April 15th has passed, but it is not time to stop thinking about taxes and strategic tax planning opportunities. Many new tax developments have been introduced which will impact tax planning for 2013 and beyond. Changes made to the Tax Code by the American Taxpayer Relief Act and the Patient Protection and Affordable Care Act take effect and the impact on individuals is significant.
Without the American Taxpayer Relief Act, individual tax rates on all income groups would have increased, taxpayer-friendly treatment of capital gains and dividends would have completely disappeared, the child tax credit would have plummeted to $500, enhancements to education tax incentives would have ended, the federal estate tax would have reverted to a maximum 55 percent, and many other popular but temporary incentives would no longer be available.
PERMANENT ALTERNATIVE MINIMUM TAX RELIEF:
The alternative minimum tax (AMT) exemption amounts for individuals have been increased for tax years beginning in 2012 and made permanent. The exemption amounts for the 2012 tax year are $78,750 for a joint return or surviving spouse, $50,600 for an unmarried individual not a surviving spouse, $39,375 for married individuals filing separately. The exemption amounts will be indexed for inflation for calendar years beginning after 2012.
Although the AMT exemption amounts for individuals have increased for 2012, the threshold levels for calculating the exemption phaseout remain unchanged, except as to an estate, trust or corporation. Thus, the exemption amount for tax years beginning in 2012 is still reduced by 25 percent for each $1 of alternative minimum taxable income (AMTI) in excess of: (1) $112,500 in the case of unmarried individuals, (2) $150,000 in the case of married individuals filing a joint return and surviving spouses, and (3) 50 percent of the dollar amount applicable to married taxpayers filing jointly in the case of married individuals filing separate returns. However, because the calculation of the phaseout amount is affected by the amount of AMTI exempted, an increase in the exemption amount will also increase the maximum amount of AMTI a person can have before the exemption amount is phased out.
INDIVIDUAL INCOME TAX RATES:
Income above these levels will be taxed at a 39.6 percent rate. Therefore, the 10, 15, 25, 28 and 33 percent marginal rates remain the same after 2012, as does the 35 percent rate for income between the top of the 33 percent rate (projected to be at $398,350 for most taxpayers) and the $400,000/$450,000 threshold at which the 39.6 percent bracket now begins. Taxpayers who find themselves within the 39.6 percent marginal income tax bracket nevertheless also benefit from extension of all Bush-era rates below that level.
The majority of U.S. businesses are pass-through entities, such as partnerships and S corporations. This means that profits are passed through to their individual owners and therefore are taxed at individual income tax rates. A “C” corporation, with its current corporate level tax rate of 35 percent (which may drop if recent corporate tax reform proposals are adopted), may become more attractive with rates rising to 39.6 percent for some individuals.
Marriage Penalty Relief
The American Taxpayer Relief Act extends all existing marriage penalty relief provisions. Before EGTRRA, married couples experienced the so-called marriage penalty in several areas. EGTRRA gradually increased the basic standard deduction for a married couple filing a joint return to twice the basic standard deduction for an unmarried individual filing a single return. Without marriage penalty relief, the standard deduction for married couples would be 167 percent of the deduction for single individuals rather than 200 percent. For joint filers in 2013, that would have meant a drop of $1,950, from $12,200 to $10,150.
EGTRRA also gradually increased the size of the 15 percent income tax bracket for a married couple filing a joint return to twice the size of the corresponding rate bracket for an unmarried individual filing a single return. Without that relief, the top of the 15 percent rate bracket in 2013 for married taxpayers filing jointly would be set at a projected $60,550 rather than $72,500.
The American Taxpayer Relief Act raises the top rate for capital gains and dividends to 20 percent, up from the Bush-era maximum 15 percent rate. That top rate will apply to the extent that a taxpayer’s income exceeds the thresholds set for the 39.6 percent rate.
All other taxpayers will continue to enjoy a capital gains and dividends tax at a maximum rate of 15 percent. A zero percent rate will also continue to apply to capital gains and dividends to the extent income falls below the top of the 15 percent income tax bracket—projected for 2013 to be $72,500 for joint filers and $36,250 for singles. Qualified dividends for all taxpayers continue to be taxed at capital gains rates, rather than ordinary income tax rates as prior to 2003.
