2011 Tax Changes: Tax man isn’t “cometh” – he’s here!

A host of tax provisions enacted in 2001 and 2003–commonly referred to collectively as the “Bush tax cuts”–expire at the end of the year. While it’s possible that new legislation could extend some or all of these expiring tax provisions, election-year politics make it difficult to predict what action, if any, Congress will take.

Bradley & Company expects that there will be sufficient political will to extend the rates for couples making less than $137,300 a year, but beyond that, it’s difficult to project political developments regarding rates for higher income brackets. In light of this, we’re responding in several ways.

Background

We expect Republican control of the US House of Representatives and a tax policy majority in the Senate after the November elections (i.e., a Republican minority with a few votes by defectors like Ben Nelson [D-NE] and Kent Conrad [D-ND]).

Republican leaders in both Houses have indicated their desire to extend all of the tax rates, but it seems unlikely the GOP will obtain sufficient majorities to completely dominate the legislative environment. Compromises will be required and we believe that higher income earners will see their marginal rates to increase in 2011. With that in mind, here’s what you need to know about the major changes that are scheduled for January.

Federal income tax brackets

At present, tax rates are expected to increase across all income brackets. The greatest percentage increases in rates come at lower levels. While it seems increasingly likely that some type of tax relief will materialize for lower income earners, we do expect that tax rates will increase for all citizens earning more than $209,250 after the first of the year. Below are the married, filing jointly, rate adjustments.

The impact of long-term capital gains tax rates

To review – for this year, if you sell shares of stock that you’ve held for more than a year, any gain is a long-term capital gain, generally taxed at a maximum rate of 15%. If you’re in the 10% or 15% marginal income tax bracket, however, you’ll pay no federal tax on the long-term gain (a 0% tax rate applies). That means if you’re a married couple filing a joint federal income tax return, and your taxable income is $68,000 or less, you pay no federal tax on the gain.

However, these rates expire at the end of 2010. Beginning in 2011, a 20% rate will generally apply to long-term capital gains. Individuals in the 15% tax bracket (remember, there won’t be a 10% bracket in 2011) will pay the tax at a rate of 10%. Special rules (and slightly lower rates) will apply for qualifying property held for five years or more.

Finally, while qualifying dividends are taxed in 2010 using the same capital gains tax rates described above (i.e., 15% and 0%), in 2011 they’ll be taxed as ordinary income subject to the increased 2011 tax brackets. This means that clients can expect the rate of dividend taxation to increase from 15% to their new marginal tax rate.

In particular, the President has stridently opposed the cuts to dividend taxes and has expressed the opinion that the sole beneficiaries of reduced dividend taxes have been wealthier Americans. We expect particularly strong resistance to continuing the lower rate for dividend taxes from the Administration, the democratic congressional leadership and from corporate executives of publicly traded firms and think it’s unlikely to survive tax policy negotiations in the next few months.

The estate tax

There is currently no estate tax for 2010, and special rules are in place that govern the way basis is calculated for property passing upon death. The estate tax reappears in 2011, however, with a $1 million exclusion amount (meaning that up to $1 million of assets will be exempt from estate tax) and a top tax rate of 55%. To put that in context, for 2009, the top estate tax rate was 45%, and estates received an exclusion of $3.5 million.

Other important changes

Other changes for 2011 include:

• Phaseout of itemized deductions and exemption amounts–Itemized deductions and personal exemption amounts will once again be phased out for higher-income individuals
• The “marriage penalty” returns–Changes made to correct the federal income tax “marriage penalty” expire at the end of 2010, resulting in a reduced standard deduction amount and lower tax bracket thresholds (i.e., higher rates will apply at lower income levels) for married couples filing jointly in 2011
• Tax credits get cut–The child tax credit will be reduced and both the Hope education tax credit and the earned income tax credit become less generous (the Making Work Pay tax credit also disappears)
• Section 179 small business expensing–The increased IRC Section 179 expense limit ends (Section 179 allows small businesses to elect to expense the cost of qualifying property rather than recover the cost through depreciation deductions); the amount that a small business may expense will drop from $250,000 in 2010 to $25,000 in 2011.

Strategy

In response, our strategy is as follows:

1. Avoid the unnecessary realization in 2010 of capital gains for all clients who have tax loss carry forwards. While much attention has been paid to the attractiveness of realizing gains at the lower rates in 2010, previously realized losses are a “deferred tax asset” that becomes more valuable with higher rates. This is particularly true for short term capital loss carry forwards.
2. Realize capital gains that are likely to be realized in 2011 anyway. In particular, portfolio rebalancing is desirable in this environment where the bias remains to expect increases in rates.
3. Aggressively harvest capital losses throughout 2010.
4. Show a greater preference for growth (non-dividend paying) stocks. We expect that the economy will generally favor growth companies overall over the next few years, but also there will be a reduction in returns associated with large dividend payers that will be felt by both taxable and non-taxable investors. This will likely change in the coming years, but for the short term, growth seems a better approach for both speculative as practical reasons.

Tax-sensitive investment management is one of the most important aspects of private wealth management. While we always endeavor to have a good understanding of our clients’ tax situation, you should always contact us immediately if you have a reason to believe that your tax situation has materially changed. Under any circumstances, it’s never a bad idea to discuss these matters with us. Please don’t hesitate to give us a call to discuss this, or any other matter.