By Bart A. Basi and Marcus S. Renwick
At the stroke of 12:01 a.m. on New Year’s Day this country officially fell off the Fiscal Cliff (the combination of increased taxes and decreased spending which would have slowed the economy). Fortunately, Congress and the President agreed to measures that allowed us to glide to a soft landing. The President has signed the bill via autopen and it is now law. The issues in the law are outlined below.
Capital Gains and Dividends
First, for those making under $200,000 individually or $250,000 per couple (200/250 taxpayers), the capital gains rates stay the same at 15%. (The same rule applies for low-bracket taxpayers as well. They pay 0%). Taxpayers making more than the 200/250 threshold pay an additional 3.8% on investment amounts under the Patient Protection and Affordable Care Act (PPACA). This tax did not exist previously in 2012. It is new for 2013.
Furthermore, for those making $400,000 individually and couples making $450,000 (400/450 taxpayers) capital gains tax rate is now 20% plus the 3.8% mentioned above. This makes the capital gains tax rate 23.8% on high-income (400/450) taxpayers.
Unfortunately, capital gains occur when most small business owners try to sell their businesses. It is our recommendation that tax planning be engaged in, not at the point of a deal, but at the point when the business owner decides to sell the business.
Ordinary Tax Rates
The law permanently extends the lower income brackets to middle class families. This means that income tax rates generally remain where they were in 2012 for the majority of Americans in 2013 and beyond.
For couples earning (in wages and salaries) over the 200/250, an additional 0.9% tax will apply under the Patient Protection and Affordable Care Act (PPACA) for Medicare. For taxpayers earning 400/450, taxes are now 39.6% for upper income amounts in addition to the 0.9% increase under the PPACA, making the top effective rate 40.5%.
Unemployment continues to be high. As of Feb. 1, the unemployment rate remains at 7.9%, ticking up slightly from 7.8% in January. Fortunately, unemployment insurance has been extended for the year of 2013. Without the extension, two million people would have lost their benefits in January 2013. While the economy has taken a hit, losing .1% in the fourth quarter of 2012, analysts expect unemployment to go down during the current 2013 year.
Child Tax Credit
The law also continued the extended child tax credit and the earned income credit. These are substantial credits for many middle class families and have been extended for one year. For many families these credits amount to between $1,000 and $8,000, providing a substantial boost.
Many business owners are familiar with Section 179 of the Internal Revenue Code. Under Section 179, most equipment and other depreciable items are subject to this advanced depreciation. The purchaser purchases the equipment, then rather than expensing it over years under conventional depreciation, the purchaser is entitled to an immediate expense. The result: lower income taxes! This is a popular Tax Code Section and is frequently used by business people
Being so popular, the Section 179 deduction is $500,000 retroactive to Jan. 1, 2012 and extends through 2013. Even though it is not permanent, it keeps the door open this year to purchase more equipment and immediately depreciate the expenses. The deduction is subject to a $2,000,000 phase out, dollar for dollar, up to $2,500,000.
It is important for the business owner to understand the distinction between Section 179 property and property eligible for bonus depreciation. Section 179 property can be brand new or used. Property eligible for bonus depreciation can only be original use/brand new property. If the equipment was previously titled or owned, it is not eligible for bonus depreciation, but may be eligible for Section 179 depreciation.
Bonus depreciation is also popular with businesses. The 50% deduction on business investment on brand new (original use) equipment has been extended for 2013 for most purchases. However, for certain long-term assets and transportation equipment, the law is extended through the 2014 tax year.
Estate and Gift Tax
Under the old law, the estate tax exemption was slated to go down to $1,000,000. This would have been harsh all things considered. Under the new law, the estate tax exemption rises to $5,250,000. It was indexed to inflation for 2012 at 5,120,000. The tax rate goes from 35% in 2012 to 40% in 2013.
Portability remains in place for 2013. What is also important to sort out here is that states have their own version of estate taxes. This makes estate planning necessary on so many levels. Not only can states have their own estate exemptions and taxes, business owners and their family faces a unique set of challenges during the process of business succession. Often times not having a successor can mean the loss of the business.
Unfortunately, the law does not extend the 2% payroll tax cut for the employees’ end of Medicare. The payroll tax will increase for most Americans. In 2011 and 2012, the regular 6.2% reserved for social security on the employee’s end was reduced to 4.2%. As of Jan. 1, 2013, the rate returned to 6.2% for all employees.
The Alternative Minimum Tax
The AMT was originally intended to be in place to make sure everyone pays taxes. Regular tax is calculated on the 1040. The AMT is calculated on form 6251. On this form, essentially a parallel tax system is implemented. If the taxable amount in the AMT is calculated above that of the amount on the Form 1040, the taxpayer pays the difference between the calculated 1040 amount and form 6251. This is the creature known as the Alternative Minimum Tax.
The exemptions have been extended and increased for 2012 and 2013. IN 2013 the exemptions for single and married taxpayers are $51,900 and $80,750 respectively. Practitioners do not necessarily like the tax; however, it is a fact of life and they must deal with the tax until it is repealed entirely, if it ever is.
This is another provision that is retroactive to 2012. The amount for one educator is $250. If two educators are married, the potential amount increases to $500. Generally, this applies to educators in grades K-12 and is very popular among educators.
Discharge of Indebtedness on Primary Residence
Before the housing crash took place last decade, any amount forgiven as a debt was a taxable income. The rule still holds true; however, for the past few tax years discharge of indebtedness on principle residence has been changed to be a nontaxable event. This rule has been extended into 2013. It was slated to end on Dec. 31, 2012. This is very helpful for those facing foreclosure or short-sale situations. The discharge of their indebtedness will not be taxable. The opposite of the situation could have created adverse effects for those affected.
This law also extends the farm bill, avoiding the “Dairy Cliff,” which would have likely shown us a 100% rise in dairy prices.
Mortgage Debt Relief
The mortgage interest deduction also stays with us. It had been considered for cutting; however, many in Congress consider this middle-class benefit to be too important to abandon.
While the PPACA expands coverage to individuals in this country starting in 2014, medical expenses must cover over 10% of adjusted gross income in order to be deductible on the individual tax return as an itemized deduction on Form 1040.
Tax planning has become even more important for those planning on selling a business or passing a business. Taxes on wealthy individuals will be higher this year and in the future. It is our recommendation that any business or personal planning include tax planning. This is particularly important for those selling businesses and those having estates worth more than $5,000,000. There are tools to utilize if you wish to sell or pass on your business. Please call the center for further advice.
Dr. Bart A. Basi is an expert on closely held enterprises. He is an attorney, a certified public accountant and the president of the Center for Financial, Legal & Tax Planning, Inc. He is a member of the American Bar Association’s Tax Committees on Closely-Held Businesses and Business Planning. Marcus S. Renwick is an attorney and the director of research and publications with the firm.