Tax legislation—Congress addresses fiscal cliff

Congress and President Obama reached an agreement to temporarily avert the so-called "fiscal cliff." The American Taxpayer Relief Act of 2012 (the Act) calls for an increase of the top tax bracket to 39.6 percent for taxpayers with income over $450,000 (married, filing joint returns). For other taxpayers, ordinary income rates remain unaffected. The Act also addresses the capital gains rate, tax rates for dividends, and numerous other tax provisions.

While the Bush tax cuts and the alternative minimum tax (AMT) patch have been made permanent for most taxpayers, tax uncertainty may remain since the agreement left unresolved the sequestration budget cuts as well as the level of the nation’s debt ceiling, which will need to be raised in the coming weeks. Accordingly, we will be monitoring developments that may impact your overall tax planning strategy.

The following are the key provisions from the Act, as well as a brief discussion of what the legislation does not address.

Individual tax provisions

Tax rates. Tax rates on ordinary income have been permanently extended, meaning rates remain the same for most taxpayers. The top rate rises to 39.6 percent for taxpayers above the "applicable threshold." The applicable threshold is $450,000 for joint filers and surviving spouses, $400,000 for single filers, and $225,000 for married taxpayers filing separately.

RateMarried filing joint and
surviving spouse
Married filing separateSingle
10%$0–$17,400$0–$8,700$0–$8,700
15%$17,400–$70,700$8,700–$35,350$8,700–$35,350
25%$70,700–$142,700$35,350–$71,350$35,350–$85,650
28%$142,700–$217,450$71,350–$108,725$85,650–$178,650
33%$217,450–$388,350$108,725–$194,175$178,650–$388,350
35%$388,350–$450,000$194,175–$225,000$388,350–$400,000
39.6%Over $450,000Over $225,000

Over $400,000

Note: these ranges are based on 2012 tables before any applicable inflation adjustments for 2013.

Capital gains and dividend rates. The Act preserves the 15 percent tax rate on capital gains and dividends for taxpayers below the applicable threshold; the rate reverts to 20 percent for taxpayers with incomes above the applicable threshold.

Previous legislation had provided for an 18 percent capital gains rate for assets held longer than five years. This rate had not been in effect due to the temporary 15 percent capital gains rate enacted in 2003. If no action had been taken, the 18 percent rate would have become effective in 2013. While the Act does not specifically address the 18 percent rate, it appears that the 18 percent rate may not apply unless a technical correction is made to the cross-referencing in the legislation. It is too early to know if Congress is aware of or will address this issue.

The zero percent capital gains rate remains in effect for taxpayers in the 10 percent and 15 percent brackets.

Please note that the capital gain and dividend tax rates mentioned above do not include the 3.8 percent Medicare tax that becomes effective in 2013.

Itemized deduction limitation. For tax years beginning after 2012, the "Pease" limitation on itemized deductions, which had previously been suspended, is reinstated with a starting threshold of $300,000 for joint filers/surviving spouse, $275,000 for heads of household, $250,000 for single filers, and $150,000 (one-half of the otherwise applicable amount for joint filers) for married taxpayers filing separately. For taxpayers subject to the "Pease" limitation, the total amount of their itemized deductions is reduced by 3 percent of the amount by which the taxpayer's adjusted gross income (AGI) exceeds the threshold amount, with the reduction not to exceed 80 percent of the otherwise allowable itemized deductions. These dollar amounts are inflation-adjusted for tax years after 2013.

Personal exemption limitation. For tax years beginning after 2012, the Personal Exemption Phase-out (PEP), which had previously been suspended, is reinstated with a starting threshold of $300,000 for joint filers/surviving spouse; $275,000 for heads of household; $250,000 for single filers; and $150,000 (one-half of the otherwise applicable amount for joint filers) for married taxpayers filing separately. Under the phase-out, the total amount of exemptions that can be claimed by a taxpayer subject to the limitation is reduced by 2 percent for each $2,500 (or portion thereof) by which the taxpayer's AGI exceeds the applicable threshold. These dollar amounts are inflation-adjusted for tax years after 2013.

Permanent AMT relief. The Act provides permanent alternative minimum tax (AMT) relief. Prior to the Act, the individual AMT exemption amounts for 2012 would have reverted to $33,750 for unmarried taxpayers, $45,000 for joint filers, and $22,500 for married persons filing separately. Retroactively effective for tax years beginning after 2011, the Act permanently increases these exemption amounts to $50,600 for unmarried taxpayers, $78,750 for joint filers and $39,375 for married persons filing separately. In addition, for tax years beginning after 2012, these exemption amounts are indexed for inflation.

Other individual provisions. The $3,000 child and dependent care credit ($6,000 for more than one), the exclusion for employer-provided educational assistance, and the employer-provided child care credit have also been extended and made permanent as part of the legislation. Additionally, the deduction for state and local general sales taxes, the exclusion from gross income of discharge of qualified principal residence indebtedness, and the above-the-line deduction for qualified tuition and related expenses have been extended through 2013.

Conversion of 401(k) balances to a Roth account. The Act allows the conversion of amounts in 401(k) plans and certain other employer retirement accounts into Roth accounts. The amounts converted will be subject to income tax. Under the Act the transfer is treated as a taxable qualified rollover contribution.

Estate and gift tax

The Act prevents steep increases in estate, gift and generation-skipping transfer (GST) tax that were slated to occur after 2012 by permanently keeping the exemption level at $5,000,000 (as indexed for inflation). However, the Act also permanently increases the top estate, gift and rate from 35 percent to 40 percent. The Act also continues the portability feature that allows the estate of the first spouse to die to transfer his or her unused exemption to the surviving spouse. All changes are effective for estate and gift transfers made after 2012.

Business tax provisions

Bonus depreciation and other tax incentives were enacted in 2009 intended to provide a short-term stimulus to the economy. Of these provisions, the following have been extended by the Act.

  • 50 percent bonus depreciation has been extended through 2013 (2014 for long-production property)
  • 15-year straight-line cost recovery for qualified leasehold improvements, restaurant buildings and improvements, and retail improvements has been extended through 2013
  • The increased section 179 expensing amount of $500,000 is extended through 2013 and reverts to $25,000 beginning in 2014.
  • The reduction in the S corporation recognition period for built-in-gains is extended through 2013, with a five-year recognition period rather than ten years.

Congress has traditionally extended numerous provisions of the tax code on a one- to two-year basis. The usual list of extenders was not fully addressed by the Act. However, many provisions were extended; some of the most significant include:

Items not addressed

Payroll tax holiday ends. The 2 percent payroll tax holiday related to the Social Security tax for all earners up to the wage base ($113,700) was not extended. As a result, everyone’s take home pay decreases in 2013.

Debt limit. The bill does not provide for an increase in the federal debt limit. Treasury Secretary Geithner has said the debt limit was reached on December 31st and that Treasury has approximately two months before the US would otherwise default on its obligations.

Sequestration. The Act delays for two months the across-the-board "sequestration" spending cuts. The Budget Control Act of 2011 provides for $1.2 trillion in spending cuts beginning in 2013 if Congress cannot agree on alternative proposals providing an equal amount of deficit reduction.

As a result of the two-month sequestration extension and impending debt limit, we can expect calls for expanded revenue and tax reform to be included in the upcoming debates. As a result, 2013 will be another year where you need to be mindful of your tax situation in an ever-changing environment.

For more information or any questions you might have on this topic, please contact your Baker Tilly advisor or send an e-mail to tax@bakertilly.com.