Fiscal Cliff Averted: The American Taxpayer Relief Act of 2012
Corporate & Finance Alert
January 25, 2013
On January 2, 2013, President Obama signed the American Taxpayer Relief Act of 2012 (the “2012 Act”), which permanently extends certain federal income tax rate reductions first enacted in 2001 and which were scheduled to expire at the end of 2012. The 2012 Act extends and modifies other tax incentives for research and investments in renewable energy property. This legislation does not include an increase in the federal debt ceiling, and postpones for two months the effects of the budget sequester provisions enacted in the Budget Control Act of 2010. Therefore, it is possible that additional significant tax legislation will be considered by the Congress in the coming months.
Provisions Affecting Individual Taxpayers
The 2012 Act permanently extends many of the tax rate reductions adopted during the administration of President George W. Bush, including:
- Permanently extending the 10%, 25%, 28%, and 33% individual income tax brackets (which otherwise would have increased to 15%, 28%, 31%, and 36%, respectively, for 2013);
- Permanently extending the reduced tax rates applicable to qualified dividends and capital gain income for individuals with taxable income of $400,000 or less (or $450,000 or less for married taxpayers filing jointly). For taxpayers with income greater than those thresholds, the tax rate on dividends and capital gain income increases to 20%. In both cases, however, the additional 3.8% Medicare surtax enacted in the Patient Protection and Affordable Care Act of 2010 (the “PPACA”) will result in a further tax burden on dividend and capital gain income; and
- Permanently increasing the exemption amounts for the individual alternative minimum tax (the “AMT”) to $50,600 for individual taxpayers and $78,750 for married taxpayers filing joint returns. These exemption amounts will be indexed for inflation, thereby avoiding uncertainty regarding application of the AMT on a going-forward basis.
As has been well-published, many of the so-called “Bush tax cuts” were not extended to higher income level taxpayers:
- The 35% individual income tax rate is no longer the highest bracket. Accordingly, for individuals with taxable income of more than $400,000 (or $450,000 for married taxpayers filing joint returns), the top income tax bracket reverts to 39.6% for 2013; and
- The phaseouts of the personal exemptions (“PEP”) and the limitation on itemized deductions (“Pease Limitation”) are reinstated for individuals with adjusted gross income of more than $250,000 (or $300,000 for married taxpayers filing joint returns). The Pease Limitation phases out itemized deductions by 3% of the amount by which a taxpayer’s adjusted gross income exceeds the applicable amount, but not more than 80% of the otherwise allowable itemized deductions.
Additional noteworthy changes affecting individual taxpayers are:
- The extension of estate, gift, and generation-skipping transfer tax relief through a permanent extension of the $5 million per person unified federal estate and gift tax exemption amount, which will be indexed annually for inflation ($5,250,000 for 2013). However, the top tax rate is now set at 40% (increased from 35%) for estates of decedents dying after 2012;
- The legislation makes permanent the portability of the unified exemption amount, which allows the executor of a decedent’s estate to transfer any unused estate and gift tax exemption amount to the decedent’s surviving spouse; and
- Taxpayers participating in Section 401(k) or similar tax-deferred retirement income plans can convert any amounts in such plans to designated “Roth” accounts within such plans (if the plans allow for conversions). Although such conversions will be fully taxable at the current (increased) rates, all future distributions of principal and earnings will be tax-free when distributed.
Importantly, the 2012 Act does not include an extension of the temporary partial social security payroll tax holiday. Thus, wage earners and self-employed individuals will experience an increase in the Social Security payroll tax beginning in 2013 relative to what it was in 2011 and 2012. For those years, the currently applicable rates of 6.2% and 12.4% had been reduced to 4.2% and 10.4% for wage earners and self-employed workers, respectively.
