On December 17, 2010, after passage by the lame duck House and Senate, President Obama signed into law the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010” (“Tax Act”). The Tax Act extends the Bush tax cuts for two more years, allows a 2% cut in payroll tax and self-employment tax for 2011, provides for a two-year patch on the Alternative Minimum Tax problem, extends the child tax credit and higher education tax credits, allows immediate write-off of new equipment and machinery purchases, extends a number of tax benefits scheduled to expire, provides for a temporary extension of unemployment insurance benefits, and provides relief in the estate and gift tax area.
This new legislation was characterized as a compromise, since neither Republicans nor Democrats were satisfied with the Tax Act as a whole. It does offer something for many disparate taxpayers, however. The Joint Committee on Taxation estimates that the cost of the Tax Act over the next 10 years will be $858 billion, with most of the cost being incurred during the first three years.
Executive Summary:
- Extension of the Bush tax cuts and a top 35% income tax rate for all taxpayers through 2012.
- Extension of the preferential 15% tax rate on long-term capital gain and qualified dividends through 2012.
- Alternative minimum tax relief in the form of a larger AMT exemption for 2010 and 2011.
- Repeal of the phase-outs related to personal exemptions and itemized deductions through 2012.
- Extension of various deductions and exclusions expected to sunset in 2009 or 2010.
- Reinstatement of a popular opportunity for those over 70 ½ to make tax free IRA distributions directly to charity with a special window of opportunity to treat January 2011 distributions as 2010 events.
- Extension of various credits, including the energy credit, child credit and education credit.
- For business taxpayers, enhanced bonus depreciation and expensing opportunities.
- Establishment of a 2% payroll and self-employment (“SE”) tax reduction for 2011.
- Estate and gift tax relief, including a lower 35% tax rate and an enhanced $5 million exemption, as well as portability of a spouse’s unused exemption for use in the survivor’s estate.
The following is a brief summary of the more important provisions of this major legislation.
Retention of the Bush tax cuts. The 2010 tax rates and brackets were extended for two more years, 2011 and 2012. The top rate will remain at 35%. Before passage of the Tax Act, the top rate was expected to increase to 39.6% and the lowest 10% bracket was to disappear, leaving the lowest tax rate at 15%. Note that despite an effort to restrict the tax rate cut to taxpayers making less than $200,000 ($250,000 for married couples), the Tax Act applies the rates to all taxpayers.
Capital gain and qualified dividend income. The Tax Act extends the 15% maximum tax rate for long-term capital gains and qualified dividends through 2012. Moreover, taxpayers in the 10% and 15% tax brackets enjoy a 0% tax rate on this income. Before enactment of the Tax Act, the maximum tax rate on long-term capital gains was to revert to 20% (18% for assets held more than five years), and qualified dividends would be subject to tax at the ordinary income rate (up to 39.6%). The Tax Act also extends the 100% gain exclusion for qualified small business stock held for more than five years and acquired between September 27, 2010 and January 1, 2012. Qualified small business stock acquired between February 17 and September 26, 2010 is allowed a 75% gain exclusion.
Alternative Minimum Tax relief. The Alternative Minimum Tax (“AMT”) exemption is a parallel tax system with a top rate of 28% and very few deductions. Taxpayers are required to compute their tax under the regular tax system, as well as the AMT system and are obligated to pay the higher tax amount. The AMT exemption, expected to drop after 2009, will actually increase under the new law to $47,750 for single filers and $72,450 for joint filers for 2010, with an additional increase for 2011. It is estimated that approximately 4 million taxpayers are subject to the AMT, and had the AMT exemption not been changed, an estimated 21 million more middle-class taxpayers would have been caught in the AMT web. The cost of permanent AMT relief is huge; hence Congress has utilized a year by year “patch.” It becomes a real burden to taxpayers in states that have high income taxes and property taxes.
Personal exemptions. Before 2010, personal exemptions were phased out based on a taxpayer's adjusted gross income, and many high income taxpayers completely lost the benefit of their personal exemptions. In 2010, the personal exemption phase-out was repealed. The Tax Act continues this treatment through 2012, allowing high income taxpayers the full benefit of personal exemptions.
Itemized deductions. In a similar vein, before 2010, itemized deductions were phased out once adjusted gross income exceeded approximately $170,000 at a 3% rate above the threshold. In 2010, this phase-out was repealed. The Tax Act continues this treatment through 2012, allowing for itemized deductions without reduction.
Deductions extended. Several tax deductions that were set to expire have been extended by the new Tax Act. They include deductions for student loan interest and Coverdell education savings accounts, both of which are extended through 2012. In addition, the deduction for state and local sales tax, the higher education tuition deduction, and the teacher's classroom expense deduction were extended through 2011.
Employer-provided education assistance. The Tax Act extends through 2012 the exclusion of up to $5,250 of employer-provided educational expense, including tuition for graduate school.
Marriage penalty relief. Because of the differences in the 15% tax bracket and standard deduction between single filers and joint filers, our tax system actually penalizes married couples. One of the provisions of the Bush tax cuts corrected this discrepancy. The Tax Act extends this marriage penalty relief through 2012.
