Your Tax Questions, Asked and Answered (by a U.S. Treasury Official)

Given the massive uncertainty about the near (and long-term) future of the U.S. tax code, we recently invited Michael Mundaca, the Assistant Secretary of the Treasury for Tax Policy, to field questions from Freakonomics readers. You asked about everything from offshore tax shelters to the messy estate/death tax situation; here are his answers. A big thanks to all.

Q.

Is this really a good year to die – tax wise? And do you expect an uptick in deaths as the calendar year ends? Have we ever seen a similar incentive to die, and did it spur deaths? – Drill-Baby-Drill Drill Team

When will congress straighten out the estate tax mess so that people will know how to plan? – n bergman

A.

In general, I wouldn’t think any year is a good year to die, but you are correct that, under current law, the estates of those who die in 2010 are not subject to the estate tax. However, not being subject to the estate tax is not advantageous to all estates and heirs. Under 2009 law, $3.5 million of each estate was essentially exempt from the estate tax, but the heirs receiving property from such an estate nevertheless received assets with a “stepped up” tax basis, meaning that when such assets were sold, tax would be due only on any appreciation during the time the heir held the asset. For example, assume that someone died with an estate valued at $3 million dollars, all in stock, which passed to one non-spouse heir. Assume that the decedent had paid $1 million for the stock. If the decedent died in 2009, no estate tax would be due (because the estate is worth less than $3.5 million), and the heir’s basis in the stock would be increased to $3 million. Thus, if the heir immediately sold the stock, no capital gains tax would be due either, as there would be no gain. If instead that same person died in 2010, again no estate tax would be due, because it has been allowed to expire, but if the non-spouse heir immediately sold the stock received, capital gains tax would be due, because the value would exceed the basis. The Administration has proposed extending the estate tax (and the related gift and generation skipping taxes) at 2009 parameters (for the estate tax, an exemption amount of $3.5 million and a top rate of 45 percent). We are hopeful that Congress will address the estate tax before year end.

Q.

Has anyone figured out exactly how it is going to work for same-sex married couples in community property states like California? My accountant still has no clue… – Paul

A.

Regarding tax issues faced by same-sex married couples in community property states such as California, there are some helpful IRS resources, including a Chief Counsel Memorandum issued in May of this year that addresses some tax issues faced by California Registered Domestic partners (the memo is available here). Same-sex couples should consider consulting a tax professional about their particular situation.

Q.

Does Warren Buffett really pay a lower tax rate than his secretary? Also, why isn’t there a financial transaction tax? Wouldn’t this serve to rein in speculation, which led to the great recession, as well as improving our federal balance sheet, affording for more stimulus jobs? – frankenduf


Why is unearned income (capital gains) taxed at a lower rate than earned income (salary)? The naive answer is that we need to “encourage” people to commit to long-term investments. But where else would people invest their money? People make long-term investments because that is where the best returns are located. The “encouragement” of a lower capital gains tax rate would only be needed if the returns from long-term investment were worse. – frippery

A.

I don’t know whether Warren Buffet actually pays income tax at a lower tax rate than his secretary, but it is possible. Under current law, dividends and long-term capital gains are subject to a maximum marginal tax rate of 15 percent, while other income, such as wages, may be taxed up to a maximum marginal rate of 35 percent. (The marginal tax rate is the rate on the last dollar of income. The effective rate, which is the share of income paid in taxes, tends to be significantly lower due to factors like deductions, credits, and lower tax brackets that apply to income below a certain level.) Thus, for example, someone who has $5 million of long-term capital gains would generally pay income tax at a rate no higher than 15 percent on the capital gains, while someone with a salary significantly lower than that, say $100,000, may pay income tax at a rate higher than 15 percent. Also note that, under current law, investment income is exempt from payroll taxes, so that could also lead to lower taxes on investment income.

The arguments in favor of taxing capital gains at a rate lower than that for ordinary income include offsetting the taxation of purely inflationary gains; reducing the tax on risky investment that would otherwise be disadvantaged by the tax system, especially because of the limits on deducting capital losses; and offsetting the “lock-in” effect where high capital gains rates can impede economically desirable asset and portfolio reallocations by imposing a tax on the sale of capital assets that can be deferred to the extent that the assets are not sold. With the exception of a few years following the Tax Reform Act of 1986, long-term capital gains generally have been taxed at preferential rates since 1921.

Q.

Any new changes as it pertains to required mandatory distributions? Or qualified retirement plan pre-mature distributions? Lots of clients have had to take more out of roll-over IRAs to survive their unemployment…thank you -?Laura

A.

There are no new changes for 2010. The longstanding required minimum distribution rules generally require qualified retirement plan and traditional IRA distributions to start shortly after age 70 1/2 and to be completed over an individual’s (or an individual’s and a beneficiary’s) lifetime. These rules reflect the purpose of a tax-favored retirement plan – to provide financial security during retirement, not to allow deferral of income tax on retirement assets indefinitely.

