U.S. Individual Tax Changes and Reforms

Implications of the American Taxpayer Relief Act of 2012 and the Affordable Care Act of 2010

Although many taxpayers are aware of the significant individual income tax reform enacted by the American Taxpayer Relief Act of 2012 (ATRA), some might have forgotten the federal income tax impact of the Patient Protection and Affordable Care Act of 2010 (ACA), which is still being phased in. The ensuing discussion will focus on the effects of these reforms for individual taxpayers.

Background

During President George W. Bush's tenure in office, Congress passed two significant acts that effectively decreased federal income taxes. The most popular legislative changes were reductions in the ordinary income tax rate and the capital gains rate. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) lowered the top ordinary individual federal income tax rate from 39.6% to 35%. In addition, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) decreased the capital gains tax rate to 5%, and eventually to 0% in 2008 (or 15%, depending upon an individual's marginal income tax rate). Furthermore, certain dividend income could be taxed at these lower capital gains rates.

The Bush-era tax cuts were scheduled to sunset as of December 31,2010; however, President Barack Obama supported the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which extended the ordinary income tax rate and capital gains tax rate reductions for two more years. This act also provided a significant payroll tax holiday for individuals, decreasing the normal employee Federal Insurance Contribution Act (FICA) payroll tax rate from 6.2% to 4.2%.

In 2012, the United States found itself moving toward the "fiscal cliff' as a number of major fiscal events loomed. The Bush-era tax cuts and the payroll tax reduction were scheduled to expire for all Americans on December 31, 2012. In addition, the deadline for the first installment of the $1.2 trillion cuts agreed upon by the bipartisan deficit reduction agreement was approaching, and an increase in the debt ceiling limit still had not been agreed upon. Some feared that the decrease in spending by the U.S. government and the increase in individual income taxes would send the U.S. economy into another recession. More and more Americans felt uneasy about spending because of the uncertainty surrounding their 2013 tax liability, a result of the unsettled legislative environment. In order to address one of the major concerns entailed in the fiscal cliff and provide reassurance to individual income taxpayers, Congress passed the ATRA.

Although the ACA was enacted on March 23,2010, many significant individual federal income tax provisions did not go into effect until January 1,2013. Included in the act were two noteworthy tax provisions for individual taxpayers: the net investment income tax and the additional Medicare tax. In order to assist in funding the ACA, an additional 3.8% tax will be assessed on net investment income and an additional 0.9% withholding tax will be applied for certain individual taxpayers for tie 2013 tax year and beyond.

Ordinary Income Tax Rates

For the 2012 taxable year, the maximum federal individual income tax rate on ordinary income was 35%; however, the top ordinary income tax rate was increased to 39.6% under the ATRA. This top marginal rate applies to individuals whose taxable income exceeds $450,000 (married filing jointly and surviving spouse), $425,000 (head of household), and $400,000 (single filers). As a result, individual income taxpayers who make less than the defined amount will not see an ordinary income tax rate change from 2012 to 2013. Taxpayers who make more than these amounts will be subject to an increased federal ordinary income tax rate of 39.6% (see Exhibit 1).

Personal Exemptions and Itemized Deductions

High-income taxpayers and their advisors should not assume that the ATRA will only affect those with taxable income between $400,000 and $450,000. After being completely eliminated with the Bushera tax cuts, reduced personal exemptions and itemized deductions will again impact certain individuals. For the 2013 tax year, if a taxpayer's adjusted gross income (AGI) exceeds a defined amount, the taxpayer's personal exemptions and itemized deductions will generally be reduced (shown in Exhibit 2). The personal exemption phaseout reduces the personal exemption amount by 2% for each $2,500 (or portion thereof) by which the taxpayer's AGI exceeds the defined amount. For example, if two taxpayers who are married filing jointly have an AGI of $350,000 and two dependents, they would be allowed four personal exemptions, or $15,200 ($3,800 x 4) for the 2012 taxable year. Under the same circumstances in 2013, however, the $15,200 of personal exemptions would be limited to $9,120, because the taxpayer's AGI would exceed the defined limit by $50,000 ($350,000 - $300,000). For each $2,500 of the $50,000 excess, the personal exemption amount would be reduced by 2%. Therefore, the exemption amount would be reduced by 40%, or $6,080 ($15,200 x 20 x 2%) and the allowable deduction would only be $9,120 ($15,200 - $6,080).

