American Taxpayer Relief Act of 2012
The American Taxpayer Relief Act of 2012 (the Relief Act) made many tax law changes, such as changes in the ordinary income tax rate, qualified dividends and long-term capital gains tax rate, Medicare tax rate, and estate and gift tax rate. It is not a tax relief act except to the US treasury which will be taking more of our money. It adversely reinstates phase-outs on total itemized deductions and personal and dependency exemptions. It further changes the status of many tax credits, such as the child tax credit, American opportunity tax credit, child and dependent care credit, and earned income credit, as well as that of IRA charitable contribution, cancellation of on up to $2,000,000 indebtedness for principal residence, but does give us a good Section 179 expensing amount.
In addition to the Tax Act, there are two more related acts: The Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2012.
The Healthcare Act imposes a new “net investment income tax” (NIIT). This article explains some important changes under the new laws. Despite the spike in tax rates, there is still a good chance of tax planning opportunities, which the article highlights.
The most noticeable change under the Relief Act is the rise of the maximum ordinary income tax rate from 35% to 39.6% for a single taxpayer having more than $400,000 of taxable income ($450,000 for a married couple filing jointly, and $425,000 for a head of household), effective 1/1/13.
Additionally, the qualified dividends and long-term capital gains tax rate increases from 15% to 20% for those taxpayers in the 39.6% tax rate bracket, but remains the same as before the Relief Act at 15% for those in the 35%, 33%, 28%, and 25% tax rate brackets, and 0% for those in the 15% and 10% tax rate brackets. As a result, under the Relief Act, there are now seven ordinary income tax brackets (10%, 15%, 25%, 28%, 33%, 35%, and 39.6%) and three qualified dividends and long-term capital gains tax brackets (0%, 15%, and 20%). It is difficult if not impossible to see where the tax relief is here except to the US Treasury. However there is, a tax saving strategy for ordinary income which may also result in tax benefits on the qualified dividends and long-term capital gains tax.
As for nonqualified dividends and short-term capital gains, both are taxed at the same rate as ordinary income. However, long-term capital gains on collectibles are taxed at a flat rate of 28% for those taxpayers who belong to higher-than-15% tax brackets, or 0% otherwise. Further, there is another kind of long-term capital gain. If a taxpayer took straight-line depreciation for business-use real estate property and sold it for a long-term capital gain, the amount of straight-line depreciation will be recaptured as long-term capital gain to be taxed at a flat rate of 25% for these taxpayers who belong to higher-than-15% tax rate brackets, or 0% otherwise. This is known as “Section 1250 un-recaptured long-term capital gains.”
There is a brand-new tax, which was effective on 1/1/13. In order to finance the Patient Act the Healthcare Act imposes a new “net investment income tax” at a rate of 3.8% of the lesser of “net investment income” or the excess of the individual’s adjusted gross income over a threshold amount. The threshold amounts are $250,000 for married taxpayers filing a joint return or $200,000 for single or head of household taxpayers. “Investment income,” includes dividends, long-term and short-term capital gains, taxable interest, rents, royalties, and passive income, and payments from annuities which are unearned income. Net investment income means “investment income” minus short-term and long-term capital losses, investment expense, and investment interest expense. Therefore, if there is no net investment income over $200,000, there is no net investment income tax. Likewise, if a taxpayer’s adjusted gross income does not go above the threshold amount, there is no net investment income tax either. This implies that the net investment income tax is intended for upper middle class and rich taxpayers only. Dividend income will not include dividends from Sub S corporations for this additional tax.
There is also another increase in Medicare tax. Also effective 1/1/13, in addition to the regular 1.45% employee portion of the Medicare tax imposed on wages or self-employment income, the Patient Act imposes an additional 0.9% Medicare tax on wages or self-employment income in excess of $200,000 for single taxpayers ($250,000 for married taxpayers filing a joint return). It should be noted that Medicare tax is based on gross wages or self-employment profit on a Schedule C or one where there is self employment earnings in an unincorporated partnership, not on adjusted gross income. The suggestion here is to consider having a LLC which has elected a Sub S form of taxation for the business or as the partner in a partnership to save money.
