The 2012 American Taxpayer Relief Act Is Enacted

The Tax Act also ended the payroll tax holiday that was initially enacted in 2011 and extended until the end of 2012. The employee portion of the FICA tax reverts to the 6.2% rate from the reduced 4.2% rate of 2011 and 2012. Law firm employees will see a small decrease in their 2013 paychecks as result of this provision. Law firm payroll departments will need to make adjustments to employee withholdings due to the changes in income and payroll tax rates. The IRS has come out with new withholding tables to reflect the increased tax rates. The IRS has also instructed employers to start using the revised withholding tables and correct Social Security tax as soon as possible but no later than Feb. 15, 2013. For any Social Security tax under-withheld before that date, employers should make the appropriate adjustment as soon as possible, but not later than March 31, 2013.

Capital Gains/Dividends Rates

Under ATRA, the top rate for long term capital gains and qualified dividends increases from 15% to 20%. The 20% rate is applied to taxpayers in the 39.6% tax bracket ($450,000 for joint and $400,000 for single). All taxpayers below that threshold will continue to enjoy the Bush-era 15% tax rate. Additionally, the 0% rate for taxpayers at lower income levels ($72,500 for joint and $36,250 for single) continues to apply, however with a slight change. Previously, if attorneys and their clients exceeded the 0% bracket threshold, the entire gain was subject to the 15% rate. Under the current legislation, it is possible to have the 0% rate apply to the capital gains/qualified dividends even if the taxpayer's income exceeds that level.

Net Investment Income Tax

Although it's not part of the fiscal cliff legislation, lawyers and clients should watch out for the new 3.8% Net Investment Income Tax (NIIT) that was effective beginning Jan. 1, 2013. This tax, which applies to taxpayers with Adjusted Gross Income (AGI) above $200,000 for single or $250,000 for joint filers, consists of a 3.8% tax on the lesser of all passive and investment income, or the excess of AGI over the relevant threshold. Note that there is no taxable income limitation, so in certain circumstances, attorneys and their clients could still be subject to this tax even with no taxable income. Generally, investment income is defined as interest, dividends and capital gains as well as passive income. In the coming year, attorneys and clients 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 3.8% NIIT. To avoid an undue tax burden, please consult your tax adviser with regard to such loans.

Itemized Deduction and Personal Exemption Limitations

The Act revives the pre-Bush phase-out of personal exemptions and limitation on itemized deductions. The phase-out and limitation begin at AGI levels of $300,000 for joint filers and $250,000 for single filers. The personal exemption is reduced by 2% for every $2,500 by which the taxpayer's income exceeds the applicable threshold. The itemized deduction limitation otherwise known as the Pease limitation (named after the senator who originally sponsored this provision) reduces itemized deductions by 3% of the amount that AGI exceeds the aforementioned thresholds. However, itemized deductions cannot be reduced by more than 80%. Certain deductions such as medical expenses, investment interest, casualty and theft losses and gambling losses are not subject to the limitations. The effect of this phase-out is to add approximately 1% to attorneys and their clients' overall tax rates.

Alternative Minimum Tax Relief

ATRA provides permanent relief for middle class income taxpayers who would have otherwise been subject to the Alternative Minimum Tax (AMT). For 2012 and all subsequent years, the Act provides for an increased exemption amount and allows certain nonrefundable tax credits to offset AMT. For 2012, the exemption amounts are $78,750 for joint filers and $50,600 for single filers. These amounts are indexed annually for inflation. Without the legislation, the exemption amounts would have been $45,000 and $33,750 for joint and single filers respectively. For attorneys and their clients in AMT, the effective tax rate has not changed from 28% for ordinary income. Capital gains and qualified dividends will continue to be taxed at favorable rates (15% or 20%). Also, the Pease limitation discussed above is not applied to attorneys and their clients in AMT. As such, attorneys and their clients in AMT may not see an increase in their tax rates unless they are subject to the 20% rate on capital gains and qualified dividends as well as the 3.8% NIIT.

