Impact of the Debt Ceiling Fallout
Have your clients been asking you tough questions about the current U.S. fiscal situation in this time of uncertainty? "Should I change my asset allocation? Should I put money in gold? Should I get out of the stock market as a whole?" This audio stream provides an overview of where the U.S. is right now from a market, economic and fiscal standpoint and also suggests various tax-motivated strategies that you might want to pursue with your clients. Note: This was recorded prior to Standard & Poor’s lowering of the U.S. credit rating.
If you prefer, you can read the entire transcript after the jump or download this and other audio webcasts from the Personal Financial Planning Section on AICPA.org.
Michael Goodman, CPA/PFS, President, Wealthstream Advisors Inc. Michael is highly active in the financial community and serves on the Personal Financial Planning Executive Committee and as the 2009 PFP Conference Chair. He earned a B.S. in Business Administration and a B.A. in Communication from State University of New York, as well as a Certificate in Finance & Management Information Systems. Michael co-founded and serves on the board of directors of Commerce Plaza Inc., a non-profit program which teaches financial skills to children at the elementary school level.
Robert S. Keebler, CPA, MST, DEP, Partner, Keebler & Associates, LLP. Bob is a 2007 recipient of the prestigious Distinguished Estate Planners award from the National Association of Estate Planning counsels. From 2003 to 2006, Bob was named by CPA Magazine as one of the top 100 most influential practitioners in the United States. He is the past Editor-in-Chief of CCH's magazine, Journal of Retirement Planning and a member of CCH's Financial and Estate Planning Advisory Board. His practice includes family wealth transfer and preservation planning, charitable giving, retirement distribution planning, and estate administration.
This audio webcast was originally recorded Aug. 5, 2011.
MICHAEL GOODMAN: Hello, everybody. On behalf of the AICPA Personal Financial Planning Division, this is Michael Goodman and Bob Keebler to discuss the current fiscal situation and how you can help your clients make smart tax decisions in this time of uncertainty. Our plan over the next 20 minutes or so is to frame where the U.S. is right now from a market, economic and fiscal standpoint, and then to take that information and suggest various tax-motivated strategies that you might want to pursue with your clients.
We just came off a 500-plus-point drop on the Dow yesterday. Why did this happen? Well, thoughts are that (A) Italy’s situation regarding their debt and ability to manage their own deficits yesterday has become a major concern for Europe. The fear of contagion is real. It used to be that the acronym for the unhealthy countries was PIGS, or P-I-G-S, which stood for Portugal, Ireland, Greece and Spain. Unfortunately, now, it seems that it’s very, very real that it’s a five-letter acronym, and it’s Portugal, Ireland, Italy, Greece and Spain. And who might be next? The thing is that the U.S. economic data is not exactly warming the hearts of investors. Unemployment is still high, and little news on the horizon is positive.
And finally, and most recently, it seems that Washington’s inability to lead the country with a substantive solution regarding our deficit reduction in recent weeks has caused investor confidence even further in the hole. To make matters worse, according to a CNN poll, the disapproval rate for Congress yesterday shot up to 84%. This is the highest in the history of the poll.
The current situation is causing people to ask some really tough questions. Should I change my investment allocation? Should I put money in gold? Should I get out of the stock market as a whole? What should I do with my cash?
Well, clearly, the bigger picture hasn’t changed too much, and I think that investors need to keep their eye on some fundamental basics. First off, if you’re investing for retirement or a long-term time horizon -- let’s just say ten, 15 years plus out -- then your investment should be focused on where you think markets will be at that time, not on where they are today. And keep in mind, even if you’re going to be retiring in ten years from now, hopefully you’re going to plan to live a long time in retirement, and make sure you understand that your investment time horizon is more than just the next ten years.
Obviously, we’ve understood now that the stock market’s volatile, but it’s also extremely important to keep your money in a well-diversified portfolio -- not just stocks, not just bonds, not just U.S.
Gold has become extremely popular lately, and there’s no doubt that it’s had incredible returns most recently. Gold, however, is more of a speculative-type investment, and you can get really caught in some of the dangerous downturns that might occur. It’s not like a stock that’s going to be based on a company that’s producing earnings, so be careful when investing in gold. It’s really more of a short-term instrument, and that can be very dangerous.
