United States: Protecting Your Wealth From Estate And Income Tax Changes

Large tax increases are scheduled to take effect in 2013 unless Congress acts – threatening to drastically alter both transfer tax and income tax rules. High net worth taxpayers face the prospect of new taxes on both their income and their estates, but also an opportunity. You may have begun considering whether 2012 is the year to reverse your income tax strategy and accelerate income and defer deductions, and whether it's time to put transfer tax strategies into play while interest rates are low and transfer tax rules are favorable.

The November election and political gridlock have made the outlook for legislation uncertain. This makes tax planning not only difficult but also more important. The decisions you make now may have a tremendous impact on your tax obligations in the future. The tax increases are scheduled to come from various sources: new Medicare taxes, the expiration of the 2001 and 2003 income tax cuts, and the expiration of the estate and gift tax rules enacted in 2010.

Strategies to accelerate income tax should be approached very cautiously. Transfer tax strategies during legislative uncertainty also carry risks. First, you need to understand exactly which taxes are scheduled to increase and by how much, and how those increases would actually affect you. You also need to understand the likelihood that these tax increases will actually occur. That's why it is prudent to prepare now but wait to act until the legislative outlook becomes clearer. This Tax Insights will help by:

  • explaining the scheduled estate and income tax increases in detail and examining the potential for legislation to defer or prevent them,
  • discussing how to approach income and transfer tax planning in this environment, and
  • discussing the specific tax issues and planning ideas that need to be addressed.

What's really coming?

Tax increases on income

Both payroll and income taxes are scheduled to increase starting on Jan. 1, 2013. Without legislative action, the 2001 and 2003 tax cuts will expire and new Medicare taxes enacted as part of the health care reform legislation in 2010 will take effect. The expiration of the 2001 and 2003 tax cuts would erase scores of benefits, including:

  • rate cuts across all income brackets,

  • the full repeal of the personal exemption phaseout (PEP) and "Pease" phaseout of itemized deductions,

  • the top rate of 15% for capital gains and dividends,

  • the zero rate for capital gains and dividends in the bottom brackets,

  • marriage penalty relief and the $1,000 refundable child tax credit,

  • the increased dependent care credit and the employer credit for child care facilities,

  • the $12,650 adoption credit and the $12,650 income exclusion for employer adoption assistance, and

  • several education related incentives.

The loss of rate cuts is the most significant threat (see chart). Because the tax increases come on the individual side, they will affect both your individual income and any business income from privately held and pass-through businesses taxed at the individual level. And on top of these tax increases comes the new Medicare taxes.

Individual income tax rates*

Ordinary income tax brackets (2012 levels)





2013 +





















Over $388,350

Over $388,350



Capital gains top rate



Dividend top rate



* Does not include Medicare taxes.

Top capital gains rate in 2013 will be 20% for assets held more than a year and 18% for assets held more than five years, not including the 3.8% Medicare tax.

First, the rate of the individual share of Medicare tax will increase from 1.45% to 2.35% on earned income above $200,000 for single filers and $250,000 for joint filers. The 1.45% employer share will not change, creating a top rate of 3.8% on self-employment income. In addition, investment income such as capital gains, dividends and interest will be subject for the first time to a new 3.8% Medicare tax to the extent AGI exceeds $200,000 (single) or $250,000 (joint). There is no cap on Medicare taxes.

Individual Medicare tax rates*

Earned income (salary, self-employment)


2013 +

$0–$200k (single)

$0–$250k (joint)



$200k + (single)

$250k + (joint)



Investment income (dividends, cap gains, interest)


2013 +

$0–$200k (single)

$0–$250k (joint)



$200k + (single)

$250k + (joint)



*Does not include 1.45% employer share on earned income, which also applies to self-employment income and will not change.

The new tax on investment income will not apply to distributions from qualified retirement plans or active trade or business income. Active S corporation income not paid as salary will still not incur Medicare tax, as it is not earned income.

A two-year partial payroll tax holiday, which cut the individual share of Social Security tax from 6.2 percent to 4.2 percent, is also scheduled to expire at the end of the year, but Social Security taxes are capped annually ($110,100 in 2012).

The combined tax increases would severely affect top rates on all types of income. The top rates on dividends, interest and earned income (see chart) would apply when income reached the top tax bracket ($388,350 in 2012), though the Medicare portion would apply at the $200,000 or $250,000 thresholds. The top rate of 23.8% rate on capital gains would be reached at $200,000 or $250,000 thresholds.

