Sullivan and Cromwell Fiscal Cliff Analysis

7/30/2019 Sullivan and Cromwell Fiscal Cliff Analysis

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January 3, 2013

Fiscal Cliff Legislation Enacted

The American Taxpayer Relief Act of 2012 Enacted

BACKGROUND

On January 1, 2013, Congress passed the American Taxpayer Relief Act of 2012 (the Act), and thePresident signed the Act on January 2, 2013. The Act permanently extends the Bush era tax rates

which otherwise would have expired for all taxpayers effective January 1, 2013for many taxpayers

while increasing tax rates for individuals with taxable income above statutory thresholds. The Act

increases the tax rate for ordinary income for affected individuals to 39.6% and increases the tax rate for

net long-term capital gains and qualified dividend income for these taxpayers to 20%. In addition, the Act

makes changes to estate and gift tax rules and extends a number of popular tax provisions that otherwise

would have expired.

The Act does not affect the 0.9% increase in Federal Insurance Contributions Act (FICA) taxes imposed

by the Patient Protection and Affordable Care Act of 2010 or thenew 3.8% tax on investment incomealso

imposed by the Patient Protection and Affordable Care Act of 2010. In addition, the Act does not extend

the 2% FICA payroll holiday that expired on December 31, 2012.

The Act does not address issues related to the debt ceiling and other spending issues which are

expected to be addressed by Congress later this year. As part of this process, there may be additional

tax changes.

SUMMARY

The Act puts in place numerous provisions, including:

enacting a top income tax rate at 39.6% on ordinary income for taxpayers with taxable income over$400,000 for individuals, $425,000 for heads of households and $450,000 for married couples filing

jointly, while permanently extending rates on other tax brackets at 2012 levels;
http://www.sullcrom.com/files/Publication/9084cf1a-4fa8-4d33-98e7-a126ff0a18d7/Presentation/PublicationAttachment/0b9331c8-c049-42a1-9cd6-b611d0cedf72/SC_Publication_IRS_Proposes_Regulations_Implementing_the_New_3.8_Tax_on_Investment_Income.pdfhttp://www.sullcrom.com/files/Publication/9084cf1a-4fa8-4d33-98e7-a126ff0a18d7/Presentation/PublicationAttachment/0b9331c8-c049-42a1-9cd6-b611d0cedf72/SC_Publication_IRS_Proposes_Regulations_Implementing_the_New_3.8_Tax_on_Investment_Income.pdfhttp://www.sullcrom.com/files/Publication/9084cf1a-4fa8-4d33-98e7-a126ff0a18d7/Presentation/PublicationAttachment/0b9331c8-c049-42a1-9cd6-b611d0cedf72/SC_Publication_IRS_Proposes_Regulations_Implementing_the_New_3.8_Tax_on_Investment_Income.pdfhttp://www.sullcrom.com/files/Publication/9084cf1a-4fa8-4d33-98e7-a126ff0a18d7/Presentation/PublicationAttachment/0b9331c8-c049-42a1-9cd6-b611d0cedf72/SC_Publication_IRS_Proposes_Regulations_Implementing_the_New_3.8_Tax_on_Investment_Income.pdf


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-2-Fiscal Cliff Legislation EnactedJanuary 3, 2013

enacting a top long-term capital gains rate at 20% for taxpayers with taxable income in excess of$400,000, $425,000 for heads of households and $450,000 for married couples filing jointly, withrates on other tax brackets permanently extended at 2012 levels;

extending the taxation of qualified dividend income at the preferential rates applicable to long-termcapital gains;

reinstating the limitation on itemized deductions for individuals with adjusted gross income above$250,000 for individuals and $300,000 for married couples filing jointly, while permanently repealingsuch limitation for individuals with adjusted gross income at or below these thresholds; under thislimitation itemized deductions are reduced by the lesser of (i) 3% of the excess of a taxpayersadjusted gross income over the relevant threshold, or (ii) 80% of the otherwise allowable itemizeddeductions;

reinstating the Personal Exemption Phaseout (described below) in respect of adjusted gross incomeabove $250,000 for individuals and $300,000 for married couples filing jointly, while permanentlyrepealing such phaseout in respect of income at or below those thresholds;

increasing the alternative minimum tax exemption amounts for 2013 to $50,600 for individuals and$78,750 for married couples filing jointly, with exemption amounts permanently indexed for inflationthereafter;

