EXECUTIVE SUMMARY
On December 17, 2010, President Obama signed into law the Unemployment Insurance Reauthorization and Job Creation Act of 2010 (H.R. 4853 – 2010 Tax Relief Act). In addition to extending the Bush-era tax cuts, the new law also provides for an Alternative Minimum Tax (AMT) “patch,” a one-year payroll tax cut, 100 percent bonus depreciation through 2011 and additional income tax breaks. The new law adopts a 24-month tax vacation for decedents dying in 2011 – 2012, implementing a new 35 percent tax rate, a $5 million exclusion (per person) and additional short-term relief detailed below.
From a tax planning perspective, we believe the following are critical for our friends and clients to consider over the next three years:
- Business owners contemplating expansion of existing property, plant or equipment must critically focus on the timing of the acquisition and financing with the new depreciation rules.
- Business owners assessing the growth of their enterprise through mergers or acquisitions, or planning for organic growth need to consider structuring their affairs to qualify for potential tax-free stock disposition after the requisite holding period.
- Family businesses in transition have a limited window of high gift tax exemption, low transfer tax, re-instatement of the Qualified Family Owned Business incentives, and reduced payroll taxes before the health care surtaxes start in 2013.
- Business energy tax credits are significant and need to follow arcane application and qualification rules to qualify for incentives whether or not the project is commenced in 2010, 2011 or 2012.
- It has never been more critical for individual clients to maintain an ongoing tax projection for a rolling three-year horizon to ensure that proper timing is arranged to coordinate zero percent capital gains tax rates, a myriad of tax credits and AMT provisions that come and go. This is in addition to the normal timing of itemized deductions.
- For clients with estates above $1 million of net worth, it is critical to not ease up in planning for the reinstatement of the pre-2001 tax law ($1 million gift and estate tax exemptions; 55 percent top tax rate) on January 1, 2013. This is a subject that will be hotly debated in the 2012 presidential election year. It represents a relatively small amount of revenue for the government, but is heavy on social policy.
With literally hours remaining before the 2001 law sunset provision took effect, our legislators provided for the following detailed provisions:
BUSINESSES
Small Business Stock. The new law enhanced the gain exclusion from qualified small business stock to non-corporate taxpayers. For stock acquired after September 27, 2010, and before January 1, 2011, which is held for at least 5 years, the 2010 Small Business Jobs Act provides an exclusion of 100 percent. The new law extends the 100 percent gain exclusion for an additional year for stock acquired before January 1, 2012.
Impact. While investors need to be patient to take advantage of this benefit (i.e., they must hold the qualified shares for at least 5 years or rollover proceeds into other qualified shares), this is a rare opportunity to potentially exclude millions of dollars of gain on qualifying sales or exchanges of small business stock from federal income tax.
Requirements. The baseline to qualify for the exclusion includes, among other things:
Energy Incentives. The authority to provide grants in lieu of tax credits for certain projects is extended for one year through December 31, 2011. Generally, the property must be placed in service in calendar years 2009, 2010 or 2011, or construction of qualified property must start in that period and be completed before 2013 for wind energy property (or other dates for other types of energy).
Requirements. An application for a grant must be made before October 11, 2011.
Depreciation. The election to expense depreciable assets under Code Section 179 has been increased again, but the most expansive provision for businesses is the bonus depreciation provision. The new law boosts 50 to 100 percent bonus depreciation for qualified investments made after September 8, 2010, but before January 1, 2012.
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The new law works in concert with the October 2010 Small Business Jobs Act, increasing the Section 179 dollar and investment limits to $500,000/$2 million, respectively for tax years beginning in 2010 and 2011. The new law provides for a $125,000 dollar limit (indexed to inflation) and a $500,000 investment limit (also indexed) for tax years beginning in 2012 (but sunsetting after December 31, 2012).
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The $500,000/$2 million thresholds were scheduled to revert to $25,000/$200,000 respectively for tax years beginning in 2012 (neither amount indexed).
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Qualifying real property does not share in the expensing benefits allowed under the new law. Under the October 2010 tax law, a taxpayer can elect up to $250,000 of the $500,000 Section 179 deduction limit for qualifying real property for any tax year beginning in 2010 or 2011. The new law does not extend this treatment.
FEDERAL ESTATE TAX
The pre-2001 estate tax (maximum tax rate of 55 percent and $1 million exclusion amount) was scheduled to be re-instated on January 1, 2011. The new 2011 – 2012 estate tax regime has delayed this reinstatement until January 1, 2013. Highlights of the new law are as follows:
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For decedents dying in 2010, the estates have the option of electing to apply either the estate tax based upon the new law just passed (making it voluntarily retroactive to January 1, 2010), or to apply the estate-tax free, stepped-up basis regime previously legislated.
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For decedents dying in 2011 – 2012, estates below $5 million will be federal estate tax free but will pay a flat tax of 35 percent for the portion of their estate above $5 million.
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For decedents dying after 2012, the pre-2001 estate tax applies ($1 million exclusion; top tax rate of 55 percent).
Exemption Portability. The new law allows a surviving spouse to use the unused exclusion from the deceased spouse, by election at death. Again, to complicate matters for estate planners, portability is available for decedents dying after December 31, 2010, but sunsets on December 31, 2012.
Analysis. With careful estate planning, married couples can effectively shield $10 million from estate tax by providing that each spouse maximize his or her $5 million exclusion. However, the utility of this law is limited to situations where both spouses die within the two-year term. Also, this portability provision does not extend to the generation skipping transfer tax.