Gift and Estate Tax Relief

The most expensive tax break in the Act, to the tune of about $368 billion over 10 years, is the permanent extension of the $5 million gift and estate exemption ($5,250,000 for 2013, as indexed for inflation). In fact, the only change to the generous provisions enacted as part of Congress's 2010 taxpayer relief is an increase in the marginal estate tax rate to 40% from 35%. Because Congress averted the expected decrease of the exemption to $1 million in 2013, attorneys and their clients may rest assured that there will not be a “clawback” of taxes for gifts already made in 2011 or 2012. The new Act also permanently enshrines “portability,” the ability of a deceased to transfer his or her unused exemption amount to the surviving spouse. Thus, in the case of decedents who transfer all of their assets to a surviving spouse at death, a surviving spouse will be able to take advantage of up to $10.5 million of exemption, as indexed for inflation. Congress's gift of certainty in the transfer tax arena will be surely be a welcome one as attorneys and clients engage in estate planning in 2013. In addition, the annual exclusion for gifts increased to $14,000 per donee as of Jan. 1, 2013.

Individual Tax Relief

The Act extended a host of exclusions, deductions, and credits that expired in 2012. Some of these provisions are permanent and some have been temporarily extended.

Permanent Provisions

Permanent provisions of the Act include the employer-provided educational assistance exclusion, which will benefit associates at law firms that pay for law school tuition. An employee may exclude up to $5,250 of education assistance per year from his or her gross income, even if the assistance is for graduate tuition. Unfortunately, this amount does not change with inflation.

Attorneys and staff who wish to adopt a child will be happy to know that the adoption expenses credit and employer-provided adoption assistance exclusion are now permanent under the Act. The adoption expenses credit allows taxpayers with adjusted gross income up to $229,710 (subject to a phaseout) to offset federal income tax and AMT by up to $12,650 of adoption fees, court costs, attorney fees, and other expenses paid or incurred to adopt a child. As a bonus, if a law firm chooses to pay some adoption expenses, employees with AGI less than $222,520 (subject to a phaseout) may exclude up to $12,170 of these payments from income.

To benefit working parents who must pay for child or dependent care in order to maintain employment, the Act permanently extended the dependent care credit at Bush-era rates. Thus, for taxpayers with AGI above $45,000, the credit will permanently be available at a rate of 20% of the first $3,000 of care expenses for a single dependent, or the first $6,000 for two or more dependents. This translates into maximum tax savings of $600 to $1,200 for each year that the dependents qualify.

As a revenue-raising provision that doubles as a useful retirement planning tool, the Act now allows all traditional 401(k) and 403(b) retirement plan participants (subject to employers amending their plans) to rollover all or some of their balance to a Roth 401(k) or 403(b) account within the same plan, and pay tax on the rolled-over funds. Previously, only participants who had already reached age 59' could make such in-plan Roth conversions. This could be advantageous for younger attorneys and staff who will now be able to pre-pay the tax on their retirement account balances and enjoy a greater share of tax-free retirement income in the future.

Temporarily Extended Provisions

To the relief of attorneys and their clients who continue to ride out an uncertain real estate market, Congress extended the exclusion of cancellation of indebtedness income for qualified principal residence indebtedness until the end of 2013. Taxpayers who acquired debt to buy, build or improve their primary home may exclude up to $2 million of income from debt discharged in foreclosure or forgiveness. Also extended through 2013 is the ability to include mortgage insurance premiums as part of the itemized deduction for qualified mortgage interest.

Another temporarily extended itemized deduction provision is the state and local sales tax deduction. For 2012 and 2013, attorneys and staff in states without state income taxes or whose sales taxes are higher than income taxes for the year may choose to deduct sales taxes paid as an itemized deduction.

In a boon for attorneys and their staff who take public transit to work, the Act restores parity for employer-provided transit and parking benefits for one year. Thus, for 2013, law firms may provide tax-free money to employees for transit passes on a monthly basis up to the same dollar limit as tax-free parking benefits (currently $245, as indexed for inflation). There are various rules for administering and substantiating transit and parking benefit plans, so law firms that wish to offer this benefit for the first time should consult an employee benefits expert.

