February 29, 1996

HOW WILL CAPITAL GAINS TAX CUTS HELP YOU?

BY ROBERT CHRISTOPFEL
Special to the Journal

The excitement in income tax circles and chatrooms across the Internet, as the 1995 calendar year was drawing to an end, was focused on a certain aspect of the tax reform-minded `Contract With America,' specifically dealing with capital gains.

At issue was the restoration of an exclusion of a certain percentage of gross income that truly benefited the entire spectrum of America. While the year, of course, has ended without a change to the existing tax laws, (hopefully), the effort will not be wasted, nor passed off as some benefit from which only the wealthy will stand to gain any appreciable advantage.

Lest you think that my position is based on protecting my `fat-cat clients,' please read on and see why.

Tax types (Internal Revenue Code junkies, such as myself) are always called upon to address the tax laws and their implications on our lives as everyday citizens. Interpreting the laws, and the cases, along with various other taxing authorities creates a backlog of information, that, at times, provides the necessary underlying background to reveal a certain perspective on a topic, such as long-term capital gain.

The Tax Reform Act of 1986 reduced the long-term capital gain exclusion (Internal Revenue Code section 1202) from 60 percent to zero. At the time, the maximum tax bracket was 50 percent so the effective tax rate on long-term capital gains was 20 percent (i.e. 40 percent of the remaining long term capital gain times a 50 percent tax rate).

The Tax Reform Act of 1986 established, the maximum rate on long term capital gain of 28 percent - a 40 percent rate increase!

The result of this significant increase in tax rate on capital gains has been met by the widespread utilization of other means to defer the current tax bite by numerous taxpayers who are entering into tax-free exchanges, or other deferred tax arrangements, such as ESOPs in the case of corporate businesses.

The average person does not get any benefit at all for long-term capital gain. The underlying principal for the establishment of the capital gain exclusion was to provide an incentive for people who put their capital at-risk (in either the stock market, venture capital, real estate ownership, etc.). That incentive, was to treat the income on an appreciably better "after-tax" basis than other types of income. The exclusion applied to the character of income that qualified as long term capital gain.

Rather than digress into a too lengthy discussion of what is and is not long term capital gain, I will assume that you all know what qualifies and what doesn't.

As you will see, the current system of taxation of capital gains, only benefits the upper income earners.

Under current tax law, there are five rates of tax 15 percent; 28 percent; 31 percent; 36 percent and 39.6 percent. These rates apply to a taxpayers' taxable income (not gross income) depending on filing status (single, married, head of household, married filing separate) and what level (how much) income the taxpayer has made during the year. If, for this example we use a married couple, the income levels and incremental tax brackets (tax year 1996) are as follows:

Taxable Incremental Income Level Tax Bracket

• $0 to $40,00015%
  
• $40,000 to $96,90028%
  
• $96,900 to $147,70031%
  
• $147,700 to $263,75036%
  
• $263,750-Unlimited39.6%

Since the average person has a mortgage (say $165,000 at 8 percent interest) on his house and manages to keep a couple of automobiles licensed, pay real estate taxes, and also somehow manages to contribute to at least a few charitable organizations, the deductions available for these 'itemized deductions' ($18,800) along with exemptions available for a spouse (1) and dependents (2), for a total of four ($10,000) raises the gross income level to $125,700 (i. e. $96,900 plus $18,800 plus $10,000) before this hypothetical taxpayer receives any benefit in "after tax" rate on capital gains (and then only to the tune of 3 percentage points on the first $50,800 of long-term capital gains). So, where is the incentive? (And what's so 'average' about gross income of $125,700???).

Had the year-end confrontation between President Clinton and the Republican party resulted in the restoration of the long-term capital gain exclusion at the proposed 50 percent exclusion, then no matter what level of income a taxpayer might find themselves in, (e. g. an elderly grandmother who has $9,000 of long-term capital gains together with some interest, dividends, and social security along with any employer pension total taxable income of $35,000, or some software-made millionaire who decided to dump some stock received in the merger), the rate of tax would become one-half of their marginal income tax rate.

Effectively, the results would provide a benefit to even the average person by only paying at a rate equal to one-half of the marginal rate of tax on the incremental amount of taxable capital gains. The incentive would be returned, and it would benefit all Americans.

One final comment regarding capital gains. With all of the pressure to run a balanced budget, and the attempts by our legislators to reward the average person with a tax break, it might be possible to structure the capital gain exclusion with a lifetime exclusion amount.

Once the exclusion amount has been utilized, then any further long-term capital gain might be subject to a flat 28 percent. If the exclusion amount was say $1,000,000 per taxpayer an amount that most average Americans would never exceed, then the incentive for preferential treatment could be mitigated when the preferential treatment has covered the vast majority of Americans.

As has been the long-term modus operandi of the income tax system, the more you make, the more you pay!

Robert Christopfel is a CPA with a practice in Seattle.