The much-publicized “fiscal cliff” that was looming over the new year involved both the expiration of the Bush-era tax cuts for most taxpayers and mandatory spending reductions that would have resulted in draconian cuts across the federal budget. The country avoided going over the fiscal cliff, at least on a temporary basis, by a deal between U.S. Congress and the president that made permanent most of the Bush-era tax cuts except those applicable to high-income individuals and by deferring the consideration of expense reductions for several months. The tax provisions of this agreement are contained in the American Taxpayer Relief Act of 2012, which was signed by President Obama on January 2.
Under the act, for tax years beginning after 2012, the income tax rates for most individuals will remain at 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent, as originally enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). However, the act provides that the highest marginal income tax rate for individuals will revert to the pre-EGTRRA rate of 39.6 percent for those individuals with taxable income in excess of $400,000 per year ($450,000 for married couples filing jointly). These thresholds will be indexed for inflation after 2013. The maximum tax rate for qualified dividends and long-term capital gains will increase from 15 percent to 20 percent but only for individuals in the new highest tax bracket. The tax rates of 28 percent and 25 percent on gains arising from the sale of collectibles and from the recapture of straight-line depreciation continue unchanged after 2012.
In reality, beginning in 2013, high-income taxpayers will pay an effective tax rate of 23.8 percent on their qualified dividends and long-term capital gains (both long-term and short-term) and 43.4 percent on short-term capital gains and other forms of investment income. This higher effective tax rate is the result of the Patient Protection and Affordable Care Act, enacted in 2010, that requires high-income taxpayers to pay an additional tax of 3.8 percent on net investment income. This tax, contained in new Internal Revenue Code Section 1411, is imposed on the lesser of the taxpayer’s net investment income or the amount by which the taxpayer’s adjusted gross income exceeds certain thresholds ($200,000 for singles/$250,000 for married couples filing joint returns). For purposes of this tax, net invested income includes capital gains and gross income from interest, dividends, annuities, royalties and rents together with gross income derived from a trade or business, which is a “passive activity” with respect to the taxpayer. Moreover, commencing in 2013, the Affordable Care Act also imposes an additional Medicare hospital insurance tax equal to 0.9 percent of any wages or income from self-employment in excess of the $200,000/$250,000 thresholds described above.
Although most of the tax increases under the act will be imposed only on high-income taxpayers, all wage earners and self-employed individuals will incur a tax increase in 2013 since the act did not extend beyond the 2012 Social Security tax “holiday” that reduced the employee portion of the Social Security tax from 6.2 percent to 4.2 percent and the tax on self-employment income by the same amount. This “holiday” was originally contained in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010.
In addition to increasing the maximum tax rates for high-income taxpayers, the act also contains a number of other income tax provisions for individuals, including the following:
• The act contains a permanent “patch” for the alternative minimum tax for 2012 and subsequent years by increasing the alternative minimum tax (AMT) exemption amount for 2012 to $50,600 for singles and $78,750 for married couples filing jointly (the exemption amounts are indexed for inflation and are projected to be increased to $51,900 and $80,750, respectively, for 2013). In addition, the act permanently allows an individual to use certain nonrefundable personal tax credits to fully offset the taxpayer’s AMT liability.
• The act reinstates a limitation on the use of itemized deductions by high-income individuals that had also been phased-out under EGTRRA. This provision reduces the total amount of a taxpayer’s otherwise allowable itemized deductions by 3 percent of the amount by which the taxpayer’s adjusted gross income exceeds an applicable threshold ($250,000 for singles/$300,000 for married couples filing jointly). However, the amount of itemized deductions cannot be reduced by more than 80 percent and certain deductions, such as medical expenses, investment interest expense and casualty, theft or wagering losses, are excluded from the limitation.
• The act restores the phase-out of the personal exemption for high income taxpayers. Under the act, the total amount of personal exemptions that may be claimed by taxpayers is phased-out to the extent adjusted gross income exceeds certain threshold levels ($250,000 for singles/$300,000 for married couples filing jointly).
• The act makes permanent the provisions contained in EGTRRA that eliminated the “marriage penalty” whereby a married couple could pay higher income taxes than they would have paid if they were not married and filed separate returns. Other “family friendly” provisions in the act make permanent the $1,000 child tax credit and the 35 percent dependent care credit for eligible expenses incurred for the care of children under age 13 and disabled dependents. The act also extends through December 31, 2014, and retroactive to January 1, 2012, the ability to deduct qualified tuition and related expenses for higher education, subject to adjusted gross income and dollar limitations.
• The act extends, retroactively to 2012, the ability of taxpayers who are age 70-and-a-half or older to make a tax-free distribution to a charity from an IRA, up to $100,000 per year. Such distributions are not included in the taxpayer’s gross income and are not subject to any limitation on charitable deductions. This provision otherwise expired on December 31, 2011.
In addition to changes in the income tax provisions of the Internal Revenue Code, the act also made certain changes to the estate and gift tax provisions. The act retains the $5 million unified exemption for estates of decedents dying after December 31, 2012, and for taxable gifts made after December 31, 2012. The act provides that the $5 million exemption will be indexed for inflation. However, the act does increase the top tax rate for taxable estates and gifts to 40 percent (from 35 percent).
The act makes permanent the “portability” aspect of the estate tax exemption, which allows the estate of a surviving spouse to apply any unused exemption remaining from the estate of the first spouse to die. The act also makes permanent the deductibility of state death taxes in the calculation of the federal estate tax and also makes permanent a variety of generation skipping transfer tax provisions that were otherwise scheduled to expire on December 31, 2012.
Although most of the act focuses on individual tax provisions, the act does contain several business tax provisions. Most significantly, the act extends through 2013 the enhanced small business expensing provisions contained in Code Section 179 and similarly extends 50 percent bonus depreciation.
Under Code Section 179, businesses are allowed to currently expense the cost of tangible personal property used in a trade or business rather than having to amortize the cost of such property over the property’s useful life. Under the act, retroactive to January 1, 2012, a business can elect to deduct up to $500,000 of the cost of new tangible property with that limitation reduced, on a dollar-for-dollar basis, to the extent that the taxpayer’s total annual aggregate purchases of such property exceed $2 million. After 2013, the annual expense limitation will be reduced to $25,000 and the aggregate annual investment limitation will be reduced to $200,000.
As an alternative to expensing the purchase of tangible personal property under Section 179, or to the extent Section 179 is not available (i.e., for larger businesses), Code Section 168(k) allows taxpayers the opportunity to claim “bonus” depreciation equal to 50 percent of the purchase price of tangible personal property used in a trade or business in the year the property is purchased and first placed in service. This provision was set to expire as of December 31, 2012, but has been extended for one year through 2013.
Congress and the president failed to reach a “grand bargain” on either comprehensive tax reform or meaningful spending cuts. Rather, the decision was made to avoid the fiscal cliff by enacting selective tax increases for high-income taxpayers, saving the prospect of tax reform and spending cuts for another day. Those tax provisions contained in the act, coupled with the tax provisions contained in the Affordable Care Act that are also effective for 2013, will significantly increase income taxes for high-income individuals. •
Mark L. Silow is the firmwide managing partner of Fox Rothschild. He formerly was chairman of the firm’s tax and estates department. His work involves a broad range of commercial and tax matters, including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits