On January 2, 2013, President Obama signed the American Taxpayer Relief Act of 2012 into law, avoiding the automatic tax increases of the “fiscal cliff.” The following is an overview of certain key provisions of the new law relating to Individual Income Taxes; Individual Retirement Accounts and Employee Benefit Plans; Estate, Gift and Generation-Skipping Taxes; and Business Taxes.
Individual Income Taxes
The new law permanently extends the Bush-era income tax rates for middle-class taxpayers, and raises the highest marginal income tax rates and the capital gains and dividends rates. In addition, it reinstates certain deduction limitations, provides Alternative Minimum Tax (“AMT”) relief, and extends certain other provisions.
- Individual Income Tax Rates: Beginning in 2013, taxpayers with taxable income exceeding the $400k/450k Thresholds will be subject to a top marginal income tax rate increase from 35% to 39.6%. The income tax rates remain the same for individuals with taxable income below the $400k/450k Thresholds. In addition, pursuant to the previously enacted Affordable Care Act, beginning in 2013, a new Medicare tax of 0.9% applies to wages and self-employment income that exceed $200,000 for single filers and $250,000 for joint filers.
- Capital Gains and Dividend Rates: For tax years beginning after 2012, the tax rate for long-term capital gains and qualified dividends will increase permanently to 20% for taxpayers with taxable income exceeding the $400k/450k Thresholds. The rate will remain at 15% for most taxpayers (0% for taxpayers with taxable income taxed at a rate below 25%).
Under the previously enacted Reconciliation Act, beginning in 2013, a new 3.8% tax applies to the lesser of net investment income or modified adjusted gross income over $250,000 (married, filing jointly), $125,000 (married, filing separately) and $200,000 (all other individual taxpayers). Net investment income generally includes dividends, capital gains and certain other types of passive activity income, less deductions allocable to such income. Accordingly, for taxpayers with taxable income exceeding the $400k/450k Thresholds, the effective tax rate on capital gains and qualified dividend income will be 23.8%.
- Phase-Out of Itemized Deductions: Prior to the new law, the limitation on certain itemized deductions (known as the “Pease limitation”) had been gradually eliminated by 2012. Under the new law, taxpayers must reduce certain of their itemized deductions by an amount equal to the lesser of (i) 3% of the excess of adjusted gross income over $250,000 for single filers and $300,000 for married, filing jointly (subject to annual inflation adjustments), or (ii) 80% of the amount of the itemized deductions otherwise allowable for the year. These limitations do not apply to medical expenses, interest expenses and casualty, theft or wagering losses. For example, a single filer with $100,000 of itemized deductions (not consisting of medical expenses, interest expenses or casualty, theft or wagering losses) and an adjusted gross income of $750,000, must reduce itemized deductions by $15,000 (i.e., the lesser of (i) 3% of $500,000 (amount of adjusted gross income over threshold) = $15,000, or (ii) 80% of $100,000 (total amount of itemized deductions) = $80,000).
- Phase-Out of Personal Exemptions: Under prior law, the limitation on the allowance of deductions for personal exemptions had been gradually eliminated by 2012. The new law reinstates these limits phasing-out personal exemptions ($3,800 each in 2012) by 2% for each $2,500, or part thereof, that adjusted gross income exceeds the itemized deduction threshold amounts (i.e., $250,000 for single filers; $300,000 for married, filing jointly). Accordingly, personal exemptions are entirely eliminated if income exceeds the applicable threshold by $125,000.
- Alternative Minimum Tax (“AMT”) Relief: The new law provides AMT relief by increasing the AMT exemption amounts. Prior to the new law, the individual AMT exemption amounts for 2012 were to have been $33,750 (unmarried taxpayers), $45,000 (married, filing jointly) and $22,500 (married, filing separately). Retroactively effective for tax years beginning after 2011, the new law increases such exemption amounts to $50,600 (unmarried taxpayers), $78,750 for (married, filing jointly) and $39,375 (married, filing separately). For tax years beginning after 2012, such amounts will be adjusted for inflation.
Other Extenders: The new law also extends many favorable tax provisions which were previously set to expire at the beginning or end of 2012.
- The new law permits taxpayers to exclude from income home mortgage debt which is discharged before January 1, 2014.
- The new law retroactively extends for two years a provision allowing taxpayers to deduct state and local sales taxes (in lieu of deducting state and local income taxes).
- The new law provides a five-year extension of the Child Tax Credit and the Earned Income Tax Credit.
- The new law retroactively extends for two years the deduction for higher education expenses.
- Reduction in Payroll Tax Expires: Notably, the new law does not extend the 2% reduction in payroll and self-employment taxes which had been in place for the last two years. Accordingly, taxpayers’ withholding for Social Security taxes will increase from 4.2% to 6.2%.
Individual Retirement Accounts and Employee Benefit Plans
The new law also includes several provisions relating to individual retirement accounts and employee benefit plans, including tax-free IRA distributions for charitable donations, Roth conversions in 401(k) plans, increased limit on employer-provided transportation benefits and tax-free employer-provided education assistance was made permanent.
- Qualified Charitable Distributions for IRAs: An IRA distribution rule in effect through 2011 allowed individuals who were 70½ or older to receive tax-free IRA distributions of up to $100,000 annually, to the extent such distributions were donated to a qualified charity. The new law reinstates this rule for tax year 2013 and provides two transition rules providing flexibility with respect to tax year 2012. First, if an individual took a required minimum distribution in December 2012, he or she can elect to treat that distribution as a 2012 qualified charitable distribution, to the extent that the distribution is transferred in cash to a qualifying charitable organization before the end of January 2013. Second, the new law allows an individual to receive a qualified charitable distribution in January 2013 and treat it as if it was made in 2012, thereby retaining the full 2013 qualified charitable distribution amount.
