SPECIAL REPORT

What the Nation's Wealthiest Can Expect From the Bush Tax Plan

Thursday, April 19, 2001

Deloitte & Touche OnLine

From the early days of his presidential campaign, George W. Bush has pitched his $1.6 trillion tax cut by arguing that, in light of expected significant budget surpluses, those who pay taxes deserve to get something back. Critics, in turn, have claimed the plan tilts too much towards the wealthy. 

Beyond the rhetoric, just what can high net worth taxpayers expect in the way of tax relief? The answer hinges upon what agreement Congress and the president reach in sculpting a cut. If current congressional proposals become law, those high wealth individuals who pay the bulk of the country's income and estate taxes, stand to see significant savings in both areas.

Proposed Rate Cuts Offer Meager First-Year Savings – But Much More to Follow

Support among congressional taxwriters for retroactive tax relief remains strong, with the Senate having just approved a budget plan that allows for an $85 billion tax cut retroactive to the current year. While the Senate left unspecified the mechanism for providing the reduction, the House last month passed its own version, which would drop the lowest tax bracket rate to12 percent starting in 2001.

Under the House plan, high income taxpayers won't recoup any more in the first year than most low-income taxpayers. At best, they could expect to see about an extra dollar a day. Down the road, however, they could reap significant savings.

New Bracket, Lower Rate – The retroactive relief proposed by the House is packaged with an across-the-board marginal tax rate cut – one of the major components of the president's tax plan. That proposal, H.R.3, passed on March 8, largely along party lines, and calls for splitting the existing 15 percent tax bracket into two brackets – a 10 and 15 percent tax bracket – after the plan is fully effective in 2006, with the lower bracket initially dropping to 12 percent in 2001. It's estimated to cost $958 billion over 10 years. Both Bush and House Ways and Means Chairman Bill Thomas, R-Calif., maintain that a retroactive tax cut would stimulate the economy by putting spending money back into the pockets of taxpayers at a time when the economy is floundering. 

Some House Democrats have said H.R. 3 offers so little relief in the first year that it won't significantly affect the economy. They also accuse Bush of painting a gloomy economic picture to rally support for the bill. But a Democratic alternative to H.R. 3 offered even less under its first-year cut and was rejected without serious consideration.

In either case, the Republican and Democratic plans would provide meager first-year savings to those with high incomes, particularly compared to the thousands of dollars that those same taxpayers would eventually reap under the fully effective Bush plan. In 2001, single taxpayers under H.R. 3 would net up to $180, while married couples would receive up to $360. Under the Democratic alternative for the same year, singles would receive up to $75, and married couples would pocket up to $150 in additional tax savings.

If H.R. 3 becomes law, those with higher incomes could see substantial savings. After the plan is completely phased in, a single person earning $1 million in wages could easily save $45,000 in one year; married couples could expect slightly more – with savings for either class of taxpayers increasing as income rises.

Senate Action Still to Come – The Senate has yet to take action on any specific element of the Bush tax plan, but Senate leadership in both parties is showing support for an immediate tax cut. Senate Minority Leader Tom Daschle, D-S.D., in a March 19 letter to Bush, offered his support for immediately lowering the 15 percent rate to 10 percent. "Meaningful tax relief ought to be provided as quickly as possible. With bipartisan cooperation in the House and Senate we can have it on the President's desk by May 1," he wrote.

If Congress were to pass an immediate drop in the marginal rates to 10 percent as Daschle has suggested, taxpayers could expect to see greater first-year savings than they would under the Republican or Democratic House plans. "It would put about $600 in the pocket of almost every family that pays income taxes," Daschle correctly claims. But that bonus amounts to little more than pocket change for high wealth taxpayers with significant tax liabilities.

Marriage Penalty Relief Heads Down the Aisle

Continuing its march toward complete passage of the president's plan, the House on March 29 voted 282-144 to approve legislation providing tax relief for married couples and families. 

