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The American Taxpayer Relief Act of 2012
January 15, 2013
Private Clients Alert

The American Taxpayer Relief Act of 2012, passed by both the House and Senate on New Year’s Day and signed into law by President Obama on January 3, 2013, addressed the revenue side of the so-called “Fiscal Cliff.” Still to come will be agreement on the expenditure side of the equation. This alert will summarize the key provisions of the Act that impact individual taxpayers.

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Summary:

 The Act made a number of changes impacting individuals:

  • A permanent extension of the current income tax rates for individuals with taxable income under $400,000 ($450,000 for joint filers);
  • An increase in the top tax rate to 39.6% for individuals with taxable income over $400,000 ($450,000 for joint filers) and for taxable trusts with taxable income over $11,950;
  • A continuation of the preferential 15% tax rate for long-term capital gain and qualified dividend income for individuals with taxable income under $400,000 ($450,000 for joint filers);
  • An increase in the long-term capital gain and qualified dividend income tax rate to 20% for individuals with taxable income over $400,000 ($450,000 for joint filers);
  • A reinstatement of the itemized deduction limitation and personal exemption phase-out for individuals with adjusted gross income over $250,000 ($300,000 for joint filers);
  • A permanent increase in the alternative minimum tax (“AMT”) exemption amount (indexed for inflation);
  • A permanent extension of the estate, gift and generation skipping tax (“GST”) exemptions to $5 million per person (indexed for inflation - $5,250,000 for 2013), with an increase in the top tax rate to 40%;
  • An extension of a number of expired tax provisions such as the child tax credit, dependent care tax credit, adoption tax credit, student loan interest deduction, sales tax deduction, exclusion for employer provided education assistance, and the American opportunity tax credit for college tuition, among other items; and
  • An extension for tax-free distributions from IRAs to charities for qualified individuals, including an opportunity to transfer December, 2012, distributions to charities for a limited period.
  • Not extended was the payroll tax holiday which allowed employees a 2% FICA tax reduction for the past few years.
  • The Act also includes a number of business and energy tax provisions, including an extension of the bonus depreciation and expensing rules.
  • Although not part of the 2012 ATRA, 2013 is the first year that the new Medicare tax will apply to individuals with adjusted gross income over $200,000 ($250,000 for joint filers) at rates of 0.9% on net earned income and 3.8% on “net investment income.”

Explanation:

  1. Tax Rates – Ordinary Income – The tax rates and brackets set in place by 2001 and 2003 legislation (the “Bush Tax Cuts”) and scheduled to sunset at the end of 2010 were extended through 2012 by the current administration. There were six tax brackets – 10%, 15%, 25%, 28%, 33% and a top bracket of 35%.

    The 2012 ATRA eliminates the sunset rule, and therefore makes the tax brackets “permanent” in nature. Of course, permanency is a bit of a misnomer, because any aspect of the tax law may be changed any time Congress is in session. However, the elimination of the sunset provisions, which have been part of the tax landscape since 2001, does provide a bit more certainty for planning purposes, and is a welcome relief.

    The Act also adds a new top tax rate of 39.6% that will apply to single taxpayers with taxable income in excess of $400,000 and joint taxpayers with taxable income in excess of $450,000. The threshold for this new top rate is below the $1 million “Plan B” proposed by the House speaker, but $200,000 higher than the level sought by President Obama.

    As discussed in more detail below, the Medicare tax on earned and unearned income will also have a significant impact on marginal tax rates.

