2012 Taxpayer Relief Act & Tax Outlook for 2013
I. Overview of Act
On January 2, President Obama signed the American Taxpayer Relief Act of 2012 (the Act) into law, averting automatic tax increases. A bipartisan effort, the Act has changed the tax landscape, but not seismically. As expected, the Clinton-era 39.6 percent tax rate was reincarnated and applies to joint filers whose income exceeds $450,000. The existing Bush-era rates for other taxpayers remain unchanged and have been made permanent, thus ensuring no tax increases for 98 percent of taxpayers.
A new 20 percent tax tier will be levied on capital gains and dividend income of taxpayers in the 39.6 percent tax bracket. Itemized deductions of joint filers with income over $300,000 will be phased out. The estate tax seems to have fared best: The lifetime exclusion amount was made permanent at $5 million, and is now indexed for inflation. “Portability” earned its wings and has been made permanent. (See February Comment) Ominous changes in the law affecting estate tax planning failed to materialize. (See IRS Matters).
Congress failed to extend the temporary 2 percent tax holiday on the employee portion of FICA tax, in effect since 2011. The measure to extend the tax break apparently lacked bipartisan support. An employee’s contribution to the Social Security withholding tax will be bumped up 2 percent, to 6.2 percent. For self-employed taxpayers, the FICA rate of 10.4 percent will revert to 12.4 percent. Wages in excess of $113,700 are not subject to FICA. For those earning at least $113,700, the FICA increase will result in $2,274 of additional tax (subject to withholding).
Taxpayers with investment income above certain thresholds will be subject to the new Medicare Surtax of 3.8 percent beginning January 1, 2013. The Medicare Payroll tax is currently 2.9 percent, divided equally between employer and employee. Under the Act, taxpayers whose wages or self-employment income exceeds certain thresholds will now pay an additional 0.9 percent (thereby increasing the employee’s portion to 2.35 percent).
II. Provisions Affecting Individuals
New Medicare Surtax and Medicare Payroll Tax
National Health Care is being funded by increased Medicare taxes, which are expected to yield $318 billion over the next ten years. (See Elder Law Planning: Deciphering the Puzzle). The new 3.8 percent Medicare Surtax is imposed on the lesser of (i) “net investment income” (NII) or (ii) the amount by which modified adjusted gross income (MAGI) exceeds $250,000 for joint filers, and $200,000 for single filers.
Net investment income includes interest, dividends, capital gains, rents, royalties, nonqualified annuities, passive activity income, and income from trading financial instruments or commodities. Expressly excluded from the calculation of net investment income are wages, self-employment income, commissions, bonuses, and tips.
In essence, the top capital gains and “qualified” dividend tax rate for those in the higher income brackets will jump to 23.8 percent, an increase of 58.7 percent from the 2012 rate of 15 percent. Ordinary investment income tax rates will now top out at 43.4 percent. The new 0.9 percent Medicare Payroll Tax apples to wages and self-employment income exceeding $200,000 for single filers, $250,000 for joint filers, and $125,000 for married taxpayers filing separately. The IRS provides the following example:
Assume a single filer earns $180,000 in wages and realizes another $90,000 from NII. The taxpayer’s MAGI is $270,000. In this case, the taxpayer would have to pay a 3.8 percent surtax on $70,000, which is the lesser of $90,000 or $70,000. Since the taxpayer is below the earned income threshold for single filers, the taxpayer would not be subject to the 0.9 percent surtax on wages.
Under new proposed regulations, Treasury confirms that gain not recognized under other Code sections (e.g., installment sales, like-kind exchanges or involuntary conversions, and gain from the sale of a principal residence up to the exclusion amount) will not be subject to the Medicare surtax. The 3.8 percent surtax applies to trusts but not to grantor trusts (although the grantor will pick up the income from grantor trusts). Charitable remainder trusts are not subject to the tax, but beneficiaries may be subject to the tax as NII. The new regulations do not articular how rents are to be treated for purposes of the 3.8 percent tax.
Treasury also warns that taxpayer efforts to manipulate NII in order to avoid the 3.8 percent tax will be challenged based upon “applicable statutes” and “judicial doctrines.”
Phase-out of Itemized Deductions and Personal Exemptions
The Act re-instituted the phase-out limitations on itemized deductions and personal exemptions for high income taxpayers. Although the new provisions are estimated to increase tax liability by only 1 percent, they activate at much lower adjusted gross income thresholds — $300,000 for joint filers and $250,000 for single filers.
Itemized deductions must now be reduced by 3 percent of adjusted gross income, but the phase-out is frozen once 80 percent of itemized deductions have been achieved. The phase-out will adversely affect taxpayers’ ability to deduct common itemized deductions such as home mortgage interest, charitable contributions and state and local income tax payments. However, some itemized deductions will be unaffected: Those include medical expenses, investment interest and gambling losses.
To illustrate, assume taxpayer and spouse have $350,000 of AGI and $50,000 of itemized deductions. Since 3 percent of the amount by which AGI exceeds $300,000 is $1,500, allowable deductions are reduced to $48,500. The new personal exemption phase-out (PEP) reduces the $3,900 personal exemption in effect for 2013 by 2 percent for each $2,500 above the income thresholds. In the example, taxpayers exceed the threshold by $50,000, which results in 20 reductions of 2 percent. Since 2 percent of $3,900 is $78, each spouse will forfeit $1,560 in exemption deductions ($78 x 20), resulting in an allowable personal exemption of $2,340 for each spouse.
Extension of Unemployment Benefits
Congress approved $30 billion in extended unemployment benefits for 2013, preserving assistance for 2.1 million long-term unemployed workers. The measure was not offset by other spending cuts. The extension provides a maximum of 47 weeks of federal benefits. Federal benefits are linked to the jobless rates in individual states and are based on a three-month average. In New York, those unemployed will be able to collect for a maximum of 63 weeks, of which New York funds 26 weeks.
Alternative Minimum Tax
The Alternative Minimum Tax, perennial headache for Congress, necessitating yearly “patches,” may have been patched for good. The exemption amount has now been raised to reflect inflation over the past 40 years, and is now indexed for inflation. The exemption amount applies retroactively to 2012, and is $50,600 for individual filers, and $78,750 for joint filers. All non-refundable personal credits are now allowed to offset AMT tax liability as well as regular tax liability.