College tax breaks continue under the Act, including a five-year extension of the popular American Opportunity Tax Credit (AOTC) for college tuition. Although rarely used by higher-income families due to AGI limits, the return of the Personal Exemption Phaseout means that this credit deserves more attention in 2013. For attorneys with AGI over $250,000 single ($300,000 joint) who have limited benefit from personal exemptions, it may be more beneficial to simply forgo a dependency exemption and allow their college-enrolled children to take the credit against their own income tax instead (please note that the refundable part of the AOTC will still not be available as long as a dependent could be claimed). For some with AGI below $65,000 single ($130,000 joint), the above-the-line deduction for up to $4,000 of qualified tuition expenses may be a better deal. Congress extended the above-the-line deduction, which decreases to $2,000 for taxpayers with AGI of up to $80,000 ($160,000 joint), through Dec. 31, 2013. To get the highest benefit from these tax breaks, please consult your tax adviser.

Residential energy credits are back for a limited time, as well as a few other energy-efficiency and green energy credits. Through Dec. 31, 2013, attorneys and staff who purchase and install certain qualifying energy-efficient building components, water heaters, heat pumps or central air conditioners for a primary home can receive a credit for 10% of the amount paid, up to $500, or $200 for windows. The credit must be reduced by the amount of the credit from earlier years. Credits for two- or three-wheeled electric vehicles, the energy-efficient home credit for homebuilders, and credits for certain energy-efficient appliances are also available until Dec. 31, 2013.

Charitably minded attorneys and their clients who own historically or ecologically important real estate may benefit from the enhanced deduction for qualified conservation easements. For easements donated through Dec. 31, 2013, the carry-forward period for donations in excess of 50% of AGI is 15 years, versus five years for other donations to charity. Contributions with shorter time limits come first, so attorneys and their clients may take advantage of both their usual charitable giving and the deduction for conservation easements (up to the 50% AGI limitation) each year until it is used up.

Business Tax Relief

ATRA also extends many popular business tax breaks. 2013 may be a good year for law firms to consider capital improvements or fixed asset purchases. The Act extends for 2012 and 2013 the enhanced Section 179 expensing rules. Law firms can expense up to $500,000 of fixed asset additions with a $2 million investment limit. The 50% bonus depreciation was also extended through the end of 2013 as well as a 15-year straight-line depreciation period for qualified leasehold, restaurant and retail improvement property.

ATRA extends through 2013 the Work Opportunity Credit, which provides credits to employers that hire employees from certain targeted groups. The amount of the credit is generally 40% of the first year wages up to a maximum of $6,000. The credit for the hiring of a qualified veteran can be as much as $9,600.

Law firms operating as S corporations that were formerly C corporations may want to consider selling certain assets in 2013. The waiting period for built-in gains tax (entity level tax on S corporations that sell appreciated assets) has been fixed at five years for assets sales occurring in 2012 and 2013. Therefore, S corporations that converted in 2007 or earlier will not be subject to built-in gains tax on 2013 asset sales.

The Act also extended through 2013 the credit for Research and Development. This provision provides a credit for taxpayers who engage in qualified research activities.

Richard H. Stieglitz, CPA, a member of this newsletter's Board of Editors, is a Tax Partner and Martin Arking, CPA, is a Tax Manager in the New York accounting firm of Anchin, Block & Anchin LLP. They can be reached at 212-840-3456 or via e-mail at [email protected] and [email protected], respectively.

The President and Congress narrowly averted the fiscal cliff with the enactment of the 2012 American Taxpayer Relief Act (ATRA), which President Obama signed into law on Jan. 2, 2013. ATRA addresses the expiring Bush tax cuts as well as a number of other expiring tax provisions. The key elements of the tax legislation are an increase in individual tax rates for high income levels, a permanent patch for the alternative minimum tax, an extension of the gift and estate tax exemption, and extension of certain expiring provisions.

