Yesterday, President Obama signed into law H.R. 8, the American Taxpayer Relief Act of 2012 (the “Act”), to avert the so-called fiscal cliff. The Act extends or makes permanent a number of expiring tax provisions and rates, while increasing taxes for upper-income taxpayers. This update will cover the following topics:
- New Top Individual Marginal Ordinary Income Tax Rate
- Qualified Dividend Income and Capital Gain Rates
- Increased Medicare Contribution Tax Unchanged
- Net Investment Income Surtax Unchanged
- Social Security Tax Cut Allowed to Expire
- Permanent Alternative Minimum Tax “Fix”
- Personal Exemption and Itemized Deduction Phase-Outs
- Transfer Tax Provisions
- Transfers in Applicable Retirement Plans to Roth Accounts
- Permanent Extensions of Expiring Provisions
- Temporary Business Tax Extenders
- Temporary Individual Tax Extenders
- Energy Tax Provisions
1. New Top Individual Marginal Ordinary Income Tax Rate
The Act makes permanent the existing 10%, 15%, 25%, 28%, 33%, and 35% marginal tax rates on ordinary income. But, for tax years beginning after 2012, it reintroduces the 39.6% marginal income tax rate for income over $400,000 ($450,000 for married couples filing jointly, $225,000 for married taxpayers filing separately, and $425,000 for heads of households). These thresholds for the new top rate are indexed to inflation.
2. Qualified Dividend Income and Capital Gain Rates
For tax years beginning after 2012, the Act increases the top rate for net capital gains to 20% for individuals in the 39.6% ordinary income tax bracket. At the same time, however, it makes the existing 0% and 15% rates on net capital gains permanent. Moreover, it makes permanent the treatment of qualified dividend income as net capital gain, meaning dividend income will continue to be normally taxed the same as capital gains for individuals.
3. Increased Medicare Contribution Tax Unchanged
The Act does not affect the increased Medicare contribution tax (Internal Revenue Code of 1986, as amended (the “Code”) §§ 3101(b) & 1401(b)) imposed by the Health Care and Education Reconciliation Act of 2010 and the Patient Protection and Affordable Care Act. Under that prior legislation, individuals with wages (or self-employment income) above $200,000 ($250,000 for married couples filing jointly, $125,000 for married taxpayers filing separately) will be subject to an additional 0.9% tax on wages (or self-employment income) in excess of that threshold beginning in 2013. The increase will apply to only the “employee” portion of the tax and not to the “employer” portion. The employer is still required to withhold the employees’ share of the Medicare contribution tax, including this increase.
4. Net Investment Income Surtax Unchanged
Likewise, the Act does not affect the surtax on net investment income (Code § 1411) imposed by the Health Care and Education Reconciliation Act of 2010. That prior legislation generally imposes a 3.8% surtax beginning in 2013 on net investment income where the taxpayer has modified adjusted gross income over $200,000 ($250,000 for married couples filing jointly, $125,000 for married taxpayers filing separately). Thus, beginning in 2013, taxpayers above this threshold will have net capital gains (including dividends) taxed at 18.8%, and taxpayers that fall into the higher 39.6% ordinary income tax bracket will have net capital gains taxed at 23.8%.
5. Social Security Tax Cut Allowed to Expire
Also not extended by the Act is the temporary 2 percentage point reduction in the employee share of the old-age, survivor, and disability insurance (“OASDI”) tax, or social security tax, that applied in 2011 and 2012. Accordingly, beginning in 2013, the employee share of social security tax will return to 6.2% on the applicable wage base for the year.
6. Permanent Alternative Minimum Tax “Fix”
The Act provides a permanent “fix” to the alternative minimum tax (“AMT”) by retroactively establishing a new baseline exemption and indexing it to inflation. For tax years beginning after 2011, the Act increases the baseline exemption from $33,750 to $50,600 for individuals and heads of households (from $45,000 to $78,750 for married couples filing jointly, from $22,500 to $39,375 for married taxpayers filing separately). Unlike prior fixes, this new baseline is permanent, and it is indexed to inflation for years after 2012. Similarly, the dollar amounts for the rate brackets and the phase-out of the exemption are indexed to inflation for years after 2012. The Act also makes permanent the ability of taxpayers to offset their regular tax liability and AMT liability with nonrefundable personal tax credits
7. Personal Exemption and Itemized Deduction Phase-Outs
Also for tax years beginning after 2012, the Act reinstates phase-outs on personal exemptions and itemized deductions. The personal exemption and itemized deductions are phased out for individuals with adjusted gross income (“AGI”) over $250,000 ($300,000 for married couples filing jointly, $150,000 for married taxpayers filing separately, and $275,000 for heads of households), indexed to inflation. For every $2,500 ($1,250 for married taxpayer filing separately) the individual’s AGI exceeds the applicable threshold, the personal exemption is reduced by 2 percentage points. Likewise, itemized deductions for an individual will be reduced by 3% of his AGI that exceeds the applicable threshold, up to 80% of the individual’s total itemized deductions.