Since the AMT tax applies if the tax calculated thereunder is higher than the tax liability calculated without reference to the AMT, a higher exemption means that the application of the AMT is narrowed. Without the legislation, upwards of 28 million taxpayers may have been subject to the AMT for the 2012 tax year.
Other Provisions Affecting Individuals
The Act also (i) allows taxpayers age 70½ or older to directly transfer up to $100,000 from their IRAs to charities without incurring income tax; (ii) extends mortgage-debt relief under IRC §108; (iii) preserves the $4,000 deduction for qualified tuition and related expenses and (iv) the student loan interest deduction.
III. Estate Tax Provisions
The Act retained the $5 million lifetime exclusion, and made it permanent. The exemption amount will be freshened each year, as an inflation adjustment has been included. The inflation-adjusted amount for 2013 is $5.25 million. The Act creates a 40 percent maximum tax rate on gifts, estate and generation-skipping taxes, which rate is higher than the 2012 rate of 35 percent, but lower than the 55 percent rate to which it would otherwise have reverted but for the Act.
Portability allows a couple to effectively shield $10.5 million in assets. However, the GST exemption is not portable. In the event of the death of one spouse and the subsequent remarriage of the other spouse, the surviving spouse will continue to be able to “port” the unused exemption amount of her deceased spouse, unless her new spouse dies, in which case she will be able to use only that new spouse’s unused exemption amount.
The gift tax has been permanently reunified with the estate tax. The annual exclusion amount is also now adjusted for inflation, but in $1,000 increments. The annual exclusion amount for 2013 is $14,000. Congress punted on four areas which are viewed as possible sources of revenue: GRATs, GST Trusts, family entity discounts, and grantor trusts. 2013 would appear to be an excellent year in which to consider taking advantage of some of these planning techniques.
For the past few years, there has been talk of eliminating short-term GRATs, and mandating a minimum 10-year term for such trusts. A proposal to limit the GST exemption to 90 years was made. This would make the GST exemption shorter than the rule against perpetuities, and if enacted would deal a severe blow to dynasty trusts.
Congress has considered eliminating the ability of taxpayers to utilized minority discounts or lack of transferability discounts. However, since the courts have sanctioned the viability of these discounts, their abrogation would be more difficult. It is not even certain that Congress could entirely legislate out of existence these discounts without causing a ripple effect into other areas of the tax law.
Some in Congress have also taken note of the revenue losses occasioned by the use of grantor trusts. The grantor trust provisions of the Code were enacted many years ago to prevent income-shifting. No longer needed to prevent income-shifting, the rules have gained prominence as a planning tool which accomplishes a royal flush in taxation: removal of an asset from the estate without creating an income tax event, and a continued liability of the grantor to pay income taxes which are no longer part of his taxable estate. Congress could conceivably shut this down in the next 5 to 10 years by legislatively overruling Revenue Ruling 85-13, the golden rule which is the wellspring of many estate plans today.
Estate planning, once concerned primarily with the estate tax, is now more focused on income tax aspects. Since no benefit will accrue from claiming deductions for estate tax purposes where the estate is not taxable, practitioners’ attention will turn to deducting these expenses on fiduciary returns. The IRS can be expected to seek revenue from challenging administration expenses under IRC §83.
In addition, the IRS can be expected to challenge efforts by taxpayers to achieve basis step-up through the use of grantor trusts when utilizing portability, by substituting assets of equal value. In essence, the estate tax playing field has changed drastically for the IRS, but the Treasury is not without the ability to enact new measures to prevent a total collapse of tax imposed on generational transfers.
While individuals are not subject to the new 39.6 percent top rate until their income exceeds $400,000, trusts become subject to that tax when income exceeds only $11,950. Trusts may also be subject to the 3.8 percent Medicare surtax, thus resulting in a top rate of 43.4 percent. Trustees can, to a considerable extent, avoid the tax by distributing income to beneficiaries in lower brackets. Alternatively, choosing grantor trust status would also obviate the problem.
IV. Business and Corporate Provisions
Section 179 Expensing & Bonus Depreciation
The Act extended the IRC §179 expensing deduction of $500,000 through the end of 2013 for tangible, depreciable personal property acquired for use in a trade or business as well as “qualified real property.” A phase-out operates to reduce the deduction dollar-for-dollar if the taxpayer places more than $2 million of Section 179 property into service during a taxable year. The Act also extends the 50 percent bonus depreciation allowed under IRC §168(k).
Section 1374 Built-in-Gains Relief Extended Through 12/31/2013
IRC §1374 applies if, during the recognition period, a C corporation converts into an S Corporation and sells at a gain assets that had appreciated at the time of the conversion. Those “built-in gains” are taxed at 35 percent. The recognition period was to increase from five years to ten years as of January 1, 2013. Under the Act, the five year recognition period will continue through the end of 2013.
Other Business Provisions
The Act also (i) retroactively extends through 2013 the research tax credit, which expired at the end of 2011; (ii) extends through 2013 the Work Opportunity Tax Credit, which grants employers a credit of 40 percent on the first $6,000 paid to employees from a targeted group; (iii) retroactively extends through 2013 the “active financing income” exception from taxation under Subpart F for income from the active conduct by a controlled foreign corporation (CFC) of a banking, financing or similar business; (iv) retroactively extends through 2013 the CFC look-through rule, which provides an exclusion from income for certain dividends, interest, rent and royalties received from a CFC from a related CFC; and (v) extends the exclusion of 100 percent of gain realized on the disposition of qualified small business stock acquired before 2014.
V. Outlook for 2013
The American Taxpayer Relief Act of 2012 prevented an estimated $500 billion shock to the economy that would have upset the fledgling recovery by imposing draconian tax rates, and would without doubt roiled the financial markets if the federal deficit had not been addressed. While the Act averted disaster, ultimately it again failed to address the deficit issue. The first tranche of automatic spending cuts that had been scheduled to go into effect on January 1st were merely postponed until March. Also left unfinished by Congress and the Administration was the crucial issue of the statutory borrowing limit of the government.
In other areas, substantial progress was made. A measure of certainty and permanency — lacking for a decade — was instilled into the estate tax regime. The AMT was given a more permanent patch. Finally, income tax rates were made permanent, which means that an act of Congress will be required in order to modify the tax rates, rather than an act of Congress being required to avert an unwanted change in the tax rates.
