Clinging to the Fiscal Cliff

Imagine New Year’s Eve as an action sequence from a film, where the protagonist is running from danger toward a cliff overlooking a deadly crevasse.  The hero appears stuck between two scenarios of certain doom, then chooses to take his/her chances and jumps off the cliff.  The pursuers stop, surprised that their target actually went over the cliff.  Cut/pan to the other side of the cliff, and the hero is dangling from roots (or maybe another ledge) that they were able to grasp on to as they fell.  That’s what happened to the US economy the evening of New Year’s Eve.  The Senate ran over the so-called fiscal cliff, but in the final moments, with a vote of 89-8, passed the “American Taxpayer Relief Act”, also known as H.R.8.  The next scene involved the House as the protagonist’s friend reaching down and helping the Senate back up on to the cliff.  Okay, so we took some liberties with that part of the metaphor, but you get the idea.  The immediate crisis has been averted, but this is only Act 2 of this film, and Act 3 has even more pitfalls.

At KatzAbosch it is our job to help our clients make well-informed decisions and navigate tax law changes, and the “American Taxpayer Relief Act” is no exception.  The following are highlights that we have determined to be the most universally relevant to our clients.  Note: all of the dollar amounts are to be inflation-adjusted for tax years after 2013.

Payroll Tax Holiday Ends: This wasn’t technically part of the Relief Act, but its omission should be noted.  It means that the 2% cut in Social Security tax for all earners up to the Social Security wage base ($113,700) will not be extended into 2013.  Employers won’t be hit by this, but their employees will.  Bottom line… taxes in 2013 will increase for all wage earners and self-employeds!

Tax Rates:  For tax years beginning after 2012, income tax rates for individuals will stay the same, except for a 39.6% rate applying to income above the threshold of $450,000 for joint filers, $425,000 for heads of household, $400,000 for single filers, and $225,000 for married taxpayers filing separately.

Personal Exemption Phaseout (PEP) Limitations for “high earners”: PEP has been reinstated in 2013 with a starting threshold for joint filers making $300,000, $275,000 for heads of household, $250,000 for single filers, and $150,000 for married taxpayers filing separately.  Total amount of exemptions that can be claimed by the taxpayer subject to limitations under the phaseout is reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer’s adjusted gross income (AGI) exceeds the relevant threshold.

Pease Limitations for “High Earners”: The “Pease” limitation on itemized deductions, which was previously suspended, is now reinstated in 2013 for those making $300,000 for joint filers, $275,000 for heads of household, $250,000 for single filers, and $150,000 for married taxpayers filing separately.  These “high earners” subject to the “Pease” limitation will have a 3% reduction in allowable itemized deductions by which the taxpayer’s AGI exceeds the threshold amount. The reduction will not exceed 80% of the otherwise allowable itemized deductions.

Capital Gain and Dividend Rates Rise for Higher-Income Taxpayers: The top rate for capital gains and qualified dividends will permanently rise to 20% (up from 15%) for taxpayers with incomes over $400,000, or $450,000 for married taxpayers.  For taxpayers whose ordinary income is generally taxed at a rate below 25%, capital gains and qualified dividends will permanently be subject to a 0% rate.  Taxpayers who are subject to a 25%-or-greater rate on ordinary income, but whose income levels fall below the aforementioned thresholds ($400k / $450k married), will continue to be subject to a 15% rate on capital gains and qualified dividends.

Estate and Gift Tax Provisions Kept Intact with Slight Rate Increase: The Act prevents steep increases in estate, gift and generation-skipping transfer (GST) tax that were going to occur for individuals dying and gifts made after 2012 by permanently holding the exemption level at $5,000,000.  However, the Act also permanently increases the top estate and gift tax rate from 35% to 40%.  Also, the Act continues the portability feature that allows the estate of the first spouse to die to transfer his or her unused exclusion to the surviving spouse.

Permanent AMT Relief: The Act includes a permanent alternative minimum tax (AMT) relief.  Prior to this Act, the individual AMT exemption amounts for 2012 were going to be $33,750 for unmarried taxpayers, $45,000 for joint filers, and $22,000 for married persons filing separately.  Retroactively effective for tax years after 2011, the Act permanently increases these exemption amounts to $50,600 for unmarried taxpayers, $78,750 for joint filers, and $39,375 for married persons filing separately.  Additionally, for tax years after 2012, it indexes these exemption amounts for inflation.