    The tax brackets applicable to single and joint individual taxpayers are listed below:

    2013 Individual Tax Rates

    Taxable Income

    Single Taxpayers

    Joint Filers

    Tax Rate

    $0–$8,925

    $0–$17,850

    10%

    $8,926–$36,250

    $17,851–$72,500

    15%

    $36,251–$87,850

    $72,501–$146,400

    25%

    $87,851–$183,250

    $146,401–$223,050

    28%

    $183,251–$398,350

    $223,051–$398,350

    33%

    $398,351–-$400,000

    $398,351–$450,000

    35%

    $400,001 +

    $451,001 +

    39.6%























    For example, assume a married couple filing a joint return reports $475,000 of taxable income. Their income up to $450,000 will be taxed under the 10% to 35% brackets listed above. Their remaining income of $25,000 (the amount exceeding $450,000) will be taxed at the new top tax rate of 39.6%.

    Taxable trusts have incredibly narrow tax brackets, and reach the top tax rate of 39.6% at $11,950 of taxable income. 

    Taking into account the 3.8% Medicare tax on net investment income and the approximately 1% impact of the itemized deduction and personal exemption phase-outs discussed below, the top combined federal marginal rate (not including state income tax) is approximately 44.4% for interest income, passive income, rents, annuities and short-term capital gain.

    For compensation income (salaries, wages and self-employment income), the top combined federal marginal rate, after considering the 0.9% additional Medicare rate and phase-out impact, is approximately 41.5%, not including state income tax.

  2. Tax Rates – Long-Term Capital Gain & Qualified Dividends – The preferential tax rate on long-term capital gain and qualified dividend income remains at 15% for taxpayers below the 39.6% threshold listed above—that is, single taxpayers with taxable income under $400,000 and joint filers with taxable income under $450,000. The 15% rate for long-term capital gain and qualified dividends was put in place by 2003 legislation and was expected to sunset in 2010, but it was extended through the end of 2012 as part of the extension of the Bush Tax Cuts. The 2003 legislation also instituted a 0% tax rate on long-term capital gain and qualified dividend income for taxpayers in the 10% or 15% ordinary income tax brackets. The Act continues this treatment for individuals in the two lowest tax brackets.

    For taxpayers with taxable income above $400,000 ($450,000 for joint filers), long-term capital gain and qualified dividends will be taxed at 20%.  

    A major concern prior to this new legislation was that qualified dividend income would lose its preferential tax rate and therefore be taxed at ordinary tax rates. This would have meant an increase from 15% to 39.6%, plus the 3.8% Medicare tax. Under ATRA, the qualified dividend preferential tax rate remains part of the permanent tax law.

    The new tax rates for long-term capital gain and qualified dividends are based on taxable income levels as follows: 

    Long-Term Capital Gain and Qualified Dividends

    Taxable Income

    Single Taxpayers

    Joint Filers

    Tax Rate

    $0–$36,250

    $0–$72,500

    0%

    $36,251–$400,000

    $72,501–$450,000

    15%

    $400,001 +

    $450,001 +

    20%


    For example, assume a single taxpayer has $420,000 of taxable income, comprised of $360,000 of salary income and $60,000 of qualified dividend income. Single taxpayers are subject to the top 39.6% ordinary tax rate at $400,000 of taxable income. Under the Act, part of the of the qualified dividend income will be subject to a 15% tax rate, and the remainder subject to the new 20% tax rate. The lesser of a) the $60,000 qualified dividend income or b) the taxable income not subject to the 39.6% tax rate ($400,000) less the taxable income reduced by the qualified dividend income ($360,000) or $40,000, is subject to the 15% rate, with the remaining $20,000 subject to the 20% rate.

    The top tax rate for a trust is reached at $11,950 of taxable income. Thus, qualified dividend income and long-term capital gain will, over this threshold, be subject to 20% taxation. 

