UNITED STATES TAX ISSUES

In a speech on Friday President Obama indicated that he interpreted his approximate 51% to 49% election victory as a mandate to increase income taxes on the wealthy which he defines as single individuals earning over $200,000 and those married filing joint tax returns earning over $250,000.

Timing

With the President Bush tax cuts expiring on December 31, 2012 and with another request to increase the budget on the horizon, there is a general consensus that something needs to be done prior to the Christmas recess with new taxes becoming effective on January 1, 2013.

Conjecture

The Social Security tax reduction from 6.2% to 4.2% that was in effect in 2011 and 2012 will expire on 12/31/12 and is unlikely to be re-instated. While this reduction added anywhere from $5 to $40 to an individual’s weekly paycheck, it deprived an already ailing Social Security program of billions of dollars of revenue.

If the President Bush tax cuts are allowed to expire for the wealthy, married couples filing joint tax returns with income over $397,000 would pay tax at a 39.6% on income over that amount. As part of the health care package passed 3 years ago they would also pay an additional 0.9% and an additional 3.8% on investment income such as dividends, interest and long term capital gains.

Income tax on investment income such as dividends, interest and long term capital gains is already scheduled to rise from 15% to 20% in 2013. This does not include the additional 3.8% from the health care legislation.

Itemized deductions such as mortgage interest, real estate tax and charitable contributions are akin to “sacred cows” and have strong backers. In the past decade a small portion of itemized deductions ranging from 1% to 3% have been disallowed.  In 2011 under a bill proposed by President Obama wealthy taxpayers would only receive a tax benefit of 28% on home mortgage interest, state and local income taxes, charitable contributions, student loan interest, college tuition, health insurance write offs, moving expenses and other deductions.  In addition municipal bond interest and employer paid medical coverage would be partly taxed. It would not be a surprise if President Obama pushes similar legislation to increase the tax on the wealthy in the next month.

 Estate Tax Exclusion

The current estate tax exclusion is $5,000,000 per person. In the past President Obama

has indicated a preference for a $3,500,000 exclusion. As this is likely to happen wealthy couples are actively using their joint $10,000,000 exclusion to reduce their future estate taxes by gifting their assets prior to December 31, 2012.  

Foreign Earned Income and Housing Exclusions

The foreign earned income and housing exclusions were watered down about 6 years ago when the exclusions were changed from the top tax rates to the bottom tax rates. In prior years lobbying on behalf of the foreign earned income and housing exclusions came primarily from the oil and gas and construction industries. As global tax rates have risen the number of Americans electing the foreign earned income and housing exclusions have decreased. For example, an American who lives and works in the United Kingdom with tax rates of 20%, 40% and 50% would generally not elect the foreign earned income and housing exclusions and choose to offset their US income tax with a direct foreign tax credit. The primary benefit of electing the foreign earned income and housing exclusions has been relegated to individuals living in countries with a lower tax rate than the United States. This would include countries such as Bermuda, Hong Kong, Saudi Arabia, the United Arab Emirates, a few other Gulf countries and perhaps Singapore. Hence, it would not be a surprise if future tax legislation addresses the foreign earned income and housing exclusions.

What To Do Now

If you are to be paid a bonus in early 2013 you might consider lobbying your employer to pay you the bonus prior to December 31, 2012 so that you can take advantage of the lower tax rates. With respect to capital gains an old strategy had been to sell off losses to offset gains. Some individuals are considering selling all long term capital gains, but not losses to take advantage of the 15% tax rate on long term capital gains. Losses will be taken in 2013 when the tax offset will be at a higher tax rate.

Contingency Planning

If the tax benefit of the foreign earned income and housing exclusions is further diminished or abolished, what will you employer do and what will you do? When the last change was made to the foreign earned income and housing exclusions most, if not all, Bermuda employers had no contingency plan in place to deal with the significant tax increase their US employees faced. Most exempt employers then either reimbursed the employee for the increased taxes, some grossed up the reimbursement, some did it for only a year or two and others are still doing it. You should consider talking to your employer as to what they will do if the tax law again changes and affects the foreign earned income and housing exclusions.

Currently, a single person receives a tax benefit of about $20,100 from electing the foreign earned income exclusion with a maximum tax benefit, dependent on what they spend for housing, from the foreign earned income and housing exclusions of about $41,000. A married couple filing a joint tax return, with only one spouse working, receives a tax benefit of about $15,800 from electing the foreign earned income exclusion with a maximum tax benefit, dependent on what they spend for housing, from the foreign earned income and housing exclusions of about $35,300. What will you do if the tax benefit of the foreign earned income and housing exclusions is further diminished or abolished?

Pursuant to the requirements relating to practice before the Internal Revenue Service, any tax advice in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related manner.

The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own U.S. tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.

James Paul Sabo, CPA, is the President of ETS Ltd., PO Box HM 1574, Hamilton HM GX, Bermuda. Questions should be sent to: jsabo@expatriatetaxservices.com