I. Overview of Act
On January 2, President Obama signed the American Taxpayer Relief Act of 2012 (the Act) into law, averting automatic tax increases. A bipartisan effort, the Act has changed the tax landscape, but not seismically.
As expected, the Clinton-era 39.6 percent tax rate was reincarnated and applies to joint filers whose income exceeds $450,000. The existing Bush-era rates for other taxpayers remain unchanged and have been made permanent, thus ensuring no tax increases for 98 percent of taxpayers.
A new 20 percent tax tier will be levied on capital gains and dividend income of taxpayers in the 39.6 percent tax bracket.
Itemized deductions of joint filers with income over $300,000 will be phased out.
The estate tax seems to have fared best: The lifetime exclusion amount was made permanent at $5 million, and is now indexed for inflation. “Portability” earned its wings and has been made permanent. (See February Comment) Ominous changes in the law affecting estate tax planning failed to materialize. (See IRS Matters).
Congress failed to extend the temporary 2 percent tax holiday on the employee portion of FICA tax, in effect since 2011. The measure to extend the tax break apparently lacked bipartisan support. An employee’s contribution to the Social Security withholding tax will be bumped up 2 percent, to 6.2 percent. For self-employed taxpayers, the FICA rate of 10.4 percent will revert to 12.4 percent. Wages in excess of $113,700 are not subject to FICA. For those earning at least $113,700, the FICA increase will result in $2,274 of additional tax (subject to withholding).
Taxpayers with investment income above certain thresholds will be subject to the new Medicare Surtax of 3.8 percent beginning January 1, 2013.
The Medicare Payroll tax is currently 2.9 percent, divided equally between employer and employee. Under the Act, taxpayers whose wages or self-employment income exceeds certain thresholds will now pay an additional 0.9 percent (thereby increasing the employee’s portion to 2.35 percent).
II. Provisions Affecting Individuals
New Medicare Surtax
and Medicare Payroll Tax
National Health Care is being funded by increased Medicare taxes, which are expected to yield $318 billion over the next ten years. (See Elder Law Planning: Deciphering the Puzzle).
The new 3.8 percent Medicare Surtax is imposed on the lesser of (i) “net investment income” (NII) or (ii) the amount by which modified adjusted gross income (MAGI) exceeds $250,000 for joint filers, and $200,000 for single filers.
Net investment income includes interest, dividends, capital gains, rents, royalties, nonqualified annuities, passive activity income, and income from trading financial instruments or commodities. Expressly excluded from the calculation of net investment income are wages, self-employment income, commissions, bonuses, and tips.
In essence, the top capital gains and “qualified” dividend tax rate for those in the higher income brackets will jump to 23.8 percent, an increase of 58.7 percent from the 2012 rate of 15 percent. Ordinary investment income tax rates will now top out at 43.4 percent.
The new 0.9 percent Medicare Payroll Tax apples to wages and self-employment income exceeding $200,000 for single filers, $250,000 for joint filers, and $125,000 for married taxpayers filing separately. The IRS provides the following example:
Assume a single filer earns $180,000 in wages and realizes another $90,000 from NII. The taxpayer’s MAGI is $270,000. In this case, the taxpayer would have to pay a 3.8 percent surtax on $70,000, which is the lesser of $90,000 or $70,000. Since the taxpayer is below the earned income threshold for single filers, the taxpayer would not be subject to the 0.9 percent surtax on wages.
Under new proposed regulations, Treasury confirms that gain not recognized under other Code sections (e.g., installment sales, like-kind exchanges or involuntary conversions, and gain from the sale of a principal residence up to the exclusion amount) will not be subject to the Medicare surtax. The 3.8 percent surtax applies to trusts but not to grantor trusts (although the grantor will pick up the income from grantor trusts).
Charitable remainder trusts are not subject to the tax, but beneficiaries may be subject to the tax as NII. The new regulations do not articular how rents are to be treated for purposes of the 3.8 percent tax.
Treasury also warns that taxpayer efforts to manipulate NII in order to avoid the 3.8 percent tax will be challenged based upon “applicable statutes” and “judicial doctrines.”
Phase-out of Itemized Deductions
and Personal Exemptions
The Act re-instituted the phase-out limitations on itemized deductions and personal exemptions for high income taxpayers. Although the new provisions are estimated to increase tax liability by only 1 percent, they activate at much lower adjusted gross income thresholds — $300,000 for joint filers and $250,000 for single filers.
Itemized deductions must now be reduced by 3 percent of adjusted gross income, but the phase-out is frozen once 80 percent of itemized deductions have been achieved. The phase-out will adversely affect taxpayers’ ability to deduct common itemized deductions such as home mortgage interest, charitable contributions and state and local income tax payments. However, some itemized deductions will be unaffected: Those include medical expenses, investment interest and gambling losses.
To illustrate, assume taxpayer and spouse have $350,000 of AGI and $50,000 of itemized deductions. Since 3 percent of the amount by which AGI exceeds $300,000 is $1,500, allowable deductions are reduced to $48,500.
The new personal exemption phase-out (PEP) reduces the $3,900 personal exemption in effect for 2013 by 2 percent for each $2,500 above the income thresholds. In the example, taxpayers exceed the threshold by $50,000, which results in 20 reductions of 2 percent. Since 2 percent of $3,900 is $78, each spouse will forfeit $1,560 in exemption deductions ($78 x 20), resulting in an allowable personal exemption of $2,340 for each spouse.
Extension of Unemployment Benefits
Congress approved $30 billion in extended unemployment benefits for 2013, preserving assistance for 2.1 million long-term unemployed workers. The measure was not offset by other spending cuts. The extension provides a maximum of 47 weeks of federal benefits. Federal benefits are linked to the jobless rates in individual states and are based on a three-month average. In New York, those unemployed will be able to collect for a maximum of 63 weeks, of which New York funds 26 weeks.
Alternative Minimum Tax
The Alternative Minimum Tax, perennial headache for Congress, necessitating yearly “patches,” may have been patched for good. The exemption amount has now been raised to reflect inflation over the past 40 years, and is now indexed for inflation. The exemption amount applies retroactively to 2012, and is $50,600 for individual filers, and $78,750 for joint filers. All non-refundable personal credits are now allowed to offset AMT tax liability as well as regular tax liability.
