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1 The views and opinions expressed in this presentation are those of the author and presenter and do not necessarily reflect the views and opinions of the sponsoring companies or their affiliates. 1

2 Disclosure Neither Andrew Friedman, nor any law firm with which he may be associated, is providing legal or tax advice as to the matters discussed herein. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. It is not intended and may not be regarded as legal or tax advice, and financial advisors and other recipients of this information may not rely upon it (including for purposes of avoiding tax penalties imposed by the IRS or state and local tax authorities). Advisors should consult with their firm’s legal and tax counsel as to matters discussed herein. Clients should consult their own legal and tax counsel before entering into any investment, annuity, estate planning, or trust arrangement, and financial advisors should advise their clients to do so. Copyright Andrew H. Friedman Printed by permission. All rights reserved.

3 2014 – Key Topics Government fiscal situation Mid-term elections
Corporate “inversions” (moves offshore) Tax reform 3

4 Fiscal Compromise (Oct 2013-Feb 2014)
Government operations funded through September 30, 2015 Government borrowing authority extended through March 15, 2015 No more crucial fiscal deadlines remain before the November elections. The fiscal battles will be quiescent until next year.  But I don’t believe this capitulation signals the end of them.  By the time next year that the debt ceiling has to be raised and the government funded again, there will be a new class of House Republicans – with new Tea Party members – who will want to take up the cudgel and fight for fiscal restraint. 4

5 2013 Federal Spending ($3.45T) (in billions of dollars)
Domestic $576 (17%) Mandatory Programs (Entitlements) $2,032 (59%) Defense $625 (18%) Almost 2/3 of 2013 spending was mandatory (entitlement programs such as social security, Medicare, Medicaid, plus interest on the debt). It is not possible to reduce the deficit simply by cutting discretionary spending (which is what sequestration did). Neither is it possible to reduce the deficit simply by raising taxes, because the aging of the baby boomers leaves too few people working to pay for escalating entitlement costs. The only way to address the deficit is to reduce entitlements, namely, Social Security and Medicare. Interest $221 (6%) Source: The Budget and Economic Outlook: Fiscal Years 2014 to 2024, Congressional Budget Office (Feb 2014)

6 Federal Debt Projections
We’ve never had a short term debt problem in this country…

7 Federal Debt Projections
We have a long term debt problem as this CBO graph explains. The trend is not our friend and at some point the debt becomes unsustainable.

8 Congressional Budget Office
U.S. Debt “The amount of debt relative to the size of the economy is now very high by historical standards. Such large and growing federal debt could have serious negative consequences, including restraining economic growth in the long term, giving policymakers less flexibility to respond to unexpected challenges, and eventually increasing the risk of a fiscal crisis (in which investors would demand high interest rates to buy the government’s debt).” Congressional Budget Office February 2014 Congress might be forced to address the increasing costs of entitlements and the growing U.S. debt when the country has trouble selling newly issued Treasuries at reasonable interest rates. 8

9 Foreign Reaction “Any reduction in Chinese purchases [of U.S. Treasuries] could destabilize the U.S. bond market and send [interest] rates higher. China buying may be helping to keep bond yields lower than they should be ahead of the Fed moving closer to raising rates. The market could wake up and get quite a shock if China changes course.” Wall Street Journal July 16, 2014 China continues to buy U.S. Treasuries to keep its exchange rate low (stimulating exports) and because of a lack of choices elsewhere to invest funds. 9

10 Geopolitical Issues – U.S. Involvement
Obama is likely to continue a middle path, offering some military support but short of full scale military involvement. 50% of the sequestration cuts are cuts to defense.  Those cuts continue for many more years.  The public is of two minds regarding U.S, response to global conflicts.  Atrocities prompt a strong desire for responsive action.  Yet people are wary of entangling troops in unwinnable local conflicts. Events that compel a strong response:  terrorist attack on U.S. soil or an invasion of Israel or a NATO country. Fiscal effects: additional borrowing or reallocation of domestic expenditures. 10

