Overview of the 2012 American Taxpayer Relief Act / Fiscal Cliff Legislation

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After weeks, indeed months of proposals and counter-proposals, seemingly endless negotiations and down-to-the-wire drama, Congress has passed legislation to avert the tax side of the so-called “fiscal cliff.” The American Taxpayer Relief Act permanently extends the Bush-era tax cuts for lower and moderate income taxpayers, permanently “patches” the alternative minimum tax (AMT), provides for a permanent 40 percent federal estate tax rate, renews many individual, business and energy tax extenders, and more. In one immediately noticeable effect, the American Taxpayer Relief Act does not extend the 2012 employee-side payroll tax holiday.

The American Taxpayer Relief Act is intended to bring some certainty to the Tax Code. At the same time, it sets stage for comprehensive tax reform, possibly in 2013. Moreover, it creates important planning opportunities for taxpayers, which we can discuss in detail.

Individuals:

Unlike the two-year extension of the Bush-era tax cuts enacted in 2010, the debate in 2012 took place in a very different political and economic climate. If Congress did nothing, tax rates were scheduled to increase for all taxpayers at all income levels after 2012.  President Obama made it clear that he would veto any bill that extended the Bush-era tax cuts for higher income individuals. The President’s veto threat gained weight after his re-election.  Both the White House and the GOP realized that going over the fiscal cliff would jeopardize the economic recovery, and the American Taxpayer Relief Act is, for the moment, their best compromise.

Tax rates.  The American Taxpayer Relief Act extends permanently the Bush-era income tax rates for all taxpayers except for taxpayers with taxable income above certain thresholds:

$400,000 for single individuals, $450,000 for married couples filing joint returns, and $425,000 for heads of households.  For 2013 and beyond, the federal income tax rates are 10, 15, 25, 28, 33, 35, and 39.6 percent.  In comparison, the top rate before 2013 was 35 percent.  The IRS is expected to issue revised income tax withholding tables to reflect the 2013 rates as quickly as possible and provide guidance to employers and self-employed individuals.

Additionally, the new law revives the Pease limitation on itemized deductions and personal exemption phaseout (PEP) after 2012 for higher income individuals but at revised thresholds. The new thresholds for being subject to both the Pease limitation and PEP after 2012 are $300,000 for married couples and surviving spouses, $275,000 for heads of households, $250,000 for unmarried taxpayers; and $150,000 for married couples filing separate returns.

Capital gains.  The taxpayer-friendly Bush-era capital gains and dividend tax rates are modified by the American Taxpayer Relief Act. Generally, the new law increases the top rate for qualified capital gains and dividends to 20 percent (the Bush-era top rate was 15 percent). The 20 percent rate will apply to the extent that a taxpayer’s income exceeds the $400,000/$425,000/$450,000 thresholds discussed above. The 15 percent Bush-era tax rate will continue to apply to all other taxpayers (in some cases zero percent for qualified taxpayers within the 15-percent-or-lower income tax bracket).

Payroll tax cut.  The employee-side payroll tax holiday is not extended. Before 2013, the employee-share of OASDI taxes was reduced by two percentage points from 6.2 percent to 4.2 percent up the Social Security wage base (with a similar tax break for self-employed individuals).  For 2013, two percent reduction is no longer available and the employee-share of OASDI taxes reverts to 6.2 percent. The employer-share of OASDI taxes remains at 6.2 percent. In 2012, the payroll tax holiday could save a taxpayer up to $2,202 (taxpayers earning at or above the Social Security wage base for 2012).  As a result of the expiration of the payroll tax holiday, everyone who receives a paycheck or self-employment income will see an increase in taxes in 2013.

