"tax Reduction And Reform Act Of 2007" (h.r. 3970)

The Tax Reduction and Reform Act of 2007 (H.R. 3970) is still on the table. If enacted, it could have profound tax consequences for traders.

By Robert A. Green, CPA

You all know the popular line, "There are two things that are certain in life: death and taxes."

There is another certainty this coming year and that is that Democrats and Republicans will wage a tax war and make it a key element in defining their differences in connection with the hotly contest 2008 Presidential election.

President Bush and the Republicans have enjoyed eight years of free reign to adopt their tax cuts, including lowering (and hopefully repealing) taxes on savings and investment income (dividends and long-term capital gains).

In November 2006, during the mid-term elections, the Democrats finally won control of both houses of Congress and they took over the bully pulpit.

Newly elected Chairman of the House Ways and Means Committee Charlie Rangel (D.-NY) crafted H.R. 3970, the "Tax Reduction and Reform Act of 2007" (introduced on Oct. 25, 2007).

In H.R. 3970, Chairman Rangel was able to showcase many of the fiscal (tax) values currently advocated by the Democrats.

Political tax maneuvering

First and foremost, Democrats want to cast off their prior image of tax raisers and spenders to become the better party of fiscal conservatism.

Democrats have cried foul about huge increases in the budget deficit since President Bush inherited surpluses from former President Bill Clinton.

The first tax mantra from controlling Democrats after November 2006 was their new creed of "pay go" - paying for tax cuts with tax increases and spending cuts.

Next up were Democratic suggestions for middle-class tax cuts, paid for by tax increases on the rich, with a combination of repeals, expiration of Bush tax cuts and more. Democrats also want some spending cuts, such as in defense and ending the costly Iraq War.

The poster boy for tax change is the Alternative Minimum Tax (AMT) and it's the cornerstone of the "Tax Reduction and Reform Act of 2007."

AMT is certainly broken, and taxpayers resent this nasty stealth tax. H.R. 3970 purports to repeal AMT.

Chairman Rangel crafted H.R. 3970 in a clever but antagonizing way to Republican leadership. The bill repeals AMT, but replaces it with new taxes on the rich and many other important repeals and changes.

H.R. 3970 probably has no chance of passage until 2009

President Bush has stated on multiple occasions that he will veto any new tax increases on the rich, specifically the ones in H.R. 3970.

This gives good reason to believe that H.R. 3970 will be effectively "dead on arrival" until there is a new President in the White House in January 2009, assuming Democrats keep control of both the Senate and House.

The last minute AMT patch for 2007 was passed without "pay go"

While H.R. 3970 caused great rancor between the parties, AMT was slated to snag 21 million Americans in 2007, drastically up from only 4 million Americans in 2006.

The structural and simple problem is that AMT is not indexed for inflation, whereas regular taxes are, so AMT bracket creep grabs more middle-class Americans each year.

The perverse problem is that AMT was targeted against the rich, but the rich for the most part no longer pay AMT. That's because the rich pay so many taxes at the highest tax rates (up to 35 percent in 2007) and the highest AMT rate is far less (up to 28 percent in 2007).

Within just five days of introducing H.R. 3970, Chairman Rangel introduced H.R. 3996, the "Temporary Tax Relief Act of 2007."

Chairman Rangel included "pay go" in H.R. 3996 (just as he had in H.R. 3970), calling for a repeal of "carried interest" tax breaks for investment managers.

After much fanfare, the Senate sided with the Republicans and President Bush to insist on another annual AMT patch (for 2007), without any new tax increases.

So where do we stand now?

The tax debate was punted down the road and it's still contained in H.R. 3970, which remains on the table.

So it's important to focus on the tax changes contained in H.R. 3970.

Current political pundits are forecasting good odds for a Democrat to win the Presidency; probably Senator Obama or Senator Hillary Clinton.

This writer believes that H.R. 3970 was crafted by Chairman Rangel while he was in communication with Senator Hillary Clinton (they both serve in NY and are long-time friends).

If Senator Obama wins the presidency, H.R. 3970 also nicely dovetails with his big tax initiative to expand the payroll tax base significantly or to an unlimited amount. See the S-Corp tax break repeal for owner compensation below.

Higher social security taxes

Senator Obama's main tax proposal is to significantly expand the social security tax (of 12.4 percent) applied against the base amount ($102,000 in 2008) to a much higher base amount or even unlimited.

This is very similar to changes made in the 1990s, created by then-first lady Hillary Clinton.

In the 1990s, the Medicare tax portion (2.9 percent) of the payroll tax of 15.3 percent was decoupled from the payroll tax base, meaning it applies to an unlimited amount of earned income and wages.

