Congress Answers Many Long-Standing Tax Questions With Fiscal Cliff Legislation

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In addition to nailing down individual income tax rates after 12 years of considering them temporary, Congress's New Year's Day moves also remedied several of the biggest headaches for taxpayers by eliminating the need for an annual alternative minimum tax patch and setting a new permanent rate for the estate tax.

In late Jan. 1 action, the House voted 257-167 to send President Obama legislation (H.R. 8) that locked in the six marginal income tax rates established in 2001 and created a new, seventh 39.6 percent tax bracket that kicks in at $400,000 for individuals and $450,000 for married couples filing jointly.


Calling the tax code a “nightmare,” Rep. Dave Camp (R-Mich.) said, “We can and will do comprehensive tax reform this year, in 2013.”

While the notion of raising taxes on anyone was deeply unpopular among Republicans--who voted nearly 2-1 against the bill--the legislation did provide long-sought certainty on key tax issues.

House Ways and Means Committee Chairman Dave Camp (R-Mich.) was among those voting for the Senate-crafted compromise, arguing that getting most of the tax cuts championed by Republicans in 2001 and 2003 made permanent was a significant win.

“Over a decade ago, Republicans acted to provide working Americans with substantial tax relief. That tax relief included lower tax rates, an enhanced child tax credit, and relief from the marriage penalty, just to name a few provisions,” Camp said. “Today, we have acted to make those tax cuts permanent--protecting middle-class Americans from the higher tax rates that were in place when President Bill Clinton occupied the White House.”

President Obama is expected to sign the bill as soon as the evening of Jan. 2.

R.I.P. AMT Patch.

One of the regular late-session activities for Congress in recent years has been the need to index the alternative minimum tax exemption levels to inflation in order to prevent it from sweeping millions of additional middle-income households into the parallel tax system, but the passage of the American Taxpayer Relief Act will end that rush to action.

While Congress is always eager to avoid allowing the AMT to capture additional taxpayers, late action to pass the patch creates added anxiety among tax preparers and the Internal Revenue Service, which will need up to a few weeks to update computer systems and process changes in the law.

In a Dec. 19 letter to Congress, Acting IRS Commissioner Steven Miller warned that without a patch, as many as 100 million taxpayers could experience delays or complications in filing their tax returns in 2013 (244 DTR G-1, 12/20/12).

One of the key concerns about the annual AMT patch is its cost, which has steadily risen to approach nearly $100 billion per year. Although some lawmakers have argued that the cost of the patch is a misnomer since no one in Congress ever expects to allow the inflation adjustment to expire and collect the tax money, official budget scoring rules require that the cost be added to the budget deficit.

Nearly half--$1.8 trillion--of the $3.9 trillion cost of the entire American Taxpayer Relief Act is eaten up by permanently indexing the AMT to inflation, according to the Joint Committee on Taxation.

Estate Tax Permanent at 40 Percent Rate.

The bill also ends uncertainty about what would happen to the estate tax, which was poised to return to a 55 percent tax rate and a $1 million per person exemption level for 2013.

Instead, the measure makes permanent the current $5.12 million per spouse exemption, indexed for inflation, and raises the tax rate from 35 percent to 40 percent. It also makes permanent a 2010 provision extending a portability law that allows a spouse to transfer his or her estate tax exemption to a surviving spouse.

The 40 percent tax rate was set as a compromise between Senate Minority Leader Mitch McConnell (R-Ky.) and Vice President Joe Biden. McConnell wanted to continue 2012's 35 percent rate and Biden wanted to move back to the 2009 level of a 45 percent tax rate and $3.5 million exemption level.

Lawmakers also compromised to set capital gains and dividends tax rates at permanently lower levels as part of the package. Individuals earning more than the $400,000/$450,000 threshold will see their capital gains and dividends taxed at a 20 percent rate, but the top rate for those with incomes below those levels will remain at 15 percent under the bill.

Critics of the president's tax policies were quick to point out that the highest earners will actually see the top rate rise to 23.8 percent because of the 2010 health care overhaul's additional 3.8 percent investment tax on individuals earning more than $200,000 ($250,000 for joint filers).

Even so, the agreement came as a relief to investors that rely on dividend-paying stocks. Without the bill, dividends would have been taxed at ordinary income tax rates.

“We are pleased that the final agreement recognizes that our tax code should not pick winners and losers--that we should treat dividends and capital gains equally,” said Edison Electric Institute President Tom Kuhn. “While there is still more work to be done to reform our tax code, Congress and the administration took the necessary steps to prevent the largest tax increase in history from occurring, a tax increase that would have affected virtually every American.”

In addition to those changes, the bill makes permanent the $1,000 child tax credit, marriage penalty relief, and a modification and simplification of the Earned Income Tax Credit. The bill also includes a repeal of the personal exemption phaseout and the limitation on itemized deductions for adjusted gross incomes of less than $250,000 for individuals or $300,000 for joint filers.