AMT. In recent years, Congress routinely “patched” the AMT to prevent its encroachment on middle income taxpayers. The American Taxpayer Relief Act patches permanently the AMT by giving taxpayers higher exemption amounts and other targeted relief. This relief is available beginning in 2012 and going forward. The permanent patch is expected to provide some certainty to planning for the AMT. No single factor automatically triggers AMT liability but some common factors are itemized deductions for state and local income taxes; itemized deductions for miscellaneous expenditures, itemized deductions on home equity loan interest (not including interest on a loan to build, buy or improve a residence); and changes in income from installment sales. Our office can help you gauge if you may be liable for the AMT in 2013 or future years.

Child tax credit and related incentives.  The popular $1,000 child tax credit was scheduled to revert to $500 per qualifying child after 2012.  Additional enhancements to the child tax credit also were scheduled to expire after 2012.  The American Taxpayer Relief Act makes permanent the $1,000 child tax credit. Most of the Bush-era enhancements are also made permanent or extended. Along with the child tax credit, the new law makes permanent the enhanced adoption credit/and income exclusion; the enhanced child and dependent care credit and the Bush-era credit for employer-provided child care facilities and services.

Education incentives.  A number of popular education tax incentives are extended or made permanent by the American Taxpayer Relief Act.  The American Opportunity Tax Credit (an enhanced version of the Hope education credit) is extended through 2017.  Enhancements to Coverdell education savings accounts, such as the $2,000 maximum contribution, are made permanent.  The student loan interest deduction is made more attractive by the permanent suspension of its 60-month rules (which had been scheduled to return after 2012). The new law also extends permanently the exclusion from income and employment taxes of employer-provided education assistance up to $5,250 and the exclusion from income for certain military scholarship programs.  Additionally, the above-the-line higher education tuition deduction is extended through 2013 as is the teachers’ classroom expense deduction.

Charitable giving.  Congress has long used the tax laws to encourage charitable giving.  The American Taxpayer Relief Act extends a popular charitable giving incentive through 2013:  tax-free IRA distributions to charity by individuals age 70 ½ and older up to maximum of $100,000 for qualified taxpayer per year.  A special transition rule allows individuals to recharacterize distributions made in January 2013 as made on December 31, 2012.  The new law also extends for businesses the enhanced deduction for charitable contributions of food inventory.

Federal estate tax.  Few issues have complicated family wealth planning in recent years as has the federal estate tax.  Recent laws have changed the maximum estate tax rate multiple times. Most recently, the 2010 Taxpayer Relief Act set the maximum estate tax rate at 35 percent with an inflation-adjusted exclusion of $5 million for estates of decedents dying before 2013. Effective January 1, 2013, the maximum federal estate tax will rise to 40 percent, but will continue to apply an inflation-adjusted exclusion of $5 million. The new law also makes permanent portability between spouses and some Bush-era technical enhancements to the estate tax.

Businesses:

The business tax incentives in the new law, while not receiving as much press as the individual tax provisions, are valuable. Two very popular incentives, bonus depreciation and small business expensing, are extended as are many business tax “extenders.”

Bonus depreciation/small business expensing.  The new law renews 50 percent bonus depreciation through 2013 (2014 in the case of certain longer period production property and transportation property). Code Sec. 179 small business expensing is also extended through 2013 with a generous $500,000 expensing allowance and a $2 million investment limit.  Without the new law, the expensing allowance was scheduled to plummet to $25,000 with a $200,000 investment limit.

Small business stock.  To encourage investment in small businesses, the tax laws in recent years have allowed noncorporate taxpayers to exclude a percentage of the gain realized from the sale or exchange of small business stock held for more than five years.  The American Taxpayer Relief Act extends the 100 percent exclusion from the sale or exchange of small business stock through 2013.

Tax extenders.  A host of business tax incentives are extended through 2013.  These include:

  • Research tax credit or R&D credit
  • Work Opportunity Tax Credit (WOTC)
  • New Markets Tax Credit
  • Employer wage credit for military reservists
  • Tax incentives for empowerment zones
  • Indian employment credit
  • Railroad track maintenance credit
  • Subpart F exceptions for active financing income
  • Look through rules for related controlled foreign corporation payments

Energy:

For individuals and businesses, the new law extends some energy tax incentives.  The Code Sec. 25C, which rewards homeowners who make energy efficient improvements, with a tax credit is extended through 2013.  Businesses benefit from the extension of the Code Sec. 45 production tax credit for wind energy, credits for biofuels, credits for energy-efficient appliances, and many more.