Since the AMT tax applies if the tax calculated thereunder is higher than the tax liability calculated without reference to the AMT, a higher exemption means that the application of the AMT is narrowed. Without the legislation, upwards of 28 million taxpayers may have been subject to the AMT for the 2012 tax year.
Other Provisions
Affecting Individuals
The Act also (i) allows taxpayers age 70½ or older to directly transfer up to $100,000 from their IRAs to charities without incurring income tax; (ii) extends mortgage-debt relief under IRC §108; (iii) preserves the $4,000 deduction for qualified tuition and related expenses and (iv) the student loan interest deduction.
III. Estate Tax Provisions
The Act retained the $5 million lifetime exclusion, and made it permanent. The exemption amount will be freshened each year, as an inflation adjustment has been included. The inflation-adjusted amount for 2013 is $5.25 million. The Act creates a 40 percent maximum tax rate on gifts, estate and generation-skipping taxes, which rate is higher than the 2012 rate of 35 percent, but lower than the 55 percent rate to which it would otherwise have reverted but for the Act.
Portability allows a couple to effectively shield $10.5 million in assets. However, the GST exemption is not portable. In the event of the death of one spouse and the subsequent remarriage of the other spouse, the surviving spouse will continue to be able to “port” the unused exemption amount of her deceased spouse, unless her new spouse dies, in which case she will be able to use only that new spouse’s unused exemption amount.
The gift tax has been permanently reunified with the estate tax. The annual exclusion amount is also now adjusted for inflation, but in $1,000 increments. The annual exclusion amount for 2013 is $14,000.
Congress punted on four areas which are viewed as possible sources of revenue: GRATs, GST Trusts, family entity discounts, and grantor trusts. 2013 would appear to be an excellent year in which to consider taking advantage of some of these planning techniques.
For the past few years, there has been talk of eliminating short-term GRATs, and mandating a minimum 10-year term for such trusts.
A proposal to limit the GST exemption to 90 years was made. This would make the GST exemption shorter than the rule against perpetuities, and if enacted would deal a severe blow to dynasty trusts.
Congress has considered eliminating the ability of taxpayers to utilized minority discounts or lack of transferability discounts. However, since the courts have sanctioned the viability of these discounts, their abrogation would be more difficult. It is not even certain that Congress could entirely legislate out of existence these discounts without causing a ripple effect into other areas of the tax law.
Some in Congress have also taken note of the revenue losses occasioned by the use of grantor trusts. The grantor trust provisions of the Code were enacted many years ago to prevent income-shifting. No longer needed to prevent income-shifting, the rules have gained prominence as a planning tool which accomplishes a royal flush in taxation: removal of an asset from the estate without creating an income tax event, and a continued liability of the grantor to pay income taxes which are no longer part of his taxable estate. Congress could conceivably shut this down in the next 5 to 10 years by legislatively overruling Revenue Ruling 85-13, the golden rule which is the wellspring of many estate plans today.
Estate planning, once concerned primarily with the estate tax, is now more focused on income tax aspects. Since no benefit will accrue from claiming deductions for estate tax purposes where the estate is not taxable, practitioners’ attention will turn to deducting these expenses on fiduciary returns. The IRS can be expected to seek revenue from challenging administration expenses under IRC §83.
In addition, the IRS can be expected to challenge efforts by taxpayers to achieve basis step-up through the use of grantor trusts when utilizing portability, by substituting assets of equal value. In essence, the estate tax playing field has changed drastically for the IRS, but the Treasury is not without the ability to enact new measures to prevent a total collapse of tax imposed on generational transfers.
While individuals are not subject to the new 39.6 percent top rate until their income exceeds $400,000, trusts become subject to that tax when income exceeds only $11,950. Trusts may also be subject to the 3.8 percent Medicare surtax, thus resulting in a top rate of 43.4 percent. Trustees can, to a considerable extent, avoid the tax by distributing income to beneficiaries in lower brackets. Alternatively, choosing grantor trust status would also obviate the problem.
IV. Business and
Corporate Provisions
Section 179 Expensing
& Bonus Depreciation
The Act extended the IRC §179 expensing deduction of $500,000 through the end of 2013 for tangible, depreciable personal property acquired for use in a trade or business as well as “qualified real property.” A phase-out operates to reduce the deduction dollar-for-dollar if the taxpayer places more than $2 million of Section 179 property into service during a taxable year.
The Act also extends the 50 percent bonus depreciation allowed under IRC §168(k).
Section 1374 Built-in-Gains
Relief Extended Through 12/31/2013
IRC §1374 applies if, during the recognition period, a C corporation converts into an S Corporation and sells at a gain assets that had appreciated at the time of the conversion. Those “built-in gains” are taxed at 35 percent. The recognition period was to increase from five years to ten years as of January 1, 2013. Under the Act, the five year recognition period will continue through the end of 2013.
Other Business Provisions
The Act also (i) retroactively extends through 2013 the research tax credit, which expired at the end of 2011; (ii) extends through 2013 the Work Opportunity Tax Credit, which grants employers a credit of 40 percent on the first $6,000 paid to employees from a targeted group; (iii) retroactively extends through 2013 the “active financing income” exception from taxation under Subpart F for income from the active conduct by a controlled foreign corporation (CFC) of a banking, financing or similar business; (iv) retroactively extends through 2013 the CFC look-through rule, which provides an exclusion from income for certain dividends, interest, rent and royalties received from a CFC from a related CFC; and (v) extends the exclusion of 100 percent of gain realized on the disposition of qualified small business stock acquired before 2014.
V. Outlook for 2013
The American Taxpayer Relief Act of 2012 prevented an estimated $500 billion shock to the economy that would have upset the fledgling recovery by imposing draconian tax rates, and would without doubt roiled the financial markets if the federal deficit had not been addressed.
While the Act averted disaster, ultimately it again failed to address the deficit issue. The first tranche of automatic spending cuts that had been scheduled to go into effect on January 1st were merely postponed until March. Also left unfinished by Congress and the Administration was the crucial issue of the statutory borrowing limit of the government.
In other areas, substantial progress was made. A measure of certainty and permanency — lacking for a decade — was instilled into the estate tax regime. The AMT was given a more permanent patch. Finally, income tax rates were made permanent, which means that an act of Congress will be required in order to modify the tax rates, rather than an act of Congress being required to avert an unwanted change in the tax rates.
