With President Obama and congressional Republicans at loggerheads over tax cut extensions for the wealthy next year, some financial advisors say they are planning for the worst. “We’re simply planning for higher tax rates. What form that will take, we don’t know,” says Merrill Lynch advisor Stephen Brown of The Brown Group in Pittsford, N.Y. “A lot of the conversations we’ve been having (with clients) are about the ineffectiveness of the current Congress. Nobody’s really making any bets either way that there’s going to be a clear direction, at least prior to the election.”

White House senior advisor David Axelrod said on Bloomberg Television today that Obama would endorse extending some of the tax cuts approved under the administration of his predecessor, George Bush; the original law expires at the end of this year. Namely, he would support extending income tax cuts for single people earning under $200,000, and couples earning $250,000 or less, but abolish tax cuts for those earning more.
House Republican Minority Leader John Boehner has urged that Bush’s tax cuts be extended for all income classes for two years.

The income tax cuts are part of a slew of tax laws that face possible change in 2011. The estate tax, which lapsed at the start of this year, would resume next year at a rate of up to 55 percent on estates valued at more than $1 million. Last year the exemption was $3.5 million and the tax rate was 45 percent.

To reduce the potential income tax bite, Brown likes to sock away client funds in municipal bonds, particularly insured, high-quality general obligation or essential services bonds. Even though municipal bond prices have already risen, he says, it’s likely they will continue to soar because demand will increase as investors react to bad tax liability news. “We’re trying to be ahead of the curve there,” he says. “We haven’t been doing anything drastic, especially relative to estate planning, because we still don’t know where that’s going to fall out.”

Non-qualified plans that allow for extensive income deferral can also be good for business owners, Brown adds, but the strategy isn’t for everyone. Most small business owners have their companies structured as S corporations, which can’t do non-qualifieds, he says. C corporations do allow them, but the income remains an asset of the company until the executive is ready to retire. That could cause problems if the business falls into bankruptcy; the executive would become a creditor of his employer.

Tax specialists are divided about whether Congress will push through tax reform before year’s end. David R. Hodgman, a partner with Schiff Hardin LLP in Chicago, thinks legislators will push to amend the estate tax law before the $1 million exemption/55 percent rate goes into effect in 2011, but that doesn’t mean it will happen. “There are too many people, including small business owners, who have come to rely on exemptions of $3.5 million per person,” he told Registered Rep. sister publication Trusts & Estates earlier this year. “Whether the legislation accomplishing that will occur before 2011 is another question. Given the highly partisan atmosphere in Washington, it seem quite possible that no agreement will be reached until they are at the brink.”

Charles A. Redd, a partner at Sonnenschein Nath & Rosenthal in St. Louis, Mo., was more pessimistic. In the political world, “the longer members of Congress can drag out estate tax reform, the more campaign contributions they can extract from those who seek to influence the outcome,” he told Trusts & Estates magazine. “If Congress extends the debate into 2011, those campaign contributions will continue to flow.”