A Historical Perspective and Analysis of the Rapidly Approaching 2013 Tax and Budget Changes

BY MICHAEL MALAKOFF, MANAGING DIRECTOR, WEALTH IMPACT PLANNING

The Fiscal Cliff: Approaching the Brink

1

News searches

during the week of

October 15, 2012

yielded anywhere

from 810 to 27,000

stories depending

on the search

engine used.

The Fiscal Cliff: Approaching the BrinkA Historical Perspective and Analysis of the Rapidly Approaching 2013 Tax and Budget ChangesBY MICHAEL MALAKOFF, MANAGING DIRECTOR, WEALTH IMPACT PLANNING

With elections less than 3 weeks away and the end of the year around the corner, the impending fiscal cliff is garnering a great deal of media attention. In fact, news searches during the week of October 15, 2012 yielded anywhere from 810 to 27,000 stories depending on the search engine used (Bing, Google and Yahoo were sampled).

HOw DiD we Get Here

It is hard to imagine the U.S. budget surpluses of 1998 through 2001 considering we are now in the fourth straight year of trillion dollar budget deficits. However, when we look back to those surplus years and the year 2000 in particular, the Congressional Budget Office (CBO) was projecting the retirement of all federal debt. What happened?

Federal Budget Surplus/Deficit

The tipping point seems to be the burst of the dot-com bubble in March of 2000. The resulting stock market crash (accelerated in part by the terrorist attacks on September 11, 2001) caused the loss of approximately $5 trillion in public company market value between

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

1990 1994 1998 2002 2006 2010

Per

cent

of

GD

P

FEDERAL BUDGET SURPLUS/DEFICIT

Source: U.S. Treasury

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InsightsThe Fiscal Cliff: Approaching the Brink

the 2001 Act

reduced the rates

of individual income

taxes (including

capital gains),

reduced the rates

of estate, gift and

generation-skipping

transfer taxes,

and increased the

amounts excluded

from taxation

with regards to

the estate and

generation-skipping

transfer tax

regimes.

March 2000 and October 2002. Casualties of the crash include a number of dot-com startups such as Broadcast.com, pets.com and WorldCom (the third largest corporate bankruptcy in U.S. history).

The peak of the U.S. economy in March 2001 followed by a period of recession from March 2001 to November 2001, according to the National Bureau of Economic Research, marked the end of the longest expansion period on record for the U.S. economy.

In addition to stock market losses and stagnant economy, there were two major pieces of tax legislation in the early 2000s that are playing an active part in the fiscal cliff. The first is the Economic Growth and Tax Relief Reconciliation Act of 2001.

The 2001 Act reduced the rates of individual income taxes (including capital gains), reduced the rates of estate, gift and generation-skipping transfer taxes, and increased the amounts excluded from taxation with regards to the estate and generation-skipping transfer tax regimes. The tax cuts of the 2001 Act were to be phased in over the next nine years, culminating in 2010 with the repeal of the estate tax (and a zero percent rate for generation-skipping transfers).

The follow up to the 2001 Act was the Jobs and Growth Tax Relief Reconciliation Act of 2003. The 2003 Act accelerated the reduction in rates and credit increases of the 2001 Act, further reduced the tax rates on capital gains and reduced the tax on qualified dividends to capital gains rates.

The tax cuts of the 2001 and 2003 Acts were extended for an additional two years in December 2010 as part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. The 2010 Act also provided for a one year reduction in the Social Security employee payroll tax (subsequently extended through 2012 by the Middle Class Tax Relief and Job Creation Act of 2012).

Concurrent with the stagnant or recessionary economy and reduced tax rates, the United States was fighting wars on two fronts in the Middle East, beginning with the ongoing war in Afghanistan in 2001 and followed in 2003 by the war in Iraq.

The total cost of these wars is difficult to estimate and has been widely disputed. For example: in the book titled “The Three Trillion Dollar War – The True Cost of the Iraq Conflict,” John Stiglitz, a former World Bank chief economist and winner of a Nobel Prize in Economics, and Harvard professor Linda Bilmes estimated the total cost of the war in Iraq alone was more than $3 trillion dollars. However, Peter Orszag, Director of the Congressional Budget Office in his October 24, 2007 testimony before the Committee on the Budget of the U.S. House of Representatives, estimated the two wars could cost U.S. taxpayers somewhere between $1.2 and $1.7 trillion dollars through the end of fiscal year 2017. No matter which figures are the most accurate, it is indisputable that the conflicts are having a significant effect (to the tune of trillions of dollars) on the U.S. economy.

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Last, we have the Great Recession, a period of global economic decline that began in December of 2007 and ended in June of 2009. Spurred in part by the bursting of the real estate bubble, losses on sub-prime mortgages and losses on derivatives such as mortgage-backed securities, the effects of the Great Recession continue to impact the global economy.

