Tax legislation news
On Dec. 17, 2010 President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the Act). While it initially appeared that the House would make some revisions to the legislation, particularly to the estate tax, in the end the Act was passed without changes from the Senate bill.
Despite the opposition, it appears likely that the tax cuts will be extended and many expiring tax provisions renewed, leaving a small window of time to implement your year-end tax strategies. To assist with your planning, the major components of the Bill are summarized here:
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Temporary extension of current rate structure
Individual income tax rates. The Bill extends the 2001 and 2003 tax cuts for individuals at all income levels through the end of 2012. The highest bracket therefore will remain at 35 percent, rather than increasing to 39.6 percent. If you previously planned for rates to increase, consider revising your year-end projections. Assuming a steady-rate environment, at least for the next two years, traditional strategies such as expensing property under section 179, utilizing bonus depreciation, and deferring income may help reduce your current-year tax bill.
Caution! The rate extension is temporary, which complicates long-term planning. Accelerating deductions into 2010 will take away deductions from potentially higher-rate years (i.e., 2013 and forward). Consider this trade-off carefully.
Capital gains and dividend rates. The current tax rate on capital gains and dividends will remain at 15 percent through the end of 2012.
Itemized deduction limitation. The itemized deduction limitation reduces the total amount of a higher-income individual’s otherwise allowable deductions. This limitation has been repealed through the end of 2012.
Personal exemption phase-out. The personal exemption phase-out has been repealed through the end of 2012.
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Temporary payroll tax holiday
Under current law, employees pay a 6.2 percent Social Security tax on all wages earned up to $106,800, while self-employed individuals pay 12.4 percent on all self-employment income up to the same threshold. For 2011 only, the Bill provides for a 2 percent payroll tax holiday. This means that employees will pay 4.2 percent on wages and self-employed individuals will pay 10.4 percent on self-employment income. This provision does not apply to the employer portion of the payroll tax but it does apply to all income levels.
Also under current law, self-employed individuals are allowed a deduction of one-half of the tax on their self-employment income when calculating adjusted gross income (AGI).
The Bill appears to allow taxpayers to base the amount of their deduction as if the full 12.4 percent was still in effect, even though they will only pay 10.4 percent. It is not entirely clear if this additional benefit was intended, and it is possible that this language will be changed in the final legislation.
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Temporary alternative minimum tax (AMT) patch
In 2009, taxpayers received an AMT exemption of $46,700 (unmarried individuals filing a single return) or $70,950 (married couples filing a joint return). In 2010, these exemption amounts were scheduled to revert to $33,750 (individuals) and $45,000 (married filing jointly), thereby subjecting many more taxpayers to AMT.
The Bill includes a two-year AMT patch. If the Bill is enacted, the exemption amounts for 2010 would be $47,450 (individuals) and $72,450 (married filing jointly); and for 2011 $48,450 (individuals) and $74,450 (married filing jointly). The Bill also allows nonrefundable personal credits to be used to reduce AMT liability.
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Temporary 100 percent bonus depreciation
In one of the most expansive benefits for businesses, the Bill increases bonus depreciation to 100 percent for investments in qualified business property acquired and placed in service after Sept. 8, 2010, through Dec. 31, 2011. The Bill also extends 50 percent bonus depreciation for qualified property acquired and placed in service from Jan.1, 2012, through Dec. 31, 2012. Unlike section 179 expensing, bonus depreciation is not limited to smaller businesses or capped at a certain dollar amount.
Caution! For property placed in service after Sept. 8, 2010, through Dec. 31, 2011, it appears that taxpayers will have to choose either 100 percent bonus depreciation or regular depreciation. The Bill does not provide the option to elect 50 percent bonus during this time period. This has the potential to exacerbate the “front-loading" of deductions in the 2010 and 2011 tax years.
