A Primer on What the Compromise Means for All TaxpayersAfter much back-and-forth negotiation — fraught with the possibility of a deadlock and failure — the terms of a fiscal-cliff resolution have finally been successfully negotiated.
Early on Jan. 1, the Senate, by an overwhelming vote of 89 to 8, approved H.R. 8, the “American Taxpayer Relief Act.” Late the same day, the House of Representatives followed suit and passed the bill by a vote of 257 to 167. The President quickly signed and enacted the bill into law on Jan. 3.
Understand that the American Tax Relief Act is nowhere close to the sweeping legislation envisioned by the president after the November election. It is effectively a stopgap measure to prevent the onus of the expiration of the Bush-era tax cuts from falling on middle-income taxpayers. The Budget Control Act of 2011 imposed sequestration (across-the-board spending cuts), effective after 2012. The American Taxpayer Relief Act temporarily postpones sequestration for two months. Congress is likely to revisit tax policy and spending cuts when it tackles the expected increase on the nation’s debt limit in February.
The American Taxpayer Relief Act of 2012 makes permanent for 2013 and beyond the lower Bush-era income-tax rates for all, except for taxpayers with taxable income above $400,000 or $450,000, depending on tax-filing status. Income above these thresholds will be taxed at 39.6%.
While this means that the federal tax-payroll withholdings for most taxpayers will not be changing, nevertheless, all taxpayers will find less in their paycheck in 2013. The tax relief act effectively raises taxes for all wage earners (and those self-employed) by not extending the 2012 payroll-tax holiday that reduced the OASDI part of Social Security taxes from 6.2% to 4.2% on earned income up to the Social Security wage base of $113,700 for 2013.
While the individual marginal tax rates of 10%, 15%, 25%, 28%, 33%, and 35% will remain, for those individuals with income above the $400,000/$450,000 threshold, the bracket ranges for the 35% rate now cover only a relatively small sliver of what constituted the upper-income range. On the positive side, taxpayers who find themselves in this higher 39.6% tax bracket will continue to benefit from the extension of the Bush-era rates below the 39.6% amount.
The American Taxpayer Relief Act also extends the beneficial Bush-era tax rate of 15% for capital gains and dividends. However, these same taxpayers will find themselves subject to a higher capital-gains and dividends rate of 20%, up from the previous 15%. All others will continue to enjoy the old, preferential rates, including the zero-percent rate, if their total income does not exceed the 15% bracket. Installment payments received after 2012 are subject to the tax rates for the year of the payment, not the year of the sale.
Also effective for 2013 and later is the Patient Protection and Affordable Care Act’s (PPACA, better known as Obamacare) 3.8% additional tax on net investment income for taxpayers with taxable income exceeding the thresholds of $200,000 or $250,000, depending on filing status. Therefore, starting in 2013, capital gains for these high-income taxpayers will effectively become 23.8%. In anticipation, many taxpayers completed transactions in 2012 to benefit from these lower rates. If any of these transactions are eligible for installment reporting, careful consideration should be given to the effect of such an election.
Short-term capital gains remained taxed at the ordinary income marginal rates. The 28% and 25% rates for certain long-term gains also remain unchanged.
The American Taxpayer Relief Act ‘patches’ the alternative minimum tax (AMT) for 2012 and subsequent years by increasing the exemption amounts and allowing non-refundable personal credits to the full amount of the individual’s regular tax against AMT. Without the patch, the AMT exemption amounts for 2012 would have been significantly reduced as compared to 2011. This patch saves more than 60 million taxpayers from being subject to AMT on returns filed in 2012.
The American Taxpayer Relief Act officially revives the phaseout of itemized deductions and personal exemptions for higher-income taxpayers. This phase-out, known as the ‘Pease’ limitation, was eliminated by the 2010 Tax Relief Act. However, its return will impact fewer taxpayers since the thresholds have increased to $300,000 for married taxpayers and $250,000 for single taxpayers. These thresholds are approximately 165% of the inflated thresholds under the previous sunset rules.
In summarizing the phaseout thresholds for the various changes, you should note that, in almost all cases, if a married couple elects to file separately, most of the thresholds are cut to one-half of the higher married threshold, which is lower than the stated single thresholds.
The recently passed legislation retained the $5 million exclusion for decedents dying after Dec. 31, 2012 and permanently provides for a maximum tax rate of 40%. Of course, ‘permanent’ is a very relative term.
Also retained and made permanent is the ‘portability’ between spouses. This allows a surviving spouse to use any unused exclusion of their previously deceased spouse. These rates and exclusions apply to gifts made after Dec. 31, 2012 as well.
Other noteworthy extensions for individual income tax payers include:
• Permanently extending the $1,000 per-child tax credit, subject to comparable phase-out provisions;
• Earned-income credit provisions in the Bush-era and subsequent legislation are extended through 2017, while some provisions are made permanent;
• Adoption credit/assistance provisions were extended permanently, subject to comparable phase-out provisions;
• The child and dependent-care credit amounts and expenditure caps from Bush-era enhancements are permanently extended;
• The American Opportunity Tax Credit for qualifying tuition was extended through 2017, subject to comparable phaseout provisions;
• Provisions related to above-the-line tuition deductions and certain student-loan interest deductions have been extended;
• The teacher classroom-expense deduction for up to $250 was extended through 2013;
• The exclusion from income of up to $5,250 of qualifying, employer-provided education assistance was extended permanently; and
• Tax-free distributions of up to $100,000 (per taxpayer, per year) to charities from IRAs by individuals over age 70 1/2 was extended through Dec. 31, 2013.
Many popular but temporary tax extenders relating to businesses are also included in the American Taxpayer Relief Act. Among them is Code Section 179 small-business expensing, research credit, and the Work Opportunity Tax Credit.
The American Taxpayer Relief Act extends through 2013 the enhanced $500,000 Code Section 179 dollar limitation for 2012 and 2013. The rule allowing off-the-shelf computer software is also extended. Also extended is the 50% bonus depreciation through 2013; the limitation was previously set at $139,000 for 2012 and $25,000 for 2013.
The act extends through 2013 the Research Tax Credit. This credit had expired at the end of 2011, but continues to enjoy bipartisan support in Congress, and President Obama has called for making the credit permanent.
The measure also extends through 2013 the Work Opportunity Tax Credit, which rewards employers that hire individuals from targeted groups with a tax credit.
Many other business provisions and credits with extremely narrow application were also extended through 2013. Perhaps the most notable is the reduced recognition period of five years for S corporations with built-in gains.
To properly evaluate how this tax act affects you or your business individually, you should consult with your tax adviser. However, you should keep in mind that, since the passage of the 2010 Tax Relief Act, several proposals for comprehensive tax reform have been unveiled in Washington that may hold promise for a more permanent solution.
For example, a presidential panel developed the so-called Simpson-Bowles plan. Also, the GOP has put forward several proposals for comprehensive tax reform, also calling for reduced individual income-tax rates, while both parties struggle to strike a grand bargain.
Later in 2013, a broader, more permanent solution may be found.
Kristina Drzal-Houghton, CPA MST is the partner in charge of Taxation at Holyoke-based Meyers Brothers Kalicka, P.C.; (413) 536-8510.