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Trends & Developments - June 2012 - What Happens If Nothing Happens?

The current political rhetoric includes many proposals relating to the structure of the federal income tax and the tax rates to be applied to various types of income.  Certain proposals call for increases in federal tax rates, while others seek a reduction in those rates. Although almost everyone seems to be in agreement that the Internal Revenue Code is too complex and contains so-called loopholes unfairly favoring wealthy individuals and certain sectors of our economy, there is no agreement on a replacement structure or a significant change in the existing structure. The two dominant political parties have created a Congressional stalemate that may continue unless one of the parties wins control of both the Senate and the House of Representatives. Unfortunately, there is the possibility that the present gridlocked situation may continue after the November election. If no Congressional agreement is reached, then on January 1, 2013 there will be an automatic increase in federal taxes for most readers of this publication.

This article explains the changes in federal tax rates and related provisions applicable to individual taxpayers that will automatically take effect on January 1, 2013 in the absence of Congressional action. It also discusses certain planning considerations that could soften the impact of increased taxes should they occur.


INCOME TAXES 

Under tax cuts enacted during the immediately preceding administrations of President Bush, for 2012 there are six basic income tax rates: 10%, 15%, 25%, 28%, 33% and 35%. The 35% rate applies to taxable ordinary income over $388,350 for joint return filers. However, qualified dividend income and net long-term capital gains are taxed at a 15% rate. The 2012 rate schedule for married persons filing a joint return is as follows:

 Taxable Ordinary Income   Marginal Tax Rate 
 Not over $17,400 10%
 Over $17,400 but not over $70,700 15%
 Over $70,700 but not over $142,700 25%
 Over $142,700 but not over $ 217,450 28%
 Over $217,450 but not over $388,350 33%
 Over $388,350 35%

If the Bush tax cuts expire because of Congressional inaction, existing statutory provisions will cause the highest federal income tax rate to rise to 39.6% on taxable ordinary income over $390,050 for joint return filers. Qualified dividend income will no longer be subject to special treatment and will be taxed as other ordinary income, with rates as high as 39.6%. Net long-term capital gains will be taxed at a 25% rate. The rate schedule for married persons filing a joint return will be as follows:

Taxable Ordinary Income (estimated)   Marginal Tax Rate  
 Not over $59,300 15%
 Over $59,300 but not over $143,350 28%
 Over $143,350 but not over $218,450 31%
 Over $218,450 but not over $ 390,050 36%
 Over $390,050 39.6%

In addition, a number of other provisions of the Internal Revenue Code will automatically be reinstated and have the effect of increasing the taxable income base to which the higher tax rates will apply. For example, for 2012 a taxpayer is allowed a deduction of $3,800 for each personal exemption and that amount is indexed annually for inflation. In tax years commencing after 2012, the allowable personal exemptions would be phased-out by 2% for each $2,500 by which a taxpayer’s adjusted gross income exceeds a certain dollar amount. For 2013, this dollar amount is estimated to be $260,500 for married persons filing jointly and $173,650 for a single taxpayer. (This personal exemption phase-out is generally referred to as “PEP.”) For those individuals who itemize their deductions – primarily real estate taxes, state and local income taxes, interest expense, and charitable contributions – commencing in 2013 most itemized deductions would again be subject to a phase-out if a taxpayer’s adjusted gross income exceeds a certain dollar amount, estimated to be $173,650 in 2013.  The reduction is 3% of the amount of the taxpayer’s adjusted gross income in excess of the specified amount, subject to a maximum reduction of 80%. (This itemized deduction phase-out is generally referred to as “PEASE.”)

It should be noted that real estate taxes, state and local income taxes, and certain types of interest expense are not deductible under current law in computing the alternative minimum tax.  Also, there is no deduction for exemptions under the alternative minimum tax. However, if the regular tax deductions for exemptions and miscellaneous itemized deductions were reduced commencing in 2013, the regular tax liability would be increased, thereby reducing or eliminating a taxpayer’s alternative minimum tax.  The increase in the regular federal tax rates would have the same tendency.

Under current proposals, there is also considerable uncertainty as to what the dollar amount of the exemption from the alternative minimum tax will be for 2012, as well as what it will be commencing in 2013. With the growing number of people becoming subject to the alternative minimum tax, Congress has had to “patch” this exemption each year by temporarily increasing it. The exemption amounts for 2011 were $48,450 for an unmarried individual and $74,450 for married persons filing jointly and surviving spouses. If Congress fails to act, for 2012 the exemption amounts will be $33,750 and $45,000, respectively.

There are many other changes in the federal income tax structure that may automatically take effect on January 1, 2013. These include:

  • A reduction in the child tax credit from $1,000 to $500 per child.
  • A reduction in the maximum adoption tax credit and greater restrictions on eligibility.
  • A reduction in the amount of the dependent care credit and greater restrictions on eligibility.
  • Reductions in the previously enacted “marriage penalty” relief, including a reduction in the allowable standard deduction for married persons filing jointly.
  • Reductions and restrictions relating to the allowable deduction for student loan interest.
  • A reduction in the maximum contribution to a Coverdell Education Savings Account from $2,000 to $500.
  • Elimination of 100% bonus depreciation on qualified business property.
  • A substantial reduction in the bonus first-year depreciation allowance (Section 179 deduction).
  • Elimination of the itemized deduction for state and local sales taxes (for those not claiming the deduction for state and local income taxes, generally because they are not subject to such taxes in their state).
  • A reduction in the tax-free transit benefit for employees.
  • A reduction in the exclusion for gain on qualified small business stock.

