Congress, in an eleventh-hour compromise agreement worked out with the Obama Administration and the GOP Leadership, has extended many of the Bush era tax reductions. The following is an overview of the more frequently encountered tax changes that will have an effect on just about every taxpayer.
Individual Tax Rates – Under the Bush era tax cuts, the individual tax rates were reduced and replaced with six tax brackets that increase with income: 10, 15, 25, 28, 33, and 35 percent. These reduced rates were scheduled to return to their original levels of 15, 28, 31, 36, and 39.6 percent beginning in 2011. That would have resulted in the lowest bracket increasing by 5 percentage points and the highest bracket 3.6 percentage points, affecting all taxpayers from the low- to the high-income. Congress has extended the lower rates for two additional years, through the end of 2012.
Capital Gains & Qualified Dividends – Under the Bush era tax cuts, the tax on long-term capital gains (assets owned for more than one year) was reduced from a 20 percent maximum rate to 15 percent for taxpayers in the 25% and higher tax brackets. The tax cuts also provided for a zero tax to the extent a taxpayer is in the 10 and 15 percent income tax brackets. Qualified dividend income, which had been taxed at ordinary tax rates, also became eligible for the lower capital gains rates under the Bush era tax cuts. These lower rates are scheduled to expire after 2010. Congress has extended the lower rates for both long-term capital gains and qualified dividends for two additional years, through the end of 2012.
Itemized Deduction Limitation – Prior to the Bush era tax cuts, itemized deductions were partially phased out for higher-income taxpayers. This phase-out was gradually eliminated beginning in 2006 and is totally repealed for 2010. However, the full phase-out was scheduled to return in 2011. Congress has extended the repeal for two additional years, through the end of 2012.
Personal Exemption Phase-Out – As with itemized deductions, prior to the Bush era tax cuts, the personal exemptions were phased out for higher-income taxpayers. This phase-out was gradually eliminated and was totally repealed for 2010. However, the full phase-out was scheduled to return in 2011. Congress has extended the repeal for two additional years, through the end of 2012.
Marriage Penalty Relief – Prior to the Bush era tax cuts, the standard deduction for a married couple was not twice the amount of the standard deduction for a single individual. Instead, it was only 167% of the single amount even though there were two people instead of one. This was often referred to as the “marriage penalty.” As part of the Bush era tax cuts, the marriage penalty was eliminated and the standard deduction for a married couple filing jointly became twice the amount for a single taxpayer. The marriage penalty also applies to the high-end cut-off point for the 15% tax bracket.
The marriage penalty was scheduled to resume in 2011. However, Congress has extended the repeal for two additional years, through the end of 2012.
Child Tax Credit – For several years, the maximum child tax credit has been $1,000 per qualified child, and, for 2009 and 2010, a portion of that credit was refundable for certain lower-income taxpayers. The credit was scheduled to drop back to $500 per child and the refundable portion reduced beginning in 2011. Congress has extended, for two additional years, the $1,000 per child credit and the enhanced refund portion, through 2012.
Earned Income Credit (EIC) – There have been a number of enhancements in the past several years including additional credit when there are three or more qualifying children and increased income beginning and end points of the EIC. Congress has extended the EIC enhancements for two additional years, through 2012.
Dependent (Child) Care Credit – As part of the Bush era tax cuts, the maximum expenses qualifying for dependent care credit were raised from $2,400 ($4,800 for two or more qualifiers) to $3,000 ($6,000 for two or more qualifiers) and the income-based maximum credit percentage was raised from 30% to 35%. However, these increases were scheduled to revert to the lower amounts in 2011. Congress has extended the higher expenses limits and credit percentage through 2012.
American Opportunity Tax Credit (AOTC) – For 2009 and 2010, the Hope education credit was replaced by an enhanced AOTC. The AOTC provides a maximum credit of $2,500, of which up to 40% can be refundable, whereas the Hope credit maximum is $1,800 and the credit is not refundable. Generally, tax credits can only be used to offset an individual’s tax liability and any excess is lost, thus the term “refundable” means a portion of the credit in excess of the tax liability can be refunded to the taxpayer.
Without extension, the AOTC was set to expire after 2010 and revert to the lower Hope credit levels without any refundable portion. Congress has extended the AOTC for two additional years, through 2012.
Above-the-Line Tuition Deduction - Taxpayers were allowed up to a $4,000 above-the-line deduction for qualified higher education tuition and related expenses. This deduction expired at the end of 2009. Congress retroactively reinstated this deduction for 2010 and extended it through 2011.