Senator Obama proposes to do a similar change with the social security portion (12.4 percent) - to either raise the base amount significantly or to make it apply to an unlimited amount (phased-in over several years). Expect a firestorm here as well. Raising the base amount only (to a reasonable amount) is more palatable.

Good news for traders: Their trading gains are exempt from these payroll or self-employment (SE) taxes, unless they trade IRC 1256 contracts as a member of an options or futures exchange (in which case it is earned income IRC 1402i).

H.R. 3970 summary of tax law changes
See a summary of H.R. 3970 on the Internet by searching for "HR 3970."

Repealing AMT entirely is the poster boy for H.R. 3970

In my view, this is not really a true repeal of AMT.

Rather, it extricates the middle-class from AMT and pays for it with a new "surcharge" and itemized deduction phase-outs on upper-income taxpayers.

Again, upper-income taxpayers were not paying AMT with their higher taxes paid vs. the 28-percent AMT rate and H.R. 3970 cleverly passes the AMT load from middle-income to upper-income taxpayers.

This is a little sneaky. AMT should be repealed for all taxpayers up and down the class-warfare ranks.

AMT was never indexed for inflation, whereas regular taxes are, and this is the fundamental problem with this tax. AMT was passed in the late 1960s to tax the rich who avoided tax with tax shelters, which were subsequently shut down anyway.

AMT is most harshly falling on taxpayers in the $200,000 to $500,000 income range.

Chairman Rangel was very clever in H.R. 3970.

The bill showcases a complete repeal of AMT (what all Americans want), yet the bill subjects upper-income people (10 percent of the highest income taxpayers and/or those earning more than $500,000 in some provisions) to a new tax "surcharge" of 4 percent to 4.6 percent.

It would be fairer to call this an "AMT pass the buck" tax, since this bill clearly passes the current AMT burden on the middle-class to upper-income taxpayers.

Phase-out itemized deductions and exemptions

H.R. 3970 also phases out itemized deductions and personal exemptions for upper-income taxpayers.

Current AMT tax law requires the add-back of several types of itemized deductions to AMT taxable income (like investment interest expense, state taxes and miscellaneous itemized deductions).

The combination of the surcharge tax on upper-income taxpayers above along with this phase-out of itemized deductions again points out how this is truly a passing of the AMT tax buck to upper-income taxpayers.

But there's good news for business traders: Most of their trading-related expenses are deducted as business expenses and not itemized deductions.

Repeal of the carried interest and deferred compensation tax breaks
Current tax law allows investment managers to receive a "profit allocation" of capital gains rather than investment fees.

Profit allocation or carried-interest gains (depending on the underlying income) can be taxed at lower long-term capital gains tax rates, or with 60/40 futures tax rates, and they are also not subject to payroll/SE taxes.

H.R. 3970 re-characterizes these carried interests as ordinary fee income, which subjects this income to ordinary income tax rates and payroll/SE tax.

The bill also repeals deferred compensation tax breaks for managers of offshore funds and corporations.

Along the same lines, this bill takes away the incentive for U.S. tax-free institutions (such as pension funds, universities and charities) to invest in offshore funds instead of domestic funds. Current tax law subjects them to UBIT taxes on domestic funds only and that will no longer apply with H.R. 3970.

S-Corps can't reduce SE tax
S-Corps will no longer have an edge in reducing SE tax vs. LLCs, partnerships and sole proprietorships (where SE tax is unavoidable for service companies).

In current law, an owner/manager of an S-Corp in a service business passes through income that is not subject to SE tax. Conversely, with LLCs, partnerships and sole-proprietorships, this earned income passes through to the owner for purposes of SE tax.

S-Corps can't avoid SE tax entirely. The IRS requires S-Corps to pay reasonable compensation to its owner/managers, which is subject to SE tax.

H.R. 3970 puts S-Corps on a level playing field with LLCs, partnerships and sole proprietorships. All S-Corp earned income will pass through as earned income to owners, whether or not they have a salary or a fee.

This is not very bad news for traders. Their trading gains are not earned income, unless they are a IRC 1256 trader/member of an options or futures exchange. So their S-Corp income can still pass through to their individual tax returns without triggering SE tax.

Business traders can use strategies to create earned income with an entity to have the opportunity to contribute funds to a tax-deductible retirement plan. This is usually done in a way that saves more in income taxes than it costs in payroll/SE taxes.

Money managers face stiff tax increases in H.R. 3970
Under current tax law, many money managers receive profit allocation (carried interest) from their hedge funds, which may be long-term capital gains or 60/40 tax treatment. Plus they don't currently owe SE tax on the profit allocation income.

H.R. 3970 would repeal carried interest; subjecting this income to higher ordinary income tax rates plus SE tax.

It's a huge difference.

Currently, a money manager for a commodity fund owes federal taxes at 23 percent (2007 rates) using 60/40.