    The Act also extends the 100% exclusion of gain on qualified small business stock acquired after September 27, 2010, and before January 1, 2014, and held for more than five years.
  3. Itemized Deduction Phase-out (Pease Limitation), Medical Deduction and Personal Exemption Phase-out (“PEP”)

    Itemized Deduction Phase-out
    —The Itemized Deduction Limitation (“Pease Limitation”) is reinstated beginning with the 2013 tax year. Under this limitation, taxpayers’ itemized deductions will be reduced by 3% of the excess of their Adjusted Gross Incomes (“AGI”) over the threshold amounts for their specific filing statuses. Medical expenses, investment interest expenses, and casualty losses are not subject to the limitation, and the total reduction may not exceed 80% of allowable itemized deductions. The filing status threshold amounts are: $300,000 for joint filers, $275,000 for heads of households, $250,000 for single filers and $150,000 for married taxpayers filing separately. These thresholds will be adjusted for inflation for tax years after 2013.

    As an example, Taxpayer A is a single filer with an AGI of $450,000 and total itemized deductions of $120,000. He does not claim any medical expenses, investment interest expenses or casualty losses. The amount of his 2013 Pease Limitation is $6,000 ($450,000 AGI minus $250,000 single filer threshold times 3%), and his allowed itemized deductions after the limitation are $114,000 ($120,000 minus $6,000).

    Medical Deduction—Although not part of the 2012 ATRA, beginning in 2013, the threshold for deducting medical expenses as an itemized deduction will increase from 7.5% to 10% of AGI. Taxpayers who are 65 and older, however, are granted an exception, and will still be able to deduct medical expenses that exceed 7.5% of their AGI.  The exception for taxpayers 65 and older will continue through 2016, and all taxpayers will be subject to the 10% threshold in 2017. 

    Personal Exemption Phase-out (“PEP”)—After a long hiatus, the phase-out of personal exemptions is also reinstated beginning with the 2013 tax year. Each personal exemption is set at $3,900 for 2013. Under this PEP calculation, a taxpayer’s personal exemptions will be reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer’s AGI exceeds specific thresholds for his or her filing status. The threshold amounts are: $300,000 for joint filers, $275,000 for heads of households, $250,000 for single filers and $150,000 for married taxpayers filing separately. These thresholds will be adjusted for inflation for tax years after 2013.

    For example, Taxpayer B is entitled to the head of household filing status and claims personal exemptions for herself and her three children (4 times $3,900 or $15,600). Her AGI is $350,000, which exceeds her $275,000 filing status threshold by $75,000. When the phase-out calculation is applied ($75,000 divided by $2,500 times 2% equals 60%), she will lose 60% of her personal exemptions ($9,360), and will only be allowed to claim $6,240 of personal exemptions.

  4. Alternative Minimum Tax Exemption (“Patch”)—Previous temporary measures to deal with the contagion of the Alternative Minimum Tax (“AMT”) expired at the end of 2011, meaning that millions of additional taxpayers faced the prospect of paying the AMT on their 2012 returns. To prevent the unintended consequence of millions of middle-income taxpayers falling victim to the AMT, Congress once again applied a “patch” to the problem. The “patch” extends a provision allowing for an increased AMT exemption amount, but this time the patch is intended as a permanent fix.  Under the new law, for tax years beginning in 2012, the AMT exemption amounts have increased to: (1) $78,750 from $74,450 in the case of married individuals filing a joint return and surviving spouses; (2) $50,600 from $48,450 in the case of unmarried individuals other than surviving spouses; and (3) $39,375 from $37,225 in the case of married individuals filing a separate return. More importantly, these amounts will be indexed for inflation after 2012, meaning that annual “patches” will no longer be needed.  For 2013, the AMT exemption amounts are $80,800 for joint filers, $58,900 for single individuals and $40,400 for married individuals who file separate returns. 

    In addition to indexing the AMT exemption amount for inflation, the 2012 ATRA has also indexed the breakpoint for the 26% and 28% tax brackets, as well as the Alternative Minimum Taxable Income (“AMTI”) level at which point the exemption amount is phased out.  For 2012, the tax-rate breakpoint is set at $175,000 and the exemption phase-out begins once an individual’s AMTI exceeds $150,000. For 2013, the AMT tax rate breakpoint and the AMT exemption phase-out floor increase to $179,500 ($89,750 for married filing separately) and $153,900, respectively.

