Smart TaxesSmart Taxes

Tax pain is only starting for the wealthy

Tax revenue may rise as the Obama administration sets its sights on America's 2.5 million high-income families.

By TheStreet Staff Apr 12, 2010 5:28PM

TheStreetBy Joe Mont, TheStreet

 

The tax deadline is three days away, but for the 2.48 million wealthy American families, the pain of higher taxes and increased scrutiny by the government is only starting.

 

President Barack Obama's proposed budget lets many of the tax cuts enacted by the Bush administration expire, a move benefitting the middle class at the expense of the richest Americans. Tax increases, including those included as part of health-care reform, will hurt those earning more than $250,000 a year, defined as "wealthy" by the IRS.

 

High-income earners can protect themselves. Here are three major tax changes, with a longer review and action plan following.

 

1. Barring Congressional intervention, 2011 income-tax rates for top earners will increase to 39.6% from 35%. Capital-gains tax rates jump from 15% to 20% in 2011 and 23.8% by 2013, and there are new tax burdens placed on investment income. Singles earning more than $200,000 and households making $250,000 will pay 0.9% more on wages and self-employment income. Because the new taxes aren't indexed to inflation, those currently earning less may still find themselves paying the increased rates.

 

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2. For the first time since 1999, the rich are at a greater risk of being audited than those in lower- and middle-income brackets, and enforcement is being ramped up even more.

 

3. Tax-related strategies for preserving wealth will require a fresh approach. Once-routine decisions such as which stocks to buy and when to sell, and how to get paid at work will need to be reassessed in light of new government policies. Dividend-paying stocks may suffer, and oft-maligned municipal bonds may gain renewed interest.

 

Dividend damage

 

In its effort to get more money from the rich, the government is targeting investments as much as basic compensation.

 

In an IRS survey of the top-earning taxpayers in 2007 (a list of 400 individuals earning at least $139 million), the group paid $23 billion in federal income taxes. Slightly more than 81% of their reported income was derived from capital gains taxed at a rate of 15%. A mere 6.5% came in the form of salaries and wages that were taxed at a higher rate of 35%. Many executives chose to accept stock options as a large portion of their compensation to take full advantage of tax incentives.

 

Richard Taylor, a principal at HLB Gross Collins, an Atlanta-based accounting and consulting firm, says the new health-care bill could lead to a quadrupling of taxes on what's currently assessed on dividends.

 

For the past seven years, qualified dividends have had a federal tax rate of 15%. In 2013, health-care reform will add an additional 3.8% Medicare tax to all dividends, interest, capital gains, annuities, royalties and rental income for joint taxpayers with adjusted gross incomes of $250,000 and single taxpayers with incomes of $200,000.

 

In addition, if the current tax law reverts back to the 2000 tax system and rate schedules at the end of 2010 when the Bush tax cuts expire, dividend income will no longer be taxed as a special category of income -- capital gains -- but considered ordinary income, Taylor says. This means that in 2013, federal taxes on dividends -- adding the higher income rate and Medicare tax -- could total 43.4%. When you factor in additional state taxes (typically in the range of 6%, but as high as 10%), dividends could be taxed as high as 49.4% or even more depending on where you live. In a best-case scenario, Congress could enact an alternate proposal that would only increase the top federal dividend tax to 23.8% in 2013.

 

Among popular dividend-paying stocks are Altria Group (MO), Bank of America (BAC), Pfizer (PFE), Verizon (VZ), Exxon Mobil (XOM) and General Electric (GE).

 

"Would investors shy away from dividend-paying companies and invest in those that pay no dividends?" Taylor asks. "This could drive down the value of some of the best companies in the country."

 

He says investors, who have long looked to dividend stocks as part of a conservative strategy, may need to rethink their game plan. With less focus on dividends, investors may seek out stocks that have a greater potential to appreciate, such as Google (GOOG) and Microsoft (MSFT).

 

The crackdown

 

Dodging taxes will be increasingly risky in the coming years. Obama is seeking more than $12.5 billion for the IRS in fiscal 2011, including a $300 million increase for enforcement.