Tax-free IRA distributions to charity. Before 2010, individuals over age 70 ½ were allowed to make distributions from their IRAs directly to charities, up to $100,000 per year. These direct distributions counted toward taxpayers’ required minimum distribution amounts. The Tax Act extends this provision through 2011. A special rule allows direct charitable transfers during January 2011, to be treated as 2010 distributions. The special rule may allow taxpayers to put back into their IRAs distributions they received late in 2010 under the 60-day rollover rule, which subsequently could be directly distributed to charity by January 31, 2011, thus avoiding 2010 taxation on the required minimum distribution amount.
Energy credit. The non-business energy credit on qualified energy efficient property, such as insulation materials, exterior windows and doors, furnaces and water heaters was extended to the end of 2011. Unfortunately, however, the credit was reduced from 30% to 10% of qualifying expenditures, with a $500 lifetime cap on the amount of the credit.
Child tax credit. The $1,000 refundable child tax credit is extended through 2012 by the Tax Act. The credit is phased out for joint filers with gross income over $110,000.
Child and dependent care credit. The child and dependent care credit, calculated at 35% of qualified expenses, is extended through 2012. The maximum amount of qualified expenses remains at $3,000 for one child and $6,000 for two or more children.
American Opportunity Tax Credit. This education credit is also extended for two more years. The credit may be claimed for all four years of postsecondary education, with a per year maximum credit of $2,500. This credit originated in 2009 and replaced the Hope Credit. It is partially refundable, up to 40%, and is phased out for single taxpayers with $80,000 of adjusted gross income ($160,000 for joint filers).
Bonus depreciation. For qualifying business assets placed in service after September 9, 2010 and through December 31, 2011, the Tax Act allows for 100% bonus depreciation. This will allow both large and small businesses to receive an immediate tax benefit for their capital purchases through 2011.
Section 179 expensing. Under current law, small businesses may expense, rather than capitalize, up to $500,000 of capital expenditures. The expensing provision is subject to a phase-out between $2 million and $2.5 million of qualifying asset acquisitions. The Tax Act partially extends the opportunity into 2012, albeit at a $125,000 maximum deduction and a $500,000 phase-out cap on expenditures.
Payroll tax cut. For 2011, both employees and self-employed individuals receive a 2% tax reduction of their social security tax and self-employment tax respectively. Employees will pay 4.2% (instead of 6.2%) up to the maximum FICA wage base of $106,800. Self-employed individuals will pay SE tax at a 13.3% rate (instead of 15.3%). Interestingly, the self-employment tax deduction, previously calculated at 50% of the SE tax liability, will remain at 7.65%, notwithstanding the rate cut.
Estate Tax. The federal estate, gift, and generation-skipping (“GST”) taxes were reinstated retroactively as of the beginning of 2010. Both the estate and gift tax are based on a flat rate of 35%. For 2010 only, the GST tax rate was zero. Fiduciaries of decedents dying in 2010 may opt out of the estate tax regime, and be subject to the carryover basis rules for income tax purposes, thus negating the opportunity to step up tax basis of assets to date of death value. For 2011 and 2012, the estate, gift and GST taxes remain at 35%, with an exemption of $5 million. For married couples, the unused exemption in the first spouse's estate may be used in the survivor's estate (introducing the concept of “portability”). The increase in gift tax exemption to $5 million ($10 million for a married couple) provides an outstanding opportunity to pass current wealth and future appreciation to lower generations, either by outright gifting or through leveraging strategies such as sales to intentionally defective trusts and grantor retained annuity trusts (“GRATs”). For more detail on the changes to the transfer tax, see the alert entitled “Estate, Gift, and GST Changes in the 2010 Tax Act”.
Other changes that will impact individuals.
E-filing. Pursuant to 2009 legislation, most tax return preparers are required to file individual, trusts, and estates income tax returns electronically.
Tax basis of covered securities. Effective in 2011, brokers required to file an information return reporting the gross proceeds of the sale of a security (Form 1099-B) must also include in the filing the customer’s adjusted tax basis in the security and whether the gain or loss, with respect to the security, is short-term or long-term. This new rule generally applies to securities acquired on or after January 1, 2011.
Information reporting for real estate owners who rent their property. Beginning in 2011, for purposes of Form 1099 reporting, persons receiving rental income from real estate will be considered as engaged in a trade or business, and thus, subject to information reporting. This will require Form 1099 reporting to service providers such as attorneys, accountants, painters, plumbers, etc. who receive payments of $600 or more during a tax year. It is good practice that property owners request and receive all service providers’ tax identification numbers (on form W-9 or its equivalent) before making any payments.
Tax increase in 2013. Healthcare reform legislation passed earlier in 2010 instituted a new and somewhat controversial tax increase beginning in 2013. Earned income in excess of $200,000 ($250,000 for joint filers) will be subject to 0.9% surtax. In addition, net investment income in excess of those levels will be subject to 3.8% surtax. If the top tax rate increases to 39.6% in 2013, as the law currently provides, marginal tax rates on investment income, with the surtax, reach 43.4%. Careful monitoring of adjusted gross income amounts is critical after 2012. One strategy may be a Roth conversion prior to 2013, in order to avoid the adjusted gross income impact of required minimum distributions from IRAs and other qualified plans.
Summary. The 2010 Tax Act provides needed relief for a long troubled economy attempting to get some traction. Most of its provisions expire at the end of 2012 however, so long-term planning is complicated. Clearly, the agenda for the 2012 election will include the extended tax cuts and other provisions, since they are set to expire just less than two months after the election. Stay tuned.