FISCAL CLIFF NOTES: ANALYSIS OF THE AMERICAN TAXPAYER RELIEF ACT OF 2012

Congress passed the American Taxpayer Relief Act of 2012 (“The Act”) on January 1st, 2013 to avoid the much-discussed “fiscal cliff,” and the President quickly signed it into law on January 2nd.  The Act prevented drastic tax increases on millions of Americans, but several increases were still enacted.  Here’s how you and/or your business might be affected:

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Individual Tax Provisions

Though there were several big changes to the tax code in the Act, they were all tied to varying levels of income, designed to target higher-income taxpayers.  For individuals earning less than $250,000 ($300,000 for married couples), virtually nothing changed, and in fact those taxpayers will now benefit from a long-term fix to the Alternative Minimum Tax that was slated to affect an estimated 30 million taxpayers in 2012.

For taxpayers earning more than those amounts, there are four big changes, and one change to note that was already slated to take place:

  • Income Tax Rates:  Though tax rates stayed the same (ranging from 10% to 35%) for those earning less than $400,000, there is a new top rate that kicks in at that $400,000 level ($450,000 for married couples) of 39.6%.
  • Long-Term Capital Gains & Qualified Dividends:  These “special” types of income have been taxed at 15% for the last decade, and will continue to be, except for taxpayers with incomes greater than $400,000 ($450,000 for married couples).  For those taxpayers, a 20% rate is in effect.  Coupled with the 3.8% Medicare surtax on higher-income taxpayers described below, the rate is effectively 23.8% for long-term capital gains and qualified dividends.
  • The Stealth Tax:  Here’s where things get a little complicated.  There are two provisions (known as PEP and Pease) – which were introduced in the 1990s, but gradually phased out in the last decade – that limit the benefit of personal exemptions and itemized deductions for higher-income taxpayers.  These provisions were re-introduced in the Act and affect taxpayers starting at the $250,000 income level ($300,000 for married couples).
    • PEP is short for Personal Exemption Phase-Out and gradually eliminates the benefit of a taxpayer’s personal exemption as their income increases, totally removing the benefit when a taxpayer’s income reaches $375,000 ($425,000 for married couples).
    • The Pease limitation similarly limits the value of a taxpayer’s itemized deduction, reducing the deductions by 3% of the amount which the taxpayer’s income exceeds the $250,000/$300,000 threshold.  The deductions are not reduced below 80%.  Since these income levels are lower than the top-line rate increases, more taxpayers will be affected than it may seem at first.
  • Social Security Tax:  For the last two years, the Social Security Tax rate on employees’ contributions has been reduced from 6.2% to 4.2%.  Starting January 1, 2013, that rate is restored to 6.2%.  Social Security Tax is paid on the first $113,700 of wages in 2013.
  • Medicare Surtax:  Enacted as part of the Affordable Care Act, this surtax comes in two flavors:
    • For starters, earned income in excess of $200,000 ($250,000 for married couples) is subject to an additional 0.9% surtax.  Your employer should withhold this surtax once your income exceeds those levels.
    • The second flavor is a 3.8% surtax on net investment income – interest, dividends, capital gains.  This tax also only applies when your income exceeds $200,000 ($250,000 for married couples), and applies to the investment income over that threshold

Additional Tax Break Extensions

A few other popular tax breaks were extended, as well:

  • the $250 deduction for teacher’s classroom expenses;
  • parity in the income exclusion for employer-provided mass-transit benefits and parking benefits;
  • deductibility of mortgage insurance premiums for certain taxpayers,
  • the deduction for state and local sales taxes in lieu of income taxes;
  • the provision which allows nontaxable IRA transfers directly to charities;
  • and the tuition and fees deductions.

The American Opportunity Tax Credit, which provides a $2,500 per-year credit for the first four years of higher education, was extended for 5 years (until 2017).

The Child Tax Credit was preserved at the $1,000-per-child level permanently (it was slated to drop to $500).

Finally, a new provision was put in place allowing taxpayers to convert their 401(k) accounts into a Roth 401(k)while currently employed, if their employer offers a Roth 401(k).  Though a Roth 401(k) is not as flexible as a Roth IRA, and you have to pay tax on the amount converted, this can be a good opportunity for younger employees.

Business Tax Provisions

There were also a few business tax breaks extended in the Act:

“Bonus Depreciation,” which allows an additional depreciation deduction of 50% of the cost of qualifying property (typically new property with a tax class life of 20 years or less) in the first year, was extended into 2013 only.  For vehicles, there is a flat $8,000 additional first year deduction, instead of the aforementioned 50%.  The Act also extends the ability to treat qualified leasehold improvements, along with restaurant property and retail improvement property, as 15-year property for tax purposes.

Further, businesses have been able to elect to deduct as expenses, rather than depreciate, the cost of certain tangible personal property under Section 179.  The amount available to be expensed is retroactively set at $500,000 for 2012 and extended into 2013.  The amount available to expense is phased out when total property placed in service exceeds $2,000,000.  After 2013, these amounts will decrease to $25,000 and $200,000, respectively.

Several other credits were extended and/or reinstated, most notably the Research Credit and the Work Opportunity Tax Credit.  In addition, the exclusion for employer-provided educational assistance was made permanent.

Gift & Estate Tax Provisions

Gift & Estate taxation has been a hot-button issue for the last two years, after the estate tax first expired in 2010, then was reinstated for 2011 and 2012 at a 35% rate and a $5 million unified exemption (combining the gift and estate taxes), along with the generous benefit of portability between spouses.  Now, for 2013 and beyond, the $5 million unified exemption was made permanent and tied to inflation, but the 35% rate on estates and gifts in excess of that exemption increased to 40%.

Portability between spouses was also made permanent; meaning any unused exemption from the first decedent in a marriage can be transferred to the surviving spouse to use upon their death.  All of these changes are good news, as they mean that attorneys and tax advisors can actually plan for the future.

 

For More Information

If you have questions or need more information on any of these provisions, please do not hesitate to contact our Tax Department.  We look forward to your questions and feedback.  For ongoing regulatory and legislative updates, please the “It’s Taxing” blog at www.bbcpa.com/blog.

 

IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.

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