But with HR 3970, and other expected tax law changes like non-extension of Bush tax rate cuts, the managers taxes may rise by 258 percent to 59.3 percent (44 percent ordinary income tax rates plus 15.3% SE tax, which may be unlimited over time).

Basis reporting by brokers on sales of stock
A very important tax law change for traders in H.R. 3970 are the new rules for significantly expanding the reporting by brokers on securities traders Form 1099-Bs.

This is not an issue for futures traders; their net "Aggregate Profit and Loss" is reported on a one-page Form 1099-B.

But for securities traders the IRS has a huge problem with the lack of current reporting. That's because current rules only require that brokers report proceeds on the sale of stock. Brokers don't have to currently report option sales and purchases, securities purchases or gain or loss on securities transactions.

As part of the IRS's "close the tax gap" initiative, the IRS wants to significantly improve tax information reporting on securities trading activities from brokerage firms by requiring most of the above missing items.

The IRS is rightfully concerned that many securities traders are botching their Schedule D reporting, and usually in their own favor.

In 2005, the IRS made a big stink of clarifying their Schedule D and D-1 instructions that require line-by-line reporting of securities transactions. Far too many traders were reporting one-line item summaries per broker and stating "see details on request."

The IRS doesn't trust taxpayers to deal with the tremendous complexities of reporting securities transactions and millions of Americans are trading hyperactively.

H.R. 3970 reinforces several earlier 2007 tax bill initiatives (H.R. 878 and S. 601, and even President Bush's 2008 Budget) to create mandatory cost basis reporting by brokers for transactions involving publicly traded securities.

The bill also requires brokers to report "adjusted cost basis with FIFO (first in first out) method unless the customer makes an adequate identification to the broker of the shares he sold."

The bill also requires brokers to report "...whether any gain or loss as a result of the transaction is short- or long term."

At committee hearings in May, there was much industry criticism about the new reporting burdens this will place on brokerage firms.

Placing undue added burdens on smaller brokerage firms during a possible slow down or recession may be a tough provision to pass. The largest full service brokerage firms already provide their customers with realized gain or loss reports and they will have a much easier time here with enhanced 1099-B reporting.

I believe the new rules will significantly expand what's reportable to the IRS, but it will fall far short of 100-percent reporting. That means that Form 1099-Bs for securities traders will not provide an adequate report for attaching to a Schedule D.

Securities traders will mostly likely still need good industry third-party software for securities trading gains and losses. Wash-sale reporting must be done across brokerage accounts and brokers can't do this.

These changes are not scheduled to begin (with phased deployment) until 2009.

One-year extenders & miscellaneous other provisions

As has generally been the case for the past few years, with great gridlock in Congress, H.R. 3970 includes many "One-Year Extenders."

The tax game seems to be to pass major new legislation when one party dominates all branches of government and to just punt short-term changes down the road until you can hit a home run.

We need more baseball-type singles and lasting legislation that one can count and plan on.

There are some "General Tax Reductions" in HR 3970 too.

The bill has an increase in the standard deduction. This does not help people who itemize their deductions, including mortgage interest, real estate taxes, state income taxes, charitable contributions and miscellaneous deductions (investment expenses). Rather, it mostly helps lower middle-class people.

The bill expands the earned income credit and refundable child credit. This also only helps lower middle-class and the poor.

Corporate tax reform
Reducing top corporate tax rates to 30.5 percent from 35 percent was a welcomed surprise from the Democrats in H.R. 3970.

But to pay for it, the bill also captures more taxation on foreign earnings in several ways. That may be a good thing, considering that America's corporations may be making more profits abroad, with our current slowdown in America underway.

With the growing divergence in individual versus corporate tax rates, many taxpayers may want to reconsider C-Corporations to park more profits in C-Corps taxed at lower tax rates.

Traders usually avoid C-Corps because of double taxation, no 60/40 treatment and other limitations. Adding a C-Corp to the mix, along with an LLC, partnership or S-Corp, may be useful and requires further study.

But is H.R. 3970 going to be a Trojan horse tax trap?

Individual tax rates go up to approximately 44 percent in H.R. 3970, after you count in the 4-percent "surcharge" and denying extensions to the Bush tax cuts (regular increase in rates).

Plus you need to consider Senator Obama's 15.3-percent SE tax proposal possibly applying to unlimited earned income.

That means federal tax rates can approach 59 percent. By the way, add state tax rates, sales taxes, and real estate taxes, and you are well over 70 percent.

If you earn money in a C-Corp, your top tax rate is 30.5 percent and you are often free of the SE tax, too.

But is it going to be 30.5 percent vs. 59 percent?

The Trojan horse is not extending the Bush tax cuts on "qualifying dividends" (currently taxed at 15 percent) and forcing taxpayers into double taxation. That's 30.5 percent plus 59 percent.

Stay tuned!