Without the American Taxpayer Relief Act, the maximum tax rate on net capital gain of all noncorporate taxpayers would have reverted to 20 percent (10 percent for taxpayers in the 15 percent bracket) starting January 1, 2013.
It should be noted that starting in 2013, under the Patient Protection and Affordable Care Act (PPACA), higher income taxpayers must also start paying a 3.8 percent additional tax on Net Investment Income (NII) to the extent certain threshold amounts of income are exceeded ($200,000 for single filers, $250,000 for joint returns and surviving spouses, $125,000 for married taxpayers filing separately). Those threshold amounts stand, despite higher thresholds now set for the 20 percent capital gain rate that previously had been proposed by President Obama to start at the same levels. The NII surtax thresholds are not affected by the American Taxpayer Relief Act. Starting in 2013, therefore, taxpayers within the NII surtax range must pay the additional 3.8 percent on capital gain, whether long-term or short-term. The effective top rate for net capital gains for many “higher-income” taxpayers thus becomes 23.8 percent for long term gain and 43.4 percent for short-term capital gains starting in 2013.
The American Taxpayer Relief Act officially revives the “Pease” limitation on itemized deductions, which was eliminated by EGTRRA. The Pease limitation, named after the member of Congress who sponsored the original provision, reduces the total amount of a higher-income taxpayer’s otherwise allowable itemized deductions by 3 percent of the amount by which the taxpayer’s adjusted gross income exceeds an applicable threshold. However, the amount of itemized deductions is not reduced by more than 80 percent. Certain items, such as medical expenses, investment interest, and casualty, theft or wagering losses, are excluded.
However, higher “applicable threshold” levels apply under the new law:
1. $300,000 for married couples and surviving spouses;
2. $275,000 for heads of households;
3. $250,000 for unmarried taxpayers; and
4. $150,000 for married taxpayers filing separately.
The applicable threshold for the Pease limitation for 2013, as adjusted for inflation and as computed under the sunset rules, would have been $178,150 ($89,075 for individuals married filing separately). Thus, the American Taxpayer Relief Act does not call for a full revival of the Pease limitation at former levels.
PERSONAL EXEMPTION PHASEOUT:
The American Taxpayer Relief Act also officially revives the personal exemption phaseout rules, but at applicable income threshold levels slightly higher than in the past:
Under the phaseout, the total amount of exemptions that may be claimed by a taxpayer is reduced by 2 percent for each $2,500, or portion thereof (2 percent for each $1,250 for married couples filing separate returns) by which the taxpayer’s adjusted gross income exceeds the applicable threshold level.
CHILD TAX CREDIT:
The American Taxpayer Relief Act extends permanently the $1,000 child tax credit. Certain enhancements to the credit under Bush-era legislation and subsequent legislation are also made permanent.
EARNED INCOME CREDIT:
The American Taxpayer Relief Act makes permanent or extends through 2017 enhancements to the earned income credit (EIC) in Bush-era and subsequent legislation. The enhancements to the EIC made by Bush-era and subsequent legislation include (not an exhaustive list) a simplified definition of earned income, reform of the relationship test and modification of the tie-breaking rule.
OTHER CHILD-RELATED TAX RELIEF:
The American Taxpayer Relief Act extends permanently Bush-era enhancements to the adoption credit and the income exclusion for employer-paid or reimbursed adoption expenses up to $10,000 (indexed for inflation) both for non-special needs adoptions and special needs adoptions. The adoption credit phases out for taxpayers above specified inflation-adjusted levels of modified adjusted gross income. The phase-out level for 2012 started at $189,710. For 2013, the beginning point for phasing out the adoption credit is projected to be $191,530. The limit on the adoption credit is projected to be $12,770 for 2013.
Child and Dependent Care Credit
The American Taxpayer Relief Act extends permanently Bush-era enhancements to the child and dependent care credit. The current 35 percent credit rate is made permanent along with the $3,000 cap on expenses for one qualifying individual and the $6,000 cap on expenses for two or more qualifying individuals. Expenses qualifying for the child and dependent care credit must be reduced by the amount of any dependent care benefits provided by the taxpayer’s employer that are excluded from the taxpayer’s gross income.
Employer-Provided Child Care Credit
The American Taxpayer Relief Act extends permanently the Bush-era credit for employer-provided child care facilities and services.