Coverdell Educational Accounts – Coverdell accounts are accounts where taxpayers can contribute funds to pay for future educational needs of their children. The amount contributed is not deductible, but the future earnings of the accounts are not taxable if used to pay for qualified education expenses. For several years, the annual maximum contribution limit to a Coverdell account has been $2,000, but was scheduled to revert to a maximum of $500 in 2011. Congress has extended the $2,000 limit for two additional years, through 2012. Also to be extended for the same time period for Coverdell distribution purposes is the definition of education expenses to include elementary and secondary school expenses.
Teacher’s $250 Above-the-Line Deduction – The special deduction for classroom expenses, which allows educators to deduct up to $250 of expenses whether or not they itemize their deductions, had expired after 2009, but it has been retroactively reinstated for 2010 and extended through 2011.
Option to Deduct Sales Tax In Lieu of State Income Tax - For several years through 2009, taxpayers had the option of deducting on Schedule A as part of their itemized deductions the LARGER of: (1) State and local income tax paid, or (2) State and local sales tax paid during the year. That option expired at the end of 2009. Congress has retroactively reinstated this option for 2010 and extended it through 2011.
Home Energy-Savings Improvement Credit – For 2009 and 2010, taxpayers were allowed a 30% credit for home energy-savings improvements with a 2-year combined maximum of $1,500. For 2011, that credit has been replaced by the more restrictive credit rules in place during 2006 and 2007 with a less lucrative 10% credit and a $500 lifetime cap. Additionally, certain efficiency standards that were weakened in the American Recovery and Reinvestment Act are restored to their prior levels, and the provision provides that windows, skylights and doors that meet the Energy Star standards are qualified improvements.
Unemployment Compensation – Congress has extended federal unemployment benefits through 2011; unemployment benefits continue to be taxable income. (For 2009, the first $2,400 of unemployment compensation received per person was excluded from being taxed; extension of this exclusion to 2010 or later years is not part of the new tax bill.)
Payroll Tax Reduction – The Making Work Pay credit, which was part of the 2009 stimulus package, provided a credit of up to $400 ($800 for married couples filing jointly), subject to income limitations, and expires after 2010. The credit has been replaced for one year only (2011) with a 2 percentage point reduction in the employee’s portion of the payroll tax (OASDI) from 6.2% to 4.2%. The reduction applies to all wage earners regardless of income. The employer’s share of the payroll tax is unaffected. For wage earners with payroll in excess of the $106,800 payroll tax cap, their savings for 2011 will be $2,136 (2% of $106,800). The OASDI portion of the SE tax for self-employed individuals would also be reduced by 2 percentage points, reducing the overall SE tax from 15.3% to 13.3%.
Tax-Free IRA to Charity Distributions Reinstated
The provision that permits taxpayers age 70½ and over to make direct distributions (up to $100,000 per year) from their Traditional or Roth IRA account to a charity has been reinstated for 2010 and 2011. The distribution is tax-free, but there is no charitable deduction. This provision can be very beneficial to taxpayers who have social security income and/or do not itemize their deductions.
Important - Because the extension of this benefit was passed so late in December, Congress included a provision that allows transfers made in January of 2011 to be treated as if made in 2010. Thus, the distribution counts against the 2010, not the 2011, $100,000 exclusion limitation and can be used toward a taxpayer’s 2010 minimum distribution requirement if it hasn’t already been met.
The key benefits of this provision lie in the fact that the distribution:
- Is not included in the taxpayer’s income for the year,
- Counts toward the taxpayer’s minimum required distribution for the year, if any, and
- Does count as a charitable contribution for the year (although not a deductible contribution).
How does a taxpayer benefit from this provision?
- By making a contribution directly from the IRA, taxpayers are able to exclude the amount that was contributed from their income for the year, which is essentially the same as deducting the contribution without itemizing their deductions.
- This technique also lowers a taxpayer’s adjusted gross income (AGI) for other tax breaks pegged at various AGI levels, such as medical expenses, passive losses, etc., allowing them greater benefits from the AGI-limited deductions.
- For taxpayers receiving Social Security (SS), the taxability of the SS is also based on income. Thus, excluding the portion of the IRA distribution directly distributed to the charity can, in some cases, reduce the taxable portion of the SS.
- Taxpayers who wish to make very large contributions (up to the 100,000 limit) can do so with IRA funds that would have otherwise been taxable to them.
