Fiscal Cliff Notes: Tax Changes in the American Taxpayer Relief Act of 2012

By Stanley Rose January 2, 2013

Over the cliff and back

While Congress was not able to avoid watching us fall over the so-called “fiscal cliff” before the year expired (and 2012 was a Leap Year; they had an extra day!), they reached a compromise late last night that reeled us back in before we spent too much time at the bottom.  As the name implies, the American Taxpayer Relief Act of 2012 (the “Act”) primarily addresses taxes, and following is a summary of some of the changes.

Individual income tax rates – ordinary income

For taxpayers reporting taxable income below certain thresholds ($400,000 for single filers, $450,000 for married filers and $425,000 for heads of households), the existing federal rates will remain intact.  Income exceeding those amounts will be subject to tax at 39.6%.  Commentary:  The resulting set of tax brackets now presents a hybrid of the tax decreases provided under President Bush and the increases provided under President Clinton, with the higher income taxpayers subject to the increases and the lower income taxpayers continuing to enjoy (if that word is applicable in the tax context!) the decreases. 

Individual income tax rates – long term capital gains and dividends

For many years, the top federal rate applicable to long-term capital gains has been 15%, and many dividends qualified for this rate as well.  A one-way ticket over the cliff would have changed the 15% top rate on long-term capital gains to 20% for everyone, but perhaps more significantly, removed dividend income from the capital gain “umbrella,” subjecting dividends to ordinary rates as high as 39.6%.  Under the Act, dividend income continues to qualify for the favorable rates applicable to long-term capital gains.  Further, the existing 15% rate remains unchanged for taxpayers whose taxable incomes are below certain thresholds ($400,000 for single filers, $450,000 for married filers and $425,000 for heads of households).  Taxpayers whose incomes exceed those levels will be subject to a top rate of 20% on dividends and long-term capital gains.

Investment income tax

Untouched in yesterday’s negotiations is a tax created by the 2010 Reconciliation Act that has come to life this year. The Unearned Income Medicare Contribution Tax (“UIMCT”) was created in 2010 to help fund the significant healthcare rules created by that year’s Patient Protection and Affordable Care Act.  This 3.8% tax, applicable beginning 2013, applies to a portion of most investment income, such as gains, interest and dividends.  Specifically, it is equal to 3.8% of the lesser of two amounts: (1) net investment income or (2) the excess of modified AGI over a threshold amount.  The threshold amounts are:

1. For taxpayers filing joint returns or surviving spouses: $250,000;
2. For married taxpayers filing separate returns: $125,000;
3. For all other individual taxpayers: $200,000;
4. For estates and trusts: The dollar amount at which the highest tax bracket begins (currently $11,950).

“Modified AGI” refers to AGI increased by net foreign income excluded by §911.  “Net investment income” includes such normal suspects such as interest, dividends, annuities, royalties and rents, but it also includes, depending on the circumstances, two additional and potentially far-reaching categories of income: (1) some trade or business income and (2) gains.  Commentary: This tax may apply to operating income allocated to a partner or S-corporation, as reported on a Schedule K-1, if the recipient’s involvement with the entity is considered “passive.”  This tax will have the effect of causing investment income to be taxed at varying rates for individuals, because the thresholds vary from those used in the 2012 Act.  Gains at 15% or 20% and ordinary income at 39.6%, when combined with this tax, will be subject to combined rates of 18.8%, 23.8% and 43.4%, respectively.  Combined with state income taxes, some taxpayers will surpass 50% for this category of income.

Deductions and exemptions

Personal exemptions and itemized deductions will be phased out for taxpayers whose adjusted gross incomes (“AGI”) exceed the following “applicable amounts”: $250,000 for single filers, $275,000 for heads of households, $300,000 for married/joint return filers and $150,000 for married/separate return filers. Itemized deductions will be reduced by the lesser of (1) 3% over the applicable amount or (2) 80% of the otherwise allowable deductions. Personal exemptions are phased out by 2 percentage points for each $2,500 (or fraction thereof) by which AGI exceeds the applicable amount. Commentary: This disallowance of otherwise allowed deductions will drive up the “effective rate” of high income taxpayers to amounts greater than the 39.6% top rate implies, and some taxpayers who are over the thresholds may see much less “bang for the buck” for optional outlays, like charitable contributions.