The American Taxpayer Relief Act makes permanent or extends a number of enhancements to tax incentives designed to promote education. Many of these enhancements were made in Bush-era legislation, extended by subsequent legislation and were scheduled to expire after 2012. Some enhancements, notably the American Opportunity Tax Credit, were made in President Obama’s first term.
American Opportunity Tax Credit
The American Opportunity Tax Credit (AOTC) is extended through 2017. The AOTC is an enhanced, but temporary, version of the permanent HOPE education tax credit. The AOTC gives qualified taxpayers a tax credit of 100 percent of the first $2,000 of qualified tuition and related expenses and 25 percent of the next $2,000, for a total maximum credit of $2,500 per eligible student. Additionally, the AOTC applies to the first four years of a student’s post-secondary education. The HOPE credit is less and applies only to the first two years of post-secondary education.
Deduction for Qualified Tuition and Related Expenses
The American Taxpayer Relief Act extends until December 31, 2013 the above-the-line deduction for qualified tuition and related expenses. The bill also extends the deduction retroactively for the 2012 tax year.
Student Loan Interest Deduction
The American Taxpayer Relief Act permanently extends suspension of the 60-month rule for the $2,500 above-the-line student loan interest deduction. The American Taxpayer Relief Act also permanently expands the modified adjusted gross income range for phaseout of the deduction and repeals the restriction that makes voluntary payments of interest nondeductible.
Coverdell Education Savings Accounts
The American Taxpayer Relief Act permanently extends Bush-era enhancements to Coverdell education savings accounts (Coverdell ESAs). These enhancements include a $2,000 maximum contribution amount and treatment of elementary and secondary school expenses as well as postsecondary expenses as qualified expenditures.
Employer-Provided Education Assistance
The American Taxpayer Relief Act permanently extends the exclusion from income and employment taxes of employer-provided education assistance up to $5,250. The employer may also deduct up to $5,250 annually for qualified education expenses paid on behalf of an employee.
The American Taxpayer Relief Act makes permanent the exclusion from income for the National Health Service Corps Scholarship Program and the Armed Forces Scholarship Program.
MORE INDIVIDUAL TAX EXTENDERS
- Teachers’ Classroom Expense Deduction. The American Taxpayer Relief Act extends through 2013 the teacher’s classroom expense deduction. The deduction, which expired after 2011, allows primary and secondary education professionals to deduct (above-the-line) qualified expenses up to $250 paid out-of-pocket during the year.
- Exclusion of Cancellation of Indebtedness on Principal Residence. Cancellation of indebtedness income is includible in income, unless a particular exclusion applies. This provision excludes from income cancellation of mortgage debt on a principal residence of up $2 million. The American Taxpayer Relief Act extends the provision for one year, through 2013.
- Transit Benefits. The American Taxpayer Relief Act extends parity in transit benefits through December 31, 2013. These benefits are a tax-free fringe benefit to employees. Parity in the exclusion limit expired after 2011.
- Mortgage Insurance Premiums. This provision treats mortgage insurance premiums as deductible interest that is qualified residence interest. The American Taxpayer Relief Act extends this provision through December 31, 2013. The provision originally expired after 2011.
- Contribution of Capital Gains Real Property for Conservation. The Act extends for two years, through December 31, 2013, the special rule for contributions of capital gain real property for conservation purposes. The special rule allows the contribution to be taken against 50 percent of the contribution base. The Act also extends for two years the special rules for contributions by certain corporate farmers and ranchers.
- IRA Distributions to Charity. The American Tax Relief Act extends for two years, through December 31, 2013, the provision allowing tax-free distributions from individual retirement accounts to public charities, by individuals age 70 1/2 or older, up to a maximum of $100,000 per taxpayer per year.
Quarterly and Year-end tax planning for 2013 requires a combination of multi-layered strategies, taking into account a variety of possible scenarios and outcomes. Every tax situation is different and requires a careful and comprehensive plan. We can assist you in aligning traditional quarterly techniques with strategies for dealing with the recent tax developments. Planning today can help maximize your tax savings going forward. Now is a good time to revisit these developments and explore how they will affect your strategic tax plans.
As always, please give our office a call or email if you would like to explore these changes and discuss potential tax saving opportunities.