The sum of these factors: budget deficits, a weak economy, reduction in tax rates and an increase in defense related spending have brought us to the brink where we now stand.

tHe FiScAl cliFF DeFiNeD

Net Federal Fiscal Stimulus

The term was coined by Ben Bernanke, Chairman of the U.S. Federal Reserve, during February 2012 testimony to the House Financial Services Committee wherein he described a massive fiscal cliff of large spending cuts and tax increases scheduled to take effect on January 1, 2013. At approximately 3.5% of 2012 gross domestic product, the combined effects of the impending fiscal cliff could drag the U.S. economy back into recession.

The large spending cuts referred to in Bernanke’s testimony were set in motion in August of 2011 in order to avoid a U.S. default on sovereign debt (a separate crisis in and of itself). As a means to avert financial disaster, the Budget Control Act of 2011 immediately increased the debt ceiling by $400 billion and allowed the President to request further increases of up to $2 trillion.

the sum of

these factors:

budget deficits, a

weak economy,

reduction in tax

rates and an

increase in defense

related spending

have brought us to

the brink where we

now stand.

-200

0

200

400

600

800

'01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 '19

Net Federal Fiscal Stimulus (Billions of $)

Bill

ions

of

$

Source: Strategas, August 2012

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InsightsThe Fiscal Cliff: Approaching the Brink

Breakdown of the estimated $670 Billion cliff

In exchange for the debt ceiling increases, or part in parcel with them, the 2011 Act specified over $900 billion in initial spending cuts (to offset the first $900 billion in available increases). The 2011 Act also provided for a bipartisan committee charged with producing legislation to reduce the deficit. That committee, the Joint Select Committee on Deficit Reduction, concluded its 2011 meetings with a statement on November 21, 2011 indicating it would not be possible to reach any bipartisan agreement before the 2011 Act’s December 31, 2011 deadline.

Since that committee failed to come to an agreement and no legislation was proposed or passed, we are now faced with estimated automatic spending cuts in excess of $200 billion. These cuts (automatic plus agreed upon) to defense and nondefense spending go into effect on January 2, 2013 absent further government action.

As if the spending cuts were not enough of a drag on the economy, they are accompanied by the largest increase in individual income tax rates in recent history.

Expiring tax cuts, $225, 34%

Payroll tax cut expiration, $116, 17%

AMT patch expiration, $94, 14%

New health care law taxes, $21, 3%

Automatic sequestration cuts defense, $85 , 13%

Automatic sequestration cuts non-defense, $84, 12%

Unemployment insurance benefit cuts, $25, 4%

Medicare physician payment cuts, $20, 3%

Source: ISI; dollars shown in billions; August 2012

As if the spending

cuts were not

enough of a

drag on the

economy, they

are accompanied

by the largest

increase in

individual income

tax rates in recent

history.

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Size of Federal tax increases as Percentage of GDP

First and foremost are approximately $225 billion in expiring tax cuts due to the expiration of the provisions of the 2001 and 2003 Acts mentioned above. After the sunset (December 31, 2012), the top rates for ordinary income will increase to 39.6% (35% in 2012), long-term capital gains rates will increase to 20% (15% in 2012), and the rate of estate/gift/generation-skipping taxes will return to 55% (35% in 2012). Of great concern to some investors is the elimination of the preferential treatment for qualified dividends. As a result of the sunset, 2013 sees a return to ordinary income rates for qualified dividends. This is by far the largest percentage increase, as the tax rate for qualified dividends in the top bracket goes from 15% in 2012 to 39.6% in 2013.

Coupled with the increased rates in 2013 also comes an additional 3.8% tax on investment income in order to fund Medicare. When combined with the 39.6% rate, a taxpayer primarily invested in dividend paying stocks (and assuming that the dividends were “qualified dividends”), would have her annual federal income tax rate nearly triple (up 289% when comparing the 2012 rate of 15% to 43.4% in 2013).

Additional 2013 tax increases include the expiration of the Alternative Minimum Tax patch and expiration of the reduced rates for Social Security payroll taxes.

Per

cent

of

GD

P 1.70%

0.40% 0.40%

1.10%

0.20%

0.60%0.40%

0.60%

2.38%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

'68 '69 '80 '82 '84 '86 '90 '93 '13

Size of Federal Tax Increases as Percent of GDP

The 2013 tax increase dwarfs the size of any previous increase in recent history.

Source: Strategas, ISI, and CBO, August 2012

As a result of the

sunset, 2013 sees

a return to ordinary

income rates for

qualified dividends.

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InsightsThe Fiscal Cliff: Approaching the Brink

2013 individual tax rate increases

wHere DO we GO NOw

My Magic 8 Ball has been decidedly noncommittal, producing answers such as “reply hazy, try again,” “ask again later,” and “cannot predict now” which is not entirely unlike the articles and commentary in the media. I can say with utmost certainty that “it depends.” With that being said, the results of the upcoming elections may give us a much better map for charting our course to, over or around the cliff.

Looking at what we know about the tax proposals of the presidential candidates, Romney would like to make the tax cuts in the 2001 and 2003 permanent (including the preferential treatment for qualified dividends), further cut all of the tax brackets by 20%, and permanently repeal the Alternative Minimum and Estate taxes.

