As signs of progress are surfacing in an effort to avoid the Country’s dive off the “fiscal cliff,” it’s a good time to take a look at which tax issues are being negotiated as the ledge quickly approaches. The tax provisions set to expire on December 31, 2012 are comprised of the following key components:
Bush Tax Cuts
The most significant element of the fiscal cliff from a tax perspective is the expiration of Bush-era tax cuts, which include a variety of provisions that reduced income taxes over the past decade. Foremost, income tax rates under the Bush provisions were lowered on most brackets, including a top rate of 39.6% reduced to 35%. Tax rates on long-term capital gains were set at 15%, reduced from 20% previously, while qualified dividends enjoyed a special 15% rate as well. Additionally, limitations on itemized deductions and phase-outs of personal exemptions were repealed.
Furthermore, the Bush-era provisions increased tax benefits for married couples and families. The child tax credit was doubled from $500 to $1,000 per eligible child, and the child and dependent care credit was also expanded. So-called “marriage penalties” were decreased by widening lower tier tax brackets for married couples and increasing the threshold for the earned income tax credit.
Other facets of the Bush tax cuts were the increased exemption and reduced rates on the estate tax. Currently, the top rate for 2012 was set at 35% and the exemption at $5.12 million (indexed for inflation). If these provisions are not extended, the top rate would increase to 55%, and the exemption would fall to $1 million (not indexed for inflation).
The second component is whether or not Congress will create a patch for the Alternative Minimum Tax (AMT) exemption. When AMT was first introduced, the calculation included an exemption amount subtracted from income subject to AMT. Unfortunately, that exemption was not indexed for inflation. Under the Bush tax cuts, the exemption amount was increased to account for inflation. This “patch” was extended several times, but technically expired at the end of 2011. If Congress does not patch it again for 2012, the exemption amounts will revert back to $45,000 from $74,450 for married taxpayers and $33,750 from $48,450 for unmarried individuals. Consequently, many more taxpayers would be subject to the alternative minimum tax in 2012.
The third key element in regards to the fiscal cliff is the potential expiration of the temporary reduction in payroll taxes. Enacted in 2011 and extended through 2012, this provision reduced the employee’s share of Social Security payroll taxes as a form of economic stimulus. The rate of social security taxes for employees shrunk from 6.2% to 4.2%, or a total of 12.4% to 10.4% for self-employed individuals. This was enacted as a temporary stimulus, and thus, is unlikely to be extended for more than a year. Should it not be extended, employees will pay an additional 2% of tax on taxable Social Security wages in 2013.
Finally, a variety of other temporary tax provisions for both individuals and businesses, commonly referred to as “tax extenders,” are set to expire at the end of 2012 or have already expired at the end of 2011. For individuals, these include the deduction for state and local sales taxes in lieu of deducting state income taxes, the deduction for mortgage insurance premiums, above-the-line deductions for tuition and educator expenses, and the refundable prior-year AMT credit. For businesses, these include the provisions for bonus depreciation allowance of 100% and increased section 179 deductions up to $125,000. These are some of the highlights, but there are a multitude of other provisions included in this segment as well.
The term “fiscal cliff” has become synonymous with uncertainty regarding the macroeconomic repercussions. The potential changes to tax law, combined with planned spending cuts, have generated anxiety for many individuals as well. While time will undoubtedly unveil our ultimate destination, this should serve as a guide map for scaling the fiscal cliff in the interim, and prepare you for what may emerge should we go over the ledge.