The Good News is the Section 179 expensing amount is increased to $500,000, and 50% bonus depreciation is extended to 2013. The 179 depreciation can be taken on up to $2,000,000 in assets and then the 50% bonus depreciation is utilized. But we do not know how much we can depend upon this amount staying in place for 2014, as the government keeps tightening the screws upon us. The federal estate and gift tax rate is reduced from 55% to 40%, and the exclusion amount is increased from $1 million to $5 million in 2013. And normally there is no Louisiana Estate tax. These changes result in tax relief for businesses and individuals.
The income items that result in the least tax liability are qualified dividends and long-term capital gains at 20%, which make them the most preferable income items. The second tier is the Section 1250 un-recaptured long-term capital gain at 25%. The third tier is the long-term capital gain on sales of collectibles at 28%. The worst income items are interest income, disqualified dividends, and ordinary income, such as salaries, at 39.6%. Taxpayers should be aware of the tax consequences of different sources of income. Actually, the Relief Act did not alter the priority. Instead, it elevates only the levels of tax rates.
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The new net investment income tax
The Healthcare Act imposes a new 3.8% net investment income tax on net investment income only on those investors who have net investment income and also have high adjusted gross income exceeding a threshold amount ($250,000 for married taxpayers filing a joint return and $200,000 for single taxpayers and heads of household). It is not imposed on those taxpayers who have no net investment income or on those taxpayers whose adjusted gross income does not exceed the threshold amount.
Actually, there are many strategies to mitigate this additional tax burden. For example, as long as a taxpayer can reduce adjusted gross income to a level below the threshold amount, no matter how high the net investment income is, no net investment income tax will occur. By the same token, as long as there is no net investment income, no matter how high a taxpayer’s adjusted gross income is, there is no net investment income tax either.
There are many examples of investment income that are nontaxable, such as interest income from municipal bonds, capital gain on appreciated properties given to a charity or on death, pension income, Roth IRA withdrawals, and social security. These income items do not give rise to net investment income; and thus no NIIT will incur.
In addition, a taxpayer is in a position to manage the timing of investment income in such a way as to take advantage of the threshold amount. For example, say a single taxpayer has $190,000 adjusted gross income every year before realizing $20,000 capital gain. If this taxpayer realizes the entire $20,000 of capital gain in the same year, $10,000 will be subject to the new net investment income tax. If this taxpayer realizes only $10,000 capital gain a year in two years, the entire $20,000 capital gain will completely escape the tax. That is because a single taxpayer enjoys a $200,000 exempt amount.
Furthermore, a taxpayer can also maximize the benefits of loss on the sale of a stock investment. For example, say a single taxpayer has $200,000 of adjusted gross income every year before capital gain or loss. If this taxpayer realizes $10,000 of capital gain in the current year and $10,000 of capital loss next year, the capital gain triggers the net investment income tax, while the capital loss does not reduce it. If the taxpayer moves the $10,000 capital loss to the current year, the $10,000 capital gain is offset by the $10,000 capital loss completely. The net investment income tax on the $10,000 capital gain in the current year is completely wiped out.
Besides, a taxpayer can also control transactions that create no taxable investment income, such as installment sales, like-kind exchanges of two properties, investments in tax-deferred IRAs or tax-exempt bonds, and a sale of a principal residence. These transactions do not result in taxable income; and hence there is no net investment income tax.
It should be noted that the 3.8% net investment income tax is a flat rate, rather than a progressive rate. It applies to the taxpayer’s taxable income in excess of the threshold amount, regardless of the taxpayer’s tax bracket. As a consequence, it can potentially raise the maximum marginal tax rate for dividends and long-term capital gains to as high as 23.8% (20% + 3.8%) and for the ordinary income tax rate to as much as 43.4% (39.6% + 3.8%). Taxpayers must be aware of the consequences of these increases.
Offsetting capital losses against capital gains
Capital gains entail tax liability, but capital losses can save income tax. The amount of tax savings from a capital loss depends on what capital gain or ordinary income it is offset against. Under the Relief Act, there are seven different ordinary income tax brackets and three long-term capital gains tax rates. By the current tax rules, the short-term capital gains and losses must be offset against each other to arrive at net short-term capital gains or loss. Likewise, long-term capital gains and losses must also be offset against each other to reach net long-term capital gains or losses. Only thereafter can the net short-term capital gains/losses and the net long-term capital gain/loss be offset against each other.