The proposal, H.R. 6, would reduce taxes for couples by increasing the standard deduction for joint filers to twice that of single taxpayers, and widening the 15 percent tax bracket for joint filers to twice that of singles. Both provisions apply to any married couple that has sufficient income, regardless of whether both spouses work. In contrast, the president's marriage penalty relief proposal – the second-earner deduction – targets only working couples. 

For couples who use the standard deduction and have taxable income of at least $55,600, the legislation would provide up to $1,265 in tax savings; a high-income couple who itemizes deductions, on the other hand, would receive only $890. 

The House-approved measure for providing marriage penalty relief gives only $890 back to high-income couples who itemize.

The House also approved a scaled-down version of the president's child credit. Intact is the promise to double the credit over a range of years, but the legislation drops any increase in the phaseout range for the credit. Bush had proposed to boost the phaseout threshold to $200,000 for singles and married couples. The House version leaves it at $75,000 for singles and $110,000 for couples.

That means high-income families won't see any relief from the House child credit proposal, since, for example, a couple with two children would have no eligible child credit after income exceeds $150,000.

Estate Tax Repeal: Back From the Dead? 

Without skipping a beat, the House quickly moved to approve on April 4 a GOP plan, H.R. 8, to repeal the estate tax. 

The bill, beginning in 2002, would gradually phase out the estate, gift, and generation-skipping transfer taxes, and replace the unified credit with a unified exemption. Following a full repeal, set to take place beginning in 2011, an heir's basis in inherited assets would equal the donor's basis in those assets at the time of death. A decedent's estate would, however, be allowed to increase the basis of assets transferred by up to a total of $1.3 million, and an additional $3 million for property transferred to a surviving spouse. 

Taxes and Headaches Still Loom in Post-Estate Tax Era – While America's wealthiest have been divided over the merits of estate tax repeal, the presumption is they're likely to see significant economic benefits by escaping a regime that imposes effective marginal tax rates as high as 60 percent on transfers made at death. 

If President Bush gets his wish and a repeal becomes law, individuals will be able to make tax-free transfers at death. That will, as expected, provide enormous savings to some large estates. 

For example, under current law a typical taxable estate of $1.2 million left by a single person could pay as much as $200,000 in estate tax, and larger estates could owe upwards of millions. More than half of an unmarried individual's $100 million taxable estate is likely to go towards federal taxes. A repeal would wipe away that debt. 

But even after a repeal, beneficiaries of estates shouldn't expect that their slates have been wiped clean of taxes. The House legislation may hold some surprises for the nation's richest estates – those taxable estates often described as falling in the highest two percentile of estates. 

The House legislation may hold some surprises for the nation's richest estates – those taxable estates often described as falling in the highest two percentile of estates.

The proposal in effect merely postpones the taxation of appreciated assets passed on to beneficiaries. Although there would be no tax on the appreciation of transferred assets at death, beneficiaries would pay capital gains tax on the appreciation when the assets were sold at some later date (also known as a carryover basis regime). Capital gains taxes, while lower than taxes owed under the current estate tax regime, remain significant, especially for estates with highly appreciated assets. 

Under this proposal, it's possible that some estates – when taking into account the subsequent capital gains tax paid by beneficiaries – could be in a worse tax situation than they would be under current law, particularly if beneficiaries quickly sold highly appreciated assets from the estate. The adverse effects, however, would be eliminated if the beneficiary instead held the assets. 

Suppose, for example, a wife inherits $9.325 million from her husband's $10 million taxable estate, with the remaining $675,000 of assets passing on to their child. Under current law, the estate would have no estate tax liability, and the surviving spouse would receive a step up in basis for all inherited assets. An immediate sale of those assets would produce no gain or loss since basis would equal fair market value.

Similarly, under the House's repeal proposal, the estate would also have no tax liability. But the surviving spouse would receive a limited step up in basis – only up to $4.3 million of fair market value, while the remaining assets of just over $5 million would have carryover basis.

Assuming the wife needed to liquidate some assets, under the worst-case scenario in which the assets she inherited had a basis of zero under a carryover basis regime, an immediate sale of these assets would realize capital gains tax, using a 20 percent rate, of $1,005,000.

