Previously published in AICPA Tax Insider, January 2013.
After months of senseless haggling, the Senate early in the morning of Jan. 1, 2013, by a vote of 89–8, and the House of Representatives late in the evening of Jan. 1, by a vote of 257–167, passed the American Taxpayer Relief Act of 2012, P.L. 112-240 (the Act). On Jan. 2, President Barack Obama signed it into law, thereby avoiding the "fiscal cliff." What was left on the table after the deal, which will set up another prolonged battle that will reinforce the divisiveness that has plagued Congress, are spending cuts, the budget, and the debt ceiling, not to mention basic tax reform.
What was confronting Congress and the president was the expiration of the George W. Bush tax cuts, which would have returned tax rates to the Clinton-era rates with a top rate of 39.6% on ordinary income, a 20% rate on long-term capital gains, and ordinary income tax rates applying to dividends. Also confronting Congress was the expiration of the increased AMT exemption amount, or "patch," certain business subsidies that had been regularly extended annually, and the 2% payroll tax cut. In addition, the automatic $1.2 trillion in cuts over 10 years to defense and discretionary spending, created under the Budget Control Act of 2011, P.L. 112-25, and commonly called the "budget sequester," was set to go into effect on Jan. 1.
General provisions
The most significant provisions of the Act made the Bush tax cuts permanent for married taxpayers filing jointly and surviving spouses with taxable incomes up to $450,000, for taxpayers filing single with taxable incomes of up to $400,000, and for taxpayers filing as heads of households with taxable incomes up to $425,000. The Act imposed a 39.6% rate on taxable income above those thresholds; extended the 15% rate on dividends and long-term capital gains for taxpayers under those threshold levels; and imposed a 20% rate on long-term capital gains and qualified dividends for taxpayers to the extent their income is above those thresholds.
The Act returned the personal exemption phaseout and a limitation on itemized deductions that had been repealed when the Bush tax cuts were enacted, and permanently indexed the AMT individual exemption amounts for inflation. Furthermore, the Act extended a variety of previously extended temporary tax provisions set to expire, commonly referred to as "tax extenders," which affect individuals, businesses, charitable giving, energy, community development, and disaster relief.
The Act also made permanent a top estate tax rate of 40% and an estate tax exclusion of $5 million (indexed for inflation) for estates of decedents dying after Dec. 31, 2012. The $5 million estate tax exclusion was coordinated with the gift tax and the generation-skipping transfer tax so that the same $5 million exclusion applies to all three taxes.
Most disappointingly, Congress allowed the 2% payroll tax cut to expire at the end of 2012, resulting in a tax increase to about 114 million taxpayers, especially middle-class and lower-income taxpayers who have more of their income subject to the payroll tax.
Individual income tax rates
In addition to the rate changes and income thresholds discussed above, all of the tax brackets and the threshold amounts are to be adjusted for inflation after 2013 based upon the standard formula, not the chained formula that considers changes in consumer buying habits as a result of increased prices, which would result in lower increases.
In addition, starting in 2013, the 0.9% Medicare surtax applies to wage income greater than $200,000 for taxpayers filing individual returns and $250,000 for married taxpayers filing joint returns. This tax was enacted in 2010 as part of health care reform (Patient Protection and Affordable Care Act, P.L. 111-148, as amended by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152 (the health care acts)).
Capital gains/dividend tax rates
To the extent that a taxpayer's taxable income exceeds the threshold amounts for the 39.6% tax rate, long-term capital gains and qualified dividends will be subject to a 20% rate, an increase from the Bush-era maximum rate of 15%. Capital gains and qualified dividends that would be subject to the 25% or 35% rates if they were ordinary income will continue to be subject to a 15% capital gains rate. A 0% rate will continue to apply to capital gains and qualified dividends that would be taxed at the 15% rate if they were ordinary income. For 2013, ordinary income below $72,500 for joint filers and $36,250 for single filers will be taxed at the 15% rate.
Under another provision from the health care acts that was not affected by the latest legislation, but that applies starting in 2013, taxpayers filing single returns whose adjusted gross income (AGI) exceeds $200,000 and married taxpayers filing joint returns whose AGI exceeds $250,000 are subject to an additional 3.8% tax on net investment income.
Alternative minimum tax relief
Ending the yearly drama of enacting an alternative minimum tax (AMT) patch, the Act patches the AMT for 2012 and subsequent years by increasing the exemption amount subject to an annual inflation adjustment and allowing nonrefundable personal credits to offset in full regular taxes and AMT. For 2012, the Act increased the exemption amount to $50,600 from $33,750 for taxpayers filing individual returns and to $78,750 from $45,000 for married taxpayers filing joint returns. For 2013, the inflation-adjusted amounts are $51,900 for single taxpayers and $80,800 for married taxpayers filing joint returns.
