Tax practitioners rarely get to experience the kind of nail-biting adventure that Indiana Jones seems to face on a daily basis. Well, this New Year’s Eve, tax aficionados finally got their chance to don a weathered fedora and champion good over evil. Specifically, as Congress first cast us over the fiscal cliff on December 31, 2012 and then reeled us back on New Year’s Day, it’s fair to say that the enactment of tax legislation has never been more gripping. By 11:00 p.m. on New Year’s Day 2013, the House of Representatives followed the Senate in passing H.R. 8, the “American Taxpayer Relief Act of 2012” (the “Act”). President Obama signed this legislation into law on January 2, 2013. Accordingly, the Act is now law.
Succinctly stated, the Act imposes an income tax increase on top-earning U.S. taxpayers, nudges up the estate tax rate to a maximum of 40% (from 35%) and extends a variety of tax incentives that either had already expired or were set to expire. The Act averts a scheduled 26.5% reduction in Medicare reimbursement rates for physicians and makes numerous other changes to Medicare and Medicaid provisions. What the Act did NOT do was implement a far-reaching make-over of the federal income tax laws, or, in the end, tamper very much at all with federal estate taxation. Tax rates on top-earning individual US taxpayers will go up by a significant amount, but triggered beginning at $400,000 instead of the originally threatened $250,000 level. The large threatened bump in tax rates on dividends was not enacted. A variety of popular tax incentives and other tax “patches” there were set to expire in 2011 were ultimately extended through the end of 2013.
We expect additional tax and health care legislation as Congress moves towards the federal debt ceiling and sequestration. The Greenberg Traurig Governmental Affairs Group is working closely with Congressional leaders those on the relevant Congressional Committees as future legislation is being drafted.
Two important tax perennial items that have been proposed for amendment were not included in the Act. First, the Act does not tax long-term capital gain income from a carried interest as ordinary income. Second, the Act does not reduce the marginal income tax rates on corporations. Thus, the United States will continue to impose one of the highest income tax rates on corporate income in the world.
I. Marginal Individual Tax Rates for 2013
For individuals with income over $400,000 in 2013, the highest marginal rate has been permanently increased to 39.6%. In addition, the Act imposes a stiff marriage penalty – married couples filing jointly with combined incomes of $450,000 are subject to the 39.6% rate. For low and moderate income taxpayers, the Act retains the existing rate structure.
The Act, however, does not use the $400,000 ($450,000 for married taxpayers filing jointly) thresholds for all purposes. Specifically, the phase-outs for itemized deductions and personal exemptions apply at adjusted gross incomes of $250,000 for individuals and $300,000 for joint returns. Also, the Pease limitation on itemized deductions will be reinstated. The Pease limitation reduces most itemized deductions by 3% of the amount by which adjusted gross income exceeds a specified threshold, up to a maximum reduction of 80% of itemized deductions. The thresholds are also going to be adjusted for inflation beginning in 2014.
II. Permanent Alternative Minimum Tax Relief for 2012 & Future Years
The alternative minimum tax (the “AMT”) is frequently referred to as the “shadow income tax.” While its original purpose was to ensure that high net worth individuals paid a minimum amount of federal income tax, over the years it has increasingly affected the middle class. If a taxpayer’s AMT liability exceeds his or her regular income tax liability, (s)he pays the higher AMT liability. The AMT does not “kick-in” until a taxpayer earns income over a certain yearly threshold amount. Thus, any increase in the AMT exemption results in fewer households being subject to the tax. To prevent an expansion of the number of households subject to the AMT, the Act increases the AMT exemption amount from $33,750 to $50,600 (and from $45,000 to $78,750 for joint returns) in 2012 and will index the AMT exemption amount, exemption phase-out threshold, and income bracket beginning in 2013. In addition, if certain tax credits reduce a taxpayer’s AMT liability below zero, such excess credits may now be carried forward to future years.
III. Dividends and Capital Gains
The federal income tax rate on long-term capital gains has been increased from 15% to 20% for individuals with incomes of $400,000 or more ($450,000 for married couples filing jointly) beginning in 2013. As detailed in our earlier GT Alert, The Lady, or the Tiger: Making Informed Choices in 2013’s Uncertain Federal Income Tax Environment (December 2012), capital gains can also be subject to a 3.8% Medicare Tax beginning in 2013.
Qualified Dividends, that is, dividends paid by U.S. and certain non-U.S. corporations to non-corporate taxpayers, are impacted by the Act, but not as significantly as had been expected. The Act does not repeal the provisions addressing qualified dividend income (“QDI”). Accordingly, QDI will remain taxable at the rates applicable to long-term capital gains, and thus at the 20% rate applicable to taxpayers with income of at least $400,000 ($450,000 for married couples).
