United States: A Brief Explanation of the American Taxpayer Relief Act of 2012

In the past few weeks, attention has focused on Washington and how the politicians would deal with the tax component of the so-called fiscal cliff (the tax increases that would automatically go into effect on January 1).  On January 1, Congress passed the American Taxpayer Relief Act of 2012 (the “Act”), and President Obama signed the Act into law on January 2.  Politicians have stated that the Act was designed to keep America from going over the fiscal cliff.  But what does that mean?  As explained below, the Act did reduce the number of tax increases that would go into effect, but unfortunately, many other tax increases still went into effect. 

What Did the Act Address?

The main component of the looming tax increases was the expiration of the tax cuts introduced under President Bush.  The rates for all federal ordinary income tax brackets were set to return to 2003 rates, which would increase the tax rates across all brackets (generally, by 3 to 5%).  The Act changed this result, keeping the Bush era tax rates in place for all taxpayers except for those over a certain high-income threshold.  This threshold (the “Act Threshold”) is $450,000 for joint filers, $400,000 for single filers, and $225,000 for married taxpayers filing separately.  Taxpayers with income over the Act Threshold will be subject to tax at a maximum rate of 39.6%.

Additionally, the Bush tax cuts generally lowered the tax rate on capital gains to 15% and provided that qualified dividends would be taxed at a preferential 15% rate (instead of at ordinary income rates).  On January 1, capital gains rates were set to increase to 20% and dividends were set to be taxed at ordinary income rates.  The Act stopped these increases for taxpayers below the Act Threshold.  For taxpayers with income over the Act Threshold, capital gains and dividends will generally be taxed at an increased rate of 20% (which, for dividends, is better than the anticipated increase to ordinary income rates).    

The Act has also increased tax liability for higher income taxpayers by reimplementing exemption and deduction phaseouts.  The threshold amount for these phaseouts (“Phaseout Threshold”) is $300,000 for joint filers, $250,000 for single filers, and $150,000 for married taxpayers filing separately.  Taxpayers with adjusted gross income above the Phaseout Threshold will be limited in the personal exemptions that they can claim, as their personal exemption amount will be reduced by 2% for each $2,500 by which the taxpayer's adjusted gross income exceeds the applicable Phaseout Threshold.  In addition, these same taxpayers will be limited in the amount of itemized deductions that they can claim.  The amount of itemized deductions that can be deducted will be reduced by 3% of the amount by which the taxpayer’s adjusted gross income exceeds the Phaseout Threshold (subject to a limitation that the reduction shall not exceed 80% of the allowable itemized deductions).

The Act also addressed the looming threat that the alternative minimum tax (AMT) will impact more taxpayers.  The Act retroactively increased AMT exemption amounts to reduce the number of taxpayers that will be subject to AMT. 

The Act extended the availability of 50% first-year bonus depreciation, and increased the expensing limitation for depreciable property for 2012 and 2013.  In 2012, the expensing limitation was $139,000 (with a phaseout threshold of $560,000), and this amount was set to be reduced dramatically in 2013.  The Act increased the expensing amount for 2012 (retroactively) and 2013 to $500,000 (with a phaseout threshold of $2 million). 

Finally, the Act addressed the impending tax increase in the estate, gift, and generation-skipping transfer area.  Absent legislation, the maximum tax rate was set to increase from 35% to 55%, with the exemption amount decreasing from $5 million (actually, $5.12 million as the exemption is adjusted for inflation) to $1 million.  The Act makes the $5 million exemption (adjusted for inflation) permanent and provides for a maximum tax rate of 40%.

What Did the Act Not Address?

Several upcoming tax increases were not addressed by the Act.  The expiring tax holiday for payroll taxes was not address, meaning that the reduced 4.2% tax rate for the employees’ portion of the Social Security payroll tax has expired and the rate has returned to 6.2%. This will be a 2% tax rate increase that employees will immediately see on their paychecks.

In addition, the new 3.8% tax (referred to as the Unearned Income Medicare Contribution) on investment income will apply to most joint filers with adjusted gross income above $250,000 and single filers with adjusted gross income above $200,000.  The tax is essentially a flat tax at a 3.8% rate on investment income above the $250,000/$200,000 threshold.  The tax applies to the following:  dividends; rents; royalties; interest, except municipal-bond interest; short and long-term capital gains; the taxable portion of annuity payments; income from the sale of a principal home above the $250,000/$500,000 exclusion; a net gain from the sale of a second home; and passive income from real estate and investments in which a taxpayer does not materially participate.  Although the tax applies only to investment income above the threshold, other income (including wages or Social Security) can increase a taxpayer’s adjusted gross income above the threshold, exposing the taxpayer to this tax. 

Finally, the Medicare tax rate will increase by .9 percent (from 1.45 percent to 2.35 percent) on wages for certain employees (i.e., those with wages over $200,000 for single filers, wages over $250,000 for joint filers, and wages over $125,000 for persons who are married but filing separately). 

In short, the Act did prevent many tax increases from going into effect, but it was only a partial fix.  Many other provisions were allowed to go into effect, with the result that many taxpayers will face greater tax liability. 

“Notice Under U.S. Treasury Department Circular 230:  To the extent that this e-mail communication and the attachment(s) hereto, if any, may contain written advice concerning or relating to a Federal (U.S.) tax issue, United States Treasury Department Regulations (Circular 230) require that we (and we do hereby) advise and disclose to you that, unless we expressly state otherwise in writing, such tax advice is not written or intended to be used, and cannot be used by you (the addressee), or other person(s), for purposes of (1) avoiding penalties imposed under the United States Internal Revenue Code or (2) promoting, marketing or recommending to any other person(s) the (or any of the) transaction(s) or matter(s) addressed, discussed or referenced herein.  Each taxpayer should seek advice from an independent tax advisor with respect to any Federal tax issue(s), transaction(s) or matter(s) addressed, discussed or referenced herein based upon his, her or its particular circumstances.”

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.

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Amanda Wilson
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