Examining the American Taxpayer Relief Act of 2012
By Eric T. Johnson, J.D., LL.M.
The tax law has changed once again, but this time with greater permanency than the extensions the Congress cobbled together over the past six or seven years. Whatever the substantive merits or demerits of the legislation, the American Taxpayer Relief Act of 2012 has at least created an environment that is stable tax wise. Now to change the tax law the Congress would have to pass something affirmatively, and the financial services professionals have witnessed for themselves the difficulty that is in the current political climate.
So planning — at least planning without the hedges and contingencies or short-term horizon — is once again possible and there are a number of issues that must be considered on behalf of clients. For most taxpayers, the rules that sprung out of the tax laws passed at the beginning of the 21st century have been made permanent. But for other taxpayers — loosely described as wealthy — there are changes, which they and their advisors must take into account.
While the tax rate structure familiar to accountants over the past ten years has been retained, new after a 12-year absence is a highest 39.6-percent tax rate applicable to wealthy taxpayers as so defined. Wealthy taxpayers are those with taxable income in excess of $400,000 for single taxpayers, $425,000 for heads of household, $450,000 for married taxpayers filing jointly, and $225,000 for married taxpayers filing separately. Such taxpayers also have a 20-percent maximum tax rate on long-term capital gains and qualifying dividends that would otherwise be taxed in the 39.6-percent bracket. A marriage penalty arises because the place where this bracket begins for a married filing jointly is only 12.5 percent higher than where the bracket for an unmarried individual begins. That marriage penalty will also be felt in the case of personal exemptions and itemized deductions. The cutbacks in such items are back in force, but only apply to taxpayers whose AGI exceeds $250,000 ($275,000 for heads of household; $300,000 for married filing jointly; and $150,000 for married filing separately).
Trusts and estates in many cases face higher taxes because their 39.6-percent rate begins at a considerably lower level of taxable income ($11,950 in 2013). Estates and trusts face a major hurdle: capital gains are ordinarily not included in distributable net income and therefore cannot be distributed out to the beneficiaries. Given the disparity as to where the NII tax kicks in for individuals (beneficiaries) and fiduciaries, the strategy of spreading investment income among multiple taxpayers — many or all of whom have a significant threshold — and away from the highly vulnerable estate or trust that has a low threshold, is thwarted in most cases. New trust instruments (and wills) must be written differently than in the past in order for the trust to avoid higher than necessary taxes on both its ordinary income and its capital gains. Planners must also inquire into various techniques that might enable a reformation of current trusts that will produce lower aggregate taxes of the entity and its beneficiaries.
In addition, and new for 2013, are two taxes, the first on excess earned income and the second on net investment income. Earned income is defined as excess if it exceeds $200,000 (unmarried taxpayer) or $250,000 for all other taxpayers ($125,000 filing separately). This tax does not depend on AGI or taxable income so the tactics taken to plan for it will differ from those of the income tax and the tax on net investment income. This latter tax imposes an additional tax on as much of the net investment income as does not exceed the taxpayer’s AGI: if taxpayer has $40,000 of net investment income but only $10,000 of excess AGI, the tax is imposed on $10,000, while if taxpayer has $30,000 of net investment income and $50,000 of excess AGI, the tax is imposed on $30,000. Planners will be focused on controlling a taxpayer’s AGI and the timing and character of income. The threshold AGI above which a taxpayer has excess AGI is the same as the limits of earned income discussed above. Because business owners are now likely to face increased capital gains tax and net investment income tax, qualified small business stock is making the C corporation more attractive and asset sales more attractive than entity sales, although there is some relief for sales of pass-through entities.
The estate and gift tax reforms enacted in 2010 nominally just for 2011 and 2012 were made permanent but at the cost of raising the highest transfer tax rate to 40 percent. The now permanent (and indexed) high exclusion amount (and applicable credit amount) has a significant impact on estate planning going forward. Planning for the use of the applicable credit amount has been at the heart of testamentary estate planning. If a married couple does not take steps to utilize the first spouse’s applicable credit amount, it will be wasted. As a result, estate planners would tend to advise all of their clients with estates in excess of $5,250,000 to plan to use the applicable credit amount. However, this has become more complicated due to the permanence of portability election, which can double this basic exclusion amount. Far more important than perhaps the marital deduction is securing the basis step up at death. With many clients not likely to need to avoid the federal estate tax even with full inclusion, flexibility must be a design feature that will enable inclusion in the estate to further the income tax purpose for appreciated assets while retaining the ability to keep assets out of the estate should they depreciate in value.
The above topics and many more are analyzed in detail in Surgent McCoy’s Best Income Tax, Estate Tax, and Financial Planning Ideas of 2013.
Eric T. Johnson is a graduate of Princeton University (A.B.), Villanova Law School (J.D.), and New York University (L.L.M (Taxation)). He has practiced law in the tax and estate planning areas in Philadelphia and its suburbs. Eric has taught courses at Villanova School of Law Graduate Tax Program and for the Pennsylvania Bar Institute, and has been on the faculty of the American College in Bryn Mawr, Pennsylvania. He has developed over 80 courses at Surgent McCoy as its head writer.