As you likely have heard, the President signed the American Taxpayer Relief Act (H.R. 8) (the "Act") on January 2, 2013. The Act, popularly known as the "fiscal cliff" legislation, permanently extends the Bush era tax cuts for individuals earning up to $400,000 ($450,000 for married couples). Income above those levels will be taxed at 39.6 percent. Notwithstanding the increase in taxes for high income earners, because the Bush era tax cuts were scheduled to expire, the Joint Committee on Taxation has estimated that the legislation will cost approximately $3.9 trillion over the next 10 years. The legislation is important for what it does, as well as what it does not do.
In addition to extending the Bush era tax rates for income under the $400,000/$450,000 thresholds, the Act contains an important permanent patch to the alternative minimum tax (AMT), a separate tax that without such a fix could have affected millions of Americans. The legislation raises capital gains and dividend tax rates for higher income earners (to 20 percent), and re-enacts phase outs of personal exemptions and itemized deduction limitations at income levels of $250,0000 for individuals ($300,000 for married couples). Although the legislators have claimed the Act only raises taxes on the wealthiest Americans, the temporary reduction in the employee portion of the social security tax enjoyed by taxpayers in 2012 is not extended by the legislation and expired on December 31, 2012. Thus, most taxpayers will see an immediate tax increase beginning January 1, 2013, as the employee portion of the social security tax increases from 4.2 percent to 6.2 percent.
A solution to the estate tax is also included, permanently fixing the exemption at $5 million (adjusted for inflation), permitting portability of the exemption between spouses, but increasing the rate to 40 percent.
For businesses, the legislation contains numerous business "extender" provisions, generally extending many expired benefits through 2013 (retroactive where relevant to taxable years beginning after December 31, 2011).
The legislation contains spending provisions, including a one-year extension of emergency unemployment benefits and a one-year extension of the Medicare payment provisions. The scheduled automatic sequestration spending cuts are averted, but only for the time being. The legislation delays those measures for two months. In addition, Treasury Secretary Geithner has advised Congress that the U.S. debt limit was reached on December 31, 2012, and that extraordinary measures would be put in place to satisfy government obligations for an additional two months.
Finally, the current continuing resolution authorizing the funding of the Federal government expires on March 27, 2013. Accordingly, the debate on the spending issues will linger. Whether broader tax reform will be part of that debate remains on open question, though the permanent nature of the provisions in this legislation may signal that additional reforms in the near term are unlikely, at least for individuals.
It is noteworthy that in addition to the new taxes included the Act, other new taxes take effect on January 1, 2013 as a result of healthcare reform. These include the new 3.8 percent Medicare tax on investment income and 0.9 percent on earned income for individuals with adjusted gross income in excess of $200,000 ($250,000 for married couples).
EXTENSIONS OF BUSH ERA TAX CUT RATES, DEDUCTIONS AND CREDITS
The most significant changes affect individual taxpayers by permanently extending certain aspects of the Bush era tax cuts. These changes include:
Permanent extension of the 10 percent rate tax bracket (applied to taxable income up to $8,700 based on 2012 rate tables).
Permanent extension of the 25, 28, 33 and 35 percent rates on income at or below $400,000 (individual filers), $425,000 (heads of households) and $450,000 (married filing jointly) for taxable year beginning after December 31, 2012. These rates were scheduled to become 28, 31, 36 and 39.6 percent beginning January 1, 2013. Income above these thresholds is taxed at 39.6 percent, while income amounts below these thresholds will still be taxed at the lower tax rates, even for individuals that earn more than the threshold amounts. For example, if 2012 tax rate tables are used (2013 rate tables will be adjusted for inflation), a single taxpayer earning $450,000 ($50,000 above the new tax rate threshold) would be taxed at 10 percent on the first $8,700, 15 percent on the income from $8,701 to $35,350, 25 percent on the income from $35,351 to $85,650, 28 percent on the income from $85,651 to $178,650, 33 percent on the income from $178,651 to $388,350, 35 percent on the income from $388,351 to $400,000 and 39.6 percent only on the $50,000 of income over the $400,000 threshold.