Although the maximum ordinary income tax rate has increased to 39.6%, any capital loss that is offset against it can save income tax up to 39.6% as well. The long-term capital gains tax rate is also increased up to 20%. Hence, any capital loss that is offset against it can also save income tax up to 20%. In other words, higher tax rates are a disadvantage, but they can also provide advantages if there is a loss. It depends on how a taxpayer uses it. The order of gains and losses offsetting rule and the timing of realizing capital losses become quite important.
Switching between individual and business expense
Because the individual tax rate is higher than the C corporation tax rate, deductible individual expenses can save more income tax than business expenses. This may cause business expenses to be turned into individual expenses. For example, say a C corporation needs to rent an office space. Rental expense is tax deductible. Should the office space be rented under a C corporation or an S corporation? Renting as a C corporation saves income tax at a rate of only 35%; whereas, renting as an S corporation can save at a rate as high as 39.6%. In that situation, it is obviously preferable to rent it under an S corporation. This strategy could generate a great deal of tax savings.
Donating appreciated property to charity
In fact, both the high individual income tax rate and the high long-term capital gains tax rate may actually result in greater tax savings by taking advantage of charitable contributions. For example, a taxpayer has a long-term capital asset that has appreciated in value. If this asset is sold, it will result in a long-term capital gain that entails a tax liability at a maximum rate of 20%. If this asset is contributed to a charity, it is deductible at its fair market value, but the long-term capital gain is tax-exempt because the asset is not sold for consideration. This immediately saves long-term capital gains tax at 20%. Better yet, the recipient’s adjusted basis for this asset will start from the fair market value. If the recipient resells this asset, it will not realize any capital gain either because of its tax-exempt status. This strategy provides an escape route for long-term capital gains tax.
By the same principle, a taxpayer may have a short-term capital asset that has appreciated in value. If it is sold, it results in a short-term capital gain that ends up with a capital gains tax rate as high as 39.6%. If it is contributed to a charity, it is deductible at its adjusted basis and no short-term capital gain is realized. The charitable contribution has saved income tax by as much as 39.6% of its adjusted basis. Moreover, it does not create taxable short-term capital gain either, though its fair market value has increased. The tax savings are quite substantial. The recipient’s adjusted basis of the asset will, this time, start from the donor’s adjusted basis. If the recipient immediately sells the asset at its fair market value, the short-term capital gain is tax-exempt because the recipient is a tax-exempt organization. This strategy can also yield a great deal of savings of capital gains tax.
Similarly, in the case of inherited property, a good tax planning strategy can save a lot of capital gains tax too. For example, say a father owned a house all of his life and sells the house before he dies. This may result in a huge amount of long-term capital gain. A capital gain that exceeds the $250,000 statutory exclusion amount results in long-term capital gains tax. If the father does not sell the house and lets his son inherit it when he dies, the father’s entire amount of long-term capital gain would have been forgiven and the son would have inherited the house at a “step-up” basis to the fair market value at that time. If the son immediately sells the house, there is no long-term capital gain. This strategy, which works no matter how high the long-term capital gains tax rate has gone up, takes advantage of tax savings due to death.
Mitigating high tax rate
The newly raised individual income tax rate of 39.6% refers to the marginal tax rate for the portion of taxable income over $400,000 for single taxpayers ($450,000 for married filing jointly). The 39.6% tax rate does not affect the taxable income below this amount. The portion of taxable income below this threshold amount is still taxed at progressive rates of 10%, 15%, 25%, 28%, 33% and 35%. The additional marginal tax rate is actually only 4.6% (39.6% – 35%). However, there is a larger impact on the qualified dividends and long-term capital gains tax rate, which is increased from 15% to 20%. It should be further noted that the 20% tax rate applies to the entire amount of qualified dividends and long-term capital gains. Therefore, this $400,000 (for single taxpayers) threshold amount becomes an important strategic point. It is not in a taxpayer’s best interest to cross this threshold.