Caution – It is important to stress that a qualified charitable IRA contribution must be directly distributed to the qualified charity. Otherwise, the distribution is taxable as income and the charitable deduction would be taken on the taxpayer’s itemized deductions subject to all the normal limitations. It may be appropriate to call this office before attempting to execute this strategy.
Alternative Minimum Tax (AMT) – For several years, Congress has failed to permanently resolve the nagging issue of the AMT, and instead, each year has applied a one-year patch without which an estimated 28 million taxpayers would be hit with this punitive tax.
This year, Congress took the AMT issue to the brink, but in the eleventh hour decided to patch it again, this time for two years, 2010 and 2011. For a change, taxpayers will be able to factor the AMT into their tax planning for 2011. The patch continues the inflation adjustments to the AMT exemption amounts and allows personal tax credits to be used against the AMT. For 2010, the AMT exemption amounts will be set at $47,450 for individuals, $72,450 for married taxpayers filing jointly, and $36,225 for married taxpayers filing separately.
Federal Estate Tax Retroactively Reinstated - The Bush era tax cuts slowly phased out the federal estate tax and abolished it altogether for decedents dying in 2010, and replaced it with a rather complicated modified carryover basis regime. Just about everyone assumed Congress would reinstate the estate tax for 2010. As the year wore on, opinions began to change to where just about everyone predicted Congress would not reinstate the estate tax for 2010. Then out of the blue, mixed in with the GOP/Obama Administration compromise agreement tax provisions, was a proposal to retroactively reinstate the estate tax with a $5 million per person exemption and a tax rate of 35%.
Because the reinstatement occurred so late in the year, Congress is allowing a choice for 2010, providing the following two options:
- Tax Option - Subject the estate to the estate tax provisions for 2010 and provide the beneficiaries with an inherited basis equal to the fair market value (FMV) of assets inherited from the decedent.
- Modified Carryover Basis Option - Not pay the retroactive estate tax and instead utilize the modified carryover basis regime for determining the basis of inherited items.
For estates worth $5 million or less, the obvious choice would be the tax option of filing an estate tax return and taking advantage of the $5 million exemption, resulting in no tax and providing beneficiaries with an inherited basis of items equal to the items’ FMV at date of death. For larger estates, the question becomes more complex: pay the tax now and provide the beneficiaries with a FMV basis and perhaps a lesser tax in the future when the asset is sold, or avoid the tax now and possibly saddle the beneficiaries with a larger tax when they dispose of an asset in the future? These decisions will have to be made after considering the beneficiaries’ financial and tax circumstances, the intended use of the inherited property, and the makeup of the estate and the ability to pay the estate tax.
Another twist is a new provision that permits the executor of a deceased spouse’s estate to transfer any unused exemption to the surviving spouse, thus eliminating the need by most couples for complicated estate planning such as certain trust arrangements; this provision would take effect for decedents dying after 2010. But don’t get rid of that trust just yet! This extension is only through 2012, and based on prior performance, can we really trust Congress to develop a permanent solution to the estate tax by then? They had eight years to devise a permanent fix last go-around and waited until the 11th hour, only to come up with a two-year, temporary fix.
The $5 million per person exemption and top tax rate of 35% applies to estate, gift and generation skipping taxes through 2012, except the exemption amount will be inflation adjusted beginning in 2012, and the increase from $1 million to $5 million for the lifetime exemption for gifts applies for 2011 and 2012, but not 2010.
Bonus Depreciation – Generally, business assets cannot be written off in the year of purchase and must be depreciated over their useful life. As an incentive to jump start the economy and promote business investment in recent years, Congress has allowed a bonus depreciation of 50% of the cost of the investment in equipment and certain leasehold improvements. Congress has increased the bonus depreciation to 100% for qualified investments made from Sept. 9, 2010 through Dec. 31, 2011. New business equipment placed in service in 2012 will be eligible for a bonus depreciation of 50%. This generally provides a tax break for large businesses and others that can’t take advantage of the Section 179 expensing deduction because of income limitations.
Section 179 Expense Deduction – For 2011, taxpayers are able to expense (rather than depreciate) up to $500,000 of the cost of certain capital expenses. Under the compromise agreement starting in 2012, the maximum Sec.179 expense will drop to $125,000, indexed for inflation.
Research Tax Credit – The research tax credit expired at the end of 2009. Congress has reinstated the credit for 2010 and extended it through 2011.
If you have questions related to these changes, please give the office a call.