With the April 15th tax filing deadline behind us and the US stock market intermittently approaching its pre-recession high, most taxpayers are likely seeking a breather from anxiety about financial and estate planning.  But there’s another important milestone on the horizon that you shouldn’t ignore for too long – January 1, 2013.

The Health Care and Education Reconciliation Act of 2010 (“Health Care Act”) establishes a 3.8% tax on net investment income for tax years beginning after December 31, 2012.

On December 17, 2010 the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (“Tax Relief Act”) was signed.  This Act significantly increases ordinary income tax rates, capital gains tax rates and estate taxes as of January 1, 2013.  Additionally, the Act extended the alternative minimum tax (“AMT”) patch only through 2011.

History of the tax laws

The Tax Relief Act:

Delays the sunset of EGTRRA and JGTRRA to December 31, 2012.

Extended the AMT patch for calendar years 2010 and 2011.  The AMT patch adds an inflation factor to the AMT exemptions originally created in the 1960s.  There is currently no AMT patch in effect for 2012.

For estate taxes, gift taxes and generation-skipping transfer (GST) taxes, the Tax Relief Act:

• Created a $5 million exemption for estate, gift and GST taxes, to be adjusted for inflation, for 2011 and 2012 and with a tax rate of 35%.
• Reduced the exemption for estate, gift and GST taxes to $1 million with a tax rate of 55%, starting in 2013.
• Creates portability of a decedent’s estate tax exemption.

The Health Care Act created a 3.8% tax on net investment income

• Net investment income is defined as income from interest, dividends, annuities and rents, and income derived from passive activity and net capital gain derived from the disposition of property.
• Net investment income does not include income from pensions, IRAs, self-employment, tax-exempt interest, an active trade or business, or gains on the sale of an active interest in a partnership or S corporation. Although they are not included in net investment income, they are included in modified adjusted income (MAGI), as explained below.
• The 3.8% tax is on the lower of net investment income or MAGI, including net investment income, in excess of $250,000 for married filing jointly and $200,000 for those filing single.  MAGI is adjusted gross income as reported on form 1040, line 37.
• Effective for tax years beginning after December 31, 2012.

Costly combination of the Health Care and Tax Relief Acts

When the taxpayer combines the impact of the Health Care Act and the Tax Relief Act, the total tax rate on dividends increases from 15% pre-January 1, 2013 to 43.4% (39.6% ordinary tax rate plus 3.8% Medicare tax) post-January 1, 2013, for taxpayers in the highest income tax bracket.  Capital gains on sales of investments will increase from 15% pre-January 1, 2013 to 23.8% (20% capital gains rate plus 3.8% Medicare tax) post-January 1, 2013.

Can the two tax laws be changed by April 15, 2014?

The Health Care Act is currently under review by the US Supreme Court, with a ruling expected in the summer of 2012.  If the Court rules the entire law unconstitutional, the 3.8% Medicare tax should be automatically repealed.

Congressional action is required for changes to any proposed tax law with approval by the president.  Tax changes, if any, could either occur after the 2012 election but before the December congressional recess, or after the installation of the new Congress in late January 2013.  If a client chooses to wait for the laws to change, he or she may miss the opportunity to adequately plan, should taxes not be reduced.

The high cost of being wrong

Not planning for the tax increase and assuming Congress will take appropriate action could be very costly and foolish.  If a couple with a $10 million estate passes away on or before December 31, 2012, their estate tax would be $0.   If the couple passes on or after January 1, 2013, the total estate tax would be $4.4 million ($5 million of assets per spouse, less $1 million exemption each, taxed at a 55% rate, times two people).

Proactive planning opportunities

Transfer taxes

Gift up to $5 million of assets into a GST dynasty trust with spousal access provisions by December 31, 2012.  Fund the trust with assets that produce net investment income as defined by the Health Care Act with the goal of reporting the income on heirs’ returns, which may be under the MAGI limit of the Health Care Act.

If uncertain about the full $5 million transfer, create a GST dynasty trust early in 2012 with only $100 of funding, in order to allow time to prepare the trust document properly.  Delay the decision about the amount of funding until December 2012.

Income taxes

Increase taxable income in 2012:

• Consider a 2012 Roth conversion
• Realize capital gains for 2013 and 2014 liquidity and diversification needs in 2012 at 15% capital gains rates, rather than in later years
• Consider selling a business in 2012 rather than after December 31, 2012
• Report taxable interest income in 2012 by selling taxable bonds with large accrued-interest income prior to December 31, 2012
• Elect out of installment sales in 2012

Decrease taxable income in 2013:

• Fund 2012 contributions to charities in 2013
• Delay payment of 2012 year-end deductions, such as state taxes and mortgage interest, to 2013

Change the nature of the transactions in 2013:

• Change Roth 401(k) elections to a traditional 401(k) election to create a 39.9% deduction and decrease MAGI
• Move from taxable bonds to tax-free bonds to avoid the 3.8% Health Care Act tax
• Tax management becomes more important with long-term capital gains rates at 23.8% and dividends at 43.4% (assuming highest tax bracket)
• Place taxable fixed income in tax-deferred accounts such as IRAs, 401(k)s and profit-sharing plans

Conclusion

As the old adage goes “An ounce of prevention is worth a pound of cure.”  With the partisanship in Congress at an all-time high, the likelihood of a decision by year-end is small, which puts investors in the challenging position of planning for the worst or hoping for the best, and that Congress extends all or parts of the existing policies.