permanently establishing the top estate and gift tax rate at 40% and the lifetime per person estateand gift exemption amount at $5,000,000, indexed for inflation from 2010;

permanently enacting portability of the estate tax exemption (by allowing the executor of a deceasedspouses estate to transfer any unused estate tax exemption amount to the surviving spouse);

permanently unifying the estate and gift taxes, with a single graduated rate schedule and a singlelifetime exemption amount;

permanently establishing the generation-skipping transfer (GST) tax rate at 40% and the GSTexemption at $5,000,000, indexed for inflation from 2010;

extending by one year the periods during which property can be acquired and placed in service andqualify for bonus depreciation;

allowing amounts in excess of amounts currently distributable in non-Roth 401(k), 403(b) or 457(k)accounts (which are taxed when distributed) to be converted into Roth accounts (which are taxedupon contribution or conversion but are not taxed when distributed); and

extending certain other expiring provisions, including, among others, the active financing exceptionand the same country exception to the anti-deferral regime in subpart F of the Internal Revenue Code(IRC).

INCOME TAX RATES

The Bush era tax rates would have expired on December 31, 2012, raising income taxes across all tax

brackets. The Act increases the top income tax rate to 39.6% on ordinary income for taxpayers with

taxable income over $400,000 for individuals, $425,000 for heads of households and $450,000 formarried couples filing jointly. All other rates are permanently extended at 2012 levels.

The effective highest rate on wages for high income individuals, particularly those in high tax states, will

actually be approximately 43.15%--the 39.6% highest ordinary income rate, coupled with the 1.2%

increase resulting from the itemized deduction limitation (discussed below), the 0.9% increase in FICA

taxes imposed by the Patient Protection and Affordable Care Act of 2010 and the existing 1.45%


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employee share of the current Hospital Insurance (HI) tax. The effective rate on net earnings from self-

employment (after giving effect to the deductibility of a portion of the FICA tax) will be approximately 44%.

CAPITAL GAINS RATES

Long-term capital gains were subject to tax at a top rate of 15% in 2012, with the rate scheduled toincrease to 20% for taxable years beginning in 2013.

1The Act increases the top capital gains rate for

individuals and joint filers with taxable income above the dollar thresholds described above ($400,000 for

individuals, $425,000 for heads of households and $450,000 for married couples filing jointly) to 20%.

The effective top rate on long-term capital gains will actually be about 25%, particularly for taxpayers in

high tax states--the 20% highest capital gains rate, coupled with the 1.2% increase from the itemized

deduction limitation (discussed below) and the 3.8% tax on investment income imposed by the Patient

Protection and Affordable Care Act of 2010. Rates for taxpayers with income below those thresholds are

permanently extended at rates applicable in 2012.

DIVIDEND INCOME

Subject to certain limitations, qualified dividend income (dividends received from U.S. corporations and

certain qualified foreign corporations) received by noncorporate taxpayers has been taxed at the

preferential rates applicable to long-term capital gains. This special treatment of qualified dividend

income was set to expire beginning in 2013, when qualified dividend income would have reverted to

treatment as ordinary income. The Act makes permanent the special rule regarding the taxation of

qualified dividend income at the preferential rates applicable to long-term capital gains.2

LIMITATION ON ITEMIZED DEDUCTIONS

The amount of itemized deductions that a taxpayer may claim has in the past been reduced by the lesser

of (i) 3% of the excess of a taxpayers adjusted gross income over a specified threshold, or(ii) 80% of the

otherwise allowable itemized deductions. This limitation was repealed in 2010, but was set to become

effective again in 2013. The Act reinstates the limitation on itemized deductions for taxpayers with

adjusted gross income above $250,000 for individuals, $275,000 for heads of household, and $300,000

for married couples filing jointly, and permanently repeals the limitation for taxpayers with income at or

below such thresholds. As a practical matter, particularly for high income individuals who reside in states

with high state or local income taxes, the limitation effectively results in an additional 3% of taxable

income (as the amount of deduction disallowed will equal 3% of adjusted gross income), or about 1.2% of

1If capital gains are realized on the sale of a collectible, tax rates may be even higher, with the toprate on gains from collectibles remaining at 28% (before taking into account the itemized deductionlimitation and 3.8% tax on investment income). In addition, the tax rate applicable to depreciationrecapture on real estate sales will remain at 25% (before taking into account the itemized deductionlimitation and 3.8% tax on investment income).

2See note 1, above.


