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.
In today’s competitive professional world it is no longer enough to be just a great technical accountant. To connect with clients we need to have a much broader understanding of the world and the environment the client operates in. To achieve this I’ve whittled it down to five key areas.