The Bill does not change the types of property eligible for bonus depreciation – current law still applies. In general, eligible property is original use property that has a recovery period of 20 years or less, or is qualified leasehold improvement property, meets certain contract date requirements, and is acquired and placed in service during the required timeframe (e.g., after Sept. 8, 2010, through Dec. 31, 2011, for 100 percent bonus depreciation).The 100 percent and 50 percent bonus depreciation provisions apply for both regular tax and AMT.
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Temporary exclusion of gain on sale of small business stock
The Bill extends the 100 percent exclusion of gain recognized upon the sale or exchange of qualified small business stock under section 1202. In general, noncorporate taxpayers will be able to exclude 100 percent of the gain on the sale or exchange of stock if it is qualified small business stock, is acquired after Sept. 27, 2010, and before Jan. 1, 2012, and is held for more than five years.
A simplified definition of qualified small business stock and qualified business is provided below:
- The stock must be issued by a corporation subject to tax under subchapter C.
- The stock must be originally issued in exchange for money, other property, or as compensation. The stock cannot be acquired from a third party, except through transfer as a gift, at death, or as a distribution such as from a partner from a partnership.
- Aggregate gross assets of the corporation, or any predecessor corporation, at all times on or after Aug. 10, 1993, and before the issuance of the stock, must be less than $50 million.
- Aggregate gross assets of the corporation must be less than $50 million after the issuance of the stock.
- The corporation generally must conduct an active, qualified trade or business. Qualified trade or business is defined by excluding most professional services, banking and financing, farming, production of oil and gas, and hospitality industries.
The pending legislation will also provide for extension of the elimination of the AMT preference on the excluded gain on the sale of the stock. Historically, taxpayers had to recognize a preference item of 7 percent of the amount of gain excluded for regular tax purposes.
Because of the Bill’s many nuances, including additional special rules and regulations that the above does not take into account, care should be taken in order to ensure all facts and circumstances are addressed accordingly.
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Temporary extension of other business and individual provisions
Unless otherwise noted, the Bill extends the following provisions through the end of 2011 (not an all-inclusive list):
- Section 179 expensing – Beginning in 2012, the maximum dollar amount of property eligible for section 179 expensing and the phase-out threshold are set at $125,000 and $500,000, respectively, and are indexed for inflation
- 15-year cost recovery period for qualified leasehold improvements, qualified restaurant property, and qualified retail improvements
- The Bill reinstates the research credit for two years through 2011 (the credit expired at the end of 2009 under current law). Under section 41, taxpayers can claim tax credit equal to 20 percent of the amount by which their qualified research expenditures exceed a base amount.
- Biodiesel and renewable diesel $1 per gallon production tax credit
- Energy-efficient new homes manufacturing credit
- Alternative fuel 50 cent per gallon tax credit, not including fuel derived from pulp and paper manufacturing (i.e., black liquor)
- Credit for the US-based manufacturing of energy-efficient appliances
- Credit for energy-efficiency improvements to existing homes
Other business provisions
- Through the Work Opportunity Tax Credit, businesses can claim a tax credit of 40 percent of the first $6,000 in wages paid to new hires from targeted groups, including members of families receiving benefits under the Temporary Assistance to Needy Families program, qualified veterans, designated community residents, food stamp recipients, supplemental security income recipients, and disconnected youths
- The new markets tax credit is renewed through 2011 but with a lower allocation amount than in previous years
- For S corporations making charitable contributions of property, the Bill extends the provision through 2011, allowing S corporation shareholders to take into account their pro rata share of charitable deductions even if such deductions would exceed a shareholder’s adjusted basis in the S corporation
- Enhanced charitable deduction for contributions of food inventory, book inventory, and computer equipment
- The election to expense environmental remediation costs incurred to clean up hazardous substances at sites used in trades or businesses
- The designation of certain economically depressed census tracts as Empowerment Zones, which provides qualified businesses and individuals within these zones special tax incentives
