On Jan. 2, 2013, President Barack Obama signed into law a massive tax package designed to help avert the fiscal cliff. Titled the American Taxpayer Relief Act of 2012 (H.R. 8), it makes sweeping changes to income, employment, and estate and gift taxes. These are too numerous to cover properly here, so only selected items will be explained now.
Some tax rules have been made permanent, while others are extended for one, two, or five years. Overall, the act is touted as a tax cut because the 10-year revenue effect is nearly a loss of $4 trillion. However, looking deeper into the act, many taxpayers may find they are paying more. Key changes that were (or were not) made by the act include:
• The reinstatement of the 39.6 percent tax bracket on “high-income” taxpayers. These include single filers with taxable income over $400,000, heads of households with taxable income over $425,000, joint filers with taxable income over $450,000, and married persons filing separately with taxable income over $225,000.
• The expiration of the payroll tax cut holiday. In 2011 and 2012, employees and self-employed individuals had their Social Security tax rate reduced by two percentage points. Thus employees paid 4.2 percent and self-employed individuals paid 10.2 percent on earnings up to the annual wage base. For 2013, employees paid 6.2 percent and self-employed individuals pay 12.2 percent on a wage base of $113,700.
• Estate and gift tax rules have been made permanent, enabling taxpayers to do estate planning with certainty. The top estate tax rate is 40 percent. The exclusion amount is fixed at $5 million, adjusted annually for inflation. For estates of decedents dying in 2012 the exclusion is $5.12 million. For estates of decedents dying in 2013, the exclusion is projected to be $5.25 million. In addition, portability, which is a rule allowing the surviving spouse to add any unused exclusion amount from his/her spouse to his/her own exclusion amount, has been made permanent. Gift taxes have been permanently reunified with estate taxes, so that the top rate on taxable gifts is 40 percent and the lifetime gift tax exclusion amount is the same as the estate tax exclusion amount.
As part of the president’s promise to make high-income taxpayers pay their “fair share,” the top rate on capital gains and qualified dividends has been raised along with the rate on ordinary income. Most taxpayers will see no difference in the taxation of long-term capital gains and qualified dividends. Thus, taxpayers in the 10 percent or 15 percent tax bracket pay zero tax on such income. Taxpayers in the 25 percent, 28 percent, 33 percent, and 35 percent tax brackets pay 15 percent on such income. However, taxpayers in the new 39.6 percent tax bracket will pay 20 percent on such income starting in 2013 (Code Sec. 1(h)).
The 20 percent rate applies to single filers with taxable income over $400,000, heads of households with taxable income over $425,000, joint filers with taxable income over $450,000, and married persons filing separately with taxable income over $225,000.
The hike in the top tax rate on capital gains and qualified dividends does not impact the rates that apply for certain other purposes. Thus, the 25 percent rate continues to apply to certain depreciation recapture, and the 28 percent rate to collectibles gains and the non-excludable portion of gains from the sale of Sec. 1202 stock.
The act extends for two years (2012 and 2013) the opportunity for taxpayers in any tax bracket to create tax-free capital gains on the sale of small business stock. As a result of the act, the 100 percent exclusion applies to stock acquired in 2012 and 2013 as long as the stock is held for more than five years. The exclusion only applies to “qualified small business stock” (Code Sec. 1202). The corporation must have gross assets below set limits and operate within certain industries, such as technology, manufacturing, retailing, and wholesaling.
Alternative Minimum Tax
Individuals who successfully reduce their regular income taxes through exclusions and deductions may find themselves subject to the alternative minimum tax (AMT) (Code Secs. 55 through 59). The problem with the AMT was the fact that the exemption amount was not indexed annually for inflation. Thus, as tax rules for regular taxes were adjusted for inflation each year, thereby helping to cut the regular tax, an increasing number of filers found that they were subject to the AMT.
