Poor Will Get Richer, Impact on Rich Varies : Wealthy Face Loss of Lucrative Tax Shelters
The most successful people, a distinguished-looking actor implies in an oft-parodied television commercial, make their money the old-fashioned way: They earn it.
Almost from start to finish, the sweeping tax bill hammered out last Saturday by House and Senate bargainers will encourage hard work by levying a top effective tax rate of 33% on income, well below the 50% peak under current law. That change promises great benefits for the very richest Americans who do not take wholesale advantage of today’s multiple tax breaks.
If Congress gives its expected approval to the bill, however, households with other ways of garnering their wealth will have the rest of 1986 to mend their ways or face a bigger tax bill in the years that follow.
Next year will mark the beginning of the end of many tax shelters--particularly including real-estate ventures--in which investors contribute money but not sweat. It will be the year when the capital gains tax on “unearned” income--profits from the sale of investments--begins rising.
Many of those who hope to legally dodge the new tax law will be netted by a new, tougher 21% minimum tax. And those who attempt to shelter riches by giving them to their children will find that avenue largely closed as well.
“The ones that are heavily sheltered are beginning to show some signs of panic,” said Len Podolin, managing director of Arthur Andersen & Co., the Chicago-based accounting firm. “Mr. Moneybags--the guy who sits back and clips coupons--is going to come out just fine.”
No tax overhaul has proved foolproof and the current proposal retains a few traditional loopholes in such politically sensitive industries as oil and gas exploration.
But for the most part, wealthy taxpayers will have few places to hide their gains. Among the major changes that primarily hit the rich:
--For the first year of the new tax law only, households earning more than $90,000 will be taxed at a 38.5% annual rate, substantially below this year’s 50% but uncomfortably above the effective 33% peak of later years.
--Taxpayers no longer may use “paper” losses from passive investments--partnerships in real estate, cattle feed lots and any other ventures where the investor is not personally involved--to offset their earned income. For years, wealthy investors have used those ventures’ huge up-front deductions for loan interest and depreciation to shelter ordinary earnings.
Under the tax revision proposal, such deductions will be phased out through 1990. After that, losses generally could be applied only against income from similar passive investments that actually make money. Just as the tax writers intended, that probably will spark a rush into genuine money-making investments--the kinds most valuable to economic health.
--Capital gains--profits from the sale of property, stocks and bonds and other investments held for more than six months--generally will be fully taxed. Current law excludes 60% of capital gains from taxation. The vast bulk of capital gains are claimed by persons making more than $200,000 annually and they will be taxed at 28% instead of 20%.
On the other hand, current law will still govern the treatment of capital losses. That means they may be used to offset capital gains plus a maximum of $3,000 of ordinary earned income.
--Some deductions that most benefit big spenders--for sales taxes, consumer interest, home business expenses and miscellaneous expenses--will be scaled down, phased out or simply abolished.
--The deductions that remain will become much less valuable as tax dodges, simply because the maximum tax rate will be lower. Under current law, for example, a taxpayer in the 50% bracket reaps a 50-cent deduction for every dollar given to charity. Under the new law, that same donated dollar will be worth no more than 33 cents in deductions.
--Tax-shelter addicts may be hit doubly hard by the new alternative minimum tax, which will be calculated under a new and tougher formula that takes shelter losses into account and will defy easy escape.
--The bill will abolish the widely used “Clifford trusts,” in which taxpayers shelter income by placing it into 10-year trusts for their children, where it is taxed at the youngster’s rate instead of the parent’s. In the future, the unearned income of dependents under age 14 generally will be taxed at the parent’s rate when it exceeds $1,000 a year. After age 14, the income will be treated as if the child had earned it.
Short-Term Solutions
Fiscal advisers say there are some short-term solutions to ease the tax bite. Some are obvious: If this is to be the final year for many tax deductions, it is logically the year to employ them to the hilt.
“If you were going to buy a car next year, remember that the sales tax deduction ends Jan. 1. Buy it this year,” Podolin said. “If you give $2,000 a year to charity, you might want to give $4,000 this year, because this year the deduction will be worth 50 cents, and next year it’ll be worth 38.5 cents.”
Those who give $25,000 a year to charity might want to place a huge sum into a private foundation, taking a tax deduction for the entire amount but doling out the gifts over several years.
Some dodges are craftier: Before the capital gains tax increases, it may make sense to sell “hot” stocks that have skyrocketed in value, pay the 20% tax and then buy the same stock again before the year ends. The seller who waits until January will pay 28% instead.
And if an investor had planned to dump a losing stock next year, it may make more sense to take the loss this year.
Parents who wish to set aside money for their children may be shorn of Clifford trusts, but other traditional tax-advantaged investments still exist, from municipal bonds to “investment-advantaged” insurance polices. The new policies require purchasers to pony up a large sum of money, often $25,000 or more, but the interest buildup on the investment is guaranteed and is tax-free until the policy matures.
If all else fails, consider work.
“If there’s any way to involve your children in earned income, that’s the more appealing alternative,” said David D. Green, manager of Touche Ross & Co.’s Washington accounting service center. “If you have a business, bring your child in as the office boy and pay him a salary. The money’s deductible to you or your company.”