Expiration of Payroll Tax Cut Allowed.

One tax provision that was left unaddressed in the package and is likely to be felt by a broad swath of middle- and lower-income taxpayers is the expiration of the payroll tax cut.

The Tax Policy Center said in a Jan. 1 analysis that taxes will rise on approximately 77 percent of households because of the expiration of the 2 percent payroll tax cut. The employee side of the tax reverted to 6.2 percent Jan. 1, reducing paychecks for a typical family by about $80 per month.

Congress did, however, include a one-year extension of emergency unemployment benefits as well as a one-year extension of provisions to prevent doctors' payments from Medicare from being cut. The bill also includes a two-month delay in the automatic $1. 2 trillion in spending cuts known as the sequester.

With few opportunities on the near-term horizon for future tax bills, lawmakers included more than $46 billion in traditional so-called tax extenders that business interests have been lobbying for extensions of during the past two years, including the $14.3 billion research and development tax credit covering tax years 2012 and 2013.

Also included in the package is the New Markets Tax Credit; the Work Opportunity Tax Credit; an extension of the 15-year straight-line cost recovery for qualified leasehold, restaurant, and retail improvements; the controlled foreign corporation look-through rule; and the subpart F exception for active financing, which was the second most expensive business extender at a cost of $11.2 billion.

The compromise includes $12 billion in tax breaks for individuals, such as a deduction for state and local sales taxes at a cost of $5.5 billion, the above-the-line deduction of up to $250 for teacher classroom expenses at a cost of $406 million, and the reinstatement of parity for employer-provided mass transit and parking benefits at a cost of $220 million.

Mortgage Forgiveness Provision Extended.

Lawmakers included a provision important to both Democrats and Republicans that would extend through 2013 a law that allows taxpayers to exclude up to $2 million of forgiven debt on their principal residence as long as the discharge of debt is directly related to a decline in the residence's value or in the financial situation of the taxpayer. The extension, with a cost of $1.3 billion, was pushed by many tax writers including Rep. Tom Reed (R-N.Y.) and Rep. Jim McDermott (D-Wash.).

Reed said that although he hoped for a longer extension of it, “having it the one year allows us to be a part of the conversation of comprehensive tax reform and knowing that we're going to do comprehensive tax reform, this is an issue that I will be very interested in and making sure it is part of the conversation.”

Additionally, negotiators included $18 billion in extensions of temporary tax measures related to the energy industry, including a $12 billion extension of the renewable electricity production tax credit.

Finally, it includes a provision that would raise $12 billion by allowing Section 401(k) account holders to convert some of their funds into Roth individual retirement accounts. The money raised is meant to offset half of the cost of the two-month sequester delay.

Tax Reform Still the Goal.

With all of the changes in the bill--some of which add further complexity to the tax code--congressional tax writers said they will still work on overhauling the Internal Revenue Code in 2013.

Prior to floor passage, Camp said the compromise package represents a “first step” on taxes, with the second step coming later this year when Congress reforms the tax code.

The tax code is a “nightmare” and Congress needs to make it simpler and fairer for families and small business, Camp said, adding that lawmakers also must make significant changes to international tax provisions to help America compete in the global marketplace.

“We can and will do comprehensive tax reform this year, in 2013,” Camp said.

Moving on to tax reform has been a top goal of both Republicans and Democrats in both chambers of Congress, and Obama expressed an openness during negotiations with House Speaker John Boehner (R-Ohio) to embark on both corporate tax reform aimed at improving international competitiveness and individual taxes to simplify the code.

The legislation to prevent an across-the-board tax increase is welcome for now, analysts said, but it is a short-term fix that needs to be better addressed with major reforms.

“The administration and Congress did what was politically easy but will soon have to return to deal with issues that are economically critical if we are to sustain a growing and vibrant economy,” said Matthew Shay, president of the National Retail Federation. “Congress and the White House still need to develop long-term plans dealing with tax reform and other fiscal issues. We have avoided the immediate crisis, but there's much more to be done before our economy is fully restored.”

Likewise, Erskine Bowles, a former chief of staff to President Bill Clinton, and former Sen. Alan Simpson (R-Wyo.), said in a joint statement that the bill represents a “truly missed opportunity” to take real action to reduce long-term fiscal problems.

“Future negotiations will need to make the far more difficult reforms that bring spending further under control, make our entitlement programs sustainable and solvent, and reform our tax code to both promote growth and produce revenue,” Bowles and Simpson said. “We take some encouragement from the statements by the President and leaders in Congress that they recognize more work needs to be done.”

By Brett Ferguson and Heather M. Rothman  


Texts of H.R. 8 and the JCT report (JCX-1-13), Estimated Revenue Effects of the Revenue Provisions Contained in an Amendment in the Nature of a Substitute to H.R. 8, the 'American Taxpayer Relief Act of 2012,' as Passed by the Senate on Jan. 1, 2013, are in TaxCore.