- Designation of District of Columbia Enterprise Zones and related incentives, including an employment credit, zero percent capital gains for certain DC Zone property, and a $5,000 first-time homebuyer credit
Key provisions that are not extended
Some significant would-be extenders were not included in the Bill:
- Making Work Pay credit, enacted as part of the American Recovery and Reinvestment Act of 2009; the payroll tax holiday is meant to take its place
- The exclusion from income of benefits for volunteer firefighters and emergency medical responders
- The standard deduction for state and local property taxes
- Several infrastructure-related incentives, such as: Build America Bonds; exempt-facility bonds for sewage and water supply facilities; recovery zone bonds; and a provision granting tax-exempt eligibility to loans guaranteed by federal home loan banks
Extended through 2012
- Modified child tax credit
- Expanded dependent care credit
- Increased adoption tax credit and adoption assistance program exclusion
- Credit for employer expenses for child care facilities
- Expanded contribution limits and definitions of education expenses for Coverdell accounts
- Exclusion for employer-provided educational assistance
- Expanded student loan interest deduction
Extended through 2011
- Above-the-line deduction for certain expenses of elementary and secondary school teachers
- Deduction of state and local general sales taxes in lieu of itemized deduction for state and local income taxes
- Above-the-line deduction for qualified tuition and related expenses
- Contributions of capital gain real property made for conservation purposes
- Tax-free distributions from individual retirement accounts for charitable purposes
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Temporary estate, gift, and generation-skipping transfer tax provisions
Estate tax. The Bill reinstates the estate tax retroactively to Jan. 1, 2010, with a $5 million exemption and a top rate of 35 percent. The exemption amount is indexed for inflation beginning in 2012. However, it is important to note that these changes are only effective through the end of 2012.
For deaths that occurred in 2010 and prior to enactment of the Bill, the executor of a decedent’s estate is given a choice to use the $5 million estate tax exemption and 35 percent tax rate, or elect no estate tax with the modified carryover basis regime in effect for 2010. Further, the estate is given a nine-month extension to file the estate tax return (or modified carryover basis return), along with any gift and generation-skipping tax returns. The estate is also given a nine-month extension to pay any estate tax due. For federal tax law purposes, heirs will also have a nine-month extension to make a disclaimer of an interest in property passing as a result of the death of such decedent (state law requirements for a disclaimer may be different). Extensions begin with the Bill’s date of enactment.
The Bill also introduces the portability of the estate tax exemption between married couples beginning in 2011, giving the executor of a deceased spouse’s estate the opportunity to transfer any unused estate tax exemption to the surviving spouse.
Gift tax. The 35 percent tax rate and the $1 million lifetime exemption remain in effect for the balance of 2010. However, an important change beginning in 2011 is that the Bill reunifies gift tax and estate tax, meaning the same $5 million exemption and graduated rate schedules would be used for gift tax as well as estate tax. This is significant because, in addition to keeping the top rate at 35 percent, individuals would no longer be limited to the $1 million lifetime gift tax exemption before paying gift tax.
Generation-skipping tax. The generation-skipping transfer (GST) tax rate beginning in 2011 would be 35 percent with a $5 million exemption. However, the GST tax is also retroactively reinstated to Jan. 1, 2010, and the rate for 2010 would be zero percent with a $5 million exemption. This retroactive application of the GST tax will provide a cure for the GST quandaries caused by the repeal of the GST tax in 2010. In addition, depending upon the effective date of the Bill, it may provide some potential opportunities for individuals wanting to make GSTs in 2010, as well as for trustees of generation-skipping trusts considering whether to make 2010 distributions to beneficiaries that would have otherwise triggered GST tax. For GSTs made prior to the Bill’s date of enactment, a nine-month extension is given to report such transfers.
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The next step in the process is for the Bill to return to the House. We believe that debate on the Bill will commence immediately in the House. It is not clear when or if the Bill will pass the House in its current form or at all. We will issue additional Tax Alerts as warranted as the Bill makes it way through the legislative process.
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