In contrast, the premature distribution rules are generally designed to encourage preservation of these assets until retirement. When qualified plan or IRA assets are taken out prematurely, the law imposes an extra 10 percent tax that recaptures part of the tax savings that result from the deferral of tax on plan and IRA contributions and earnings. Without such rules, retirement plan assets could be used at any time for any purpose, and retirement plans would become little more than vehicles for making deductible contributions to tax-sheltered accounts.

In response to the financial crisis that began in the fall of 2008, Congress, on a one-time-only basis, waived the requirement to take a distribution in 2009. In assessing any additional changes to these rules, it is important to balance any short-term benefit against possible long-term effects on retirement security, and on the deficit.

Q.

Google cuts its tax bill by over $1 billion per year by clearing most of its foreign profits through Ireland and the Netherlands to Bermuda. Is this a good loophole for American corporations by lowering already high corporate tax rates relative to the rest of the world? Would shutting this technique down increase tax revenue or drive business away? -?Marty Stern

A.

I can’t comment on any particular taxpayer’s tax positions or tax strategies, but the Administration is concerned about U.S. companies’ shifting of profits out of the United States to avoid U.S. taxes. In our FY2011 Budget, we proposed tightening the tax rules governing the transfer of intangible assets-patents and copyrights, for example-to low-tax jurisdictions, which is a strategy some businesses use to inappropriately reduce their U.S. tax bills. Addressing it as we have proposed would make it harder to shift profits overseas to avoid U.S. tax and thereby increase U.S. tax revenues.

Q.

Having paid a minor differential due to the AMT in two separate years, two things have stuck in my mind regarding AMT: first, it seems to be in implementation, more or less the “flat tax” Grover Norquist and the like are always gasbagging on about; and second, it doesn’t seem like it would have been difficult to tie the cutoff limit to some other federal definition of inflation such as the CPI-U or COLA.

I gather that, in olden times, “the law” as an entity didn’t have a good understanding of inflation, but it seems that in the last 50 years, the federal government now has a good institutional understanding of inflation. The question remains, why can’t the AMT limits (and the annual process of adjusting other income limits for marginal rates, IRA contributions, and so on) just become automatically tied to some federal measure of inflation? Why does every Congress need to twiddle the dials on these amounts? Is “always having cutoff amounts in political play” some kind of degree of freedom that tax policy horse trading needs? -?keith

A.

The Alternative Minimum Tax (AMT) was introduced in 1969, although its current form dates essentially from 1982. As you note, the AMT parameters, unlike many other aspects of the Internal Revenue Code, are not indexed for inflation. Thus, without changes, more and more taxpayers would be subject to the AMT each year. Congress has acted over the years to increase the exemption amount and change other aspects of the AMT, and more recently has enacted one-year “patches” to keep the number of taxpayers subject to the AMT essentially constant. No patch has yet been enacted for 2010, however. The Administration has proposed to eliminate the uncertainty of these year-by-year fixes and provide permanent protection to taxpayers by indexing the parameters for inflation based on the 2009 level. We are hopeful that Congress will address this issue before year end.

Q.

I work for a (very) small business, namely an unincorporated sole proprietorship.?As I understand it, the new healthcare law requires us to issue 1099s for goods purchased in excess of $400. This is a huge hassle, and I have a few questions regarding it.

A. How do we issue a 1099 to an entity that, as far as I know, lacks a TIN (such as our local government for our property taxes)?
B. How do we issue a 1099 to an entity that will not reveal their SSN/TIN (such as a seller on e-bay or a non-chain store)?
C. How do we issue a 1099 to an entity that we do not have an address for (such as a seller on e-bay or Amazon Marketplace)?
D. When we use an intermediary forum to make a purchase, such as Amazon Marketplace, do we issue a 1099 to Amazon, or to the actual vendor?
E. Will this in fact generate more revenue than the total amount spent by businesses & the IRS on enforcing this insanity?
- Peter

What’s this change with the 1099 needing to be sent to corporations (rather than the previous rule, in which you sent it only to sole proprietorships and partnerships)??Does it apply only to businesses, or should every single resident be sending a 1099 to the grocery store and the electric utility next year? -?I wonder

A.

