The recent agreement to avert the "fiscal cliff," known as the American Taxpayer Relief Act of 2012 (the "Act"), makes a number of changes — including extending certain Bush-era tax provisions, — for taxpayers under certain thresholds. While the general news media has simplified the new rules as extending Bush-era tax cuts for single taxpayers with adjusted gross incomes ("AGIs") of $400,000 or less and for married taxpayers, who file jointly with AGIs of $450,000 or less ("higher income taxpayers"), the new rules are actually significantly more complex than that. The $400,000/$450,000 threshold applies for determining the cut-off for the new, higher 39.6 percent tax on ordinary income; however, different thresholds apply to the phase-out of exemptions and the partial phase-out of itemized deductions. Further, taxpayers will still be subject to the new 3.8 percent Medicare Surtax, if certain different thresholds are met (which is not part of the Act, but which is addressed below), and the temporary 2 percent reduction in FICA and self-employment tax is eliminated.
The Act makes permanent the special treatment of "qualified dividends," which will be taxed at the capital gains tax rate of the taxpayer, although higher income taxpayers will be denied qualified dividends treatment. The Act also makes permanent the top long-term capital gains rate of 15 percent for most types of capital gains, except higher income taxpayers will be subject to a top long-term capital gains rate of 20 percent for most types of capital gains.
Most the provisions under the Act are "permanent," with automatic "sunsetting," which has been common in recent tax legislation. Further, the most important thresholds under the Act are indexed for inflation. The general absence of sunsetting (except in the case of bonus depreciation, the look-through rule for controlled foreign corporations ("CFCs") and certain other areas) and the indexing of thresholds for inflation are welcome improvements over recent tax legislation.
In addition to the changes impacting individuals, the Act contains the extension of certain taxpayer-favorable corporate law provisions, including the extension of the look-thru rule for CFCs, the extension of the shortened 5-year recognition period for S corporation built-in gains tax, the extension of the New Markets Tax Credit, the extension of 15-year depreciation for certain leasehold improvements, and the extension and expansion of bonus depreciation.
This summary addresses the most important provisions contained in the Act. Because a large number of provisions are addressed in the Act, readers are advised to consult their tax advisor for advice as to how the Act impacts their particular circumstance.
1. Changes to Rates
The Act provides for the extension of the Bush-era tax rates for single individuals with AGIs of $400,000 or less and individuals who are married and file jointly with AGIs of $450,000 or less. Higher income taxpayers with AGIs over these thresholds will be subject to income tax at a top rate of 39.6 percent.
Long-term capital gains rates remain unchanged for individuals under the $400,000/$450,000 threshold, with the top capital gains rate being 15 percent for those under the threshold and 20 percent for higher income taxpayers. The act retains the taxation of qualified dividends at long term capital gains rates, although for individuals with AGIs above the $400,000/$450,000 threshold, this rate will now be 20 percent, plus the 3.8 percent Medicare Surtax. Capital gains, dividends, and any other income meeting the definition of "investment income" will potentially be subject to the additional 3.8 percent Medicare Surtax, discussed below.
2. Phaseout on Itemized Deductions
For 2010, 2011 and 2012, there was no phaseout of itemized deductions. The Act provides a phaseout for itemized deductions for single individuals with AGIs that are more than $250,000 and married individuals, who file jointly, with AGIs exceeding $300,000. Itemized deductions are phased out by 3 percent of the amount of the taxpayer's income exceeds the applicable threshold, up to a maximum phaseout of 80 percent of the itemized deduction. These thresholds will be indexed for inflation, beginning in 2014.
3. Phaseout of Exemptions
The Act also reinstates the phaseout of personal exemptions (the exemption claimed for one's self, spouse and dependents) for individuals who are single with AGIs that exceed $250,000 and for individuals who are married, filing jointly, with AGIs that are more than $300,000. Individuals with AGIs under these thresholds are entitled to the full exemption amount.
4. Elimination of Temporary Reduction in Wage Tax
The Act eliminates the temporary reduction of the employee's FICA contribution from 6.2 percent of wages to 4.2 percent, returning the rate to 6.2 percent, with a corresponding increase in self-employment tax. This increase will impact all wage earners and self-employed individuals.
5. New 3.8 percent Medicare Surtax on Investment Income
The new 3.8 percent Medicare Surtax went into effect on Jan. 1. This Medicare Surtax was not part of the Act, and, contrary to its name, the revenue generated from this tax is not earmarked for Medicare. The tax applies to investment income if the sum of net investment income and modified adjusted gross income exceeds $200,000 for single taxpayers or $250,000 for taxpayers who are married, filing jointly. The Medicare tax does not apply to income from an active trade or business or rental income from a Schedule E real estate rental activity, even if the real estate rental activity is passive.