11 Remaining Open Item - Extenders
A number of tax provisions expired at the end of Congress is considering legislation to renew them.  Example: IRA / charitable contribution provision permits tax free contribution of up to $100K from IRA to charity. A number of tax provisions expire at the end of every year or two unless Congress renews them.  Typically Congress passes an “extenders” bill that extends these provisions.  Broadly speaking, at this point the Senate is willing to take up an extenders bill, but the House wants to wait until Congress can consider comprehensive tax reform, since reform is likely to affect each of the expired provisions. My guess is later this year Congress will realize that tax reform is not going to happen in 2013, and will move the extenders bill, which will extend the provisions retroactive to January 1, 2014.  11

12 Health Care Reform

13 Health Care Reform

14 Health Care Reform

15 Health Care Reform

16 Health Care Reform

17 2014 Elections – House Redistricting
State legislatures reset House districts in wake of census. Republicans controlled most state legislatures after election. Most House incumbents worry more about primaries than general election. Primary reason for polarization in Washington. State legislatures have reset Congressional districts to make most districts safe for one party or the other (typically in favor of Republicans because Republicans controlled most state legislatures). So most House incumbents are not worried about winning the general election. They are more concerned about being challenged in a primary on the right (Rs) or left (Ds) as not sufficiently conservative or liberal. This is why controversial legislation that is susceptible to compromise is the Senate (e.g., immigration) gets nowhere in the House. Legislation can pass only upon a “forcing event” – an event that makes inaction intolerable (such as defaulting on the national debt). 17

18 2014 Elections – House Redistricting
State legislatures have reset Congressional districts to make most districts safe for one party or the other (typically in favor of Republicans because Republicans controlled most state legislatures). So most House incumbents are not worried about winning the general election. They are more concerned about being challenged in a primary on the right (Rs) or left (Ds) as not sufficiently conservative or liberal. This is why controversial legislation that is susceptible to compromise is the Senate (e.g., immigration) gets nowhere in the House. Legislation can pass only upon a “forcing event” – an event that makes inaction intolerable (such as defaulting on the national debt). 18

19 2014 Elections - House Democrats need to pick up 17 seats for majority. Potential pick-ups (based on 2012 election): 17 Republicans hold seats in districts Obama won 9 Democrats hold seats in districts Romney won Only 14 races are considered toss ups. President’s party has never gained as many as 17 seats in a mid-term election. Wall Street Journal (July 28, 2013) Absent a party-wide scandal that affects the Republicans, it will be very difficult for Democrats to pick up enough seats to take the House, particularly given dissatisfaction with the Administration’s roll-out of Obamacare. 19

20 2014 Elections - Senate Republicans must gain six seats for majority.
Up for election: 21 Democrats (5 committee chairs retiring) 14 Republicans Senate Democrats running for re-election won in Some of those won on Obama’s coattails, and might have difficulty winning again. 20

21 2014 Elections - Senate Likely Republican pick-ups: (Montana, South Dakota, West Virginia) Toss-ups (Democratic incumbent): (Alaska, Arkansas, Colorado, Iowa, Louisiana, Michigan, North Carolina) Toss-up (Republican incumbent): 1 (Kansas) Possible but unlikely Republican pick-up: 1 (N.H.) Possible but unlikely Democrat pick-ups: (Georgia, Kentucky) Here is a good summary of the state of play in the Senate races.  Note that we might not know which party has a majority until a run-off race in Louisiana on Dec 6. 21

22 “Republicans have not missed an opportunity to miss an opportunity.”
2014 Elections “Republicans have not missed an opportunity to miss an opportunity.” Sen. Michael Bennett (D-Co.) 22

23 2014 Elections – Republican Split: Ideologues vs
2014 Elections – Republican Split: Ideologues vs. Moderates (Compromisers) Compromisers are willing to moderate – particularly on social issues – to win Independent and minority votes. Ideologues would rather nominate a “true conservative” who will fight rather than someone who will compromise core beliefs on moral issues, even if it means holding only the House to block legislation. Independents now compose 42% of the electorate, the highest percentage ever. (Republicans compose 25%, the lowest in 25 years.) More People Say They Are Independents Than Ever Before (Washington Post, January 9, 2014). To gain Senate seats Republicans must attract independent votes in states that have elected Democrats in the past. Independents typically care more about economic issues than social issues. So Republicans must nominate someone willing to compromise on social issues. Many ideological Republicans are unwilling to accept compromise on what they believe are fundamental moral issues. Seven of the 12 Republican Senators up for reelection next year face capable or potentially tough primary challenges from the right. Republicans had a similar opportunity to take over the Senate in 2012, and they actually lost seats. In many cases the candidates who won the primaries were too conservative to win the general election. 23

