Tax basics of the “fiscal cliff” deal

Pulling back from the “fiscal cliff” at the 13th hour, the US Congress on Tuesday preserved most of the George W. Bush-era tax cuts and extended many other lapsed tax provisions.
 
Shortly before 2am Tuesday, the Senate passed a bill that had been heralded and, in some quarters, groused about throughout the preceding day. By a vote of 89 to 8, the chamber approved the American Taxpayer Relief Act, H.R. 8, which embodied an agreement that had been hammered out on Sunday and Monday between Vice President Joe Biden, a Democrat, and Senate Minority Leader Mitch McConnell, a Republican. The House of Representatives approved the bill by a vote of 257–167 late on Tuesday evening, after plans to amend the bill to include spending cuts were abandoned. President Barack Obama signed the bill Wednesday.

“The uncertainty of the tax law has unnecessarily impeded the long-term tax and cash flow planning for businesses and prevented taxpayers from making informed decisions,” said Edward Karl, vice president–Tax for the American Institute of CPAs, adding that the Institute was pleased an agreement had been reached. “The agreement should also allow the (Internal Revenue Service) and commercial software vendors to revise or issue new tax forms and update software, and allow tax season to begin with minimal delay.”

With some modifications targeting the wealthiest Americans with higher taxes, the act permanently extends provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16 (EGTRRA), and Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27 (JGTRRA). It also permanently indexes for inflation the alternative minimum tax (AMT) exemption amounts for individuals. The AMT provisions were designed to prevent taxpayers with substantial economic income from avoiding tax liability by using certain exclusions, deductions and credits. Because the AMT exemption amounts for individuals were not automatically adjusted for inflation, the AMT annually threatened to ensnare a large number of middle-income individual taxpayers.

The act also temporarily extends many other tax provisions that had lapsed at midnight on December 31st and others that had expired a year earlier.

In addition, the act delays until March a broad range of automatic federal spending cuts known as sequestration that otherwise would have begun this month.

Among the tax items not addressed by the act was the temporary lower 4.2% rate for employees’ portion of the Social Security payroll tax, which was not extended and has reverted to 6.2%.

Here are the act’s main tax features:

Business tax extenders

The act extended many business tax credits and other provisions. Notably, it extended through 2013 and modified the Sec. 41 credit for increasing research and development activities, which expired at the end of 2011. The credit is modified to allow partial inclusion in qualified research expenses and gross receipts those of an acquired trade or business or major portion of one. The increased expensing amounts under Sec. 179 are extended through 2013. The availability of an additional 50% first-year bonus depreciation (Sec. 168(k)) was also extended for one year by the act. It now generally applies to property placed in service before January 1st 2014 (January 1st 2015 for certain property with longer production periods).

Other business provisions extended through 2013, and in some cases modified, are:

• Temporary minimum low-income tax credit rate for non-federally subsidised new buildings (Sec. 42);
• Housing allowance exclusion for determining area median gross income for qualified residential rental project exempt facility bonds (Section 3005 of the Housing Assistance Tax Act of 2008);
• Indian employment tax credit (Sec. 45A);
• New markets tax credit (Sec. 45D);
• Railroad track maintenance credit (Sec. 45G);
• Mine rescue team training credit (Sec. 45N);
• Employer wage credit for employees who are active duty members of the uniformed services (Sec. 45P);
• Work opportunity tax credit (Sec. 51);
• Qualified zone academy bonds (Sec. 54E);
• Fifteen-year straight-line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements (Sec. 168(e));
• Accelerated depreciation for business property on an Indian reservation (Sec. 168(j));
• Enhanced charitable deduction for contributions of food inventory (Sec. 170(e));
• Election to expense mine safety equipment (Sec. 179E);
• Special expensing rules for certain film and television productions (Sec. 181);
• Deduction allowable with respect to income attributable to domestic production activities in Puerto Rico (Sec. 199(d));
• Modification of tax treatment of certain payments to controlling exempt organisations (Sec. 512(b));
• Treatment of certain dividends of regulated investment companies (Sec. 871(k));
• Regulated investment company qualified investment entity treatment under the Foreign Investment in Real Property Tax Act (Sec. 897(h));
• Extension of subpart F exception for active financing income (Sec. 953(e));
• Lookthrough treatment of payments between related controlled foreign corporations under foreign personal holding company rules (Sec. 954);
• Temporary exclusion of 100% of gain on certain small business stock (Sec. 1202);
• Basis adjustment to stock of S corporations making charitable contributions of property (Sec. 1367);
• Reduction in S corporation recognition period for built-in gains tax (Sec. 1374(d));
• Empowerment zone tax incentives (Sec. 1391);
• Tax-exempt financing for New York Liberty Zone (Sec. 1400L);
• Temporary increase in limit on cover-over of rum excise taxes to Puerto Rico and the Virgin Islands (Sec. 7652(f)); and
• American Samoa economic development credit (Section 119 of the Tax Relief and Health Care Act of 2006, P.L. 109-432, as modified).