Finally, cash. A lot of people have refused to keep large sums in cash because they feel that they’re not getting a good rate of return on that, and I think what people need to realize is that the return you get on cash is not the focus. The focus on cash is the freedom, the power and the safety that it gives you to move through different economic cycles, both positive and negative events in your personal life such that you don’t make stupid, dangerous or expensive decisions with your investments.
Okay, let’s briefly look at the stock market and where it is. While the Dow is down roughly 11% over the last two weeks, a sharp, sharp drop, you know, as far as the year goes, up until recently the Dow has been a very -- in positive territory. Granted, the large-cap market is not at its peak from 2007, but we’ve come a long way from the depths of the 2008, 2009 market declines. Returns in the market since the bottom in 2009 have been extraordinary, and a breather in the market is not that shocking. No doubt, these are volatile times. No doubt that these last two weeks have been very scary. But we really need to think about the investment time horizon and the time frame for markets, and what happens in the short period of time when you look back in the future and you look back on history, this little blip in the market will hopefully be just that.
Further, and perhaps even more important to investors, a very recent study by Vanguard showed that over long periods of time there’s absolutely no correlation between the economic growth of a country based on its GDP and the stock market performance. In the short term, investor sentiment -- feelings, fear and greed -- moves the market on the day-to-day basis. But in the long run, people are only going to pay for stocks that make money, and not in the economy of a broader country.
For the remainder of this podcast, we’d like to tee up where we think the U.S. government is and what might be coming from our Congress in the coming months so that you can make some good decisions on assisting your clients in strategies to save them some funds regarding taxes. Bob, can you take it from here?
BOB KEEBLER: Well, thank you, Michael. That was a great overview. What I’m going to do is very quickly highlight some of the numbers, economic numbers, and then we’ll jump right into the possible tax strategies we should be looking at in the next five months. Bottom line is, no one knows what’s going to come out of the Super Congress, and we’ll talk about this.
Now, let me give you a thumbnail accounting sketch of kind of where we are. Most of you know that the debt is $14.4 trillion. So just remember $14.4 trillion. Hard to put the trillion in perspective. Now, we are spending in 2011 $3.71 trillion, and we’re only bringing in $2.2 trillion. So from an accounting perspective, by the time we got out of our second accounting class, we would realize that there was a deficit of $1.479 million [sic] [?] [00:06:49]. Putting that a different way, currently the federal government is spending $1.66 for every dollar brought in.
In preparing for this, Michael and I talked briefly about what happens if interest rates go up. Recognize, the rate -- the weighted average rate on our loan portfolio right now as a country is fairly low. If we saw -- You know, for every 1% increase in that rate, we’re going to add 144 billion, with a B, dollars to the interest expense, which is really going to -- You know, that is going to start to affect our deficit, when you look at how much we’re spending. So we have to be very careful with this, and that’s -- We have to change the trajectory. Everybody realizes that, and that’s what Congress did in this bill.
Now, in this bill, cutting through, right to the heart of it, there is a trillion dollars of spending cuts in stage one. So in stage one, there’s a trillion dollars. That’s in action, but that does not include any revenue hikes. Now, stage two is a little bit different. Stage two, you’re probably aware that if the Super Congress cannot agree, there are going to be some very painful cuts that are distasteful to both the Republicans and Democrats. So those cuts are designed -- those forced cuts are basically designed to make everybody come together on this.
Now, stage two, though, potentially includes fundamental tax changes. There certainly is going to be a lot of discussion about closing loopholes such as the famous carried interest, where President Obama -- I think he actually put it very eloquently, where he said it’s probably not right that a Wall Street executive pay a lower tax rate than his or her secretary. Now, I think everybody can agree with that. So carried interest will probably be gone. On the business side, they might take away accelerated depreciation, the domestic production activities deduction. LIFO accounting. Imagine that. We won’t have to learn LIFO anymore.
But when you look at this, what we’re talking about is some very fundamental changes. But everyone is worried, rightfully so, on the effect of these changes on our economy. So this all has to be balanced.
Clearly, at the heart of this debate, in 30 seconds or less, President Obama has tried both Keynesian economic policies of government intervention, government spending more money to smooth out the economy, while at the same time people are criticizing him on the Keynesian side. We basically had a lot of supply-side and monetary policy that’s also favorable to the economy. Clearly, interest rates are very low, and we’ve had some very large tax reductions to help us through this, 100% depreciation for business and, like Michael alluded to, there’s a sentiment or confidence factor, and that’s why businesses simply aren’t adding capital right now. And of course, you add capital before you add jobs. So we have some perspective.
