Jan. 16, 2013 – On New Year’s Eve 2012, the country fell off the fiscal cliff, only to find a congressional trampoline at the bottom of the abyss, bouncing us back to the top, and allowing us to take a few steps back from the precipice.
On Jan. 2, President Barack Obama signed the American Taxpayer Relief Act of 2012, also known as the fiscal cliff bill, after Congress passed the highly publicized legislation. The act took effect Jan. 1, 2013. Unlike the Bush-era tax cuts, with some exceptions, these new provisions are generally not set to expire.
This article addresses the major tax provisions included within the American Taxpayer Relief Act. While the new law protects many from dramatic tax increases, it is axiomatic of the legislation that taxes will still increase for most taxpayers immediately.
Tax Increases in 2013
The mainstream media focused on the increase, from 35 percent to 39.6 percent, of the highest individual marginal income tax bracket for married taxpayers with incomes above $450,000 ($400,000 single). But the law includes a number of other tax increases.
Payroll and self-employment taxes will increase by 2 percent as the so-called payroll tax holiday comes to an end. Investment earnings and wages are subject to the new 3.8 percent surtax on married taxpayers with incomes above $250,000 ($200,000 single) as a result of the 2010 Affordable Care Act.
For many, beginning in 2013, itemized deductions and personal exemptions are subject to phase-outs for the first time in over a decade. Businesses will regale at the continuation of the 50 percent bonus depreciation through the end of 2013.
In a surprise and unprecedented maneuver, Congress retroactively reinstated the $500,000 cap on the election to expense capital assets (the so-called Section 179 depreciation deduction) back to Jan. 1, 2012 (it was previously set at $139,000).
As an encore, the same $500,000 cap was extended through Dec. 31, 2013. However, practitioners need to be critically aware that this deduction drops to a maximum of $25,000 on Jan. 1, 2014. Because of the nature of the interaction between bonus depreciation and Section 179 expense, there is a strong motivation to use bonus depreciation to the extent possible as a first preference, and then make the Section 179 election separately.
Capital Gains and Medicare Surtax
In addition to protecting the above-mentioned business tax benefits, the new law does protect the Bush-era tax rates for most, but not all, individual taxpayers. Marginal income tax rates for married taxpayers below $450,000 ($400,000 single) stay the same, whereas inaction by Congress would have reinstated relatively higher marginal brackets.
Capital gains and qualified dividends, while still generally taxed at 15 percent for married taxpayers with incomes below $450,000 ($400,000 single), are subject to the 3.8 percent Medicare surtax effective Jan. 1, 2013, as are married taxpayers with incomes above $250,000 ($200,000 for single taxpayers).
For example, a married taxpayer with $250,000 of earned income who sells a home for $550,000 could have $50,000 (the amount above the residential gain exclusion) subject to the 15 percent capital gain rate in addition to the 3.8 percent Medicare surtax.
Above $450,000 ($400,000 single), the new capital gain and qualified dividend rate jumps to 20 percent. This means that capital gains and qualified dividends are subject to a much more complex, and progressive, rate structure, requiring careful planning.
Estate and Gift Tax Provisions
While the new tax law penalizes many high income earners, it creates much needed relief for lower income taxpayers. The Alternative Minimum Tax (AMT) personal exemption was raised to $78,750 for married taxpayers ($50,600 for singles), and was indexed to inflation. In addition, five-year extensions to tax credits, such as the earned income tax credit, are now provided to allow a higher degree of certainty.
In another unprecedented move, the estate and gift tax laws now remain unified, permanently. The estate and gift tax exemptions were set to retreat to the $1 million pre-Bush tax cut levels, creating an exemption cut-off for the first $1 million.
Instead, the American Taxpayer Relief Act sets the estate and gift tax exemptions at the 2012 level of $5.12 million per person, indexed to inflation, permanently.
The generation skipping transfer tax (GSTT) followed the same suit. Finally, the estate, gift and GSTT tax exemptions were all indexed to inflation for future years and portability was made permanent. The state death tax credits were also legislated so that Wisconsin’s inheritance tax will remain repealed, unless the state legislators act.
Challenges for Attorneys
For most Wisconsin attorneys, the new tax law creates challenges resulting from new complications to the federal income tax system, shifting focus for estate planners from technical tax analysis to values-based estate planning.
The new law also provides much-needed permanency to our federal investment and transfer tax systems. Increased complexity is directly correlated with the introduction of the 3.8 percent Medicare surtax, which taxes investment income when a married client’s income goes over $250,000 ($200,000 single).
Operating much like the AMT, this new tax uses a complicated add-back formula to compute the surtax, which is then added into the total tax bill on a client’s 1040.
For many estate planners, the shift to a $10+ million exemption for a married couple ($5+ million single), along with the certainty of the exemption for estate and gift tax purposes, and the reinstatement of portability (a tax law phenomenon that allows the decedent spouse’s unused exemption to be carried forward to the surviving spouse) makes nearly obsolete the previous hyper-technical analysis of exemption planning.
In fact, there is now a larger incentive to hold appreciated assets to attain the dual basis step-up within the $5 million exemption framework. Estate planners should, however, more than ever, revisit clients’ estate plans.
Life insurance previously used to fund the estate tax liability for illiquid assets like family farms and family-owned businesses can now be reevaluated for its purpose, and restructured to meet the family’s new needs.
Estate planners should also shift focus from educating clients on the technical nature of the transfer taxes to making sure that their plan operates to fulfill their clients’ objectives. This may be as subtle as evaluating trustee succession or as complex as establishing appropriate governance structures in the family-owned business.
In particular, because agriculture is such a prominent industry in Wisconsin, attorneys with clients in this industry who have seen land values grow exponentially in the past decade, need to adjust succession planning to now anticipate basis step-up benefits, versus planning the previous estate tax liability.
The country averted the tax aspects of the so-called fiscal cliff by working out a deal that provides more permanency and includes some nice tax breaks, relative to where the tax laws were heading. However, nearly all of our clients will pay more taxes as a result of recent legislation. Now is the time to work with clients on investment tax and estate planning issues and help them navigate the increased complexities and opportunities the new law provides.
About the Author
Robert A. Mathers (William Mitchell 1990) is a shareholder in the Fox Valley office of Davis & Kuelthau S.C. and works in the firm’s Corporate Practice Group. Also a Certified Public Accountant (CPA), Mathers advises businesses and their owners, and provides estate planning and private wealth services to individuals. He can be reached by email email@example.com or by phone at (920) 232-4855.