8. Transfer Tax Provisions
The top estate tax rate is increased under the Act to 40% for estates of decedents dying, generation-skipping transfers, and gifts made after 2012. But, the $5 million exemption (as indexed for inflation) and the ability of a surviving spouse to use the unused exemption of the decedent spouse (so-called “portability”) were made permanent. In addition, the Act permanently reunifies the gift and estate taxes under a single rate schedule and exemption for future gifts.
9. Transfers in Applicable Retirement Plans to Roth Accounts
The Act allows qualified retirement plans under section 401(k), 403(b), or 457(b) that include Roth accounts to permit participants to transfer amounts from a non-Roth account to a Roth account even if those amounts are not otherwise distributable to the participants. The participants would be subject to ordinary income tax on such transferred amounts.
10. Permanent Extensions of Expiring Provisions
A number of expiring provisions are permanently extended by the Act for tax years beginning after 2012:
- 2001 modifications to the Child Tax Credit (Code § 24);
- marriage penalty relief for the standard deduction, the application of the 15% marginal tax bracket, and the Earned Income Tax Credit (Code § 32);
- 2001 expansion of Coverdell Education Savings Accounts (Code § 530);
- exclusion of expanded employer-provided Educational Assistance (Code § 127);
- expanded student loan interest deduction (Code § 221);
- qualification of amounts received under the National Health Service Corps Scholarship Program and the Armed Forces Health Professions Scholarship and Financial Assistance program for Qualified Scholarship exclusion (Code § 117);
- 2001 expansion of the Adoption Tax Credit (Code § 23, and formerly Code § 36C) and Adoption Assistance Programs (Code § 137);
- expanded Dependent Care Credit (Code § 21);
- Employer-Provided Child Care Credit (Code § 45F);
- special provisions for Electing Alaska Native Settlement Trusts (Code § 646);
- additional increase in the Arbitrage Rebate exception for bonds financing public school capital expenditures (Code § 148(f)(4)(D)(vii)); and
- treatment of Qualified Public Educational Facilities as qualifying use of proceeds for Exempt Facilities Bonds (Code § 142).
11. Temporary Business Tax Extenders
The Act also retroactively extends through 2013 a number of business-related tax relief provisions that expired in 2011 or 2012. The extended provisions include provisions related to business investments, tax credits and bonds, cost recovery, and other items.
1. Extended provisions relating to business investment include the following:
- special exception to Excess Payments to Controlling Exempt Organizations (Code § 512(b)(13)(E));
- exemption for Interest-Related Dividends (Code § 871(k)(1)) and Short-Term Capital Gain Dividends (Code § 871(k)(2)) from regulated investment companies (“RICs”);
- treatment of RICs as Qualified Investment Entities for the purposes of provision Foreign Investment in Real Property Tax Act (“FIRPTA”) (Code § 897(h)(4)(A)), provided that the related withholding provisions do not apply retroactively;
- Subpart F exception for Exempt Insurance Income (Code §§ 953(e)(10), 954(i));
- Subpart F exception for income from Active Banking, Financing, or Similar Business (Code § 954(h));
- look-thru treatment of payments between related Controlled Foreign Corporations (“CFCs”) (Code § 954(c)(6));
- exclusion of 100% of gain on certain Small Business Stock (Code § 1202(a));
- limitation of S corporation shareholder basis adjustment for charitable contributions of corporation (Code § 1367(a)(2)); and
- reduction of S corporation built-in gains recognition period (Code § 1374(d)(7)).
2. Extended provisions relating to tax credits and bonds include the following:
- Research Tax Credit (Code § 41), which is also amended to provide revised rules for commonly controlled entities and special rules where a trade or business is acquired;
- Temporary Minimum Low-Income Tax Credit for non-federally subsidized housing (Code § 42(b)(2));
- Indian Employment Tax Credit (Code § 45A);
- New Markets Tax Credit (Code § 45D);
- Railroad Track Maintenance Credit (Code § 45G);
- Mine Rescue Team Training Credit (Code § 45N);
- Employer Tax Credit for Active Duty Employees (Code § 45P);
- Work Opportunity Tax Credit (Code § 51);
- Qualified Zone Academy Bonds (Code § 54E); and
- Housing Allowance Exclusion for determining area median gross income for Qualified Residential Rental Project Exempt Facility Bonds.
3. Extended provisions relating to cost recovery include the following:
- 50% Bonus Depreciation (Code § 168(i)(15)), with amendments allowing taxpayers to elect to accelerate AMT credits in lieu of bonus depreciation, allowing property placed in service in 2013 to be Qualified Property whose allocation of costs under the percentage of completion method is separate from depreciation, and clarification of certain “normalization” rules for public utilities;
- 15-year straight-line cost recovery for certain qualified improvements (Code § 168(e)(3)(E)(iv), (v) & (ix));
- 7-year recovery period for Motorsports Entertainment Complexes (Code § 168(i)(15));
- accelerated depreciation for business property on an Indian reservation (Code § 168(j));
- increased expensing limitation for Section 179 Property (Code § 179);
- treatment of Qualified Real Property as Section 179 Property (Code § 179(f));
- election to expense Advanced Mine Safety Equipment (Code § 179E); and
- special expensing rules for Qualified Film and Television Productions (Code § 181).
