As you no doubt are aware, Congress just passed, and the President just signed into law, the American Taxpayer Relief Act of 2012 (the “Act”). The Act is effective as of January 1, 2013. This summary addresses certain of the key income tax provisions of the Act. A summary of the estate and gift tax provisions can be read here.
“Nothing is permanent except change”
With respect to many of the income tax provisions in the Act, we suggest you keep the above quote in mind. As you may recall, the 2001 Bush tax cuts were subject to sunset, and that sunset was scheduled to occur on December 31, 2012 (originally, it was December 31, 2010, but it was later extended). Thus, the Bush tax cuts were considered to be “temporary” tax cuts. Apparently, as far as Congress is concerned, any tax changes that do not, by their terms, sunset can be labeled as “permanent.” In contrast, the tax provisions in the Act designated as “temporary” are simply those that are subject to a specified sunset date. But don’t be fooled by labels – this is Congress and it can change what it has done at any time. Thus, although many of the tax provisions in the Act are labeled as “permanent,” the reference simply means that there is no specified sunset. It doesn’t mean that they can’t, or they won’t, be changed down the road. Indeed, we will be surprised if we don’t see further changes to the income tax laws in the next year or two.
Individual Tax Provisions
1. Permanent Extension of Tax Rates. The Act permanently extends the tax rates enacted in 2001 under the Bush Administration for taxpayers with taxable income at or below $400,000 for unmarried individuals, $425,000 for heads of households and $450,000 for married couples filing jointly. Any taxable income in excess of those thresholds will be taxed at the maximum tax rate in effect prior to 2001 (i.e., a rate of 39.6%).
2. Permanent Repeal of Phase-out of Personal Exemptions. The Act permanently repeals the phase-out of personal exemptions for taxpayers with adjusted gross income (“AGI”) at or below $250,000 for unmarried individuals, $275,000 for heads of households and $300,000 for married couples filing jointly. For taxpayers with AGI in excess of those thresholds, the total amount of personal exemptions that may be claimed is reduced by 2% for each $2,500 or portion thereof until fully phased out at AGIs of $375,000, $400,000 and $425,000, respectively.
3. Permanent Repeal of Phase-out of Itemized Deductions. The Act permanently repeals the phase-out of itemized deductions for taxpayers with AGI at or below $250,000 for unmarried individuals, $275,000 for heads of households and $300,000 for married couples filing jointly. For taxpayers with AGI in excess of those thresholds, the total amount of itemized deductions that may be claimed is reduced by 3% of the amount by which the taxpayer’s AGI exceeds the taxpayer’s applicable threshold, up to a maximum 80% reduction in itemized deductions.
4. Permanent Extension of Tax Rates on Capital Gains and Qualified Dividends. The Act permanently extends the maximum 15% income tax rate for long term capital gains (gains from the sale of capital assets held for more than 1 year) and qualified dividends for taxpayers with taxable income at or below $400,000 for unmarried individuals, $425,000 for heads of households and $450,000 for married couples filing jointly. For taxpayers with taxable income above those thresholds, the maximum income tax rate on long-term capital gains and on qualified dividends is 20%. However, taking into account the additional 3.8% Medicare tax on investment income of taxpayers with taxable income in excess of $200,000 for unmarried individuals and $250,000 for married couples filing jointly which took effect on January 1, 2013, those subject to the 15% maximum income tax rate on long term capital gains and qualified dividends will effectively be subject to a maximum tax rate on long term capital gains and qualified dividends of 18.8% and those subject to the maximum income tax rate of 20% will effectively be subject to a maximum tax rate on long term capital gains and qualified dividends of 23.8%. For all taxpayers, the maximum tax rate on short term capital gains will be 43.4% (39.6% plus 3.8%).
5. Temporary Extension of Tax-Free Distributions from IRAs to Charities. The Act extends, but only through 2013, the ability for individuals age 70 ½ or older to make tax-free distributions from IRAs to public charities, up to a maximum of $100,000 per taxpayer per year. Two special transition rules apply as well. First, any qualified charitable distribution made during January 2013 will be deemed to have been made on December 31, 2012. Second, any distribution from an IRA in December 2012 to an individual may be treated as having been transferred directly to the public charity if that individual transfers the distribution to the public charity during January 2013.
