Jesse Palmer

On February 1, 2010, President Obama released his proposed budget for the government’s 2011 fiscal year. Included are numerous tax proposals that, if enacted by Congress, would impact both businesses and individual taxpayers. Given the expected budget deficit of more than $1.5 trillion, most of the tax proposals seek to raise revenue. The 2011 budget expects to raise $1.1 trillion as a result of new tax policies. This article will highlight a few of the major tax proposals for both businesses and individuals.

Tax Proposals for Business Taxpayers

• Extend the maximum Section 179 deduction of $250,000 for qualifying property placed in service for taxable years beginning in 2010, with phaseout of benefit beginning once a taxpayer purchases more than $800,000 of qualifying property. Absent this extension, the maximum §179 deduction for 2010 would drop to $134,000 as indexed for inflation
• Extend 50 percent first-year bonus depreciation deduction to qualifying property acquired in 2010. Generally, property must be new with a recovery period of 20 years or fewer to qualify
• Make the research and experimentation credit permanent as of January 1, 2010. The research credit has expired and been reinstated numerous times in the past, making it difficult to factor the credit into the decision-making process regarding research project investments. The proposal to make the credit permanent is anticipated to increase the credit’s effectiveness and spur economic growth
• Eliminate capital gains tax on investments in small business stock held for at least five years and acquired after February 17, 2009. Taxpayers may exclude 50 percent of the gain from the sale of certain small business stock purchased at original issue and held for at least five years. Under the American Recovery and Reinvestment Act of 2009 (ARRA), the exclusion was increased to 75 percent for stock acquired after February 17, 2009, and before January 11, 2011
• Tax “carried interest” as ordinary income. This would apply to a profits interest in a partnership that is received in exchange for services. In addition, the service partner would pay self-employment taxes on such income. Gain recognized on the sale of a profits interest also would be taxed as ordinary income.
• Repeal of last-in, first-out (LIFO) method of accounting for inventories. During periods of rising prices, the LIFO method generally results in a lower inventory value and higher cost of goods sold expense than first-in, first-out (FIFO) method. Repeal of LIFO would require taxpayers to include as income difference between LIFO and FIFO inventory amounts. The proposal would allow this income to be taken into account ratably over 10 years, starting with the first tax year beginning after 2011
• Repeal of the lower-of-cost-or-market inventory costing method for tax years beginning after 12 months from the enactment date. Any adjustment would be included in income ratably over four years
• Elimination of several tax preferences for oil, gas and coal companies, including:

• Repeal expensing of intangible drilling costs

• Repeal of enhanced oil recovery credit

• Repeal of percentage depletion for oil, natural gas wells, coal and other hard mineral fossil fuels

• Repeal domestic manufacturing deduction for oil and gas, coal and other hard mineral fossil fuels

• Several international tax reform measures, including:

• Foreign tax credit calculations would be made on an aggregate basis for all of a U.S. taxpayer’s foreign subsidiaries

• Tougher tax treatment on transfers of intangible assets, e.g., trademarks, copyrights, etc., to offshore entities