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2012 Taxpayer Relief Act & Tax Outlook for 2013
View in PDF: Tax News & Comment — February 2013
2012 Taxpayer Relief Act & Tax Outlook for 2013
I. Overview of Act
On January 2, President Obama signed the American Taxpayer Relief Act of 2012 (the Act) into law, averting automatic tax increases. A bipartisan effort, the Act has changed the tax landscape, but not seismically. As expected, the Clinton-era 39.6 percent tax rate was reincarnated and applies to joint filers whose income exceeds $450,000. The existing Bush-era rates for other taxpayers remain unchanged and have been made permanent, thus ensuring no tax increases for 98 percent of taxpayers.
A new 20 percent tax tier will be levied on capital gains and dividend income of taxpayers in the 39.6 percent tax bracket. Itemized deductions of joint filers with income over $300,000 will be phased out. The estate tax seems to have fared best: The lifetime exclusion amount was made permanent at $5 million, and is now indexed for inflation. “Portability” earned its wings and has been made permanent. (See February Comment) Ominous changes in the law affecting estate tax planning failed to materialize. (See IRS Matters).
Congress failed to extend the temporary 2 percent tax holiday on the employee portion of FICA tax, in effect since 2011. The measure to extend the tax break apparently lacked bipartisan support. An employee’s contribution to the Social Security withholding tax will be bumped up 2 percent, to 6.2 percent. For self-employed taxpayers, the FICA rate of 10.4 percent will revert to 12.4 percent. Wages in excess of $113,700 are not subject to FICA. For those earning at least $113,700, the FICA increase will result in $2,274 of additional tax (subject to withholding).
Taxpayers with investment income above certain thresholds will be subject to the new Medicare Surtax of 3.8 percent beginning January 1, 2013. The Medicare Payroll tax is currently 2.9 percent, divided equally between employer and employee. Under the Act, taxpayers whose wages or self-employment income exceeds certain thresholds will now pay an additional 0.9 percent (thereby increasing the employee’s portion to 2.35 percent).
II. Provisions Affecting Individuals
New Medicare Surtax and Medicare Payroll Tax
National Health Care is being funded by increased Medicare taxes, which are expected to yield $318 billion over the next ten years. (See Elder Law Planning: Deciphering the Puzzle). The new 3.8 percent Medicare Surtax is imposed on the lesser of (i) “net investment income” (NII) or (ii) the amount by which modified adjusted gross income (MAGI) exceeds $250,000 for joint filers, and $200,000 for single filers.
Net investment income includes interest, dividends, capital gains, rents, royalties, nonqualified annuities, passive activity income, and income from trading financial instruments or commodities. Expressly excluded from the calculation of net investment income are wages, self-employment income, commissions, bonuses, and tips.
In essence, the top capital gains and “qualified” dividend tax rate for those in the higher income brackets will jump to 23.8 percent, an increase of 58.7 percent from the 2012 rate of 15 percent. Ordinary investment income tax rates will now top out at 43.4 percent. The new 0.9 percent Medicare Payroll Tax apples to wages and self-employment income exceeding $200,000 for single filers, $250,000 for joint filers, and $125,000 for married taxpayers filing separately. The IRS provides the following example:
Assume a single filer earns $180,000 in wages and realizes another $90,000 from NII. The taxpayer’s MAGI is $270,000. In this case, the taxpayer would have to pay a 3.8 percent surtax on $70,000, which is the lesser of $90,000 or $70,000. Since the taxpayer is below the earned income threshold for single filers, the taxpayer would not be subject to the 0.9 percent surtax on wages.
Under new proposed regulations, Treasury confirms that gain not recognized under other Code sections (e.g., installment sales, like-kind exchanges or involuntary conversions, and gain from the sale of a principal residence up to the exclusion amount) will not be subject to the Medicare surtax. The 3.8 percent surtax applies to trusts but not to grantor trusts (although the grantor will pick up the income from grantor trusts). Charitable remainder trusts are not subject to the tax, but beneficiaries may be subject to the tax as NII. The new regulations do not articular how rents are to be treated for purposes of the 3.8 percent tax.
Treasury also warns that taxpayer efforts to manipulate NII in order to avoid the 3.8 percent tax will be challenged based upon “applicable statutes” and “judicial doctrines.”
Phase-out of Itemized Deductions and Personal Exemptions
The Act re-instituted the phase-out limitations on itemized deductions and personal exemptions for high income taxpayers. Although the new provisions are estimated to increase tax liability by only 1 percent, they activate at much lower adjusted gross income thresholds — $300,000 for joint filers and $250,000 for single filers.
Itemized deductions must now be reduced by 3 percent of adjusted gross income, but the phase-out is frozen once 80 percent of itemized deductions have been achieved. The phase-out will adversely affect taxpayers’ ability to deduct common itemized deductions such as home mortgage interest, charitable contributions and state and local income tax payments. However, some itemized deductions will be unaffected: Those include medical expenses, investment interest and gambling losses.
To illustrate, assume taxpayer and spouse have $350,000 of AGI and $50,000 of itemized deductions. Since 3 percent of the amount by which AGI exceeds $300,000 is $1,500, allowable deductions are reduced to $48,500. The new personal exemption phase-out (PEP) reduces the $3,900 personal exemption in effect for 2013 by 2 percent for each $2,500 above the income thresholds. In the example, taxpayers exceed the threshold by $50,000, which results in 20 reductions of 2 percent. Since 2 percent of $3,900 is $78, each spouse will forfeit $1,560 in exemption deductions ($78 x 20), resulting in an allowable personal exemption of $2,340 for each spouse.
Extension of Unemployment Benefits
Congress approved $30 billion in extended unemployment benefits for 2013, preserving assistance for 2.1 million long-term unemployed workers. The measure was not offset by other spending cuts. The extension provides a maximum of 47 weeks of federal benefits. Federal benefits are linked to the jobless rates in individual states and are based on a three-month average. In New York, those unemployed will be able to collect for a maximum of 63 weeks, of which New York funds 26 weeks.
Alternative Minimum Tax
The Alternative Minimum Tax, perennial headache for Congress, necessitating yearly “patches,” may have been patched for good. The exemption amount has now been raised to reflect inflation over the past 40 years, and is now indexed for inflation. The exemption amount applies retroactively to 2012, and is $50,600 for individual filers, and $78,750 for joint filers. All non-refundable personal credits are now allowed to offset AMT tax liability as well as regular tax liability.
