Press Room: Tax Release

January 11, 2013

Certainty in Tax Planning…For Now: The American Taxpayer Relief Act of 2012

Less than 12 hours into the new year, the House of Representatives passed The American Taxpayer Relief Act of 2012 (the Act). President Obama signed the Act on January 2, 2013, mitigating the tax aspects of the so-called “fiscal cliff.” Although technically a tax reduction bill, the Act results in an increase in income and transfer tax rates relative to those applicable in 2012. Further, two new taxes that were part of the Health Care and Education Reconciliation Act of 2010 (commonly known as Obamacare) took effect on January 1, 2013.

We expect that many are trying to understand the impact of these changes on their individual situations. Those with taxable income (TI) less than $250,000 per year will experience very little change relative to the last few years. However, those with TI in excess of $250,000 will experience increases, and those increases will become very significant for those with TI greater than $450,000. The magnitude of the potential increases varies based on the type of income one earns, making it difficult to provide a simple answer to the question, “how much will my tax rate increase in 2013?”

To help clarify the potential impact of the changes, Table 1 summarizes the increase from 2012 to 2013 in the highest marginal rates of tax on different classes of income for a married couple filing jointly. It also reflects the threshold amounts at which the incremental effect of the changes will begin to apply. The threshold amounts are stated as either TI or adjusted gross income (AGI), which simply stated is taxable income before subtracting itemized deductions and personal exemptions. The last column in Table 1 reflects the maximum increase in the marginal tax rate for different classes of income. The table is not intended to provide precise answers for every situation, but rather to give a general idea of the magnitude of the increase in tax rate for a married couple filing a joint return with income in excess of the threshold amounts. 

By way of example, assume a married couple has taxable income in 2013 of $1 million that is comprised primarily of salary and wages, and that the couple itemizes deductions. The aggregate increase in their tax rate that applied in 2012 (35%) on taxable income in excess of $450,000 is approximately 6.7% or $36,850 ($550,000 x 6.7%). For a couple with a similar amount of income derived primarily from qualified dividends and capital gains, the increase in rate would be approximately 9.4%. Estimating the increase becomes more complicated when income includes multiple categories, but one can approximate the rate increase by interpolating among the amounts reflected on the chart. A more thorough analysis of the changes resulting from the Act follows.

The Act permanently extends the 2012 “ordinary” income tax rates for the 10%, 15%, 25%, 28%, 33% and 35% brackets, as well as the 0%, 10% and 15% rates on qualified dividends and long-term capital gains. New income tax rates were added that apply to TI exceeding thresholds of $400,000 (single filers), $425,000 (heads of households), $450,000 (married, filing jointly) and $225,000 (married, filing separately). The new rates on TI in excess of these thresholds are 39.6% for ordinary income and 20% for qualified dividends and long-term capital gains. The threshold amounts are indexed for inflation beginning after 2013. 

The highest rate for alternative minimum tax (AMT) purposes will continue to be 28% for ordinary income. The highest AMT rate for capital gains and qualified dividends will be 20%. In addition, a taxpayer friendly, permanent “AMT patch” was passed, which increases the AMT exemption to $50,600 for individual filers (previously $33,750) and $78,750 for married filing jointly filers (previously $45,000), while also allowing nonrefundable personal credits against AMT. The Act allows the exemption and phaseout amounts to be indexed for inflation. This permanent patch will prevent the annual rush to pass a temporary solution to prevent millions of middle-class taxpayers from being subject to AMT. 

There are two other features of the pre-Bush tax era that will effectively increase the marginal tax rate above 39.6% for many higher income individuals. The Personal Exemption Phaseout (PEP) is reinstated for those with AGI above $250,000 (single filers), $275,000 (heads of households), $300,000 (married filing jointly) and $150,000 (married filing separately). Taxpayers above the applicable thresholds must reduce the amount of their exemption by 2% for each $2,500 by which their AGI exceeds the threshold. The exemptions are completely eliminated when AGI exceeds the threshold by $125,000. 

The “Pease” limitation, named for its original sponsor, Congressman Donald Pease, also returns. It limits certain itemized deductions by taxpayers whose AGI is above the same thresholds as applied for PEP. It reduces the itemized deductions a taxpayer is eligible to take by 3% of the amount by which the taxpayer’s AGI exceeds the threshold. The total reduction cannot exceed 80% of itemized deductions otherwise permitted.

Despite the debates and various proposals regarding the gift, estate, and generation-skipping transfer tax (GST) regimes—and to the surprise of many—very little was actually changed relative to 2012. The estate, gift and generation-skipping transfer tax exemptions remain at $5 million plus inflation adjustments (indexed for inflation – the 2012 amount was $5.12 million). The tax rate permanently increased from 35% to 40%. Since the Act avoids the return to pre-Bush law (with the adjustment of the highest rate), provisions such as portability of any unused exemption to a surviving spouse and deductibility of state estate taxes paid are also permanently extended. 

It is also worth noting that, despite much talk about closing “loopholes,” the Act did not include any of the following proposals:

  1. Grantor retained annuity trusts (GRATs) - eliminating zeroed out GRATs and requiring a 10-year minimum term;
  2. Valuation discounts - eliminating discounts for interests in family-owned entities;
  3. GST exempt trusts - limiting their term to 90 years;
  4. Defective grantor trusts - requiring that a trust be a non-grantor trust if a completed gift is made to that trust; and
  5. Carried interests - eliminating capital gains treatment for income generated from carried interests.

It is entirely possible that these proposals will be revisited at some point in the future when/if tax reform is considered.

Action Should be Considered Now for Some Changes

Along with these more publicized provisions, the Act also allows for additional planning opportunities related to individual retirement accounts (IRAs) and 401(k) accounts. Action may be needed before the end of January 2013. The Act extends the ability of individuals to convert traditional IRAs to Roth IRAs regardless of income, as well as revoke this election before the filing due date of the individual’s tax return for that year. Factors to consider in making the election include age, current and expected future income tax rates, and intended use of IRA funds.   

The Act also extends for 2012 and 2013 the ability of an individual age 70 ½ or older to arrange for a direct distribution to charity from his/her IRA, up to $100,000 each year, and exclude it from income. A taxpayer who received an IRA distribution in December 2012 can contribute some or all of that amount, again up to $100,000, to charity this month and exclude it from 2012 income. A taxpayer also has the option to make a distribution this month from an IRA directly to charity and have it treated as made in 2012 and excluded from income. This might be advantageous, for example, for a taxpayer who wants to maximize over two years the IRA funds used for charitable purposes — up to $200,000 could be distributed from an IRA in 2013 directly to charity with some excluded in 2012 and the rest excluded in 2013.

The ability to convert an IRA or 401(k) account to a Roth IRA and pay the tax today still exists under the Act. Individuals should consider the benefit of paying the tax on conversion today and having the appreciation grow tax free. The company 401(k) plan may have to be amended to allow such a conversion.

Owners of qualified small business stock (QSBS) also received an extension of beneficial treatment that applied to QSBS acquired from September 27, 2010 through December 31, 2011. They can continue to exclude 100% of the gain from the sale of such stock that is held for five or more years provided that it is acquired before January 1, 2014, up to the greater of $10,000,000 or ten times the taxpayer’s basis in the stock. 

Whether viewed as a taxpayer friendly bill or not, the Act did remove the uncertainty that has existed since 2010, and earlier. While more sweeping tax legislation is always possible, at least for now, taxpayers and their advisors know what they face in 2013 and beyond.