September 14, 2012
The 2013 tax year is looming and with it comes a lot of uncertainty due to the lack of knowledge as to the fate of the “Bush-era” tax cuts. The Bush-era tax cuts refer primarily to the tax measures enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). Tax cuts under these acts were focused on the individual, capital gains, dividends and estate tax rates, but they also included over 30 other major changes to the Tax Code which are going to sunset at the end of 2012 if Congress doesn’t act to extend them. In addition, on June 28, 2012, the Supreme Court upheld the 2010 Patient Protection and Affordable Care Act, which will bring its own tax rate increases. Congress is also committed to mandatory reductions in federal spending under the Budget Control Act of 2011. This uncertainty makes year-end tax planning for 2013 and beyond very challenging. Here’s a closer look at the changes ahead.
If the Bush-era tax cuts expire, the individuals’ taxable income will be subject again to five tax brackets, taxed at the 15%, 28%, 31%, 36%, and 39.6% marginal tax rates instead of the current six tax brackets (10%, 15%, 25%, 28%, 33%, and 35%). The lowest rate of 10% will be eliminated and the highest rate will increase from 35% to 39.6%. Employees’ social security tax rate, which was recently reduced to 4.2% on the first $106,800 of the employee’s wages, will increase back to 6.2% on an employee wage bases up to $113,700. These changes will by far impact the most U.S. taxpayers. There will also be a .9% increase in Medicare payroll tax. Right now, the Medicare tax on salary and/or self-employment (SE) income is 2.9%. If you're an employee, 1.45% is withheld from your paycheck, and the other 1.45% is paid by your employer. If you're self-employed, you pay the whole 2.9% yourself. Starting in 2013, an extra 0.9% Medicare tax will be charged on: (1) salary and/or SE income above $200,000 for an unmarried individual, (2) combined salary and/or SE income above $250,000 for a married joint-filing couple, and (3) salary and/or SE income above $125,000 for those who use married filing separate status.
Another area affecting a large number of taxpayers is the sunset of the reduced capital gains tax rate. After 2012, the 15% reduced rate (0% for taxpayers in the 10% and 15% tax brackets) on qualifying long term capital gains is scheduled to increase to 20%. Certain beneficial rates will remain unchanged, including the 28% rate for collectibles, the 25% rate for recaptured Sec. 1250 gains, and the ordinary income rates for short term gains. As for qualifying dividends, the reduced rate of 15% (0% for taxpayers in the 10% and 15% tax brackets) will be replaced by ordinary income tax rates, with the highest rate scheduled to be 39.6%. These increases are in addition to the Medicare tax on investment income discussed below.
On June 28 the U.S. Supreme Court upheld the 2010 Patient Protection and Affordable Care Act. With this decision, the 3.8% Medicare Contribution Tax (MCT) becomes effective January 1, 2013. As discussed above, in 2012 the maximum federal income tax rate on long-term capital gains and qualified dividends is only 15%. Starting in 2013, the maximum rate on long-term gains is scheduled to go up to 20% and the maximum rate on dividends is scheduled to increase to 39.6%.
Also starting in 2013, all or part of the net investment income, including long-term capital gains and dividends, received by higher income taxpayers, may also pay an additional 3.8% "Medicare contribution tax." Therefore, the maximum federal rate on long-term gains for 2013 and beyond will actually be 23.8% (versus the current 15%) and the maximum rate on dividends will be 43.4% (versus the current 15%).
The additional 3.8% Medicare tax will only apply if your adjusted gross income (AGI) exceeds: (1) $200,000 if you're single, (2) $250,000 if you're a married joint-filer, or (3) $125,000 if you use married filing separate status.
The additional 3.8% Medicare tax will apply to the lesser of your net investment income or the amount of AGI in excess of the applicable threshold amounts above. Net investment income includes interest, dividends, royalties, annuities, rents, income from passive business activities, income from trading in financial instruments or commodities, and gains from assets held for investment like stock and other securities. (Gains from assets held for business purposes are not subject to the extra tax.)
So what will this look like to a taxpayer? A married joint-filing couple with AGI of $265,000 and $60,000 of net investment income would pay the 3.8% tax on $15,000 ($265,000 - $250,000). If the same couple has AGI of $850,000, they would pay the 3.8% tax on $60,000 (the entire amount of their net investment income since this amount is now less than the AGI difference of $850,000-$250,000 or $600,000).
It is also important to remember that the majority of U.S. businesses are pass-through entities such as partnerships and S corporations. If the individual income tax rates rise as expected, the current C corporation rate of 35% might become more favorable, especially for individuals with pass-through income from partnerships or S corporations. This is because these profits are passed out to the individual owners who will now be taxed at a rate higher than the corporate tax rate.
To minimize the impact of the expected individual tax rate increases, taxpayers should consider accelerating income into 2012 by exercising stock options, accelerating bonuses, Roth Conversions, etc. Consideration should also be given to deferring deductions to 2013. However, this must be looked at in conjunction with the changes to itemized deductions discussed later. With the likelihood of an increased capital gain rate, taxpayers should consider the acceleration of sales of appreciated capital assets into 2012. This will guarantee the current low capital gain rates. The sale must be a bona-fide sale and the money must be received in 2012. One suggestion would be to sell your appreciated capital gain property, lock in to the 15% tax rate, and immediately re-buy the capital asset. This will allow you to continue to hold a position you want in your portfolio long term-but take advantage of the current reduced rate. Remember – wash sale rules only apply to losses on the sale of capital assets: if the asset is sold at a gain, there is no waiting period to re-buy the same security. As for qualifying dividends, the reduced rate of 15% (0% for taxpayers in the 10% and 15% tax brackets) will be replaced by ordinary income tax rates, with the highest rate scheduled to be 39.6%. The current concern is that dividend paying stocks will not be as attractive to investors at these higher rates and we could see stock prices fall.
