President Barack Obama’s reelection to another four-year term sets the stage for a broad and significant impact on tax professionals, financial service providers and the wealth management industry. The year-end tax planning for 2012 and beginning the subsequent years murky prospects for certainty to allow any quality and predictability in helping clientele end 2012 and enter 2013. Will Obama’s Presidency past and future yield a bright light for advisors to guide their clients through the maze of the Executive Branch v. Congress? Can you predict that the President will continue in the same direction on taxes and the economy as he has in the first four years? Two constants are the continuation of the Obama administration and the Democratic majority in the Senate. It is quite possible that we will see a rapid implementation and enforcement of the Dodd Frank Wall Street Reform and Consumer Protection Act. You might remember that the Dodd-Frank’s mandate creates a uniform fiduciary standard to all financial advisors and brokers for more disclosures on how the advisors are paid for their services and disclosure of perceived conflicts on interest.
The Act also gives the SEC the authority to impose a fiduciary duty on brokers who give investment advice wherein that advice must be in the best interest of their customers. Obama’s Administration may also push for the Volcker Rule that restricts financial services institutions from making “speculative” investments that don’t benefit clients and instead stick to safer investments such as U.S. Treasury bonds.
However, the big dilemmas are the looming “fiscal cliff,” the expiration of the Bush-era tax cuts and the imposition of mandatory spending cuts with these triggers being pulled on January 1, 2013. Dissipating the dilemmas will require bipartisan collaboration when Congress is back in session nearer year’s end. There are some predictions that the “fiscal cliff,” if left unaddressed, will propel the country into another recession. In a pragmatic utopian world, it is likely that Congress and the President’s Administration will make some temporary measures to continue to kick that can further down the road for a period well into 2013 and maybe beyond.
Clearly, Obama proposes to raise taxes on the affluent as an integral part of his tax reform. Obama defines affluent as Americans earning $250,000 or more. This revenue raising may not be enough with the increase in spending and repayment of government debts. It is possible that long-running entitlements like Social Security and Medicare will suffer.
We now immediately face a lame duck Congress and a backlog of unfinished business from the 112th Congress. Congress may, but is not required to, quickly hold a session, but the length of the lame duck session varies based on the business the Congressional leadership decides to process. The upcoming lame duck session is likely to be very active and lengthy because of the “fiscal cliff” that will happen on January 1, 2013 if Congress fails to act. The fiscal cliff is comprised of many elements, from the expiration of several tax provisions to various spending cuts that go into affect on January 1, 2013, as part of the Budge Control Act of 2011, which increased the debt limit in exchange for spending cuts. There are several elements of the fiscal cliff that are emphasized when read with the recently passed Congressional Budget Office (CBO) report regarding the potential economic effects of the fiscal cliff if Congress fails to act.
From a tax perspective, the fiscal cliff is a replay of 2010. The tax components of the fiscal cliff are the expiration of more than 50 temporary tax provisions (extenders), the expiration of the Bush 2001/2003 tax cuts, the expiration of the payroll tax cut, and the expiration of the alternative minimum tax (AMT) patch.
The extenders package expired at the end of 2011, and it includes the research and experimentation credit (Internal Revenue Code (I.R.C.) § 41), the active financing exception to subpart F, and I.R.C. § 954(c)(6) (controlled foreign corporation look through). The Senate Committee on Finance passed an extenders bill on August 2, 2012 (the Family and Business Tax Cut Certainty Act of 2012), but the bill will not be considered prior to the election. A two-year extension of the extenders (retroactively to January 1, 2012 and 2013) costs $59.7 billion over ten years. The House Committee on Ways and Means held a hearing on extenders to consider which provisions it will include in a bill, but the Committee has yet to mark up or pass a bill. The House and Senate disagree on whether certain expired clean energy and stimulus provisions should be extended. However, the two committees agree that they will not offset extenders with revenue increases or “loophole” closers. Both committees want to save any revenue increases for tax reform or permanent changes to the Internal Revenue Code, IRC.
The Bush 2001 and 2003 tax cuts are comprised of rate reductions for all brackets, preferential rates for dividends and capital gains (top rate of 15%), and estate and gift tax relief. Without Congressional action, the top income tax rate will increase from 35% to 39.6%, the dividend rate will increase from 15% to 39.6%, and the capital gains rate will increase from 15% to 20% (plus 3.8% pursuant to the Affordable Care Act of 2010). The estate tax rate will also increase.
The following tables illustrate, for married individuals filing joint returns, the 2012 tax rates, the projected 2013 income tax rates if Congress does nothing, and the projected 2013 income tax rates if Congress again extends the lower rates.