Permanent repeal of the personal exemption phaseout ("PEP") for taxpayers with income at or below adjusted gross income of $250,000 (individual filers), $275,000 (heads of households) and $300,000 (married filing jointly) for taxable years beginning after December 31, 2012. The PEP was scheduled to be reinstated at pre-Bush era tax cut levels beginning January 1, 2013. Taxpayers earning greater than these thresholds will have their personal exemptions phased out. The PEP reduces personal exemptions for taxpayers and dependents by 2 percent for each $2,500 of adjusted gross income that exceeds the threshold for the relevant filing status. Thus, a married couple's personal exemptions would be completely phased out at $425,000 of income. This may indirectly increase state income taxes for these taxpayers as well.
Permanent repeal of the itemized deduction limitation on adjusted gross income at or below $250,000 (individual filers), $275,000 (heads of households) and $300,000 (married filing jointly) for taxable years beginning after December 31, 2012. Thus, taxpayers earning greater than the $250,000/$275,000/$300,000 thresholds may face increased taxes as a result of their itemized deductions being limited. The limitation reduces most itemized deductions by 3 percent of the amount by which adjusted gross income exceeds the threshold amount, up to a maximum reduction of 80 percent of itemized deductions. Thus, for example, a married couple with adjusted gross income of $350,000 would have their itemized reductions reduced by 3 percent of $50,000, or $1,500 worth of itemized deductions up to a maximum of 80 percent of all itemized deductions.
Permanent extension of the so-called marriage penalty relief for the standard deduction amount, 15 percent rate bracket and earned income tax credit for taxable years beginning after December 31, 2012. The marriage penalty (which results in married couples filing jointly paying more taxes under the progressive tax-rate structure than they would have had they been unmarried filing separately) is reinstated for taxpayers earning greater than the upper income threshold for the 15 percent rate bracket. If 2012 inflation adjusted rate tables are used, for example, the marriage penalty would be reinstated for married taxpayers earning more than $70,700 (the upper income threshold for the 15 percent rate bracket for 2012).
Numerous other deductions and provisions were permanently extended, including the state and local general sales tax deduction, expanded student loan interest deduction, exclusion for amounts of income received under certain scholarship programs, arbitrage rebate exception for school construction bonds, exemption for interest on private activity bonds for qualified education facilities, expanded dependent care tax credit and numerous other small provisions.
The single most significant provision as measured by budgetary impact is the permanent increase in the the AMT exemption threshold, which is estimated to cost $1.8 trillion over ten years. Absent this change, a taxpayer would have been entitled to an exemption of $33,750 (individuals and heads of households) and $45,000 (married filing jointly) under the AMT, and these amounts were not indexed for inflation when originally enacted. The Act increases the exemption amounts for 2012 to $50,600 (individuals and heads of households) and $78,750 (married filing jointly) and indexes the exemption amounts to inflation. The Act also allows nonrefundable personal credits against the AMT.
The new tax rates are in addition to increased Medicare taxes under the Patient Protection and Affordable Care Act ("PPACA" or "Obamacare"). The Medicare tax rate will be increased by 0.9 percent (from 1.45 percent to 2.35 percent) on wages over $200,000 (single) and $250,000 (married filing jointly). Employers are required to withhold this additional Medicare tax, but there is no employer matching requirement and no requirement that the employer notify employees of the additional withholding.
CAPITAL GAINS TAX RATES
From 2003 through 2012, taxpayers earning income levels at or below the 25 percent tax rate bracket paid no capital gains tax and no tax on qualified dividends. All other taxpayers paid 15 percent on certain capital gains and qualified dividends. These rates were scheduled to expire at the end of 2012, and capital gains were to become taxed at 10 percent for taxpayers below the 25 percent rate bracket, and 20 percent for all other taxpayers. The Act extends the current rates on capital gains and dividends (i.e., no tax for taxpayers earning below the 25 percent tax rate bracket, and 15 percent for all other taxpayers) on income at or below $400,000 (individuals), $425,000 (heads of households) and $450,000 (married filing jointly) for taxable years beginning after December 31, 2012. For taxpayers with income in excess of $400,000 (individuals), $425,000 (heads of households) and $450,000 (married filing jointly), capital gains and qualified dividends will be taxed at 20 percent.
