Year-end individual tax planning is especially difficult this year due in large part to the following in 2013: (i) the new 3.8% nondeductible Medicare tax on investment income, and the new 0.9% nondeductible Medicare tax on wages, of high income individuals, (ii) the scheduled expiration of the 2001/2003 Bush income tax rates, (iii) possible limitations on itemized deductions and personal exemptions, (iv) doubt regarding renewal of extending various tax benefits, (v) a scheduled dramatic decrease in the estate and gift tax exemption and increase in estate and gift tax rates, and (vi) the threat of massive federal spending cuts. Although 2012 about to close, it is uncertain whether the lame duck U.S. Congress will successfully avert the "fiscal cliff" resulting from more than $600 billion in federal tax increases and spending cuts automatically scheduled to occur in 2013.

INCOME/MEDICARE TAX

Obamacare Medicare Tax Increase. The following additional Medicare taxes will be imposed on certain individuals, starting in 2013 (individuals not filing joint returns are subject to different thresholds).

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Medicare Tax on Excess Investment Income. Net investment income includes (a) capital gains (including gain on disposition of interests in partnerships or S corporations attributed to the entity's nonbusiness property), (b) income from partnerships, LLCs and S corporations if a taxpayer does not materially participate; (c) dividends, royalties, interest and rental income, and (d) gain from sale of residence exceeding the $500,000 exclusion for married filing joint ($250,000 exclusion for other individuals).

Thus, the 3.8% Medicare tax does not apply if the taxpayer's MAGI does not exceed the threshold (e.g., $250,000 for married filing joint).

  • Exemptions: The 3.8% tax does not apply to (w) tax exempt interest, (x) distributions from qualified retirement plan accounts, (y) self-employment income, and (z) tax free build-up in certain life insurance plans.  
  • Trusts and Estates: The 3.8% tax is imposed on the lesser of (i) undistributed net investment income of trusts and estates or (ii) the excess of adjusted gross income over the income level at which the highest trust and estate bracket begins ($11,650 for 2012).

Medicare Tax on Excess Compensation. Total Medicare tax for affected employees and other service providers increases from 1.45% to 2.35% on compensation above $250,000 for married filing joint (above $125,000 for other individuals). Compensation subject to 0.9% tax includes self-employment earnings. Compensation subject to the new 0.9% tax is not capped.

Expiration of Bush Tax Cuts. The Bush Tax Cuts enacted during 2001 and 2003 are scheduled to automatically expire, unless legislation is enacted to extend or modify such cuts.

  • Scheduled Increased Income Tax Rates. Maximum federal income tax rates for married individual filing joint (excluding the impact of any phase-out of itemized deductions and personal exemptions):

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Phase-Out of Itemized Deductions and Personal Exemptions

  • Itemized Deductions. The scheduled expiration of the Bush tax cuts includes phasing out itemized deductions, excluding medical expenses, investment interest, and casualty and theft losses. Itemized deductions would be disallowed equal to 3% of AGI exceeding an inflation adjusted threshold ($166,800 for 2009, the last calculation year), with the disallowance amount not exceeding 80% of the total itemized deductions).
  • Personal Exemption. If the Bush tax cuts expire, the personal exemption deduction ($3,700 for 2011 amount) per taxpayer and dependent would be phased out, at the rate of 2% of the deduction for each $2,500 by which the taxpayer's AGI exceeds a threshold (for 2009, the threshold was $250,200 for taxpayers filing a joint return).

Potential Opportunities. Commencing in 2013, the additional 3.8% and 0.9% Medicare taxes will increase the tax burden of many individuals. Further, if the Bush tax cuts expire at the end of 2012 without modification, the overall tax rates of certain individuals may increase significantly.

Individual taxpayers should consider the possible financial benefits and detriments of tax planning strategies to mitigate the tax cost relating to 2013 tax increases, including (i) accelerating into 2012 capital gain from the sale of assets, or bonuses and other ordinary income, that otherwise would be recognized during 2013, (ii) electing out of any 2012 installment sales, thus subjecting the deferred gain to 2012 tax rates, (iii) completing a Roth IRA conversion before 2013 to offset against income taxed at a higher rate, (iv) invest in tax-exempt bonds (avoiding the 3.8% Medicare tax on the exempt interest), (v) defer triggering 2012 losses until 2013, and (vi) possibly deferring deduction of itemized deductions (although the benefit of such deferral may be partially or totally offset by new limitations on itemized deductions in 2013). Of course, it is impossible to predict with any certainty whether Congress will seek to extend, modify or otherwise limit the Bush tax cuts for 2013.

ESTATE AND GIFT TAX

Expiration of the Bush Tax Cuts would also raise the maximum marginal estate and gift tax rate and reduce the federal unified estate and gift tax exclusion, effective Jan. 1, 2013 as follows:

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Possible 2012 Estate and Gift Tax Planning. Consideration should be given to making large gifts in 2012 that exceed $1 million to the extent the exclusion is available. Further, estate plans should be reviewed in the near future to determine if they need to be updated for the new exemption thresholds. However, individuals should undertake such planning knowing that it is uncertain whether Congress will extend or modify the current estate and gift tax rates and exclusion.