By Ken Berry
The agreement hammered out in the Senate just before the clock struck midnight on December 31 – and subsequently approved by the House on January 1 – pulled the nation back from the edge of the fiscal cliff. President Obama promptly signed the "American Taxpayer Relief Act of 2012" into law on January 2. Following is an overview of the key tax provisions in store for individual and business clients in 2013.
Tax Provisions for Individual Taxpayers
Individual income taxes. Across-the-board tax rate increases scheduled for 2013 are repealed. Instead, the new law permanently retains the 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent individual income tax rates. However, the top tax rate of 35 percent is boosted to a 39.6 percent rate for single filers with income above $400,000 and joint filers with income above $450,000.
Investment income. Prior to 2013, investors could benefit from a maximum tax rate of 15 percent on net long-term capital gains and qualified dividends (0 percent for certain low-income investors). Without the new law changes, long-term capital gains would have been taxed at a maximum 20 percent rate (10 percent for certain low-income investors), while qualified dividends would have been taxed at ordinary income rates. The new law retains the previous favorable tax rates, but still imposes a maximum 20 percent tax rate on single filers with income of more than $400,000 and joint filers with income of more than $450,000. Reminder: Under the 2010 health care legislation, a 3.8 percent Medicare surtax may also apply to investment income received by high-income clients.
Itemized deductions. Due to the return of the so-called "Pease amendment", most itemized deductions were scheduled to be reduced by 3 percent of the amount of adjusted gross income (AGI) above a specified threshold, beginning in 2013. The new law establishes higher thresholds of $250,000 for single filers and $300,000 for joint filers. Note that the overall reduction in itemized deductions can't exceed 80 percent. Also, this reduction rule doesn't apply to deductions for medical expenses, investment interest expenses, wagering losses, and casualty and theft losses.
Alternative minimum tax. The new law provides a permanent "patch" to the alternative minimum tax (AMT) by increasing exemption amounts (the current exemption of $33,750 individual and $45,000 married is increased to $50,600 single and $78,750 married) and allowing nonrefundable personal credits to offset the full AMT liability. In addition, the exemption amounts will be indexed for inflation in future years. The change is retroactive to 2012, so an estimated thirty million additional taxpayers will avoid AMT liability in the upcoming tax filing season.
Payroll taxes. For 2011 and 2012, a "payroll tax holiday" resulted in a 2 percent reduction in the Social Security portion of FICA tax paid by employees on amounts up to the annual wage base; thus, the effective tax rate was reduced from 6.2 percent to 4.2 percent. Similarly, the rate for self-employed individuals was reduced from 12.4 percent to 10.4 percent. Now the 2 percent reduction has expired. For 2013, the rate reverts to 6.2 percent for employees and 12.4 percent for self-employed individuals on amounts up to the wage base of $113,700.
Family tax breaks. The new law extends several family-related tax breaks for varying periods of times. This includes provisions for tax relief from the so-called marriage penalty, the enhanced child tax credit, the expanded dependent care credit, the adoption tax credit and adoption assistance program exclusion, and the earned income credit.
Education tax breaks. Among other tax-based education incentives, the new law permanently extends the expanded $2,000 contribution limit for Coverdell Education Savings Accounts (ESAs), the expanded exclusion for employer-provided education assistance, and the enhanced student loan interest deduction. Also, the American Opportunity Tax Credit (AOTC) is extended for five years. A client can claim a maximum AOTC of $2,500 for qualified higher education expenses subject to a phaseout for single filers with a modified adjusted gross income (MAGI) of more than $80,000 and joint filers with a MAGI of more than $160,000. Finally, the new law extends for 2012 and 2013 the deduction for tuition and other fees, subject to slightly different phaseout thresholds. A $4,000 deduction is available for a MAGI up to $65,000 for single filers and $130,000 for joint filers, and then a $2,000 deduction is available for a MAGI up to $80,000 for single filers and $160,000 for joint filers. This above-the-line deduction may be claimed in lieu of a higher education credit.
Estate and gift taxes. The new law averts several dire estate and gift tax consequences due to a related series of provisions "sunsetting" after 2012. This includes the following permanent changes:
- The unified estate and gift tax system, which was severed and then reunified, will remain reunified after 2012. Thus, the estate tax exemption continues to apply to lifetime gifts as well as inheritances.
- The estate tax exemption, which was scheduled to plummet from $5 million (inflation-indexed to $5.12 million in 2012) to $1 million, remains at $5 million (with inflation indexing).
- The provision allowing "portability" of exemptions between spouses remains in effect for decedents dying after 2012.
- The top estate tax rate, which was scheduled to increase from 35 percent to 55 percent, rises only slightly to 40 percent, in 2013 and thereafter.