IV. State Sales Tax Deduction
Taxpayers who live in states without income taxes have been permitted to deduct sales taxes instead. (In fact, all taxpayers may elect to deduct either sales or income taxes.) The ability to deduct sales and use taxes was set to expire in 2011. The Act extends the election to deduct sales and use taxes through 2013.
V. Estate and Gift Taxes
The Act also includes changes to the Federal Estate, Gift and GST Taxes. Specifically:
1. The marginal Federal estate, gift and GST tax rate will go up to 40% from 35%
2. In 2013, the applicable exclusion amount for estate and gift tax purposes, as well as the GST exemption, will be $5 million, indexed for inflation (approximately $5.25 in 2013).
3. State death taxes will continue to be deductible under section 2058 in calculating the federal taxable estate.
4. The unified credit or exclusion amount (or “exemption”) will remain portable for estate and gift tax purposes, but not for GST tax purposes.
5. The changes are made “permanent” by eliminating the sunset provisions contained in the 2001 and 2010 Tax Acts, thereby extending the additional tax relief contained in prior legislation.
VI. Retirement Funds and Individual Retirement Accounts
The Act extends, until December 31, 2013, the ability of individuals who have attained age 70½ to transfer up to $100,000 per year directly from an IRA to certain public charities without including the amount transferred in their gross income. The Act also permits IRA distributions in January of 2013 to be treated as having been made in 2012 for these purposes and permits taxpayers who received distributions in December of 2012 to treat the portion of that distribution that is transferred in cash to a public charity before February 1, 2013 as if it had been transferred directly from the IRA to the charity for these purposes.
The Act also permits 401(k) and other qualified plans, Section 403(b) plans and Section 457(b) plans that permit Roth contributions to allow participants to elect to have the plan transfer to Roth accounts under the plan amounts that otherwise would not be distributable under the plan (for example, because of the limitations generally applicable to 401(k) or other elective deferrals). Participants would be subject to immediate tax on the amounts transferred. This provision is effective for transfers after December 31, 2012.
VII. Mutual Fund Shares Held by Non-U.S. Persons
Congress had provided mutual funds a beneficial exception to the Foreign Investment in Real Property Tax Act (also known as “FIRPTA”). Under the special rules, pre-2012 distributions to non-U.S. persons by publicly-traded mutual funds of proceeds of sales of appreciated real property and interests in domestically-controlled mutual funds that held substantial U.S. real property interests were not subject to the special FIRPTA tax. This exception was retroactively extended to 2012 and now extends through 2013.
VIII. Subpart F Income
In general, U.S. shareholders who own 10% or more of a controlled foreign corporation (“CFC”) are subject to current taxation on several types of passive income, which are generally referred to as “Subpart F Income.” Foreign Personal Holding Company Income, Foreign Base Company Sales Income, Foreign Base Company Services Income, and Insurance Income are among the categories of Subpart F Income.
For taxable years beginning after 1998, an exemption from Foreign Personal Holding Company Income, has existed for CFCs that derive more than 70% of their gross income from the “active and regular conduct of a lending or finance business.” Such excluded income includes (i) income derived in the active conduct of banking, financing or similar business, (ii) certain income earned by securities dealers and (iii) certain income earned from an insurance business. This provision has never been made permanent and has been extended from year to year. The provision expired at the end of 2011, but the Act extends the provision through 2013.
The Act also extends look-through treatment of payments between related CFCs under the Foreign Personal Holding Company rules through 2013. Certain types of passive income (namely dividends, interest, rents, and royalties) that were received or accrued by one CFC (the payee CFC) from a related CFC (the payer CFC) have not been not treated as Foreign Personal Holding Company Income to the extent that such income (i) was attributed to income of the payer CFC that was not subpart F income, and (ii) was not effectively connected with a U.S. trade or business. A related CFC for this purpose would be a CFC that controls or is controlled by the other CFC, or a CFC that is controlled by the same person(s) that control the other CFC. For this purpose, ownership of more than 50% by vote or value constitutes control.
In addition, provisions for mutual funds that pay “interest-related dividends,” that is, dividends that are treated as the payment of interest because they relate to interest received by the mutual fund, have been extended as well. Specifically, through the end of 2011, interest-related dividends were not subject to U.S. withholding tax in the hands of non-U.S. persons. Like the FIRPTA exception, this exception was retroactively extended to 2012 and now extends through 2013.
IX. Small Business Stock
The Act extends the exemption for 100% of the gain on sales of certain small business stock (generally, stock held for five years issued by a qualified small business, which is, in general, a business with assets of no more than $50 million). The exemption generally is for 50% of the gain. However, the exempt amount had been increased to 100% for stock acquired after September 27, 2010, and before January 1, 2012. The Act extends this 100% exclusion to stock acquired through the end of 2013.