Business Tax Provisions
The 2012 Act extends through 2013 several expired or expiring temporary business tax provisions, including:
- Extending the credit for research and experimentation expenses under Internal Revenue Code (the “Code”) Section 41 through the end of 2013, subject to certain modifications in calculating the credit;
- Extending the 50% bonus depreciation for qualified property under Code Section 168(k) for one year, applied to qualified property placed in service before January 1, 2014 (before January 1, 2015 for certain longer-lived transportation assets). Generally, qualified property includes: (1) property with a MACRS recovery period of 20 years or less; (2) certain computer software; (3) water utility property; or (4) qualified leasehold improvement property;
- Retroactively extending through 2013 the 15-year recovery period for qualified leasehold improvements, qualified retail improvements, and qualified restaurant property;
- Increasing the maximum amount and phase-out threshold in 2012 and 2013 for small business expensing under Code Section 179 to the 2010 and 2011 levels. Beginning in 2013, the limitation is raised to $500,000 but is reduced if the cost of Code Section 179 property placed in service exceeds $2 million. Within those thresholds, the 2012 Act allows taxpayers to expense up to $250,000 of the cost of qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. After 2013, the small business expensing limitation will return to $25,000, and the investment limit of Code Section 179 property placed in service will return to $200,000.
- Providing for a temporary election to accelerate some AMT credits in lieu of bonus depreciation for property placed in service in 2013. This allows corporations to monetize their AMT credits instead of claiming bonus depreciation;
- Extending the 100% exclusion from gross income of gain from the sale of qualified small business stock, as long as the stock was purchased after December 31, 2011 and before January 1, 2014; and
- Extending retroactively the exception in Subpart F of the Code allowing for deferral of the active financing income of a controlled foreign corporation (a “CFC”) engaged predominantly in banking, financing, or similar activity. Also, the Code Section 954(c)(6) look-through treatment for payments between related CFCs is extended through 2013.
Planning Considerations for Individual Taxpayers
If you are an individual with taxable income of more than $400,000 (or a married couple filing joint returns with taxable income of more than $450,000), you can expect your highest marginal federal income tax rate to go up to 39.6% for 2013. Combined with the PEP and Pease phase-outs, and the 3.8% Medicare surtax, the impact of the 2012 Act could be significant. As tax rates increase, so does the benefit of tax-advantaged accounts. Therefore, higher income earners should consider maximizing contributions to 401(k), IRA, and HSA savings accounts. If employers offer it, a nonqualified deferred compensation plan is also worth considering. Because taxable bond interest income is taxed at ordinary income rates, investment in municipal bonds should provide income free of federal income tax. However, municipal bonds typically offer lower yields than similar taxable bonds.
The new 3.8% Medicare surtax applies to income traditionally considered “investment income,” such as interest, dividends, rents, royalties, and capital gains, as well as to “passive income” (business income if the taxpayer does not participate in the business). For those investors with modified adjusted gross income greater than $200,000 (single filers) or $250,000 (married filing jointly), this 3.8% Medicare surtax will impact their income from capital gains and dividends. Income from these sources continues to be taxed at the 15% rate (for a total rate of 18.8% including the Medicare surtax) for lower income taxpayers. However, those with taxable income greater than $400,000 (single filers) or $450,000 (married filing jointly) will pay a top capital gains rate of 20%, and a total rate of 23.8% including the Medicare surtax. Investors should therefore consider tactics for minimizing taxable income, such as utilizing tax losses or holding tax-inefficient assets such as taxable bonds, dividends-paying stocks, or high-turnover equity funds through tax-deferred accounts such as 401(k) plans, IRAs, or tax-deferred annuities.
Under the fiscal cliff deal, the unified federal estate and gift tax exemption stays at the 2012 level of $5,120,000 per person (subject to inflation adjustments), but the top unified estate and gift tax rate was raised from 35% to 40%. For 2013, the inflation-adjusted unified federal estate and gift tax exemption is $5,250,000. For larger estates taxable at the federal or state level (for example, the New York and New Jersey estate exemption is much lower than the federal amount), charitable giving and trust or other ownership structures that allow for the transfer of wealth outside of the taxable estate should be considered.
In addition, taxpayers should examine the possible effects of the AMT. If AMT is expected in one year but not the next, consider accelerating ordinary income or deferring deductions that will provide no AMT benefit. If no AMT is anticipated in the current year but is expected in the next year, consider accelerating deductions that would not be allowable for AMT purposes next year into the current year, or deferring ordinary income.
IRS Circular 230 Disclaimer: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (1) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (2) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.