Taxpayers' itemized deductions will also be phased out in 2013 by the amount of AGI in excess of the defined amount, multiplied by 3%; however, the entire phaseout cannot exceed 80% of otherwise allowable itemized deductions. Itemized deductions related to medical expenses, investment interest, or casualty and theft losses are excluded from this limitation. For example, if two taxpayers who are married filing jointly have an AGI of $550,000 and $60,000 of itemized deductions subject to the phaseout, their 2013 itemized deductions would be reduced. Their AGI would exceed the defined amount by $250,000 ($550,000 - $300,000); when multiplied by 3%, this results in a reduction of $7,500 ($250,000 x 3%). Because no phaseout for itemized deductions was in place for 2012, the taxpayers would previously have been allowed the entire $60,000 deduction; in 2013, they would only be allowed $52,500 ($60,000 - $7,500) of itemized deductions when calculating their 2013 taxable income.

Investment Income

The most misunderstood modification to individual federal income tax is related to the taxation of investment income. Not only did the ATRA adjust the capital gains tax rate; the ACA also enacted a 3.8% net investment income tax for certain individuals.

Under prior law, certain investment income was taxed at preferential rates. Gains derived from selling stocks or bonds held for longer than one year (i.e., longterm capital gain income) were not subject to ordinary income tax rates, but were instead taxed at a 0% or 15% rate. In addition, certain dividend income-generally dividends received from a domestic corporation and where the stock had been held for a certain period of time-was also taxed at the reduced capital gains rates. For individuals with an ordinary marginal tax rate of 15% or less, the capital gains tax rate was 0%, whereas individuals with a marginal tax rate above 15% were subject to a capital gains tax rate of 15%. The ATRA increased the 15% capital gains tax rate to 20% for individuals in the 39.6% bracket. The 0% and 15% capital gains rate will remain the same for taxpayers with a marginal ordinary income tax rate of less than 39.6%.

The change in taxation of investment income is affected by the ACA (Internal Revenue Code [IRC] section 1411). In general, an additional tax of 3.8% will apply to investment income if a taxpayer's AGI is greater than $250,000 (individuals married filing jointly or surviving spouse), or $200,000 (head of household or single filer). The additional application of the 3.8% tax will be limited to the lesser of the investment income or the amount that AGI exceeds the defined amount.

It is important to note that although investment income is generally defined as long-term capital gains income and qualified dividend income, the ACA provides a much broader definition, which includes interest, annuities, dividends, royalties, and rents that are not derived from the ordinary course of trade or business. In addition, net investment income includes gross income derived from a trade or business that is characterized as passive in nature.

The combination of both the ATRA and the ACA has created four different tax rates that could apply to qualified dividend income and long-term capital gains rates:

* 0% for taxpayers with a 10% or 15% marginal income tax rate

* 15% for taxpayers with a marginal tax rate above 15% but below 39.6%, with AGI less than $250,000 (married filing jointly or surviving spouse) or $200,000 (head of household or single filer)

* 18.8% (15% + 3.8%) for taxpayers with a marginal tax rate above 15% but below 39.6%, with an AGI above $250,000 (married filing jointly or surviving spouse) or $200,000 (head of household or single filer)

* 23.8% (20% + 3.8%) for taxpayers with a marginal tax rate of 39.6%.

For example, consider two taxpayers who are married filing jointly and have taxable income greater than $450,000, including qualified dividend income of $15,000 and long-term capital gain income of $20,000; they would see a significant increase in taxes related to their net investment income. In 2012, the maximum tax rate that applied to capital gain income was 15%. Therefore, only $5,250 ($35,000 x 15%) of federal income tax was due, related to the qualified dividend income and long-term capital gain income; however, because the taxpayers' marginal tax rate would be 39.6% in 2013, the tax rate on capital gain income would increase to 20%, or $7,000 ($35,000 x 20%). In addition, because the taxpayers' AGI was greater than $250,000, the investment income would also be subject to an additional 3.8%, or $1,330 ($35,000 x 3.8%). Therefore, the taxpayers would have an increase of $3,080 ($8,330 - $5,250), representing 8.8% of their qualified dividend and long-term capital gain income.

