On January 2, President Barack Obama signed into law the American Taxpayer Relief Act of 2012, H.R. 8 (ATRA), preserving many of the key tax provisions passed during the George W. Bush presidency, which were scheduled to lapse at the end of 2012. The Senate passed the original bill, which avoids what had come to be known as the “fiscal cliff,” early in the morning on January 1 by a vote of 89 to 8. The House of Representatives approved the bill later that evening by a vote of 257-167.
With some changes that largely target high-income taxpayers, ATRA permanently retains many favorable tax provisions passed during the Bush era, most importantly the individual income tax rate structure. Here are some of the key features of ATRA:
Individual Tax Rates
All individual marginal federal income tax rates from the Bush era are retained. Beginning in 2013, individual taxpayers are subject to seven marginal tax brackets, 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. The new 39.6% marginal tax rate applies to the amount of the individual’s taxable income that exceeds $400,000 for singles, $425,000 for heads-of-household, $450,000 for married taxpayers filing jointly (and surviving spouses), and $225,000 for married taxpayers filing separately. For tax years after 2013, these threshold amounts will be adjusted for inflation.
Long-term Capital Gains and Dividends
Beginning in 2013, the top federal income tax rate for long-term capital gains and dividends will rise permanently to 20% (up from 15%) for taxpayers with taxable income exceeding $450,000 for joint filers (and surviving spouses), $425,000 for heads of household, $400,000 for single filers, and $225,000 for married taxpayers filing separately. Without these changes made by ATRA, all long-term capital gains and dividends would have been taxed at ordinary income tax rates.
For taxpayers whose ordinary income is generally taxed at a rate below the 25% ordinary income tax rate, long-term capital gains and dividends will be subject to a 0% rate permanently. Taxpayers who are subject to a 25% ordinary income tax rate (or greater), but who have taxable income not in excess of the 20% long-term capital gain thresholds provided above, will continue to be subject to a 15% rate on long-term capital gains and dividends. A taxpayer’s long-term capital gain and dividend rate is determined by reference to the taxpayer’s ordinary individual income tax rate, and, therefore, will be indexed for inflation for tax years after 2013.
Phase-out of Personal Exemptions and Itemized Deductions
Beginning in 2013, personal exemption phase-outs, which had been suspended under the Bush-era tax provisions, are reinstated with a starting threshold of $300,000 for joint filers and surviving spouses, $250,000 for single filers, and $150,000 for married taxpayers filing separately. The amount of the exemption is reduced under the phase-out by 2% for every $2,500 by which the taxpayer’s adjusted gross income exceeds the applicable threshold. The threshold amounts will be indexed for inflation for tax years after 2013.
Beginning in 2013, the phase-out of itemized deductions for high income taxpayers, which had been suspended under the Bush-era tax provisions, is reinstated with a starting threshold of $300,000 for joint filers and surviving spouses, $250,000 for single filers, and $150,000 for married taxpayers filing separately. Under these phase-out provisions, the total amount of the applicable taxpayer’s itemized deductions is reduced by 3% of the amount by which the taxpayer’s adjusted gross income exceeds the threshold amount. The reduction may not, however, exceed 80% of the otherwise allowable itemized deductions. Threshold amounts are indexed for inflation for tax years after 2013.
Alternative Minimum Tax (AMT)
AMT is a second federal tax system parallel to the regular federal income tax system. AMT is the excess, if any, of the tentative minimum tax for the year over the regular federal tax for the year. In arriving at the tentative minimum tax, a taxpayer begins with taxable income, modifies it with various adjustments and preferences (common adjustments that are added back to regular federal taxable income are: 1. miscellaneous itemized deductions subject to the 2% floor; 2. the standard deduction and personal exemptions; 3. qualified home mortgage interest; and 4. certain state, local and foreign taxes), and then subtracts an exemption amount. The exemption amount phases out at higher income levels. The result is alternative minimum taxable income (AMTI), which when multiplied by an applicable AMT rate, produces tentative minimum tax. A taxpayer’s AMT equals any excess of tentative minimum tax over the taxpayer’s regular federal income tax.
Historically, the AMT exemption amount was not indexed for inflation and thus, over time, a growing number of taxpayers have owed AMT. For a number of years, Congress has passed one-year fixes, known as “patches,” that are aimed at reducing the number of taxpayers subject to AMT. Under ATRA, retroactively effective for tax years beginning after 2011, the AMT exemption amounts are increased permanently with indexing for inflation. As a result, for 2012, the exemption amounts are $78,750 for married taxpayers filing jointly, $50,600 for single filers, and $39,375 for married taxpayers filing separately. These exemption amounts are indexed for inflation. ATRA also permits nonrefundable personal credits, such as the adoption credit and the child credit, to offset AMT.
Estate, GST, and Gift Tax
The estate, generation skipping transfer (GST), and gift tax exclusion amounts are retained at $5 million, indexed for inflation from 2011 ($5.12 million in 2012 and, based on currently available inflation data, $5.25 million in 2013), but the top tax rate increases from 35% for gifts made and decedents dying in 2012 to 40% for gifts made and decedents dying after 2012. The estate tax “portability” election, authorized by the 2010 Tax Relief Act, has been made permanent. The portability election allows estates of decedents to elect to transfer any of a decedent’s unused estate tax exclusion amount to his or her surviving spouse. The surviving spouse’s estate and gift tax exemption amount is increased by the decedent’s unused exemption amount.