So while neither the estate nor the spouse had tax liabilities (estate tax and capital gains tax) under current law, the wife could face a tax liability in excess of $1 million under the repeal – if she disposes of the inherited assets. Even if appreciated assets had a carryover basis, the wife would still owe more taxes under a repeal than under the current regime.

It should be emphasized that the wife would never owe capital gains tax if the assets were held and passed on through her estate, so timing of the sale can determine whether the estate is better or worse off under the repeal.

Complexity and New Reporting Requirements – Under a repeal, capital gains may not be the only surprise. Beneficiaries of large estates will face new complexities for determining basis of inherited assets and will need to comply with new reporting requirements.

Under the House legislation, estate executors will elect which assets are to receive a step up in basis, while also determining the extent to which each asset receives an increase in basis. Some property would be ineligible for step up, including certain assets acquired by the decedent by gift.

Determining carryover basis for other assets could be problematic, especially for assets held by decedents for a number of years, or assets that were purchased through reinvestment programs over the course of the decedent's life. In these cases, obtaining documentation to determine the decedent's basis is often onerous.

The House bill also includes new rules that would require more extensive reporting of some types of gifts and transfers made at death. Information on basis and character of the property, along with the name and taxpayer identification number of the recipient would have to be provided by the donor or estate to the Internal Revenue Service. Penalties for noncompliance could be as high as $10,000.

Alternative Minimum Tax   

Along with the provisions already considered, taxwriters feel mounting pressures to provide broad alternative minimum tax (AMT) reform as they foresee its growing impact on taxpayers over the next 10 years. But the question of whether Congress will make substantive AMT reforms remains unanswered. Thomas's marriage penalty proposal includes a provision that would increase the AMT exemption for married couples to $46,500 in 2006 with additional increases proposed in later years and permanently allow taxpayers to take the child credit to the extent of an individual's regular income and AMT liabilities.

Lawmakers feel mounting pressures to provide broad AMT reform as they foresee its growing impact on taxpayers over the next 10 years.

Of the three House measures already passed, none address another prominent AMT issue – the tax treatment of incentive stock options (ISOs). As a result of the recent stock market decline, some taxpayers who exercised stock options earlier in 2000 when stock prices were higher are saddled with an AMT liability that exceeds the current value of the stock.  It is uncertain whether Congress will move to address this very complex issue.

End Games

The House on March 28 passed a budget resolution that would fully fund President Bush's proposed 10-year, $1.6 trillion tax cut. For its part, the Senate, while adhering to the idea of retroactive tax relief, dealt a blow to the Bush tax plan on April 6 when it approved a budget resolution calling for only $1.2 trillion in tax relief over 10 years.

Differences between the two resolutions will be resolved in conference some time after lawmakers return from their spring recess later this month. But with the size of an enacted tax cut now becoming more likely to fall within the $1.2-1.6 trillion range established by the two chambers, parts of the president's individual tax cut plan now appear to be in jeopardy.

Between marginal rate cuts, marriage penalty relief, and estate tax repeal, the House has already allocated over $1.54 trillion for tax cuts. And Bush has other tax priorities, including permanently extending the research and development credit ($50 billion), and allowing non-itemizers to deduct charitable contributions ($52 billion). In addition, estimates for fixing AMT problems that would be exacerbated by the Bush plan range up to $292 billion.

Provisions benefiting high net worth individuals are certain to come under the scrutiny of Senate taxwriters looking for alternatives to curb revenue loss.

It remains to be seen how lawmakers will juggle the president's as well as their own priorities into the remaining tax cut. Given the existing constraints, taxwriters may have to consider options such as scaling back a full repeal of the estate tax or only temporarily extending the research and development tax credit – which is currently set to expire on June 30, 2004 – rather than making it permanent.

Provisions benefiting high net worth individuals are certain to come under the scrutiny of Senate taxwriters looking for alternatives to curb revenue loss. Some senators already have suggested preserving the estate tax but with greater exemptions, as well as reducing the size of marginal rate cuts in upper-income tax brackets.

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Tax News & Views is produced by the Legislative & Regulatory Services Group at Deloitte & Touche LLP.

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