2012 American Taxpayer Relief Act: Individuals

After much debate and anticipation, Congress has passed the American Taxpayer Relief Act of 2012 (ATRA) which averts the tax side of the fiscal cliff, provides numerous extenders and avoids the automatic sunset provisions that were scheduled to take effect after 2012. The impact on individuals is significant.

Permanent Alternative Minimum Tax Relief

The alternative minimum tax (AMT) exemption amounts for individuals have been increased for tax years beginning in 2012 and made permanent. The exemption amounts for the 2012 tax year are $78,750 for a joint return or surviving spouse, $50,600 for an unmarried individual not a surviving spouse, $39,375 for married individuals filing separately. The exemption amounts will be indexed for inflation for calendar years beginning after 2012.

INDIVIDUAL INCOME TAX RATES

ATRA makes permanent for 2013 and beyond the lower Bush-era income tax rates for all individuals, except those taxpayers with taxable income above $400,000 ($450,000 for married taxpayers, $425,000 for heads of households).

Income above these levels will be taxed at a 39.6 percent rate. Therefore, the 10, 15, 25, 28 and 33 percent marginal rates remain the same after 2012, as does the 35 percent rate for income between the top of the 33 percent rate (projected to be at $398,350 for most taxpayers) and the $400,000/$450,000 threshold at which the 39.6 percent bracket now begins. Taxpayers who find themselves within the 39.6 percent marginal income tax bracket nevertheless also benefit from extension of all Bush-era rates below that level.

The majority of U.S. businesses are pass-through entities, such as partnerships and S corporations. This means that profits are passed through to their individual owners and therefore are taxed at individual income tax rates. A “C” corporation, with its current corporate level tax rate of 35 percent (which may drop if recent corporate tax reform proposals are adopted), may become more attractive with rates rising to 39.6 percent for some individuals.

Marriage Penalty Relief. ATRA extends all existing marriage penalty relief provisions. Before the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), married couples experienced the so-called marriage penalty in several areas. EGTRRA gradually increased the basic standard deduction for a married couple filing a joint return to twice the basic standard deduction for an unmarried individual filing a single return.

EGTRRA also gradually increased the size of the 15 percent income tax bracket for a married couple filing a joint return to twice the size of the corresponding rate bracket for an unmarried individual filing a single return.

CAPITAL GAINS/DIVIDENDS

ATRA raises the top rate for capital gains and dividends to 20 percent, up from the Bush-era maximum 15 percent rate. That top rate will apply to the extent that a taxpayer’s income exceeds the thresholds set for the 39.6 percent rate.

All other taxpayers will continue to enjoy a capital gains and dividends tax at a maximum rate of 15 percent. A zero percent rate will also continue to apply to capital gains and dividends to the extent income falls below the top of the 15 percent income tax bracket—projected for 2013 to be $72,500 for joint filers and $36,250 for singles. Qualified dividends for all taxpayers continue to be taxed at capital gains rates, rather than ordinary income tax rates as prior to 2003.

It should be noted that starting in 2013, under the Patient Protection and Affordable Care Act (PPACA), higher income taxpayers must also start paying a 3.8 percent additional tax on Net Investment Income (NII) to the extent certain threshold amounts of income are exceeded ($200,000 for single filers, $250,000 for joint returns and surviving spouses, $125,000 for married taxpayers filing separately). Those threshold amounts stand, despite higher thresholds now set for the 20 percent capital gain rate that previously had been proposed by President Obama to start at the same levels. The NII surtax thresholds are not affected by the American Taxpayer Relief Act. Starting in 2013, therefore, taxpayers within the NII surtax range must pay the additional 3.8 percent on capital gain, whether long-term or short-term. The effective top rate for net capital gains for many “higher-income” taxpayers thus becomes 23.8 percent for long term gain and 43.4 percent for short-term capital gains starting in 2013.

PEASE LIMITATION

ATRA officially revives the “Pease” limitation on itemized deductions, which was eliminated by EGTRRA. The Pease limitation, named after the member of Congress who sponsored the original provision, reduces the total amount of a higher-income taxpayer’s otherwise allowable itemized deductions by three percent of the amount by which the taxpayer’s adjusted gross income exceeds an applicable threshold. However, the amount of itemized deductions is not reduced by more than 80 percent. Certain items, such as medical expenses, investment interest, and casualty, theft or wagering losses, are excluded.

However, higher “applicable threshold” levels apply under the new law:

  1. $300,000 for married couples and surviving spouses;
  2. $275,000 for heads of households;
  3. $250,000 for unmarried taxpayers; and
  4. $150,000 for married taxpayers filing separately.

The applicable threshold for the Pease limitation for 2013, as adjusted for inflation and as computed under the sunset rules, would have been $178,150 ($89,075 for individuals married filing separately). Thus, ATRA does not call for a full revival of the Pease limitation at former levels.

PERSONAL EXEMPTION PHASEOUT

ATRA also officially revives the personal exemption phase-out rules but at applicable income threshold levels slightly higher than in the past:

  1. $300,000 for married couples and surviving spouses;
  2. $275,000 for heads of households;
  3. $250,000 for unmarried taxpayers; and
  4. $150,000 for married taxpayers filing separately.

Under the phase-out, the total amount of exemptions that may be claimed by a taxpayer is reduced by two percent for each $2,500, or portion thereof (two percent for each $1,250 for married couples filing separate returns) by which the taxpayer’s adjusted gross income exceeds the applicable threshold level.

