Diane Lane in Secretariat
In the 2010 movie Secretariat, Diane Lane portrays Penny Chenery, the main two-legged character in the story, who takes over running her ailing father's Meadow Stables in Virginia--and with it the fate of the future Triple Crown champion. After the father dies, Penny's brother informs her that they will need to sell Secretariat (then known as "Red") in order to pay the $6 million or so in taxes levied on their father's estate. Penny will have none of that, and she comes up with a successful plan to raise the needed cash by creating a breeding rights syndicate. Even though all ends well in the movie, the estate tax challenge here makes for a cautionary tale, especially given that estate and other taxes are set to return to more onerous--confiscatory, actually--levels on January 1, 2013.
Unless Congress acts to extend or modify the law, we will all wake up on the first day of 2013 to the expiration of the current tax arrangement known as the "Bush tax cuts," and that will mean at least two unwelcome tax increases. First, the estate tax personal exemption (the amount that an individual can pass on to his or her heirs free of estate tax) will go from the current $5 million amount to the $1 million amount in place before the tax cuts; estate tax rates will also return to their previous higher levels. The current maximum tax rate of 15% on qualified dividends will also expire, meaning that dividends will be taxed as ordinary income, at rates almost triple the current 15%. When I remind people of the potential for this coming change, the typical response I hear is that "Congress wouldn't do that." I then have to remind them that Congress doesn't have to do anything for this tax increase to happen--and doing nothing seems to be something at which Congress excels.
The movie actually does an excellent, albeit brief, job of dramatizing the problems with--and arguments against--the estate tax. The bottom line is that the government will take the majority of your lifetime's worth of saving, investing, or building a business with money that has already been taxed. Yes, the assets in your estate have been accumulated with after-tax dollars, but the government just has to extract more pounds of flesh at your death. As horrific as this is, it gets even worse when those estate assets are not liquid, the situation in the movie. If your estate mainly consists of stocks, bonds, and cash, then you know the worth of your assets at any hour of any given day. As ridiculous and frustrating as it is to hand over the bulk of that value to the government, at least there is the tiny consolation that the cash can be raised fairly easily to pay the taxes. However, if your main asset is a family farm or closely-held family business, then your heirs may have to sell the farm or the business in order to pay Uncle Sam. If you have been accumulating cash as a reserve to pay those future taxes, you must also realize that the cash will be taxed along with the rest of your assets because it is in your estate. One of the few ways to make provisions for the payment of those future taxes is with life insurance that is not held as part of your estate. If any of this is touching a nerve, I suggest that you pick up the phone and call your estate attorney without delay.
The estate tax is bad enough as a concept, but the situation is more pernicious if the exemption goes back to the $1 million amount. It is just not that uncommon today for someone who has been successful in life to accumulate an estate worth more than this threshold amount. Just add up the value of a home where the mortgage has been paid off; the market value of all jewelry, art, silver, and other personal items and collectibles; the market value of a vacation home; and an investment portfolio that has been built over a lifetime. Now throw in ownership of a small business. The point is that there are many people who don't think of themselves as millionaires, but who nonetheless will owe estate taxes at their death.
What are the odds that the worst will happen? The problem is that nobody knows, but I wouldn't bet heavily against it, because the worst is already baked into the cake. This is an election year, so we can expect more than the usual political demagoguery on the issue. The Republicans, I suspect, will not want to push an extension or other favorable outcome before the November elections, because the Democrats will then portray them as pursuing a policy that benefits only the affluent. Even if Republicans keep the House and gain control of the Senate and the White House, the newly-elected won't take office until after January 1. The path of least resistance, then, leads to the destination of the most pain.
From an investment standpoint, what will be the effect of a higher tax on dividend income? In theory, that depends partly on how much differential there is between the tax rate on dividends versus that on capital gains. Qualified dividends and long-term capital gains are taxed at the same rate under current law, but for years capital gains were taxed at the lower rate. Ceteris paribus (a Latin phrase favored by economists that means "all other things being equal"), taxing dividends at a higher rate than capital gains should cause investors to prefer growth stocks that don't pay dividends over more established companies that do, given the potential for investors to receive their return as a capital gain. Another attraction here is that you don't pay taxes on capital gains unless you take them, and investors do not have such control over the payment of dividends. However, there is no ceteris paribus in real life, because all other things are neither controllable nor constant. A dividend is a "bird in the hand," while a capital gain can be a more elusive winged creature. There is understandably much debate over the extent to which dividend-paying stocks will be affected by a tax increase, and the reality is that many other factors, including risk tolerance, come into play here. So, don't be in too big of a hurry to sell your Johnson and Johnson (JNJ, $65; 3.47% dividend yield) shares to buy more Priceline (PCLN, $720; no dividend). Also, the fact that seldom is mentioned in the tax debate is that dividends are taxed at a lower rate because that money has already been taxed at the corporate level. Instead, the politicians prefer the class warfare approach that paints dividend recipients as fat cats who get preferential tax treatment.
The mind-numbing absurdity of the tax increase is matched only by the mind-boggling ludicrousness of the surrounding political debate. Paul Krugman, the columnist for The New York Times, argues against major cuts in government spending because such reductions would be a threat to the fragile economy. I actually agree with him to an extent here, because draconian cuts could have such an effect if they were implemented right now. I would favor a multi-year plan that reduces government spending dramatically through major entitlement reform and other spending reductions, with those cuts agreed to now but phased in over the next few years as the economy strengthens. However, Mr. Krugman also opposes tax cuts, which would stimulate the economy arguably more than government spending; he is actually in favor of increasing taxes. So, how can he argue against spending cuts based on a concern for the economy and at the same time support tax increases? The answer is simple. Mr. Krugman is fine with the government taking more of your money in taxes as long as the government spends it all. His is an ideological position, not an economic one: he favors the government over the private sector.
If all of this has you boiling mad, then I suggest you consult your attorneys and accountants to try to minimize the damage if the worst case, but not unlikely, scenario unfolds. At least this Tax Sword of Damocles should give heightened urgency to my customary valediction:
Life is short. Get busy.
Jim
Disclosure/Disclaimer: My family members and/or I own shares of PCLN. Individual stocks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as investment advice or the recommendation to buy or sell any security.
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