6. Permanent Extension of Marriage Penalty Relief. The Act permanently extends marriage penalty relief, which relief has been in the form of (i) an increase in the standard deduction for a married couple filing jointly to twice the standard deduction that is provided for an unmarried individual filing a single return and (ii) an increase in the 15% tax bracket for a married couple filing jointly to twice the size of the corresponding 15% tax bracket for an unmarried individual filing a single return.
7. Increase in Exemption and Permanent Extension of Alternative Minimum Tax Relief. The Act increases the amounts of the alternative minimum tax (“AMT”) exemptions and makes permanent these increased amounts, and maintains an indexing of the exemption amounts for inflation. For 2012, the AMT exemption is increased from $33,750 to $50,600 for unmarried individuals and heads of households, from $45,000 to $78,750 for married couples filing jointly and from $22,500 to $39,375 for married taxpayers filing separately. The Act also allows nonrefundable personal credits to be offset against the AMT.
8. Permanent Extension of Expanded Dependent Care Credit. As a result of Bush-era enhancements, current law allows taxpayers a credit for a percentage of dependent care expenses incurred with respect to caring for children who are under the age of 14 or for disabled dependents. The Act permanently extends the increased caps on the amount of expenses eligible for the dependent care credit, with the caps remaining at $3,000 for one child/disabled dependent and $6,000 for two or more children/disabled dependents. The phase out of the applicable credit rate of 35% continues to start at $15,000 AGI, with taxpayers whose AGI is above $43,000 having an applicable credit rate of 20%.
9. Permanent Extension of Increased Adoption Tax Credit and Adoption Assistance Programs. As a result of Bush-era enhancements, current law allows a tax credit for qualified adoption expenses and allows the exclusion from income of adoption expenses paid by an employer. The Act permanently sets the cap for this credit at the current increased level of $10,000, and provides that up to $10,000 of adoption expenses paid by an employer will continue to be excludible from income. These caps will be indexed for inflation.
10. Permanent Extension of Increased Child Tax Credit. The Act permanently sets the child tax credit at $1,000, the increased level set during by Bush-era enhancements. This credit continues to be subject to certain income phase-outs and still has no inflation adjustments.
11. Extension of Education Incentives (Some Permanent, Some Temporary). The Act permanently extends several education tax incentives, including (i) the $2,000 annual contribution to Coverdell Education Savings Accounts, (ii) the exclusion from gross income of up to $5,250 of employer provided education assistance, and (iii) subject to certain income phase-outs, an “above-the-line” deduction (a deduction in determining AGI) of up to $2,500 interest on qualified education loans. In addition, the Act extends, but only through 2013, an above-the-line deduction for qualified tuition and related expenses, subject to certain income phase-outs.
12. Temporary Extension of Deduction of Teacher Classroom Expenses. The Act extends, through 2013, the above-the-line deduction for up to $250 of classroom expenses incurred by an elementary or secondary school teacher.
13. Temporary Extension of Mortgage Debt Relief. Normally cancellation of debt triggers taxable income under the Internal Revenue Code. As a result of a special provision previously enacted, taxpayers who have mortgage debt cancelled on their primary residence do not recognize taxable income. This provision was set to expire after 2012. The Act extends this special provision, but only through 2013.
14. Temporary Extension of Exclusion for Transit Benefits. The Act extends, but only through 2013, the exclusion of certain employer-provided mass transit benefits.
15. Temporary Extension of Deduction of Premiums for Mortgage Insurance. The Act extends, but only through 2013, the ability to treat mortgage insurance premiums as qualified residence interest. However, such treatment continues to be subject to certain income phase-outs.
16. Temporary Extension of Deduction for State and Local Sales Taxes. The Act extends, but only through 2013, the ability to elect to deduct state and local general sales taxes as an itemized deduction in lieu of a deduction for state and local income taxes. Thus, taxpayers in states without income taxes (such as Florida) will continue to be able to elect in 2013 to claim an itemized deduction for state and local sales taxes.
