Obama’s 2010 Tax Proposals: What’s New, What’s Old

By Steven M. Etkind and Roger D. Lorence

The Treasury Department has released its explanation of the President’s February 2010 tax proposals. Many of these proposals, in enacted, would significantly impact the tax position of many readers. These proposals largely repeat the proposals issued in May 2009, which we described in the President’s Budget Proposals.  The President proposes that the tax apply on July 1, 2010 and be subject to quarterly estimated corporate income tax filings.   A brief narrative for each item follows.

Repeal of the Carried Interest

The manager of a partnership may receive an incentive allocation of partnership profits which is treated as a share of the various income components realized by the partnership that taxable year. This special allocation of profit is termed the “carried interest” and has been a major spur to development in the oil and gas, real estate, and fund industries. The President proposes to repeal the carried interest rules for taxable years beginning after December 31, 2010. This is the same effective date as in the 2009 proposals. The carried interest would be taxed as “services partnership interest” income that would be ordinary income, whatever the character of income generated by the partnership, and would be subject to self-employment taxes. Only a manager’s profits on its own capital interest in the partnership would be exempt from these rules.

Higher Taxes From High Net-Worth Taxpayers

To fund deficit reduction, the President proposes numerous provisions aimed at the highest income taxpayers. Among them: higher tax rates (up to 39.6%), a 20% tax on long-term capital gains and qualifying dividends, and limitations on deductions. When combined with a proposed surcharge in the House version of the health care bill, upper-income taxpayers are looking at a 45% proposed rate, plus, of course, Social Security taxes and state and local income taxes, as applicable.

Attack on Dividend Swaps

Foreign taxpayers that receive dividends from U.S. corporations are subject to a 30% withholding tax on the gross amount of the dividend, unless the rate is reduced under an applicable income tax treaty. However, if a foreign taxpayer enters into a “dividend swap” whereby the foreign taxpayer receives swap payments based on the dividend yield of U.S. corporations, no U.S. withholding taxes are applied, based on longstanding Treasury regulations. The President proposes to reverse current law, for swap payments made after December 31, 2010, the same effective date as in 2009’s proposals. There is a proposed exception for certain kinds of equity swaps that are speculative in nature, as opposed to a dividend-capture type of strategy. If enacted, the proposal may lead to double taxation of the same dividend; once in the hands of the domestic recipient (such as the swaps dealer entering into the contract with the foreign counterparty) and then to the foreign counterparty as well, as a “deemed” dividend.

Attach on Tax Shelters

The President would enact into law the so-called “economic substance” doctrine which has been applied by courts in inconsistent ways. A transaction would have economic substance only if it changes in a meaningful non-tax way, the taxpayer’s economic position and the taxpayer has a substantial non-federal tax purpose for entering into the transaction. A 30% penalty would be applied to any tax deficiency attributable to a transaction lacking economic substance (reduced to 20% if the taxpayer disclosed the relevant facts on the return). The rule would apply to transactions entered into after the date of enactment.

International Tax Proposals

The President again takes aim at the regimes governing taxation of U.S. multinational corporations and U.S. taxpayers having bank accounts and financial accounts in other countries. U.S. corporate income taxes are presently among the highest among all industrialized nations, and it is not clear what impact the proposals, if enacted, would have on U.S. multinational corporations.

Life Insurance and Other Longevity Products

Life Settlements

Life Settlements are purchases of life insurance contracts from the insured by investors, who pay the remaining premiums due on the policy, and receive the death benefit (or cash surrender value of the policy). The President proposes to tighten up current rules regarding transfers of life insurance contracts in three instances. First, the purchaser of the contract whose death benefit is at least $500,000 (2009: $1 million) must report the purchase price, the buyer’s and seller’s tax identification numbers (“TINS”), the name of the issuer, and the policy number, to the Internal Revenue Service (“IRS”), the insurance company issuing the policy, and the seller. A new IRS Form 1099 is required.

Second, the insurance company making payments to a buyer of a life insurance contract must report to the IRS and the payee the gross benefit payment, the buyer’s TIN, and the insurance company’s estimate of the buyer’s basis. A new IRS Form 1099 is required. It is unclear how the insurance company can estimate the buyer’s basis, as this information is maintained on a confidential basis and is not provided to the life insurance company.