CHILD TAX CREDIT

ATRA extends permanently the $1,000 child tax credit. Certain enhancements to the credit under Bush-era legislation and subsequent legislation are also made permanent.

EARNED INCOME CREDIT

ATRA makes permanent or extends through 2017 enhancements to the earned income credit (EIC) in Bush-era and subsequent legislation. The enhancements to the EIC made by Bush-era and subsequent legislation include (not an exhaustive list) a simplified definition of earned income, reform of the relationship test and modification of the tie-breaking rule.

Other Child-Related Tax Relief

Adoption Credit/Assistance. ATRA extends permanently Bush-era enhancements to the adoption credit and the income exclusion for employer-paid or reimbursed adoption expenses up to $10,000 (indexed for inflation) both for non-special needs adoptions and special needs adoptions. The adoption credit phases out for taxpayers above specified inflation-adjusted levels of modified adjusted gross income. The phase-out level for 2012 started at $189,710. For 2013, the beginning point for phasing out the adoption credit is projected to be $191,530. The limit on the adoption credit is projected to be $12,770 for 2013.

Child and Dependent Care Credit. ATRA extends permanently Bush-era enhancements to the child and dependent care credit. The current 35 percent credit rate is made permanent along with the $3,000 cap on expenses for one qualifying individual and the $6,000 cap on expenses for two or more qualifying individuals. Expenses qualifying for the child and dependent care credit must be reduced by the amount of any dependent care benefits provided by the taxpayer’s employer that are excluded from the taxpayer’s gross income.

Employer-Provided Child Care Credit. ATRA extends permanently the Bush-era credit for employer-provided child care facilities and services.

Education Incentives

ATRA makes permanent or extends a number of enhancements to tax incentives designed to promote education. Many of these enhancements were made in Bush-era legislation, extended by subsequent legislation and were scheduled to expire after 2012. Some enhancements, notably the American Opportunity Tax Credit, were made in President Obama’s first term.

American Opportunity Tax Credit. The American Opportunity Tax Credit (AOTC) is extended through 2017. The AOTC is an enhanced, but temporary, version of the permanent HOPE education tax credit. The AOTC gives qualified taxpayers a tax credit of 100 percent of the first $2,000 of qualified tuition and related expenses and 25 percent of the next $2,000, for a total maximum credit of $2,500 per eligible student. Additionally, the AOTC applies to the first four years of a student’s post-secondary education. The HOPE credit is less and applies only to the first two years of post-secondary education.

Deduction for Qualified Tuition and Related Expenses. ATRA extends until December 31, 2013 the above-the-line deduction for qualified tuition and related expenses. The bill also extends the deduction retroactively for the 2012 tax year.

Student Loan Interest Deduction. ATRA permanently extends suspension of the 60-month rule for the $2,500 above-the-line student loan interest deduction. ATRA also permanently expands the modified adjusted gross income range for phase-out of the deduction and repeals the restriction that makes voluntary payments of interest nondeductible.

Coverdell Education Savings Accounts. ATRA permanently extends Bush-era enhancements to Coverdell education savings accounts (Coverdell ESAs). These enhancements include a $2,000 maximum contribution amount and treatment of elementary and secondary school expenses as well as postsecondary expenses as qualified expenditures.

Employer-Provided Education Assistance. ATRA permanently extends the exclusion from income and employment taxes of employer-provided education assistance up to $5,250. The employer may also deduct up to $5,250 annually for qualified education expenses paid on behalf of an employee.

Federal Scholarships. ATRA makes permanent the exclusion from income for the National Health Service Corps Scholarship Program and the Armed Forces Scholarship Program.

More Individual Tax Extenders

Teachers’ Classroom Expense Deduction. ATRA extends through 2013 the teacher’s classroom expense deduction. The deduction, which expired after 2011, allows primary and secondary education professionals to deduct (above-the-line) qualified expenses up to $250 paid out-of-pocket during the year.

Exclusion of Cancellation of Indebtedness on Principal Residence. Cancellation of indebtedness income is includible in income, unless a particular exclusion applies. This provision excludes from income cancellation of mortgage debt on a principal residence of up $2 million. ATRA extends the provision for one year, through 2013.

Transit Benefits. ATRA extends parity in transit benefits through December 31, 2013. These benefits are a tax-free fringe benefit to employees. Parity in the exclusion limit expired after 2011.

Mortgage Insurance Premiums. This provision treats mortgage insurance premiums as deductible interest that is qualified residence interest. ATRA extends this provision through December 31, 2013. The provision originally expired after 2011.

Contribution of Capital Gains Real Property for Conservation. ATRA extends for two years, through December 31, 2013, the special rule for contributions of capital gain real property for conservation purposes. The special rule allows the contribution to be taken against 50 percent of the contribution base. ATRA also extends for two years the special rules for contributions by certain corporate farmers and ranchers.

IRA Distributions to Charity. ATRA extends for two years, through December 31, 2013, the provision allowing tax-free distributions from individual retirement accounts to public charities, by individuals age 701/2 or older, up to a maximum of $100,000 per taxpayer per year.

Obviously, the American Tax Relief Act is significant and impacts all taxpayers, including you. This letter provides some of the highlights. If you would like more information on the impact to your tax liability, please call our office for an appointment. We will be happy to discuss the details of the American Tax Relief Act.