• Increased reporting and withholding requirements on certain foreign accounts

Tax Proposals for Individual Taxpayers

• Extend the optional deduction for state and local general sales taxes through December 31, 2011
• Permanently extend the alternative minimum tax (AMT) “patch” by increasing the AMT exemption amount based on annual indexing of the AMT exemption amounts in effect for 2009. Annual indexing of the exemption is intended to prevent millions of additional taxpayers from becoming subject to AMT
• Increase the child and dependent care credit for families earning up to $113,000 annually
• Extend the Making Work Pay (MWP) credit for one year through December 31, 2011. The MWP provides a refundable tax credit equal to 6.2 percent of earned income up to a maximum credit of $400 ($800 for joint filers). The credit begins to phase out once a taxpayer’s income exceeds $75,000 ($150,000 for joint filers)
• Make the American Opportunity Tax Credit (AOTC) permanent. The ARRA created the AOTC to replace the Hope Scholarship credit for 2009 and 2010. The maximum credit per year is $2,500 and is based on qualified tuition and related expenses for the first four years of post-secondary education. The credit phases out for taxpayers with income exceeding $80,000 ($160,000 for joint filers)
• Extend the Consolidated Omnibus Budget Reconciliation Act (COBRA) premium assistance eligibility period. Originally enacted under ARRA, individuals involuntarily terminated from employment are allowed to continue their health insurance coverage under COBRA at 35 percent of the normal COBRA premium. Certain recapture rules applied for individuals with income above $125,000 ($250,000 for joint filers). The proposal would extend the eligibility period to individuals who qualify for COBRA coverage as a result of an involuntary termination of employment prior to January 1, 2011. The duration of the premium assistance period would be 12 months for involuntary terminations after February 28, 2010, as opposed to 15 months for involuntary terminations between September 1, 2008, and February 28, 2010
• Reinstate the 39.6 percent tax rate. This rate would apply to taxable incomes exceeding $373,650 in 2011 and would be indexed for inflation. The 39.6 percent rate was temporarily reduced to 35 percent as a result of the Economic Growth Tax Relief Reconciliation Act of 2001 (EGTRRA). Absent congressional action, the 35 percent tax rate is set to revert to 39.6 percent after 2010, meaning nothing has to occur for this proposal to go into effect in 2011
• Reinstate the 36 percent tax rate for taxpayers with income exceeding $200,000 ($250,000 for joint filers) after 2010. Under EGTRRA, the 36 percent rate was reduced to 33 percent but is set to sunset after 2010. The proposal would limit the tax increase to taxpayers earning more than $200,000 ($250,00 for joint filers)
• Increase capital gains rate from 15 percent to 20 percent for taxpayers with income exceeding $200,000 ($250,000 for joint filers) for taxable years beginning after December 31, 2010. This proposal also would apply to qualified dividends
• Expand the 28 percent tax bracket so taxpayers earning less than $200,000 ($250,000 for joint filers) would not see their taxes rise as a result of the increase in top two tax brackets
• Reinstate itemized deduction and personal exemption phaseouts and limit tax benefit of itemized deductions to 28 percent. Prior to EGTRRA, personal exemptions and certain itemized deductions were reduced once a taxpayer’s income exceeded a certain amount. EGTRRA has gradually reduced the phaseout for personal exemptions and itemized deductions and completely eliminates it for 2010. However, the full phaseout will return in 2011. The proposal would adjust the income phaseout level for both personal exemptions and itemized deductions to begin at $200,000 ($250,000 for joint filers) in 2011 and index it annually for inflation. In addition, the rate at which itemized deductions reduce tax liability for both regular tax and AMT would be limited to 28 percent for taxpayers who earn more than the $200,000/$250,000 income limit

Retirement Savings Proposals

The budget includes a few provisions to help encourage individuals to save. Employers who do not offer a retirement savings plan would be required to enroll employees in a direct-deposit individual retirement account (IRA). An employee would be automatically enrolled at a default rate of 3 percent of compensation unless he or she opted out of the plan. Only employers in business for at least two years with more than 10 employees would be subject to this rule. To help offset plan costs, employers can claim a credit of $25 per enrolled employee up to $250 per year for two years. To help encourage employers to offer other retirement plans, a tax credit of up to $1,000 per year for three years would be offered to help offset start-up costs and plan administration costs. This credit would not apply to the automatic IRA plan. For individuals, the budget proposes to modify the current Savers Credit by matching 50 percent of the first $500 in contributions per year, increasing the eligibility income threshold and making credit fully refundable.

Estate Tax Proposals

Under EGTRRA, the estate tax has completely disappeared for estates of decedents dying in 2010 but is scheduled to return in 2011 with an exemption of $1 million and a top rate of 55 percent. Despite uncertainty of the constitutionality of a retroactive change, President Obama’s budget assumes the estate tax will be reinstated at 2009 levels retroactively to January 1, 2010. Based on this assumption, the budget proposes new basis reporting requirements for taxpayers inheriting or receiving property by gift that requires a valuation. For purposes of valuing an interest in a family-controlled entity transferred to a family member, the budget proposes creating a new category of restrictions that would be ignored. A proposal also is included that would require a grantor retained annuity trust (GRAT) to have a 10-year minimum term and a remainder value greater than zero and would prohibit any decrease in the annuity during the GRAT term. This proposal only would apply to GRATs created after date of enactment.

Proposed Jobs Credit

Although not specifically addressed in the 2011 budget proposals, President Obama has recently announced a proposal to provide businesses with a tax credit of $5,000 per new worker hired during 2010. Businesses also would receive a credit of social security taxes paid if they increase wages by more than the rate of inflation. The proposal is in response to the continuing lack of job growth despite indications of an economic recovery. Job bills containing some variation of the president’s proposal have been introduced in Congress.

As the budget indicates, higher tax rates and the loss of certain tax benefits are likely to occur in the near future, which makes proactive tax planning even more valuable. Please consult your BKD advisor for more information.