Third, the President would tighten up exemptions that provide where a policy is transferred for “fair value” the buyer must report gain on the policy to the extent amounts are received in excess of tax basis. The main exemptions relate to transfers where the transferee’s basis is determined in whole or in part, by the transferor’s basis. The mechanics by which the transfer-for-value rules would be tightened are not provided.

The 2010 proposals retain the January 1, 2011 effective date contained in the 2009 proposals. Because the forms, instructions, regulations and other guidance that would be required to complete the Form 1099 reporting for each transaction are not likely to be issued by that date, taxpayers will need to be very careful in collecting data. Every affected taxpayer will be required to make significant changes to their software and their business procedures in order to comply.

Separate Accounts

Investors may invest part of their life insurance premiums in a tax-deferred separate account at the life insurance company issuing the policy. The President proposes to require life insurance companies to report to the IRS detailed information about separate accounts, but only for those that are part of a group in which related persons own at least 10% of that separate account’s value. The 2010 proposal would be effective for taxable years beginning after December 31, 2010, the same as in 2009 proposals.

Corporate Owned Life Insurance (“COLI”)

Many corporations hold life insurance policies on the lives of key personnel, which includes employees, officers, directors and 20% owners. Current law permits a corporation to deduct interest expense on loans taken out to fund premiums on such policies, subject to certain limitations. The President proposes to repeal the deduction for interest expense except for policies on the lives of persons owning at least 20% of the business, effective for life insurance contracts entered into after the date of enactment of the provision.

Annuities

Annuity contracts are usually issued by a life insurance company, whose customer transfers cash in exchange for the right to receive present, or future, payments for a term of years, or for life. Part of each payment is a return of capital and the rest is income to the annuity recipient. A proposal new to 2010 targets taxpayers that elect what is termed “partial annuitization,” in which the holder of an annuity contract elects to use some of the account for a stream of periodic payments and the rest is kept in a tax-deferred account until it is used to support future payments. The President proposes to reform the rules for partial annuitizations entered into after December 31, 2010 so as to increase the portion of each payment that is taxable.

Commodities Dealers

Current law treats U.S. persons who are dealers in commodities, equity options, commodity derivatives as entitled to treatment under Section 1256 of the tax law whereby 60% of gain or loss is long-term capital gain and 40% is short-term capital gain (for so-called “60/40” contracts). The President proposes in a verbatim repeat of 2009’s proposals, that dealer income of commodities dealers, including dealers in equity options and commodities derivatives, be taxable as ordinary income, effective for taxable years beginning after the date of enactment.

“Financial Crisis Responsibility Fee”

Despite the huge complexity such a tax and the enormous revenue it would raise, less than one and a half pages is devoted to this measure. The tax, which is intended to replace revenues lost on the bailout of the financial system, would be paid by banks, thrifts (such as savings and loans institutions), their holding companies, and securities broker-dealers. Institutions with under $50 billion of consolidated assets are exempt.

The tax will be “approximately” 0.0015 (15 basis points) times “covered liability amounts” (“CLA’s”). CLA’s are the worldwide consolidated liabilities of U.S. financial institutions and the liabilities of U.S. subsidiaries of foreign institutions, minus deposits as to which the Federal Deposit Insurance Corporation assesses fees, and for insurance companies, “certain” (unspecified) policy-related liabilities. The tax will be a “deterrent against excessive leverage for the largest financial firms” and encourage “less risky activities, such as lending against certain high quality collateral.” Arguably, the tax would also deter lending to small businesses and other would-be borrowers that cannot produce “high quality collateral.”

If you have any questions concerning this Tax Alert or any related matters, please contact Steven M. Etkind, 212-573-8412 (setkind@sglawyers.com) or Roger D. Lorence, 212-573-8413 (rlorence@sglawyers.com).  We welcome your input.

About Alex Akesson

Alex has been specializing in hedge fund and alternative investment news since April 2006. Working mainly in research and manager interviews, she has published breaking news on the hedge fund industry on her blog, as well as several industry publications. Her access to hedge fund managers gives her insight into news stories as well, and the ability to track press releases and other breaking news in real time.
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