X. Health Care Provisions
The Act extends current Medicare physician payment rates through December 31, 2013, preventing a scheduled reduction of 26.5% under the flawed sustainable growth rate (“SGR”) formula. Several other Medicare provider payment provisions are extended through December 31, 2013 under the Act, including: the 1.0 floor on the geographic adjustment to the “physician work” index; the exception process to all outpatient therapy caps on services, received both from non-hospital providers and in hospital outpatient departments; the add-on payment for ground ambulance transports, including in super rural areas, and the air ambulance add-on (the latter is extended only until June 30, 2013); and the adjustment for low-volume hospitals that have less than 1,600 Medicare discharges and are 15 miles or greater from the nearest like hospital. Additionally, the Act extends the Medicare Dependent Hospital (“MDH”) program until October 1, 2013, extends the authority of Medicare Advantage special needs plans (“SNPs”) to target enrollment to certain populations through 2015, allows certain Medicare cost plans to continue to operate through 2014, and continues funding through 2013 for a Federal contract for activities relating to health care performance.
The Act also provides for a one-year extension of funding for several Medicare and Medicaid programs that provide assistance to low-income and special needs individuals, including for State Health Insurance Counseling Programs (“SHIPs”), Area Agencies on Aging (“AAAs”), Aging and Disability Resource Centers (“ADRCs”), and The National Center for Benefits Outreach and Enrollment; the Qualifying Individual (“QI”) program; the Transitional Medical Assistance (“TMA”) program; the Medicaid and CHIP Express Lane Eligibility (“ELE”) option; Family to Family Health Information Centers (“F2F HIC”); and for the Special Diabetes Program for Type 1 diabetes and for Indians.
Additionally, the Act includes a number of provisions that aim to generate savings in order to offset a portion of the costs associated with the payment and program extensions above.1 The Act phases in the recovery of past overpayments to hospitals made as a result of the transition to Medicare Severity Diagnosis Related Groups (“MS-DRGs”), for an estimated savings of $10.5 billion. The Act updates Medicare End Stage Renal Disease (“ESRD”) payments to meet recommendations from the General Accountability Office (“GAO”), by re-pricing the bundled payment to account for changes in behavior and utilization of drugs, which is estimated to save $4.9 billion. Additionally, starting in April 2013, the law applies prices established through competitive bidding to non-mail order diabetic test strips under Medicare, for an estimated savings of $600 million.
The Act also increases the Medicare Multiple Procedure Payment Reduction to 50% for therapy services that are provided on the same day, for an estimated savings of $1.8 billion. The Act equalizes payments for certain radiology services provided under the Medicare hospital outpatient payment system, for an estimated savings of $400 million, and increases the utilization factor used in setting the Medicare payment rate for advanced imaging services to 90%, for an estimated savings of $800 million. The Act reduces by 10% the payment rates for non-emergency ambulance transport services provided to individuals with ESRD for an estimated savings of $400 million. The Act also increases the Medicare Advantage (”MA”) plan coding intensity adjustment, which adjusts plans’ risk-adjustment payments to reflect differences between traditional Medicare and MA coding practices, for an estimated savings of $2.5 billion.
The Act addresses program integrity and quality of care in Federal health care programs. The Act increases the statute of limitations for recovery of Federal overpayments from three to five years, based on recommendations from the Office of Inspector General (“OIG”) at the Department of Health and Human Services (“HHS”), and eliminates all $1.7 billion in funding for the Medicare Improvement Fund. The Act establishes a Commission on Long Term Care tasked with developing a plan for the establishment, implementation, and financing of a high quality system that ensures the availability of long-term services and supports for individuals.
The Act amends several programs established under the Affordable Care Act (“ACA”) by repealing the Community Living Assistance Services and Supports (“CLASS”) program, which had previously been defunded, and rescinding all unobligated funds for the Consumer Operated and Oriented Plan (“CO-OP”) program. However, the Act creates a contingency fund with 10% of the unobligated CO-OP funds, which is to be used for currently-approved, already-created co-ops. The Act also extends for one year changes made by the ACA to Medicaid Disproportionate Share Hospital (“DSH”) payments and requires future DSH allotments to be determined based off of the rebased level using current law methodology, for an estimated savings of $4.2 billion.