Now, there is going to be a Balanced Budget Amendment vote between September 30th and December 31st, and Article V of the U.S. Constitution provides that three-fourths of the state legislatures have to also approve the Balanced Budget Amendment. So we have to go all the states, and you’re going to have to have 75% of the states vote for the Balanced Budget Amendment. Maybe very difficult when you look at some of the states -- New York, California -- are largely recipients of the federal government’s generosity, and they have very large congressional delegations. So those are going to be things we work through.
The bill creates a select committee on deficit reduction. The goal of this committee is going to be to reduce the deficit by at least 1.5 trillion over a period of 2012 to 2021. Read about this. Get your arms around it as an accountant and thing about what’s going on here. This is not as good as it looks, because what they’re talking about is reducing the projected budgets, and there’s already some inflation and other adjustments all worked into these numbers. So this is not nearly as good as it looks.
Now, there are some key dates which I think are very important. This Super Congress is going to be 12 individuals, and they will be appointed by August 16th, and they’re going to be appointed by the various Congressional leaders. We’ll go through that in a second. Then they have a month to do nothing, and on September 16th, the committee holds its first meeting. Personally, in the crisis we’re in, the first meeting should be on the 17th of August, regardless of the need for Congress to take vacation. October 14th, the House and Senate committees transmit recommendations to the Joint Committee, and November 23rd, the day before Thanksgiving, the committee makes its recommendations to the public. Very stereotypical Washington. We’re going to release information that’s troubling the day before a major holiday. So that’s the day before Thanksgiving that’s released.
On December 2nd, the Joint Committee submits proposed legislation to the Executive and to Congress. So the President and Congress will actually see statutes at that point in time, and then probably between December 2nd and the end of the year there will be some votes up or down on this.
Now, already, this committee is being challenged on a constitutional basis by Representative Dr. Ron Paul out of Texas, and many of you know, Ron Paul is probably one of the more vocal libertarians in the Congress. I fully expect, regardless of the merits of this case -- and different lawyers that I’ve spoken to that understand it look at differently -- that he probably will try to get standing and bring this perhaps to the Federal District Court in Washington, D.C., or maybe back in his home district in Texas.
Now, the composition of the committee, Senate Majority Leader Harry Reid appoints three members. Senate Minority Leader Mitch McConnell will appoint three members. Speaker Boehner appoints three members, and Minority Leader Pelosi, former Speaker, also appoints three members. So that’s your 12 members. They’re all members of Congress.
Keep in mind, greatly divided ideas here. On one side you have the Tea Party, who would only like spending cuts, and on the other side there are the progressive Democrats, who would like to solve this entire problem with just raising revenue. So what’s really happened, to quote some of the commentators, is Congress just kicked the can down the road. They did virtually nothing with this bill, and that’s part of why the market undoubtably is reacting the way it is.
Now, so the committee can reduce expenses. The committee can increase revenue. The committee can create a balanced approach, like the President continues to suggest. Now, a balanced approach may involve many, many spending cuts, and we’ll talk about that. If you want to read something good on this, you’re going to want to look at what the Gang of Six has put together. Six senators, all very experienced, very learned and very well respected have put together a list of ideas, and we’ll talk about some of the more poignant ideas.
So the first round of deficit covers 2012 through ’21, a trillion dollars, with a T, in reduction in spending that does not include any revenue hikes. The second round, like I mentioned a moment ago, basically is going to have a 1.5 trillion deficit reduction, and in there we may see some substantial tax changes.
Now, other things this committee is going to have to address, or is going to have to be addressed by the Joint Committee, the normal Joint Committee, is the expiration of the Bush-era tax cuts. We are now 14 and a half months away from this happening. I mean, we have to step back and realize it’s almost 2013. In 2013, we lose our qualified dividends. We lose our 15% capital gains rate. The estate tax goes back to a million dollars, and income tax rates go up, plus you have the 3.8% health care surtax on investment income. So there are some serious things coming at us very quickly.