Each year, Congress had to pass a law to raise the exemption amount in order to keep approximately 25 to 30 million taxpayers from owing this tax. Many had advocated that this tax be eliminated entirely, but the cost of doing so was too great. Instead, Congress adopted indexing for the AMT exemption amount. Even so, the Joint Committee on Taxation estimates that the 10-year revenue effect will be a loss of $1.815 trillion.
This change eliminates uncertainty for individuals and enables them to do tax planning with the AMT in mind.
As a result of the act, the exemption amounts for 2012 (and 2013) are:
• Singles and heads of households: $50,600 ($51,900)
• Joint filers and surviving spouses: $78,750 ($80,750)
• Married persons filing separately: $39,375 ($40,375)
The act did not change any of the other basic rules for the AMT. This means that the two tax rates of 26 percent and 28 percent continue to apply. Similarly, the adjustments and tax preference items included in the AMT computation have not been changed.
The act also made permanent the rule allowing personal nonrefundable tax credits to be used as an offset to the AMT. This means such tax credits as the dependent care credit, the nonbusiness energy credit, and the adoption credit can be used to reduce or eliminate AMT liability.
Looking ahead, individuals potentially subject to the AMT will be able to take appropriate actions. For example, there is no tax savings from accelerating state and local tax payments otherwise due in 2014 into 2013 if the AMT will apply; such taxes are nondeductible. Timing the exercise of incentive stock options (ISOs) is important and, in light of the certainty about the exemption amount, possible.
Return of Pease and PEP
For 2010 through 2012, there was no limit on the amount of itemized deductions and personal exemptions that individuals could claim on their returns. Starting in 2013, this changes. High-income taxpayers are now subject to limitations on these write-offs.
Pease Limitation. Starting in 2013, there is an overall limit on itemized deductions (Code Sec. 68). This means that itemized deductions (with exceptions listed below) are reduced by 3 percent of the amount exceeding the applicable threshold. Named after Congressman Donald Pease, who sponsored the cap in Congress, the Pease limitation cannot reduce itemized deductions by more than 80 percent. The threshold varies with filing status. For 2013, the applicable thresholds are:
• Singles: $250,000
• Heads of households: $275,000
• Joint filers and surviving spouses: $300,000
• Married persons filing separately: $150,000
The limitation has been made permanent. Each year, the applicable thresholds will be adjusted for inflation.
Itemized deductions that are not subject to the Pease limitation are:
• Medical expenses
• Investment interest
• Casualty and theft losses
• Gambling losses
The Pease limitation is likely to impact charitable giving because the deduction for donations can be impacted. It remains to be seen how much of an effect the limitation will have in 2013 and in the future.
PEP Limitation. For 2013, it is expected that the personal and dependency exemption amount will be $3,900. While there is no cap on the number of exemptions that can be claimed, starting in 2013, there is an overall cap that can reduce or completely eliminate a deduction for exemptions (Code Sec. 151). The personal exemption phase-out (PEP) begins to apply when adjusted gross income exceeds a threshold amount applicable to the taxpayer’s filing status. The same threshold amounts for the Pease limitation apply as well to the PEP.
IRA Transfers to Charity
Individuals age 70½ or older can make direct transfers of IRA funds up to $100,000 to public charities without paying tax on these distributions. This break had expired at the end of 2011. The act extends it for 2012 and 2013.
Because of the late enactment, many IRA owners in this age group took their annual required minimum distributions (RMD) in order to avoid the 50 percent penalty even though they may have preferred to transfer the RMDs directly to their favorite charitable organization. The act provides some relief to those who act quickly:
• Re-characterize distributions made in January 2013 as having been made on Dec. 31, 2012.
• Treat distributions from IRAs made to the owner in December 2012 as a direct transfer as long as the owner transfers the funds to a charity before Feb. 1, 2013. Distributions made before December 2012 (e.g., distributions taken in November 2012) do not qualify for this relief.
The act makes numerous other changes for individuals and businesses. Over time, IRS guidance on these changes will help taxpayers take full advantage of tax-saving opportunities presented by the new law.
Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink, consulting editor to CCH, author and lecturer.