Other warning signs include electricity up less than 1% for the past 12 months,  housing sales falling 25% in the first quarter, and collapsed newbuilding orders from the Yangtze shipyards.

According to The Telegraph, if China were a “normal” country, its economy would be “hurtling toward a brick wall”, and a hard landing would be a certainty.  However, whether the Chinese hybrid system of ‘market Leninism’ operates in line with the principles of Western monetary  theory is a hotly contested topic.  And one that will likely be settled sooner rather than later.

You can read the entire article in the May 15th online edition of The Telegraph here.

In a nutshell, the shortfall can be explained by three factors: mortality, demographics and economic growth.

You can read the entire article here.

In this April 19, 2012 article in the Financial Times entitled “A Workforce on the Wane”, the author reviews three possible scenarios for why this has happened.  One is sad, one is more cheerful, and one says this could have been predicted over 60 years ago.  You can read the entire article here.

You can read his comments in Investment News here, and his full commentary on the Hussman website here.

Corporate Trustee
A corporate trustee might be the best choice when neither the grantor nor the charity is willing or able to serve as trustee. All trustees are subject to fiduciary obligations requiring them to act impartially, and balance the interests of the income beneficiary and the remainder beneficiary. This may be easier for a corporate trustee than either the grantor or the charity.

A corporate trustee also may be necessary when the trust allows “sprinkling” of income among various members of a class (such as children or grandchildren). If the grantor holds the power to determine income distributions, the trust will be considered a grantor trust and will be disqualified under the IRS code section 664.

A major consideration in using a corporate trustee is cost. Small trusts, in particular, may fall below the corporate trustee’s size threshold.

Charity
Some charities are willing and able to serve as trustees of CRT’s. Charities may impose restrictions on the ages of the income beneficiaries, the size of the trust, or the portion passing to the charity at the end of the income interest. Also, most charities won’t serve as trustee when the donor retains the right to change the charitable beneficiary.

Charities may provide trustee services at low or no cost. This may be important to donors or income beneficiaries of charitable remainder unitrusts, where the annual payout is directly affected by the value of the trust assets, as determined each year. It’s critical to review state law before naming a charity as trustee, to determine whether there are any restrictions or special requirements.

Donor or other individual
There is no prohibition against the donor acting as trustee of a CRT. But serious consideration should be given to the donor’s financial expertise and knowledge of fiduciary responsibilities. In addition to the issue of “sprinkling” powers, there are other considerations to take into account before naming the donor as trustee.

Donors often elect to serve as trustee when they want to avoid the expense of naming a corporate trustee and don’t quality under restrictions imposed by the charity. The donor/trustee is not required to personally fill out the required tax forms that must be filed each year, but is required to make sure that they are completed and filed on time. If a donor serves as trustee of a unitrust that owns hard-to-value assets, an independent appraisal must be obtained annually to avoid the need for a separate trustee for valuation.

On of the hardest concepts for donors/trustees to understand is probably the duty of impartiality. In the case of a charitable remainder unitrust, where the beneficiary’s income is determined by the annual value of trust assets, there may be a temptation to invest for income, guessing that the charity will be satisfied with whatever it receives. Also, because the nature of the beneficiary’s income is determined under the four-tier system, there may be a temptation for the donor/trustee to invest in municipal bonds, at the expense of growth of the trust for the charitable remaindermen. The donor/trustee should also be aware of private foundation rules regarding investments.

If you are considering establishing a trust, or have already done so, and have questions about the role of the trustee, please contact your Maas Capital advisor today. We’d be pleased to consult with you and your attorney to ensure that your trust meets all of its objectives, while also remaining compliant with the law.

Even though many US adults report they don’t have financial investments, they are still keeping an eye on the market. Fifty-five percent of US adults said they follow the stock market in some capacity, with one quarter (25%) reporting they track its ups and downs at least once a week.  When it comes to young adults, there was a significant difference between men and women.  Fifty-nine percent of men ages 18 to 34 said they follow the stock market, compared to 30% of women ages 18 to 34.

While some Americans report they are intimidated by the complexity of the market, others said if the economy were more stable, they would be more likely to invest.  Thirty-nine percent said they were much or somewhat more likely to invest money in the market if the economy were more stable; 46% said they weren’t any more or less likely to invest if the economy were more stable; and 15% said they were much/somewhat less likely to invest.

Regardless of apprehensions in investing in the stock market, many US adults said they would be open to learning more about the process.  Forty-three percent would be at least somewhat likely to consider taking a course or class to learn more about the stock market and investments.

The survey was conducted online within the US by Harris Interactive on behalf of CouponCabin from February 7 to 9, 2012, among 2,339 U.S. adults ages 18 and older.

If you would like to learn more about prudent investing strategies and saving for retirement or other goals you may have, please feel free to email us at askus@maascapital.com or call us at (888) 354-6227.

You can read the excerpt in Investment News here, and the entire letter on GMO’s website here.