 

In the IRS's recently released "data book" of 2009 statistics, it reported a 16% increase in audits for those earning $5 million to $10 million and an 8.5% increase for those with earnings of at least $10 million. For those making $1 million or more, 8% were audited, meaning the odds of additional scrutiny is one in 12. Those earning less than $200,000 a year now have about a 1% chance of being audited.

 

The shift in policy makes good on the IRS's recent, but ineffective, attempt to alter audit strategies. Despite IRS claims in a 2008 press release that it was making "strong progress in a number of key enforcement areas," especially for "those with incomes of $1 million or more," Transactional Records Access Clearinghouse (TRAC), a government research organization at Syracuse University, found the audit rate on returns reporting incomes of more than $1 million fell at least 19%.

 

Last year, the IRS also launched the Global High Wealth Industry Group, an effort targeting those earning at least $10 million a year by looking into the use of offshore holdings and residency, international bank accounts and a variety of domestic tax strategies.

 

"We will take a unified look at the entire web of business entities controlled by a high-wealth individual," IRS Commissioner Douglas Shulman said at George Washington University's International Tax Conference in December.

 

"The IRS has historically been tripping over millionaires to get to Grandma's Social Security check," says Richard Boggs, head of Nationwide Tax Relief, a Los Angeles-based company that negotiates on behalf of delinquent taxpayers. "That is all changing. We've always thought that there were much easier ways for the IRS to spend less money and collect a whole lot more."

 

The IRS is not only going after those with greater income (especially those in the $1 million to $10 million range who have traditionally been avoided by random audits), the agency is also more willing to compromise with the less affluent.

 

The IRS has increased its collection of revenue from lower-income delinquents through negotiations. This cooperative approach, though successful from a government viewpoint, doesn't offer much solace for those about to be taxed more.

 

"It is causing a rift where it seems the IRS is reaching out to Main Street while laying a hammer down on Wall Street," Boggs says.

 

Planning your strategy

 

High-earners' options for minimizing their tax burden are decreasing.

 

Certain small-cap stocks, for example, may be an alternative to blue-chip companies that pay dividends. But there is still a capital-gains tax to consider.

 

Investors may consider cashing in some stock, both winners and losers, sooner rather than later. Capital losses can be applied to offset capital gains. Lacking gains, or if losses amount to more, up to $3,000 of a capital loss can be used to offset ordinary income. Additional losses can be carried forward to future years. At the very least, the wealthy can gain some interest on money before it's surrendering to Uncle Sam.

 

Tax-exempt municipal bonds are worthy of consideration as they're not affected by the new Medicare tax. Still, they tend to yield less than corporate debt, which isn't tax-free.

 

Henry Paula, a tax principal at Reznick Group in Charlotte, N.C., suggests taxpayers consider taking less in wages in return for more distributions of each year's taxable income. Increasingly, executives have struck agreements that allow them to defer a portion of their compensation -- basic income as well as bonuses -- to a later date, up to and including retirement. Such a strategy may not ultimately pay off, but could offer relief as tax brackets and laws change over time. Conversely, bonuses may be paid out prior to 2013 to escape higher taxes.

 

Paula also suggests workers max out their 401(k) and other qualified retirement plans.

 

"Stuff as much as possible into your tax deferred accounts and manage them," he says. "It is just that simple."

 

In addition to traditional tax benefits, retirement plans -- including IRAs and Roth IRAs -- will be subject to the additional Medicare tax.

 

This may make this year's introduction of new Roth IRA conversion rules even more of a boon to high-income individuals. Roth IRAs, unlike traditional IRAs, aren't tax-deferred but do have tax-free withdrawals. Starting this year, the $100,000 income cap on converting to a Roth has been lifted, giving wealthier individuals their first, and only, opportunity to take advantage of the plans.

 

Boggs is clear on one tax strategy to steer clear of -- not reporting all income or avoiding efforts to collect what is owed.

 

"You can stick your head in the sand, but the IRS owns the beach," he says.

 

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