United States: Congress Passes American Taxpayer Relief Act And Averts Most Tax Elements Of The Fiscal Cliff

January 2013 (No. 1)

Business Tax

On January 2, 2013, President Obama signed into law via the autopen, the American Taxpayer Relief Act of 2012 (H.R. 8) (the "Act"), legislation that brings an eleventh-hour end to most of the controversial fiscal cliff negotiations.

Except for certain high-income individuals, the Act retains many of the favorable tax breaks that were scheduled to expire, and prevents several tax hikes that were scheduled to go into effect this year. However, because the temporary reduction of the Social Security Tax rate was not extended, most taxpayers will see a tax increase beginning in 2013.

Below is a summary of the key provisions included within the Act:

Individual Income Tax Rates

The Act introduces a new income tax rate bracket for certain high-income individuals. While the current tax brackets will remain at 10%, 15%, 25%, 28%, 33% and 35%, a new 39.6% tax rate will apply to taxpayers with income in excess of: (1) $450,000 for joint filers and surviving spouses, (2) $400,000 for single filers, and (3) $225,000 for married taxpayers filing separately. These dollar amounts are adjusted for inflation for tax years after 2013.

Capital Gain and Dividend Rates

Similarly, the Act provides that for tax years beginning after 2012, the top rate for capital gains and dividends will permanently increase from 15% to 20% for individual taxpayers with incomes exceeding (1) $450,000 for married taxpayers, or (2) $400,000 for other taxpayer¹

For taxpayers whose ordinary income is taxed at a rate below 25%, capital gains and dividends will permanently be subject to a 0% rate.

Limitations on Personal Exemptions and Itemized Deductions (the "PEP and Pease Limitations")

The Act reinstates the previously suspended Personal Exemption Phaseout (the "PEP"). Under the PEP, the total amount of personal exemptions that a taxpayer can claim is reduced by 2% for each $2,500 (or portion thereof) of the taxpayer's adjusted gross income ("AGI") that exceeds the following threshold amounts (subject to inflation after 2013): (1) $300,000 for joint filers and a surviving spouse; (2) $275,000 for heads of household; (3) $250,000 for single filers; and (4) $150,000 for married taxpayers filing separately (collectively, the "Threshold Amounts").

The Act also reinstates the previously suspended "Pease" limitation. The "Pease" limitation reduces the total amount of a taxpayer's itemized deductions by an amount equal to 3% multiplied by the excess of the taxpayer's AGI over the Threshold Amounts. The total "Pease" limitation cannot exceed 80% of the taxpayer's otherwise allowable itemized deductions.

Alternative Minimum Tax

Retroactive for tax years beginning after 2011, the Act permanently increases the alternative minimum tax ("AMT") exemption amounts (known as the "AMT patch") to: (1) $50,600 for unmarried taxpayers; (2) $78,750 for joint filers; and, (3) $39,375 for married persons filing separately. For tax years beginning after 2012, these exemption amounts are indexed for inflation.

The Act also permanently allows individuals to offset their entire regular tax liability and AMT liability by nonrefundable personal credits.

American Recovery and Investments Tax Act of 2009 Extenders

The Act provides a five-year extension of the American Opportunity Tax Credit, the eased qualification rules for the child credit, and various earned income tax credit changes, all of which were originally enacted as part of the American Recovery and Investments Tax Act of 2009.

Other Individual Extenders

The Act extends the following provisions beyond their prior termination date:

• The deduction for certain expenses of elementary and secondary school teachers is revived for 2012 and continues through 2013;
• The exclusion for discharge of qualified principal residence indebtedness applies to discharges through the end of 2013;
• Exclusions for employer-provided mass transit and parking benefits is revived for 2012 and continues through 2013;
• The treatment of mortgage insurance premiums as qualified residence interest is revived for 2012 and continues through 2013;
• The option to deduct state and local general sales taxes is revived for 2012 and continues through 2013;
• Special rules for contributions of capital gain real property made for conservation purposes is revived for 2012 and continues through 2013;
• The above-the-line deduction for qualified tuition and related expenses is revived for 2012 and continues through 2013; and
• Tax-free distributions from individual retirement plans for charitable purposes is revived for 2012 and continues through 2013.

Depreciation Provisions

Under the Act, a handful of depreciation provisions were extended. Most notably, the 50% bonus depreciation for certain property, including property with a recovery period of less than 20 years, certain computer software, water utility property, and qualified leasehold improvement property, has been extended for one year to the end of 2013. The modifications to these rules include extending the special rule for long-term contracts to qualified property placed in service in 2013 and extension of the election to accelerate the alternative minimum tax credit in lieu of bonus depreciation. Additionally, the Act retroactively extended through 2013 the following depreciation provisions: (a) 15-year straight line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements; (b) the 7-year recovery period for motorsports entertainment complexes; and (c) the accelerated depreciation for business property located on an Indian reservation.