Individual tax rates

All the individual marginal tax rates under EGTRRA and JGTRRA are retained (10%, 15%, 25%, 28%, 33%, and 35%). A new top rate of 39.6% is imposed on taxable income over $400,000 for single filers, $425,000 for head-of-household filers, and $450,000 for married taxpayers filing jointly ($225,000 for each married spouse filing separately).

Phase-out of itemised deductions and personal exemptions

The personal exemptions and itemised deductions phase-out is reinstated at a higher threshold of $250,000 for single taxpayers; $275,000 for heads of household; and $300,000 for married taxpayers filing jointly.
 
Capital gains and dividends

A 20% rate applies to capital gains and dividends for individuals above the top income tax bracket threshold; the 15% rate is retained for taxpayers in the middle brackets. The zero rate is retained for taxpayers in the 10% and 15% brackets.

Alternative minimum tax

The exemption amount for the AMT on individuals is permanently indexed for inflation. For 2012, the exemption amounts are $78,750 for married taxpayers filing jointly and $50,600 for single filers.
 
Estate and gift tax

The estate and gift tax exclusion amount is retained at $5 million indexed for inflation ($5.12 million in 2012), but the top tax rate increases from 35% to 40% effective January 1st 2013. The estate tax “portability” election, under which, if an election is made, the surviving spouse’s exemption amount is increased by the deceased spouse’s unused exemption amount, was made permanent by the act.
 
Permanent extensions

Various temporary tax provisions enacted as part of EGTRRA were made permanent. These include:

• Marriage penalty relief (i.e., the increased size of the 15% rate bracket (Sec. 1(f)(8)) and increased standard deduction for married taxpayers filing jointly (Sec. 63(c)(2));
• The liberalised child and dependent care credit rules (allowing the credit to be calculated based on up to $3,000 of expenses for one dependent or up to $6,000 for more than one) (Sec. 21);
• Expanded adoption credit (Sec. 23) and adoption-assistance programme (Sec. 137) amounts;
• The exclusion for National Health Service Corps and Armed Forces Health Professions scholarships (Sec. 117(c)(2));
• The exclusion for employer-provided educational assistance (Sec. 127);
• The enhanced rules for student loan deductions introduced by EGTRRA (Sec. 221);
• The higher contribution amount and other EGTRRA changes to Coverdell education savings accounts (Sec. 530);
• The employer-provided child care credit (Sec. 45F);
• Special treatment of tax-exempt bonds for education facilities (Sec 142(a)(13));
• Repeal of the collapsible corporation rules (Sec. 341);
• Special rates for accumulated earnings tax and personal holding company tax (Secs. 531 and 541); and
• Modified tax treatment for electing Alaska Native Settlement Trusts (Sec. 646).

Individual credits expired at the end of 2012

The American opportunity tax credit for qualified tuition and other expenses of higher education was extended through 2017. Other credits and items from the American Recovery and Reinvestment Act of 2009, P.L. 111-5, that were extended for the same five-year period include enhanced provisions of the child tax credit under Sec. 24(d) and the earned income tax credit under Sec. 32(b). In addition, the bill permanently extends a rule excluding from taxable income refunds from certain federal and federally assisted programmes (Sec. 6409).

