Details of tentative deal that averts the fiscal crisis

Income tax rates:  Extends decade-old tax cuts on incomes up to $400,000 for individuals, ($450,000  married filing joint). Earnings above those amounts would be taxed at a rate of 39.6% up from the current 35 %.  Extends the Clinton-era caps on itemized deductions and the phase-out of the personal exemption for individuals making more than $250,000 and couples filing joint earning more than $300,000.

The estate and gift tax exclusion amount is retained at $5 million indexed for inflation ($5.12 million in 2012), but the top tax rate increases from 35% to 40%  effective Jan. 1, 2013. The estate tax “portability” election, under which, if an election is made, the surviving spouse’s exemption amount is increased by the deceased spouse’s unused exemption amount, was made permanent by the act.

Capital gains, dividends:  the tax rate on capital gains and dividend income for taxpayers with income exceeding $400,000 ($450,000 for married filing joint) increases from 15 % to 20 %.

Alternative minimum tax: permanently indexes it for inflation to prevent nearly 30 million middle-and upper-middle income taxpayers from being hit with higher tax bills averaging almost $3,000. The tax was originally designed to ensure that the wealthy did not avoid owing taxes by using loopholes.

Extends a tax credit for research and development costs and for renewable energy such as wind-generated electricity.

Unemployment benefits: Extends jobless benefits for the long-term unemployed for one year.

Cuts in Medicare reimbursements to doctors:  Blocks a 27 % cut in Medicare payments to doctors for one year.

Social Security payroll tax cut: Allows a 2 percentage point cut in the FICA tax, first enacted two years ago, to lapse, which restores the FICA tax to 6.2 %.

Across-the-board cuts:  delays for two months $109 billion worth of across-the-board spending cuts that were set to start striking the Pentagon and domestic agencies January 1. Cost of $24 billion is divided between spending cuts and new revenues from rules changes on converting traditional individual retirement accounts into Roth IRAs.  [Fox News, on-line ed.,  January 1, 2013, “Fiscal Cliff  Deal reached between Senate and White House- what’s inside the Senate’s ‘fiscal cliff’ solution?”  Fox News’ Ed Henry, Chad Pergram and Mike Emanuel contributed to this report].

OTHER PROVISIONS

Permanent extensions:

(1) Marriage penalty relief (i.e., the increased size of the 15% rate bracket (Sec. 1(f)(8)) and increased standard deduction for married taxpayers filing jointly (Sec. 63(c)(2))
(2) The child and dependent care credit rules (allowing the credit to be calculated based on up to  $3,000 of expenses for one dependent or up to $6,000 for more than one) (Sec. 21)
(3) The exclusion for National Health Services Corps and Armed Forces Health Professions  Scholarships (Sec. 117(c)(2))
(4) The exclusion for employer-provided educational assistance (Sec. 127)
(5) The enhanced rules for student loan deductions introduced by EGTRRA (Sec. 221)
(6) The higher contribution amount and other EGTRRA changes to Coverdell education savings accounts (Sec. 530)
(7) The employer-provided child care credit (Sec. 45F)
(8) Special treatment of tax-exempt bonds for education facilities (Sec 142(a)(13))
(9) Repeal of the collapsible corporation rules (Sec. 341)
(10) Special rates for accumulated earnings tax and personal holding company tax (Secs. 531 &  541)
(11) Modified tax treatment for electing Alaska Native Settlement Trusts (Sec. 646).

Extension of individual credits that were set to expire at the end of 2012:

(1) American Opportunity Tax Credit. Up to $2,500 tax credit for qualified tuition and other expenses of higher education was extended through 2018.
(2) Other credits and items from the American Recovery and Reinvestment Act of 2009, P.L. 111-5, that were extended for the same five-year period include
(3) enhanced provisions of the child tax credit under Sec. 24(d).
(4) earned income tax credit under Sec. 32(b). In addition, the bill permanently extends a rule excluding from taxable income refunds from certain federal and federally assisted programs (Sec. 6409).

