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The 2013 Fiscal Cliff: Expiring Tax Cuts and the Implementation of New Tax Provisions

Article

Corporate & Finance Alert

July 12, 2012

By: Peter J. UlrichLeonard G. Sprishen

Unless Congress does something, the “Bush-era tax cuts” automatically expire at year end and are automatically replaced by rates that may shock you. If Congress fails to act, at year end:

    • individual income tax rates will increase
    • capital gains rates will increase
    • dividend rates will increase
    • some Social Security self-employment taxes will increase
  • some Medicare taxes will increase.

The fate of the Bush-era tax cuts has been in contention for several years now, and as the presidential election approaches, there is no apparent resolution in sight. Democrats and Republicans continue to disagree over whether to extend all or some of the Bush-era tax cuts and other tax incentives scheduled to sunset after 2012. Late in 2010, President Obama and the GOP agreed to extend the Bush-era tax cuts for only two years subject to automatic expiration, in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “2010 Tax Relief Act”). However, taxpayers again face significant uncertainty in tax planning for 2013 and beyond.

The term “Bush-era tax cuts” refers specifically to the measures enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) and the Jobs and Growth Tax Relief Reconciliation Act (“JGTRRA”) of 2003. Along with the individual, capital gains, dividends, and estate tax rates that remain the focus of current attention, EGTRRA made over thirty other major changes to the Tax Code, all of which are set to sunset at the end of 2012 automatically. The 2010 Tax Relief Act extended all of these measures through 2012, but no further.

In addition, pursuant to the Obama Administration’s healthcare reform legislation, the Medicare portion of the self-employment tax will rise from 2.9 percent to 3.8 percent, and the investment income of certain taxpayers will be subject to a 3.8 percent Medicare tax.

Individual Income Tax Rate Increases

Under current law, the reduced individual income tax rates created by EGTRRA and extended by the 2010 Tax Relief Act are scheduled to automatically sunset at the end of 2012. Unless extended again, the individual marginal tax rates, currently at 10, 15, 25, 28, 33, and 35 percent, are scheduled to revert to (increase to) 15, 28, 31, 36, and 39.6 percent, effective for tax years beginning after December 31, 2012.

Capital Gains Rate Increase

Under current law, reduced tax rates on qualified long-term capital gains are scheduled to automatically sunset at the end of 2012. The 2010 Tax Relief Act extended the reduced maximum rate of 15 percent on net long-term capital gains through 2012. After December 31, 2012, absent another extension, the maximum tax rate on capital gains of non-corporate taxpayers will revert to 20 percent (10 percent for taxpayers in the 15 percent bracket).

Dividends Rate Increase

The maximum tax rate for qualified dividends received by an individual is 15 percent for tax years beginning before January 1, 2013. A zero percent rate applies to qualified dividends received by an individual in the 10 or 15 percent income tax brackets. Absent an extension, after December 31, 2012, qualified dividends will be taxed at the applicable ordinary income tax rates, with the highest rate scheduled to be 39.6 percent.

Health Care Reform Impact: Employment, Self Employment and Medicare Tax Increases

In 2011 and 2012, many employees and self-employed individuals temporarily benefited from a 2 percent reduction in the amount of Social Security tax withheld from payroll checks. Effective January 1, 2013, this tax rate will automatically revert to 7.65 percent from the current 5.65 percent. Additionally, certain employees will see their Medicare portion of employment taxes rise from 1.45 percent to 2.35 percent, so that the total Medicare taxes paid by both the employee and the employer will rise to 3.8 percent (employee at 2.35 percent, and employer at 1.45 percent).

In addition, the Health Care and Education Reconciliation Act of 2010 (P.L. 111-152) (the “2010 Health Care Tax Act”) increases the Medicare portion of the self-employment tax by 0.9 percent – from 2.9 percent to 3.8 percent – on earnings in excess of $250,000 in the case of married taxpayers filing a joint return, $125,000 if married and filing separately, and $200,000 for all other taxpayers, effective for tax years beginning after December 31, 2012.

Perhaps more critically, for the first time in the history of Social Security, the 2010 Health Care Tax Act further subjects investment income (predominantly “passive income”) to the 3.8 percent Medicare tax, although no provision has been made for the transfer of this tax from the General Fund of the United States Treasury to the Medicare Trust Fund. Effective January 1, 2013, new section 1411(a)(1) of the Internal Revenue Code imposes this tax on the lesser of (a) “net investment income,” or (b) the excess of modified adjusted gross income over $250,000 in the case of married taxpayers filing a joint return, $125,000 for married taxpayers filing a separate return, and $200,000 for all other taxpayers.

“Net investment income” includes income from:

    1. Non-business interest, dividends, annuities, royalties, and rents;
    2. Other gross income of a passive activity or a business trading financial instruments;
    3. Net gain on the disposition of non-business property (including net gain indirectly derived from disposition of a partnership interest or S corporation stock); and
    4. Income from the investment of any business’s working capital.

Comparison Table

A comparison of certain income and gain categories is below, reflecting the current tax rates for 2012, the projected rates for 2013 if Congress and the President do not act to alter this, including income and gain becoming subject to the 3.8 percent Medicare tax on net investment income, and the rates for 2013 for income and gain not subject to the 3.8 percent Medicare tax on net investment income.

2013

Income/Gain 2012 Tax Subject to 3.8% Not Subject to 3.8% Tax
Qualified Dividend 15% 43.4% 39.6%
Long-Term Capital Gain 15% 23.8% 20.0%
Short-Term Capital Gain 35% 43.4% 39.6%

The 3.8 percent Medicare tax on net investment income creates a new dynamic in tax planning for passive activities. Passive activity income has generally been perceived to be favorable because it could be absorbed by otherwise non-deductible passive activity losses. This new tax may cause taxpayers and advisers to rethink this understanding.

Possible Changes in Taxpayer Strategies Prior to Year End 2012

Subject to any congressional and presidential action in the coming months, taxpayers should evaluate their planning strategies now in respect of the approaching “fiscal cliff.” Among other mitigating measures, individuals who anticipate the possibility of being subject to a higher income tax rate after 2012 should consider shifting the timing of income or deductible expenses, since deferring deductions into 2013 may help to offset income that would be subject to a higher tax rate.

In addition, taxpayers may wish to consider accelerating capital gains into 2012 while the tax rates are lower. Accelerating the sale of capital assets is the most frequently used means to effectuate this strategy.

Taxpayers may also wish to consider investment in tax-exempt securities. This can be a prudent means of minimizing the effect of the scheduled increase in tax rates, especially given the substantial tax rate increase for qualified dividends.

Rather than merely waiting for Washington to act, taxpayers should discuss with their tax or investment advisors the prospective implementation of potential protective tax strategies to minimize any applicable taxes in respect of the sunsets and upcoming changes to the tax law.

Gibbons P.C.:

This alert was written by Peter J. Ulrich, Director, and Leonard G. Sprishen, Associate, with the Gibbons Corporate Department in its Newark, New Jersey office.