24 2014 Elections “We ought to be focusing on economic security for the future, not divisive social issues. That’s how we lost several key Senate races last cycle. It plays into the Democrats’ hand.” Brian Walsh, Former Communications Director, National Republican Senatorial Committee May 2014 “Conservatives ought not to delude themselves that if Republicans win the Senate majority, it will somehow be a conservative majority. We should have no expectation whatsoever that they will listen. That’s why we’re fighting.” L. Brent Bozell III, President, Media Research Center.  May 2014 24

25 2014 Elections – Split Government Continues
Republicans keep House. Obama finishes out term. Republican ability to take over Senate depends on candidates who win nominations. Neither party gets 67 votes in Senate to overcome presidential veto, or 60 votes to overcome filibuster. But, even if the Republicans take the Senate, they are unlikely to get the 60 seats needed to stop a filibuster. This means that any Democrat can stop legislation. So, even if Republicans run the table and take the White House, Democrats will still have a seat at that table. Democrats have eliminated the filibuster for nominations to federal office (which are approved only by the Senate). They have not done so (at least not yet) for legislation. Even if Democrats eliminated the filibuster for legislation, the House would be likely to block any partisan bills. If Republicans took the Senate and eliminated the filibuster for legislation, the President could veto any partisan bills. 25

26 Corporate Inversions Increasingly, U.S. based multi-national companies are considering merging with smaller offshore entities as a means of moving their parent company out of the U.S. These “inversions” permit the combined company to avoid tax when foreign earnings are repatriated to the new offshore parent. (The U.S. tax law imposes tax when offshore earnings are repatriated to a U.S. parent.) Thus, the inversion gives the parent access to cash to pay dividends, buy back stock, or redeploy in operations elsewhere. What is a corporate “inversion”? A U.S. parent company “inverts” by merging with a company overseas. Through the combination of the two companies’ operations, the U.S. company moves its headquarters to that of the overseas company. As a result, the parent company ceases to be a U.S. taxpayer. Typically the offshore merger partner is smaller than the U.S. company. The name "inversion" comes from turning the company upside down, with the smaller offshore unit becoming the new parent. Why are U.S. companies considering moving their headquarters overseas? The U.S. has the highest corporate tax rate among developed countries.  For many years, that has prompted many U.S. companies to move some operations overseas, where taxes are lower.  Except in unusual cases, a company avoids U.S. tax on overseas operations. Moving company headquarters overseas is the logical next step. And once a few companies move, others conclude they must do so for competitive reasons. Does moving headquarters overseas permit the U.S. company to avoid all U.S. tax? No. The company still must pay U.S. tax on its operations in the U.S. For instance, if Burger King’s merger with Tim Hortons goes through, Burger King still must pay U.S. tax on the profits generated by its U.S. locations. But by moving its headquarters overseas, a business avoids U.S. tax on its foreign income. Under the tax law, profits earned by overseas subsidiaries of a U.S. parent are not subject to U.S. tax as long as they remain offshore. When these earnings are repatriated to the U.S. parent, they are subject to U.S. tax at the full 35% federal rate. For this reason, many multi-national businesses leave the bulk of their foreign earnings offshore. Doing so is inefficient, as the company cannot use the earnings to pay dividends, buy back stock, or redeploy the cash in operations elsewhere. By moving its headquarters overseas, a foreign parent can recoup its foreign earnings with little or no tax. Unlike the U.S., most developed countries do not impose tax when foreign earnings are repatriated to a resident parent. 26