Individual provisions expired at the end of 2011

The act also extended through 2013 a number of temporary individual tax provisions, most of which expired at the end of 2011:

• Deduction for certain expenses of elementary and secondary school teachers (Sec. 62);
• Exclusion from gross income of discharge of qualified principal residence indebtedness (Sec. 108);
• Parity for exclusion from income for employer-provided mass transit and parking benefits (Sec. 132(f));
• Mortgage insurance premiums treated as qualified residence interest (Sec. 163(h));
• Deduction of state and local general sales taxes (Sec. 164(b));
• Special rule for contributions of capital gain real property made for conservation purposes (Sec. 170(b));
• Above-the-line deduction for qualified tuition and related expenses (Sec. 222); and
• Tax-free distributions from individual retirement plans for charitable purposes (Sec. 408(d)).

Energy tax extenders

The act also extends through 2013, and in some cases modifies, a number of energy credits and provisions that expired at the end of 2011:

• Credit for energy-efficient existing homes (Sec. 25C);
• Credit for alternative fuel vehicle refuelling property (Sec. 30C);
• Credit for two- or three-wheeled plug-in electric vehicles (Sec. 30D);
• Cellulosic biofuel producer credit (Sec. 40(b), as modified);
• Incentives for biodiesel and renewable diesel (Sec. 40A);
• Production credit for Indian coal facilities placed in service before 2009 (Sec. 45(e)) (extended to an eight-year period);
• Credits with respect to facilities producing energy from certain renewable resources (Sec. 45(d), as modified);
• Credit for energy-efficient new homes (Sec. 45L);
• Credit for energy-efficient appliances (Sec. 45M);
• Special allowance for cellulosic biofuel plant property (Sec. 168(l), as modified);
• Special rule for sales or dispositions to implement Federal Energy Regulatory Commission or state electric restructuring policy for qualified electric utilities (Sec. 451); and
• Alternative fuels excise tax credits (Sec. 6426).

Foreign provisions

The Internal Revenue Service’s authority under Sec. 1445(e)(1) to apply a withholding tax to gains on the disposition of US real property interests by partnerships, trusts or estates that are passed through to partners or beneficiaries that are foreign persons is made permanent, and the amount is increased to 20%.

New taxes

In addition to the various provisions discussed above, some new taxes also took effect January 1st as a result of 2010’s health care reform legislation.

Additional hospital insurance tax on high-income taxpayers. The employee portion of the hospital insurance tax part of payroll taxes, normally 1.45% of covered wages, is increased by 0.9% on wages that exceed a threshold amount. The additional tax is imposed on the combined wages of both the taxpayer and the taxpayer’s spouse, in the case of a joint return. The threshold amount is $250,000 in the case of a joint return or surviving spouse; $125,000 in the case of a married individual filing a separate return; and $200,000 in any other case.

For self-employed taxpayers, the same additional hospital insurance tax applies to the hospital insurance portion of Self-Employment Contributions Act tax on self-employment income in excess of the threshold amount.

Medicare tax on investment income. Starting January 1st, Sec. 1411 imposes a tax on individuals equal to 3.8% of the lesser of the individual’s net investment income for the year or the amount the individual’s modified adjusted gross income (AGI) exceeds a threshold amount. For estates and trusts, the tax equals 3.8% of the lesser of undistributed net investment income or AGI over the dollar amount at which the highest trust and estate tax bracket begins.
 
For married individuals filing a joint return and surviving spouses, the threshold amount is $250,000; for married taxpayers filing separately, it is $125,000; and, for other individuals, it is $200,000.

Net investment income means investment income reduced by deductions properly allocable to that income. Investment income includes income from interest, dividends, annuities, royalties and rents, and net gain from disposition of property, other than such income derived in the ordinary course of a trade or business. However, income from a trade or business that is a passive activity and from a trade or business of trading in financial instruments or commodities is included in investment income.

Medical care itemised deduction threshold. The threshold for the itemised deduction for unreimbursed medical expenses has increased from 7.5% of AGI to 10% of AGI for regular income tax purposes. This is effective for all individuals, except, in the years 2013–2016, if either the taxpayer or the taxpayer’s spouse has turned 65 before the end of the tax year, the increased threshold does not apply and the threshold remains at 7.5% of AGI.

Health flexible spending arrangement. Effective for plan years beginning after December 31st 2012, the maximum amount of salary reduction contributions that an employee may elect to have made to a health flexible spending arrangement for any plan year is $2,500.

—Paul Bonner (pbonner@aicpa.org) is a CGMA Magazine senior editor and Alistair M. Nevius (anevius@aicpa.org) is the CGMA Magazine’s editor-in-chief, tax.