This article was originally published in the Journal of Accountancy, January 2013. Copyright 2013 by the American Institute of Certified Public Accountants. All rights reserved. Reprinted with permission.
Pulling back from the “fiscal cliff” at the 13th hour, Congress on Tuesday preserved most of the George W. Bush-era tax cuts and extended many other lapsed tax provisions. See: Fiscal Cliff vs. Jimmy Cliff: How the leap may look more like Y2K or the Mayan calendar.
Shortly before 2 a.m. Tuesday, the Senate passed a bill that had been heralded and, in some quarters, groused about throughout the preceding day. By a vote of 89 to 8, the chamber approved the American Taxpayer Relief Act, H.R. 8, which embodied an agreement that had been hammered out on Sunday and Monday between Vice President Joe Biden and Senate Minority Leader Mitch McConnell, R-Ky. The House of Representatives approved the bill by a vote of 257-167 late on Tuesday evening, after plans to amend the bill to include spending cuts were abandoned. The bill now goes to President Barack Obama for his signature.
“The AICPA is pleased that Congress has reached an agreement,” said Edward Karl, the organization’s vice president—tax. “The uncertainty of the tax law has unnecessarily impeded the long-term tax and cash flow planning for businesses and prevented taxpayers from making informed decisions. The agreement should also allow the IRS and commercial software vendors to revise or issue new tax forms and update software, and allow tax season to begin with minimal delay.” See: How 10 top groups define 'fiduciary’.
With some modifications targeting the wealthiest Americans with higher taxes, the act permanently extends provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003. It also permanently takes care of Congress’ perennial job of “patching” the alternative minimum tax. It temporarily extends many other tax provisions that had lapsed at midnight on Dec. 31 and others that had expired a year earlier. See: Here’s a 15-item checklist of low-hanging tax tips for financial advisors.
The act’s nontax features include one-year extensions of emergency unemployment insurance and agricultural programs and yet another “doc fix” postponement of automatic cuts in Medicare payments to physicians. In addition, it delays until March a broad range of automatic federal spending cuts known as sequestration that otherwise would have begun this month. See: Fiscal Cliff is ready for his close-up — whether we are or not.
Among the tax items not addressed by the act was the temporary lower 4.2% rate for employees’ portion of the Social Security payroll tax, which was not extended and has reverted to 6.2%.
Here are the act’s main tax features:
Individual tax rates
All the individual marginal tax rates under EGTRRA and JGTRRA are retained (10%, 15%, 25%, 28%, 33%, and 35%). A new top rate of 39.6% is imposed on taxable income over $400,000 for single filers, $425,000 for head-of-household filers, and $450,000 for married taxpayers filing jointly ($225,000 for each married spouse filing separately).
Phaseout of itemized deductions and personal exemptions
The personal exemptions and itemized deductions phaseout is reinstated at a higher threshold of $250,000 for single taxpayers, $275,000 for heads of household, and $300,000 for married taxpayers filing jointly.
Capital gains and dividends
A 20% rate applies to capital gains and dividends for individuals above the top income tax bracket threshold; the 15% rate is retained for taxpayers in the middle brackets. The zero rate is retained for taxpayers in the 10% and 15% brackets.
Alternative minimum tax
The exemption amount for the AMT on individuals is permanently indexed for inflation. For 2012, the exemption amounts are $78,750 for married taxpayers filing jointly and $50,600 for single filers. Relief from AMT for nonrefundable credits is retained. See: Here’s a 15-item checklist of low-hanging tax tips for financial advisors.
Estate and gift tax
The estate and gift tax exclusion amount is retained at $5 million indexed for inflation ($5.12 million in 2012), but the top tax rate increases from 35% to 40% effective Jan. 1, 2013. The estate tax “portability” election, under which, if an election is made, the surviving spouse’s exemption amount is increased by the deceased spouse’s unused exemption amount, was made permanent by the act.
