The Treasury recently released a general explanation of the revenue proposals in President Obama’s budget for 2014. In an attempt to broker a deal between Republicans and Democrats, President Obama’s budget proposals include both spending cuts and tax hikes.

Cuts to Social Security Benefits

President’s budget would cut Social Security by changing the index used to calculate inflation adjustments, including increases in Social Security payments. The current inflation-adjustment formula is based on the CPI for all Urban Consumers (CPI-U). The CPI-U is an index that measures prices paid by typical urban consumers on a broad range of products. According to the Treasury:

The CPI-U typically overstates the effects of inflation because it does not fully reflect changes in consumption patterns in response to relative price changes. The chained CPI-U (C-CPI-U) would account more fully for this substitution effect and therefore better reflect changes in the cost of living.

The President wants to ditch the CPI-U in favor of the C-CPI-U. Economists agree that a chained CPI is a more accurate measure of how people spend when prices rise. But adopting the C-CPI-U will lower the inflation rate that is used to calculate cost-of-living increases for Social Security recipients. These lower inflation adjustments for Social Security benefits will effectively reduce future payments to Social Security recipients.

Thirty Percent Minimum Tax on Millionaires

The President would impose a new minimum tax, called the Fair Share Tax (FST), on high earners. The FST targets itemized deductions, which disproportionately benefit high-income taxpayers. These deductions, coupled with preferential capital gains rates, can give high-income taxpayers a lower average tax rate than a lower-income, wage-earning taxpayer.  The President believes that restricting deductibility with an across-the-board minimum tax would make the tax system more progressive and distribute the cost of government more fairly among taxpayers.

The tentative FST equals 30 percent of AGI, less a credit for 28 percent of charitable gifts. The FST would be phased in linearly starting at $1 million of AGI ($500,000 in the case of a married individual filing a separate return). The FST is fully phased in at $2 million of AGI ($1 million in the case of a married individual filing a separate return).

Restrictions on Itemized Deductions that Exceed 20 Percent of AGI

Under current law, individual taxpayers can choose to itemize their deductions instead of claiming the standard deduction (currently $6,100 for individuals and $12,200 for married taxpayers filing jointly). Common itemized deductions include:

• Medical and dental expenses that exceed 10 percent of AGI (7.5 percent for taxpayers over age 65);
• State and local property and income taxes; and
• Gifts to charities.

In addition to itemized deductions, taxpayers can reduce their income by excluding certain types of income and claiming certain deductions in the computation of AGI (“above the line” deductions).

The administration believes that limiting these deductions will help close the tax gap. The President’s budget proposal would limit the tax value of certain deductions and exclusions from AGI and all itemized deductions for taxpayers in tax brackets that are 33 percent and above. That would hit individuals with income over $185,000 ($225,000 for married couples).

This new restriction would affect items that have generally considered tax-free. For example, the new rule would effectively impose a tax of up to 11.6 percent for tax-exempt interest and the value of employer-provided health insurance. Other targets include health insurance costs of self-employed individuals, interest on education loans, employee contributions to defined contribution retirement plans and IRAs, contributions to HSAs and Archer MSAs, and higher education expenses.

Restrictions on Contributions to Large Retirement Plans

Current law limits contributions to and benefits paid from different types of retirement plans. For 2013:

• The maximum amount permitted to be paid under a qualified defined benefit plan is $205,000 annually;
• The maximum annual contribution to a defined contribution plan is $51,000, with a separate $17,500 elective deferral limit;
• The maximum annual contribution to an individual retirement account or annuity (IRA) is $5,500, with an additional $1,000 for taxpayers who are over age 50.

The annual contribution limit for IRAs is applied by aggregating all of the taxpayer’s IRAs. But the limitation on accruals from defined benefit plans and the limitation on contributions are generally not aggregated.  This effectively allows taxpayers with multiple plans established by different employers to exceed the limits.

The Obama administration believes that the current rules do not adequately limit the extent to which a taxpayer can accumulate amounts through the use of multiple plans.  Under the proposed 2014 budget, taxpayers could make no further contributions or receive additional accruals from tax-favored retirement accounts that exceed the amount necessary to provide the maximum annuity permitted for a tax-free defined benefit plan under current law (the $205,000 limitation mentioned above).

