Now that the election is over and Congress has returned to Washington, the debate will begin in earnest on how to deal with numerous expiring tax provisions and across-the-board spending cuts that will have a major effect on the federal budget and the U.S. economy. This dilemma facing the nation has been referred to as the “fiscal cliff.”
The “fiscal cliff” is what Federal Reserve Board Chairman Ben Bernanke has called the many major fiscal events that could happen simultaneously at the close of 2012 and the beginning of 2013. These events include the expiration of the Bush-era tax cuts, the payroll tax cut and other important tax-relief provisions, which would significantly raise taxes on all taxpayers. The events also include the first installment of the $1.2 trillion across-the-board spending cuts to domestic and defense programs required under last summer’s bipartisan deficit reduction agreement. And, around the same time, lawmakers may have to raise the debt ceiling once again, and that could potentially trigger another standoff in Congress.
If all these tax increases and spending cuts take effect without Congressional action, the country could fall off the “fiscal cliff,” into a new recession, according to the Congressional Budget Office.
How do the political parties line up on the “fiscal cliff?” The Democrats are concerned about a too-fast and too-deep deficit reduction based on the theory that government spending helps to stimulate the economy. Republicans are more enthusiastic about deficit reduction, but mainly by cutting or slowing the rate of growth of domestic programs and entitlements. However, they oppose the drastic cuts in defense spending. In addition, Republicans support extending the Bush-era tax cuts for all Americans, including the wealthy.
How Congress chooses to address these issues will have a significant impact on the size of the budget and on the pace of economic recovery going forward. Are we about to fall off the “fiscal cliff?”
In his first post-election speech on November 9, and in his press conference on November 14, President Obama reiterated that he will not sign any plan to avoid the fiscal cliff that does not include raising taxes on the wealthiest 2% of Americans. President Obama and Democrats in Congress believe that wealthy Americans are not paying their fair share of taxes and are insisting that tax rates for the wealthy, those making more than $200,000 or more than $250,000 for married taxpayers, should return to the tax rates in effect during the Clinton presidency. Republicans on the other hand, argue that the Bush-era tax cuts should remain in place pending major overhaul of the U.S. tax system that should be taken up by the new Congress during 2013. Republicans fear that tax increases on “job creators” proposed by President Obama and the Democrats will cause the economy to again falter and fall back into recession.
Even if Governor Romney had won the presidential election, Senate Democrats had already made clear that they would not vote to extend the Bush-era tax cuts to wealthy Americans during the lame duck session of Congress.
Accordingly, since we have the same post-election President, the same Senate and the same House, should we expect the same gridlock, or will someone blink to avoid taking the U.S. over the “fiscal cliff?” In short, it is only reasonable to expect that tax rates will rise in 2013.
Tax Rate Changes
There are four possible tax rate scenarios for 2013 as we face expiration of the Bush-era tax cuts:
- the complete sunset of the Bush-era tax rates for all taxpayers
- a complete extension of the Bush-era tax rates for all taxpayers (The Republican-backed plan)
- the sunset of rates for higher-income individuals only (The Obama Plan), and
- the sunset of rates for millionaires only (the plan advanced by Democrats in the House and Senate).
The following table compares the existing 2012 tax rates to the 2013 “sunset rate” if Congress fails to extend the Bush-era tax rates:
For 2013, the 36% tax bracket would apply to taxable income of single taxpayers ranging from $182,600 to $397,000, and to married taxpayers’ incomes of between $222,300 and $397,000. The 39.6% rate applies to 2013 incomes in excess of $397,000.
Under President Obama’s proposal, the 2013 rates would change as follows:
Capital Gains and Dividends
Without Congressional action, the tax rates on capital gains and dividends are scheduled to increase significantly after 2012. For 2012, taxpayers in the 10% and 15% tax brackets pay zero tax on capital gains and qualified dividends. All other taxpayers pay a rate of 15%. Starting in 2013, these favorable rates will be replaced by the pre-2003 capital gain rate of 10% for taxpayers in the 15% bracket, and a maximum rate of 20% for all other taxpayers. A reduced rate of 18% will apply to property held for five or more years (8% for those in the 15% bracket). The tax rate on dividends, on the other hand, will revert to being taxed at the ordinary income tax rates.
The higher capital gain and dividend rates beginning in 2013 could be aggravated by the introduction of the new 3.8% Medicare contribution tax on unearned income beginning on January 1, 2013. This Medicare surtax will be imposed on a high-income taxpayer’s net investment income (i.e., single with AGI of $200,000 or $250,000 for married taxpayers). For these high-income taxpayers, the Medicare surtax adds significantly to the overall tax rate on capital gains and dividends.
Expiring Tax Provisions
December 31, 2012 marks an uncertain expiration date for a number of tax incentives for businesses. Whether the lame duck Congress will extend any of these provisions or whether they will be put before the new Congress for extension is uncertain at this time.
The most notable tax incentives for businesses facing a December 31, 2012 expiration date are:
- 50% Bonus depreciation, and
- Code Section 179 Expensing
50% bonus depreciation is scheduled to expire on December 31, 2012. Thus, if taxpayers wish to take advantage of the bonus depreciation rules for 2012, any equipment eligible for bonus depreciation must be placed in service, not just purchased, by year-end. However, since bonus depreciation is not mandatory, some taxpayers may benefit from electing-out of bonus depreciation to spread depreciation deductions out over years with higher tax rates.
The dollar limitations of Code Section 179 Expensing are scheduled to fall quite dramatically after 2012. Currently, Section 179 gives businesses the opportunity to deduct $139,000 of the cost of qualified equipment purchases in the year of purchase with a $560,000 investment ceiling. The Section 179 dollar limit is scheduled to drop to $25,000 for 2013 with a $200,000 investment ceiling. Accordingly, businesses will want to be sure to accelerate at least $139,000 of equipment purchases into 2012 to take full advantage of the higher deduction available for 2012.
It should be noted that the research tax credit expired after 2011. Traditionally, this credit has been retroactively extended many times over the years due to substantial bipartisan support. Accordingly, there is high probability that Congress will reinstate the credit for 2012.
Because of the unusual complications and uncertainty surrounding the tax law for 2013 at this time, we would advise all business owners and high-net-worth individuals to meet with their tax advisors at their earliest convenience to devise a game plan that can adapt to each of the possible scenarios regarding 2013 tax rates.
Hopefully, Congress can reach an acceptable compromise on spending and taxes to avoid taking the nation over the “fiscal cliff.”
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