Various temporary tax provisions enacted as part of EGTRRA were made permanent. These include:
- Marriage penalty relief (i.e., the increased size of the 15% rate bracket (Section 1(f)(8)) and increased standard deduction for married taxpayers filing jointly (Section 63©(2));
- The liberalized child and dependent care credit rules (allowing the credit to be calculated based on up to $3,000 of expenses for one dependent or up to $6,000 for more than one) (Section 21);
- The exclusion for National Health Services Corps and Armed Forces Health Professions scholarships (Section 117©(2));
- The exclusion for employer-provided educational assistance (Section 127);
- The enhanced rules for student loan deductions introduced by EGTRRA (Section 221);
- The higher contribution amount and other EGTRRA changes to Coverdell education savings accounts (Section 530);
- The employer-provided child care credit (Section 45F);
- Special treatment of tax-exempt bonds for education facilities (Section 142(a)(13));
- Repeal of the collapsible corporation rules (Section 341);
- Special rates for accumulated earnings tax and personal holding company tax (Sections 531 and 541); and
- Modified tax treatment for electing Alaska Native Settlement Trusts (Section 646).
Individual credits expired at the end of 2012
The American opportunity tax credit for qualified tuition and other expenses of higher education was extended through 2018. Other credits and items from the American Recovery and Reinvestment Act of 2009 that were extended for the same five-year period include enhanced provisions of the child tax credit under Section 24(d) and the earned-income tax credit under Section 32(b). In addition, the bill permanently extends a rule excluding from taxable income refunds from certain federal and federally assisted programs (Section 6409).
Individual provisions expired at the end of 2011
The act also extended through 2013 a number of temporary individual tax provisions, most of which expired at the end of 2011:
- Deduction for certain expenses of elementary- and secondary-school teachers (Section 62);
- Exclusion from gross income of discharge of qualified principal residence indebtedness (Section 108);
- Parity for exclusion from income for employer-provided mass transit and parking benefits (Section 132(f));
- Mortgage insurance premiums treated as qualified residence interest (Section 163(h));
- Deduction of state and local general sales taxes (Section 164(b));
- Special rule for contributions of capital gain real property made for conservation purposes (Section 170(b));
- Above-the-line deduction for qualified tuition and related expenses (Section 222); and
- Tax-free distributions from individual retirement plans for charitable purposes (Section 408(d)).
Business tax extenders
The act also extended many business tax credits and other provisions. Notably, it extended through 2013 and modified the Section 41 credit for increasing research and development activities, which expired at the end of 2011. The credit is modified to allow partial inclusion in qualified research expenses and gross receipts those of an acquired trade or business or major portion of one. The increased expensing amounts under Section179 are extended through 2013. The availability of an additional 50% first-year bonus depreciation (Section 168(k)) was also extended for one year by the act. It now generally applies to property placed in service before Jan. 1, 2014 (Jan. 1, 2015, for certain property with longer production periods).
Other business provisions extended through 2013, and in some cases modified, are:
- Temporary minimum low-income tax credit rate for non-federally subsidized new buildings (Section 42);
- Housing allowance exclusion for determining area median gross income for qualified residential rental project exempt facility bonds (Section 3005 of the Housing Assistance Tax Act of 2008);
- Indian employment tax credit (Section 45A);
- New-markets tax credit (Section 45D);
- Railroad track maintenance credit (Section 45G);
- Mine rescue team training credit (Section 45N);
- Employer wage credit for employees who are active duty members of the uniformed services (Section 45P);
- Work opportunity tax credit (Section 51);
- Qualified zone academy bonds (Section 54E);
- Fifteen-year straight-line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements (Section 168(e));
- Accelerated depreciation for business property on an Indian reservation (Section 168(j));
- Enhanced charitable deduction for contributions of food inventory (Section 170(e));
- Election to expense mine safety equipment (Section 179E);
- Special expensing rules for certain film and television productions (Section 181);
- Deduction allowable with respect to income attributable to domestic production activities in Puerto Rico (Section 199(d));
- Modification of tax treatment of certain payments to controlling exempt organizations (Section 512(b));
- Treatment of certain dividends of regulated investment companies (Section 871(k));
- Regulated investment company qualified investment entity treatment under the Foreign Investment in Real Property Act (Section 897(h)); – Extension of subpart F exception for active financing income (Section 953(e));
- Look-through treatment of payments between related controlled foreign corporations under foreign personal holding company rules (Section 954);
- Temporary exclusion of 100% of gain on certain small-business stock (Section 1202);
- Basis adjustment to stock of S corporations making charitable contributions of property (Section 1367);
- Reduction in S corporation recognition period for built-in gains tax (Section 1374(d));
- Empowerment Zone tax incentives (Section 1391);
- Tax-exempt financing for New York Liberty Zone (Section 1400L);
- Temporary increase in limit on cover-over of rum excise taxes to Puerto Rico and the Virgin Islands (Section 7652(f)); and – American Samoa economic development credit (Section 119 of the Tax Relief and Health Care Act of 2006, P.L. 109-432, as modified).