The 3.8 percent Medicare Surtax applies to "net investment income," which is income from interest, dividends, annuities, royalties and rents, other than such income derived in the ordinary course of an active trade or business ("investment income") netted against investment deductions. The Medicare Surtax also applies to net gain, including capital gains, to the extent that such gains are not derived in the ordinary course of an active trade or business. Significantly, the sale of business assets used in an active trade or business are not subject to the Medicare Surtax. The Medicare Surtax does not apply unless the modified AGI of the taxpayer exceeds the $200,000/$250,000 threshold mentioned above.
The Medicare Surtax does not apply to wages, income from the exercise of compensatory options, income from the vesting of restricted stock and retirement plan distributions from: (i) an IRA, (ii) a Roth IRA, (iii) a qualified pension, profit sharing or stock bonus plan, (iv) a qualified annuity plan, annuity for employees of tax-exempt organizations or public schools, or (v) the deferred compensation plan of state or local governments and tax-exempt organizations. The 3.8 percent figure is no accident, however, because it attempts to equal the level of Medicare tax that does apply to wages, when combining the 1.45 percent Medicare tax paid by employers and the 1.45 percent Medicare tax paid by employees (or the 2.9 percent Medicare tax paid by self-employed individuals). Under rules that predate the Act, the employee's portion of the Medicare tax increases by 0.9 percent under the new hospital insurance tax for wages in excess of $200,000 for single individuals or $250,000 for married individuals who file jointly, as does the tax on self-employed individuals. Thus, wages and self-employment incomes are not subject to the 3.8 percent Medicare Surtax, but they are subject to tax rates of up to 3.8 percent (i.e., 1.45 percent + 1.45 percent +0.9 percent) for higher income wage earners and self-employed individuals.
6. Permanent Extension of AMT Patch.
The Act permanently extends the AMT (alternative minimum tax) patch, which provides an exemption from AMT for the first $50,600 of income for single individuals and $78,750 for married individuals who file jointly. These AMT exemptions are phased out by 25 percent of the amount that AMT income exceeds $150,000 in the case of taxpayers who are married, filing jointly, and $112,500 in the case of single individuals. These amounts will also be indexed for inflation, starting in 2013.
7. Significant Corporate Provisions.
The Act contains certain other provisions that may be significant to businesses and their owners. Among the key developments are:
- A 2-year extension of the look-through rule for CFCs that, in certain instances, permits the look through to lower-tier CFCs to determine whether income is from an active trade or business or is Subpart F income for years prior to Jan. 1, 2014.
- The extension of the special 5-year recognition period for the built-in gains tax on S corporations that were previously C corporations.
- The extension of the New Markets Tax Credit.
- The extension of the special 15-year deprecation period for certain leasehold improvements.
- The 1-year extension of bonus depreciation for property placed in service prior to Jan. 1, 2014, or for certain longer period production property placed in service prior to Jan. 1, 2015.
The discussion above is an overview of the American Taxpayer Relief Act of 2012 and is not intended as tax advice. Taxpayers should consult their tax advisor with respect to how the provisions of the Act may impact their particular circumstances.
Circular 230 Statement.
Federal Estate, Gift and Generation-Skipping Transfer Tax Changes under the Act
At the end of 2012, taxpayers were faced with the prospect of a $1 million estate and gift tax exemption and a 55 percent estate and gift tax rate for 2013. During 2012, there were a number of proposals that would have provided some relief from the backward slide to the 2001 rates (for example, a $2.5 million exemption coupled with a 45 percent maximum rate). But none of the proposals would have provided the advantages of the $5 million exclusion and 35 percent rate available throughout 2010-2012.
With a good bit of theatrical drama to which the entire nation was a witness, Congress, in the American Taxpayer Relief Act of 2012 (the “Act”), finally passed on Jan. 1, surprisingly retained most of the estate and gift tax benefits available in 2012. Here is summary of the estate and gift tax provisions available under the Act to taxpayers in 2013 and beyond.
- The exemption for estate and gift taxes is permanently retained at $5 million.
- The exemption will continue to be indexed for inflation. The inflation adjusted exemption amount in 2012 was $5.12 million. The 2013 inflation adjusted exemption is projected to be $5.25 million.
- This exemption continues to be “unified,” that is, a taxpayer may use it during his or her lifetime to make gifts, with any balance available at death to be utilized against estate taxes due.
- The maximum estate and gift tax rate is raised from 35 percent to 40 percent.
- The other estate and gift tax provisions from the 2010 act are permanently extended. This includes the concept of “portability,” which permits a surviving spouse to take advantage of the unused exemption of a predeceased spouse. If portability is elected, the surviving spouse can then use both exemptions to make gifts or pass assets through his or her estate. The principal prerequisite to portability is that an estate tax return for the first spouse to die must be filed, indicating that portability is being elected, even if no estate tax is owed.
- Separate and apart from the American Tax Relief Act, the IRS announced in November that the annual gift tax exclusion under Section 2503 of the Code will rise in 2013 from $13,000 to $14,000.
We are happy to discuss the Act and the possibilities for gifting thereunder with any client who may wish to do so.
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