4. Other miscellaneous extended provisions include the following:
- Domestic Production Activities in Puerto Rico deduction (Code § 45G);
- enhanced charitable deductions for contributions of food inventory (Code § 170(e)(3)(c));
- period for qualifying for Empowerment Zones Tax Incentives (Code § 1391) retroactively extended through 2013, and extension of gain on stock of Empowerment Zone Businesses (Code § 1202(a)(2));
- tax-exempt financing for New York Liberty Zone (Code § 1400L(d));
- increase in limit on Cover Over of Rum Excise Taxes to Puerto Rico and the U.S. Virgin Islands (Code § 7652(f)); and
- American Samoa Economic Development Tax Credit (§ 119 of the Tax Relief and Health Care Act of 2006), as amended to include additional qualifying activities.
12. Temporary Individual Tax Extenders
A number of expiring individual tax incentives are also retroactively extended through 2013:
- exclusion from gross income of discharged Qualified Principal Residence Indebtedness (Code § 108(a)(1)(E));
- increased exclusion from gross income of employer-provided mass transit and parking benefits (Code § 132(f)(2));
- treatment of Qualified Mortgage Insurance premiums as Qualified Residence Interest (Code § 163(h)(3)(E));
- election to deduct state and local general sales taxes (Code § 164(b)(5));
- special rule for contributions of capital gain real property made for conservation purposes (Code § 170(b)(1) & (2));
- deduction for Qualified Tuition and Related Expenses (Code § 222);
- deduction for certain expenses of elementary and secondary school teachers (Code § 62(a)(2)(D)); and
- exclusion from income of distributions from Individual Retirement Plans (IRAs) for charitable purposes (Code § 408(d)(8)).
- The following expiring provisions of the American Recovery and Investment Tax Act of 2009 are extended by the Act for 5 years, through 2018:
- American Opportunity Tax Credit (Code § 25A(i)) for qualified tuition and related expenses;
- 2009 expansion of the refundable Child Tax Credit (Code § 24) dealing with qualifying portion of earnings; and
- 2009 expansion of the Earned Income Tax Credit (Code § 32) dealing with amounts and phase-outs.
13. Energy Tax Provisions
The credit for New Qualified Plug-In Electric Drive Motor Vehicles (Code § 30D), which was formerly limited to vehicles with at least 4 wheels, is extended by the Act to 2- or 3-wheel plug-in electric drive vehicles acquired in 2012 or 2013. For those vehicles to qualify, they must generally follow the existing rules, but may have a battery capacity of only 2.5 kilowatt hours (instead of 4 kilowatt hours) and must be capable of achieving a speed of at least 45 miles per hours.
The Cellulosic Biofuel Producer Credit (Code § 40(a)(4)) is retroactively extended to qualified cellulosic biofuel produced through 2013. Additionally, the term “cellulosic biofuel” is changed to “second generation biofuel,” and its definition is expanded to include cultivated algae, cyanobacteria, or lemna. Similarly, the special cost recovery allowance for cellulosic biofuel is retroactively extended for qualifying property placed in service through 2013 and changed to apply to the more expansive “second generation biofuel.”
The production tax credits for a variety of renewable energy resources are likewise extended and modified. The production tax credit for Qualified Facilities (Code § 45(d)) is retroactively extended for Wind, Closed-Loop Biomass, Open-Loop Biomass, Geothermal, Landfill Gas, Trash, Qualified Hydropower, and Marine and Hydrokinetic Renewable Energy Facilities the construction of which is begins before 2014. In the case of Closed-Loop Biomass Facilities, the credit is also extended to facilities the qualifying modification of which begins before 2014, and in the case of Qualified Hydropower Facilities, the credit is also extended to qualifying efficiency improvements or additions to capacity the construction of which begins before 2014. Moreover, the election to treat Qualified Investment Credit Facilities as Energy Property (Code § 48(a)(5)(C)) is also extended through 2013 for the foregoing Qualified Facilities. But, the Act revises the definition of “municipal solid waste” for these purposes to exclude paper that is commonly recycled and that has been segregated from other solid waste (Code § 45(c)(6)).
A number of other expiring tax provisions related to energy are retroactively extended by the Act through 2013 as well:
- Nonbusiness Energy Credit (Code § 25C);
- Alternative Fuel Vehicle Refueling Property Credit (Code § 30C);
- Biodiesel and Renewable Diesel Fuel Credit (Code § 40A);
- Biodiesel Mixture Excise Tax Credit and Outlay Payments (Code §§ 6426(c) & 6427);
- Alternative Energy Fuels and Mixtures Excise Tax Credit and Outlay Payments (Code §§ 6426(d), 6426(e) & 6427);
- Indian Coal Production Facilities Credit (Code § 45(e)(10));
- New Energy Efficient Homes Credit (Code § 40A), subject to the requirement that the construction be in accordance with the 2006 International Energy Conservation Code (rather than the 2003 International Energy Conservation Code);
- Energy Efficient Appliance Credit (Code § 45M), subject to certain limitations; and
- special rules for sales or dispositions to implement Federal Energy Regulatory Commission or state electric restructuring policy (Code § 451(i)).