Charitable Contributions from IRAs
ATRA extends the ability of a taxpayer age 70½ or older to exclude up to $100,000 from gross income for distributions made directly from a traditional or Roth IRA to a qualified charity. Although this provision expired in 2011, it is now extended retroactively for 2012 and then into 2013. ATRA contains two time-sensitive provisions giving taxpayers flexibility with respect to the 2012 tax year. First, if a taxpayer took a required minimum distribution in December of 2012, he or she can elect to treat some or all of that required minimum distribution as a qualified charitable contribution to the extent that the distribution (up to $100,000) is transferred in cash to a qualifying charitable organization before February 1, 2013, and meets the other charitable rollover requirements. Second, a qualified charitable contribution made in January 2013 may be treated as having been made on December 31, 2012.
Conversions to Roth Accounts
Traditional retirement accounts, if allowed by the plan documents, may be converted to Roth accounts with the transfer being a taxable qualified rollover contribution (beginning in 2010, distributions from traditional retirement accounts could be contributed directly to an employer-offered Roth account only when the individual separated from service, reached age 59 ½, died or became disabled). ATRA allows the conversion in all circumstances after December 31, 2012.
The credit for research and development activities, which expired at the end of 2011, was reinstated retroactively for 2012, and then extended through the end of 2013.
Retroactively effective for tax years beginning in 2012, ATRA increases the maximum expensing amount under Internal Revenue Code (IRC) Section 179 from $139,000 to $500,000. IRC Section 179 allows a taxpayer to elect to treat the cost of any qualified business property (generally tangible depreciable business property) as a deductible expense in the year in which the qualified business property is placed into service (rather than deducting the cost of the property through depreciation over multiple tax years). The maximum expensing amount will be $500,000 for qualified business property placed into service before January 1, 2014, but then it is scheduled to drop to $25,000 for qualified business property placed into service on or after January 1, 2014.
Taxpayers that have already filed a tax return for some portion of 2012, such as fiscal year corporations, that placed qualified business property into service or conducted research and development activities in 2012, should consider filing an amended return to claim a refund for any additional tax paid as a result of not claiming amounts now eligible for the augmented IRC Section 179 expensing amount or the research and development credit.
Additional first-year depreciation (also called bonus first-year depreciation), which is generally allowed equal to 50% of the adjusted basis of qualified property, is extended so that it applies to qualified property acquired and placed into service before January 1, 2014.
A number of other business tax provisions, such as the new markets tax credit and the work opportunity tax credit, were extended through 2013.
ATRA did not extend the temporary payroll tax holiday, which expired at the conclusion of 2012. The payroll tax holiday, authorized by the Middle Class Tax Relief and Job Creation Act of 2012, had reduced the employee’s share of Social Security tax from 6.2% of wages to 4.2% of wages. Wage earners will pay 6.2% in social security on all wages up to $113,700 in 2013.
In addition to the provisions of ATRA, new taxes also took effect on January 1, 2013 as a result of the Patient Protection and Affordable Care Act (Obamacare), some of which are:
Beginning January 1, 2013, new IRC Section 1411 imposes a 3.8% surcharge on a taxpayer’s net investment income if the taxpayer’s modified adjusted gross income exceeds a threshold amount ($250,000 for joint filers and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 in other cases). Net investment income is the net amount, accounting for allowable and allocable deductions, of income from interest, dividends, annuities, royalties, passive activities, net gain from the disposition of property not used in a trade or business, and from a business that trades in financial instruments or commodities. Income or net gain from the disposition of property held in a trade or business is not included in computing net investment income. Modified adjusted gross income, for purposes of calculating the threshold amounts to which the 3.8% surcharge applies, is defined as adjusted gross income with any previously deducted net foreign income added back. The modified adjusted gross income threshold amounts triggering the imposition of the 3.8% surcharge are not indexed for inflation.
As a result, beginning in 2013, effectively the overall federal income tax rate on long-term capital gains and dividends for taxpayers in the 20% long-term capital gain bracket will be 23.8%. In addition, effectively the overall federal income tax rate on long-term capital gains and dividends for those taxpayers in the 15% long-term capital gain bracket will be 18.8% if those taxpayers are also subject, as a result of exceeding the applicable thresholds, to the 3.8% surcharge on net investment income. There will be some taxpayers in the 15% long-term capital gain bracket that will not face the 3.8% surcharge on net investment income.
The employee portion of the hospital insurance tax part of FICA (Federal Insurance Contributions Act), normally 1.45% of covered wages, is increased by 0.9% on wages that exceed a threshold amount. The threshold amount is $250,000 for joint filers or surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 in other cases. These threshold amounts are not indexed for inflation.
In most cases, the threshold for the itemized deduction of unreimbursed medical expenses has increased from 7.5% of adjusted gross income to 10% of adjusted gross income (i.e., in most cases, a taxpayer will only be able to deduct as part of his or her itemized deductions the amount of any eligible unreimbursed medical expenses in excess of 10% of the taxpayer’s adjusted gross income).
This article is only an overview and does not cover all of the provisions of the Taxpayer Relief Act of 2012, the Patient Protection and Affordable Care Act of 2010, the 2010 Tax Relief Act, or the Middle Class Tax Relief and Job Creation Act of 2012. Readers should consult an attorney or accountant regarding the applicability of any tax law or change in tax law to their particular situation. Attorneys at Poyner Spruill LLP have experience in a wide variety of tax matters and are available to help clients address any tax issues that they should encounter.