Congress reached a compromise on the tax aspects of the fiscal cliff in the American Taxpayer Relief Act of 2012 (the “Act”), which was passed by Congress on January 1, 2013 and signed into law on January 3, 2013, by President Obama.
How does this compromise impact you?
The Act made permanent the existing rate structure, but increased rates for individuals earning over certain thresholds. Unlike prior law, the provisions of the Act that most affect individual taxpayers—rate changes and estate exemption amounts, for example—were enacted without an expiration date. Alongside this brave new world of stable tax rates, however, exists a separate regime of temporary tax provisions aimed at business—for instance, credits, depreciation schedules, and expensing allowances. Thus, while individual taxpayers should feel more secure in the permanency of these changes, there are still several changes which are fleeting and individuals and businesses should act immediately to take advantage of some of the Act’s tax benefits which are scheduled to sunset.
While the act dealt with several tax provisions, there was no agreement on the corporate tax rates or the spending cuts scheduled under the sequester. These provisions will hopefully be addressed when Congress faces the sequester deadline on spending cuts which was only extended for 2 months under the Act.
Here is a brief summary of some of the tax changes under the Act.
Top Estate and Gift Tax Rate Increased: Under the Act, the top estate and gift tax rate increases from 35 percent to 40 percent. The recently added provision of portability — a surviving spouse’s ability to use his or her spouse’s unused estate and gift tax lifetime exclusion — has now been made permanent, and advisors should remember to review this on the first spouse’s death as an estate tax return must be filed in order to claim portability. Additionally, the estate and gift tax exemption amounts remain the same (several proposals recommended a return to the pre-2010 decoupling where the gift tax remained at $1.0m). The $5 million, inflation-indexed exclusion enacted for taxable years 2011 and 2012 will remain in place. Unlike prior Acts, none of these changes are subject to expiration or “sunset” provisions.
Top Individual Tax Rate Increased: The current 10-, 25-, 28-, and 33-percent tax brackets (including the marriage penalty relief) will remain in place under the new law, and the 35-percent bracket will remain for a certain amount of taxable income. However, income above the “applicable amount”—that is, $450,000 for married couples filing jointly, $400,000 for single filers, or $425,000 for heads of household—will pay tax on 39.6 percent of their income above the applicable amount.
Qualified Dividends did not expire and were retained in this Act rather than reverting to the ordinary income tax rates. However, individuals with income over the applicable amount will be subject to a higher marginal rate for income from long-term capital gains and qualified dividends. Though the 2012 rate structure of 0-, 10-, and 15-percent brackets will remain in place, individuals with income above the applicable amount will pay tax at a rate of 20 percent on long-term capital gains and qualified dividend income.
Keep in mind that some taxpayers are subject to a 3.8% surtax on their investment-type “unearned” income starting in 2013—taxpayers filing jointly with over $250,000, married taxpayers filing singly with over $125,000, or single filers with over $200,000 are subject to this surtax. The application of the surtax to the new rates will result in overall tax rates of 18.8 and 23.8 percent on dividends and long-term capital gains.
All rate changes are permanent and not subject to change without additional congressional action.
Deductions For Top Brackets: The law reinstates two major limitations on the deductions. First, a personal exemption phaseout (PEP) will apply to taxpayers earning at least $300,000 (married filing jointly), $275,000 (heads of household), or $250,000 (individual filers). The PEP reduces the amount of allowable personal exemptions by 2% for every $2,500 of income the taxpayer has above the threshold amount. So, for example, married taxpayers with $310,000 of income must reduce their personal exemptions by 8% of the original overall amount of those exemptions.
The second major limitation, known as the “Pease limitation,” limits the amount of deductions that may be taken by taxpayers who itemize their deductions. Under the Pease limitation—which will only apply to those taxpayers with sufficient income to be subject to the PEP—3% of all itemized deductions above the threshold amount (as set forth in the preceding paragraph) will be disallowed. However, another provision caps the Pease phase-out at no more than 80% of all itemized deductions taken by the taxpayer. Married taxpayers filing a joint return with income of $350,000 must therefore reduce their itemized deductions by $1,500. Both the Pease limitation and the PEP are in effect indefinitely.
Permanent AMT Patch Enacted: Congress finally made permanent the Alternative Minimum Tax patch by creating an inflation-indexed exemption amount of $50,600 for single filers and $78,750 for married couples filing jointly. The law is applicable indefinitely.
Non-taxable IRA Distributions to Charity Extended: The new law provides that for individuals greater than 70 ½ years old, IRA distributions to charities of up to $100,000 may be made on a tax-free basis. This provision applies for the 2012 and 2013 taxable years. Distributions made in January 2013 or charitable contributions of 2012 MRD made in January 2013 may be counted as 2012 charitable IRA rollovers.
Above-the-Line Education Expense Deductions Extended: The new law extends the above-the-line deduction of qualified education expenses through the end of 2013. This allows for a maximum deduction of $4,000 for individuals with AGI of $65,000 or less and a maximum deduction of $2,000 for those with AGI of $80,000 or less (these amounts are doubled for joint returns).
Payroll Tax Cut Not Extended: Congress declined to extend the two-year payroll tax cut, which stood at 4.2% for 2011 and 2012. For 2013 and beyond, the payroll tax withholding returns to 6.2%.
Option to Deduct State and Local Sales Taxes Reinstated: Under the new law, taxpayers itemizing deductions may choose whether to deduct from income their state and local sales taxes or their state and local income taxes. This provision lasts through the end of 2013 and applies retroactively to the 2012 taxable year.
Section 179 Deduction Amounts Liberalized: The new law extends, for 2013 and retroactively for 2012, the liberal section 179 deductions from the past several years. The maximum amount that may be expensed under section 179 for these two years is $500,000, while the phase-out amount begins at $2 million. These provisions expire at the end of 2013 and will revert to prior levels of a maximum section 179 deduction of $25,000 and phase outs beginning at $200,000 of investment.
Energy Industry Tax Breaks Extended: The domestic wind energy production credit was extended, covering wind energy projects that have begun construction by the end of 2013. Additionally, the Mine Rescue Team Training credit of up to $10,000 and the expensing of 50% of the cost of advanced mine safety equipment were both extended retroactively to apply to taxable years 2012 and 2013.
Bonus First-Year Depreciation Allowance Reinstated: A first-year depreciation allowance of 50% of the basis of qualifying depreciable property was extended for certain property purchased and placed in use prior to January 1, 2014 (or January 4, 2015 for certain long-lived properties).
Reduced S Corp Recognition Period for Built-in Gains Extended: The new law provides that for taxable years 2012 and 2013, the recognition period for an S Corp is the 5-year period beginning with the first day of the first tax year in which the company was an S Corporation. This provision is set to expire at the end of 2013. Past recognition periods have been 7 or 10 years.
Robert Tweel is the attorney responsible for the content of this article.