Congressional lawmakers have adjourned for the August recess after holding a series of votes on tax provisions that either expired at the end of 2011 or are set to expire at the end of 2012. No legislation is expected before the elections, but the votes do set the stage for tax negotiations during a lame duck session in November.

Lawmakers will return this fall to face a long list of tax issues that need to be addressed before the end of the year, including:

  • tax "extenders," such as the research credit, which expired at the end of 2011;
  • the alternative minimum tax (AMT), with no "patch" yet for 2012;
  • the 2001 and 2003 tax cuts, scheduled to expire at the end of 2012; and
  • estate and gift rules agreed to in 2010, which will also expire at the end of 2012.

The House and Senate have each approved bills to extend the 2001 and 2003 tax cuts and have each voted down the proposal from the other side. Tax writers on the Senate Finance Committee have also agreed on a package that would address many of the extenders that expired at the end of 2011. Little other progress has been made.

The votes taken so far should be viewed largely as vehicles to stake out campaign positions, and none of the current bills are likely to be enacted in their current form. But the differences in the bills and the outcome of the votes do offer clues to what may eventually emerge in a compromise. The outlook for unfinished tax issues is discussed in the following.

2001 and 2003 tax cuts

Senate Democrats and House Republicans have each passed bills to extend the 2001 and 2003 tax cuts. The Senate approved its bill (S. 3412) in a 51-48 vote on July 25 after rejecting a Republican alternative (S. 3413). The House rejected the Senate's bill 170-257 on Aug. 1 before approving its own version (H.R. 8) in a 256-171 vote.

The tax cuts originally enacted in 2001 and 2003 are scheduled to expire at the end of the year but currently provide:

  • rate cuts across all tax brackets, with a top rate of 35% (see chart)
  • top rates on capital gains and dividends of 15%,
  • full repeal of the personal exemption phaseout (PEP) and "Pease" phaseout of itemized deductions,
  • a zero rate for capital gains and dividends in the bottom brackets,
  • marriage penalty relief,
  • $1,000 refundable child tax credit, and
  • several other benefits, including increased dependent care and adoption credits and enhanced education incentives.

These tax cuts were originally set to expire at the end of 2010, but an agreement late that year extended them through the end of 2012. The House bill would further extend these tax cuts in their entirety through 2013. The Senate bill would also provide a one-year extension but would allow the rate cuts to expire for income above the specific thresholds:

  • $200,000 minus the standard deduction and one personal exemption (singles)
  • $225,000 minus the standard deduction and one personal exemption (head of household)
  • $250,000 minus the standard deduction and two personal exemptions (joint)

Capital gains and dividends above these thresholds would be subject to a top rate of 20%, and PEP and Pease would be reinstated with phase-ins beginning at these thresholds. The Democratic plan largely follows President Obama's platform, except on dividends. The president has recently called for treating dividends as ordinary income, with a top rate of 39.6%, although in previous budgets he called for a top rate of 20%.

It appears for now that Democrats are committed to campaigning on the promise to roll back the tax cuts for income above the $200,000 and $250,000 thresholds, but there may be room for negotiation in a lame duck session. Several Democratic lawmakers previously floated the idea of extending the 2001 and 2003 tax cuts on income up to $1 million.

It is difficult to predict a final outcome. No legislation is expected until after the election, and the results will have an impact on negotiations. But a bipartisan compromise will still be needed. If President Obama is re-elected, he will need to negotiate with Republicans in Congress. If Republicans take both chambers and the White House, they will still need to negotiate with Democrats in the Senate to overcome procedural hurdles. President Obama agreed to an extension of all the tax cuts in 2010 but is now facing an increased national debt, and he has been more rigid this year in his calls for additional revenue.

Estate and gift

The extension of the tax cuts in 2010 also created new estate, gift and generation-skipping transfer (GST) tax rules for 2011 and 2012. The rules generally provide:

  • reunification of estate and gift taxes with a 35% rate and $5 million exemption ($5.12 million in 2012),
  • identical rates for GST tax, and
  • portability in estate tax exemption amounts between spouses.

If no legislation is enacted, the estate, gift and GST taxes will all revert to the rules in place in 2000, with top rates of 55% and exemptions of just $1 million. The House Republican bill would extend the current rules through 2013. Senate Democrats initially offered a provision that would have applied the rules in place in 2009 to 2013 ($3.5 million exemptions and a top rate of 45%), but backed away after several moderate Democrats in conservative states said they might not support such a reversion.