Looking ahead

The negotiations and passage of the new law are likely a dress rehearsal for comprehensive tax reform during President Obama’s second term.  Both the President and the GOP have called for making the Tax Code more simple and fair for individuals and businesses.  The many proposals for tax reform include consolidation of the current individual income tax brackets, repeal of the AMT, moving the U.S. from a worldwide to territorial system of taxation, and a reduction in the corporate tax rate. Congress and the Obama administration also must tackle sequestration, which the American Taxpayer Relief Act delayed for two months. All this and more is expected to keep federal tax policy in the news in 2013. Our office will keep you posted of developments.

If you have any questions about the American Taxpayer Relief Act, please contact Origins Group at (310) 691-5040 or (818) 691-1234 or via e-mail at info@originsgroup.com.  We can schedule an appointment to discuss how the changes in the new law may be able to maximize your tax savings.

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IRS Guidance on Portability of Deceased Spousal Exclusion

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The IRS has recently issued guidance on the so-called portability election and the applicable estate and gift tax exclusion amount. As a surviving spouse, this guidance may impact your estate planning opportunities.

In general, the estate tax is imposed on a decedent’s gross estate as increased by the decedents’ taxable lifetime gifts, and reduced by any allowable estate tax deductions, such as the charitable or marital deduction.

In addition, the estate of every decedent is allowed a credit (the “applicable credit amount”) in determining the amount of estate tax due. The applicable credit amount effectively acts to exclude a certain amount of property from the estate tax (the “applicable exclusion amount”). With proper planning a married couple could take advantage of the applicable exclusion amount in each of their respective estates. However, prior to the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (2010 Tax Relief Act) it was possible for a married couple to waste the applicable exclusion amount of the first spouse to die. Consequently, the 2010 Tax Relief act introduced the concept of “portability” with respect to the unused portion of the applicable exclusion amount of a predeceased spouse, referred to as the deceased spousal unused exclusion amount (DSUEA).

For estates of decedents dying after 2010, the applicable exclusion amount is equal to the sum of the basic exclusion amount and any available DSUEA, if previously elected. The basic exclusion amount is $5 million, which is adjusted for inflation beginning in 2012. A “portability election” passes along a decedent’s unused estate and gift tax exclusion amount to a surviving spouse.

The IRS guidance discusses the following:

  1. the estate and gift tax applicable exclusion amount, in general;
  1. the requirements for electing portability of any DSUEA to the surviving spouse; and
  1. the applicable rules for the use of the DSUEA by the surviving spouse.

It should be noted that as is the case for other changes made to the estate and gift tax rules by the Economic Growth and Tax Relief Reconciliation Act of 2001, and the 2010 Tax Relief Act, the concept of “portability” of a deceased spouse’s unused exclusion amount will end for the estates of decedents dying after December 31, 2012, unless Congress acts to extend this provision.

Regardless, the estate tax return on which the portability election is made must be filed within the time prescribed by law. In that way, the surviving spouse can take advantage of the DSUEA, should the portability provision be extended.

The IRS guidance explains the requirements for what is considered to be a “complete and properly-prepared return.” If the return is being filed only for the purpose of electing portability, the executor does not have to report the value of certain property qualifying for the marital or charitable deduction. The total value of the gross estate must be estimated based on a determination made with good faith and due diligence regarding the value of all assets includable in the gross estate.

If the executor does not wish to make the portability election, regulations require the executor to make an affirmative statement on the estate tax return indicating this to be the case. When no return is required to be filed for the decedent’s estate, not filing a timely filed return will be considered to be an affirmative statement of the decision not to make a portability election. With certain limited exceptions, only the executor of the estate is allowed to file the estate tax return and make the portability election.