For example, if a taxpayer’s taxable income is exactly $400,000, the marginal income tax rate is 35% and the qualified dividends and long-term capital gains tax rate is 15%. If this taxpayer has a chance to earn an additional $1 wage, it would cause the marginal income tax rate to go up from 35% to 39.6%. It would also cause this taxpayer’s qualified dividends and long-term capital gains tax rate to go up from 15% to 20% on the entire amount of qualified dividends and long-term capital gains. The entire amount of qualified dividends and long-term capital gains is taxed at 20% as a result of this increase in $1 income. As a result, it is not worth earning this additional $1 wage when taxable income exceeds the $400,000 threshold for single taxpayers.
It should be noted that at the juncture of the $36,250 ($72,500 for married filing jointly) threshold amount of taxable income there is also a beneficial tax planning strategy. If the amount of qualified dividends or long-term capital gains causes the total taxable income to cross this threshold amount, the portion of the qualified dividends or long-term capital gains below the threshold amount is taxed at zero percent (0%), while the remainder is taxed at 15%. For example, say a single taxpayer has taxable income in the amount of $36,150 before the $300 qualified dividends. How should the $300 qualified dividends be taxed? The first $100 ($36,250 – 36,150) is taxed at 0%, while the remaining $200 ($300 – 100) is taxed at 15%, i.e., $30 ($200 × 15%). Thus, the total qualified dividends tax is $30 ($0 + 30). The additional $200 qualified dividends have crossed the marginal income tax rate boundary from 15% to 25%. As a consequence, it also causes the qualified dividends tax rate to go up from 0% to 15%. This indicates that it is advisable to have only $100 of qualified dividends distribution, not $300. The taxpayer should try to defer the additional $200 qualified dividends distribution to the following year.
A taxpayer should be aware of the threshold points at different qualified dividends and long-term capital gains tax rates so as to minimize the tax liability. In other words, there are always strategies to mitigate the higher tax rate. This strategy has become even more important as the Relief Act has created one more tax rate bracket at 39.6% for ordinary income and 20% for qualified dividends and long-term capital gains.
Phase-out of itemized deductions
In addition to the tax rate spikes, there is a back-door increase in tax burden through the phase-out of total itemized deductions and personal and dependency exemptions. The Relief Act stipulates that, beginning 1/1/13, an individual’s otherwise deductible total itemized deductions are reduced by the lesser of:
(1) 3% of adjusted gross income in excess of the threshold amount of $300,000 for married taxpayers filing a joint return (or $275,000 for a head of household, or $250,000 for a single).
(2) 80% of otherwise deductible total itemized deductions other than medical expenses, investment interest expenses, casualty and theft losses, and wagering losses. In other words, the otherwise allowable itemized deductions include only state income tax, property tax, mortgage interest, charitable deductions, and miscellaneous deductions.
This means that an affluent taxpayer’s total itemized deductions can be greatly reduced when the adjusted gross income goes too far beyond the threshold amount, and the deductions for state income tax, property tax, mortgage interest, charitable deductions and miscellaneous deductions become too large. This implies that a portion of the total itemized deductions may be denied to wealthy taxpayers.
Actually, there are strategies that can mitigate the impact of the phase-out of total itemized deductions. It should be noted that the phase-out is based on adjusted gross income rather than taxable income. There are many adjustments before reaching adjusted gross income, such as capital losses from sales of investment in stock, business losses, rental loss, IRA contributions, contributions to 401(k) retirement plans, health and dental insurance premiums, moving expenses, and alimony payments. These items directly reduce adjusted gross income (for AGI deductions). A taxpayer should attempt to augment these adjustments.
There are many nontaxable income items, such as interest income from municipal bonds, withdrawals from Roth IRAs, social security, life insurance proceeds, donation of appreciated property to charity, and capital gains of a property at the time of death. These income items do not increase adjusted gross income. A taxpayer should take advantage of these tax-free income items.
There are deductions that reduce taxable income, but not adjusted gross income (from AGI deductions), such as itemized deductions and personal and dependency exemptions. If a taxpayer can move these “from AGI” deductions to “for AGI” deductions, it would be more advantageous. For example, a business travel expense as an employer is a reduction of business profit, and thus it is a “for AGI” reduction of adjusted gross income. However, a travel expense as an employee is an itemized deduction, which makes it a “from AGI” reduction of taxable income. That is why it is always better for the employer to pay for the business expenses even if the employee’s wages are reduced.