The higher tax rate for capital gains and qualified dividends is applied to all capital gains and dividends above the $400,000/$425,000/$450,000 thresholds, regardless of whether these thresholds are met by capital gains or ordinary income. For example, a married couple (filing jointly) earning $400,000 in ordinary income and $100,000 in capital gains would be taxed at a maximum tax rate of up to 35 percent on ordinary income, and the first $50,000 in capital gains would be taxed at 15 percent, with the remaining $50,000 in capital gains taxed at 20 percent. If, instead, a married couple earned $500,000 in ordinary income and $100,000 in capital gains, then $50,000 of ordinary income would be taxed at the pre-Bush era tax cut rate of 39.6 percent, and all $100,000 of the capital gains would be taxed at 20 percent.
In addition to the new capital gains tax rate structure, the new 3.8 percent Medicare contribution tax passed as part of the PPACA will apply to investment income for income over $200,000 (single) and $250,000 (married filing jointly). Thus, the highest rate for long-term capital gains is increased to a combined rate of 23.8 percent for taxpayers earning more than $400,000 (single) or $450,000 (married filing jointly). Moreover, the manner in which the new Medicare tax applies could vary depending on the type of entity involved (e.g., on S-corporations, limited liability companies or partnerships) and the owner's participation in the business.
ESTATE, GIFT AND GENERATION SKIPPING TAX RELIEF
Estate and generation skipping taxes were scheduled to be fully repealed in 2010, and the gift tax rate was to be lowered to 35 percent with a $1,000,000 exemption. In 2010, the exemption amount for all three taxes was increased to $5,000,000 per person and the taxes were extended with a top tax rate of 35 percent. Absent legislative action all three taxes would have returned to pre-2001 levels. The Act makes the estate, gift and generation skipping taxes permanent and applies the same $5,000,000 exemption amount and a new 40 percent rate to all three taxes. In addition, the Act makes permanent the ability of an executor to transfer any unused exemption to a surviving spouse.
BUSINESS TAX EXTENDERS
In addition to the individual tax changes, the legislation includes numerous (though not all) business-related tax relief provisions that had been routinely extended (the "extenders" package) for one or two years at a time, but which had expired without extension on December 31, 2011. The Act generally retroactively extends those provisions through 2012 (in some cases, for taxable years beginning after December 31, 2011), and prospectively extends them further through December 31, 2013 (or, in some cases, for taxable years beginning before December 31, 2013). Most significant, the research and experimentation ("R&E") tax credit was extended for two years (to expenditures made through December 31, 2013), and the common control rules and the rules for computing the amount of the credit when a business is transferred were simplified. In addition to the R&E tax credit, the following significant business tax provisions were extended:
The New Markets Tax Credit program is extended through the end of 2013, providing a 39 percent tax credit, with a maximum annual amount of qualified investments of $3.5 billion per year for 2012 and 2013.
The work opportunity tax credit, providing a tax credit of up to 40 percent of the first $6,000 of wages paid to individual new hires in one of eight targeted groups, is extended through for employees hired before January 1, 2014.
Fifteen-year straight line depreciation for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements is extended for two years, allowing increased depreciation deductions for property placed in service before January 1, 2014.
The expanded section 179 deduction for certain capital investments was extended and expanded to apply to investments during taxable years beginning in 2012 and 2013. The deduction limit is modified to $125,000 and can be applied on up to $500,000 in capital purchases for 2012 (adjusted for inflation). The provision expires for taxable years beginning after 2013, whereupon the deduction reverts to a maximum of $25,000 and is phased out at $200,000 in capital investments.
Bonus depreciation, allowing businesses to take an additional deduction allowance equal to 50 percent of the cost of depreciable property, is extended for property acquired or placed in service before January 1, 2014 (or certain property placed in service before January 1, 2015).
