Top estate tax rate (2)       45%                     -0-                        55%
Exemption                       $3.5 mil.           Unlimited                $1 mil.

      Notes
(1) Rates apply to capital gain on assets held for more than one year.  Ordinary income tax rates apply to assets held for one year or less.

(2) For 2010, there is no estate tax unless Congress enacts a retroactive tax. The Bush tax cuts increased the exemption to $3.5 million in 2009, but for 2010, the estate tax went to zero. The assumption was that Congress would enact new legislation by the end of 2009. It didn’t, so the zero rate is currently in effect until 2011 when the old rates in effect prior to 2001 are re-established.

SUGGESTED ACTIONS

Corporate Bonuses

Taxpayers should plan now for a higher rate structure. Corporations will need to consider whether 2011 bonuses should be accelerated to the current year to lessen the impact on high income earning employees.

Reconsider C Corporation vs. Pass - Through Entities for Conducting Business

For owners of closely held companies, this may be the time to evaluate the benefits of using a C corporation vs. an S corporation, or a partnership or LLC for all or part of one’s business. The first $100,000 of taxable income in a C corporation results in a federal tax of $22,500 compared to $39,600 in 2011. The top personal tax rate is even higher than 40% if one considers the various phase outs on personal returns and possible self employment taxes added on.

Dividend Policy

The tax rates on qualified dividends and capital gains were “harmonized” under the Bush changes. Since 2003, the top tax rate on both dividends and long term capital gains is 15%. With respect to increasing the tax rate on dividends, the Obama Administration may need to consider several factors.

Most economists and tax strategists agree that keeping the rates on dividends and capital gains the same allows companies to better manage their dividend policy. If the tax on dividends increases by almost 25%, companies may focus more on stock buy-backs or redemptions as a preferred strategy for shareholders, subject to rules related to a reduction in ownership to qualify for capital gains treatment.

Qualified dividends eligible for the 15% rate include dividends received from foreign companies incorporated in countries where an income tax treaty exists. Investors may rethink whether owning equities in either US or foreign companies for their dividend yield, is a good strategy if the tax rates increase to 39.6%.

For companies contemplating paying a dividend in Q1 of 2011, particularly with closely held companies, the different tax rates would in most cases favor accelerating dividend payments into the current year.

For both US and foreign hedge funds where there are substantial holdings by US investors, the fund managers should encourage investee companies to accelerate dividends into the current year. This strategy also applies to funds with foreign equities that pay qualified dividends. S corporations and other closely held pass through entities with ownership in US and foreign equities are well advised to do the same.


OTHER CONSIDERATIONS

Impact on real estate strategies

Economics aside, how should one factor in the potential tax increases noted above?

• For pending sales, the seller should attempt to close the sale prior to the end of this year.
• Old rates may continue if the sale is concluded, or a contract is executed prior to the effective date of the new rates. If the current 15% rates are "grandfathered", installment payments received in future years on sales made in 2010 may qualify for the lower rates.

Economic Policy

A Bloomberg commentator brought things into perspective for middle America with the following analysis this week:

• There are over 300,000 Americans earning over $1 million per year in the US
• For the $1 million earner, higher rates will result in an increased tax of approximately $45,000, equal to the cost of a BMW Roadster convertible

Will higher tax rates really hurt the U.S. economy? We recently had the following internal debate in the firm:

·        People over the $1 million earnings threshold might not decrease their

      spending due to higher tax rates

·        The additional money raised by higher taxes can be used to reduce

      the national debt

·        If our debt decreases, our currency will be stronger

·        If our currency is stronger, we’re less vulnerable to inflation

·        Keeping inflation in check helps everyone in the economy, so spending

      will not decline

·        If the general spending and investment level is maintained, businesses

      will have time to recover which translates into jobs which is the key

      determinant for a healthy economy

However,

·        The Administration may not use the additional revenue to pay down the

      national debt

·        The 99% of Americans earning less than $1 million may alter their

      spending habits which could drive down spending and create more

      deflation

Our final conclusion: Based on Bloomberg, you may wish to "short" your BMW stock!

Best Regards,

Brian Rowbotham

COMING SOON:

TAX PLANNING STRATEGIES FOR INVESTMENT FUND MANAGERS