Friday, November 30, 2012

What is the Fiscal Cliff? and How will it affect ME?

This paper is not intended to be political in any way but due to political gridlock in Washington DC it may sound political.   This material is solely for tax implications to the public.
The 112th Congress, which convened on 5 January 2011, is now set to enter the record books as the least productive in a generation, passing a mere 173 public laws as of 31 Oct 2012.  That is well below the so-called do-nothing Congress of 1947-1948 that enacted 906 laws.  It’s extraordinary that with a $16 trillion debt and the threat of enormous tax increases and mindless across-the-board spending cuts that Washington hasn’t even passed a budget in three years.
Tax Increases. The bulk of the fiscal cliff, over $200 billion (per year), entails automatic tax increases, including, but not limited to, higher income tax rates for ALL wage earners, increased investment tax rates for long term capital gains and dividends, a return of the marriage penalty and higher estate and gift tax levels. This category also includes an already expired alternative minimum tax (AMT) “patch” (increased exemption), which, if not retroactively applied for 2012, could subject over 60 million taxpayers to the alternative tax for the current tax year (4 million paid the AMT in 2011).  The President’s payroll tax cut for 2011, a 2% reduction on the employee Social Security tax rate, was extended for 2012, and now expires at the end of the year. It alone costs almost $130 billion.
The IRS maintains that it cannot wait much longer to issue 2012 tax year forms without delaying the start of the 2013 filing season. Meanwhile, if the law isn't changed, the Congressional Budget Office estimates that over 60 million Americans will become subject to the AMT tax. 
So what is the Fiscal Cliff? It is a combination of the following three major events:
1.      Bush-era tax cuts expiring, extended by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010,
2.      Federal Sequestering 40% across-the-board spending cuts take effect under the Budget Control Act of 2011;
3.      Obama Heath Care Tax implications
Effective January 1, 2013:
Payroll Tax Holiday
Take home pay will also be immediately reduced if Washington does not extend the employee-side payroll tax holiday, or enact some replacement for it. The employee-share of Social Security Tax is scheduled to return to 6.2 percent instead of 4.2 percent.  
INDIVIDUALS Income Tax Rate Increases
Top Income  Rate
10% to 35%
15% to 39.6%
Capital Gains
Social Security Rate
Estate & Gift Rate
Estate & Gift
$5.12 MM
$1.0 MM

Personal Exemption Phase-out (PEP)
As part of the automatic sunset of Bush-era tax benefits, after 2012 higher-income taxpayers also would once again be subject to the Personal Exemption Phase-out (PEP) on itemized deductions. 
Capital Gains/Dividends
Under current law, taxpayers in the 10 and 15 percent income tax brackets pay zero percent tax on qualified capital gains and dividends.  The zero and 15 percent capital gains and dividend tax rates would increase for some taxpayers to 39.6% this represents almost a 300 percent increase when 39.6 percent rate is combined with the new 3.8 percent Medicare contributions tax on net investment income. Combined with a jump in the capital gains rate from 15 percent to 20 percent (23.8 percent with the NII tax), some economists are predicting a massive market sell-off at year end as taxpayers engage in basis-resetting strategies and reallocation of portfolio assets.
Alternative Minimum Tax
If the alternative minimum tax (AMT) exemption amounts are not patched and made retroactive for 2012, they would be dramatically less than the exemption amounts for 2011. Under current law, the AMT exemption amounts for 2012 are $33,750 for single individuals, $45,000 for married couples filing joint returns and surviving spouses, and $22,500 for married couples filing separate returns. In comparison, the AMT exemption amounts for 2011 were $48,450 for single individuals, $74,450 for married couples filing joint returns and surviving spouses, and $37,225 for married couples filing separate returns.
Child Tax Credit
After 2012, the $1,000 child tax credit is scheduled to revert to $500 per qualifying child and taxpayers who cannot take full advantage of the child tax credit because the credit is more than the taxes they owe will no longer receive this as a refundable credit.
Few provisions in the Tax Code have been as uncertain in their long-term fate as the federal estate tax. In 2001, Congress set in motion a gradual reduction of the federal estate tax rate and repealed it for estates of decedents dying in calendar year 2010.