XI. Business Tax Extenders (All to Begin Sunset on 12/31/2013)
Numerous tax incentives aimed at businesses were set to expire December 31, 2012 in the absence of Congressional action. In general, the business tax incentives outlined below have been extended through the end of 2013:
1. Extend and modify tax credit for research and experimentation expenses.
2. Create a LIHC rate floor of 9 percent.
3. LIHTC treatment of military housing allowances.
4. Indian employment tax credit.
5. New markets tax credit ($3.5 billion allocation in 2012 and 2013).
6. 50% tax credit for certain expenditures for maintaining railroad tracks.
7. Mine rescue team training credit.
8. Employer wage credit for activated military reservists.
9. Work opportunity tax credit.
10. Qualified zone academy bonds ($400 million allocation in 2012 and in 2013).
11. 15-year straight-line cost recovery for qualified leasehold, restaurant, and retail improvements.
12. 7-year recovery period for certain motorsports racing track facilities.
13. Accelerated depreciation for business property on Indian reservations.
14. Enhanced charitable deduction for contributions of food inventory.
15. Increase in section 179 expensing amounts and threshold limits $500,000/$2,000,000.
16. Election to expense mine safety equipment.
17. Special expensing rules for certain film and television productions.
18. Deduction allowable with respect to income attributable to domestic production activities in Puerto Rico.
19. Modify tax treatment of certain payments under existing arrangements to controlling exempt organizations.
20. Basis adjustment to stock of S corporations making charitable contributions of property.
21. Reduction in recognition period for S corporation built-in gains tax.
22. Empowerment zone tax incentives.
23. New York Liberty Zone tax-exempt bond financing.
24. Temporary increase in limit on cover over of rum excise tax revenues (from $10.50 to $13.25 per proof gallon) to Puerto Rico and the U.S. Virgin Islands.
25. Extension and modification of economic development credit for American Samoa.
26. Extension and modification of bonus depreciation.
XII. Individual Tax Extenders (All to begin Sunset on 12/31/2013)
Several other tax incentives aimed at individuals at different levels of income were extended only by one year. As a result, the following individual tax incentives were extended by one year, and Congress will have to renegotiate these before the end of 2013:
1. Above-the-line deduction of up to $250 for teacher classroom expenses.
2. Discharge of indebtedness on principal residence excluded from gross income of individuals.
3. Parity for exclusion for employer-provided mass transit and parking benefits.
4. Premiums for mortgage insurance deductible as interest that is qualified residence interest.
5. Contributions of capital gain real property made for qualified conservation purposes.
6. Deduction for qualified tuition and related expenses.
XIII. Energy Tax Extenders (All to Begin Sunset on 12/31/2013)
Finally, the Act also extended by one year specific federal income tax incentives for businesses in the energy industry.
1. Extension and modification of section 25C nonbusiness energy property.
2. Alternative fuel vehicle refueling property (non- hydrogen refueling property).
3. Expand section 30D credit for qualified plug-in electric drive motor vehicles to include electric motorcycles.
4. Credit for production of cellulosic biofuel with a maximum credit of $1.01 per gallon and inclusion of fuel from algae.
5. Extension of credits for biodiesel and renewable diesel.
6. Credit for production of Indian coal.
7. Extension and modification of credits for renewable energy.
8. Credit for construction of energy-efficient new homes.
9. Credit for energy-efficient appliances.
10. Special depreciation allowance for cellulosic biofuel plant property and inclusion of algae-based fuel plant property.
11. Special rule for sales or dispositions to implement Federal Energy Regulatory Commission (“FERC”) or State electric restructuring policy.
12. Excise tax credits and outlay payments for alternative fuel, and excise tax credits for alternative fuel mixtures.
XIV. Temporary Extension of Certain Tax Cuts Enacted in 2009 (all will begin to Sunset on 12/31/17)
During President Obama’s first year at the White House, numerous tax incentives were provided for individual taxpayers (the “2009 Obama Tax Cuts”). As opposed to the two Bush Tax Cuts, however, most of the 2009 Obama Tax Cuts were in the form of deductions, credits and similar incentives. These incentives were aimed mostly to households with relatively lower income thresholds. The Act extended the following 2009 Obama Tax Cuts to December 31, 2017:
1. The American Opportunity Tax Credit.
2. The reduction in the earnings threshold for the refundable portion of the Child Tax Credit to $3,000.
3. The Earned Income Tax Credit ("EITC") for larger families.
4. EIC modification and simplification - increase in joint returns, beginning and ending income level for phase-out by $5,000 indexed after 2008.
5. Refunds disregarded in the administration of Federal programs and federally assisted programs.
1 All savings estimates contained herein are from the Congressional Budget Office, Detail on Estimated Budgetary Effects of Title VI (Medicare and Other Health Extensions) of the American Taxpayer Relief Act of 2012, January 1, 2013. Available at: http://cbo.gov/publication/43830.©2014 Greenberg Traurig, LLP. All rights reserved.