Energy tax extenders
The act also extends through 2013, and in some cases modifies, a number of energy credits and provisions that expired at the end of 2011:
- Credit for energy-efficient existing homes (Section 25C);
- Credit for alternative fuel vehicle refueling property (Section 30C);
- Credit for two- or three-wheeled plug-in electric vehicles (Section 30D);
- Cellulosic biofuel producer credit (Section 40(b), as modified);
- Incentives for biodiesel and renewable diesel (Section 40A);
- Production credit for Indian coal facilities placed in service before 2009 (Section 45(e)) (extended to an eight-year period);
- Credits with respect to facilities producing energy from certain renewable resources (Sectiob 45(d), as modified);
- Credit for energy-efficient new homes (Section 45L);
- Credit for energy-efficient appliances (Section 45M);
- Special allowance for cellulosic biofuel plant property (Section 168(l), as modified);
- Special rule for sales or dispositions to implement Federal Energy Regulatory Commission or state electric restructuring policy for qualified electric utilities (Section 451); and
- Alternative fuels excise tax credits (Section 6426).
The IRS’ authority under Section 1445(e)(1) to apply a withholding tax to gains on the disposition of U.S. real property interests by partnerships, trusts or estates that are passed through to partners or beneficiaries that are foreign persons is made permanent, and the amount is increased to 20%. See: The next step in the IRS pursuit of high-net-worth individuals.
In addition to the various provisions discussed above, some new taxes also took effect Jan. 1 as a result of 2010’s health care reform legislation. See: What RIAs need to know about health care reform.
Additional hospital insurance tax on high-income taxpayers. The employee portion of the hospital insurance tax part of FICA, normally 1.45% of covered wages, is increased by 0.9% on wages that exceed a threshold amount. The additional tax is imposed on the combined wages of both the taxpayer and the taxpayer’s spouse, in the case of a joint return. The threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case.
For self-employed taxpayers, the same additional hospital insurance tax applies to the hospital insurance portion of SECA tax on self-employment income in excess of the threshold amount.
Medicare tax on investment income. Starting Jan. 1, Section 1411 imposes a tax on individuals equal to 3.8% of the lesser of the individual’s net investment income for the year or the amount the individual’s modified adjusted gross income exceeds a threshold amount. For estates and trusts, the tax equals 3.8% of the lesser of undistributed net investment income or AGI over the dollar amount at which the highest trust and estate tax bracket begins.
For married individuals filing a joint return — and surviving spouses — the threshold amount is $250,000; for married taxpayers filing separately, it is $125,000; and for other individuals it is $200,000.
Net investment income means investment income reduced by deductions properly allocable to that income. Investment income includes income from interest, dividends, annuities, royalties and rents, and net gain from disposition of property, other than such income derived in the ordinary course of a trade or business. However, income from a trade or business that is a passive activity and from a trade or business of trading in financial instruments or commodities is included in investment income.
Medical-care itemized-deduction threshold. The threshold for the itemized deduction for unreimbursed medical expenses has increased from 7.5% of AGI to 10% of AGI for regular income tax purposes. This is effective for all individuals, except, in the years 2013—2016, if either the taxpayer or the taxpayer’s spouse has turned 65 before the end of the tax year, the increased threshold does not apply and the threshold remains at 7.5% of AGI.
Health flexible spending arrangement. Effective for cafeteria plan years beginning after Dec. 31, 2012, the maximum amount of salary reduction contributions that an employee may elect to have made to a flexible-spending arrangement for any plan year is $2,500.
Paul Bonner (email@example.com) is a JofA senior editor and Alistair M. Nevius (firstname.lastname@example.org) is the JofA’s editor-in-chief, tax.