Extension of individual provisions that expired at the end of 2011:

The act also extended through 2013 a number of temporary individual tax provisions, most of which expired at the end of 2011:

(1) $250 deduction for certain expenses of elementary and secondary school teachers (Sec. 62). This is per teacher. On a joint return, if both spouses are teachers, they may deduct only $250 EACH.  If one spouse-teacher does not have $250 in expenses, the other spouse-teacher cannot use the balance from the other spouse-teacher. Amounts in excess of $250 ($500) can be deducted as a employee business expense under miscellaneous itemized deductions-allowable to the extent they exceed 2% of AGI.
(2)  Exclusion from gross income of discharge of qualified principal residence indebtedness (Sec. 108)
(3) Parity for exclusion from income for employer-provided mass transit and parking benefits (Sec. 132(f))
(4) Mortgage insurance premiums treated as qualified residence interest (Sec. 163(h))
(5) Deduction of state and local general sales taxes (Sec. 164(b))
(6) Special rule for contributions of capital gain real property made for conservation purposes (Sec. 170(b))
(7) Above-the-line deduction (deduction for AGI) for qualified tuition and related education expenses for taxpayer and dependents (Sec. 222)
(8) Tax-free distributions from individual retirement plans for charitable purposes for taxpayers age 70½ or older (Sec. 408(d)).

Business tax extenders:

(1) Modified the Sec. 41 credit for increasing research and development activities, which expired  at the end of 2011. The credit is modified to allow partial inclusion in qualified research expenses and gross receipts for those of an acquired trade or business or major portion of one.  Extended  through 2013.
(2) The increased expensing amounts under Sec. 179 are extended through 2013.
(3) The availability of an additional 50% first-year bonus depreciation (Sec. 168(k)) was also  extended for one year by the act. It now generally applies to personal property placed in service  before January 1, 2014 (Jan. 1, 2015, for certain property with longer production periods).
(4)   Temporary minimum low-income tax credit rate for non-federally subsidized  new buildings (Sec. 42);
(5) Housing allowance exclusion for determining area median gross income for qualified residential rental project exempt facility bonds (Section 3005 of the Housing Assistance Tax Act of 2008)
(6) Indian employment tax credit (Sec. 45A)
(7) New markets tax credit (Sec. 45D)
(8) Railroad track maintenance credit (Sec. 45G)
(9)   Mine rescue team training credit (Sec. 45N)
(10)  Employer wage credit for employees who are active duty members of the uniformed services (Sec. 45P)
(11) Work opportunity tax credit (Sec. 51)
(12) Qualified zone academy bonds (Sec. 54E)
(13) Fifteen-year straight-line cost recovery for qualified leasehold improvements, qualified  restaurant buildings and improvements, and qualified retail improvements (Sec. 168(e))
(14) Accelerated depreciation for business property on an Indian reservation (Sec. 168(j))
(15) Enhanced charitable deduction for contributions of food inventory (Sec. 170(e))
(16) Election to expense mine safety equipment (Sec. 179E)
(17) Special expensing rules for certain film and television productions (Sec. 181)
(18) Deduction allowable with respect to income attributable to domestic production activities in Puerto Rico (Sec. 199(d))
(19) Modification of tax treatment of certain payments to controlling exempt organizations (Sec. 512(b))
(20) Treatment of certain dividends of regulated investment companies (Sec. 871(k))
(21) Regulated investment company qualified investment entity treatment under the Foreign Investment in Real Property Act (Sec. 897(h))
(22) Extension of subpart F exception for active financing income (Sec. 953(e))
(23) Look-through treatment of payments between related controlled foreign corporations under foreign personal holding company rules (Sec. 954)
(24) Temporary exclusion of 100% of gain on certain small business stock (Sec. 1202)
(25) Basis adjustment to stock of S corporations making charitable contributions of property (Sec. 1367)
(26) Reduction in S corporation recognition period for built-in gains tax (Sec. 1374(d))
(27) Empowerment Zone tax incentives (Sec. 1391)
(28) Tax-exempt financing for New York Liberty Zone (Sec. 1400L)
(29) Temporary increase in limit on cover-over of rum excise taxes to Puerto Rico and the Virgin Islands (Sec. 7652(f))
(30) American Samoa economic development credit (Section 119 of the Tax Relief and Health Care Act of 2006, P.L. 109-432, as modified).