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income tax, because 3% of adjusted gross income will generally be greater than 80% of his or her

itemized deductions.3

PERSONAL EXEMPTION PHASEOUT

Personal exemptions have in the past been phased out for taxpayers with adjusted gross income abovecertain levels. This phaseout has been repealed since 2010, but was set to become effective again for

taxable years beginning in 2013. The Act reinstates the personal exemption phaseout for individual

taxpayers with adjusted gross income in excess of $250,000, $275,000 for heads of household, and

$300,000 for married couples filing jointly, and permanently repeals the phaseout for taxpayers with

income at or below such thresholds. For example, under the Act, a taxpayer with adjusted gross income

in excess of $425,000 will not be entitled to claim any personal exemption.

ALTERNATIVE MINIMUM TAX

The alternative minimum tax is imposed on a taxpayers income that exceeds an exemption amount. In

1993, the exemption amounts were permanently set at $33,750 for individuals and $45,000 for married

couples filing jointly. Since 2001, Congress has designated special higher amounts for each taxable year

(e.g., $47,450 and $74,450 for 2011), while leaving the permanent amounts set at 1993 levels.

The Act sets the exemption amounts for taxable years beginning in 2012 at $50,600 for individuals and

$78,750 for married couples filing jointly, with exemption amounts permanently indexed for inflation for

taxable years beginning after 2012.

ESTATE AND GIFT TAX RATESIn 2011 and 2012, the top estate and gift tax rate was set at 35%, and the lifetime per person exemption

amount was set at $5,000,000, indexed for inflation from 2010. The top estate and gift tax rate was to

rise to 55% in 2013, and the per person exemption amount was to drop to $1,000,000 for 2013. The Act

establishes a top estate and gift tax rate of 40% for estates of decedents dying after December 31, 2012

and gifts made after that date. The $5,000,000 estate and gift exemption, indexed for inflation from 2010,

is made permanent by the Act.

PORTABILITY

Until 2010, unused estate tax exemption amounts of a deceased spouse were not able to be used by the

surviving spouse. Since 2010, so-called portability rules under IRC 2010(c) have been in effect,

allowing the executor of a deceased spouses estate to transfer any unused estate and gift exemption

3 For example, if an individual is subject to state income tax at a 5% rate, and has no other itemizeddeductions, 80% of his or her deduction for state income tax ( i.e., 4%) would generally exceed 3% ofadjusted gross income. As a result, the 3% of adjusted gross income limit would apply.


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amount to the surviving spouse. Such portability rules were set to expire for 2013. The portability rules

are made permanent by the Act.

ESTATE AND GIFT TAX UNIFICATION

Prior to 2001, the estate and gift taxes were unified, with a single graduated rate schedule for both. In2001, these systems were decoupled, but were subsequently recoupled for 2011 and 2012. The

recoupling was set to expire in 2013. The Act permanently unifies the estate and gift taxes, with a single

graduated rate schedule and a single lifetime exemption amount.

GENERATION-SKIPPING TRANSFER TAX RATES AND EXEMPTION

The GST tax rate tracks the highest estate tax rate, so that the GST tax rate was set to rise to 55% in

2013. The Act establishes a 40% rate for GST tax for transfers after December 31, 2012. The GST

exemption amount, which tracks the estate tax exemption amount, is set by the Act at $5,000,000,

indexed for inflation from 2010. The Act also extends certain GST tax provisions set to expire in 2013,

including provisions regarding deemed allocation of the GST exemption amount and relief from late GST

allocations and elections.

BONUS DEPRECIATION

IRC 168(k) allows a taxpayer to claim bonus depreciation deductions with respect to qualifying property

equal to 50% of a propertys adjusted basis in the year the qualifying property is placed in service. In the

case of certain transportation property, certain aircraft and certain other property with a recovery period of

at least ten years, the bonus depreciation deduction is equal to 100% of the propertys adjusted basis.

Under prior law, property qualified for bonus depreciation only if, among other requirements: (i) the

property was acquired by the taxpayer before January 1, 2013 or pursuant to a written binding contract

entered into before January 1, 2013 and (ii) the property was placed in service by the taxpayer before

January 1, 2013. A 50% bonus depreciation deduction was also available for the type of property that

would otherwise qualify for the 100% deduction so long as the taxpayer satisfied the other requirements

and the property was placed into service before January 1, 2014.