Under the rules currently in effect, businesses have to report payments of $600 or more for services (but not goods) when such payments are made to non-corporate entities such as partnerships and sole proprietorships (but not when they are made to corporations). Starting with transactions in 2012, businesses must report payments of $600 or more for both services and goods to both non-corporate and corporate entities. The new law seeks to increase the information available to the IRS, in order to improve tax compliance. While businesses do not need to start filing information returns on the expanded set of payments until January of 2013, some groups have already raised concerns about the burden that this new provision may impose. As the President has said, it is important to look at whether this burden is too great for businesses to manage. Treasury and IRS are sensitive to these concerns and will look for opportunities to minimize burden and avoid duplicative reporting. Over the last few months, we have been soliciting input from businesses of all types and sizes, as well as their advisors and service providers, regarding how best to implement the law. Already, we have used our administrative authority to exempt from this new requirement business transactions conducted using payment cards such as credit and debit cards. So, whenever a business uses a credit or debit card, no information report will need to be filed, and there will thus be no new burden under the new law. We look forward to gathering input from the business community, and as we proceed with our implementation planning, we won’t hesitate to consider alternate approaches, including working with Congress, to address any potential implementation issues that may arise during this process.

Q.

Is there any way for a taxpayer to get accurate (and up to date) information on where and how my taxes are being spent? I am interested in rather detailed explanations. Not just categories like military, social programs etc.?If there is not, why not? I expect those taxing me to be able to track those funds. Transparency.?- Jerod

A.

The Administration publishes each year an analysis of the Federal budget, which includes a good deal of detail regarding Federal expenditures and receipts. For the current budget, see here, and for past budgets take a look at this. In the current budget, you can find a lot of detail on precisely how much is spent on each agency and program – from total salaries paid by the Supreme Court to the medical services provided to veterans through the VA, for example – in Table 33-1, available here. In addition, a less detailed pie chart of Federal government expenditures is contained in the instruction booklet for the annual individual income tax return.

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  1. Kathleen L. says:

    In your response to the first question, regarding estate tax, you say:

    “If instead that same person died in 2010, again no estate tax would be due, because it has been allowed to expire”

    What is the “it” in that sentence? I’m not clear on what is expiring (set aside the issue of the stepped-up basis; that I understood). You say that in 2009, the first $3.5 million passes basically tax-free. What changes (if anything) in 2010? I have to know, just in case somebody dies and leaves me $3.5 million in their will.

    By the way, as to whether 2010 is a better year to die than 2009, it’s a curious way to phrase the question. I understand that 2010 may be a better year to inherit than 2009, but it doesn’t appear to me that the relative financial position of a dead person changes much after the actual act of dying.

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  2. Frank Johnson says:

    It seems to me that by doing away with income shifting we will force more U.S. corporations to simplly locate to some overseas country to completely avoid U.S. taxes and this would eleminate even more jobs. If our corporate rate was lowered they might have more incentive not to shift taxes or jobs. We keep shooting ourselves in the foot.

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  3. DPD says:

    I find it puzzling that Michael Mundaca and the Obama administration could be concerned about 2010 estates under the $3.5 MM threshold who did not receive a full step-up in cost basis, as they would have in 2009. Curiously, Mundaca fails to mention that 2010 estates do receive a step-up in cost basis of $1.3 MM under modified carry-over basis rules. Assuming the extreme circumstance of a zero cost basis on all estate property, the maximum long term federal capital gains tax bill would be $255,000 in Mundaca’s $3MM gross estate example, or 15% of $1.7MM. And this also assumes heirs sell all of their property triggering that gain.

    If we were to apply 2008 estate tax rates to that same $3MM taxable estate, the tax bill would have been as high as $450,000, or 45% of $1 MM. The unified credit exemption in 2008 was $2 MM.

    I hardly believe that Mundaca or Obama is really concerned about the hardship 2010 estates under the $3.5MM threshold will experience due to the limited step up in cost basis this year.

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  4. David says:

    Frank (#2) so, what do you propose doing to stop a race to the bottom?

    As long as businesses can shift assets/taxes/localities there will be competition among governments to garner a small percentage of asses because small revenues from a company are better than no revenue. There are only two solutions I see: require business to pay US tax on all income with deductions for taxes paid overseas or increase transaction costs to keep businesses from moving.

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  5. Lee says:

    Extending the 2009 estate tax levels is already very expensive- $256 billion over 10 years compared to current law. I hope the President fights hard for his estate tax position. We don’t ned another billionaire bailout!

    I notice Mr. Mundaca did not respond to the suggestion that we should have a financial transaction tax. Any chance you can get him to reply?

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  6. bmz says:

    I notice that Mr. Mundaca has no defense or explanation for the highest marginal tax rates being levied on retirees earning $50,000 to $60,000/yr.

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  7. Charles says:

    @Frank Johnson and David:

    Take a look at the FairTax Plan. It would solve a lot of problems while saving a lot of money. I asked a question about it but it wasn’t answered. (Probably because Mr. Mundaca would be negatively affected by its passing)

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  8. Alex in Chicago says:

    Dave #4. We could eliminate the corporate income tax and simply shift the nominal tax income to a non-distorting tax scheme like a VAT.

    In fact, be simplifying the tax scheme, removing the estate tax, lowing corporate income taxes, and tacking out random deductions we could nearly eliminate the two non-productive industries of accounting and estate planning.

    Not to mention the millions of IRS agents we could get rid of.

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