Energy Tax Extenders:

The act also extends through 2013, and in some cases modifies, a number of energy credits and provisions that expired at the end of 2011:

(1) Credit for energy-efficient existing homes (Sec. 25C)
(2) Credit for alternative fuel vehicle refueling property (Sec. 30C)
(3) Credit for two- or three-wheeled plug-in electric vehicles (Sec. 30D)
(4) Cellulosic biofuel producer credit (Sec. 40(b), as modified)
(5) Incentives for biodiesel and renewable diesel (Sec. 40A)
(6) Production credit for Indian coal facilities placed in service before 2009 (Sec. 45(e)) (extended to an eight-year period)
(7) Credits with respect to facilities producing energy from certain renewable resources
(Sec. 45(d), as modified)
(8) Credit for energy-efficient new homes (Sec. 45L)
(9) Credit for energy-efficient appliances (Sec. 45M)
(10) Special allowance for cellulosic biofuel plant property (Sec. 168(l), as modified)
(11) Special rule for sales or dispositions to implement Federal Energy
Regulatory Commission or state electric restructuring policy for qualified electric utilities (Sec. 451)
(12) Alternative fuels excise tax credits (Sec. 6426).

Foreign Provisions:

The IRS’s authority under Sec. 1445(e)(1) to apply a withholding tax to gains on the disposition of U.S. real property interests by partnerships, trusts, or estates that are passed through to partners or beneficiaries that are foreign persons is made permanent, and the amount is increased to 20%.

New Taxes:

These are effective January 1 as a result of 2010’s health care reform  (“Obama Care”) legislation:

(1) Additional hospital insurance tax on high income taxpayers. The employee portion of the hospital insurance tax part of FICA, normally 1.45% of covered wages, is increased by 0.9% on wages that exceed a threshold amount. The additional tax is imposed on the combined wages of both the taxpayer and the taxpayer’s spouse, in the case of a joint return. The threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case.
(2)  For self-employed taxpayers, the same additional hospital insurance tax applies to the hospital insurance portion of SECA tax on self-employment income in excess of the threshold amount.
(3)  Medicare tax on net-investment income. Starting  January 1, Sec. 1411 imposes a tax on individuals equal to 3.8% of the lesser of the individual’s net investment income for the year or the amount the individual’s modified adjusted gross income (MAGI) that exceeds a threshold amount.  For married individuals filing a joint return and surviving spouses, the threshold amount is $250,000; for married taxpayers filing separately, $125,000; for other individuals $200,000.  For estates and trusts, the tax equals 3.8% of the lesser of undistributed net investment income or AGI over the dollar amount at which the highest trust and estate tax bracket begins.  Net investment income means investment income reduced by deductions properly allocable to that income. Investment income includes income from interest, dividends, annuities, royalties, and rents, and net gain from disposition of property, other than such income derived in the ordinary course of a trade or business. However, income from a trade or business that is a passive activity and from a trade or business of trading in financial instruments or commodities is included in investment income. [Note: I have posted two articles on this topic on TaxConnections.com Tax Blog].
(4)  Medical care itemized deduction threshold. The threshold for the itemized deduction for unreimbursed medical expenses has increased from 7.5% of AGI to 10% of AGI for regular income tax purposes. This is effective for all individuals, except, in the years 2013–2016, if either the taxpayer or the taxpayer’s spouse has turned 65 before the end of the tax year, the increased threshold does not apply and the threshold remains at 7.5% of AGI.
(5) Health flexible spending arrangement. Effective for cafeteria plan years beginning after December  31, 2012, the maximum amount of salary reduction contributions that an employee may elect to have made to a flexible spending arrangement for any plan year is $2,500.

