US Tax Law Changes: View from the Cliff

By Ken Meissner

(First of three parts)

First Published in Business World (4/15/2013)

Just as the US Congress was about to take US taxpayers over the cliff, standing by and allowing massive tax increases and across-the-board budget cuts to kick in under previous legislation, cooler heads prevailed. The parties agreed to a limited package of tax increases, revisions, and extensions of key provisions that were about to “sunset”, and that avoided the so-called “Fiscal Cliff.”

As a result, income tax rates will go up for a small number of high-income taxpayers. Some key elements of the tax law that have been a source of continuing uncertainty, with provisions that the US Congress had to keep revisiting and revising annually or biennially, have now gained some stability. In addition, some favorable provisions that many taxpayers had come to rely on have been given another year or two of life, setting the stage for more cliffhanger negotiations in 2014 or 2015. Here’s a rundown of key changes:

Income tax rates in general. Congress cut income tax rates for people at every income level back in 2001. However, due to some quirks in US tax legislation, they were able to put those rate cuts in place only through the end of 2010. When the older, higher tax rates and tax brackets were about to expire at the end of 2010, they managed to keep those lower rates in place for everyone, but only for two more years. Technically, everyone was pushed into the higher pre-millennium tax brackets at the stroke of midnight on December 31, 2012. In the early morning hours of January 1, 2013, the US Senate, and later on that same day, the US House of Representatives, passed the “American Taxpayer Relief Act” which President Obama signed into law. Here are the tax brackets that are now in place retroactive to January 1, 2013. Unlike before, these new brackets have no built-in expiration date. Most of the rates have not changed. The ones that have changed are shown here in boldface.

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* Before 2001, there was a so-called “marriage penalty,” because when two single people with jobs married, and both continued working, they often found the tax on their combined incomes was higher than the tax they paid when they were single. The 2001 rate cut law did not completely eliminate this marriage penalty, but it softened the penalty by expanding the 15% rate bracket for joint returns to twice the amount of the 15% rate bracket for single taxpayers. From 2011, the married couples’ 15% bracket was scheduled to revert to 1⅔ the size of the singles’ 15% bracket. Congress postponed this change for two years at the end of 2010. Now the more-generous 15% bracket for couples has been made permanent.

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No more “holiday” for Social Security Tax. The employee portion of the Social Security and Medicare Tax goes back up to a 6.2% rate. It had been temporarily reduced to 4.2% for 2011 and 2012. Employees in the US will see a small decrease in their 2013 paychecks as result of this provision.

Income tax rates on dividends and long-term capital gains. The 2001 rate cut law reduced the tax rate for long term capital gains to 15% for most taxpayers. Before that, it was 20% for most people. That 20% top rate has now been reinstated, but only for high-income taxpayers, whose top regular tax rate is now 39.6%. The more-favorable 15% rate (0% for some low-income taxpayers) has now been made permanent.
In 2003, most corporate dividends were made eligible for the same, low tax rates that applied to long-term capital gains — – a major exception applies to foreign corporations whose home countries do not have comprehensive income tax treaties with the US. There are also some holding period requirements designed to keep people from rapidly buying and selling stock, holding shares just long enough to harvest low-rate dividend income.

This reduced rate for most dividends—which was set to expire several times over the last decade—is now permanent. Most dividends are now subject to a maximum tax rate of 15%. High income taxpayers who pay a 20% rate on long-term capital gains will pay 20% on most dividend income as well.

What’s more, the zero percent rate for lower income taxpayers (US$72,500 for joint return filers and US$36,250 for singles) continues to apply, but with a slight change. Previously, if taxpayers exceeded the zero percent bracket threshold, the entire gain was subject to the 15% rate. Under the new law, the zero percent rate can still apply to capital gains and qualified dividends even if the taxpayer’s income exceeds the zero-bracket level.

New Tax on Net Investment Income for high income taxpayers
One significant new feature of US tax law starting in 2013 is not a result of the new Fiscal Cliff law. To help pay for some aspects of the new health care system often referred to as “Obamacare,” Congress has mandated a new tax on net investment income.

This tax, which applies to taxpayers with Adjusted Gross Income (AGI) above US$200,000 for single taxpayers or US$250,000 for joint filers, is 3.8%. It applies to the lower of two numbers: (1) all of a taxpayer’s passive and investment income, or (2) the portion of a taxpayer’s AGI that exceeds the relevant US$200,000 or US$250,000 threshold. Note that this tax applies based on the taxpayer’s adjusted gross income. In some cases, a taxpayer could have zero taxable income —– or even a net loss –— and still be subject to this tax if his gross income is high enough and his passive and investment income is a positive number. Investment income is generally defined for this purpose as interest, dividends and capital gains as well as passive income. Taxpayers should pay close attention to intercompany loans and personal loans to businesses. In some cases, the interest from such loans may unnecessarily create net investment income subject to the new 3.8% tax.

Over the next two weeks, we will continue to highlight the various significant features of the recent changes to US tax laws.

Ken Meissner is a Tax Senior Director of SGV & Co.

To ensure compliance with requirements imposed by the Internal Revenue Service (IRS) of the United States of America (US), we inform you that any US tax advice contained in this communication was not intended or written to be used, and cannot be used, by the recipient, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.