NEW TAX ON INVESTMENT INCOME 

Another provision in the Internal Revenue Code that will be effective on January 1, 2013 imposes a new tax on “net investment income.” This tax will be imposed at a 3.8% rate on the lesser of (a) net investment income (e.g., income from interest, dividends, capital gains and other unearned income) or (b) the excess of modified adjusted gross income over a specified dollar amount. This dollar amount is $250,000 for married persons filing jointly or a surviving spouse, $125,000 for married persons filing separately and $200,000 for other taxpayers. This new tax is in addition to the regular income tax imposed on items of net investment income.

For those taxpayers subject to the new 3.8% tax on net investment income, their effective federal tax rate on net long-term capital gains will be 23.8%. If the taxpayer is in the various phase-out ranges for deductions, the effective rate will be 25%.  For long-term capital gains on collectibles, the base rate will remain at 28% but the new 3.8% tax will also apply. The tax rate on depreciation recapture will remain at 25% but the new 3.8% rate will also apply. This new tax will cause affected taxpayers to be subject to a 43.4% tax on dividends, interest and short-term capital gains.


SOCIAL SECURITY AND MEDICARE TAXES 

For 2012, each of an employer and an employee pays a tax for old age, survivors, and disability insurance (“OASDI”) on wages up to the taxable wage base of $110,100. The employer pays this tax at a 6.2% rate and the employee pays this tax at a 4.2% rate.  In the absence of Congressional action, the rate of tax paid by the employee will revert to 6.2% and there will be an inflationary increase in the taxable wage base. It is estimated that the wage base for 2013 will increase to $113,700.  Moreover, starting in 2013 the employee’s portion of the OASDI tax will be subject to an additional tax of 0.9% of wages in excess of a specified dollar amount.  For married persons filing jointly, this additional tax will be computed on the combined wage income of both spouses. The dollar amounts above which this additional tax will be imposed are $250,000 for married persons filing joint returns or a surviving spouse, $125,000 for married individuals filing separately, and $200,000 for unmarried individuals and heads of households.

In addition to the OASDI tax, each of the employer and employee pays a Medicare tax on all wages at a 1.45% rate. There is no scheduled change in this Medicare tax.

Self-employed persons (including working partners and limited liability company members) are subject to self-employment taxes that roughly parallel the OASDI and Medicare taxes. Thus, for 2012 a self-employed person is subject to a tax rate of 10.4% on his or her net self-employment income up to a taxable base of $110,100. This rate is set to automatically increase to 12.4% in 2013. As noted above, the 2013 wage base is estimated at $113,700. A self-employed person also pays a 2.9% Medicare tax on all of his or her net self-employment income. The additional 0.9% Medicare tax will also be imposed on self-employed persons whose income exceeds the applicable dollar amounts noted above. For income tax purposes, a self-employed person is entitled to a deduction equal to one-half of his or her self-employment tax.

ESTATE, GIFT AND GENERATION-SKIPPING TAXES 

For 2012, the maximum federal estate tax and gift tax rate is 35% and there is a $5,120,000 exemption. Similar provisions apply to generation-skipping transfers (e.g., to grandchildren and more remote descendants).  In the absence of Congressional action, on January 1, 2013 the highest tax rate on these transfers will revert to 55% (on transfers in excess of $3 million) and there will be only a $1 million exemption.

Please see the article entitled “Lifetime Gifts: A Window of Opportunity” in the February 2012 issue of EisnerAmper’s Trends & Developments for a fuller explanation of certain planning possibilities relating to these taxes.

PLANNING CONSIDERATIONS

John Boehner (R-OH), the Speaker of the House of Representatives, recently announced that the House would take up legislation this summer to extend the Bush tax cuts.  It appears that this is mere political gamesmanship and that there will be no actual tax legislation enacted before the November elections. Even after the elections, a lame duck Congress will be in session until January 2013. It is possible that Congress will act sometime in 2013 to change the Internal Revenue Code to avoid the automatic tax increases described above. It is also possible that such legislation will be retroactive to January 1, 2013. However, at this time nobody can reliably predict future legislation and the automatic changes will probably go into effect at least temporarily.

Given the uncertainty surrounding future changes in our tax laws, taxpayers should be prepared to act when things become more certain. For those taxpayers who will be affected by the automatic changes, certain actions should be considered:

  • Assuming that one is not subject to the alternative minimum tax, consideration should be given to accelerating income into 2012 and deferring deductions into 2013. However, the alternative minimum tax cannot be ignored and the potential value of tax savings actions should be analyzed by using detailed tax projections for 2012 and 2013 under the laws presently in effect.
  • Recognize capital gains in 2012.
  • Invest in tax-free municipal bonds.
  • Accelerate withdrawals from qualified plans in 2012, including conversions to Roth IRAs.
  • Delay payment of charitable contributions until 2013.
  • Recognize income in 2012 that may have been deferred under the installment sales rules.
  • Cash in U.S. Treasury bonds on which the interest has been deferred before December 31, 2012.

It is not too early to begin analyzing the advisability of these and other actions.  When December 2012 arrives – if there is no enacted legislation or a realistic prospect of retroactive legislation to vitiate the adverse impact of the automatic changes described above – there will be very little time to take appropriate action.

 

Trends & Developments - June 2012

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