[Paul Bonner and Alistair M. Nevius, Journal of Accountancy, on-line. ed., January 1, 2013]

REACTIONS  AND  COMMENTS

Edward Karl, Vice President–Tax for the AICPA said  “The AICPA is pleased that Congress has reached an agreement. The uncertainty of the tax law has unnecessarily impeded the long-term tax and cash flow planning for businesses and prevented taxpayers from making informed decisions. The agreement should also allow the IRS and commercial software vendors to revise or issue new tax forms and update software, and allow tax season to begin with minimal delay.”  [Paul Bonner and Alistair M. Nevius, Journal of Accountancy, on-line. ed., January 1, 2013]

There have been many critics of the legislation signed by the president, particularly due to its potential effect on the economy and not enough reduction in spending.  It did nothing to patch up the broken Social Security, Medicaid, and Medicare programs. The new congress convened on January 3 and the House reelected  John Boehner as Speaker. John Boehner and Mitch McConnell, Senate minority leader, said the GOP will use this legislation as a bargaining chip for more reductions in government spending (the debt limit has to be raised by February 28) that the Democrats are sure to resist. On March 1, automatic spending cuts, deferred by the act, will take place. Defense and domestic cuts will be hardest hit. In mid-March, congress must vote on a continuing resolution to fund government operations through September 30.

Self-employed and owners of S corporations will be faced with higher taxes since many of them will have income exceeding $400,000 where the tax rate increases from  35%  to 39.6%.  According to Vistage Polling, “29% of the chiefs of small firms planned to hire fewer workers. An additional  32%  expect lower investment spending, or fewer purchases of vehicles, property and equipment.” A small businessman said  “any added tax bill, which will be paid out of cash flow, would prevent him from offering employees raises and profit sharing.” [Emily Maltby and
Angus Loten, “Cliff  Fix Hits Small Business”, The Wall Street Journal, January 3, 2013].

David Limbaugh, a Fox News political analyst, appeared January 2 on Hannity. He was critical of the president saying  “the White House isn’t finished with revenue increases. He [the president] plans to put caps and phase-outs on deductions and go after the so called wealthy. The president refuses to reform entitlements and [wants to] tax and destroy the wealthy.”

Appearing on the same program, Charles Krauthammer, a syndicated columnist and Fox News analyst, said  “Obama only demanded increases in tax rates because it would accentuate the fractures, and that’s what happening on the House vote. If he [the president] can get the House GOP out of the way, he can be dominant in Washington for his entire term.”

Higher income taxes and the payroll tax increase is likely to stunt the growth of the economy. Joel Naroff, president of Naroff  Economic Advisors, said  “It’s [the new tax law] a huge hit.  It hits people whether they’re making $10,000 or they’re making $2 million.  It doesn’t matter who you are . . .the lower  your income, the more of your income you’re spending.  So, if your taxes go up, its going to come out of your spending. And that’s bad news for an economy that is 70 percent consumer spending.”  Mark Zandi, chief economist at Moody’s Analytics, stated  “. . . the higher payroll tax will reduce economic growth by .6 percent in 2013. . . higher taxes on household incomes above $400,000 a year will slice just  0.15 percentage point off economic growth.”  [Associated Press, “Economy likely loser in any deal”, The Albany Times Union, January  2, 2013].

The long drawn out political standoff between the president and the GOP added uncertainty that discouraged consumers from spending and businesses from hiring and investing. Mark Vitner, senior economist at Wells Fargo, predicts the economy will expand only 1.5 percent in 2013, down from a lackluster 2.2 percent in 2012. Unemployment stands at  7.7 percent.  Many economists are disappointed that Congress and the White House couldn’t reach an agreement to significantly reduce the deficit over the next 10 years. That could have increased business and consumer confidence and accelerated growth. Another shortcoming in the legislation is the failure to reform the big entitlement programs, particularly Social Security and Medicare. Joseph Lavorgita, an economist at Deutsche bank, said  “Nothing really has been fixed. There are bigger philosophical issues that we aren’t addressing yet.”  [Associated Press, “Economy likely loser in any deal”, The Albany Times Union, January 2, 2013].

Another prominent businessman, Steve Forbes, chairman and editor-in-chief of Forbes Media, appeared January 3 on The Willis Report, and was very critical of the tax increase. He said the tax increases remove capital from the economy, substantially hurts small businesses, and  middle class taxpayers [due to the payroll tax increase]. The tax increase will hurt wage earners, capital creators, and risk takers. The complexity of the Internal Revenue Code has increased which will harm the economy.  He was also critical of the president’s position on tax increases.  “President Obama doesn’t want tax reform and simplicity in the tax code recommended by Simpson-Bowles. He only wants to raise tax rates, and take away exemptions and deductions.  He doesn’t want to raise revenue; he only wants “justice” and income redistribution. He thinks rich people shouldn’t be allowed to keep as much as they earn today. He doesn’t care if it [tax increases] hurts the economy.”