Should a taxpayer convert his or her home to a business office? The property tax on the home is an itemized deduction, while property tax on the business office is a business expense. The former reduces taxable income only, but not adjusted gross income; whereas, the latter reduces both. Obviously, the latter is more beneficial.
Finally, assume that a taxpayer is eligible to claim tuition either as “tuition and fees” as an adjustment or as “education expense” as a miscellaneous itemized deduction. What is the better strategy? The former is a “for AGI” deduction that reduces the adjusted gross income; whereas, the latter is a “from AGI” deduction that reduces taxable income, but not adjusted gross income. Obviously, the former is more advantageous than the latter, which makes it more beneficial to claim a tuition and fees deduction rather than an education expense.
Phase-out of personal exemptions
Along with the phase-out of itemized deductions there is another back-door reduction in personal and dependency exemptions. The Relief Act further stipulates that, beginning 1/1/13, an individual’s otherwise allowable deduction for personal and dependency exemptions is reduced by 2% for each $2,500 or fraction thereof by which the adjusted gross income exceeds the threshold amount of $300,000 for married taxpayers filing a joint return (or $275,000 for a head of household, or $250,000 for a single taxpayer).
It means that by the level of $375,000 adjusted gross income for a single taxpayer, the amount of personal exemptions is completely phased-out to zero [($375,000 – 250,000) / 2,500 = 50, and 2% × 50 = 100%). For upper middle class and wealthy taxpayers it is possible that both the total itemized deductions and the personal and dependency exemptions may be entirely denied.
There are five major changes, among others, under the Relief Act. It increases the maximum individual income tax rate from 35% to 39.6%, and the dividends and long-term capital gains tax rate from 15% to 20%. Effective 1/1/13, in conjunction with the Relief Act, there is a new NIIT at a rate of 3.8% of net investment income. In addition, the Relief Act reinstates the phase-out provision on total itemized deductions and personal and dependency exemptions. All these changes have a detrimental impact on taxpayers, particularly the middle class and the affluent.
These changes take effect only above certain threshold amounts. The 39.6% income tax rate and the 20% dividends and long-term capital gains tax rate apply only when the taxable income goes above $400,000 for a single taxpayer ($450,000 for married taxpayers filing a joint return). The 3.8% new NIIT is imposed only on the net investment income, but only when the taxpayer has adjusted gross income in excess of $200,000 for a single taxpayer ($250,000 for married taxpayers filing a joint return). Both the total itemized deductions and the personal and dependency exemptions start to phase-out only after the adjusted gross income reaches $250,000 for a single taxpayer ($300,000 for married taxpayers filing a joint return).
Taxpayers should be aware of these triggers. They serve as a pivotal point in tax planning strategies. The income tax rate and the dividends and long-term capital gains tax rate depend on taxable income, while the new NIIT rate and the phase-out of total itemized deductions and personal and dependency exemptions depend on adjusted gross income. Therefore, tax planning strategies should aim at taxable income when a taxpayer is concerned with income tax rate and the dividends and long-term capital gains tax rate. However, if the taxpayer is more concerned with the new NIIT and the phase-out of the total itemized deductions and the personal and dependency exemptions, the strategies should be designed to reduce adjusted gross income.
There are many effective strategies. For example, taxpayers may change a business form from a sole proprietorship, or incorporate as a partner in partnership. Further, it might be preferable to switch from personal itemized deductions to business expenses, because the latter reduces adjusted gross income, but not the former. In addition, when a taxpayer is about to sell a personal-use property for a gain, less income tax may result if the property is converted to business-use. Furthermore, it may be advisable for a taxpayer to donate an appreciated property to a charity because the capital gain on the property is tax-exempt. These strategies represent some of the effective ways that taxpayers can avoid paying higher taxes after the passage of the Relief Act.
There are enough changes here when combined with trying to strategize the alternative income tax also at the same time to make even an accountant want a flat tax.