The continued existence of the AMT is uncertain if Congress tackles comprehensive tax reform. In addition, President Obama has proposed replacing the AMT with the so-called Buffett Rule, under which taxpayers making more than $1 million would pay an effective rate of 30%.
Itemized deduction limitation
The Act has reinstated the Pease limitation (named after the congressman who sponsored the original provision) to reduce itemized deductions for taxpayers who meet certain thresholds by 3% of the amount by which the taxpayer's AGI exceeds the thresholds The threshold amount is $250,000 for single taxpayers and $300,000 for married taxpayers filing joint returns. These thresholds are subject to adjustment for inflation for tax years after 2013. Under the Pease limitation, the amount of itemized deductions cannot be reduced by more than 80%.
Personal exemption phaseout
The phaseout of personal exemptions for taxpayers whose income is above certain threshold amounts was repealed for 2010, and the repeal was extended through 2012. The Act reinstates the phaseout of personal exemptions for taxpayers whose AGI exceeds the threshold amounts applicable to the Pease limitation. Under the Act, the total amount of exemptions that may be claimed by a taxpayer is reduced by 2% for each $2,500 by which the taxpayer's AGI exceeds the applicable threshold amount, e.g., $250,000 for single taxpayers and $300,000 for married taxpayers filing joint returns.
Estate, gift, and generation-skipping transfer taxation
For 2013, the maximum estate tax rate was scheduled to revert to 55%, and the exclusion amount was scheduled to be reduced from $5 million to $1 million. The Act provides for a maximum rate of 40% and a lifetime exemption amount of $5 million subject to adjustment for inflation for taxpayers dying after Dec. 31, 2012. For 2013, the inflation-adjusted amount is $5.25 million. Surviving spouses can take advantage of the unused lifetime exemption amount of a deceased spouse (commonly referred to as the portability election).
In addition, the Act has unified the estate, gift, and generation-skipping tax, creating a single rate of 40% and a single exemption amount of $5 million.
Conversion of traditional IRAs to Roth IRAs
To offset the costs of delaying the sequester for two months, the Act broadens provisions allowing participants to convert their pretax retirement plan accounts to Roth accounts. Previously, a taxpayer could accomplish such a conversion only for amounts that were distributable, which generally occurs as a result of separation from service or attaining the age of 59½. Under the Act, any amount in a non-Roth account can be converted to a Roth account in the same plan, regardless of whether the amount is distributable.
Marriage penalty relief
The Act extended all marriage penalty relief. It kept the standard deduction for married taxpayers filing joint returns at twice the standard deduction for taxpayers filing individual returns, rather than allowing it to fall to 167% of the standard deduction for taxpayers filing individual returns. It also kept the 15% bracket for married taxpayers filing joint returns at 200% of the corresponding tax bracket for taxpayers filing individual returns. However, in the other areas of the Act dealing with threshold levels, Congress made no effort to extend marriage penalty relief.
Miscellaneous
The Act extends for five years certain tax breaks for low- and middle-income taxpayers, such as the earned income tax credit, the child tax credit, and the American opportunity tax credit. In addition, the Act extends through 2013 the deduction of up to $250 for certain expenses incurred by elementary and secondary school teachers; the exclusion from income for discharge of qualified principal residence indebtedness; the treatment of mortgage insurance premiums as qualified residence interest; the option to deduct state and local general sales taxes; the above-the-line deduction for qualified tuition and related expenses; and the exemption for 100% of the gain on sales of certain small business stock.
In a nontax provision that may be just as important to the economy as the preservation of lower tax rates, federal unemployment insurance was extended for a year, providing benefits to those unemployed for longer than 26 weeks.
Conclusion
At the cost of a $3.9 trillion increase in the deficit over the next 10 years, the enactment of the American Taxpayer Relief Act of 2012 has moved the ball down the field, but as of yet the ball has not crossed the goal line. Taxpayers will have to wait until Congress deals with the sequester, the debt ceiling, and meaningful and significant tax reform.
This article is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The description of the results of any specific case or transaction contained herein does not mean or suggest that similar results can or could be obtained in any other matter. Each legal matter should be considered to be unique and subject to varying results. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.
Duane Morris LLP, a full-service law firm with more than 700 attorneys in 24 offices in the United States and internationally, offers innovative solutions to the legal and business challenges presented by today's evolving global markets. Duane Morris LLP, a full-service law firm with more than 700 attorneys in 24 offices in the United States and internationally, offers innovative solutions to the legal and business challenges presented by today's evolving global markets. The Duane Morris Institute provides training workshops for HR professionals, in-house counsel, benefits administrators and senior managers.