So what we want to look at is, what does this mean? Now, I want to -- I kind of summarized some of the things President Obama said after signing the Budget Control Act of 2011. Again, this will give you -- and of course, the Tea Party advocates are saying pretty much the opposite of what the President’s saying. But the President would like to see a balanced approach. Everything is on the table. Wants adjustments to protect Medicare and similar health care programs, would like to see a reformation of the tax code so that the wealthy and large corporations pay their fair share. Some of this you’ve heard. Eliminate tax loopholes that help billionaires pay a lower tax rate than teachers and nurses. Quote, everyone chips in. Clearly, carried interest and corporate jets are on the top of the President’s list.
Now, Senator Coburn is a Republican from Oklahoma. He’s on the Gang of Six, and he -- The Gang of Six basically came up with a plan to reduce the deficit by $9 trillion over the next ten years. That plan can be found on Senator Coburn’s Senate website. I would encourage you to print that out and at least look through it. There are many things in there. Some are laughable, but many are very serious. Some of the more serious are home interest mortgage deductions on vacation properties would be gone. Home mortgage interest deductions on second mortgages would be gone.
Home mortgage interest deductions on a mortgage of over $500,000 would be gone. Now, that is a scary proposition. Maybe not from my perspective in Green Bay, Wisconsin. But Michael and I were talking, getting ready for this, if you go ten, 20 minutes, an hour outside New York, you have to pay $750,000 for a home you would probably pay 200,000 for in Green Bay, Wisconsin. So for much of the country, this 500,000 is just going to be very onerous and perhaps unfair. So we have to look at that. Certainly, if you have clients with those big mortgages and they are considering investing or reducing their mortgage, you’re going to have to look at that for them, because if you’re paying today a 5% mortgage rate and you’re in the 40% bracket, you’re paying about 3% effectively. But if you lose some of the top of that deduction, you’re going to have to evaluate is the best thing to do to reduce that mortgage?
The other thing that no one has talked about, although we need some learned economists to weigh in, if you change that, you’re clearly going to have a negative impact on the housing market. Maybe not in the long term of 50 years, but certainly in the short term.
Now, the ideas by Senator Coburn would also look at ending some tribal economic bonds. One of the abuses in his write-up was he talked about this beautiful complex -- I’ve seen it with my own eyes -- in Phoenix, Arizona, where there’s 12 ball fields and right next to a casino. But many of the Major League Baseball teams have their spring training at this facility, and just absolutely incredible. But all paid for by -- or most of it paid for by the federal government.
There are also -- There are some things in here that are just for show. Ending tax breaks on NASCAR. Ending tax breaks on Hollywood. Taking away a tax break for Eskimo whaling captains that saves 4 million, with an M, million -- M-I-L-L-I-O-N. Some of these things are just for show, but there are some good ideas in this. Read it and become familiar with it.
Now, let’s cut to the heart of this. Year-end tax planning for business owners. What we’re looking at is, right now we can still get fairly good bonus depreciation, aggressive 179 deductions. I think what you’re going to have to do, since we do not know where any of this is going, we’re all going to have to create what we’re calling pivot points with our clients. We have to develop a strategy that goes a couple of different ways -- lay out two or three plans, depending on how the legislation works out.
Keep in mind, right now you can still invest in new startups. If you have a client that invests in a new startup and they hold that property for five years, that gain is going to be 100% excluded. That’s Section 1202 stock. Basically, one of the contentions of many Congressmen, including the Gang of Six in the Senate, is that if we eliminated a lot of the tax expenditures -- i.e., loopholes -- we could actually reduce the rates, making America more competitive.
Now, I think that has to be carefully analyzed not by Congressmen but by expert economists who would then advise Congress. But the bottom line is, if tax rates are going down, there are some things we probably shouldn’t be doing. We probably shouldn’t be accelerating income. We probably shouldn’t be doing Roth conversions. On the other hand, if the law just stays the way it is, rates are going up. So you do not know what to tell your clients. I’m meeting with a gentleman and his wife who currently work for a major multinational, and they’re living in Japan right now, and we’re meeting in about a half hour here. But at the end of the day, what do I tell these people? Because they’re looking at 5, $6 million of income that they’re going to be taking out of deferred comp, NSOs, ISOs, and how do we handle this? What do we plan on doing in 2011 and ’12? The only thing we can do is create pivot points.