IRS guidance also clarifies the computation of the DSUEA in certain circumstances and addresses the use of the DSUEA by the surviving spouse, including:

  1. the date the DSUEA may be taken into account by the surviving spouse;
  2. the last deceased spouse limitation on the DSUEA available to a surviving spouse; and
  3. the DSUEA available in the case of multiple spouses and previously applied DSUEA.

The portability election should be reviewed as part of your overall estate planning. We are available to discuss all of your options.

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2012 Year-End Tax Planning For Individuals

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As 2012 draws to a close, many taxpayers are asking how they can plan in light of the uncertainty surrounding the fate of the Bush-era tax cuts and other expiring tax incentives.

2012 began with great uncertainty over federal tax policy and now, with the end of the year approaching, that uncertainty appears to be far from any long-term resolution. A host of reduced tax rates, credits, deductions, and other incentives (collectively called the “Bush-era” tax cuts) are scheduled to expire after December 31, 2012. To further complicate planning, over 50 tax extenders are up for renewal, either having expired at the end of 2011 or scheduled to expire after 2012. At the same time, the federal government will be under sequestration, which imposes across-the-board spending cuts after 2012. The combination of all these events has many referring to 2013 as “taxmeggedon.”

Expiring incentives

Effective January 1, 2013, the individual income tax rates, without further Congressional action, are scheduled to increase across-the-board, with the highest rate jumping from 35 percent to 39.6 percent. The current 10 percent rate will expire and marriage penalty relief will sunset. Additionally, the current tax-favorable capital gains and dividends tax rates (15 percent for taxpayers in the 25 percent bracket rate and above and zero percent for all other taxpayers) are scheduled to expire. Higher income taxpayers will also be subject to revived limitations on itemized deductions and their personal exemptions. The child tax credit, one of the most popular incentives in the Tax Code, will be cut in half. Millions of taxpayers would be liable for the alternative minimum tax (AMT) because of expiration of the AMT “patch.” Countless other incentives for individuals would either disappear or be substantially reduced after 2012. While a divided Congress may indeed act to prevent some or all of these tax increases, a year-end planning strategy that protects against “worst-case” situations may be especially wise to consider this year.

Year-end planning

Income tax withholding. Expiration of the reduced individual tax rates will have an immediate impact. Income tax withholding on payrolls will immediately reflect the increased rates. One strategy to avoid being surprised in 2013 is to adjust your income tax withholding. Keep in mind that the current two percent payroll tax holiday is also scheduled to expire after 2012 so it is a good time to review if you are having too much or too little federal income tax withheld from your pay.

As mentioned, traditional year-end planning techniques should be considered along with some variations on those strategies. Instead of shifting income into a future year, taxpayers may want to recognize income in 2012, when lower tax rates are available, rather than shift income to 2013. Another valuable year-end strategy is to “run the numbers” for regular tax liability and AMT liability. Taxpayers may want to explore if certain deductions should be more evenly divided between 2012 and 2013, and which deductions may qualify, or will not be as valuable, for AMT purposes.

Harvesting losses. Now is also a good time to consider tax loss harvesting strategies to offset current gains or to accumulate losses to offset future gains (which may be taxed at a higher rate). The first consideration is to identify whether an investment qualifies for either a short-term or long-term capital gains status, because you must first balance short-term gains with short-term losses and long-term ones with long-term losses. Remember also that the “wash sale rule” generally prohibits you from claiming a tax-deductible loss on a security if you repurchase the same or a substantially identical asset within 30 days of the sale.

Education expenses. Taxpayers with higher educational expenses may want to consider the scheduled expiration of the American Opportunity Tax Credit (AOTC) after 2012 in their plans. The AOTC (an enhanced version of the HOPE education credit) reaches the sum of 100 percent of the first $2,000 of qualified expenses and 25 percent of the next $2,000 of qualified expenses, subject to income limits. If possible, pre-paying 2013 educational expenses before year-end 2012 could make the expenses eligible for the AOTC before it expires. Another popular education tax incentive, the Lifetime Learning Credit, is not scheduled to expire after 2012.