17. Temporary Extension of Special Rules for Contributions of Capital Gains Real Property for Conservation. The Act extends, but only through 2013, a special rule that allows a charitable contribution of real property (including certain partial interests in real property) for conservation purposes to be currently deducted as long as the contribution does not exceed 50% of the donor’s contribution base (after taking into account other charitable contributions).
Business Tax Provisions
1. Temporary Extension of Increased Section 179 Deduction and Phase-Out Threshold. Current law allows taxpayers to deduct the cost of new or used business equipment placed in service during the taxable year, rather than to depreciate the property. This ability to immediately write off business equipment is phased out when the total cost of eligible assets exceeds certain amounts. The Act increases the maximum Section 179 deduction amount applicable for 2012 to $500,000 and sets the same increased maximum for 2013. For each of 2012 and 2013, this deduction begins to phase-out dollar for dollar once the total cost of eligible assets placed into service during the year exceed $2,000,000.
2. Temporary Extension of Bonus Depreciation. Current law allows taxpayers to take an additional depreciation deduction on new business equipment equal to 50% of the cost of the business equipment. The Act extends this provision through 2013 for all business equipment and through 2014 for certain long production period property.
3. Temporary Extension of Research Tax Credit. The Act extends the research tax credit, but only through 2013.
4. Temporary Extension of Employment Based Credits. The Act extends the Work Opportunity Credit and the Returning Heroes and Wounded Warriors Work Opportunity Tax Credits, but in each case only through 2013.
5. Temporary Extension of 15 year Straight Line Recovery Period for Qualified Leasehold Improvements, Qualified Retail Improvements and Qualified Restaurant Property. The Act extends, but only through 2013, the 15 year straight line recovery period for qualified leasehold improvements, qualified retail improvements and qualified restaurant property.
6. Temporary Extension of Special Rules for Small Business Stock. In the case of a taxpayer other than a corporation, any gain from the sale or exchange of qualified small business stock held for more than 5 years is 100% excluded from income if it was acquired after September 27, 2010 and before January 1, 2012. The Act extends this 100% exclusion of gain so as to extend the acquisition date deadline from January 1, 2012 to January 1, 2014.
7. Temporary Extension of Basis Adjustment to Stock of S Corporations Making Charitable Contributions of Property. A special provision that had expired for tax years beginning after December 31, 2011 provided that a shareholder’s basis in an S corporation would be decreased by the shareholder’s pro rata share of the adjusted basis of property donated by the S corporation to a charity. The Act extends this provision through 2013.
8. Reduction in S Corporation Recognition Period for Built-In Gains Tax. The general rule is that when a C corporation converts to an S corporation, for a period of 10 years after the date of the S election (the “Recognition Period”), any net unrealized built-in gain of the corporation’s assets existing as of the effective date of the S election would remain subject to tax at the corporate level at C corporation rates. Then, after the expiration of that Recognition Period, any unrealized built-in gain would no longer be subject to tax at the corporation level. The Recognition Period had been shortened to 7 years for sales of assets in 2009 and 2010 and to 5 years for sale of assets in 2011. The Act extends the 5 year Recognition Period for sales of assets in 2012 and 2013.
1. Temporary Extension of Credit for Energy Efficiency Improvements. The Act extends, but only through 2013, the $500 credit for individuals who make energy efficiency improvements.
2. Temporary Extension of Other Energy Credits. The Act extends, but only through 2013, several other energy credits, including the credit to US-based manufacturers of energy efficient appliances and the credit for new energy efficient homes.
New Rule Allowing Roth Conversions of Retirement Plans
The Act contains a new permanent provision that permits retirement plans to allow individuals to convert amounts in a non-Roth 401(k) account to an account within the retirement plan that qualifies as a 401(k) Roth account. The new rule basically lets 401(k) participants in plans that add this option to convert everything in a traditional 401(k) account, including all pre-tax salary deferrals, at any age, into a Roth 401(k) account. However, any such amount converted to a Roth account must be included in the income of the individual in the year the conversion takes place.