27 Corporate Inversions – Washington Reaction
President Obama has criticized inversions and has vowed to take action to stop them. But the administrative options appear to be limited, as Congress has provided a bright line test when an inversion will be recognized as such for tax purposes. The Administration might be able to stop some of the add-on transactions (such as “earnings stripping”) that enhance the tax savings of inversions. Congress could change the tax law to stop inversions, but there appears to be little agreement on how to do so. Can the Administration do anything to stop inversions? President Obama has called companies moving offshore “unpatriotic” and has vowed to take action to stop them. The Administration does not appear to have the power to stop inversions outright, however. The tax law gives a bright line test when an inversion will be respected (20% foreign shareholders), which presumably cannot be changed by regulation.  The Administration might be able to curtail the practice of “earnings stripping” that often accompanies inversions. In earnings stripping, the (now offshore) parent company loans funds to its U.S. subsidiary.  The U.S. subsidiary can claim a tax deduction for interest paid on those loans, reducing its U.S. taxes due. Can’t Congress change the tax law? Congress certainly could raise the required non-U.S. shareholder threshold. Indeed, there has been a suggestion to raise the threshold to 50% non-U.S. entities.  But the fear is that would lead to the takeover of U.S. companies by foreigners. Congress also could pass a more targeted law to curtail earnings stripping. To date, Republicans have mostly resisted attempts to change the law. (The best way to stop inversions is tax reform, reducing the tax rates and thus the incentive to relocate.) 27

28 Corporate Inversions – Investor Consequences
Lower corporate tax enhances company earnings. Freeing up cash for parent could lead to increased dividends and stock buy-backs. But recent study found that half of inverted companies lagged the market. Shareholders of the U.S. company typically must recognize taxable gain when they exchange existing shares for shares in the new offshore parent. Evaluate inversion from business perspective first. When Companies Flee U.S. Tax System Investors Often Do Not Realize Big Returns, Reuters (August 18, 2014). All other things being equal, an inversion should increase shareholder value by lowering the company’s tax bill. And the ability to move cash from subsidiaries to the overseas parent without significant tax can provide additional funds for dividend payments or stock buy-backs. A recent study by Reuters, however, warns that inversions, while providing tax savings, do not always lead to better market performance. Reuters looked back at inversion transactions completed over the past three decades. Nineteen of the inverted companies subsequently outperformed the S&P 500, while 19 others underperformed. One can speculate why some inverted companies might lag the market. In their zeal to achieve tax savings, companies might pursue merger targets that are not good organizational fits, allowing the tax tail to wag the business dog. Also, operations might not run as smoothly from overseas as inefficiencies and lack of operational oversight might creep in. Inversions also impose a significant hidden cost on investors. Under an inversion as typically structured, shareholders of the U.S. company are required to recognize taxable capital gain on their shareholdings -- equal to the difference between the market value of their stock and their basis -- when they exchange their existing shares for shares in the new offshore parent. This gain recognition is particularly burdensome because the shareholders typically receive no cash with which to pay the tax. Long-term shareholders intending to hold shares until death to receive a stepped-up basis will find their plans thwarted. Investors should evaluate inversions as they would any other merger: from a business perspective first and a tax perspective second. They should consider how well the business objectives and executive oversight of the two companies are likely to mesh, and whether there is synergistic value and cost savings to be derived by combining the two companies’ operations. 28

29 Tax Reform Reduce tax rates Eliminate “loopholes”
Simplify the tax code Eliminate the alternative minimum tax 29

30 Tax Reform – Stumbling Blocks
Revenue neutral or generate new revenue Favorable to the middle class rather than the wealthy Eliminate lower rates for dividends and capital gains? Eliminate or cap deductions and exemptions But full scale tax reform will be a very heavy lift for a polarized Congress. 30

