By Kenneth H. Bridges, CPA, PFS January 2013
While most of you were hopefully enjoying a New Year’s Eve party or watching the Chick-Fil-A Bowl or the Ryan Seacrest/Jenny McCarthy special, I was fixated on C-SPAN, anxiously watching to see how the “fiscal cliff” aversion would play out. While the C-SPAN anchors did a great job of adding high drama to the normally quite dull legislative process, in reality it all played out in a very predictable manner. The Democrat controlled Senate announced on New Year’s Eve (although the vote actually took place in the early hours of January 1) that an agr eement had been reached to avoid going over the fiscal cliff. Later on January 1, the Republican controlled House approved the same measure. Since the “Bush tax cuts” had technically expired at midnight December 31 (meaning a tax increase for almost all taxpayers), conservative Republicans (who had sought to avoid any tax rate increases) are now able to say that they voted for a tax cut, not a tax increase, although taxes will now rise for “the wealthy” (as sought by President Obama and the Democrats). While President Obama had originally defined “the wealthy” as those with annual income over $250,000, for purposes of this legislation such is defined as income above $400,000 – $450,000 (depending on filing status). Thus, both sides can declare victory.
Below is a brief synopsis of the major tax provisions in the legislation.
- Ordinary income tax rates – For 2012, the tax rates on ordinary income were 10%, 15%, 25%, 28%, 33% and 35% (depending on income level). For 2013, those rate brackets were scheduled to increase to 15%, 28%, 31%, 36% and 39.6%. The new legislation preserves the existing rate brackets for those with income below $400,000 (or $425,000 for heads of household and $450,000 for married couples filing jointly). Income above the $400,000 – $450,000 amount will be subject to the 39.6% rate. For earned income (above $200,000 – $250,000), you can add to that the new 0.9% Medicare tax, and for investment income (above $200,000 – $250,000) you can add another 3.8% for this new tax. For those in high tax states (e.g. California where the highest rate is now 13.3%) and with self-employment income (15.3% on earned income up to $113,700), the total marginal tax rate could in some situations be in excess of 60%.
- Qualified dividend income – For 2012, the highest rate on “qualified dividends” (which includes most dividend income other than interest income equivalents like money market mutual fund dividends) was 15%. Effective January 1, the highest rate was scheduled to revert to 39.6% (plus the 3.8% Medicare tax). The new legislation preserves the 15% rate for those with income below the $400,000 – $450,000 thresholds. For those with income above this level, the new rate will be 20%. In each case, the new 3.8% Medicare tax may also apply (i.e. a top Federal rate of 23.8%). For those taxpayers whose ordinary income rate is below 25%, qualified dividends will enjoy a 0% Federal rate.
- Long-term capital gains – For 2012, the highest rate on “long-term capital gains was 15%. Effective January 1, the highest rate was scheduled to revert to 20% (plus, potentially, the 3.8% Medicare tax). The new legislation preserves the 15% rate for those with income below the $400,000 – $450,000 thresholds. For those with income above this level, the new rate will be 20%. In each case, the new 3.8% Medicare tax may also apply (i.e. a top Federal rate of 23.8%). For those taxpayers whose ordinary income rate is below 25%, long-term capital gains will enjoy a 0% Federal rate.
- AMT exemptions – For 2011, singles received an alternative minimum tax exemption of $48,450 and married couples an exemption of $74,450. These amounts were subject to phaseout for singles with income over $112,500 (zero exemption once income reached $306,300) and couples with income over $150,000 (zero exemption once income reached $447,800). Absent Congress retroactively extending these higher exemption amounts, the exemptions would have reverted to the pre-2001 level of $33,750 for singles and $45,000 for couples. This would have meant a tax increase of up to $3,822 for singles and $7,657 for couples. The IRS estimated this would impact approximately 28 million taxpayers. As anticipated, Congress has retroactively extended the higher exemptions. The new amounts are $50,600 for singles and $78,750 for married couples, and these amounts will be indexed up for inflation each year. The exemption phaseout based on income level continues to apply, so higher income taxpayers will not derive any benefit from this exemption increase.