Recovery Act Extenders: The Act extends for five years the following items that were originally enacted as part of the American Recovery and Investment Tax Act of 2009 and that were slated to expire at the end of 2012:

  • the American Opportunity tax credit, a credit equal to 100% of the first $2,000 of qualified tuition and related expenses, and 25% of the next $2,000 of qualified tuition and related expenses (for a maximum tax credit of $2,500 for the first four years of post-secondary education);
  • eased rules for qualifying for the refundable child credit; and
  • various earned income tax credit (EITC) changes relating to higher EITC amounts for eligible taxpayers with three or more children.

 

Historical individual extenders. The Act extends the following items/periods:

  • deduction for certain expenses of elementary and secondary school teachers is now revived for 2012 and continued through 2013;
  • exclusion for discharge of qualified principal residence indebtedness is now continued to apply for discharges before Jan. 1, 2014;
  • parity for the exclusions for employer-provided mass transit and parking benefits is now revived for 2012 and continued through 2013;
  • treatment of mortgage insurance premiums as qualified residence interest is now revived for 2012 and continued through 2013;
  • option to deduct State and local general sales taxes is now revived for 2012 and continued through 2013.
  • special rule for contributions of capital gain real property made for conservation purposes, which expired at the end of 2011 and which is now revived for 2012 and continued through 2013;
  • the above-the-line deduction for qualified tuition and related expenses is now revived for 2012 and continued through 2013; and
  • tax-free distributions from individual retirement plans for charitable purposes is now revived for 2012 and continued through 2013. Because 2012 has already passed, a special rule permits distributions taken in 2012 to be transferred to charities for a limited period in 2013.

 

Depreciation Provisions Modified and Extended: The following depreciation provisions are retroactively extended by the Act through 2014:

  • 15-year straight line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements;
  • 7-year recovery period for motorsports entertainment complexes;
  • accelerated depreciation for business property on an Indian reservation;
  • increased expensing limitations and treatment of certain real property as Code Sec. 179 property;
  • special expensing rules for certain film and television productions; and
  • the election to expense mine safety equipment.

The Act also extends and modifies the bonus depreciation provisions with respect to property placed in service after Dec. 31, 2012, in tax years ending after that date.

Business Tax Breaks Extended:

  • Research credit is modified and retroactively extended for two years through 2013.
  • Code Sec. 45P employer wage credit for employees who are active duty members of the uniformed services is retroactively extended for two years through 2013.
  • Code Sec. 51 work opportunity tax credit is retroactively extended for two years through 2013.
  • Exclusion from a tax-exempt organization’s unrelated business taxable income (UBTI) of interest, rent, royalties, and annuities paid to it from a controlled entity under Code Sec. 512(b)(13)(E)(iv) is extended through Dec. 31, 2013.
  • Exclusion of 100% of gain on certain small business stock acquired before Jan. 1, 2014.
  • Basis adjustment to stock of S corporations making charitable contributions of property under Code Sec. 1367(a) in tax years beginning before Dec. 31, 2013.
  • The reduction in S corporation recognition period for built-in gains tax under Code Sec. 1374(d)(7) is extended through 2013, with a 10-year period instead of a 5-year period.

 

Energy-related Tax Breaks Extended: Various energy credits are extended, but the most relevant to our clients is that the non-business energy property credit for energy-efficient homes is retroactively extended for two-years through 2013.  A taxpayer can claim a 10% credit on the cost of: (1) qualified energy efficiency improvements, and (2) residential energy property expenditures, with a lifetime credit of $500 ($200 for windows and skylights).

Closing Remarks:  President Obama has stated he will sign this Act into law quickly.  However, while this may appear to have prevented the U.S. economy from going over the “Fiscal Cliff”, there is still much economic uncertainty looming on the horizon.  The new congress has two months to work out the “sequestration” or “budget cut” side of the cliff.  Only after then can they devote time to address the much needed overhaul of our Tax Code, which has grown well beyond comprehension to nearly everyone other than us Tax Professionals.  So… please stay tuned for Act 3 of this harrowing adventure!

For more information or specific questions, please contact a KatzAbosch tax advisor at 410-828-CPAS (2727) or email magetstein@katzabosch.com

Submitted by KatzAbosch’s Tax Department Chair, Michael J. Agetstein, PFS, CPA

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