    By finally indexing the AMT exemption, the tax-rate breakpoint and the AMTI floor to inflation, the 2012 ATRA should slow the spread of the AMT burden that has been impacting millions of middle-income taxpayers over the past few years.

    Another provision in the Act provides AMT relief for taxpayers claiming personal tax credits. The tax liability limitation rules generally provide that certain nonrefundable personal credits (including the dependent care credit and the elderly and disabled credit) are allowed only to the extent that a taxpayer has regular income tax liability in excess of the tentative minimum tax, which has the effect of disallowing these credits against the AMT. Temporary provisions had been enacted that permitted these credits to offset the entire regular and AMT liability through the end of 2011. The new law extends this relief permanently.

  5. Estate, Gift, and Generation Skipping Tax Exemption and Rate—Under 2001 legislation, the estate, gift and generation skipping tax (“GST”) was phased out and fully repealed in 2010, putting in its place a modified carryover basis regime.  However, 2010 legislation reinstated the estate and GST tax, setting an exemption of $5 million per person and a top tax rate of 35% through 2012. The exemption amount was indexed for inflation, and the exemption for 2012 was $5.12 million per person. The 2010 legislation also introduced the concept of portability for deaths after 2010.  Portability allows a surviving spouse to use any unused exemption of the deceased spouse in the surviving spouse’s estate.

    The 2012 ATRA eliminates the sunset provision and makes the $5 million exemption permanent (indexed for inflation). The 2013 indexed exemption is $5,250,000.  Moreover, the concept of portability was made part of the permanent tax law.

    The Act did, however, increase the top tax rate from 35% to 40%. Under the existing sunset provisions, the top tax rate would have increased to 55%, and the exemption would have dropped to $1 million.  

    Regarding the gift tax, the $5 million lifetime gift tax exemption (indexed for inflation) was also scheduled to revert to $1 million after 2012. The 2012 ATRA makes the $5 million lifetime exemption permanent (indexed for inflation), again unifying the estate and gift tax regimes on a permanent basis. Prior to 2001, the two regimes were unified, and were decoupled for the 2001–2010 period.  

    Previously, certain commentators raised a potential risk of a “clawback” of prior taxable gifts if the exemption were to revert to $1 million. That concern is negated by the “permanent” indexed exemption provision.

    A summary of the exemption amount and the top tax rate follows:

    Estate, Gift & GST Regimes

    Year

    Exemption

    Top Tax Rate

    2011

    $5,000,000

    35%

    2012

    $5,120,000

    35%

    2013

    $5,250,000*

    40%

    2014 & Future

    Indexed for Inflation

    40%

    *The 2013 exemption amount of $5,250,000 equates to a unified credit equivalent of $2,045,800.

    Notwithstanding the unification of the estate and gift tax system, the basic math almost always favors a lifetime gift as opposed to holding the property until death (income tax basis rules ignored). For a rough example, assume a marginal $1 million investment portfolio. If $714,000 is transferred as a gift during lifetime (and assuming the lifetime gift exemption has already been used), the taxpayer will pay about $286,000 of gift tax, thus reducing the portfolio in the hands of the taxpayer to $0. On the other hand, if the $1 million portfolio is held until death, the estate tax would be $400,000, with $600,000 left for the family, an amount that is clearly lower than the $714,000 the family would receive through a lifetime gift. The reason: the gift tax is exclusive (it does not calculate the tax including the gift tax due), while the estate tax is inclusive (it does calculate the tax including the estate tax due). 

    Interestingly, the Act does not include any provisions related to the current administration’s proposals to restrict the use of grantor retained annuity trusts (“GRATs”), to eliminate sales to intentionally defective trusts by making grantor trusts includable in one's taxable estate, to restrict the use of valuation discounts or to eliminate the use of dynasty trusts by restricting the GST exemption period to 90 years. Thus, these techniques continue to be viable alternatives for planning one’s estate.

