United States: Explanations And Advice For Those Hit Hardest By New Tax Increases

Last Updated: January 16 2013

Article by Paul Sullivan

WHILE the affluent will pay more in taxes this year, that is probably not the case for the very wealthiest — those worth hundreds of millions or more. They may still be paying a lower tax rate than Warren Buffett's secretary.

Many millionaires are certainly paying at least 30 percent of their income in taxes, a goal President Obama set out in last year's State of the Union address. But they're more likely to be doctors, lawyers and people working in the financial services industry who get the bulk of their earnings in the form of paychecks.

Partners in private equity firms and hedge fund managers, on the other hand, earn much of their money as a share of their funds' earnings. And that income gets preferential tax treatment as so-called carried interest.

A similar special tax treatment still holds true for Mr. Buffett as long as the bulk of his income comes from his investments and not a paycheck. The long-term capital gains rate for incomes over $400,000 is 23.8 percent, including the Medicare surcharge. That's a far cry from the top marginal tax rate on income above that amount of 40.5 percent, which includes a 0.9 percent Medicare surcharge on earned income.

How are people going to react to all of this? Here is advice and observations from some experts in wealth management:

INCOME ISSUES This year, income taxes are going up for almost everyone, even if the taxes go by different names. Greg Rosica, a tax partner at Ernst & Young and a contributing author to the firm's tax guide, laid out five tiers where taxes are increasing.

The bottom one includes everyone who receives a paycheck and is affected by the 2 percentage point increase in the payroll tax. In the top one are couples making more than $450,000 a year, who will pay higher rates on income and investments, be subject to the Medicare surcharges of 0.9 percent on income and 3.8 percent on investments and lose some portion of their itemized deductions and exemptions.

Using assumptions on wages and deductions from Internal Revenue Service statistics, Mr. Rosica calculated that a person making $500,000 a year would pay $9,124, or 7 percent, more in taxes in 2013. A couple earning $1 million a year in wages and business and investment income would pay $53,350 extra, or 20 percent more in taxes.

"It's hitting every line item of income," he said. "It's phasing in all the way up the scale." This has made strategies that defer income more attractive than they were in the years when George W. Bush was president and tax rates were historically low. "At the base level, it's 401(k) plans. Or, for the self-employed person or person who sits on boards, they can defer into a SEP I.R.A.," a retirement plan for the self-employed, or into one's own defined-benefit plan, said Christopher Zander, the national head of wealth planning at Evercore Wealth Management. "That's very attractive. Even if income tax rates are higher later, I think the tax deferral" makes up for that increase.

There are risks, though. People could defer too much into a qualified plan, like an I.R.A., and end up having to pay a penalty if they need the money before they turn 59 1/2 years old. Or they could put too much into a company-sponsored deferred-compensation plan and face two problems. The company could go bankrupt, as Lehman Brothers did, and they could lose that money, or the payout schedule they selected when they put the money in — say 10 annual payments at retirement — may end up providing them with too much or too little income.

CARRIED-INTEREST CONUNDRUM At the very top of the income ladder, the group for whom the changes in the tax code will not hurt as much includes people like hedge fund managers and private equity partners whose earnings come in the form of carried interest. The income for these people comes from the fees they charge, and that income will continue to be taxed at a lower rate than ordinary income.

"Carried interest rules are helpful for hedge fund managers, but they're incredibly helpful for private equity guys," said Richard A. Rosenberg, a certified public accountant and co-founder of RR Advisory Group, which advises hedge fund and private equity partners. "Private equity funds typically get the stronger treatment because there is less turnover and the holding periods of the funds are longer."

How the partners' share is taxed depends on how the underlying investments are taxed. In the case of private equity, many of the investments are held for longer than a year. Through last year, the distributions would have been taxed at the long-term capital gains rate, which was 15 percent. Even now, the rate is still a relatively low 20 percent for an individual earning above $400,000.

In the case of a hedge fund, the earnings are probably a combination of various rates, like short- and long-term capital gains, dividend and interest income, with capital losses factored in. Still, the rate on the carried interest is likely to be lower than the rate paid by someone who earns a high salary.

But for individuals who invest in private equity and hedge funds, the tax situation will be worse. Since they have little control over when those managers buy and sell things — and at what rate those investments get taxed — advisers said that it may be more beneficial to own those investments in tax-deferred accounts.

SMALL BUSINESS BURDENS Despite what both political parties say about the importance of small-business owners for creating jobs, the new tax rates will adversely effect everyone whose businesses are set up so their earnings flow through to their individual income tax returns.

J. Leigh Griffith, a lawyer and partner at Waller, a national law firm based in Nashville, said many in this group would be paying taxes at a higher marginal rate than big corporations like I.B.M. and General Electric. He said about half of all companies today were structured as so-called pass-through entities.

"Both parties have talked about how our corporate rate of 35 percent, which is the highest in the developed world, puts us at a competitive disadvantage," Mr. Griffith said. But we take a 35 percent bracket on pass-through business entities and raise it to 39.6 percent plus the investment tax."

While he said it was too early to quantify the impact this will have, these business owners will probably have to pay higher rates of interest to borrow money. And some business owners may become frustrated and look to shelter more money from taxes. While many legitimate vehicles exist, like profit-sharing plans or defined-benefit plans, he said he was concerned that some small-business owners would turn to tax avoidance schemes.

He said this year was only eight days old when he heard of the first tax shelter linking itself to the new law (which was signed on Jan. 2): it was an offer to invest in a film with a 100 percent tax write-off on the investment — and a producer credit.

INVESTING WITH TAXES IN MIND In an ideal world, taxes would be seen as a way to raise revenue for necessary services and wouldn't prompt people to change their behavior to avoid them. But this isn't an ideal world.

Beyond risky tax shelters, there are other, seemingly sensible investments that, when overdone, can also have adverse effects on any long-term investment plan. The interest payments on municipal bonds are tax-free, but not every city or service that issues municipal bonds is equally solid. And municipal bonds are still subject to capital gains tax when sold.

Seth J. Finkel, managing director at Neuberger Berman Wealth Management, said some clients were looking at investing in master-limited partnerships — many of which operate pipelines — because they are not taxed at the corporate level and the dividends are structured so the entire amount is not subject to tax. But there is an inherent risk in anything that relies on transporting natural resources because demand can vary.

"We want to look at the bottom line and not make bad decisions," Mr. Finkel said. "But taxes do matter." For people with large holdings of stock that have appreciated greatly over the year and are subject to a 23.8 percent tax, Mr. Zander said there was the temptation to put those shares into exchange funds — essentially a pool of other highly appreciated stock — or buy so-called collars that keep the price within a particular range.

"Many times, the decision becomes to sell outright, even though rates are higher," Mr. Zander said. "There's immediate diversification and less administrative hassle."

Originally published in The New York Times, January 11, 2013

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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