For those making over $450,000 a year, New Year’s Eve brought no good news. These high income individuals were hit with all the tax increases that were threatened by the “fiscal cliff”. The top rate on investment income increased by 24%; from a 35% top rate to 43.4% after including the Medicare tax. In addition, a portion of these taxpayers’ itemized deductions will be disallowed through the reinstatement of the Pease limitations.

The maximum tax rate on long term capital gains increased by 58%. The maximum rate under the Bush tax cuts was 15%, it is now 23.8%. The only good news was that dividends were to be continued to be taxed as if the dividends were long-term gains.

The tough work of cutting spending has been put off for a few months. When the budget process is re-opened we would expect that they will also be looking for new sources of revenue. The President has proposed some revenue raisers in each of his budgets that we expect to be re-visited by those creating a new budget.

The proposal that would affect investors most is the proposal to limit the value of deductions.

The President observes that a $100 charitable contribution saves the richest $39.60 in taxes. If a low income taxpayer made the same $100 contribution they might be saving only $28 or even less. The President’s four budgets have proposed limiting deductions to a maximum of 28 cents on the dollar. Since 2001, the Congressional Budget Office has looked at a 15 cent on the dollar maximum. The Republicans suggested a hard cap on deductions that would render deductions above the cap valueless. These proposals would affect leveraged investments the hardest as expenses would be deducted at a lower rate than profits would be taxed.

Other changes ahead

We also expect a change in the taxation of carried profits interest and a lengthening of the minimum term for GRATs. We suggest that any family interested in wealth transfer look at GRATs now while a GRAT with as little as a two year life is deemed acceptable. We also point out that the Section 7520 rate is at a historic low (1%) making now an even more attractive time to fund a GRAT.

We’re sure there will much more to dissect as we get closer to the negotiations but for now, act on the items we can all see coming before it’s too late.