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           President's Budget Can Hit Investors Hard

April 11, 2013

     The Budget contains some Old Standbys, a few Pieces of the Camp

       Tax Reforms and One Big Surprise


The President released his Budget for Fiscal Year 2014. It contains a host of revenue raisers relevant to taxpaying investors. This Budget is a conglomeration of 1)  proposals discussed in recent tax reform hearings held by Ways and Means Committee Chair Camp 2) proposals the President has made in his previous Budgets that Congress did not pickup and 3) and a shocker (or two).

The Budget formally put forward a number of proposals released for comment recently in studying tax reform. These ideas have not been formally proposed or analyzed in depth previously. There are two Camp tax reform revenue raisers that, if passed, can dramatically impact investors. The first change would force taxpayers to use an average cost basis in computing their gains and losses. Under current law, if an investor sells less than all their shares, the taxpayer can choose which lot of shares are to be delivered (assuming they had purchased shares at different times and prices). The change is forecast to cost investors over $2 billion over the next 10 years.

The second revenue raiser from the Camp tax reform project is to tax all derivatives as ordinary income (or loss) and mark-to-market all derivatives at each year-end. This proposal has been seen as much too wide ranging and difficult to implement. As an example, it is suggested that owners of convertible bonds value the imbedded call option in their convertible bonds and then pay tax on that amount. Attorneys also observed that the proposals could reach to ADRs or even all common stocks.  Taxing derivatives in this manner is “scored” to raise almost $19 billion over the next 10 years so this may not go away. I wouldn’t be too surprised though to see the tax treatment of ETNs change after all the tussle is over. For more on the Camp proposals, refer to Tax Reform of Financial Products?.

There was multiple revenue raisers repeated from the President’s past Budgets. A 30% “Buffett” tax was proposed again. The proposal to tax carried interest as ordinary income is one idea that I think will eventually make it into law. Investors and the Carried-Interest Debate, discussed how changes in carried interest taxation can negatively affect investors. If managers start taking their fees in cash instead of as a carried interest, investors could wind up with lots more phantom income. Past estate and gift proposals involving the minimum time for GRATs, valuation issues and other odds and ends thought to raise $7 billion are repeated too. A surprise was proposing, in 2018, to restore the estate, gift and GST tax parameters to those that were in effect in 2009 this would raise $71 billion in the five years of 2019-2023.

The most costly revenue raiser is also a retread from old Budgets but I think this time the environment is right for the President to get his way in limiting the value of deductions. The President feels that highly taxed citizens get an unfair advantage because $1 of a deduction “saves” a highly taxed person more than it “saves” a more lightly taxed citizen. He proposes that a $1 deduction should be worth no more than 28 cents to even the most heavily taxed person. Since the Senate Democrats included this in their budget blueprint, the Republicans seemed to like the idea in the presidential campaign and because it raises $529 billion. I think we will see a limit on deductions if there is any tax bill this year.

The proposal to limit deductions would kill the after-tax return on leveraged investments. If interest expense is only deductible at a 28% rate then every dollar I pay in interest expense will cost me 72 cents. If I then invest, and I’m lucky enough to be right, I make a short-term gain taxed at 43.4%. I keep 56.6 cents of every dollar when I win. Given this new arithmetic, I now have to earn 127% of my borrowing costs just to breakeven!

Everyone was shocked by a new proposal that would cap the amount of money you could have in your tax-preferred retirement plan. The idea is that any tax preference should be waived once you’ve put away “substantially more than is needed to fund reasonable levels of retirement saving”. The White House mentioned $205,000 a year in retirement as enough with a capped amount of $3.4 million. Utilizing those numbers the proposal is estimated to raise $9 billion over the next 10 years. The irony that the issue of multi-million dollar IRAs first came up during the Presidential campaign was quickly noted by the press.

Some of these proposals will go nowhere, others will return like perennials and one or two you may have to deal with before the year is out.




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