The subpart F exception for active financing income is extended through taxable years of a foreign corporation beginning before January 1, 2014. This allows the U.S. parent of a foreign subsidiary engaged in banking, financing or a similar business to defer taxation on the income earned from that business.
Subpart F look-thru treatment for payments between related foreign corporations is extended through taxable years of a foreign corporation beginning before January 1, 2014.
The exclusion for gains from the sale of qualified small business stock is extended for two years through the end of 2013. One hundred percent of the gain from the sale of certain small business stock is excluded from taxable income for stock that is acquired before January 1, 2014, and held for more than five years. After this date, the exclusion reverts to 50 percent.
Numerous other smaller extenders are included, such as the credit rate for low-income housing tax credits, military housing credit, Indian employment tax credit, railroad tax credit, returning heroes and wounded warriors work opportunity tax credit, section 199 domestic production activities for activities in Puerto Rico, treatment of certain dividends of regulated investment companies ("RICs"), the RIC exception from FIRPTA, empowerment zone tax incentives and many other extenders.
In addition to the above business tax extenders, numerous energy provisions were also extended, including the following:
The section 45 wind energy credit is modified and extended. Taxpayers can claim a 2.2 cent per kilowatt hour credit for wind energy produced from a wind facility on which construction begins by the end of 2013.
Biodiesel and renewable diesel credit in the amount of $1.00 per gallon is extended through the end of 2013.
The tax credit for energy-efficient clothes washers, dishwashers and refrigerators is extended through the end of 2013.
The credit for construction of energy-efficient homes is extended through the end of 2013.
The section 25C credit for energy-efficient improvements to existing homes is extended through the end of 2013.
The 30 percent investment tax credit for alternative vehicle refueling property is extended for two years through the end of 2013.
The plug-in electric vehicle credit is modified and extended through the end of 2013.
In addition, numerous other small "green" energy credits and rules were extended through the end of 2013.
The Act includes a few notable provisions related to charitable contributions that apply for the 2012 and 2013 taxable years:
Individual Retirement Account ("IRA") owners 70½ or older may continue to have up to $100,000 of their IRA balance distributed to a charitable organization (with certain exceptions) without recognizing income on the distribution (or generating a charitable deduction from income tax). For 2012 only, a special rule permits such an owner to elect to treat a distribution made from the IRA to a qualified charitable organization in January 2013 as having been made on December 31, 2012. In addition, a distribution made in December 2012 to an IRA owner, which is then transferred in cash from the IRA owner to a qualified charitable organization (as opposed to directly from the IRA to the charity) in January 2013, also qualified for such treatment. This is intended to save plan participants who waited to the last minute to take their required minimum distribution from their IRA accounts in the hope they would still be able to rely on the rollover.
The increased contribution limits and carryforward period for contributions of real property for conservation purposes is extended through the end of 2013.
The enhanced charitable deduction for food is extended through the end of 2013.
At the end of the day, the Act did not address the spending or the debt ceiling aspects of the fiscal cliff, and it focuses almost entirely on taxes. There are certain features of the legislation, such as the permanent AMT patch, that can be considered to be simplification. Other aspects, such as the phase out of deductions and exemptions, add complexity. The legislation does not constitute tax reform, but nonetheless sufficiently addresses the urgent issues in the individual tax system to allow Congress to direct its "fiscal cliff" attention over the next two months to the sequestration and debt ceiling challenges. It is unclear what this means for individual tax reform. Moreover, there remains interest among many members of Congress in corporate tax reform, and we expect to hear more about that as the new Congress begins its work in 2013.
If you have any questions about the material presented in this Alert, please contact any member of the BakerHostetler Tax Group or your regular BakerHostetler contact.
Authorship Credit: Michael W. Nydegger, Paul M. Schmidt, Jeffrey H. Paravano, Christopher J. Swift, Edward J. Beckwith, Edward G. Ptaszek, Jr., William J. Weber and John R. Lehrer II