In other words, under the President’s budget proposal, individuals with total retirement plan assets that exceed the threshold amount could no longer make tax-favored contributions to their retirement plans.  The threshold is based on the present value of a $205,000 for a 62-year-old (currently $3.4 million). Although the existing balance in the accounts could continue to grow, no additional contributions would be permitted.  If enacted, this proposal would effectively curtail the use of tax-favored retirement planning for wealthy individuals.

Loosening of Distribution Rules for Modest Retirement Plans

Under current law, the required minimum distribution (RMD) rules require participants in tax-favored retirement plans to start drawing distributions after reaching age 70½. The purpose of these rules is to prevent taxpayers from stretching the tax deferral by over-funding retirement and not withdrawing funds, leaving the accounts to accumulate tax-free for estate planning purposes.

The President’s budget recognizes that the RMD rules affect millions of senior citizens with only modest tax-favored retirement accounts. The budget explanation states that taxpayers with small retirement accounts are less likely to be motivated by estate planning purposes to leave funds to accumulate tax-free for the benefit of the next generation.  Under the President’s budget proposal, taxpayers with less than $75,000 in tax-favored retirement accounts would not be subject to the RMD rules.

Republican Response to the President’s 2014 Budget

As to be expected, top Republicans are less than enthusiastic about President Obama’s proposals. Senate Republican Leader Mitch McConnell has already called it “just another left-wing wish list” that “does not represent some grand pivot from left to center. It’s really just a pivot from left – to left.”

But some Republicans have also given a nod of approval to the President for at least proposing spending cuts. House Speaker John Boehner stated:

While the president has backtracked on some of his entitlement reforms that were in conversations that we had a year and a half ago, he does deserve some credit for some incremental entitlement reforms that he has outlined in his budget. But I would hope that he not hold hostage these modest reforms for his demand for bigger tax hikes.

To call this a measure of bipartisan support, though, would be unrealistic. It is likely that this budget will—like the President’s prior budgets—end up as a position statement with no real chance of becoming law. The continuing lack of bipartisan solutions signals a difficult road to tax reform.

For most small businesses, ownership of real estate by a C corporation is a bad idea. Unlike S corporations, partnerships, and LLCs taxed as partnerships, C corporations are taxed twice on all income:  once when it is earned and once when it is distributed to shareholders.

Double taxation is a common problem when real estate is owned by a C corporation. When appreciated real estate is sold, the corporation will pay Federal tax at the corporate tax rates (which range from 15 percent to 39 percent).  Under the rules governing distributions from C corporations, the same income is taxed again at the shareholder level when it is distributed to the shareholders.

S corporations and limited liability companies can provide the liability protection of a corporation without the double taxation. If the business will own real estate, these “passthrough entities” are usually a better choice than a C corporation. But a few decades ago, limited liability companies were not widely accepted and S corporations were subject to more restrictions than they are now. Corporations were often used to hold real estate, creating a legacy of tax inefficiency.

When it comes to getting appreciated real estate out of a C corporation, there are no quick and easy solutions. But the tax problem usually gets worse if it is not addressed. The best time to deal with the issue is usually ten years ago; the second best time is now.

Fortunately, now may be the best time in years to move real estate out of a C corporation.  After several years of declining property values, we may be at the bottom of the real estate market. This gives taxpayers the opportunity to transfer real estate out of a corporation at a relatively low tax cost. If the business owners act now, future appreciation of the real estate as the market improves can escape double taxation.

There are three ways to deal with appreciated real estate owned by a C corporation:

1. Distribute the property in kind to the shareholders;
2. Sell the real estate to the shareholder or an unrelated party; or
3. Convert the C corporation into a subchapter S corporation.

This article will look at the tax consequences of the first two choices.  Later articles will deal with converting a C corporation to another form of business entity.

Distributing Appreciated Real Estate to Shareholders

One option is for the corporation to simply deed the appreciated real estate to one or more shareholders. The transfer is treated as a “deemed sale” that is taxable to both the corporation and the shareholders. At the corporate level, the distribution is treated as a sale to the shareholder for fair market value.[1]  To the extent that the fair market value exceeds the corporation’s basis in the real estate, the corporation will have taxable gain. The shareholders that receive the property will be taxed on the full amount of the distribution. To the extent that the corporation has current or accumulated earnings and profits, the distribution will be treated as a dividend.[2]

Whether this “deemed sale” treatment will be feasible depends on the circumstances. If the corporation has a low basis in the real estate due to depreciation deductions, the built-in gain may be substantial.  To make matters worse, there is no actual infusion of cash to the corporation in connection with the transfer. Unless the corporation has a cash surplus, this can leave a shortage of corporate funds to pay the taxes on the deemed sale.  In these situations, an in kind distribution may not be a viable alternative.