Gift Tax Relief. Gifts made in 2010 will be subject to an exclusion amount of $1 million. However, for gifts made after 2010, the gift tax is reunified with the estate tax with a new exclusion of $5 million. The presence of a $5 million gift exclusion in 2011 and 2012 provides what may be a limited window of opportunity to transfer wealth to succeeding generations during life time rather than upon death. Lifetime transfers are often preferred due to the ability to shelter both asset value and later appreciation from the imposition of estate tax on death. The value of such planning can be further leveraged through the use of split interest trusts which have, at least temporarily, survived despite prior threats to impose further restrictions by Congress.
INDIVIDUALS
Lower Individual Income Tax Rates. The 2001 law made across the board rate reductions and the 2010 Tax Relief Act keeps all of them, albeit only for 2 years, at an estimated price tag of about $186 billion. The president stated that he will make the sunset of the two highest brackets an issue in the 2012 presidential campaign. Also subject to debate in the next two years is the status of post-2012 health care taxes – higher income individuals will be faced with additional taxes after 2012 in the form of additional Medicare tax.
Example. An example of the tax cuts is as follows: An individual earning $50,000 in 2011 will see an approximate tax savings of $1,890 in combined income tax and payroll tax rate reductions ($890 and $1,000 respectively) over what was scheduled under the 2001 tax law that would have sunset at the end of 2010.
Lower Investment Income Tax Rates. Qualified capital gains and dividends currently are taxed at a maximum rate of 15 percent for 2010. The new law extends this treatment through December 31, 2012. Without the tax relief, the rate on qualified dividends also would have raised from 15 percent to the tax rates on regular income that threatened to reach as high as 39.6 percent. The new law also excludes 100 percent of the gain realized from “Qualified Small Business Stock” that is held for more than 5 years.
Planning Tip. While the extension of the lower capital gains rates received most of the publicity from the press, continuation of the zero percent rate will be equally as important to many taxpayers, from college students to retirees. To the extent that capital gains and dividends do not exceed the top of the 15 percent income tax bracket ($34,500 for singles; $69,000 for joint filers in 2011), those capital gains and dividends are effectively tax-free, subject to the zero percent rate.
Caution. Beware of installment payments, which are subject to the tax rates for the year of payment, not the year of sale. Even under the new law, watch out for capital gains from installment sales falling into the pre-2001 capital gains tax treatment after December 31, 2012.
Itemized Deductions. The 2010 Tax Relief Act extends the full repeal of the limitation of itemized deductions for two years, through December 31, 2012.
Extension of the Charitable IRA. The new law extends tax-free distribution from IRAs for charitable purposes and special rules for other contributions through 2011. This provision has been dormant since December 31, 2009, and has several other touch points to qualify for the tax-free distribution.
Marriage Penalty Relief. By increasing the basic standard deduction for a married couple filing a joint return to twice the amount for a single individual, the new law continues the dampening of the so-called marriage penalty. Under the old law’s sunset rules, the 2011 standard deduction for married couples filing jointly was projected to be $9,650. Under the new law, based upon our information, it will be $11,600 for 2011.
Tax Credits. From the American Opportunity Tax Credit to the Earned Income Tax Credit, expect numerous extensions and modifications as we move into 2011. These changes are too numerous to specifically identify in this article.
Example. While both the adoption credit and the exclusion amount phase out ratably for taxpayers with modified AGI between $182,520 and $222,250, these phase outs are now indexed for inflation; however, the 2010 Tax Relief Act does not extend the enhancements to the adoption credit and exclusion made by the Patient Protection and Affordable Care Act (PPACA). Therefore, the credit is not refundable for 2011 and 2012, and the additional $1,000 under the PPACA is not available after December 31, 2010.
Impact. The 2009 Recovery Act tripled the $500 individual energy credit to $1,500 and provided that previous 10 percent credits and other sub-capped items would be eligible for the full 30 percent credit up to $1,500. The new law does not renew any of these enhancements for 2011. Also, the so-called 25C credit for individuals remains nonrefundable under the new law.
Education. The $5,250 employee tuition reimbursement exclusion is still available, as it has now been extended 2 years, through December 31, 2012. Numerous other education incentives have also been extended, including Student Loan Interest Deduction, Coverdell Education Savings Accounts, Favorable Scholarship treatment and many others.
Comment. The amount of qualified tuition and related expenses for the higher education tuition deduction must be reduced for certain items. These include any exclusion from gross income for a Coverdell ESA and income from savings bonds used to pay higher education tuition and fees. Other limits also apply relating to the HOPE and Lifetime Learning credits.
Alternative Minimum Tax. The so-called “patch” has been put into place, without which, an estimated 21 million additional households would be subject to the AMT higher exemptions amounts and other targeted relief for 2010.
Payroll Tax Cut. The new law reduces the amount of the employee-share of the Social Security tax from 6.2 percent to 4.2 percent for wages earned in calendar year 2011 up to the taxable wage base of $106,800. Self-employed individuals would pay 10.4 percent on self-employment income up to the threshold.
Example. A $50,000 wage earner’s employee’s share of OASDI tax is reduced from 6.2 percent to 4.2 percent for 2011. Instead of paying $3,100 in OASDI tax for 2011, an individual would pay only $2,100, resulting in a $1,000 tax savings. The purpose of this payroll tax holiday is estimated to inject over $110 billion into the economy in 2011.
If you have questions about this article or other tax related issues, please contact your Davis & Kuelthau attorney