Table 1. 2012 Rates
|
Taxable Income Over |
But Not Over |
Pay |
% on Excess |
Of the amount over- |
|
$0 |
$17,400 |
$0 |
10% |
$0 |
|
$17,400 |
$70,700 |
$1,740 |
15% |
$17,400 |
|
$70,700 |
$142,700 |
$9,735 |
25% |
$70,700 |
|
$142,700 |
$217,450 |
$27,735 |
28% |
$142,700 |
|
$217,450 |
$388,350 |
$48,665 |
33% |
$217,450 |
|
$388,350 & above |
$105,062 |
35% |
$388,350 |
Table 2. Projected 2013 Rates if Congress Does Nothing.
|
Taxable Income Over |
But Not Over |
Pay |
% on Excess |
Of the amount over- |
|
$0 |
$60,550 |
$0 |
15% |
$0 |
|
$65,550 |
$146,400 |
$9,082 |
28% |
$60,550 |
|
$146,400 |
$223,050 |
$33,120 |
31% |
$146,400 |
|
$223,500 |
$398,350 |
$56,882 |
36% |
$223,050 |
|
$398,350 & above |
$119,990 |
39.6% |
$398,350 |
Table 3. Projected 2013 Rates if Congress Extends EGTRRA Lower Rates.
|
Taxable Income Over |
But Not Over |
Pay |
% on Excess |
Of the amount over- |
|
$0 |
$17,900 |
$0 |
10% |
$0 |
|
$17,900 |
$72,500 |
$1,790 |
15% |
$17,900 |
|
$72,500 |
$146,400 |
$9,980 |
25% |
$72,500 |
|
$146,400 |
$223,050 |
$28,445 |
28% |
$146,400 |
|
$223,050 |
$398,350 |
$49,917 |
33% |
$223,050 |
|
$398,350 & above |
$107,766 |
35% |
$398,350 |
The promise of increasing income tax rates frustrates the very core of modern tax planning. Nearly all tax-savings strategies are based on the two underlying principles that individual taxpayers benefit from: deferring income and accelerating deductions. This dual-principled approach is turned on its head, however, when an income tax rate increase is threatened. Instead, an analysis of one’s potential tax liability may well prove that payment of tax at current rates results in a lower overall tax burden than if the payment is delayed. Consequently, in anticipation of some adjustment next year in the higher tax rates, individual taxpayers affected by such higher rates may be best served where practical by deferring deductions and accelerating income. Such taxpayers should consider (again, where practical to do so) the following planning opportunities to take advantage of any future rate increase:
Recognizing deferred compensation during 2012;
Accelerating the execution of profitable commercial contracts into 2012;
Postponing charitable cash contributions until 2013; and
Delaying mortgage interest or deductible health expenditures until 2013.
CAPITAL GAINS RATE
Since 2003, taxpayers have enjoyed a maximum tax rate of 15 percent on all long-term capital gains. In addition, dividends received by individuals have been taxed at the capital gains rate rather than being treated as ordinary income. Unless the law is changed, beginning January 2013, the capital gains rate will revert to the pre-2003 rates of 20 percent instead of 15 percent; and taxpayers in lower brackets who did not pay capital gains tax under the 2010 Tax Relief Act will be subject to a 10 percent capital gains tax rate in 2013. Dividends will no longer be taxed as capital gains.
In preparation, taxpayers should consider implementing the following techniques where practical:
Accelerating the sale of property with built-in gains into 2012;
Avoiding realization of losses on sale of depreciated property until 2013; and
In the case of C corporations, declaring dividends this year.
ALTERNATIVE MINIMUM TAX
Congress has increased the Alternative Minimum Tax exemption over the last several years to protect many taxpayers who perhaps were not intended to be subject to the AMT. However, those increased exemptions expired at the end of 2011. If Congress does nothing, the Alternative Minimum Tax exemption will revert to $45,000 from the $74,450 level applicable prior to 2012, in the case of married taxpayers filing jointly.
MEDICARE CONTRIBUTION TAX
Beginning in 2013, individuals, estates and trusts are subject to a tax at the rate of 3.8 percent on the lesser of net investment income or excess modified adjusted gross income for the year over a threshold amount.
The tax is 3.8 percent of the lesser of the taxpayer’s net investment income for the year or modified adjusted gross income in excess of $200,000 in the case of individuals, $250,000 in the case of joint filers and $125,000 in the case of married taxpayers filing separately.
In the case of an estate or trust, the tax is 3.8 percent of the lesser of undistributed net investment income or any excess of modified adjusted gross income over the dollar amount at which the highest bracket applicable to the year begins ($11,650 for 2012 and possibly $11,950 for 2013).
Separately, and also beginning in 2013, the employee’s share of the hospital insurance tax will be increased by 0.9 percent on wages in excess of $250,000 for married taxpayers filing a joint return, $125,000 for married taxpayers filing separately, and $200,000 in all other cases; as well as will be imposed on net earnings from self-employment.
