United States: Fiscal Cliff Tax Changes

On New Year's Day 2013, the "American Taxpayer Relief Act of 2012" (the Act) was enacted to avoid the impact of automatic "fiscal cliff" tax increases. The Act, effective January 1, 2013, retains and makes permanent the Bush-era income tax rates for all but high-income taxpayers, makes permanent the current estate tax exemption with a slight increase in the marginal estate tax rate, and makes important business tax changes. The elimination of "sunset" provisions in the income and estate tax should provide a more predictable tax environment and enable long-term planning for individuals, but the business tax changes are for the most part temporary and provide limited windows for planning. Important highlights of the Act are summarized below.

I. Individual Income and Payroll Taxes

The Act keeps income tax rates at their current levels for all but high-income taxpayers beginning in 2013. Those in the highest-income categories see their tax rates rise to 39.6 percent for ordinary income over $450,000 taxable income for married taxpayers filing jointly and over $400,000 taxable income for single taxpayers. In addition to higher rates under the Act, the new taxes under the Patient Protection and Affordable Care Act (Obamacare) go into effect in 2013: a new 3.8 percent tax applies to net investment income of taxpayers with modified adjusted gross incomes over $250,000 (married filing jointly), and a new additional Medicare tax of 0 .9 percent is imposed on taxpayers with wages in excess of $250,000 (married filing jointly). Also of note, the 2 percent payroll tax holiday was not extended for 2013, so the social security taxes revert to 12.4 percent (6.2 percent on the employee and 6.2 percent on the employer).

Before 2010, itemized deductions, and personal and dependency exemptions were phased out or limited for high-income individuals. As part of the Act, high-income individuals will again be subject to a phase-out of the personal exemption and itemized deductions beginning in 2013.

The chart below sets forth the various income levels and tax rates for individuals in 2013.

A. AMT and Individual Tax Credits

Middle class taxpayers will benefit from a permanent fix to the alternative minimum tax (AMT) as the Act permanently adopts new inflation-indexed AMT exemption amounts ($78,750 for married taxpayers filing jointly). In addition, the Act extends for an additional five years (through 2017) the American Opportunity tax credit for education expenses, the child tax credit and the earned income tax credit.

B. Dividends

The Act extends capital gains rate treatment for qualified dividends. Without this extension, dividends paid after December 31, 2012 would have been subject to tax at rates of up to 43.4 percent in 2013. Under the Act, qualified dividends will be continue to be taxable at 15 percent for most taxpayers, but the rate will increase to 20 percent for taxpayers with income above $400,000 (for single filers) or $450,000 (for joint filers). Generally, qualified dividends include dividends received from a domestic corporation or a qualified foreign corporation on stock held by the taxpayer for more than 60 days during a specified 121-day period. Note that dividends may also be subject to the 3.8 percent Obamacare tax, depending on the individuals income levels

C. Obamacare Tax on Investment Income

Beginning in 2013, a taxpayer is required to pay a 3.8 percent Obamacare tax on the taxpayer's net investment income over a threshold. (Note: This is an income tax because the proceeds are not earmarked for Medicare, but many people refer to it as a Medicare tax). Net investment income includes interest, dividends, annuities, royalties, rents, capital gains, and passive activity income, less deduction allocable to such income. Income from trading in financial instruments or commodities, minus allowable deductions, is treated as net investment income for this purpose. Special rules exist for the gain from the sale of an interest in a partnership or an S corporation. Such gain constitutes net investment income to the extent of the net gain that is attributed to the entity's non business property. Conversely, net gain or loss attributable to property held by the entity that is attributable to an active trade or business, in which the taxpayer actively participated, is not taken into account in computing net investment income. The tax applies to individuals with modified adjusted gross income of $250,000 (for a couple filing a joint return), $125,000 (for married individuals filing separate returns), and $200,000 (for all other individual taxpayers). For most individuals, modified adjusted gross income will be their adjusted gross income. The 3.8 percent tax is paid on the lesser of the taxpayer's net investment income, or the amount by which his or her modified adjusted gross income exceeds the threshold. Taxpayers who have net investment income but whose modified adjusted gross income is below the thresholds will not be subject to this tax. In addition, taxpayers with income higher than the threshold but with no investment income (either because they had no gross income of the types subject to the tax or the allocable deductions exceed the gross income) will not be subject to the 3.8 percent tax.