- In-Plan Roth Rollover/Conversion for Retirement Plans: In the past, an eligible retirement plan (e.g., 401(k) plan, 403(b) plan, etc.) could permit participants who were eligible to receive a distribution under the plan, to “rollover” or “convert” such amount into a Roth account under the plan. Pursuant to the new law, an eligible retirement plan now may permit such “in-plan” Roth rollover/conversion from any amounts a participant may have under the plan, regardless of whether the amounts are currently eligible for distribution or not. Any in-plan Roth rollover/conversion, however, must be permitted under the plan terms and will be fully taxable to the participant, assuming pre-tax dollars are being used for the rollover/conversion.
- Transportation Expense Reimbursement Plan Limit Parity: Prior to February 17, 2009, an employee could exclude from his or her income a lesser amount for employer-provided transit passes and vanpooling benefits ($120, as adjusted for inflation for 2009), as compared to employer-provided parking benefits ($230, as adjusted for inflation for 2009). The transit pass and vanpooling limits were then raised for 2009, 2010 and 2011 to be equal with the parking limit. The parity between these benefits then expired as of December 31, 2011. However, the new law restored the parity between these benefits retroactive to January 1, 2012. Therefore, for 2012 an employee may exclude from his or her income up to $240 (the indexed amount for 2012) in employer-provided transit passes, vanpooling benefits, or parking benefits. These amounts are increased for inflation to $245 for 2013.
- Section 127 Made Permanent: Employers historically have been able to provide tax-free expense reimbursement for an employee’s qualified education expenses, up to $5,250 annually, pursuant to a temporary provision in the tax code. The new law makes this provision permanent.
Estate, Gift and Generation-Skipping Taxes
For more than a decade, estate tax planning has been complicated by uncertainty in the estate tax laws. The new law begins to reduce some of that uncertainty for individuals by permanently preventing steep increases in estate, gift and generation-skipping (“GST”) taxes that were set to occur for individuals dying and gifts made after 2012.
- Estate, Gift and GST Exemption Level: The estate, gift and GST exemption amounts for 2013 and beyond remain at $5 million indexed for inflation. For tax year 2013, this amount will be $5.25 million. By retaining the $5 million exemption, the new law alleviates concerns about whether an automatic reduction in exemptions would result in any “clawback” or “recapture” of prior gift tax savings.
- Estate, Gift and GST Tax Rate: The new law increases the top estate, gift and GST rate from 35% in 2012 to 40%.
- Portability: The new law continues the portability feature that allows any unused exclusion amount of the first spouse to die, to be portable to the surviving spouse for estate and gift tax purposes. Notably, portability is not available for GST purposes.
- Effective Date: The new law applies to estates of decedents dying, gifts made and generation-skipping transfers made after December 31, 2012, except for the portability provision, which is retroactively effective for tax year 2011.
- Permanent Changes: Notably, the new law permanently adopts these changes to the estate tax laws.
The new law also extends certain favorable business and tax credit provisions through 2013.
- Section 179 Expensing: In general, certain taxpayers may elect to treat the cost of certain tangible personal property placed in service during the tax year in the taxpayer’s trade or business as a deductible expense up to a certain amount. In general, the maximum annual amount that may be expensed is reduced dollar-for-dollar by the cost of qualifying property placed in service during the tax year in excess of an investment ceiling. Prior to the new law, for tax years beginning in 2012 the maximum annual expensing amount was to be $125,000 and the investment ceiling was to be $500,000 (each increased for inflation). For tax years beginning in 2012 and 2013, the new law increases the maximum expensing amount to $500,000 and the investment ceiling to $2 million. The new law also provides that for tax years beginning in 2012 or 2013, up to $250,000 of qualified real property (i.e., certain qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property) may be expensed.
- First-Year Bonus Depreciation: The new law extends 50% first-year bonus depreciation for qualified property acquired and placed in service before January 1, 2014. In general, qualified property includes most tangible personal property, certain depreciable computer software, qualified leasehold improvement property and certain water utility property.
Other Business Tax Extenders: The new law also provides for the extension of various other business tax provisions.
- The new law retroactively extends the research credit for two years so that it applies to amounts incurred before January 1, 2014. The new law also liberalizes the research credit rules with respect to taxpayers that acquire a trade or business and allocation of the credit among members of a controlled group.
- The new law retroactively extends a provision permitting taxpayers to exclude 100% of gain from the disposition of qualified small business stock acquired before January 1, 2014.
- The new law retroactively extends for two years a favorable provision reducing the S corporation recognition period for built-in gains tax on gain from the disposition of assets previously held by a C corporation.
Tax Credit Extenders: The new law also provides for the extension of various tax credits.
- The new law extends the new markets tax credit through 2013.
- The new law extends the biodiesel tax credits.
- The new law extends and modifies the renewable electricity production credit.
- The new law extends the alternative fuel excise tax credit and alternative fuel mixture excise tax credits.
Many provisions of the new law involve complex and overlapping areas of tax law. The extension of and change in tax rates are permanent in that they do not lapse or expire. However, additional tax legislation may be enacted in the future, which may alter any one or all of the provisions of the new law.