31 Camp Tax Reform Proposal (Individual)
25% tax rate, plus 10% surtax on income > $450K Tax-exempt bond interest and employer-provided health insurance premiums included in surtax. No deductions (other than charitable contributions) allowed in computing surtax. Mortgage interest deduction limited to $500K of debt No deduction for state and local taxes Charitable contributions deductible only to extent greater than 2% of AGI Half of 401k contributions treated as Roth (non-deductible) AMT repealed Top individual tax rate of 25% with 10 percentage point surtax on family income over $450K ($400K single), raising top tax rate to 35% Surtax would apply to regular taxable income, plus non-taxable income such as employer- provided health insurance and municipal bond interest. Retirement account contributions and Itemized deductions (other than charitable contributions) could not be taken against the surtax. Surtax would not be imposed on domestic manufacturing income. Retains Obamacare 3.8% surtax on investment income Annual contributions in excess of $8,750 to 401k would be treated as contributions to Roth plans (no deduction now, no income later) Eliminates state and local tax and medical expense deductions Caps mortgage interest deduction at $500K of debt. No deduction for interest on home equity lines. Does not apply to existing mortgages, refinancing of existing mortgages before 2018, or interest paid on existing home equity indebtedness. Charitable contributions deductible only to the extent they exceed 2% of AGI Repeals 2% floor on miscellaneous itemized deductions Repeals overall limitation on itemized deductions Repeals lower tax rate for dividends and net capital gains. Instead, taxpayers could claim an above-the-line deduction equal to 40 percent of dividend or gain. So tax rate is 60% x 35% = 21% (plus 3.8% Obamacare tax). Repeals AMT Curtails stretch IRAs and 401k’s: requires beneficiaries (other than spouses, or children during their minority) to take distributions within five years of death. No change to estate tax or life insurance build-up 31

32 Camp Tax Reform Proposal (Business)
25% tax rate Modified accelerated depreciation and LIFO accounting repealed Repatriation of future offshore earnings taxed at 5% Offshore earnings from intangibles taxed currently at 15% rate Deemed repatriation of prior offshore earnings at 8.75% tax rate 70% of earnings of participating owners of pass-through entities subject to employment taxes Asset-based tax on large financial institutions Corporate tax rate of 25% Repeals modified accelerated cost recovery system (MACRS), for property placed in service after 2015 Taxes gain from sale of carried interest as ordinary income (real estate partnerships excluded) Repeals LIFO accounting Permits businesses with gross receipts < $10 million to use the cash method of accounting Repeals foreign tax credit. 95% dividend exemption for dividends received from offshore subsidiaries (territorial system of worldwide taxation). Income derived from exploitation of intangibles offshore immediately taxed in US at 15% rate. Deemed repatriation of current offshore earnings over eight years at 8.75% tax rate Subchapter S avoidance of employment taxes: 70% of income earned by owners who materially participate in business conducted by pass-through entities subject to employment taxes New tax on assets of large banks and insurance companies (.035% tax on assets > $500B) 32

33 Tax Rates – Investment Income
Family income Ordinary Investment Cap gain / Dividend Income Tax Rate Tax Rate < $250K % max % max (no change) $250K – $300K % % (3.8% surtax) $300K - $450K % % (Pease phase-out) > $450K % % (Bush tax cuts expire) “Ordinary income” is income that is taxed at an unreduced rate.  Types of investment income taxed as ordinary income include interest (other than tax exempt interest), rents, and royalties. Dividends, capital gains, and tax exempt interest are not ordinary income as they are taxed at lower rates (or not at all). Compensation income (income from a job) also is “ordinary income” because it is taxed at an unreduced rate. The 3.8% does not apply to compensation income.  However, this slide deals only with the taxation of investment income (per the title).

34 Investment Planning Give increased attention to “tax drag” on investments. Harvesting losses Buy-and-hold strategies Municipal bonds, master limited partnerships, REITs Tax-efficient mutual funds Other professionally managed tax-advantaged strategies Consider investments that provide tax deferral and retirement income. 34

35 “Forcing” Events As predicted, market retreated between the time the market recognized the twin deadlines approaching, and the time Republicans acknowledged they could no longer hold up a settlement (Sept 18-Oct 8, DJII down 5.7%, S&P down 4.1%). Also, as predicted, the markets rebounded when it became likely a compromise would be reached (Oct 8-17, DJII up 4.0%, S&P up 4.7%, all time high for S&P). Investors who missed that buying opportunity might be able to take advantage of market reaction as later deadlines approach. 35

36 To stay current: TheWashingtonUpdate.com -- from Andy Friedman
@TheWashUpdate 36

37 The views and opinions expressed in this presentation are those of the author and presenter and do not necessarily reflect the views and opinions of the sponsoring companies or their affiliates. 37


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