Example A married couple's modified adjusted gross income is $400,000 for the year 2013, and they have a total of $100,000 of net investment income. In this case, the modified adjusted gross income over the threshold is $150,000 ($400,000-$250,000). Because the investment income is less, the Obamacare tax is imposed on the net investment income; therefore, the Obamacare tax liability will be 3.8 percent x $100,000 = $3,800. If, however, the couple has $200,000 of net investment income, the Obamacare tax will be imposed on the excess of the couple's modified adjusted gross income over the applicable threshold; therefore, the Obamacare tax liability will be 3.8 percent x ($400,000 - $250,000) = $5,700.

D. Additional Medicare Tax

Also beginning in 2013, an additional Medicare payroll tax of 0.9 percent will be imposed on wages and self-employment income in excess of $250,000 for a couple filing a joint return, $125,000 for married individuals filing separate returns, and $200,000 for all other taxpayers. The tax is added to the existing 1.45 percent Medicare tax on wages and the 2.9 percent self-employment income above these thresholds. Thus, the payroll tax imposed on wage earners who earn more than the above thresholds will increase from 1.45 percent to 2.35 percent and the rate for self-employed individuals for payments over the threshold will increase from 2.9 percent to 3.8 percent . In the case of employees, the tax is collected through withholding. In the case of a joint return, the additional tax is on the combined wages of the employee and the employee's spouse. Married employees will need to determine their withholding tax related to their combined wages with spouses, and in some cases may find that there has been insufficient withholding on their wages.

The following charts illustrate the combined effect of all the new federal individual income tax rates described above:

E. Estate and Gift Tax

The Act permanently extends many of the gift, estate and generation-skipping transfer (GST) taxes, credits and exemptions that existed in 2012 that were set to expire. The Act provides for an inflation-adjusted $5 million applicable exclusion amount for transfers made by estates of decedents dying after December 31, 2012 and for gifts made after such date. The applicable exclusion amount for estate, gift tax and GST exemption purposes in 2013, after application of the inflation adjustment, is now $5,250,000. The Act also made permanent the "portability" elements of the applicable exemption amount, which allows the surviving spouse to use the unused federal estate tax exemption of the first spouse to die, but only if the estate of the first spouse to die files a federal estate tax return. Absent the passage of the Act, the applicable exemption amount was to have been reduced to $1 million without any "portability" provisions.

In addition, the Act increases the highest gift, estate and GST tax rate to 40 percent, which is an increase from the 35 percent rate effective in 2012, but far less than the 55 percent rate that would have been in place had the "Bush tax cuts" been allowed to expire. The Act also retains the deduction for state death taxes thereby avoiding what would have been an increase in aggregate state and federal death taxes in many states.

F. 'Charitable Rollover' from IRA

The Act reinstates the ability of an individual to make a tax-free distribution from an individual retirement account (IRA) directly to a qualified charity, which technically expired on December 31, 2011. Because the "charitable rollover" from an IRA was not available in 2012, the Act includes a special rule permitting a payment made directly to a charity in January 2013 to be treated as a tax-free 2012 distribution from the IRA. Additionally, the same limited window of one month applies to reallocate a December 2012 distribution as though it was originally paid directly to a charity in 2012. To accomplish this reallocation, the taxpayer must make a payment in cash to a qualified charitable organization before February 1, 2013 in an amount less than or equal to the amount of the distribution withdrawn in December.

II. Business Tax Extenders

The Act extends through 2013 many popular but expired temporary business tax provisions that are known as "extenders." The Act extends a number of favorable business tax provisions through 2013, which had expired at the end of 2011. The extenders that expired at the end of 2011 are retroactively extended to the beginning of 2012.

A. Section 179 Expensing Limitation

Several provisions allow taxpayers to deduct the cost of certain depreciable property for the year in which the property is placed in service. Section 179 was the first such provision and it generally allows businesses to immediately deduct the cost of depreciable property. Accelerated recovery under Section 179 is available for depreciable property under Section 168; and computer software that is depreciable under Section 167 rather than Section 197, but only if the property is described in Section 1254(a)(3) (i.e., off –the- shelf computer software); as long as the property is acquired by "purchase" for use in the "active conduct" of a trade or business.

