Article first appeared in the Los Angeles Daily Journal.
The Obama administration’s Fiscal Year 2014 Budget of the U.S. Government includes a number of proposed tax law changes. Below is summary of some of the more notable provisions. It is difficult to predict whether any of these proposals will become law, but they do reflect a wish list of the administration.
The Fair Share Tax
The “Fair Share Tax” would implement the so-called “Buffett Rule.” The tax would function as a second minimum tax on top of the existing alternative minimum tax. It would effectively apply a minimum 30 percent tax rate on high-income taxpayers’ adjusted gross incomes.
The Fair Share Tax would not apply to taxpayers with less than $1 million of adjusted gross income ($500,000 for married individuals filing separately). Over that threshold, it would be phased in on a straight line basis until it is fully phased in for taxpayers with $2 million of adjusted gross income ($1 million for married individuals filing separately). These thresholds would be indexed for inflation beginning after 2014.
Taxing “Carried Interests” as Ordinary Income
Currently, partners of partnerships (including those with “carried interests” or “profits interests”) are taxed on partnership income on a flow-through basis. So, if the partnership has long-term capital gain income or qualified dividend income, the partner will generally have the same kind of income, taxable at the lower preferential rates.
The budget proposal would instead tax any income allocated to a holder of an “investment services partnership interest” in respect of that interest (and any gain on the sale of that interest) as ordinary income to the holder, regardless of the character of the income to the partnership. An investment services partnership interest is generally a “carried interest” or “profits interest” in an “investment partnership” granted to a service provider. This definition would likely capture most carried interests or profits interests held by managers or investment professionals of private equity funds, hedge funds, and real estate funds. But, to the extent the service provider also has “invested capital” that is pari passu with other significant investors, allocations attributable to that interest would continue to be subject to the current rules.
Average Basis Method for Portfolio Stock
Currently, a holder of stock has separate basis in each share of stock it acquires. This means that if different lots of identical stock are acquired at different prices, the holder will generally have basis in the stock in each lot determined separately based on the purchase price paid for each lot. When the holder sells stock, the holder’s gain will be determined based on the basis of the shares treated as sold.
When selling stock, a taxpayer is by default treated as selling the earliest acquired shares of stock, and the basis of those shares is used. However, if a taxpayer “specifically identifies” which shares he is selling, he will generally be treated as selling the identified shares.
Under the budget proposal, taxpayers would generally be required to use the average basis method for all portfolio stock with a long-term holding period. Under this method, the taxpayer’s basis in any particular shares will be determined by averaging the basis of all identical shares.
Mark-to-Market Taxation of Derivative Contracts
Current law includes a variety of different rules for different derivative contracts. For example, gain or loss is generally only recognized on forward contracts when they are transferred or settled and has capital character. Similarly, options are generally only taxable when they are transferred, settled, or lapse, and the gain or loss is normally capital. Certain exchange-traded and more exotic instruments have yet different sets of rules.
The budget proposal would require a taxpayer to treat covered derivatives as being sold on the last business day of the taxpayer’s taxable year (marked-to-market). Gain or loss recognized under these rules would generally be treated as ordinary income. Covered derivatives would include any contract the value of which is determined, directly or indirectly, by the value of actively traded property. So, for example, this would apply to options and forward contracts on publicly traded stock, even if the option itself is not traded.
The rule would also apply if such a derivative is embedded in other financial instruments or contracts and would provide special rules for straddle transactions other than certain properly-identified business hedging transactions.
Accrual of Market Discount
The difference between a debt instrument’s stated redemption price at maturity and the price at which the instrument was acquired is “market discount.” Market discount typically arises when a debt instrument is purchased on the secondary market for a price that is lower than its remaining face amount. Under existing law, the market discount accrues while the taxpayer holds the instrument, but it is not taxed until the instrument is sold or partially or fully repaid. When it is taxed, the market discount is taxed as ordinary income.
The budget proposal would require a taxpayer to pay tax on market discount on a current basis as it accrues. However, to prevent overaccrual of market discount on distressed debt, the proposal would also cap market discount at the greater of (a) the instrument’s yield to maturity at issuance plus 5 percentage points and (b) the applicable federal rate (AFR) plus 10 percentage points.
Where businesses hold fungible inventory, a variety of methods of accounting have developed to provide rules for valuing and accounting for the inventory.
A common method of determining which item is sold is the last-in-first-out (LIFO) method, under which the company is generally treated as selling first the last item that it produced. Where the cost of producing inventory is increasing, a company will generally have less taxable income with a LIFO method than some other methods because the earlier-produced items have a lower cost.
Other methods of accounting, such as the lower-of-cost-or-market (LCM) and subnormal goods methods, provide special rules for valuing inventory at a price that differs from the actual cost. The LCM method generally allows a taxpayer to mark-down inventory if the cost of replacing the item is lower than the cost of producing it. Similarly, the subnormal goods method generally allows a taxpayer to mark-down an inventory item that is not saleable at normal prices because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes. These items are marked down to the reasonably anticipated selling price of the items, less the direct cost of disposition of those items. These markdowns generally reduce the taxpayer’s taxable income.
The administration proposes prohibiting the use of LIFO, LCM and subnormal goods methods.
Tax Incentives for Insourcing and Discouraging Outsourcing
A new provision designed to incentivize moving jobs into the U.S. would provide a tax credit equal to 20 percent of eligible expenses incurred while reducing or eliminating a trade or business (or line of business) conducted outside the U.S. and starting up, expanding, or otherwise moving that same trade or business into the U.S. to the extent it results in more jobs in the U.S. Similarly, to disincentivize moving U.S. jobs overseas, the provision would disallow deductions for covered expenses incurred in connection with reducing or eliminating a trade or business conducted inside the U.S. and starting up, expanding, or otherwise moving that same trade or business outside the U.S. to the extent it results in fewer jobs in the U.S.
Temporary Small Business New Job and Wage Increase Tax Credit
Another proposal in the budget would allow qualified small business employers a tax credit of up to $500,000 for increases in wage expenses. The credit would be equal to 10 percent of the increase in the employer’s eligible wages. Eligible wages would mean the employer’s Old Age, Survivors, and Disability Insurance (OASDI) wages paid to employees performing services in a trade or business. The employer’s increase in wages would be the excess, if any, of (a) the employer’s eligible wages for the year following enactment over (b) the employer’s eligible wages paid in 2012. The credit would only be available for employers with less than $20 million of OASDI wages in 2012.
Exempt Foreign Pensions from FIRPTA
Normally, a foreign person is not subject to U.S. tax on gain from the sale of capital assets, even if they are located within the U.S. However, under the Foreign Investment in Real Property Tax Act (FIRPTA), foreign persons are subject to tax as if they were U.S. persons if they have gain on the sale of U.S. real property interests, even if those interests are capital assets. U.S. real property interests include not only direct interests in land, but also indirect interests, such as options to acquire land and stock of certain real estate holding corporations. The administration proposes to exempt foreign pension funds from the application of FIRPTA.