Alternative Minimum Tax (“AMT”)

The Act greatly increases individual AMT exemptions and permanently indexes them for inflation.  The exemption amounts for 2013 are $50,600 for single filers and heads of households, $78,750 for married/joint return filers and $39,375 for married/separate return filers.  Commentary: Many readers, including some who have paid it, may not understand AMT.  Although we will not attempt to explain the complex computations here, a general explanation follows.  Many years ago certain high-income taxpayers were able to escape all or most federal taxation by structuring their affairs in a manner that income was not taxable and/or deductions exceeded income.  While this planning was completely legal under the existing tax rules, it was deemed inequitable that the very wealthy could pay so little, so Congress created the aptly named Alternative Minimum Tax as a parallel tax computation.  It contained far fewer deductions and exempted less income from taxation, and it neutralized much of the scheming that produced the deemed inequity.  If the tentative AMT was higher than the “regular” tax, AMT would apply.  To ensure it applied only to the high income individuals (who tend to have more ability to manipulate their incomes), exemptions were created that would prevent AMT from being assessed on most lower or middle income taxpayers.  Those exemptions, though, were not indexed for inflation, and as inflation grew, more and more individuals who were never intended to be caught it its grasp became subject to AMT.  Indexing has taken place in the past, but never on a permanent basis.  The Act makes indexing permanent, which is very significant.

Payroll tax “holiday”

In 2011 and 2012, employees and self-employed have enjoyed a 2% reduction in FICA tax.  This reduction was allowed to expire as scheduled, effective January 1, 2013.  Commentary:  Interestingly, this expiration likely will be felt more broadly than other scheduled increases that were reversed by the Act, and it will be felt immediately.  It was designed to stimulate the economy by providing more discretionary spending to workers.  While most would argue the economy still needs it, it was always made clear this benefit would be temporary. While some were hopeful it might be extended, this author speculates the benefit was allowed to expire for a couple of reasons.  First, this holiday decreased funding of the Social Security program, rather than the country’s “general” coffers, and the solvency of that program is a growing concern of many.  Second, this benefit was doled out primarily via wage withholding, and there is no practical way to implement this for certain income levels but not others.

Individual tax credits

A Child Tax Credit of $1,000 scheduled to drop to $500 after 2012 has been reinstated at $1,000 through the year 2017.  A temporary provision enhancing the Earned Income Credit for taxpayers with 3 or more qualifying children was extended through 2017.  The American Opportunity Tax Credit, providing a tax reduction of as much as $2,500 to students or their parents, was set to expire after 2012, but has been extended through 2017.

Research credit

The Credit for Increasing Research Activities allowed under Section 41 of the Internal Revenue Code has expired, only to be retroactively renewed for a year or so at a time, more times than accountants care to remember.  We find ourselves in familiar territory, as the credit expired at the end of 2011, but was extended through the Act to cover expenditures incurred in 2012 and 2013.

Bonus depreciation deduction

The so-called “bonus depreciation” deduction has existed in some form during nearly every year in the last decade, but was set to expire after 2012.  The Act extended it for a year, though, allowing the immediate write-off of 50% of the cost of qualifying capital additions placed in service through the end of this year.

Section 179 deduction

Section 179, like bonus depreciation, allows immediate write-off of the cost of certain fixed assets, subject to several limits.  The write-off was capped at $139,000 for 2012, and was scheduled to drop to $25,000 for 2013.  The Act, however, increased the cap retroactively to $500,000 for 2012 and 2013.  This benefit begins to be phased out if qualifying additions exceed $2,000,000 in either year.  Also, while computer software is not included in the definition of qualifying assets for this purpose, its inclusion has been allowed in recent years.  That inclusion was scheduled to expire, but has been extended through 2013 as well.

Estate tax

The estate tax exemption amount was scheduled to drop from $5,000,000 (indexed for inflation) to $1,000,000 after 2012.  Under the Act, it remains flat at $5,000,000 (indexed for inflation).  However, the top rate will increase from 35% to 40%.

Spending cuts

A year and a half ago, the country experienced a downgrade in its debt rating, and Congress averted a default on its debt by raising the debt limit.  The Budget Control Act of 2011 that accomplished this called for a long-term solution to the debt problem to be reached by an elite group of Senate and House members.  If solution was not reached, massive automatic spending cuts would take place effective January 1, 2013.  No long-term solution was reached, but the Act provided a two-month extension of the effective date of the automatic cuts.  Commentary:  While frustrating to watch Congress merely kick the can further down the road, they have shown repeatedly that they are more adept at manipulating revenue than controlling spending, and it seems likely the tax efforts included in the Act would have gone off the rails were it not for this extension.

There are many other changes provided in the American Taxpayer Relief Act of 2012 that are too voluminous to discuss here, and our goal with this alert is to provide our readers with some timely updates and useful thoughts.  We likely will provide more guidance on provisions in the Act as we digest its changes further and contemplate their impact.  In the meantime, the full text of the Act may be found here.

If you would like to discuss further, please call your BNN advisor at 800.244.7444