Under the 2010 Tax Relief Act, federal estate taxes again applied to estates of decedents dying after December 31, 2009, and before January 1, 2013 (although estates of decedents dying in calendar year 2010 could opt out of the federal estate tax and apply a modified carryover basis regime). President Obama has proposed extending the federal estate and gift tax under parameters in effect for calendar year 2009 for estates of decedents dying after December 31, 2012. That level would set the estate tax exclusion at $3.5 million with a 45 percent rate and the gift tax lifetime exclusion of $1 million.
Absent Congressional action, the maximum estate tax rate is scheduled to be 55 percent for estates of decedents dying after 2012 with a $1 million combined estate and gift tax exclusion amount. Opponents of the estate tax continue to maintain that it hurts family-owned businesses to the detriment of the economy.
For 2012, a unified estate and gift tax exclusion stands at $5.120 million, with a 35 percent rate imposed on the excess. The exclusion effectively becomes $10.24 million for married couples. Depending upon a wealthy individual's estate plan and the type of assets held, some practitioners recommend making large gifts before 2013 to take advantage of the $5.12 million/$10.24 million amounts that may be transferred gift-tax free before 2013.
The 2010 Tax Relief Act also provided for portability, which increases the surviving spouse's lifetime exclusion for estate and gift taxes by the portion of the deceased spouse's exclusion that is unused at the deceased spouse's death. Portability is scheduled to sunset after 2012.
Small Business Expensing
Enhanced Code Sec. 179 expensing is scheduled to expire after 2012. Unless extended, the current expensing amount of $139,000 (as indexed for inflation) is scheduled to fall to $25,000 and the current $560,000 investment limit (as indexed for inflation) is scheduled to fall to $125,000.
Bonus Depreciation
Bonus depreciation at its current 50 percent rate is scheduled to expire after 2012 (after 2013 for certain transportation property and longer-lived property). It is unclear if President Obama will support an extension of 50 percent bonus depreciation.
Linked to the Bush-era tax cuts are a package of so-called tax extenders. These are popular but temporary tax incentives.

Individual Extenders
  • Higher education tuition deduction
  • State and local sales tax deduction
  • Teachers' classroom expense deduction
  • Qualified charitable distributions from IRAs
  • Deduction for qualified mortgage insurance premiums
  • Code Sec. 25C residential energy property credit
The Code Sec. 25D residential energy efficient property credit is available for qualified property placed in service before January 1, 2017. Qualified property includes certain geothermal energy property and small wind energy property.
Business Extenders
  • Code Sec. 41 research tax credit
  • Code Sec. 179 small business expensing
  • Work Opportunity Tax Credit (WOTC)
  • 15-year recovery for qualified leasehold improvements, restaurant property and retail improvements
  • New Markets Tax Credit
Under current law, employers can take advantage of an enhanced WOTC for hiring qualified military veterans. The enhanced WOTC for veterans is scheduled to expire after 2012 but is a good candidate for renewal. However, it is unclear at this time if the WOTC for other target groups, which expired after 2011, will be extended.
Itemized Deduction for Medical Expenses
For tax years beginning after December 31, 2012, the Affordable Care Act increases the 7.5 percent threshold for itemizing medical expenses to 10 percent. However, the Affordable Care Act temporarily exempts individuals age 65 and older from the 10 percent threshold.  Taxpayers (or their spouses) who are age 65 or older before the close of the tax year may continue to apply the 7.5 percent threshold for tax years ending before 2017.
American Opportunity Tax Credit (AOTC)
The AOTC, which is an enhanced version of the HOPE education credit, is scheduled to expire after 2012.  If the AOTC expires, it will be replaced by the traditional HOPE education tax credit which is about one-half of AOTC and is not refundable.
Student loan interest deduction
If not extended, the incentive would only be available for the first 60 months after repayment begins and would phase-out for taxpayers with adjusted gross income between $40,000 and $55,000 ($60,000 and $75,000 for married couples filing joint returns).
Return of marriage penalty
The tax consequence of the marriage tax penalty will be reinstated (government effort to discourage marriage).  Instead of standard deduction being twice that of two single people for married couples (as it currently is today) the law would only provide a married couple 167% of the standard deduction instead of the 200% two single people would receive.
President Obama's second term is expected to see the continuing implementation of the Patient Protection and Affordable Care Act (Affordable Care Act). Many tax-related provisions in the Affordable Care Act are scheduled to take effect in 2013 and beyond, including:
  • 3.8 percent Medicare contribution tax (2013)
  • 0.9 percent additional Medicare tax (2013)
  • $2,500 contribution limit on health flexible spending accounts (2013)
  • Increased threshold for itemized medical expenses (2013)
  • New tax on medical devices (2013)
  • State health insurance exchanges (2014)
  • Individual shared responsibility payments (the individual mandate) (2014)
  • Employer shared responsibility payments (2014)
  • Premium assistance tax credit (2014)
  • No annual dollar limits on health insurance coverage (2014)
  • Increase in small employer health insurance tax credit (2014)
  • New tax on "Cadillac" health insurance plans (2018)
The U.S. Supreme Court upheld the Affordable Care Act's individual insurance mandate in NFIB v. Sebelius, 2012-2 ustc ¶50,573. However, opponents argue that the employer's shared responsibility payment was not addressed by the Court in NFIB v. Sebelius. Some taxpayers have also challenged the Affordable Care Act's contraceptive provisions.
Health Flexible Spending Arrangements
After 2012, the Affordable Care Act caps the maximum salary reduction contribution to a health flexible spending arrangement (health FSA) at $2,500. Salary reductions in excess of $2,500 will subject the employee to tax on distributions from the health FSA. The $2,500 limit will be indexed for inflation for tax years beginning after December 31, 2013.  Effective January 1, 2011, the Affordable Care Act prohibited health FSA dollars from being used to reimburse the cost of over-the-counter medicines (except insulin).
Medical Devices
The Affordable Care Act imposes a 2.3 percent excise tax on the sale of qualified medical devices by manufacturers, producers and importers after December 31, 2012.
Below is a detailed chart explaining Major Bush Tax Cuts and other tax items that are expiring or have already expired earlier in year 2012.
Major Bush Tax Cuts Provisions Expiring at the End of 2012