- Research tax credit – The Federal research tax credit which had expired at the end of 2011 has been retroactively extended through 2013.
- Phaseout of itemized deductions and exemptions – The first President Bush attempted to increase taxes without increasing rates by enacting provisions whereby personal exemptions and itemized deductions were limited for higher income taxpayers. The second President Bush enacted provisions phasing out the phaseouts. Now, effective January 1, the phaseouts will be back again. Higher income taxpayers will find themselves not receiving any personal exemptions and having their itemized deductions reduced (up to 80%) by 3 cents for each dollar of income over $250,000 for singles and $300,000 for joint filers. Absent the new legislation, the phaseout would have kicked in at $178,000 of income.
- Estate and gift tax – For 2012, the exemption equivalent for the unified credit against estate and gift tax was $5,120,000, and the tax rate was 35%. Effective January 1, 2013, the exemption amount was scheduled to revert to only $1,000,000, and the top rate to revert to 55%. The new legislation retains the $5,120,000 exemption (as indexed each year for inflation) and sets the tax rate at 40%.
- Payroll tax break – For the past two years, employees have enjoyed a 2 percentage point reduction in their FICA rate (a savings of up to $2,202). This break expired at the end of 2012, and was not extended by the new legislation.
- Bonus depreciation – For most new depreciable assets (other than buildings) placed in service during 2012, 50% of the cost could be expensed immediately. This provision has been extended through 2013.
- Section 179 expense – For 2011, most companies could elect to expense up to $500,000 of the cost of furniture and equipment against otherwise taxable profit. The maximum annual expensing amount was reduced dollar-for-dollar by the amount of section 179 property placed in service during the tax year in excess of $2,000,000. Absent the new legislation, the maximum amount would have been reduced to $139,000 for 2012 and $25,000 for 2013, and the overall investment limitation would have been reduced to $560,000 for 2012 and $200,000 for 2013. The new legislation extends the $500,000 expensing amount and the $2,000,000 investment limitation for 2012 and 2013.
- S-corp built-in gains period – S corporations that were formerly C corporations may be subject to what is known as the “built-in gains tax”. In a nutshell, the built-in gains tax applies when an S corporation disposes of assets that had unrealized built-in gain at the date of the S election. Historically, the tax has been imposed on assets disposed of during the ten-year period beginning with the first S-corp year. However, for 2009 and 2010 the recognition period was reduced to seven years, and for 2011 it was further reduced to five years, but only for the 2011 year. The new legislation extends the reduction of the recognition period to five years through 2013.
- Charitable distributions from IRAs – For 2010 and 2011, individuals age 70 ½ or older could distribute up to $100,000 tax-free from their IRAs to certain charitable organizations without having to include the distribution in gross income. The distribution had to be made directly by the trustee to the charitable organization (note that it must be to a “50 percent organization” and not to a donor advised fund or supporting organization). The new legislation extends these provisions through 2013. It is not too late to take advantage of this provision for 2012. Any qualified charitable distribution made after December 31, 2012 and before February 1, 2013 will be deemed to have been made on December 31, 2012. Perhaps more importantly, any portion of a distribution from an individual retirement account to the taxpayer after November 30, 2012 and before January 1, 2013 can be treated as a qualified charitable distribution to the extent that such portion is transferred in cash to the charitable organization.
- American opportunity tax credit – For singles with income of up to $90,000 and married couples with income up to $180,000, a tax credit of up to $2,500 per student is available for each of their first four years of college. Absent the new legislation, 2012 would have been the final year of this credit. The new legislation extends this credit through the 2017 tax year.
- Tuition and fees deduction – In certain situations, it can be more advantageous for a taxpayer to claim a deduction for tuition and fees rather than the American opportunity credit referred to above. For singles with income of up to $80,000 and married couples with income up to $160,000, a deduction of up to $4,000 per year may be taken for tuition and fees. The deduction expired at the end of 2011. The new legislation has revived this deduction for the 2012 tax year and extended it through 2013.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.