- The provisions relating to the generation-skipping tax are coordinated with other aspects of the unified estate and gift tax system.
Several other tax law provisions are extended for varying periods of time, including the following:
- The up-to-$250 deduction for classroom expenses allowed to teachers and other educators is extended through 2013, retroactive to 2012.
- The exclusion from mortgage debt forgiveness on a maximum $2 million of debt is extended through 2013.
- The maximum monthly $240 exclusion for employer-provided mass transit and vanpooling benefits is extended through 2013, retroactive to 2012.
- The deduction for mortgage interest premiums, subject to a phaseout for an AGI of more than $110,000, is extended through 2013, retroactive to 2012.
- The optional state sales income tax deduction, which can be claimed in lieu of deducting state and local income taxes, is extended through 2013, retroactive to 2012.
- Enhancements in the deduction allowed for charitable donations of property for conservation purposes are extended through 2013, retroactive to 2012.
- A provision allowing tax-free distributions going from an IRA directly to a charity by clients age 70½ or over, up to a maximum of $100,000, is extended through 2013, retroactive to 2012.
Tax Provisions for Business Taxpayers
Section 179 deduction. Under Section 179 of the Internal Revenue Code, a business can elect to "expense" the cost of qualified property placed into service during the year, subject to a maximum limit and a phaseout for amounts above a specified threshold. For 2012, the maximum deduction was set at $125,000 (inflation-indexed to $139,000) with a $500,000 threshold (inflation-indexed to $560,000). The new law restores the previous limits of a $500,000 maximum deduction and a $2 million threshold through 2013, retroactive to 2012. It also permits expensing of up to $250,000 of the cost of qualified leasehold improvement property, restaurant property, and retail improvement property, as was allowed under prior law.
Bonus depreciation. For 2012, a business client could generally claim 50 percent bonus depreciation for qualified property placed in service during the year (reduced from 100 percent bonus depreciation in 2011), in addition to a Section 179 deduction and regular depreciation deductions. The new law generally extends the 50 percent bonus depreciation deduction through 2013 (2014 for certain other property).
Research and experimentation credit. Under prior law, a business could claim a tax credit equal to 20 percent of qualified research and experimentation (R&E) costs above a base amount or an alternative simplified credit of 14 percent. The new law extends the R&E credit, which had officially expired after 2011, through 2013 and makes it retroactive to 2012.
New Markets Tax Credit. The New Markets Tax Credit (NMTC) program encourages private investment into businesses in low-income communities. Under this program, a client may obtain a 39 percent tax credit, spread out over seven years. The new law extends the NMTC program through 2013, retroactive to 2012.
Work Opportunity Tax Credit. A business may claim a Work Opportunity Tax Credit (WOTC) for hiring someone from one of several economically disadvantaged groups. The WOTC is generally equal to 40 percent of the first $6,000 in wages paid to a new hire. It officially expired after 2011, although an enhanced credit was available through 2012 for hiring certain veterans. The WOTC is extended through 2013, retroactive to 2012, including a one-year extension of the enhanced credit for hiring certain veterans.
Leasehold improvements. Under prior law, a fast fifteen-year cost recovery period using the straight-line method was available for qualified leasehold improvements, restaurant buildings and improvements, and retail improvements. This tax break officially expired after 2011. The new law extends the fifteen-year cost recovery period through 2013, retroactive to 2012.
Charitable deductions. Several tax law provisions allowing enhanced deductions for charitable donations of property by a business – including gifts of food inventory, books, and computer equipment – expired after 2011. The new law only extends the enhanced deduction for donations of food through 2013, retroactive to 2012.
Qualified small business stock. Previously, an investor in qualified small business stock (QSBS) could exclude from tax 100 percent of the gain on the sale of QSBS acquired after September 27, 2010, and before January 1, 2012, and held for more than five years. (The exclusion was gradually increased from 50 percent, to 75 percent, and then to 100 percent before it expired.) The new law extends the 100 percent exclusion from the sale of QSBS acquired before January 1, 2014.
S-corporation BIG tax. If a corporation converts into an S-corporation, the S-corporation must hold assets for a specified time to avoid a built-in gains (BIG) tax. The holding period was gradually reduced from a high of ten years to seven years and finally to five years for sales of assets in 2011. The new law extends the reduced five-year holding period for sales through 2013, retroactive to 2012.
Energy tax incentives. Finally, the new law extends for varying time periods, with certain modifications, a number of provisions relating to energy-saving improvements adopted by business entities.
The impact of the American Taxpayer Relief Act will be far-reaching. We will focus on specific aspects of the new law in greater detail throughout the year.