IRS Code
2012 Provision
2013 Provision                                                  Without Congressional Action
§1 (income tax brackets)
Income tax brackets are:                                                                                   10, 15, 25, 28, 33, 35%
Income tax brackets are 15, 28, 31, 36 and 39.6% (with a marriage penalty returning - the 15% bracket for taxpayers filing joint returns as well as qualified surviving spouses being 167% of the 15% bracket rather than 200%)                                                                                           [Note:  Dividends paid to individuals taxed at ordinary income rates]
Inclusion of child's gross income exceeding set amount plus 10% of lesser of (a) inflation-adjusted standard deduction for dependent child, or (b) excess of child's gross income over amount in (a)
10% figure changes to 15%
§1 (h) (capital gains)
0% for those in the 15% bracket and lower; 15% for taxpayers in higher brackets
10% for lower income taxpayers; 20% for taxpayers in higher brackets
§21 (credit for household and dependent care expenses)
$3,000 for 1 qualifying individual, and $6,000 for 2 or more; maximum credit percentage of 35% and AGI-based reduction starting at $15,000
$2,400 for 1 qualifying individual, and $4,800 for 2 or more; maximum credit percentage of 30% and AGI-based reduction starting at $10,000
§24 (child tax credit)
$1,000 per qualifying child and is allowed against the AMT
$500 per qualifying child with no allowance against the AMT
§32 (earned income tax credit)
Earned income and AGI must be less than $19,190 (MFJ) for taxpayers with no qualifying children and $50,270 (MFJ) for taxpayers with 3 or more qualifying children
Beginning of phase-out range lower; phase-out of credit computed with reference to MAGI rather than AGI; earned income includes exempt income; EITC reduced by AMT; credit maxes out with 2 dependents
§36C (adoption credit) goes back to §23
$10,000 maximum credit                                                                          $12,650 ($10,000 statutory amount as adjusted for inflation)
Maximum credit lower; eligible expenses limited; reduced phase-out range; inapplicable against AMT; available only for special-needs child.
§45F (credit for employer provided child care facilities)
§63 (standard deduction)
Married taxpayers get 200% of the standard deduction that applies for single taxpayers
Married taxpayers get 167% of the standard deduction that applies for single taxpayers
§68 (overall limitation on itemized deductions)
Pease limitation not applicable in 2012
Greater limitations apply; for higher-income taxpayers, itemized deductions are reduced by 3% of AGI above a certain amount with reduction not exceeding 80%
§127 (exclusion for employer provided educational assistance)
Unavailable; also gone is the allowance of the exclusion tied to graduate-level education; expenses paid by employer for education or training provided to the employee excluded only if qualified as working condition fringe
151(d) (phase-out of personal exemptions)
Set level
Phase-out for higher income taxpayers
§221 (above-the-line deduction for student loan interest)
Available, but reduced phase-out range and applicable just to interest paid during first 60 months of required interest payments
§530 (Coverdell Education Savings Accounts)
Contribution limit $500; lower phase-out range for MFJ; applicable only for higher education expenses; no special rules for special needs beneficiaries; no rule allowing corporations (and other entities) to make contributions; can't make contributions for current year by April 15 of following year
Major Bush Tax Cuts Provisions Expiring at the End of 2012 (continued)
2012 Provision
2013 Provision                                                  Without Congressional Action
§§531 and 541                              (accumulated earnings tax rate and personal holding company tax rate)
§2001 (estate tax)
35% rate of tax on taxable amounts above $5.12 million
55% rate on taxable amounts above $1 million; reinstatement of §2057 family-owned business deduction; reinstatement of credit against state death tax
§2505 (gift tax)
35% maximum rate; $5.12 million exemption (unified credit exemption equivalent)
55% maximum rate with $1 million exemption (unified credit exemption equivalent)
§2631 (generation-skipping transfer tax)
35% maximum rate
55% maximum rate above an exemption of between $1,360,000 - $1,430,000 (to be determined based on an inflation adjustment)
§3402 (backup withholding on gambling winnings)
25% rate
28% rate

