The pending expiration of the Bush tax cuts at the end of 2012 is one of the most important events in taxes since they were enacted some 10 years ago. While House Speaker John A. Boehner said the House will vote on the issue this summer and the majority of our legislators believe the cuts, in general, should be extended, the general inability of Congress to act in a timely fashion should be cause for concern among taxpayers.
It's more than likely that many of the important provisions will be extended (lower tax rates; preferential treatment for long-term capital gains; etc.), but there could be important modifications that could affect many taxpayers. Congress will have to balance the fragile economy against the looming deficit. The real danger here is that the higher taxes are automatic. All Congress has to do is fail to act.
At this time it's virtually impossible to predict which provisions will be extended unchanged, which modified, and which eliminated. In this article we'll list the most important expiring provisions and attempt to provide some guidance with respect to planning.
This is probably the most important provision. The current rates of 10, 15, 25, 28, 33, and 35 percent would increase in 2013 to 15, 28, 31, 36, and 39.6 percent (if the cuts expire, the 10-percent rate would be eliminated). Even low-income taxpayers would feel a significant impact. Upper-income individual taxpayers will feel a much greater impact.
The reversion to the old rates would almost surely have a severe impact on the economy. It's likely Congress will not let the reduced rates expire completely, but somewhat higher rates are possible. On a long-range basis you might want to consider accelerating income into 2012 and delaying deductions to 2013. But you've got to be careful not to overdo it for two reasons. First, the cuts may not expire and you could find yourself increasing your taxes. Second, accelerating too much income into 2012 could put you in a higher bracket than you might find yourself in in 2013.
Capital Gains and Dividends
Capital gains on individuals and other noncorporate taxpayers (gains of S corporations, LLCs, etc. are passed through and taxed to the owners) and taxed at a maximum of 15 percent (0 percent for those in the 10 or 15-percent brackets). Without extension, the rates would go to 20 percent (10 percent for taxpayers in the 15-percent bracket). In addition, gains on assets held longer than five years would be taxed at a maximum of 18 percent (8 percent for taxpayers in the 15-percent bracket).
The higher rates would apply to proceeds received in 2013 and future years. Thus, in order to insure the lower rates, the sale must be consummated and the proceeds received in 2012. You might consider accelerating installment payments to be received in 2013 and future years into 2012.
Qualifying dividends are currently taxed like capital gains, that is at no more 15 percent for individuals in the 25-percent and higher brackets (0 percent for those in the 10 or 15-percent brackets). Should the provisions not be extended, they would be taxed at ordinary income rates.
While abandoning dividend paying stocks in your portfolio makes little sense, increasing your investment in such stocks might be delayed until the law is settled. If you do business or have an interest in a regular corporation, or an S corporation with accumulated earnings and profits, you might consider a dividend before the end of the year.
Another point. The accumulated earnings tax and the tax on undistributed personal holding company income would revert to the highest individual tax rates. Paying dividends from corporate entities subject to the tax might be considered.
Phaseout of Itemized Deductions and Personal Exemption
Without extension, higher income individuals will once again face the phaseout of their personal exemptions and certain itemized deductions. (For itemized deductions, casualty, theft, wagering losses, investment interest, and medical expenses are not subject to the provision.) The phaseout of itemized deductions would begin at about $175,000; for married individuals filing joint the phaseout of personal exemptions would begin at about $260,000.
There isn't too much planning you can do here with the possible exception of accelerating charitable contributions and taxes into 2012, and even that might not be helpful because of the effect of tax payments on the alternative minimum tax.
Other Provisions Expiring
- Marriage Penalty. The Bush cuts included a provision that lessened the "marriage penalty" encountered by some couples. The impact of sunsetting of this provision would increase the burden on some taxpayers filing married, joint and reduce the standard deduction.
- Child Tax Credit. The $1,000 credit for dependents under age 17 would drop to $500.
- Child Care Credit. The child and dependent care credit would be reduced by decreasing the maximum qualifying expenses from $3,000 per child to $2,400.
- Student Loan Interest Deduction. The expiration of the current rules would mean the deduction would be phased out at lower adjusted gross income.
- American Opportunity Tax Credit. The expiration of this credit would mean that the Hope credit would once again provide the most credit for tuition deductions. But the benefits of the Hope credit can be considerably less. The maximum Hope credit per year is less than the American Opportunity Tax Credit (AOTC) and is only available for the first two years versus four years for the AOTC.
- State and Local Sales Tax Deduction. This provision allowed taxpayers to deduct either state and local sales taxes or income taxes as an itemized deduction.
- Cancellation of Mortgage Debt. This provision allowed taxpayers to exclude from income cancellation of debt income from the cancellation of a mortgage on a taxpayer's principal residence.
- Small Business Stock Gain Exclusion. Noncorporate taxpayers can exclude a percentage of the gain on the sale of qualified small business stock in a C corporation. A portion of the excluded gain is treated as a preference item for purposes of the alternative minimum tax.
- Exclusion of IRA Distributions for Charitable Contributions. This provision allows taxpayers to exclude from income distributions from an IRA that are directly contributed to a charitable organization.
- Earned Income Credit. The earned income credit benefits would be reduced on the expiration of the current provisions.
- Alternative Minimum Tax. The current "patch" for the alternative minimum tax expires at the end of this year. It's unlikely Congress will "fix" the tax. It's expected to legislate another patch with an increased exemption amount.
- Additional Medicare Tax. Beginning in 2013 high income taxpayers ($250,000 for married, filing joint; $200,000 for others), will face an additional medicare tax of 0.9 percent on renumeration and self-employment income.
- Medicare Tax on Unearned Income. Beginning in 2013, the law imposes a Medicare contribution tax on unearned income of 3.8 percent. Unearned income includes interest, dividends, annuities, royalties, rents, and capital gains. The tax applies to a taxpayer whose modified adjusted gross income is in excess of $250,000 (married filing joint; $200,000 for other filers except married, separate).
- Higher Threshold for Medical Expenses. Currently, only the amount of medical expenses in excess of 7.5 percent of a taxpayer's AGI (adjusted gross income) is deductible. Beginning in 2013, that percentage increases to 10 percent.
- Estate and Gift Taxes. The more liberal estate and gift tax rules expire at the end of 2013. We won't go into detail here, but, unless the current provision is extended, these taxes will go back up to much earlier levels.
It's probably too early take any concrete steps, but you should be aware of the problem and know what plan of action you're going to follow when the fate of the law becomes clear. For example, you might want to look for ways to accelerate income into 2012, even if you wait till the end of the year to do so. And, if you were planning to sell some investment acreage in the next few years, you might want to put it on the market now to get the process started.
Many tax planning moves here are tricky. Unfortunately, most computer tax programs won't be of much help at this point. Professional help is strongly advised.
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