Business Tax Breaks

The Act also extends many business tax credits and other incentives through 2013, many of which are retroactive for 2012. Those extensions include:

• The 20% credit for research expenses, which also includes modifications to the rules related to acquisition and disposition of a trade or business, as well as aggregation of expenditures;
• Two additional rounds of the new markets tax credit;
• The exception for active financing income of controlled foreign corporations ("CFCs") and the look-through treatment of payments between related CFCs;
• The exclusion from a tax-exempt organization's unrelated business taxable income of interest, rent, royalties, and annuities received from a controlled entity;
• The minimum applicable percentage under the low-income housing tax credit for new, non-federally subsidized buildings;
• The exclusion of 100% of the gain on the sale or exchange of certain small business stock of C corporations;
• Basis adjustments to stock of S corporations that make charitable contributions of property;
• Reduction of the recognition period for built-in gain on property contributed to an S corporation, which is reduced to 5 years for 2012 and 2013 and in the case of an installment sale, provides for the application of the rules applicable to tax year of the sale;
• Qualified zone academy bonds;
• The employer wage credit for employees who are active duty members of the uniformed services;
• The work opportunity tax credit for the hiring of certain targeted groups, including veterans;
• The enhanced charitable deduction for contributions of food inventory;
• Exemption for interest-related dividends from regulated investment companies related to the tax on nonresident alien individuals;
• The inclusion of regulated investment companies as a "qualified investment entity" under the FIRPTA rules;
• Expensing rules related to certain real property, mine safety equipment, and film and television productions; and
• The deduction with respect to income from domestic production activities in Puerto Rico for the first eight tax years of the taxpayer before January 1, 2014.

Gift, Estate and GST Taxes

The Act provides the following with respect to gift, estate and generation-skipping transfer ("GST") taxes:

• The Act permanently extends all changes made to the estate, gift and GST taxes in 2001, and in addition increases the maximum estate tax rate from 35% to 40%;
• The Federal gift, estate and GST lifetime exemption amounts remain unified and will not revert to $1,000,000 as previously scheduled but will instead remain at $5,000,000, adjusted annually for inflation – approximately $5,250,000 in 2013;
• The Act also makes permanent "portability," allowing any unused exemption of a decedent to be transferred to his or her surviving spouse to be used during the survivor's lifetime, or at the survivor's death;
• State death taxes continue to be deductible for Federal estate tax purposes;
• The deemed allocation provisions of the GST tax, and relief from late GST allocations, both scheduled to expire, are permanently extended;
• Estate planning techniques which were widely expected to be limited, restricted or prohibited, including the income taxation of Grantor Trusts, Grantor Retained Annuity Trusts ("GRATs"), Sales to Defective Trusts, Charitable Lead Annuity Trusts ("CLATs"), Spousal Limited Access Trusts ("SLATs") and Qualified Personal Residence Trusts ("QPRTs"), continue to be viable vehicles for efficient transfer of wealth from one generation to the next;
• Finally, the gift tax annual exclusion amount increases by $1,000 to $14,000 per donor/per donee beginning in 2013.

Unemployment Insurance

The Act temporarily extends federal unemployment insurance benefits through 2013.

Energy Tax

The Act extends several energy tax credits through 2013, including those for (1) energy-efficient homes (both existing and new), (2) alternative fuel vehicle refueling property, (3) 2- or 3-wheeled plug-in electric vehicles, (4) cellulosic biofuel producers, (5) biodiesel and renewable diesel, (6) production tax credit for Indian coal facilities, (7) production tax credit for renewable resources, which also includes modifications to exclude paper commonly recycled from the definition of municipal solid waste and the definitions of "qualified facility", (8) energy-efficient appliances, (9) the special allowance for cellulosic biofuel plant property, with a modification to treat algae as a qualified feedstock for purposes of bonus depreciation, (10) the special rule for sales or dispositions in order to implement FERC or state electric restructuring policy for qualified electric utilities; and (11) alternative fuels excise tax credits.

Extension of Payroll Tax Reduction NOT Included in H.R. 8

Notably absent from the Act is an extension of the two-percentage-point reduction in the employee's share of Social Security taxes. Thus, beginning in 2013, the employee's share of Social Security taxes will be increased from a 4.2% rate to a 6.2% rate on wages.

If you have any questions regarding the Act, or its impact on your tax planning, please contact a member of our Business Tax Practice Group.

To ensure compliance with IRS Circular 230, you are hereby notified that any discussion of federal tax issues in this advisory is not intended or written to be used, and it cannot be used by any person for the purpose of: (A) avoiding penalties that may be imposed on them under the Internal Revenue Code, and (B) promoting, marketing or recommending to another party any transaction or matter addressed herein. This disclosure is made in accordance with the rules of Treasury Department Circular 230 governing standards of practice before the Internal Revenue Service.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.