Combined top rates*

Type of income


2013 +

Earned income









Capital gains



*Includes only employee share of Medicare taxes

Tax increases on wealth transfers

The good news is that the transfer tax rates through the end of 2012 are at historic lows, and exemption levels are at historic highs. The bad news is that these rules are scheduled to change at the end of the year. The current rules (agreed to in 2010 as part of an extension of the 2001 and 2003 tax cuts) generally reunite the estate and gift taxes with the following rules:

  • 35% rate
  • $5.12 million exemption
  • Portability of estate tax exemption amounts between spouses

If no legislation is enacted, the estate, gift and generation-skipping transfer (GST) taxes will all revert to the rules in place in 2000, with a top rate of 55 percent and an exemption of just $1 million (see chart).

Exemptions and rates for estate, gift, and GST


2013 +


$5.12 million

$1 million




Potential for legislation

Congress has so far made little progress. Both parties held votes on separate plans to extend the 2001 and 2003 tax cuts before adjourning for the August recess, but these votes were largely vehicles to stake out campaign positions. No legislation is expected until after the elections, when lawmakers are likely to return in November to work on a lame duck compromise. In a similar process in 2010, the president agreed to extend the 2001 and 2003 tax cuts for two years, but an agreement may be more difficult this year.

The bills voted on by Democrats and Republicans would both extend the tax cuts for one year, except the Democratic bill would allow the tax cuts to expire for income above certain thresholds ($200,000 minus the standard deduction and a personal exemption for singles and $250,000 minus the standard deduction and two personal exemptions for joint filers). Capital gains and dividends above these thresholds would be subject to a top rateof 20%, and PEP and Pease would be reinstated with phase-ins beginning at these thresholds.

Regarding transfer taxes, Senate Democrats initially included a provision applying the rules in place in 2009 to 2013 ($3.5 million exemptions and a top rate of 45%), but backed away after several moderate Democrats in relatively conservative states said they may not support such a reversion. House Republicans proposed to extend the current transfer tax rules through 2013.

Despite their political nature, the votes do offer insight into the outlook for eventual legislation. For one, lawmakers appear to have settled on an extension for just one year. A one-year extension is meant to give lawmakers time and leverage for a potential tax reform effort in 2013.

The votes also reveal that congressional Democrats are committed to campaigning on a promise to roll back the tax cuts above the $200,000 and $250,000 thresholds, although there may be room for negotiation in a lame duck session. Several Democratic lawmakers had previously floated the idea of extending the 2001 and 2003 tax cuts on income up to $1 million. It is also clear that Democrats are far from unified on transfer taxes. This may give Republicans a slight advantage on the issue.

It is difficult to predict a final outcome. The results of the election will have an impact, but a bipartisan compromise will still be necessary. If President Obama is re-elected, he will need to negotiate with Republicans in Congress. If Republicans take both chambers and the White House, they will likely need to negotiate with Democrats in the Senate to overcome procedural hurdles. President Obama agreed to an extension of all the tax cuts in 2010, but is now facing a more dire debt situation and has been more rigid in his calls for additional revenue. The extension of most of the 2001 and 2003 tax cuts remains likely, but the outcome for the tax cuts at high income levels and for transfer tax rules is uncertain. The repeal of the new Medicare tax may be an uphill battle, given the current condition of the Medicare trust fund and the political sensitivity of the issue.

Considerations for your 2012 tax strategy

Income taxes and payroll taxes

With the clear potential for tax increases, taxpayers may be tempted to accelerate tax into 2012 by deferring deductions and recognizing income. But a careful analysis of several factors should come first, and there are many reasons why accelerating tax is a bad idea.

First, determine whether the tax increases will apply to you. Tax increases are unlikely to affect any income below the income thresholds of $200,000 (single) or $250,000 (joint), and it's possible taxes won't increase at all. Accelerating tax in 2010 provided little or no benefit when the tax cuts were extended. That's why it will be prudent to prepare now but act only when the legislative outlook becomes clearer.

If you're subject to the alternative minimum tax, you may not benefit from any acceleration in tax. In addition, remember you may be in a lower tax bracket at retirement. You also need to consider transfer tax consequences. Triggering gain can backfire if an asset otherwise would have received a step up in basis at death.

You also need to consider the actual rate change versus the time value of money. The tax increases would affect many types of income in many different ways. When thinking about accelerating tax, it will be important to understand exactly how much tax would be paid in the future and how long you otherwise could have deferred the tax. Even at today's low interest rates, the time value of money will still make deferral the best strategy in many situations. You probably do not want to trigger gain on property you would otherwise have held onto for years just to avoid a capital gain rate increase from 15% to 20%. Economic considerations should always come before any tax-motivated sale.

