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During the campaign for President, Sen. Barack Obama’s campaign positions included proposals for various changes in the tax law. Now that he is President-elect, those ideas have taken on greatly increased relevance.

Because the proposals are President-elect Obama’s, they are most likely to become the subject of proposed legislation after his inauguration in 2009. However, we understand that some tax issues may be addressed in a lame-duck legislative session taking place before the end of 2008. The result of that lame-duck session should be known by December, potentially presenting a window of opportunity for year-end tax planning. While we generally would expect the changes to be prospective, there is some precedent for legislation enacted late in a year to be effective as of the beginning of that year. Some key provisions of the official tax plan, as well as other changes that President-elect Obama has indicated may be proposed, are summarized below.

Individual Tax Provisions

Adjustment of individual income tax rates. The plan would reinstate the pre-2001 top two income tax brackets of 36 and 39.6 percent (currently 33 percent and 35 percent). Those rate increases would affect married couples with taxable income in excess of $250,000 (or single individuals with taxable income in excess of $200,000). For taxpayers in those top two income tax brackets, the tax rate on dividends and capital gains would increase from 15 percent to 20 percent. The plan would also reinstate the phase out of the personal exemption and itemized deductions at $250,000 for married couples and $200,000 for single individuals, and would index these amounts for inflation.

Other changes. The plan would make permanent certain of the Bush tax cuts, including the child tax credit, marriage-penalty relief, and the first four tax rates of 10, 15, 25, and 28 percent.

Alternative minimum tax. The plan would extend the 2008 patch (consisting principally of an increased exemption amount), and would index it for inflation.

Tax relief targeted at middle- and lower-income taxpayers. While the plan does not include reductions of tax rates for middle- and lower-income taxpayers, it includes various provisions intended to reduce their overall tax burden. Those provisions include:

• A refundable credit of 6.2 percent on the first $8,100 of earnings to offset the payroll tax. Thus, in effect, the credit would be limited to $500 for individuals and $1,000 for married couples, both of whom have taxable earnings of at least $8,100.
• Expand the earned income tax credit and the child and dependent care tax credits.
• A refundable ten percent mortgage tax credit for non-itemizers.
• A refundable tax credit of up to $4,000 for the costs of attending college.
• Expanded tax credit for purchasing fuel-efficient vehicles and equipment.
• Eliminate income taxation of seniors earning less than $50,000.

Retirement savings. The plan proposes incentives for retirement savings:

• Provide automatic enrollment in employer plans.
• Require employers without plans to enroll employees in direct-deposit individual retirement accounts.
• Increase the saver’s credit and make it refundable.

Employment tax increase. The plan would increase Social Security taxes beginning about a decade after enactment. If enacted, the increase could create a “donut” phenomenon in which income below a certain limit would be subject to the taxes, the next level of income would not be was not subject to tax (the “donut hole”), and the top level would be subject to a combined (employer and employee) rate of tax of between 2 and 4 percent.

Estate tax. The plan would apply the estate tax only to estates in excess of $7,000,000 per couple, with a maximum estate tax rate of 45 percent. Because the current temporarily low estate tax rates and high exemption amounts are scheduled to expire soon, this proposal is considerably more generous to taxpayers than what current law provides.

Business Tax Provisions

Elimination of capital gains for entrepreneurs and investors in small businesses. The plan would eliminate the capital gains tax for investments in small businesses, but does not define what will constitute a small business or what other requirements will apply.

Fifty-percent small business healthcare tax credit. Small businesses (to be later defined) will receive a refundable tax credit equal to 50 percent of their costs of providing employee health insurance.

Corporate tax rate. The plan supports lowering the 35 percent corporate tax rate, but does not indicate what the new rate would be.

Research tax credit. The plan would permanently extend the research tax credit.

Tax policies to encourage domestic creation and retention of jobs. Federal tax law includes many provisions oriented toward the imposition of United States taxes on investment-type operations carried on offshore by United States persons, but those provisions generally have not been extended to true operating businesses carried on offshore. In general, trade or business income earned offshore by controlled foreign corporations is not subject to United States taxation until the earnings are repatriated to the United States. Also, because of the availability of foreign tax credits, those provisions have not had a significant impact on the domestic taxation of operations carried on in non-tax haven countries. We would expect to see some combination of an expansion of the existing offshore tax provisions and targeted tax incentives for domestic employment. We do not expect the result to be a simplification of the tax law.
 

Revenue Raisers

The plan contains a number of proposals to raise revenue to pay for some of the tax proposals.

These proposals include:

• Modifying the international tax rules to end the incentive for companies to move jobs overseas, and to close the offshore pension loophole.
• Tax “carried interests” as ordinary income rather than capital gain. A carried interest is the fund manager’s right to a specified share of a fund’s profits without contributing a proportionate share of the fund’s capital.
• Eliminate oil and gas tax incentives.
• Close the “CEO pay loophole.”
• Codify the economic substance doctrine under which certain transactions’ claimed tax benefits may be ignored because the transactions lack adequate economic reality.
• Increased reporting of securities transactions.
• Crackdown on offshore tax havens.

Additional Proposals to Respond to the Economic Crisis

• Extend unemployment benefits and temporarily eliminate taxes on benefits received.
• Allow penalty-free hardship withdrawals from individual retirement accounts and 401(k) accounts of 15 percent (up to $10,000) for 2008 and 2009. The withdrawals would be subject to income tax.
• Temporarily suspend the minimum distribution requirements for retirees over 70½, and exempt from tax the required minimum distribution amount.
• Create a refundable credit of $3,000 for each additional full-time employee hired in 2009 and 2010.
• Increase the small business expensing limit under section 179 to $250,000 through December 31, 2009 (it is $250,000 in 2008 and is currently scheduled to decrease to $125,000 in 2009).

Action Items

With the taxable year coming to a close, it may be worthwhile to explore ways to benefit from (or at least mitigate the effect of) the above potential changes. Of course, no legislative proposal survives its first contact with Congress; it is impossible to predict which proposals will actually be enacted and which as-yet unproposed changes will be added. Therefore any planning will involve a fair amount of guesswork. Possible action items include:

• Accelerate income on the assumption that tax rates will be lower in 2008 than later.
• Defer losses on the assumption that losses will be more valuable after 2008 than in 2008.
• Review estate plans in light of the potential changes
• Consider possible increased differential between corporate and individual tax rates in structuring business enterprises.
• Consider business effects of the incentives that may be created by the proposed tax changes.

As always, Smith & Howard is available to discuss these matters and assist you with any planning needed to optimize your responses to the changing tax environment.