Friday, July 8, 2011

THE NEW TAX CODE - INVESTMENT INCOME

Here is how investment interest would be taxed in my new simple, fair and consistent Tax Code.

(1) When it comes to the question of taxing municipal bond interest I am “bi” – I could go either way. I am not against taxing the interest earned on municipal bonds, and the dividends paid by mutual funds that invest in mutual bonds. But I would also be willing to continue to exempt this income from federal taxation. Or I could tax only the earnings of “private activity” bonds, which are currently taxed under the dreaded AMT.

However, I think at this point I would tend toward taxing municipal bond interest the same as any other kind of interest.

(2) My new Tax Code would do away with “qualified” dividends. All dividends would once again be taxed as ordinary income.

The reason certain dividends were allowed “qualified” status and as such taxed at lower rates was to somewhat alleviate the “double-taxation” of corporate dividends. Corporate profits are taxed on the corporate return, and dividends, which are a distribution of corporate profits, are also taxed on the individual tax return of the shareholder. My new Tax Code would do away with the double taxation of corporate dividends by allowing corporations to claim a tax deduction for “dividends paid”.

If a corporation had a net profit of $100,000, and paid $90,000 out to shareholders in dividends, it would pay federal corporate income tax on only $10,000. The shareholders would pay tax on the dividends received at ordinary income rates.

Coupled with this new “dividends paid” deduction for corporations would be the total abolition of all current special interest corporate deductions, credits and loopholes. A corporation would simply report gross income and deduct “ordinary and necessary” business expenses and come up with a net profit or loss. Dividends paid to shareholders would be deducted from any gain to determine taxable income.

There would be no “special deduction” for dividend income, and charitable contributions would be 100% deductible as a business expense on the Form 1120, regardless of the amount of profit or loss.

One side benefit to doing away with the category of “qualified” dividends on the Form 1040 is that brokerage and mutual fund houses will no longer need until the middle of March to properly prepare year-end Consolidated 1099 reports. The 1099 information can be prepared and sent to taxpayers by January 31st, as was done before qualified dividends were created, and there will be no more need for one or more “corrected” copies.

(3) When it comes to the taxation of long-term capital gains, and capital gain distributions, I would return to my early days in “the business”. I would not have a separate, lower tax rate for long term capital gains (as I would not have a separate, lower tax rate for qualified dividends) – instead my new Tax Code would bring back the 50% “capital gain exclusion”.

When I first started preparing 1040s back in the early 1970s the Schedule D allowed for a 50% deduction for net long-term capital gain – only half of such gains were included in taxable income. So if net long-term capital gain was $10,000, only $5,000 was carried over to Form 1040 as income. There was only one set of tax rates for all income – no special lower rates for capital gains. This 50% exclusion was later increased to 60%.

The result would be that capital gains, and capital gain distributions, would be taxed at a rate half that of the rate for “ordinary income”, without having to create a separate set of tax rates and a separate tax calculation. If net long-term capital gain on Schedule D was $10,000, and the taxpayer was in the 25% tax bracket, the effective tax on the net capital gain would be 12.5% - calculated at 25% tax on $5,000 of income.

I would also increase the maximum net capital loss deduction from $3,000 to $5,000 and index it for inflation. And I would allow taxpayers net capital losses to elect to “carryback” losses for three years to apply against capital gains reported in prior years.

I first proposed this idea in a letter to Dubya back in 2002. Here was my thinking at the time (see my post Dear George) –

During the late 1990s and into 2000, when the stock market was flourishing, many taxpayers realized, and were taxed on, large capital gains, including excessive capital gain distributions from mutual funds. In most cases these capital gains were reinvested in the market and in additional mutual fund shares. In 2001 and 2002 the bear market provided these same investors with substantial capital losses.”

I had clients who had 6-figure gains in one year and 6-figure losses in the next. The net effect of 24 months of investing was basically 0 gains or an actual net loss. However the clients paid tons of tax to Sam on the gains in the first year, but were limited to deducting $3,000 in losses in the next year and a loss carryover that will last for decades and, unless they have a big score in the future, may never be fully deducted.

It seems only fair in such a situation that investors be allowed to carry back the losses to apply against the earlier gains of a bull market and get a refund of the taxes paid on these gains.

FYI, in response to my letter I received a brief form “thank-you for sharing your views and concerns” letter from the “Director of Presidential Correspondence”.

(4) Since the new Tax Code will not allow a deduction for depreciation of real property, I would remove the income and deduction limitations on claiming losses from rental real estate with active participation.

Business, including rental, losses passed through to “limited” partner investors on a Form K-1 would be treated similar to investment interest, with the deduction limited to net K-1 income from all passive activity K-1s. Suspended losses could be deducted in the year the investment is sold or terminates. The “at risk” rules would remain as currently written.

As mentioned above under my discussion of corporations, all current special interest deductions, credits and loopholes for partnerships, limited or otherwise, would be abolished. A partnership would simply report gross income and deduct “ordinary and necessary” business expenses and come up with a net profit or loss to be allocated on the K-1s.

So what do you think about these proposals?

TTFN

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