Payroll Tax

The decision to not extend the payroll tax holiday resulted in the ATRA's biggest impact. The Tax Relief Act of 2010 had provided a reduction, from 6.2% to 4.2%, in Social Security tax paid by employees for the 2011 and 2012 taxable year. Selfemployed individuals could reduce their Social Security tax from 12.4% to 10.4%, which included the employee's reduced rate of 4.2% and the employer's rate of 6.2%. Social Security is normally considered a regressive tax because it is only assessed up to the maximum wage base, which was $110,100 for the 2012 taxable year. Any amount earned over the $110,100 for the 2012 taxable year was not subject to Social Security tax.

The decision not to extend the payroll tax holiday has had a significant impact on individual taxpayers' after-tax pay. For the 2012 tax year, the maximum amount of Social Security payroll tax savings for an individual earning $110,100 or more was $2,202; for a family with two individuals making $110,100, it was $4,404 (see Exhibit 3).

In addition to the removal of the payroll tax holiday, the ACA also increased payroll taxes on wages and self-employment income. If a married filing jointly return includes wages and self-employment income that exceeds $250,000 ($200,000 for other filers), an additional 0.9% Medicare tax will be applied on the earnings that exceed the defined amount. The additional 0.9% Medicare tax could raise potential problems for married individuals (if both spouses are working) because the tax is imposed on joint spousal income exceeding $250,000; the separate employers of each spouse will be incapable of determining when the joint limit is met.

Due to the payroll tax changes initiated for the 2013 taxable year, a married filling jointly return with $450,000 in wages ($225,000 per spouse) will face a payroll tax increase of approximately $6,400. With the payroll tax holiday expired, each individual is subject to an additional 2% of Social Security tax on wages up to the 2013 maximum wage base of $113,700. Therefore, the couple's after-tax pay will decrease by $4,458 ($113,700 x 2% x 2 individuals), due to the expiration of the payroll tax holiday. In addition, the couple will have to pay an additional 0.9% of Medicare tax ($1,800) on earnings that exceed $250,000 ([$450,000 - $250,000] x 0.9%).

Budgetary Concerns

There are differing opinions on how the ATRA will affect the U.S. federal budget deficit, depending upon the baseline used for the analysis. The Congressional Budget Office's baseline scenario is dependent upon the Bush-era tax cuts expiring for all individuals as of December 31, 2012, thereby increasing federal income tax for the majority of individuals. Using this baseline scenario, the ATRA, which limited the increase in individual income taxes to a defined group, is estimated to have increased the U.S. deficit by approximately $4 trillion over the next 10 years, not including further borrowing costs (http://msnbcmedia. msn.com/i/MSNBC/Sections/NEWS/ AJDocs/130104_CliftAnalysis.pdf).

On the other hand, the president and the Treasury Department use a "current policy baseline" to measure an act's effect on the U.S. deficit. This baseline assumes that the policy in place at the end of 2012 would remain in existence going forward-specifically, that the Bush-era tax cuts would continue. Therefore, any legislation passed that would increase revenue, such as the higher individual income and capital gains tax rates, would decrease the deficit. Using the current policy baseline, the Treasury estimated the deficit would be reduced by $737 billion over the next 10 years (Mike Godfrey, "Analysts Differ over ATRA's Deficit Impact," Tax-News, http://www.taxnews.com/news/Analysts_Differ_Over_ ATRAsDeficitlmpact 59056.html).

Regardless of whether the ATRA will increase or decrease the deficit over the next decade, both political parties agree that additional changes are needed in order to create a balanced budget. Recent events- including the partial government shutdown in October; the extension of the government budget to only January 7, 2014; and the need to again address the debt ceiling by February 7, 2014-clearly reflect that the budgetary concerns of the U.S. federal government remain unresolved. The ATRA is only the beginning of significant changes to federal income taxes, with corporate tax reform being the next most likely target for raising additional revenue. ?

The most misunderstood modification to individual federal income tax is related to the taxation of investment income.

There are differing opinions on how the ATRA will affect the U.S. federal budget deficit, depending upon the baseline used for the analysis.

Lynn Mucenski-Keck, CPA, is an assistant professor of accounting at St. John Fisher College, Rochester, N.Y.