On the other hand, if the property has not appreciated substantially, or if the corporation has a net operating or capital loss to offset the corporation’s gain, the deemed sale may not create a significant tax problem. In that case, the shareholders may decide to “bite the bullet” and make the distribution now, before the real estate market rebounds.

Selling Appreciated Real Estate to C Corporation Shareholders or Third Parties

A second option is to actually sell the real estate. The sale of the real estate will be taxable to the corporation. But unlike the “deemed sale” treatment that applies to in kind distributions of real estate to shareholders, an actual sale will generate cash for the corporation to pay the tax incurred on the sale. Although the proceeds from the sale will ultimately be taxed when they are distributed, there is no immediate tax to the shareholders on the sale.

It will often make sense for a shareholder to purchase the property from the corporation and rent it back to the corporation. The shareholder will take a cost basis in the property, allowing the shareholder to take increased depreciation deductions. In some situations, depreciation deductions can help offset the rental income from the property.

Whether a sale of real estate will is a good alternative depends on the situation. At a minimum, the shareholder (or other buyer) must have the ability to fund the purchase.  And, like a distribution of real estate in kind, this transaction does not entirely avoid double taxation. The appreciation in the property will still be taxed twice: once to the corporation at the time of the sale and again to the shareholders when the proceeds are distributed.

As mentioned above, there is a third method of dealing with appreciated real estate owned by a C corporation: The shareholders can convert the C corporation into a subchapter S corporation. Unlike these first two alternatives, conversion to subchapter S status can completely avoid double taxation. This technique will be discussed in a later article.

The Internal Revenue Service has issued guidance on electing portability of the unused exclusion of a deceased spouse. Notice 2011-82, which was issued on September 29, 2011, reminds estates of deceased married individuals to file a Federal estate tax return to transfer the decedent’s unused gift and estate tax exclusion amount to the surviving spouse.

Tax practitioners have been achieving portability with estate planning techniques (credit shelter dispositions) for decades, but portability didn’t become a part of the tax laws until the Tax Relief Act of 2010, which was signed into law on December 17, 2010.  This new feature allows the estates of predeceased spouses to pass any unused exclusion amount (currently $5 million) to the surviving spouse.

For example, a decedent who used $3 million of his $5 million exclusion amount can pass the remaining $2 million on to his surviving spouse.  This will increase the surviving spouse’s exclusion amount from the usual $5 million to $7 million, assuming the surviving spouse does not remarry.

Since portability can only be elected on a timely-filed estate tax return of the predeceased spouse, a failure to file the return could result in loss of the opportunity.  Even if the predeceased spouse’s estate is not large enough to require a Federal estate tax return (Form 706), executors should consider filing a return solely to make the portability election.

The portability election is available to estates of decedents who died after December 31, 2010.  Given that the Federal estate tax returns are due 9 months from the date of death, the first estate tax returns for estates that are eligible to make the portability election were due as early as October 3, 2011. If an estate is unable to meet this deadline, it can request an automatic six-month extension by filing Form 4768.

The IRS is working on regulations to provide further guidance on the portability election and is looking for input from the public.  Specifically, the IRS is asking for comments on the following issues:

1. The determination in various circumstances of the deceased spousal unused exclusion amount and the applicable exclusion amount;
2. The order in which exclusions are deemed to be used;
3. The effect of the last predeceasing spouse limitation described in section 2010(c)(4)(B)(i);
4. The scope of the Service’s right to examine a return of the first spouse to die without regard to any period of limitation in section 6501; and
5. Any additional issues that should be considered for inclusion in the proposed regulations.

To be considered, comments must be submitted in writing by October 31, 2011, using one of the following ways:

1. By mail to CC:PA:LPD:PR (Notice 2011-82), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC  20044.
2. Electronically to Notice.Comments@irscounsel.treas.gov.  Please include “Notice 2011-82” in the subject line of any electronic communications.
3. By hand-delivery Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (Notice 2010-82), Courier’s Desk, Internal Revenue Service, 1111 Constitution Ave., NW, Washington, DC  20224.

The IRS is unrolling a major compliance initiative targeting transfers of real estate between family members for less than full consideration.  The goal is to identify taxpayers who failed to file a Form 709 (gift tax return) to report the gift.  If the amount of the gift exceeds the annual exclusion (currently $13,000), gift tax returns are required even if the gift itself would not be taxable.

