Senate Democrats this week will try to cobble together the 60 votes required to pass legislation that would renew dozens of tax breaks — and introduce several tax hikes — some of which would significantly affect the financial planning industry.
The so-called tax extenders measure, which totals approximately $140 billion, also would extend unemployment benefits and increase spending for infrastructure, summer jobs and disaster relief. The House passed a similar but smaller bill, 215-204, just before the congressional Memorial Day recess.
Among the expired tax breaks that would be restored are the deduction allowed for state and local sales taxes, and tax-free contributions from retirement accounts to charitable organizations.
In order to pay for the tax cuts and spending increases, the package also would raise taxes, closing what supporters of the bill term tax “loopholes.”
One such provision that would affect the clients of many advisers would subject private-equity, venture capital and real estate investors to higher tax rates on their share of the profits of a company or development project. Under the Senate bill, 65% of so-called carried interest would be taxed as ordinary income, while 35% would be taxed at the much lower capital gains level, beginning in 2013.
The rates would be adjusted to 55% as ordinary income and 45% as capital gains for the sale of an asset held for seven years or more. Under current law, all carried interest is taxed at the much lower capital gains rate. The House bill would treat 75% of carried interest as ordinary income, effective in 2011.
Supporters of the levy view it as a way to force investment fund managers to pay their fair share of taxes on carried interest that is simply income from their services rather than a return on capital.
Critics argue that it threatens to curtail investment in startups — especially in the technology sector — that create millions of jobs.
“If the incentive capital is not part of this process, who is going to take these companies to the point where they can grow?” said Mark Heesen, president of the National Venture Capital Association.
If venture firms decline to invest due to unfavorable tax treatment, it could influence the decisions of major individual investors, who usually provide the initial funding.
“The angels are either going to have to do the whole process themselves, which can be costly and time-consuming, or they will have to step back and evaluate whether they should be investing in early emerging-growth companies at all,” Mr. Heesen said.
Another measure, one that would result in a tax increase for self-employed service professionals, would affect many advisers directly. Advocates of the hike said that they are trying to ensure that people who take their income through an S corporation are paying the appropriate amount of Medicare and Social Security taxes — rather than declaring only a small part of the firm's proceeds as their salary and sharply reducing their tax liability.
Investment advisers and financial planners who have formed small partnerships are in the firing line for the tax crackdown on self-employed professionals, said G. Joseph Votava Jr., chief executive of Seneca Financial Advisors LLC.
“This is a major tax hit,” he said. “[The bill] could have an impact on financial planning practices that organize as S corporations.”
With growing constituent concern about the federal deficit, which is projected to reach $1.4 trillion this year, Democrats and Republicans have put a much stronger emphasis on paying for tax cuts and spending increases.
In previous years, Congress has passed tax cuts like clockwork. Now the battle over so-called “revenue raisers” has slowed down the tax extension package.
Tax policy in general is languishing. Congress has yet to address several major Bush administration-era tax breaks, casting a cloud over financial planning.
The Bush tax cuts, such as an elimination of the estate tax and a reduction in the top tax rate, potentially have a much bigger impact on the nation's fiscal situation and could generate a bigger political battle than the one sparked by the extenders package. The Bush measures expire at the end of the year.
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While the politicians duke it out, financial planners and their clients are swimming in murky tax waters.
“At the end of the meeting, the two of you kind of look at each other and say, "We have no idea where this is going',” Mr. Votava said. “It creates an awful lot of uncertainty. It defeats the benefits of planning.”
For instance, when clients convert from a Roth individual retirement account to a regular IRA, the tax burden can be distributed over a couple of years. Determining the impact of that move in 2011 and 2012, however, is difficult.
“Right now, we don't know what those rates will be,” Mr. Votava said.
One of the most important parts of financial planning — helping people determine how they can cover their expenses and save money based on their cash flow — is undermined by the uncertainty.
“The whole area of tax policy is central to that analysis,” said Kirk Loury, president of Wealth Planning Consulting Inc. “There's a risk that people will find themselves in the situation where they haven't thought things through very well.”
E-mail Mark Schoeff Jr. at mschoeff@investmentnews.com.