The Wall Street Journal, in an editorial, was very critical of the bill approved by Congress, due to a tax increase on what they call middle class taxpayers. Their editorial centered around why the new much ballyhooed $450,000 income threshold for the highest tax rate is largely fake and a political fiction.  The editor stated:

Under the new law, some of the steepest tax increases will fall on upper-middle class earners with incomes just above $250,000. During the negotiations, the White House won a concession from the Republicans to allow phaseouts for personal exemptions and limitations on itemized deductions, starting at an income level of $250,000 for individuals and $300,000 for joint filers…. the loss of the personal exemption, currently $3,800 per family member, can mean a 4.4 percent point rise in the marginal tax rate for a married couple with two kids and income above $250,000.  A family in that income range faces about a six percentage point marginal rate hike. The restored limitation on itemized deductions can raise the tax rate by another one percentage point. Add it together [phaseouts on exemptions and caps on deductions] and families in the 33%  tax bracket could see their marginal rate paid on each additional dollar earned rise to above 38%.  Add in the new ObamaCare investment taxes and the tax rare on interest income is close to 45% [Review and Outlook, “The Stealth Tax Hike”, January 5-6, 2013].

Carly Fiorina,, a Republican national strategist and former CEO of Hewlett Packard appeared on NBC’s Meet The Press January 6. Regarding the fiscal cliff compromise she said  “. . . the latest deal complicates the tax code and continues corporate welfare [she did not elaborate on what she meant by this]. We need to broaden and simplify the tax code. close the loopholes, lower the tax rates, deal with health care costs, stabilize Social Security, and get spending under control.”

Eugene Robinson, a nationally syndicated columnist was also very critical of the fiscal cliff deal.  He said:

To say that Congress looked like a clown show last week is an insult to self-respecting clowns. Our august legislature-aided and abetted by President Barak Obama-manufactured a fake crisis. They then proceeded to handle it so incompetently that they turned into a real one…. they could only manage to avoid hurtling to their doom, and ours, by deciding not to decide much of anything. Obama “won” this bloody battle, but what did he really gain, aside from bragging rights for the next few weeks?  More important, what did the nation gain? Practically zilch, except reprieve from hardships that its elected leaders were bizarrely threatening to impose on the citizens who elected them. The bill Congress passed and the President signed contains no significant new stimulus to boost the recovery. And while it raises taxes… the non-partisan Congressional Budget Office estimates the bill actually adds $4 trillion to the debt over the next decade, mostly by keeping the Bush middle class tax cuts in place.  [“Lets hand the clowns the script”, The Albany Times Union, January 6, 2012].

The next big crisis facing Congress is action on raising the national debt limit which we will hit at the end of February. Mr. Boehner and Mr. McConnell both said they will be holding out for spending cuts and will not stand for any tax increases on any agreement raising the debt limit. President Obama said he will not agree to spending cuts and wants more tax increases to raise revenue. If the GOP holds out on their insistence on spending cuts and no tax increases, the Democrats will likely resist spending cuts. This showdown could possibly shut down the government until an agreement is reached. The next big showdown will come in March when the delayed sequester on spending cuts expires.  At that date, unless a compromise is reached between the president and congress, there will be automatic large spending cuts in defense and other domestic programs. Another area that congress must deal with is entitlement cuts and reforms to Social Security Medicaid, and Medicare.

If a deal is not reached on spending cuts and raising the debt limit, Moody’s Investor Services and Standards and Poors said they may lower the U.S. credit rating unless there is more deficit reduction.

I will continue to monitor future tax legislation in Congress, particularly tax reform.  If anything significant takes place, I will post another article to discuss it.

CIRCULAR 230 DISCLOSURE:  Pursuant to regulations governing practice before the IRS, any tax  advice contained herein is not intended or written to be used and cannot be used by the taxpayer  for the purpose of avoiding tax penalties that may be imposed on the taxpayer.