Since the AMT tax applies if the tax calculated thereunder is higher than the tax liability calculated without reference to the AMT, a higher exemption means that the application of the AMT is narrowed. Without the legislation, upwards of 28 million taxpayers may have been subject to the AMT for the 2012 tax year.
Other Provisions Affecting Individuals
The Act also (i) allows taxpayers age 70½ or older to directly transfer up to $100,000 from their IRAs to charities without incurring income tax; (ii) extends mortgage-debt relief under IRC §108; (iii) preserves the $4,000 deduction for qualified tuition and related expenses and (iv) the student loan interest deduction.
III. Estate Tax Provisions
The Act retained the $5 million lifetime exclusion, and made it permanent. The exemption amount will be freshened each year, as an inflation adjustment has been included. The inflation-adjusted amount for 2013 is $5.25 million. The Act creates a 40 percent maximum tax rate on gifts, estate and generation-skipping taxes, which rate is higher than the 2012 rate of 35 percent, but lower than the 55 percent rate to which it would otherwise have reverted but for the Act.
Portability allows a couple to effectively shield $10.5 million in assets. However, the GST exemption is not portable. In the event of the death of one spouse and the subsequent remarriage of the other spouse, the surviving spouse will continue to be able to “port” the unused exemption amount of her deceased spouse, unless her new spouse dies, in which case she will be able to use only that new spouse’s unused exemption amount.
The gift tax has been permanently reunified with the estate tax. The annual exclusion amount is also now adjusted for inflation, but in $1,000 increments. The annual exclusion amount for 2013 is $14,000. Congress punted on four areas which are viewed as possible sources of revenue: GRATs, GST Trusts, family entity discounts, and grantor trusts. 2013 would appear to be an excellent year in which to consider taking advantage of some of these planning techniques.
For the past few years, there has been talk of eliminating short-term GRATs, and mandating a minimum 10-year term for such trusts. A proposal to limit the GST exemption to 90 years was made. This would make the GST exemption shorter than the rule against perpetuities, and if enacted would deal a severe blow to dynasty trusts.
Congress has considered eliminating the ability of taxpayers to utilized minority discounts or lack of transferability discounts. However, since the courts have sanctioned the viability of these discounts, their abrogation would be more difficult. It is not even certain that Congress could entirely legislate out of existence these discounts without causing a ripple effect into other areas of the tax law.
Some in Congress have also taken note of the revenue losses occasioned by the use of grantor trusts. The grantor trust provisions of the Code were enacted many years ago to prevent income-shifting. No longer needed to prevent income-shifting, the rules have gained prominence as a planning tool which accomplishes a royal flush in taxation: removal of an asset from the estate without creating an income tax event, and a continued liability of the grantor to pay income taxes which are no longer part of his taxable estate. Congress could conceivably shut this down in the next 5 to 10 years by legislatively overruling Revenue Ruling 85-13, the golden rule which is the wellspring of many estate plans today.
Estate planning, once concerned primarily with the estate tax, is now more focused on income tax aspects. Since no benefit will accrue from claiming deductions for estate tax purposes where the estate is not taxable, practitioners’ attention will turn to deducting these expenses on fiduciary returns. The IRS can be expected to seek revenue from challenging administration expenses under IRC §83.
In addition, the IRS can be expected to challenge efforts by taxpayers to achieve basis step-up through the use of grantor trusts when utilizing portability, by substituting assets of equal value. In essence, the estate tax playing field has changed drastically for the IRS, but the Treasury is not without the ability to enact new measures to prevent a total collapse of tax imposed on generational transfers.
While individuals are not subject to the new 39.6 percent top rate until their income exceeds $400,000, trusts become subject to that tax when income exceeds only $11,950. Trusts may also be subject to the 3.8 percent Medicare surtax, thus resulting in a top rate of 43.4 percent. Trustees can, to a considerable extent, avoid the tax by distributing income to beneficiaries in lower brackets. Alternatively, choosing grantor trust status would also obviate the problem.
IV. Business and Corporate Provisions
Section 179 Expensing & Bonus Depreciation
The Act extended the IRC §179 expensing deduction of $500,000 through the end of 2013 for tangible, depreciable personal property acquired for use in a trade or business as well as “qualified real property.” A phase-out operates to reduce the deduction dollar-for-dollar if the taxpayer places more than $2 million of Section 179 property into service during a taxable year. The Act also extends the 50 percent bonus depreciation allowed under IRC §168(k).
Section 1374 Built-in-Gains Relief Extended Through 12/31/2013
IRC §1374 applies if, during the recognition period, a C corporation converts into an S Corporation and sells at a gain assets that had appreciated at the time of the conversion. Those “built-in gains” are taxed at 35 percent. The recognition period was to increase from five years to ten years as of January 1, 2013. Under the Act, the five year recognition period will continue through the end of 2013.
Other Business Provisions
The Act also (i) retroactively extends through 2013 the research tax credit, which expired at the end of 2011; (ii) extends through 2013 the Work Opportunity Tax Credit, which grants employers a credit of 40 percent on the first $6,000 paid to employees from a targeted group; (iii) retroactively extends through 2013 the “active financing income” exception from taxation under Subpart F for income from the active conduct by a controlled foreign corporation (CFC) of a banking, financing or similar business; (iv) retroactively extends through 2013 the CFC look-through rule, which provides an exclusion from income for certain dividends, interest, rent and royalties received from a CFC from a related CFC; and (v) extends the exclusion of 100 percent of gain realized on the disposition of qualified small business stock acquired before 2014.
V. Outlook for 2013
The American Taxpayer Relief Act of 2012 prevented an estimated $500 billion shock to the economy that would have upset the fledgling recovery by imposing draconian tax rates, and would without doubt roiled the financial markets if the federal deficit had not been addressed. While the Act averted disaster, ultimately it again failed to address the deficit issue. The first tranche of automatic spending cuts that had been scheduled to go into effect on January 1st were merely postponed until March. Also left unfinished by Congress and the Administration was the crucial issue of the statutory borrowing limit of the government.
In other areas, substantial progress was made. A measure of certainty and permanency — lacking for a decade — was instilled into the estate tax regime. The AMT was given a more permanent patch. Finally, income tax rates were made permanent, which means that an act of Congress will be required in order to modify the tax rates, rather than an act of Congress being required to avert an unwanted change in the tax rates.