President Obama, on the other hand, supports the sunset of the 2001 and 2003 tax cuts, including the return to ordinary rates for qualified dividends, advocates increases in the top rate brackets for capital gains as well as ordinary income, and would like to retain the Estate tax with rates and exemptions based on 2009 levels (45% with a $3.5 million exemption).

No matter who’s driving, a number of scenarios seem probable. The first (in no particular order) is a compromise during the 2012 lame duck session that would mitigate the effects of the fiscal cliff. The second could be a last minute patch and extension whereby Congress and the President punt to make any real decisions on a later date (much like the 2010 Act passed on December 16, 2010 and signed into law on December 17, 2010). The third possibility would be real long-term tax and spending reform in 2013. The fourth and last is that the standoff could continue. In the last scenario, the full tax and spending effects of the fiscal cliff would take effect, and if experts such as Bernanke and the Congressional Budget Office are correct, the U.S. economy would be slowed, possibly to the point of another period of recession, at least in the short-run.

35%

15%15%

35%

0%

39.6%

20%

39.6%

55%

3.8%

0%

10%

20%

30%

40%

50%

60%

OrdinaryIncome

(wages/interest)

Capital Gains Dividends Estate, Gift andGST Tax *

InvestmentIncome Surtax

Maximum Federal Tax Rates

2012 Scheduled 2013

* Note: In addition, estate and gift tax exemptions will decrease from $5,120,000 to $1,000,000.

the results of

the upcoming

elections may give

us a much better

map for charting

our course to, over

or around the cliff.

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tO MitiGAte Or NOt tO MitiGAte (tHAt iS tHe QueStiON)

We are nearing the edge of the fiscal cliff, with its combination of tax increases and spending decreases, but there is no need to jump. We still have time to act.

Assuming no further action by Congress, the highest priority seems to be gifting in 2012 in order to take full advantage of the $5.12 million gift tax exemption. This is the first time since the early 1900s when a couple may transfer in excess of $10 million free of transfer taxes. Failure to utilize this gift from the government in full could mean an additional $4.5 million in estate taxes for a couple who passes away with a combined taxable estate greater than $10 million (assuming rates revert to 55% and the exemption returns to $1 million per person). Hopefully, we are beating a dead horse here and plans have already been made to make 2012 gifts, or, at the very minimum, discussions around the full utilization of the increased gift tax exemption prior to December 31, 2012 have been had.

On the income tax side, there are a number of ideas to examine with your tax advisor during your year-end planning discussions. Potential actions such as: recognizing long-term capital gains in 2012 to take advantage of the 15% rate and avoid the additional Medicare tax, converting your Traditional IRA to a Roth IRA (again to take advantage of lower rates), and deferring certain deductions like state tax, real property taxes or charitable deductions until January of 2013, should be explored with your tax advisor. We note that caution should be exercised when deferring deductions, as the repeal of the overall limitation on itemized deductions and the repeal of the personal exemption phase outs are part of the provisions of the 2001 and 2003 Tax Acts that expire on December 31, 2012.

The final action item - and this may be one that can be addressed in 2013 - is taking a close look at your investment portfolio. There may be steps that you can take in order to minimize the tax effects of the increased rates on passive income; this will be especially important considering the nearly three-fold tax increase on qualified dividends. Ideas to discuss may include increasing your concentration of growth assets and decreasing your dividend paying assets.

In the end, only time will tell who wins the elections and which course is ultimately plotted for our future. Regardless of the outcome, we can all benefit by taking action now. Be sure to talk to your wealth, tax and legal advisors, to take full advantage of the transfer tax opportunities available and to position yourself for a soft landing in the event we are pushed off of the cliff.

there may be

steps that you

can take in order

to minimize the

tax effects of

the increased

rates on passive

income; this will

be especially

important

considering the

nearly three-fold

tax increase on

qualified dividends.

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iMPOrtANt DiSclOSureS

Investment products, including shares of mutual funds, are not deposits or obligations of, or guaranteed by, U.S. Bank or any of its affiliates, nor are they insured by the Federal Deposit Insurance Corporation or any other government agency. An investment in such products involves risk, including possible loss of principal.

U.S. Bank and its representatives do not provide tax or legal advice. Each individual’s tax and financial situation is unique. Individuals should consult their tax and/or legal advisor for advice and information concerning their particular situation.

The information provided represents the opinion of U.S. Bank and is not intended to be a forecast of future events or guarantee of future results. This information is not intended to serve as a recommendation or solicitation for the purchase or sale of any particular product or service. It does not constitute advice and is issued without regard to any particular objective or the financial situation of any particular individual. These views are subject to change at any time based upon market or other conditions and are current as of the date indicated on these materials.

Factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness.

Michael Malakoff holds a J.D. and an LL.M. and has practiced as an attorney and tax consultant. He now serves as Managing Director, Wealth Planning for Ascent Private Capital Management of U.S. Bank.

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