Overview of the American Taxpayer Relief Act of 2012 and Some Important Estate Planning Opportunities for High Net Worth Individuals
On January 2, 2013, President Obama signed the American Taxpayer Relief Act of 2012 (the “Act”). While the Act increases income taxes for certain high-income individuals, it also avoids several other tax rate increases and extends certain tax benefits. The following is a sampling of the key elements of the new tax law:
- Income Tax Rates. Ordinary income tax rates for individuals will remain at 10%, 15%, 25%, 28%, 33% and 35%, but a 39.6% rate will apply to income in excess of $450,000 for joint filers and qualifying widow(er)s; $425,000 for heads of household; $400,000 for single filers; and $225,000 for married taxpayers filing separately. These dollar amounts will be inflation-adjusted for tax years after 2013. However, the income threshold for application of the 39.6% rate to non-grantor trusts remains very low (e.g., $11,650 in 2012), so trustees of non-grantor trusts will have even greater incentives to distribute trust income to beneficiaries in lower tax brackets in 2013 and beyond.
- Estate Tax. The new law prevents steep increases in estate, gift and generation-skipping transfer (“GST”) tax that were slated to occur for individuals dying and gifts made after 2012 by keeping the exemption levels at $5,000,000 (indexed for inflation). The 2013 level, while not yet official, has been estimated to be $5,250,000. However, the new law increases the top estate, gift, and GST rate (for transfers in excess of the exemption amounts) from 35% to 40%. It also continues the portability feature that allows the estate of the first spouse to die to elect to transfer his or her unused estate and gift tax exemptions (but not his or her unused GST exemption) to the surviving spouse. For states that impose a separate state estate tax (including Maryland and the District of Columbia), the combined effective estate tax rate could approach 50%. Thus, lifetime gifts continue to be an excellent planning technique to avoid state estate taxes and to remove future appreciation from the taxable estate, since most states do not impose a separate gift tax on lifetime transfers. With the inflationary increases in the exemption levels, clients who attempted to exhaust their gift and GST tax exemptions in 2012 will have some additional exemption to work with in 2013 and beyond. Note that unrelated to the new law, the annual gift tax exclusion for 2013 has increased to $14,000.
- Capital Gains and Qualified Dividends Rates. The top rate for capital gains and dividends will increase to 20% (up from 15%) for taxpayers with incomes exceeding $400,000 (single) or $450,000 (joint filers). For taxpayers whose ordinary income is generally taxed at a rate below 25%, capital gains and dividends will be subject to a 0% tax rate. The rate of 15% will continue to apply to taxpayers subject to at least a 25% rate of tax on their ordinary income, but whose income is below the $400,000/$450,000 thresholds. It should be noted that the 20% top rate does not include the new 3.8% surtax on investment-type income and gains for tax years beginning after 2012, which applies on investment income above $200,000 (single) and $250,000 (joint filers) in adjusted gross income. So actually, the top rate for capital gains and dividends beginning in 2013 will be 23.8% if income falls in the 39.6% tax bracket. For lower income levels, the tax will be 0%, 15%, or 18.8%.
- Personal Exemption Phaseout. Beginning in 2013, personal exemptions will be phased out (i.e., reduced) for adjusted gross income over $250,000 (single), $275,000 (head of household) and $300,000 (joint filers). Taxpayers claim exemptions for themselves, their spouses and their dependents. Last year, each exemption was worth $3,800.
- Itemized Deduction Limitation. Beginning in 2013, itemized deductions will be limited for adjusted gross income over $250,000 (single), $275,000 (head of household) and $300,000 (joint filers). For taxpayers subject to the limitation on itemized deductions, the total amount of their itemized deductions is reduced by 3% of the amount by which the taxpayer’s adjusted gross income exceeds the threshold amount, not to exceed 80% of the otherwise allowable itemized deductions.