The Bush-era tax cuts and the Working Families Tax Relief Act of 2004 (WFTRA) phased-in an increase in the size of the 15% regular income tax rate bracket for a married couple filing a joint return to equal twice the size of the corresponding rate bracket for single individual to provide marriage penalty relief. A marriage penalty occurs when the couple pays a higher tax rate on the same total income than they would pay if each were single. This provision is scheduled to expire after December 31, 2012 and revert to married-joint filer’s bracket equaling 167% instead of 200% of the corresponding single filer’s bracket. Similarly, the standard deduction for joint filers will revert to 167% of the standard deduction amount allowable for single taxpayers. It is estimated that the standard deduction for joint filers will drop from $11,900 to approximately $9,950. Married individuals might be forced to increase their withholdings and make larger estimated tax payments in 2013 to account for the sunset of the Marriage Penalty Relief provisions previously enacted.
Under current law, total itemized deductions are not subject to the overall limitation on itemized deductions also referred to as the “3%/80% rule” or the “Pease limitation.” Before EGTRRA, certain itemized deductions were reduced by the lesser of 3% of the amount by which AGI exceeded a certain limit or 80% of the itemized deductions subject to the reduction rules. Certain itemized deductions weren’t subject to the reduction rules such as medical expenses, investment interest, casualty and theft losses, and gambling losses. In the face of the possible return of the overall limitation on itemized deduction, individuals might consider moving deductions from 2013 into 2012 to reduce the overall tax bill. Again, an individual needs to work closely with their tax professional to be sure the benefit of this additional deduction in 2012 outweighs the benefit that could be received by deferring the deduction into 2013 when it can offset income now taxed at a higher rate.
In 2010, 2011, and 2012, individual taxpayers are entitled to the full personal exemption amount regardless of the amount of their adjusted gross income (AGI). The personal exemption phase-out (PEP), under which the exemption amount of a taxpayer whose adjusted gross income exceeds a specified threshold amount is reduced by an applicable percentage, is expected to be in effect for tax years beginning after 2012. The applicable percentage was previously 2% for each $2,500 by which the AGI of a taxpayer exceeded the threshold amount for the taxpayer. The AGI threshold amounts were indexed for inflation. If PEP was in effect in 2012, the applicable threshold would have been $173,650 for single taxpayers and $260,500 for married filing jointly.
As of today, there is still pending legislation in Congress regarding the future of the Alternative Minimum Tax (AMT). The House GOP wants to abolish the AMT completely while the Democrats want to introduce the "Buffet Rule" to replace part of the AMT. In layman’s terms, the Buffet Rule would ensure that taxpayers who make over $1 million annually would pay an effective tax rate of 30%. Current legislation states that for 2012, unless changed by Congress, the AMT exemption amounts will drop significantly from $48,450 for unmarried individuals to $33,750 and from $74,450 for married individuals filing a joint return to $45,000. The main purpose of the AMT "patches," which were created by the EGTRRA and subsequent laws, is to increase exemption amounts for the growing number of taxpayers subject to AMT. The patches also included a provision that allowed nonrefundable personal tax credits to offset both regular tax and AMT to their full extent. Without passing of an extension for the current patch or the passing of a similar patch, only certain nonrefundable tax credits will be allowed to offset AMT liability.
The 2010 Tax Relief Act provided for a maximum estate tax rate of 35% for decedents dying after December 31, 2009 and before January 1, 2013 as well as an applicable exclusion amount of $5,000,000 ($5,120,000 in 2012). If the Act is not extended, the federal estate tax rate is scheduled to revert to 55% after 2012 with an applicable exclusion amount of $1,000,000. Also, an estate provision set to expire is the concept of “portability” which allows the estate of a decedent who is survived by a spouse to make a portability election to permit the surviving spouse to apply the decedent’s unused exclusion to the surviving spouse’s own transfers during life and at death. In addition to these estate tax provisions, the state death tax deduction allowed under EGTRRA will expire and revert back to the state death tax credit. The federal gift tax, under the 2010 Tax Relief Act, follows the estate tax and therefore has a maximum 35% tax rate with applicable $5,000,000 exclusion. ($5,120,000 in 2012). These current, more favorable rates are set to expire at the end of 2012, but there is still much uncertainty regarding what the rates will become.
This uncertainty makes it very difficult to plan estates effectively, but many taxpayers are choosing to gift some portion (if not all) of the current $5,120,000 exemption before it sunsets. This can be done through outright gifts or setting up gifting trusts to benefit intended recipients in future years. The generation-skipping transfer (GST) tax is also set to sunset at the end of 2012 and will revert from a maximum amount of 35% with an applicable exclusion of $5,120,000 in 2012 back to 55% with an application exclusion of $1,000,000. A number of other GST tax-related provisions are scheduled to expire at the end of 2012, including GST deemed allocation and retroactive allocation provisions, clarification of valuation rules with respect to the determination of the inclusion ratio for GST tax purposes, provisions for allowing for a qualified severance of a trust for GST-tax purposes and relief from late GST allocations and elections.
There is no way of knowing whether Congress will extend any of the provisions into 2013. Due to this uncertainty, taking preemptive measures is critical and the time to do so is NOW. You should be working with your tax and financial planning advisors to be sure the timing of transactions is carefully considered in order to minimize the negative impact the changes may bring with them. Many tax saving techniques require months to implement, especially if valuations or appraisals are needed. Although you may not feel this way, U.S. taxpayers currently pay the lowest rates in decades – and that may be ending very soon.