Job search expenses. Some expenses related to a job search may be tax deductible. There is one important limitation: the expenses must be spent on a job search in your current occupation. You may not deduct expenses you incur while looking for a job in a new occupation. Examples of job search expenses are unreimbursed employment and outplacement agency fees you pay while looking for a job in your present occupation. Travel expenses to look for a new job may be deductible. The amount of job search expenses that you can claim on your tax return is limited. You can claim the amount of expenses only to the extent that they, together with other “miscellaneous” deductions exceed two percent of your adjusted gross income.

Gifts. Gift-giving as a year-end tax strategy should not be overlooked. The annual gift tax exclusion per recipient for which no gift tax is due is $13,000 for 2012. Married couples may make combined tax-free gifts of $26,000 to each recipient. Use of the lifetime gift tax exclusion amount ($5.12 million for 2012) should also be considered. Without Congressional action, the exclusion amount drops to $1 million in 2013.

Charitable giving. For many individuals, charitable giving is also a part of their year-end tax strategy. Under current law, the so-called “Pease limitation” (named for the member of Congress who sponsored the law) is scheduled to be revived after 2012. The Pease limitation generally requires higher income individuals to reduce their tax deductions by certain amounts, including their charitable deduction. A special rule for contributing IRA assets to a charity by individuals age 70 ½ and older expired after 2011 but could be renewed for 2012.

New Medicare taxes

In 2013, two new taxes kick-in. The Patient Protection and Affordable Care Act (PPACA) imposes an additional 0.9 percent Medicare tax on wages and self-employment income and a 3.8 percent Medicare contribution tax. The 3.8 percent Medicare contribution tax will apply after 2012 to single individuals with a modified adjusted gross income (MAGI) in excess of $200,000 and married taxpayers with an MAGI in excess of $250,000. MAGI for purposes of the Medicare contribution tax includes wages, salaries, tips, and other compensation, dividend and interest income, business and farm income, realized capital gains, and income from a variety of other passive activities and certain foreign earned income. For individuals liable for the tax, the amount of tax owed will be equal to 3.8 percent multiplied by the lesser of (1) net investment income or (2) the amount by which their MAGI exceeds the $200,000/$250,000 thresholds. Taxpayers with MAGIs below the $200,000/$250,000 thresholds will not be subject to the 3.8 percent tax.

More changes for 2013

Many employers with health flexible spending arrangements (health FSAs) limit salary reduction contributions to between $2,500 and $5,000. Effective 2013, the PPACA requires health FSA’s under a cafeteria plan to limit contributions through salary reductions to $2,500. After 2013, the $2,500 limitation is scheduled to be adjusted for inflation. Individuals with unused health FSA dollars should consider spending them before year-end, or a 2 ½ month grace period if applicable, to avoid the “use it or lose it” rule. Keep in mind that health FSA dollars cannot be used for over-the-counter medications (except for insulin) after 2011.

Additionally, the threshold to claim an itemized deduction for unreimbursed medical expenses increases from 7.5 percent of adjusted gross income (AGI) to 10 percent of AGI after 2012. The PPACA provides a temporary exception for individuals (or their spouses) who are age 65 and older. This exception ends after 2017. While many medical expenses cannot be timed for tax-deduction purposes, batching expenses into 2012, when the threshold is 7.5 percent, may make it more likely that the expenses will exceed that threshold.

Looking ahead

In July 2012, the House and Senate passed competing bills to extend many of the expiring incentives one more year. Both bills would extend the current income tax rates (10, 15, 25, 28, 33, and 35 percent) through 2013. The House bill would extend the current capital gains and dividends treatment but the Senate bill would extend the tax favorable rates only for individuals with incomes below $200,000 (families with incomes below $250,000). For income in excess of $200,000/$250,000 the tax rate on capital gains and dividends would be 20 percent. Both bills would extend the $1,000 child tax credit through 2013 and provide for an AMT patch for 2012 (the House bill also provides an AMT patch for 2013).