So we’re looking at do we defer income or do we accelerate income? One of the things that’s often talked about when they’re talking about tax expenditures are qualified plans. Personally, all of us should do whatever we can to maximize our qualified plan contributions this year, because they may reduce some of these, the contributions that are available. If that happens, it’s going to be very hard to save for retirement.
We’re also looking at changes in the charitable provisions in the Code, and that, again, would -- may impact charities very negatively. There’s a lot of lobbying going on not to touch them.
Now, looking at tax planning in 2012 and beyond, basically many people are going to be trying to accelerate income into 2012. One of the techniques we’re looking at there, there’s a number of techniques, especially in the bond market, of selling bonds, in December 2012 bringing that interest forward. We’ll talk about those things more as time goes on.
Now, keep in mind, C corp dividends. If -- One of the things that’s certainly going to be looked at and discussed is qualified dividend treatment. Part of the Bush cuts, rates used to be 39.6% on dividends. Now rates are down. Okay? Now rates are down to 15%. Congress is certainly going to look at that, okay? So Congress is going to look at that, and we’re going to have to address it.
If rates do go down -- or do go up, excuse me -- you’re going to have to look at taking dollars out of C corporations in the next 15 months. Bottom line, many of us represent people with very large C corporations that have old retained earnings. Perhaps those should be taken out, even if they have to be lent back to the corporation. When you do that, be very diligent with your minutes. Your corporate minutes have to be in accordance with state law. The meeting where that board meeting is called should be in accordance with state law. Don’t let the IRS come back and say, “You know, guys, you were supposed to give 15 days’ notice under your bylaws. You didn’t do that. The dividend doesn’t count. You really took the dividend later, after your next board meeting.”
Now, 401(k) conversions. Remember, you can convert a 401(k) into a Roth 401(k). The problem with that is no right of recharacterization. Be very careful with that. You do have the right of recharacterization with a regular Roth-to-Roth conversion. One of the things is, with the volatility of the stock market, we may want to do some recharacterizations now and then do reconversions in January of 2012. The obvious reason is then we have until October 15th, 2013, to figure out what’s happened not only with the stock market, but with tax rates. If rates have gone down, we would jump out of those conversions.
On the estate and gift side, right now we have a $5 million exemption from the gift tax, and for your wealthy clients, I think you aggressive need to look at how to use that. In all likelihood, even if we keep our $5 million estate tax exemption, which in my mind is unlikely, we’re going to lose -- we’re likely going to lose our $5 million gift tax exemption. Those will not be unified forever.
In the President’s prior bills, he’s looked at taking away dynasty trusts, so I think we need to take a quick look at funding dynasty trusts. GRATs are certainly under attack. The short-term GRAT is going to be gone one way or the other, and if you’re going to be doing short-term GRATs, we need to do them now, just like discounting. If you have clients that own 100% of a business, in the next five months, get them to give that away, recap it with voting and nonvoting stock. Also, remember, beginning January 1st, 2013, we hit the 3.8% Medicare surtax.
There is a lot of opportunity here, and you have such a responsibility to meet with your clients, talk to them about these tax planning things, create these pivot points. Use some of my ideas kind of as a mental checklist, and just be active and be there for your clients. What your clients need most of all is a little bit of assurance, like Michael tried to give us, on -- that, you know, in the long run, things are going to be okay, but we are going to have a very choppy road in the next several years.
So on behalf of the AICPA, this has been Michael Goodman and Bob Keebler. We’d like to thank you for joining us today.
MICHAEL GOODMAN: I’d just like to add, Bob, real fast that, as you sort of alluded to at the end of your little chat there, no doubt these are tough times. No doubt that we have this responsibility to reach out. But even more so, this is an opportunity for you to grow your businesses. Reach out to your clients, talk about these issues. It’s okay that we’re not sure what’s going to happen, but it’s important to you to reach out and explain the possibilities to clients, because there might be things going on that you can help them with, and in these tough times, that’s where you’ll create the glue to stick with your clients in the long run.
I encourage you all tremendously to stay in touch with the PFP Division and keep connected. Our goal is to provide these kinds of resources to you over and over again, and if there’s anything specific you’d like to hear about, don’t be afraid to give some feedback. Check out our topics via the weekly AICPA PFP News, and by visiting the website at AICPA.org/PFP. Thank you.