OTHER CHANGING PROVISIONS
In addition to the increasing income tax, capital gains, dividend, and estate tax rates, other expiring taxpayer-favorable provisions include:
Phase-out of Personal Exemptions: The personal exemptions for taxpayers with higher incomes will once again be subject to phase-out when their adjusted gross income exceeds an inflation-adjusted threshold. It is estimated that the inflation-adjusted threshold will be $261,650.
Reduction in Itemized Deductions: The overall limitation on itemized deductions under Section 68(g), generally known as the “Pease limitation” (named after the congressman who aided in the creation of the legislation) will be fully restored so as to limit itemized deductions after December 31, 2012, which will have the effect essentially of further increasing tax rates. This limitation will not apply to deductions for medical and dental expenses, investment interest, and casualty and theft losses.
Reduction in Election to Expense Certain Depreciable Business Assets: Taxpayers may currently elect to expense certain depreciable business assets in the year of purchase rather than capitalize such costs. While the ability to make this election will continue into 2013, the limitations on the amounts for which a taxpayer may elect to expense under this election are drastically reduced.
Reduction of Child Tax Credit: The maximum child tax credit will be reduced from $1,000 to $500 per child, and the credit may no longer be used to offset Alternative Minimum Tax liability.
Reduction in Credit for Household and Dependent Care Expenses: The dollar limitation for qualified expenses will decrease from $3,000 to $2,400 for one qualifying individual and $6,000 to $4,800 for two or more qualifying individuals. Further, the Applicable Percentage used to determine the amount of expenses that are allowed, as a credit will be reduced from 35 percent to 30 percent.
Education Provisions
Interest on Education Loans: The ability to deduct interest payments on student loan debt will only apply to interest paid during the first 60 months of the period in which interest payments are required. Also, the deduction will phase out at modified adjusted gross income amounts, which are estimated to be $75,000 for joint returns and $50,000 for all other returns.
Qualified Tuition and Related Expense: The deduction provided for qualified tuition payments and certain related expenses will no longer be available.
Coverdell: The increase of maximum annual contributions to Coverdell education savings accounts (also known as Educational IRAs) from $500 to $2,000 under Section 530(b)(1)(A)(iii) will be eliminated after December 31, 2012. Furthermore, the definitional expansion of qualified education expenses will revert to its pre-2001 limitation under Section 530(b)(2), which will include the elimination of the definition of elementary and secondary education expenses under Section 530(b)(3). Finally, Section 530(b)(4), allowing current-year contributions to be made until April 15 of the following year, will be eliminated.
Principal Residence Sales Exclusion: The $250,000 exclusion from gross income of gain on the sale of a principal residence will no longer apply to heirs, estates and qualified revocable trusts that were treated as owned by the decedent immediately prior to death.
Increase in Floor for Deduction of Medical, Dental, etc. Expenses: As amended by the 2010 Patient Protection and Affordable Care Act, the current 7.5 percent floor for deduction medical and dental expenses will be increased to 10 percent.
ESTATE AND GIFT TAXES
The estate, gift and generation-skipping transfer (GST) tax laws are also scheduled to change significantly on January 1, 2013. Currently the highest estate tax rate is 35 percent and the applicable exclusion per person from the estate and gift tax is $5,120,000. Without Congressional action to alter the scheduled changes, the highest estate tax rate will rise to 55 percent (with a 5 percent surcharge on certain large estates), and the applicable exclusion will decrease to $1,000,000 on January 1, 2013. In addition, portability of the estate tax exclusion will expire on January 1, 2013. The following chart illustrates the dramatic changes in rates and exclusions for the estate, gift and GST taxes.
|
2012 |
2013 and beyond |
|
| Highest Estate Tax Rate |
35% |
55% |
| Estate Tax Exclusion |
$5,120,000 |
$1,000,000 |
| Highest Gift Tax Rate |
35% |
55% |
| Gift Tax Exclusion |
$5,120,000 |
$1,000,000 |
| GST Tax Rate |
35% |
55% |
| GST Tax Exclusion |
$5,120,000 |
$1,000,000* |
| Portability of Estate Tax Exclusion |
YES |
NO |
*Indexed for inflation occurring after 1997
Helpful to some extent, the annual exclusion for federal gift taxes is $13,000 in 2012 and is projected to be $14,000 for 2013.
SUMMARY
This Alert is intended to be a general review of various tax rates and other tax provisions that could change in the near future, and is not intended as advice under any specific facts and circumstances. Tax planning in these uncertain times starts with an understanding of your specific facts and circumstances. As a result, you should consider consulting with a tax advisor before the end of this year, 2012.
Michael B. Nelson, Esq.