At this time, it is increasingly likely that the fate of all the expiring tax provisions will be decided by the lame-duck Congress after the November elections. Although the House and Senate bills passed in July differ, they have many points in common; the most important being that lawmakers could agree on a one-year extension of the Bush-era tax cuts. However, some observers anticipate no resolution until January 2013 or beyond.

Today’s uncertainty makes doing nothing or adopting a wait and see attitude very tempting. Multi-year tax planning, which takes into account a variety of possible scenarios and outcomes, however, can provide a win-win combination irrespective of what happens. Please contact our office at (310) 691-5040 or (818) 691-1234 or by e-mail at info@originsgroup.com for more details on how we can customize a tax strategy for you in uncertain times.

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Tax Planning with the Annual Gift Tax Exclusion

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You may not be aware just how useful the annual gift tax exclusion can be as a tax planning tool and tax saving strategy. It is one of the easiest and most effective ways to transfer property without incurring a transfer tax.

What is the gift tax? The gift tax applies to the transfer of property by gift, from a donor to a donee. The transferred property can be real, personal, tangible or intangible, but does not include donated services. The transferred property or evidence of it needs to be delivered to the donee and the donor has to give up all control over the property in order for the gift to be subject to tax.

Annual exclusion amount. The first $13,000 of gifts made by a donor to each donee during the 2012 tax year is excluded from the total amount of the donor’s taxable gifts for that year. The annual exclusion is available to all donors, including nonresident citizens. Also, the donee does  not have to be a U.S. citizen or resident for the annual exclusion to apply. While a lifetime exclusion amount is also available to shelter gifts from current gift tax, gifts given under that provision may reduce the amount that can ultimately pass to your heirs estate tax free. For 2012, that unified lifetime gift and estate tax exclusion is $5.12 million. Starting in 2013, however, it is scheduled to plummet to the $1 million level that existed pre-2001 unless Congress acts.  The annual gift tax exclusion amount, however, is projected to stay at $13,000 for 2013 based upon the current rate of inflation, and no change to it is anticipated by Congress.

Only present interests qualify. Gifts of present, rather than future, interests in property qualify for the annual exclusion. A present interest in property is an unrestricted right to the immediate use, possession, or enjoyment of property or the income from the property (for example, when a father gives cash to each of his children). On the other hand, a future interest involves the postponement of the right to use, possess, or enjoy the transferred property (for example, interests in property that are contingent upon the happening of an event at some future date).

Gifts of property. If property is given instead of cash, the value of the gift is the fair market value of the property. For example, if 100 common shares of XYZ Inc. are trading at $10,000 on the date the shares are transferred to the donee, $10,000 is the value of the gift for gift tax purposes and, therefore, is covered by the $13,000 annual exclusion. The potential downside of any gift of property, however, is that your tax basis in the property (usually equal to what you paid for it) gets carried over to your donee. That means when your donee sells the property, he or she must pay tax on any gain computed using your original basis. Nevertheless, if your donee is in a lower tax bracket, you will come out ahead overall.  If your tax basis is higher than the property’s fair market value at the time of the gift, however, you generally should sell the property first so that you can realize a tax loss.

Spouses splitting gifts. If spouses consent to split all gifts that are made by either one of them during any year and each spouse is also a U.S. citizen or resident, then the gifts can be deemed as having been made one half by each spouse. Therefore, spouses who consent to split their gifts can transfer twice the annual per donee exclusion amount each year, free of gift tax ($26,000 for 2012).

As seen from the above discussion, there several factors to evaluate in determining if gifts you have made or will make qualify for the annual exclusion amount. Please do not hesitate to contact us if you have any questions regarding such exclusions. We would be happy to analyze your tax situation and advise you appropriately.

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