At midnight on December 31, 2012, the United States briefly fell off of the much-anticipated and highly publicized "fiscal cliff," with income tax rates rising on most taxpayers and a host of substantial spending cuts affecting the Pentagon and other major federal programs. In response, on the morning of January 1, 2013, the Senate overwhelmingly passed H.R.8, the "American Taxpayer Relief Act" (the "Act"). Late on the same day, by a vote of 257 to 167, the House of Representatives also approved the Act.
President Obama is expected to swiftly sign the Act into law, thereby preventing many of the tax increases that were scheduled to otherwise take effect and preserving many favorable tax breaks that also were scheduled to expire. In an effort to raise additional revenue for the federal government, however, the Act will increase federal income tax rates for some high-income individuals, increase the tax rate on most dividends and long-term capital gains and also slightly increase transfer tax rates. What the Act does not deal with — except temporarily through a two-month patch intended to facilitate future congressional negotiations on the subject — are spending cuts.
An explanation of some of the most significant of the Act’s provisions follows here:
Income Tax Rates. For tax year 2013 and thereafter, the income tax rates for most individuals will remain at the 2012 levels of 10, 15, 25, 28, 33 and 35 percent. (These rates had been scheduled to increase, with the fiscal cliff, to 15, 28, 31, 36 and 39.6 percent). However, the Act introduces a 39.6 percent rate for some income of certain high-income taxpayers. This 39.6 percent rate only applies to income in excess of an "applicable threshold," which is $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. These dollar amounts will be inflation-adjusted for tax years after 2013.
Capital Gains/Dividends. Long-term capital gains and "qualified dividends" will, for most taxpayers, continue to be taxed at a maximum rate of 15 percent, with those persons in the 10 and 15 percent income tax brackets continuing to be exempt from further tax on long-term capital gains and qualified dividends. Qualified dividends are dividends paid by U.S. corporations and dividends paid by "qualified foreign corporations," which are foreign corporations located in a U.S. possession or in a country with which the United States has a comprehensive income tax treaty that contains an information exchange program, and which the IRS has approved for this purpose. However, those taxpayers who are subject to the 39.6 percent income tax rate explained immediately above will be subjected to an increased 20 percent tax rate on such capital gains and dividends.
Transfer Taxes. The Act retains the 2012 estate and gift tax exemption amount of $5 million (indexed for inflation, with 2011 as the base year), but increases the federal estate and gift tax rates on transfers in excess of this amount from 35 to 40 percent. For 2013, the inflation-adjusted exemption amount is expected to be $5.25 million. The Act also continues the portability feature of the estate tax law, which allows a surviving spouse to utilize his or her deceased spouse's unused exemption amount, and makes permanent many other technical amendments to the transfer tax law that have been enacted over the past 12 years.
PEP limitations to Apply to "High-Earners. "For tax years beginning after 2012, the Act reinstates the Personal Exemption Phaseout (PEP), which previously had been suspended, with a starting threshold of adjusted gross income (AGI) above $300,000 for joint filers and surviving spouses, $275,000 for heads of household, $250,000 for single filers and $150,000 for married taxpayers filing separately. Under the phaseout, the total amount of exemptions that may be claimed by a taxpayer who is subject to the limitation is reduced by 2 percent for each $2,500 (or a portion thereof) by which the taxpayer's AGI exceeds the relevant threshold. These dollar amounts will be inflation-adjusted for tax years after 2013.
Pease limitations to Apply to "High-Earners." For tax years beginning after 2012, the Act also reinstates the “Pease“ limitation on itemized deductions, which had previously been suspended, with a starting threshold of AGI above $300,000 for joint filers and surviving spouses, $275,000 for heads of household, $250,000 for single filers and $150,000 for married taxpayers filing separately. Thus, for taxpayers subject to the “Pease” limitation, the total amount of their itemized deductions is reduced by 3 percent of the amount by which the taxpayer's AGI exceeds the threshold amount, with the reduction not to exceed 80 percent of the otherwise allowable itemized deductions. The Pease limitation affects all deductions, including the charitable donation deduction and the deduction for home mortgage interest. These dollar amounts will be inflation-adjusted for tax years after 2013.
Alternative Minimum Tax (AMT). The Act provides some permanent AMT relief for tax years 2012 and later by retroactively increasing the applicable exemption amounts to $50,600 for unmarried taxpayers, $78,750 for joint filers and $39,375 for married persons filing separately. In addition, for tax years beginning after 2012, the Act automatically indexes these exemption amounts for inflation.