The Act allows property to be acquired until January 1, 2014 or pursuant to a written binding contract

entered into before January 1, 2014, and allows the property to be placed into service until January 1,

2014. In the case of property that would otherwise qualify for the 100% deduction, the Act allows the

50% bonus depreciation deduction so long as the taxpayer satisfied the other requirements and the

property is placed into service before January 1, 2015.


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ROTH CONVERSIONS

Taxpayers generally participate in retirement 401(k), 403(b) or 457(k) plans on a non -Roth basis, under

which amounts are contributed tax-free but distributions are taxable. Under prior law, taxpayers could

convert amounts that were currently distributable from such accounts to Roth accounts, with the account

balances taxable on the conversion date and all of the principal and earnings tax-free when distributed.

The Act permits all amounts (including amounts not currently distributable) in non-Roth accounts to be

converted into Roth accounts in the same plan. Taxpayers would be taxable on such converted amounts,

but would not be subsequently taxed when distributions are subsequently made from the Roth account.

EXTENDERS

There are a number of taxpayer-friendly provisions in the IRC that were scheduled to sunset that are

known as extenders. The Act extends many of these for taxable years beginning in 2013. The

extenders we believe will be of most interest to our clients are:

Mortgage debt relief. Taxpayers who have debt cancelled or forgiven are generally required toinclude the amount of such cancelled debt in income. However, for taxable years beginning in 2007to 2012, taxpayers who had mortgage debt cancelled or forgiven were allowed to exclude anaggregate of up to $1,000,000 of forgiven mortgage debt from income ($2,000,000 for marriedcouples filing jointly). The Act extends this mortgage debt relief for taxable years beginning in 2013.

Active financing exception. A U.S. shareholder of a controlled foreign corporation (CFC) isgenerally required to include its share of the CFCs passive or Subpart F income in theshareholders income as a deemed dividend. Although interest income generally is Subpart Fincome, income derived by a CFC from such CFCs active banking, financing or similar businesseswas specifically excluded from the CFCs Subpart F income under a provision that applied to taxable

years beginning before 2012. The Act extends the active financing exception for taxable yearsbeginning in 2012 and 2013.

Look-through treatment of payments between related CFCs. For taxable years beginning in 2006to 2011, dividends, interest, rents and royalties received or accrued by a CFC from a related CFCwere excluded from the recipients Subpart F income to the extent that they were paid out of thepayors active income. The Act extends this exclusion for taxable years beginning in 2012 and 2013.

Research tax credit. Congress enacted a research tax credit as part of the 1981 EconomicRecovery Tax Act, and prior to the Act the tax credit only applied to taxable years beginning before2012. The Act extends the tax credit for research expenses for 2012 and 2013 and the rules fortaxpayers under common control and the rules for computing the research tax credit when a portionof a trade or business changes hands are also modified by the Act.

Tax-free distributions from individual retirement plans for charitable purposes. The Pension

Protection Act of 2006 provided an exclusion from gross income for otherwise taxable distributionsfrom a traditional or a Roth retirement plan in the case of qualified charitable distributions made bytaxpayers seventy-and-one-half years or older of up to $100,000 per taxpayer per taxable year for taxyears beginning in 2006 to 2011. The exclusion applies only if a charitable contribution deduction forthe entire distribution otherwise would be allowable, determined without regard to the generallyapplicable percentage limitations. The provision is extended by the Act for taxable years beginning in2012 and 2013.

Coverdell Education Savings Accounts. Coverdell Education Savings Accounts are tax-exemptsavings accounts used to pay the higher education expenses of a designated beneficiary. The


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annual contribution limit to Coverdell accounts of $2,000 is extended by the Act and the definition ofeducation expenses is expanded to include elementary and secondary school expenses for taxableyears beginning in 2013.

Exclusion for employer-provided educational assistance. An employee may exclude from grossincome for income and employment tax purposes up to $5,250 per year of employer-providededucation assistance for undergraduate or graduate-level education. The Act extends this provision

for taxable years beginning in 2013.

Student loan interest deduction. Certain individuals who have paid interest on qualified educationloans may claim an above-the-line deduction for such interest expenses, with the maximum deductionfor any tax year set at $2,500 and the income phase-out levels of between $55,000 to $70,000 and$110,000 to $140,000 for married couples filing jointly. For interest paid on loans before 2002, thededuction for interest on a qualified education loan was allowed only for interest payments due andpaid during the first 60-month period of the loan, and the benefits phased out for taxpayers with theincome of between $40,000 to $55,000 and $60,000 to $75,000 for married couples filing jointly.Such restrictions were set to come back into effect in taxable years beginning in 2013. The Actextends the 2012 treatment for taxable years beginning in 2013.