I. Overview of Act
On January 2, President Obama signed the American Taxpayer Relief Act of 2012 (the Act) into law, averting automatic tax increases. A bipartisan effort, the Act has changed the tax landscape, but not seismically.
As expected, the Clinton-era 39.6 percent tax rate was reincarnated and applies to joint filers whose income exceeds $450,000. The existing Bush-era rates for other taxpayers remain unchanged and have been made permanent, thus ensuring no tax increases for 98 percent of taxpayers.
A new 20 percent tax tier will be levied on capital gains and dividend income of taxpayers in the 39.6 percent tax bracket.
Itemized deductions of joint filers with income over $300,000 will be phased out.
The estate tax seems to have fared best: The lifetime exclusion amount was made permanent at $5 million, and is now indexed for inflation. “Portability” earned its wings and has been made permanent. (See February Comment) Ominous changes in the law affecting estate tax planning failed to materialize. (See IRS Matters).
Congress failed to extend the temporary 2 percent tax holiday on the employee portion of FICA tax, in effect since 2011. The measure to extend the tax break apparently lacked bipartisan support. An employee’s contribution to the Social Security withholding tax will be bumped up 2 percent, to 6.2 percent. For self-employed taxpayers, the FICA rate of 10.4 percent will revert to 12.4 percent. Wages in excess of $113,700 are not subject to FICA. For those earning at least $113,700, the FICA increase will result in $2,274 of additional tax (subject to withholding).
Taxpayers with investment income above certain thresholds will be subject to the new Medicare Surtax of 3.8 percent beginning January 1, 2013.
The Medicare Payroll tax is currently 2.9 percent, divided equally between employer and employee. Under the Act, taxpayers whose wages or self-employment income exceeds certain thresholds will now pay an additional 0.9 percent (thereby increasing the employee’s portion to 2.35 percent).
II. Provisions Affecting Individuals
New Medicare Surtax
and Medicare Payroll Tax
National Health Care is being funded by increased Medicare taxes, which are expected to yield $318 billion over the next ten years. (See Elder Law Planning: Deciphering the Puzzle).
The new 3.8 percent Medicare Surtax is imposed on the lesser of (i) “net investment income” (NII) or (ii) the amount by which modified adjusted gross income (MAGI) exceeds $250,000 for joint filers, and $200,000 for single filers.
Net investment income includes interest, dividends, capital gains, rents, royalties, nonqualified annuities, passive activity income, and income from trading financial instruments or commodities. Expressly excluded from the calculation of net investment income are wages, self-employment income, commissions, bonuses, and tips.
In essence, the top capital gains and “qualified” dividend tax rate for those in the higher income brackets will jump to 23.8 percent, an increase of 58.7 percent from the 2012 rate of 15 percent. Ordinary investment income tax rates will now top out at 43.4 percent.
The new 0.9 percent Medicare Payroll Tax apples to wages and self-employment income exceeding $200,000 for single filers, $250,000 for joint filers, and $125,000 for married taxpayers filing separately. The IRS provides the following example:
Assume a single filer earns $180,000 in wages and realizes another $90,000 from NII. The taxpayer’s MAGI is $270,000. In this case, the taxpayer would have to pay a 3.8 percent surtax on $70,000, which is the lesser of $90,000 or $70,000. Since the taxpayer is below the earned income threshold for single filers, the taxpayer would not be subject to the 0.9 percent surtax on wages.
Under new proposed regulations, Treasury confirms that gain not recognized under other Code sections (e.g., installment sales, like-kind exchanges or involuntary conversions, and gain from the sale of a principal residence up to the exclusion amount) will not be subject to the Medicare surtax. The 3.8 percent surtax applies to trusts but not to grantor trusts (although the grantor will pick up the income from grantor trusts).
Charitable remainder trusts are not subject to the tax, but beneficiaries may be subject to the tax as NII. The new regulations do not articular how rents are to be treated for purposes of the 3.8 percent tax.
Treasury also warns that taxpayer efforts to manipulate NII in order to avoid the 3.8 percent tax will be challenged based upon “applicable statutes” and “judicial doctrines.”
Phase-out of Itemized Deductions
and Personal Exemptions
The Act re-instituted the phase-out limitations on itemized deductions and personal exemptions for high income taxpayers. Although the new provisions are estimated to increase tax liability by only 1 percent, they activate at much lower adjusted gross income thresholds — $300,000 for joint filers and $250,000 for single filers.
Itemized deductions must now be reduced by 3 percent of adjusted gross income, but the phase-out is frozen once 80 percent of itemized deductions have been achieved. The phase-out will adversely affect taxpayers’ ability to deduct common itemized deductions such as home mortgage interest, charitable contributions and state and local income tax payments. However, some itemized deductions will be unaffected: Those include medical expenses, investment interest and gambling losses.
To illustrate, assume taxpayer and spouse have $350,000 of AGI and $50,000 of itemized deductions. Since 3 percent of the amount by which AGI exceeds $300,000 is $1,500, allowable deductions are reduced to $48,500.
The new personal exemption phase-out (PEP) reduces the $3,900 personal exemption in effect for 2013 by 2 percent for each $2,500 above the income thresholds. In the example, taxpayers exceed the threshold by $50,000, which results in 20 reductions of 2 percent. Since 2 percent of $3,900 is $78, each spouse will forfeit $1,560 in exemption deductions ($78 x 20), resulting in an allowable personal exemption of $2,340 for each spouse.
Extension of Unemployment Benefits
Congress approved $30 billion in extended unemployment benefits for 2013, preserving assistance for 2.1 million long-term unemployed workers. The measure was not offset by other spending cuts. The extension provides a maximum of 47 weeks of federal benefits. Federal benefits are linked to the jobless rates in individual states and are based on a three-month average. In New York, those unemployed will be able to collect for a maximum of 63 weeks, of which New York funds 26 weeks.
Alternative Minimum Tax
The Alternative Minimum Tax, perennial headache for Congress, necessitating yearly “patches,” may have been patched for good. The exemption amount has now been raised to reflect inflation over the past 40 years, and is now indexed for inflation. The exemption amount applies retroactively to 2012, and is $50,600 for individual filers, and $78,750 for joint filers. All non-refundable personal credits are now allowed to offset AMT tax liability as well as regular tax liability.