    The following is a summary of the new estate, gift and GST tax rates:

    2013 Estate, Gift, and GST Tax Rates

    $0–$100,000

    Varies From

    18%–28%

    $100,001–$150,000

    30%

    $150,001–$250,000

    32%

    $251,001–$500,000

    34%

    $500,001–$750,000

    37%

    $750,001–$1,000,000

    39%

    $1,000,001 +

    40%

  6. Extension of Miscellaneous Tax Provisions—The Act extended, with certain modifications and for various durations, a number of tax provisions that will impact individual taxpayers. Some of these provisions expired at the end of 2012, while others expired at the end of 2011 and are being extended retroactively to the beginning of 2012.

    Credits and other provisions that have been extended permanently include:

    • Earned Income Tax Credit
    • Child Tax Credit
    • Dependent Care Tax Credit
    • Adoption Tax Credit and employer-provided adoption assistance program exclusion
    • Employer-Provided Childcare Tax Credit
    • Nonbusiness Energy Property Credit for qualified energy-efficient improvements and residential energy property expenditures.
    • Coverdell Education Savings Accounts
    • Qualified tuition deduction
    • Student loan interest deduction
    • Exclusion from income for employer-provided education assistance
    • Exclusion from income for certain scholarships

    The American Opportunity Tax Credit for college tuition and related education expenses, which may result in a credit of up to $2,500 for each of the first four years of post-secondary education, has been extended for five years, through 2017.

    Other credits and provisions that have been extended only through 2013, when they will once again expire, include:

    • Deduction for mortgage insurance premiums (PMI)
    • Option to deduct state and local general sales taxes
    • Above-the-line deduction for qualified tuition and related expenses
    • Deduction for certain expenses of elementary and secondary school teachers
    • Exclusion for discharge of qualified principal residence indebtedness
    • Special rule for charitable contributions of real estate conservation easementsprincipal residence indebtedness

  7. Tax-Free Distributions from IRAs—The 2012 ATRA temporarily extends existing tax law, which had expired at the end of 2011, so taxpayers age 70 ½ or older may continue to make tax-free distributions from their individual retirement accounts (“IRAs”) directly to qualifying charities. The extension is through the 2012 and 2013 tax years. This means that taxpayers who (in anticipation of retroactive extensions of the law) made direct transfers from their IRAs to qualifying charities during 2012 may qualify those transfers for favorable tax treatment. Furthermore, because 2012 has already passed, the 2012 ATRA provides two special provisions in the area of qualified charitable distributions. First, an eligible taxpayer who received a distribution after November 30, 2012, but before January 1, 2013, may treat any portion of the distribution as a qualified charitable distribution provided, (i) such portion is transferred in cash, after the distribution, to a qualified charitable organization before February 1, 2013, and (ii) such portion is not more than the $100,000 annual distribution limitation. Second, another special rule deems distributions made after December 31, 2012, and before February 1, 2013, as being made on December 31, 2012. Therefore, those taxpayers who waited patiently, hoping that the qualified charitable distribution provision would be extended for 2012, only to be disappointed when December 31, 2012, passed without passage of an extenders package, now have a short window during the month of January, 2013, in which to make a charitable gift from their IRAs that will be treated as a 2012 distribution.

  8. New Medicare Tax on Earned and Unearned Income—Although not part of the 2012 ATRA, taxpayers will be subject to an additional tax burden beginning in 2013 in the form of a Medicare tax, legislated under the Patient Protection and Affordable Care Act (“PPACA”). Although the PPACA was signed into law over two years ago, it contains several revenue provisions that will affect individual taxpayers beginning in 2013.