The initiative is focusing on transfer records in 15 states for evidence of property transfers to family members.  The current roster of states includes Connecticut, Florida, Hawaii, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Tennessee, Texas, Virginia, Washington, and Wisconsin.  It is expected that the program will expand to other states soon.  The IRS is being aggressive with this initiative (it went to court to force the California Board of Equalization to disclose transfer data).  Those involved in preparing estate and gift tax returns should counsel their clients of the need to file a Form 709 for intrafamily transfers of real estate for less than full consideration.

After the relative calm following the enactment of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRA 2010), we are beginning to see signs of turbulence in the estate tax arena.  (Note:  See my Guide to the New Estate Tax Law for an overview of TRA 2010.)

President Obama’s 2012 Budget

When President Obama reached a compromise with top-ranking Republicans in 2010 to raise the Federal estate tax exemption to $5 million with rates of 35 percent, he warned that this “generous treatment” would only be temporary.  The President’s 2012 budget seeks to follow through on that warning.

Estate and Gift Tax Exemptions and Rates

President Obama’s 2012 budget, which was released in mid-February, would return the Federal estate exemption to its 2009 level of $3.5 million.  The gift and generation-skipping transfer (GST) tax exemption would be set at $1 million.  A 45 percent tax rate would apply for all transfer taxes.

Portability of Deceased Spouse’s Unused Exemption

Portability allows a surviving spouse to take advantage of the unused exemption of a predeceased spouse.  Under TRA 2010, spouses of individuals who die after December 31, 2010, but before January 1, 2013, can increase their exclusion amount by the amount of the exemption that was unused by their predeceased spouse.   President Obama’s budget would make portability permanent (it is currently set to expire at the end of 2012).

Restrictions on the Use of Grantor Retained Annuity Trusts (GRATs)

The President’s 2012 budget would curb the use of GRATs to arbitrage the applicable Federal interest rate.  In a low-interest rate environment, GRATs are used to transfer wealth between family members at a reduced gift tax cost if the grantor survives the term of the GRAT (for a more detailed explanation of GRATs, see my article on Making Good Use of GRATs in 2010). This has resulted in the widespread use of short-term, “zeroed out” GRATs as a tax planning technique.  The President’s budget would curb this technique by requiring a 10-year minimum term and a remainder value that is greater than zero.

Restrictions on Valuation Discounts

Valuation discounts are often used in estates that are worth more than the Federal estate tax exemption.  These discounts are especially appropriate in family-owned businesses, where the value of the business is likely to be impaired by lack of marketability to the general public.  It is not uncommon for valuation discounts to reach 30 to 40 percent, resulting in a substantial tax savings.

The IRS is aware of these techniques and has litigated a string of family limited partnership cases, with mixed success in the courts.  President Obama’s budget creates a new class of tax restrictions that would prevent the use of valuation discounts in some family-controlled companies.

Curbing the Use of Dynasty Trusts

Dynasty trusts are funded with assets that pass free of the GST tax exemption. These trusts are typically created in a jurisdiction that does not follow the common law rule against perpetuities, allowing the trusts to continue indefinitely.  This allows the trust assets to be sheltered from transfer taxes throughout the term of the trust over many generations.  The Obama administration would curb this benefit by placing a 90-year maximum term on new dynasty trusts or money added to existing dynasty trusts.

Discussions Beginning in Congress

In early June, the New York Post reported that Senate Republicans are retreating from their push for an all-out repeal of the estate tax.

According to the Post, both sides of the aisle are comfortable with a $5 million exemption amount.  But there is disagreement about the tax rates that should apply.  Democrats are pushing for a 45 percent tax rate; Republicans prefer the current 35 percent rate.

A Few Concluding Thoughts

This isn’t the first time we’ve seen what President Obama is proposing.  A similar bill (H.R. 4154, Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009) was passed by the House of Representatives in 2009.  No Republicans voted for the bill, and it died in the Senate.

Based on previous legislative attempts, it is not clear that a return to 2009 levels is a viable option.  It seems more likely that President Obama’s budget is intended to appease those in his party who were critical of the concessions at the end of 2010 while leaving himself room to compromise in return for concessions from top-ranking Republicans.

I see these recent developments as more of a starting point for discussions, preliminary volleys before the real fight begins.  With any luck, we won’t need to wait until December 2012 to see how it ends.