Other Tax Law Provisions Expired at the beginning of 2012 and have yet to be reinstated

Nonbusiness energy property credit
Refundability of adoption credit
Research credit
Credit for construction of new energy efficient homes
Energy efficient appliance credit
Work opportunity tax credit for non-veterans
$250 above-the-line deduction for specified expenses of elementary and secondary school teachers
Ability to treat mortgage insurance premiums as deductible qualified residence interest
Election to deduct state and local general sales taxes in lieu of state and local income tax deduction
15-year depreciation for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement
7-year straight-line depreciation for motorsports entertainment complexes
§168(k)(1) and (5)
100% first-year bonus depreciation (reduced to 50% for 2012)
§170(b)(1)(E); (b)(2)(B)
Tax incentives for contributions of capital gain real property for conservation purposes
Enhanced charitable deduction for contributions of book inventories to government schools
§170 (e)(6)(G)
Corporate contributions of computer equipment for educational purposes
Expense method depreciation ($139,000 for 2012 with investment ceiling of $560,000)
Election to expense production costs of qualified film and television products in the U.S.
Tax-free distributions up to $100,000 annually for taxpayers over age 70-1/2 from an IRA for charitable purposes
Suspension of income limitations on percentage depletion for marginal wells
Exclusion of gain on certain small business stock (only 50% for 2012 and 60% for qualified business entity stock as defined by the statute)
Lower shareholder basis adjustments for charitable contributions by S corporations
Some  Code Provisions Expire at the end of 2012 outside of Bush Tax Cuts
American Opportunity Tax Credit - credit basically cut in half (maximum credit becomes 100% of first $1,000 of qualified tuition and related expenses, and 50% of next $1,000 of qualified tuition and related expenses); other expiring provisions include the enhanced AGI limits, the reduction of the refundable portion, and the elimination of the course materials credit allowance
Work Opportunity Tax Credit inapplicable with respect to qualified veterans hired after 2012
Refundable credit for unused AMT credit
Exclusion for qualified principal residence debt that is discharged
§§168(k)(1) and (k)(4)
50% first-year bonus depreciation; election to accelerate AMT credits in lieu of claiming bonus depreciation
Expense method depreciation - amount will be $25,000 in 2013 and investment ceiling will be $200,000
§§3101 - 3111
Payroll tax cut expires - 4.2% (employee OASDI tax) becomes 6.2%; 10.4% (self-employed OASDI rate under SECA) becomes 12.4%