To ensure that the provision targets small businesses, the Section 179 allowance is limited to a dollar amount. For example, absent the changes included in the Act, for tax years beginning in 2012, the threshold would have been limited to $125,000, with a $500,000 investment limit and for years subsequent to 2012, the amounts would have reverted to $25,000 with a $200,000 investment limitation.

The Act extends through 2013 small business expensing under section 179 to the levels in effect in 2010 and 2011. For 2012 and 2013, the limitation is raised to $500,000 and would be reduced if the cost of section 179 property placed in service exceeds $2 million. Within those thresholds, the Act allows a taxpayer to expense up to $250,000 of the cost of qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. The Act also extends the provision for off-the-shelf software.

B. Bonus Depreciation

Bonus depreciation is generally 50 percent of the adjusted basis of qualified property, but for some qualified property acquired during specified periods, 100 percent bonus depreciation was made available as additional stimulus. Although 100 percent bonus depreciation is generally no longer available, the Act extends 50 percent bonus depreciation for certain qualifying property (e.g., certain computer software, water utility property, and qualified leasehold property).

The Act extends the 50 percent bonus depreciation for qualified property under Section 168(k) and bonus depreciation placed in service in 2013. For certain transportation property with a longer production period, 50 percent bonus depreciation is available through 2014.

Property eligible for bonus depreciation is generally limited to certain qualifying property depreciable under MACRS (Modified Accelerated Cost Recovery System) and the property must have a recovery period of 20 years or less. The provision applies to new property that is placed in service before January 1, 2014 (before January 1, 2015 for certain longer-lived and transportation assets).

The Act also modifies bonus depreciation, separating bonus depreciation from allocation of contract costs under the percentage of completion accounting method rules for assets with a depreciable life of seven years or less that are placed in service in 2013. With respect to regulated utilities, the Act clarifies that it is a violation of the normalization rules to assume a bonus depreciation benefit for ratemaking purposes when a utility has elected not to take a bonus depreciation.

Further, a temporary election under Section 168(k)(4)(D) extends the ability of businesses to accelerate the AMT credit in lieu of bonus depreciation from 2013 to 2014. This election allows corporations to claim a portion of AMT credits instead of claiming bonus depreciation.

C. 15-Year Recovery Period for Qualified Leasehold Improvements, Qualified Restaurant Buildings, and Qualified Retail Improvements

Certain property, such as qualified leasehold improvements, qualified restaurant buildings and qualified retail improvements, qualify as 15-year property, which allows for the accelerated recovery of costs. The American Jobs Creation Act of 2004 added qualified leasehold improvement property and qualified restaurant property as 15-year property under Section 168. A third type of property, qualified retail improvement property, was added by the Tax Extenders and Alternative Minimum Tax Relief Act of 2008. The accelerated recovery period of 15 years for these types of property was introduced as a stimulus measure.

These three provisions were set to expire but the Act retroactively extends the 15-year straight-line cost recovery for these properties that are placed in service before January 1, 2014.

D. Research Credit

The Act extends the research credit under Section 41 of the Code with respect to qualified research expenses, basic research expenses, and payments to an energy consortium for energy research paid or incurred on or before December 31, 2013.

In addition, the Act clarifies the amount of qualified research expenditures and gross receipts to be taken into account in computing the research credit includes those that are attributable to the acquisition or disposition of a major portion of a trade or business or a separate unit of a trade or business during a measurement period for purposes of computing the credit for a tax year ending after the acquisition or disposition. The Act also clarifies the method of allocating qualified expenditures among members of a controlled group, and among commonly controlled taxpayers.