    Beginning in 2013, the Medicare payroll tax will increase by 0.9% on the earned income (wages and self-employment income) of single and married filing jointly taxpayers in excess of $200,000 and $250,000, respectively. The increased Medicare tax applies to employees only, not to employers. Accordingly, the increased Medicare tax rate on wages over the $200,000/$250,000 thresholds will be 2.35% (increased from 1.45%) and the increased Medicare tax rate on self-employment income over the $200,000/$250,000 thresholds will be 3.8% (increased from 2.9%). The $200,000 threshold for single taxpayers and the $250,000 threshold for married taxpayers filing jointly are not indexed for inflation, so it is possible that a greater number of taxpayers will be subject to this tax increase in subsequent years.

    Employers will apply the increased 0.9% Medicare tax when wages exceed $200,000, regardless of the employee’s filing status or wages paid by another employer. Married taxpayers who individually earn less than $200,000 but jointly earn more than the threshold amount (i.e., more than $250,000 together) will pay additional Medicare taxes through increased withholding adjustments, estimated tax payments or when they file their 2013 Forms 1040.

    Effective in 2013, the PPACA imposes a 3.8% Medicare surtax on the unearned income of single taxpayers with Modified Adjusted Gross Income (“MAGI”) in excess of $200,000 and joint taxpayers with MAGI in excess of $250,000. For the purpose of this tax, MAGI is comprised of AGI plus foreign earned income. This new tax is noteworthy, as this is the first time, since its implementation in 1966, that Medicare taxes have ever been applied to anything other than wages and self-employment income.

    The Medicare surtax will be imposed on the lesser of a taxpayer’s unearned income or the excess of the taxpayer’s MAGI over the specific MAGI filing status threshold. For example, a single taxpayer with a MAGI of $230,000 ($30,000 over the threshold) and $50,000 of unearned income will pay the 3.8% tax on $30,000. Similarly, joint taxpayers with a MAGI of $400,000 ($150,000 over the threshold) and $40,000 of unearned income will pay the 3.8% tax on $40,000.

    Sources of unearned income subject to this Medicare tax include interest, dividends, capital gains, annuities, royalties and passive rental income. Tax-exempt interest and distributions from retirement plans(401(k) Plans, IRAs, Roth IRAs, Profit Sharing Plans and Defined Benefit Plans)are not subject to the 3.8% Medicare surtax. 

     The Medicare tax rates at applicable AGI levels are as follows:  

    2013 Medicare Tax Rates

    Modified Adjusted Gross Income (MAGI)

    Single Taxpayers

    Joint Filers

    Earned

    Income*

    Net Investment

    Income

    $0–$200,000

    $0–$250,000

    1.45%

    0%

    $200,001+

    $250,001+

    2.35%

    3.8%

    *For self-employed individuals, the rate up to $250,000/$250,000 is 2.9% and 3.8% for amounts in excess of these thresholds.

  9. Other Provisions—The 2012 ATRA did not extend the payroll tax holiday that applied to the 2011 and 2012 tax years. For the past two years, employees paid a 4.2% FICA tax on their wages up to the Social Security limit ($110,100 for 2012), a 2% reduction from the normal 6.2%. Many commentators feel that this will be the one provision in the Act that will have the most impact on taxpayers.

     ATRA includes a number of business tax breaks. The Act extends the additional first-year depreciation deduction known as bonus depreciation for one year. In general, 50% of the adjusted basis of qualified property acquired in 2013 may be claimed as bonus depreciation. Moreover, the first-year depreciation for autos and trucks acquired in 2013 is also enhanced by an additional $8,000 depreciation deduction, extending the rule that was to sunset at the end of 2012.

    The Act also retroactively increases the maximum Section. 179 expensing amount (in lieu of depreciation) to $500,000 for tax years 2012 and 2013, with a phase-out if total investment in depreciable assets exceeds $2 million.

    There are a number of other business tax provisions in the 2012 ATRA that are beyond the scope of this alert. 

Conclusion:

The Act provides some clarity for planning purposes.  On the horizon is the next battle, which would be an agreement on the expenditure side of the equation.  Please stay tuned!

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The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.