The final bill that passed the Senate did not include any transfer tax changes, a sign that Democrats are far from unified on the issue. The support for more generous transfer tax rules among some Democrats may give Republicans an advantage on the issue, but transfer taxes will likely be just one piece of a larger negotiation that will be subject to significant congressional horse trading.

Medicare tax and health care reform

New Medicare taxes enacted in the health care legislation are also scheduled to take effect in 2013, and Republicans are pushing to repeal them before the end of the year. The new Medicare taxes come in two pieces.

First, the rate of the individual share of Medicare tax will increase from 1.45% to 2.35% on earned income above $200,000 for single filers and $250,000 for joint filers. The 1.45% employer share will not change, creating a top rate of 3.8% on self-employment income. Second, investment income such as capital gains, dividends and interest will be subject for the first time to a new 3.8% Medicare tax to the extent AGI exceeds $200,000 (single) or $250,000 (joint). This tax will not apply to active trade or business income that is not otherwise considered to be self-employment income, or to distributions from qualified retirement plans.

House Republicans have already voted to repeal the whole health care bill, and while that isn't likely this year, Republicans are campaigning on a promise to repeal it in the future. But Republicans did not include a repeal of the Medicare tax in their legislation to extend the 2001 and 2003 tax cuts, even though the Medicare tax will become effective at the same time the tax cuts expire and at the same basic income threshold at which Democrats want to end the tax cuts. Republicans do not appear to be rhetorically linking these issues and may have trouble arguing for the repeal or postponement of the Medicare tax in a lame duck compromise. Democrats will defend the tax as crucial to health care reform.

Extenders and AMT

Lawmakers must also deal with dozens of popular tax provisions that expired at the end of 2011. Many of these are referred to as extenders because they are not permanent, but instead have been extended repeatedly by Congress on a short-term basis. In addition to the traditional extenders, Congress must also address the AMT and a handful of other tax provisions that will expire at the end of this year.

Democratic tax writers on the Senate Finance Committee recently approved, in a 19-5 committee vote, a bipartisan bill that would address many of these provisions. The bill would provide AMT relief for 2012 and 2013 relief that was also offered in both the Senate and House bills extending the 2001 and 2003 tax cuts. Lawmakers are nearly certain to grant AMT relief in any legislative compromise enacted before the end of the year.

The outlook for other provisions is less clear. The Senate Finance Committee bill would extend through 2013 many of the most important expired provisions, including:

  • research credit,
  • special 15-year recovery periods for qualified leasehold improvements and qualified restaurant and retail property,
  • alternative fuel credit (including propane used in forklifts),
  • work opportunity credit,
  • new markets tax credit,
  • reduced five-year holding period for S corporation built-in gains,
  • 100% exclusion from gain on qualified small business stock,
  • wind energy production credit,
  • the ability to take the Section 48 credit in lieu of the Section 45 credit,
  • the Subpart F "active financing" exception and the "look through" treatment for payments between related controlled foreign corporations (CFCs), and
  • increased limits on Section 179 expensing (the bills that passed the House and Senate and the Senate Finance Committee all contained varying increases in Section 179 expensing).

However, tax writers on both sides of the aisle also agreed not to include extensions of some key provisions, including:

  • expensing of "brownfields" environmental remediation costs,
  • energy grants under section 1603 of the 2009 economic recovery bill,
  • tax credits for ethanol, and
  • bonus depreciation.

An extension of bonus depreciation was also omitted from both chambers' bills to extend the 2001 and 2003 tax cuts. Taxpayers were allowed to fully expense property placed in service last year under 100% bonus depreciation, and property placed in service in 2012 is eligible for 50% bonus depreciation (certain long-production-period property like airplanes have later deadlines for placing bonus depreciation property in service). Bonus depreciation would not be available in 2013 under current law, and the lack of support for an extension so far likely means it faces an uphill battle.

The bipartisan Senate bill provides a good indication of which provisions have the most support in Congress and which are falling out of favor, but it will not be the last word. House lawmakers have different policy preferences and no current plans to mark up a bill. The extenders are instead likely to be negotiated along with the 2001 and 2003 tax cuts in a lame duck session after the election. Some provisions omitted from the Senate bill will probably be extended, while others in the Senate bill might not be.

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