Transfer taxes

Transfer taxes are a different story. Given the legislative uncertainty and the current economic conditions, 2012 may provide a unique window for estate and gift tax planning. Interest rates are at historic lows, and values of property and other assets have declined because of past economic conditions, which now appear to be improving. When both of these conditions exist, property transfer is almost always beneficial, even if gift tax is incurred.

Specific issues and planning ideas that need to be considered

Income and payroll taxes

Once you understand how the tax increases would affect your particular situation, there are several specific issues and planning opportunities to consider before the end of the year. Even if it appears unwise to accelerate tax, you want to carefully evaluate your typical year-end decisions.

You may be able to control the timing of many types of ordinary income, including:

  • self-employment income,
  • bonuses,
  • consulting income, and
  • retirement plan distributions.

You may also be able to affect tax by timing how you exercise options. The spread between the exercise price and the fair market value of nonqualified stock options (NSOs) is ordinary income when exercised and the holding period for long-term capital gain treatment begins. If you do not plan to hold incentive stock options (ISOs) long enough to qualify for capital gain treatment, you can sell them before rates increase.

You can consider a conversion from a 401(k) or traditional IRA to a Roth IRA now while tax rates are low. Tax will be owed on the amount of the conversion now in exchange for no tax on future distributions if the conversion is made properly.

But the easiest thing to control is capital gains. You can trigger gain and pay tax on stock and other securities without changing position. There is no wash sale rule on capital gains, so stock can be sold and bought back immediately to recognize the gain. But if much of your net worth is tied up in one asset because you're deferring the tax bill on a large gain, this might be a good time to reallocate that equity. Turning over assets besides securities will likely involve higher costs and more complications. Strategies that seek to recognize gain but allow you to retain some control or use of the assets must satisfy rules that determine whether ownership has indeed been transferred effectively. You may also consider electing out of the deferral of gain recognition available in an installment sale. Deferred income on most installment sales can be accelerated by pledging the installment note for a loan.

Pass-through vehicles such as partnerships and S corporations are taxed at the individual level, so remember entity-level decisions can accelerate income and defer deductions for you as a partner or a shareholder. But remember that accounting method changes and other depreciation decisions can delay deductions, and decisions on advanced payments can accelerate income — but these decisions but will continue to delay deductions and accelerate income incrementally in future years. It is NOT likely that there are many situations where this will help.

Special considerations for Medicare tax

The new Medicare tax on investment income includes an exception for active trade or business income and gain on the sale of trade or business assets or S corporation shares. Owners in pass-through businesses should start thinking of strategies to deal with the Medicare tax before it takes effect in 2013. If it is possible to reorganize business interests and activities so that they meet the test for active rather than passive income (without causing it to be considered self-employment income) this may save significant taxes in the future.

Transfer taxes

Exhausting your gift tax exemption during your lifetime is often a solid transfer tax strategy. The estate and gift taxes are "reunified" in 2012, meaning that using your gift tax exemption will reduce your estate exemption at death. However, giving away assets now can save transfer taxes in the long run by removing any appreciation and annual earnings from your estate. Assuming modest 5% after-tax growth, $5.12 million can easily turn into more than $13.5 million over 20 years.

Making taxable gifts at the currently low 35 percent gift tax rate can also create benefits. For one, the amount of gift tax paid is removed from the estate. The gift tax is a "tax exclusive" tax because you do not pay tax on the gift tax itself, while the estate tax is "taxinclusive." For example, if you had a taxable estate of $1.35 million and gave it all away during your life, your heir could receive a full $1 million gift with your paying gift tax of $350,000 (35 percent). If your estate is instead transferred at death, your heir would receive only $877,500 after paying 35 percent, or $472,500, on the full $1.35 million. Even more important, making the gift now can remove future appreciation and earnings from your estate.

Many tax strategies can help you leverage your gift tax exemption and get more value from your gifts, and they are more valuable than ever with today's historically low interest rate and depressed asset values. These strategies include:

  • grantor retained annuity trusts (GRATs),
  • sales to intentionally defective grantor trusts (IDGTs),
  • transfers to a family limited partnership (FLPs), and
  • transfers to a charitable lead trust (CLTs).

Regardless of where the exemption amounts and rates end up, you should review your plan regularly to ensure it fits in with any changes in tax law and your circumstances.

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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