The clock is ticking toward the 2010expiration of the favorable capital gainstaxation laws enacted under the Bush administration in 2003. This portends hugeimplications for individuals and small businesses alike because small businesses areoften structured as sole proprietorships orpass-through entities, so capital gains arepassed along to the owners, and becausestock ownership is now commonplaceamong Americans. In 1980, only 13 percentof Americans owned stock, but by 1998, thatnumber had grown to 52 percent. One thingis certain, the next president must deal withthe issue, and the options include everythingfrom maintaining the more favorable rates totreating capital gains as ordinary income.
“The sunset on the Bush legislation is nearing,” says John M. Wyson, tax partner withHaskell & White LLP. “The capital gains taxnow affects so many of us that when politicians argue that the capital gains tax is a taxon the rich, they are painting with an increasingly broad brush. Business owners shouldbe more interested than ever to hear whatthe candidates are proposing.”
Smart Business spoke with Wyson aboutwhat business owners should know aboutthe expiration of the capital gains tax ratesand the current positions of the leading presidential candidates.
How do capital gains and ordinary incomediffer in terms of rates?
The most common form of ordinaryincome is salary and wages, and it is taxed atprogressively tiered rates with brackets ranging from 10 to 35 percent. If capital gainsbecome taxed as ordinary income, it will betaxed at those same rates, and there’s somehistoric precedent for that because, prior to1921, capital gains were generally taxed atthe same rates as ordinary income. Then in1921, Congress enacted favorable tax ratesfor sales of long-term capital assets. Sincethat time, the tax rate on capital gains hasvacillated. In the mid-1980s, the maximumtax rate on long-term capital gains was set at28 percent until 1997 when it was lowered to20 percent. It was reduced to the present day15 percent in 2003. Although the rates havevaried, Congress generally remained consistent by encouraging longer-term investments.
Short-term capital gains, sales of capitalassets held less than 12 months, are still generally taxed at the less favorable ordinaryincome rates.
Will the political party controlling the WhiteHouse impact the new tax rate?
It’s perceived that Republicans generallywant to lower taxes and Democrats want toraise them. However, the capital gains ratewas raised in 1986, during President Reagan’sterm, and lowered in 1997, during PresidentClinton’s term. So, the political party of thepresident does not always dictate which waythe rate will go.
What can we expect from the likely candidates we see today?
John McCain has indicated a desire toextend the 15 percent rate on capital gains.Barack Obama, as part of his ‘Tax Fairnessfor the Middle Class’ plan, supports a returnto the 28 percent maximum rate on capitalgains. Hilary Clinton has expressed her intention to raise taxes on capital gains eitherthrough a proactive change in the enactedrate or by simply allowing the Bush tax cutsto expire.
Who will be affected by changes in the capital gains tax rates?
Those affected may include the rich, middle class and even working class families;basically, anyone who holds and sells stockor other capital assets at a gain. The tax alsowidely affects small businesses. Large corporations are generally unaffected by changesin the capital gains rates because a corporation’s regular income and capital gains areeach taxed at corporate rates.
It’s worth mentioning that the capital gainstax does not apply if you don’t sell. As WarrenBuffett has said, ‘The capital gains tax is nota tax on capital gains; it’s a tax on transactions.’ As a result, wise investors, like Buffett,who are really in it for the long-term, can endup with very low effective tax rates.
What action should business owners take inadvance of the election?
Most experts agree that, regardless ofwhich party is in the White House next year,capital gains rates will likely remain at 15 percent through 2010. So, there doesn’t appearto be any urgency to trigger gains by sellingcapital assets between now and the election.However, if taxpayers have a significantamount of ‘gain’ property, they should discuss the various options of minimizing capital gains taxes with their tax adviser.
How will California capital gains tax rates beimpacted?
Unfortunately, California has no favorabletax rate for capital gains. Rather, capital gainsare taxed as ordinary income. With the topindividual tax rate in California at 10.3 percent, the extra state tax paid on capital gainscan be significant, particularly when a taxpayer is in an alternative minimum tax position and is unable to get a federal deductionfor the state taxes paid. While the expirationin 2010 won’t affect California’s rates, taxpayers always have the opportunity to expresstheir opinions and perhaps influence ratesthat nurture long-term investments.
JOHN M.WYSON is a tax partner with Haskell & White LLP. Reach him at email@example.com or (949) 450-6200.