- AMT Relief. The new law provides some alternative minimum tax (“AMT”) relief for certain taxpayers. The AMT is the excess, if any, of the tentative minimum tax for the year over the regular tax for the year. The tentative minimum tax is calculated by modifying a taxpayer’s taxable income with various adjustments and preferences, and then subtracting an exemption amount. Prior to the Act, the individual AMT exemption amounts for 2012 were to have been $33,750 for unmarried taxpayers, $45,000 for joint filers, and $22,500 for married persons filing separately. Retroactively effective for tax years beginning after 2011, the new law increases these exemption amounts to $50,600 for unmarried taxpayers, $78,750 for joint filers and $39,375 for married persons filing separately. In addition, for tax years beginning after 2012, it indexes these exemption amounts for inflation.
- Tax Break Extenders. Many of the “traditional” tax extenders are extended for two years, retroactively to 2012 and through the end of 2013. Among many others, the extended provisions include the election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes.
- Payroll Tax Cut Expires. The 2% payroll tax cut was allowed to expire at the end of 2012.
What the Act Did Not Do: Although the Act prevented the steep increases in estate, gift and GST tax that were slated to occur after 2012, it did not implement various other transfer tax changes that had been suggested by the Obama administration as part of its annual federal budget proposals, including (i) the imposition of a 10-year minimum term for grantor retained annuity trusts; (ii) inclusion of grantor trust assets in the taxable estate; (iii) limits on the duration of the GST tax exempt status of dynasty trusts; and (iv) elimination of valuation discounts for transfers of interests in family-owned entities. However, these proposals may emerge as options to raise revenue in the future as Congress continues to look for ways to reduce the deficit.
Observation: As previously noted, the Act will increase, directly or indirectly, the rate of tax applicable to certain high income taxpayers in 2013 and thereafter by the combination of the increase in the highest marginal rate to 39.6% and the limitation on itemized deductions and personal exemptions. However, if the taxpayer would otherwise be subject to the alternative minimum tax (for example, because he or she pays significant state residential real estate tax and state income tax), the direct and indirect increase in regular taxes may have only a comparatively modest impact, or even no impact, on the taxpayer’s tax liability, depending upon the taxpayer’s particular facts.
Planning Opportunity: In 2011 and 2012, many of our clients made substantial gifts in trust for the benefit of children and grandchildren, and in some cases also for the benefit of spouses, in order to take advantage of the large gift tax and GST tax exemptions available in those two years. Apparently as a trade-off for income tax increases, the Act continues these large exemptions on a supposed permanent basis for 2013 and thereafter. Most of the 2011 and 2012 trusts were drafted as grantor trusts. In February and March of this year, the Republican controlled House, Democratic administration and Democratic controlled Senate will negotiate spending cuts desired by House Republicans. We may witness another trade-off in which spending cuts are exchanged for elimination of perceived tax loopholes. As noted above, based on prior proposals by the Obama administration, elimination of perceived loopholes may include elimination of valuation discounts for family-controlled entities; term limits on long-term dynasty trusts for grandchildren and subsequent generations of lineal descendants; and most important, the inability to utilize a grantor trust for, on the one hand, selling assets to the trust without income tax consequences and, on the other hand, shielding the trust assets from estate tax. However, there is still time to leverage grantor trusts created in 2011 or 2012 — and even grantor trusts to be created in January of 2013 for those who did not fully utilized their gift tax exemption in 2011 and 2012 — by selling interests in closely-held family entities or other investment interests to a grantor trust in exchange for a long-term promissory note from the trust. The leverage can be substantial and could involve the sale of assets having up to ten times the value of the corpus of the grantor trust. If the interests sold have a potential for an increase in value (for example, interests in entities owning commercial real estate whose present value is below projected values several years hence), the estate tax savings could be very large. Because of the potential legislation, perhaps as early as March, any such sales should be made promptly, in this month of January if possible.
If you would like more details about these provisions or any other aspect of the new law, or if you would like to schedule an appointment to discuss your estate plan in light of the new law, please contact a member of our Wealth Planning & Management team.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.