In January, Congress passed the American Taxpayer Relief Act of 2012. While the ATRA averted going over the "fiscal cliff," it presents many tax law changes that could have a tremendous impact on family law clients. For example, let's consider a hypothetical divorced couple, Jim and Mary, with the following scenario:
• Jim earns $600,000 per year and Mary earns $50,000 per year.
• Jim and Mary reside in Philadelphia.
• Jim and Mary each have portfolio interest, dividends and income subject to long-term capital gains tax.
• Jim pays Mary alimony of $100,000 per year.
Because of various aspects of the ATRA, the husband's total state and federal tax for 2013 will increase by approximately 10 percent compared to 2012.
Why did this tax increase occur? This article addresses some of the reasons for the increased tax burden that will be felt by many of our clients.
Change in Ordinary Tax Rates
The ATRA added a higher tax bracket of 39.6 percent for single and head-of-household filers. While the other tax brackets remain substantially unaffected, the new 39.6 percent bracket was created at the expense of the 35 percent bracket. Because of a narrowing of the income range to be included in the 35 percent bracket, that bracket includes significantly fewer taxpayers now than it did prior to the existence of the ATRA.
Payroll Tax Holiday
In 2011 and 2012, the payroll tax holiday reduced an employee's share of old age, survivors and disability insurance from 6.2 percent to 4.2 percent up to the Social Security wage base of $110,100. As part of the ATRA, the payroll tax holiday ended. Additionally, the Social Security wage base increased to $113,700 in 2013. So, beginning January 1, a taxpayer earning $113,700 pays $7,049 per year in Social Security taxes, versus $4,624 that he or she would have paid in 2012 on $110,100 of earnings. The payroll tax holiday expiration and the increase in the Social Security wage base account for an increase of $2,425 in taxes in 2013.
Capital Gains Rate Changes
As part of the ATRA, the tax rate on long-term capital gains and qualified dividends has increased from 15 percent to 20 percent for single individuals with taxable income greater than $400,000. Single taxpayers with income in the 15 percent income bracket up to the $400,000 threshold continue to be taxed at the 15 percent rate.
Medicare Tax on Portfolio Income
Effective January 1, there is an additional 3.8 percent Medicare tax on net investment income. This tax is calculated by multiplying the 3.8 percent tax rate by the lower of the following two amounts:
• Net investment income (which includes nonbusiness income from interest, dividends, annuities, royalties, rents, capital gains and pass-through income from passive businesses).
• Modified adjusted gross income over the $200,000 threshold for single filers.
It is important to note that net investment income does include capital gains on the sale of a residence (to the extent of gain realized in excess of any exclusion on the principal residence). As a result, the federal tax rates on long-term capital gains range from 18.8 percent to 23.8 percent.
A tax tip: Taxable alimony can trigger Medicare tax on portfolio income.
High-Income Medicare Tax
For the first time in history, employers are required to withhold an additional 0.9 percent Medicare tax on employees earning greater than $200,000 per year. This represents the imposition of a tax that we have never seen before and is new to all of us.
Personal Exemption Phase-Out
The PEP may be considered a "hidden" tax increase, as it reduces the tax benefits for high-income earners. The PEP reduces the value of each personal exemption from its full value by 2 percent for each $2,500 or part thereof, depending on one's filing status. The starting adjusted gross income (AGI), adjusted for inflation, and the projected AGI for complete phase-outs are $250,000 and $375,000 for single filers and $275,000 and $400,000 for heads of households.
A tax tip: If the paying spouse's income is too high, consider the assignment of the personal exemption for the child(ren).
Phase-Out of Itemized Deductions
In addition to the PEP, high-income taxpayers once again face a limitation on itemized deductions. This limitation cuts itemized deductions by 3 percent of AGI above specified thresholds, but not by more than 80 percent. The income threshold, indexed for inflation, is $250,000 for single filers and $275,000 for heads of households. Both the PEP and the phase-out of itemized deductions result in an increased effective tax rate.
A tax tip: Taxable alimony can result in a phase-out of a portion of your itemized deductions.
Alternative Minimum Tax Patch
The AMT has been "permanently" patched by the ATRA. The exemption amount for single filers is $50,600, permanently indexed for inflation.
A tax tip: Certain tax planning can reduce the impact of the AMT.
Estate and Gift Tax Laws
Under the ATRA, the estate and gift tax exemption amount will stay at $5 million, indexed for inflation. For 2012, the exemption was $5.12 million, and the exemption for 2013 is now $5.25 million. Without this adjustment in the exemption, the exemption amount would have reverted back to $1 million. Although the exemption increased, the maximum federal estate tax rate was increased to 40 percent from the 35 percent rate in 2012.
Because of the expected reversion of the gift tax exemption to $1 million and the expectation of increased personal taxes in 2013, many taxpayers accelerated gifting in 2012 to utilize the higher exemption amount and shifted income into 2012 from 2013 to benefit from lower tax rates.
In preparation for going over the cliff, many clients may have engaged in significant financial transactions during 2012, thereby creating an "income bulge." We can expect that divorce clients may have accelerated income and transferred assets in order to take advantage of the 2012 tax rates and gift tax exemption. Specifically, some areas in which we are likely to observe abnormal activity include:
• Acceleration of long-term capital gain transactions (including the sale of a primary residence).
• Acceleration of dividends.
• Conversion of traditional IRAs to Roth IRAs.
• Acceleration of cash bonuses.
• Nondeferral of income.
• Opting out of installment sales.
• Large tax overpayments.
• Consumption of capital loss carryovers.
• Gifting activity.
• Establishment of trusts as part of estate planning.
In reviewing clients' tax returns going forward, we need to be cognizant of both the direct and reverse impact of the income bulge. Inflated numbers may serve as ammunition for spouses seeking higher spousal support and alimony, while these amounts may be unsustainable for the payer spouse. Additionally, as a result of accelerated income in 2012, we expect to see less income for the 2013 tax year.
The tax law changes may present challenges for cases that have previously settled, and they will raise new questions and require new thought processes going forward. We anticipate facing many questions and challenges as a result of the potential income modification and transfer of assets that occurred in 2012 among divorcing couples. In drafting future settlement agreements, be mindful of year-over-year tax return changes from 2011 to 2012 and the possible 2012 income bulge.
The ATRA tax changes can affect existing settlement agreements and the interpretation of provisions in both previously executed and future agreements. These changes could have a significant impact on equitable distribution scenarios as well as alimony obligations that are paid over a number of years.
Megan Gilberg and Henry Guberman are both members of ParenteBeard's forensic, litigation, and valuation services group. Gilberg is a manager and Guberman is a partner.