Exclusion of Gain on Certain Small Business Stock

Section 1202 of the Internal Revenue Code generally provides an exclusion from tax for gain recognized by (i) a non-corporate taxpayer, (ii) with respect to qualified small business stock (QSBS), (iii) that the taxpayer holds for more than five years. For QSBS acquired after September 27, 2010 and before January 1, 2012 that exclusion was 100 percent - no tax on the gain up to $10 million or 10 times the taxpayer's original cost (whichever is greater). The dates for acquisition have been extended to include stock that was acquired before January 1, 2014. Thus, under this provision, 100 percent of gain from the sale of QSBS acquired in 2012 and 2013 can be excluded for qualifying taxpayers. The rules are fraught with exceptions and limitations, and more can be read about them online at http://www.pepperlaw.com/publications_update.aspx?ArticleKey=2519.

Reduction in Recognition Period for S Corporation Built-In Gains Tax

S corporations which were formerly C corporations or which acquired assets of a C corporation are subject to a built-in gains tax (i) with respect to assets either (A) held at the time the corporation converted from a C corporation to an S corporation or (B) acquired from a C corporation in a tax-free transaction (collectively, "Acquisition Events"), (ii) to the extent of the gain existing on the date of the Acquisition Event, and (iii) if such assets are sold within a specified period of time (the "recognition period") of the Acquisition Events.

Generally, the recognition period for the built-in gain tax is 10 years; however, for assets sold in taxable years beginning in 2009 or 2010, the recognition period was reduced to 7 taxable years, and for taxable years beginning in 2011, the recognition period was further shortened to 5 calendar years. The Act extends the five-year recognition period for assets sold by an S corporation in taxable years beginning in 2012 or 2013. Thus, if an S corporation sold its assets in 2012 and believed it would be subject to the built in gains tax, it may have a pleasant surprise in store.

Wind Facility Credit Extended and Modified

The Code generally allows a renewable energy production credit (the PTC) based on the amount of electricity sold to an unrelated taxpayer that is produced at a qualified renewable energy facility (including a wind facility) over a 10-year period beginning on the date the facility is placed in service. Over the 10 years, the owners of the qualified facilities are able to offset their federal taxes due with the credits generated from the sale of this electricity. To qualify for the PTC, the Code required the facility to be placed in service before a January 1, 2013.

Most wind energy facilities have a lead time of a couple of years and the impending cut-off date dramatically reduced the amount of wind facility transactions last year. The Act not only changes the placed-inservice date to January 1, 2014, it importantly adds that a qualified wind facility, as well as certain other renewable energy, needs to have begun construction before January 1, 2014 to receive the credits. The IRS will have to issue guidance addressing what is considered beginning construction for purposes of satisfying this provision. The IRS will presumably borrow language from the 1603 Treasury grants that also had provided a beginning construction provision. Unlike the 1603 Treasury grants, there appears to be no end date for completing the construction for this new rule. This may provide new life into a number of wind deals that were delayed pending the outcome of legislation.

International Tax Extenders

Subpart F

The Act extends two crucial provisions of Subpart F, albeit for a short window:

The active finance exception from Subpart F income under Section 954(h) of the Code now applies for taxable years of a controlled foreign corporation that begin before January 1, 2014. In general terms that grandfathered the 2012 tax year and will cover 2013 as well. While this change is not the permanent fix many were hoping for, at least the 2012 year can be resolved without a significant income inclusion.

The "look through rule" under Section 954(c)(6) of the Code that permits a controlled foreign corporation to look through interest, dividend and royalties to decide if the income should be classified as foreign personal holding company income is similarly extended for tax years of the foreign corporation that begin before January 1, 2014.

FIRPTA Withholding by Partnerships with Foreign Partners

In certain circumstances, a US partnership that is disposing of an interest in U.S. real property is obligated to withhold taxes on proceeds applicable to foreign partners. Consistent with the general increase of the capital gains rate to 20 percent, the Act increases the rate of FIRPTA withholding under Section 1441(e)(1) of the Code with respect to a foreign partner's share of gain on the disposition of a US real property interest from 15 percent to 20 percent. Note that this does not alter the general rule that imposes a 10 percent withholding on gross proceeds on the sale of US real property interests by non-US persons.

RIC Withholding

The Act extends for 2012 and 2013 the exemption under Section 871(k) of the Code for U.S. withholding on dividends paid by a regulated investment company (RIC) that are related to interest received or short term capital gains.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.