Since the AMT tax applies if the tax calculated thereunder is higher than the tax liability calculated without reference to the AMT, a higher exemption means that the application of the AMT is narrowed. Without the legislation, upwards of 28 million taxpayers may have been subject to the AMT for the 2012 tax year.
Other Provisions
Affecting Individuals
The Act also (i) allows taxpayers age 70½ or older to directly transfer up to $100,000 from their IRAs to charities without incurring income tax; (ii) extends mortgage-debt relief under IRC §108; (iii) preserves the $4,000 deduction for qualified tuition and related expenses and (iv) the student loan interest deduction.
III. Estate Tax Provisions
The Act retained the $5 million lifetime exclusion, and made it permanent. The exemption amount will be freshened each year, as an inflation adjustment has been included. The inflation-adjusted amount for 2013 is $5.25 million. The Act creates a 40 percent maximum tax rate on gifts, estate and generation-skipping taxes, which rate is higher than the 2012 rate of 35 percent, but lower than the 55 percent rate to which it would otherwise have reverted but for the Act.
Portability allows a couple to effectively shield $10.5 million in assets. However, the GST exemption is not portable. In the event of the death of one spouse and the subsequent remarriage of the other spouse, the surviving spouse will continue to be able to “port” the unused exemption amount of her deceased spouse, unless her new spouse dies, in which case she will be able to use only that new spouse’s unused exemption amount.
The gift tax has been permanently reunified with the estate tax. The annual exclusion amount is also now adjusted for inflation, but in $1,000 increments. The annual exclusion amount for 2013 is $14,000.
Congress punted on four areas which are viewed as possible sources of revenue: GRATs, GST Trusts, family entity discounts, and grantor trusts. 2013 would appear to be an excellent year in which to consider taking advantage of some of these planning techniques.
For the past few years, there has been talk of eliminating short-term GRATs, and mandating a minimum 10-year term for such trusts.
A proposal to limit the GST exemption to 90 years was made. This would make the GST exemption shorter than the rule against perpetuities, and if enacted would deal a severe blow to dynasty trusts.
Congress has considered eliminating the ability of taxpayers to utilized minority discounts or lack of transferability discounts. However, since the courts have sanctioned the viability of these discounts, their abrogation would be more difficult. It is not even certain that Congress could entirely legislate out of existence these discounts without causing a ripple effect into other areas of the tax law.
Some in Congress have also taken note of the revenue losses occasioned by the use of grantor trusts. The grantor trust provisions of the Code were enacted many years ago to prevent income-shifting. No longer needed to prevent income-shifting, the rules have gained prominence as a planning tool which accomplishes a royal flush in taxation: removal of an asset from the estate without creating an income tax event, and a continued liability of the grantor to pay income taxes which are no longer part of his taxable estate. Congress could conceivably shut this down in the next 5 to 10 years by legislatively overruling Revenue Ruling 85-13, the golden rule which is the wellspring of many estate plans today.
Estate planning, once concerned primarily with the estate tax, is now more focused on income tax aspects. Since no benefit will accrue from claiming deductions for estate tax purposes where the estate is not taxable, practitioners’ attention will turn to deducting these expenses on fiduciary returns. The IRS can be expected to seek revenue from challenging administration expenses under IRC §83.
In addition, the IRS can be expected to challenge efforts by taxpayers to achieve basis step-up through the use of grantor trusts when utilizing portability, by substituting assets of equal value. In essence, the estate tax playing field has changed drastically for the IRS, but the Treasury is not without the ability to enact new measures to prevent a total collapse of tax imposed on generational transfers.
While individuals are not subject to the new 39.6 percent top rate until their income exceeds $400,000, trusts become subject to that tax when income exceeds only $11,950. Trusts may also be subject to the 3.8 percent Medicare surtax, thus resulting in a top rate of 43.4 percent. Trustees can, to a considerable extent, avoid the tax by distributing income to beneficiaries in lower brackets. Alternatively, choosing grantor trust status would also obviate the problem.
IV. Business and
Corporate Provisions
Section 179 Expensing
& Bonus Depreciation
The Act extended the IRC §179 expensing deduction of $500,000 through the end of 2013 for tangible, depreciable personal property acquired for use in a trade or business as well as “qualified real property.” A phase-out operates to reduce the deduction dollar-for-dollar if the taxpayer places more than $2 million of Section 179 property into service during a taxable year.
The Act also extends the 50 percent bonus depreciation allowed under IRC §168(k).
Section 1374 Built-in-Gains
Relief Extended Through 12/31/2013
IRC §1374 applies if, during the recognition period, a C corporation converts into an S Corporation and sells at a gain assets that had appreciated at the time of the conversion. Those “built-in gains” are taxed at 35 percent. The recognition period was to increase from five years to ten years as of January 1, 2013. Under the Act, the five year recognition period will continue through the end of 2013.
Other Business Provisions
The Act also (i) retroactively extends through 2013 the research tax credit, which expired at the end of 2011; (ii) extends through 2013 the Work Opportunity Tax Credit, which grants employers a credit of 40 percent on the first $6,000 paid to employees from a targeted group; (iii) retroactively extends through 2013 the “active financing income” exception from taxation under Subpart F for income from the active conduct by a controlled foreign corporation (CFC) of a banking, financing or similar business; (iv) retroactively extends through 2013 the CFC look-through rule, which provides an exclusion from income for certain dividends, interest, rent and royalties received from a CFC from a related CFC; and (v) extends the exclusion of 100 percent of gain realized on the disposition of qualified small business stock acquired before 2014.
V. Outlook for 2013
The American Taxpayer Relief Act of 2012 prevented an estimated $500 billion shock to the economy that would have upset the fledgling recovery by imposing draconian tax rates, and would without doubt roiled the financial markets if the federal deficit had not been addressed.
While the Act averted disaster, ultimately it again failed to address the deficit issue. The first tranche of automatic spending cuts that had been scheduled to go into effect on January 1st were merely postponed until March. Also left unfinished by Congress and the Administration was the crucial issue of the statutory borrowing limit of the government.
In other areas, substantial progress was made. A measure of certainty and permanency — lacking for a decade — was instilled into the estate tax regime. The AMT was given a more permanent patch. Finally, income tax rates were made permanent, which means that an act of Congress will be required in order to modify the tax rates, rather than an act of Congress being required to avert an unwanted change in the tax rates.
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