Also, prior to the Act, nonrefundable personal credits, other than the adoption credit, the child credit, the savers' credit, the residential energy efficient property credit, the non-depreciable property portions of the alternative motor vehicle credit, the qualified plug-in electric vehicle credit and the new qualified plug-in electric drive motor vehicle credit, were allowed only to the extent that the individual's regular income tax liability exceeded his tentative minimum tax, determined without regard to the minimum tax foreign tax credit. Retroactively effective for tax years beginning after 2011, the Act permanently allows an individual to offset his entire regular tax liability and AMT liability by the nonrefundable personal credits.
Exclusion of Small Business Capital Gains. Generally, non-corporate taxpayers may exclude 50 percent of the gain from the sale of certain small business stock acquired at original issue and held for more than five years. For stock acquired after February 17, 2009 and on or before September 27, 2010, the exclusion is increased to 75 percent. For stock acquired after September 27, 2010 and before January 1, 2011, the exclusion is 100 percent and the AMT preference item attributable for the sale is eliminated. The Act extends for one year the 100 percent exclusion of the gain from the sale of qualifying small business stock through 2013.
Look-Through Rule for Foreign Personal Holding Company Income (FPHC income). Under the Subpart F rules applicable to controlled foreign corporations, in years prior to 2011, a special look-through rule provided that dividends, interest, rents and royalties received or accrued from a controlled foreign corporation that was related to the recipient were not treated as Subpart F income to the extent attributable or properly allocable to non-Subpart F income of the related payor, or to income of the payor that was not treated as being effectively connected with a U.S. trade or business. The Act extends this Subpart F look-thru rule to the 2012 (retroactively) and 2013 tax years.
Subpart F Exception for Active Financing Income. Under the Subpart F rules applicable to controlled foreign corporations, certain income generally is recognized by U.S. shareholders on an annual basis, whether or not such shareholders actually receive distributions during the year in question. The Internal Revenue Code contains certain exceptions to this rule, including exceptions for certain insurance income and financing income from the active conduct of a banking, financing, insurance or similar business. The Act extends the foregoing exceptions, which had expired at the end of 2011, to the 2012 (retroactively) and 2013 tax years.
Other Miscellaneous Deductions and Credits. The Act extends provisions allowing deductions for $250 of teachers' classroom expenses, tuition and related expenses and state sales taxes in lieu of state income taxes, as well as the $100,000 charitable donation of IRA assets by account owners age 70.5 and older.
The Act also extends for five years the American Opportunity Tax Credit. For many taxpayers this dollar-for-dollar credit is worth up to $2,500. The Act also would extend for five years the current versions of the Child Tax Credit and Earned Income Tax Credit, which are claimed by many lower-income workers making up to approximately $50,000.
The Act includes a one-year extension of current "bonus" depreciation rules, which allow businesses to deduct up to 50 percent of the cost of a wide variety of property and equipment, excluding real estate.
Additionally, the Act extends through 2013 the exclusion of certain income from the discharge of qualified principal residence indebtedness. The Act further includes a one-year "doc fix" that will prevent Medicare providers from facing substantial cuts in reimbursement that were otherwise scheduled to take effect.
The Act also extends several energy-related tax credits for an additional year, including a wind tax credit and a credit for certain plug-in electrical vehicles.
Increase in Employee-Paid Payroll Taxes. The two percent payroll tax holiday that taxpayers have enjoyed for the past two tax years is allowed to expire under the Act (the reduction had decreased the rate from 6.2 to 4.2 percent). For an individual earning the maximum 2013 cap of $113,700 or more, this increase will amount to $2,274 in 2013.
Unemployment Benefits. The Act includes a one-year extension of unemployment insurance benefits.
Debt Ceiling.Not included in the Act is an option to increase the U.S. debt limit. Thus, the debt ceiling remains at $16.394 trillion. The Treasury Department is taking on "extraordinary measures"that are forecast to keep Congress from having to raise the ceiling until approximately February.
Spending Cuts. Under the Act, the $1.2 trillion in automatic spending cuts that were scheduled to take effect and would have affected the Pentagon and many other domestic programs are delayed for two months, paid for by a reduction in the discretionary spending cap for 2013 and 2014.
According to various estimates, the Act is expected to increase revenues to the federal government by approximately $600 billion over 10 years. Although the Act succeeds in averting immediate severe spending cuts, as well as preventing income tax increases for most Americans, it fails to adequately address the debt ceiling or provide any long-term plan for needed reductions in federal spending. Since the Act merely delays for two months the issue of spending cuts, it is clear that further congressional action will be needed between now and the end of February to avoid a second fiscal cliff.
We will be closely monitoring these negotiations and will continue to provide our clients with updates. If you would like to discuss the potential impact of the Act on you and your business, please contact the authors or your Holland & Knight attorney.