Mortgage insurance premiums deductible as interest that is qualified residence interest. Fortaxable years beginning in 2007 to 2011, taxpayers with adjusted gross income not in excess of

$110,000 were permitted to treat the cost of mortgage insurance on a qualified personal residence asdeductible qualified residential interest. That rule is extended by the Act for taxable years beginningin 2012 and 2013.

Deductions for state and local sales taxes. For taxable years beginning in 2004 to 2011, ataxpayer was permitted to elect to claim an itemized deduction for state and local general sales taxesin lieu of the itemized deduction for state and local income taxes. The Act extends the right to makethis election to taxable years beginning in 2012 and 2013.

Contributions of appreciated real property made for conservation purposes. The Act extendsfor 2012 and 2013 the special rule that increased the contribution limits and carry-forward period forqualified conservation contributions

4of appreciated real property for conservation purposes for

taxable years beginning in 2012 and 2013. The rule was initially added to the IRC in 1980, and priorto the Act only applied to taxable years beginning before 2012 but is extended by the Act for taxable

years beginning in 2012 and 2013. New Markets tax credit. For taxable years beginning in 2004 to 2011, the New Markets tax credit

provided a 39% tax credit, spread over seven years, to encourage private investment in businesses inlow-income neighborhoods. The Act extends the New Markets tax credit for taxable years beginningin 2012 and 2013 and the carry-over period for using such credits is extended from taxable yearsbeginning in 2016 to taxable years beginning in 2018.

Treatment of certain dividends of regulated investment companies as interest-relateddividends. For taxable years beginning in 2005 to 2011, IRC 871(k)(1) permit a regulatedinvestment company to designate as an interest-related dividend a dividend that the company paidout of certain interest income that would not be subject to tax in the hands of a shareholder that is aforeign corporation or a nonresident alien. The Act extends for 2012 and 2013 the provision allowinga regulated investment company to designate all or a portion of a dividend as an interest-related

dividend. Inclusion of regulated investment companies in the definition of a qualified investment

entity.The Act extends for 2012 and 2013 the inclusion of regulated investment companies in thedefinition of a qualified investment entity for purposes of the Foreign Investment in Real Property

4 IRC 170(h) outlines four requirements of a qualified conservation contribution, namely that (i) theproperty contributed must be a qualified real property interest; (ii) the property must be donated to aqualified organization; (iii) the gift must be for conservation purposes; and (iv) the contributionmust be exclusively for conservation purposes.


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Tax Act (FIRPTA). Sales of stock in a domestically controlled qualified investment entity are notincluded in the definition of a U.S. real property interest and are not subject to tax under FIRPTA. Inaddition, under FIRPTA, any distribution by a qualified investment entity to a nonresident alienindividual, foreign corporation or other qualified investment entity is, to the extent attributable to gainfrom sales or exchanges of U.S. real property interests, treated as gain recognized by suchnonresident alien individual, foreign corporation or other qualified investment entity as gain from thesale or exchange of a U.S. real property interest, unless5 the distribution is with respect to any classof stock which is regularly traded on an established securities market in the U.S. and suchnonresident alien individual or foreign corporation did not own more than 5% of such class of stock atany time during the 1-year period ending on the date of such distribution. Distributions exempt fromFIRPTA under this rule, however, are treated as ordinary dividends subject to 30% withholding,except to the extent reduced by treaty.

Reduction in S corporation recognition period for built-in gains tax. If a taxable corporationconverts into an S corporation, the conversion is not a taxable event. However, following such aconversion, an S corporation must hold its assets for a certain period in order to avoid a tax on anybuilt-in gains that existed at the time of the conversion. The five-year time period for which an Scorporation must hold its assets to avoid a built-in gains tax on gains that existed at the time ofconversion to an S corporation in effect since 2011 is extended for 2012 and 2013 by the Act andcertain rules for carry-forwards and installment sales are clarified.

EFFECTIVE DATE

All of the Acts provisions are effective from January 1, 2013, except for those extenders that the Act

renews retroactively to January 1, 2012.

* * *

5Such exception was enacted in 2004.

Copyright Sullivan & Cromwell LLP 2013


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Sullivan and Cromwell Fiscal Cliff Analysis