Individual Tax Rates

Starting in 2013 and beyond, ATRA introduces a top individual tax rate of 39.6% for attorneys with taxable incomes in excess of $450,000 for joint filers and $400,000 for single filers. All income below these thresholds will continue to be taxed at the Bush-era lower tax rates. This legislation represents a compromise between the President, who proposed a threshold of $250,000/$200,000 and the Republicans, who wanted to extend the Bush-era rates for all taxpayers.

The Tax Act also ended the payroll tax holiday that was initially enacted in 2011 and extended until the end of 2012. The employee portion of the FICA tax reverts to the 6.2% rate from the reduced 4.2% rate of 2011 and 2012. Law firm employees will see a small decrease in their 2013 paychecks as result of this provision. Law firm payroll departments will need to make adjustments to employee withholdings due to the changes in income and payroll tax rates. The IRS has come out with new withholding tables to reflect the increased tax rates. The IRS has also instructed employers to start using the revised withholding tables and correct Social Security tax as soon as possible but no later than Feb. 15, 2013. For any Social Security tax under-withheld before that date, employers should make the appropriate adjustment as soon as possible, but not later than March 31, 2013.

Capital Gains/Dividends Rates

Under ATRA, the top rate for long term capital gains and qualified dividends increases from 15% to 20%. The 20% rate is applied to taxpayers in the 39.6% tax bracket ($450,000 for joint and $400,000 for single). All taxpayers below that threshold will continue to enjoy the Bush-era 15% tax rate. Additionally, the 0% rate for taxpayers at lower income levels ($72,500 for joint and $36,250 for single) continues to apply, however with a slight change. Previously, if attorneys and their clients exceeded the 0% bracket threshold, the entire gain was subject to the 15% rate. Under the current legislation, it is possible to have the 0% rate apply to the capital gains/qualified dividends even if the taxpayer's income exceeds that level.

Net Investment Income Tax

Although it's not part of the fiscal cliff legislation, lawyers and clients should watch out for the new 3.8% Net Investment Income Tax (NIIT) that was effective beginning Jan. 1, 2013. This tax, which applies to taxpayers with Adjusted Gross Income (AGI) above $200,000 for single or $250,000 for joint filers, consists of a 3.8% tax on the lesser of all passive and investment income, or the excess of AGI over the relevant threshold. Note that there is no taxable income limitation, so in certain circumstances, attorneys and their clients could still be subject to this tax even with no taxable income. Generally, investment income is defined as interest, dividends and capital gains as well as passive income. In the coming year, attorneys and clients 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 3.8% NIIT. To avoid an undue tax burden, please consult your tax adviser with regard to such loans.

Itemized Deduction and Personal Exemption Limitations

The Act revives the pre-Bush phase-out of personal exemptions and limitation on itemized deductions. The phase-out and limitation begin at AGI levels of $300,000 for joint filers and $250,000 for single filers. The personal exemption is reduced by 2% for every $2,500 by which the taxpayer's income exceeds the applicable threshold. The itemized deduction limitation otherwise known as the Pease limitation (named after the senator who originally sponsored this provision) reduces itemized deductions by 3% of the amount that AGI exceeds the aforementioned thresholds. However, itemized deductions cannot be reduced by more than 80%. Certain deductions such as medical expenses, investment interest, casualty and theft losses and gambling losses are not subject to the limitations. The effect of this phase-out is to add approximately 1% to attorneys and their clients' overall tax rates.

Alternative Minimum Tax Relief

ATRA provides permanent relief for middle class income taxpayers who would have otherwise been subject to the Alternative Minimum Tax (AMT). For 2012 and all subsequent years, the Act provides for an increased exemption amount and allows certain nonrefundable tax credits to offset AMT. For 2012, the exemption amounts are $78,750 for joint filers and $50,600 for single filers. These amounts are indexed annually for inflation. Without the legislation, the exemption amounts would have been $45,000 and $33,750 for joint and single filers respectively. For attorneys and their clients in AMT, the effective tax rate has not changed from 28% for ordinary income. Capital gains and qualified dividends will continue to be taxed at favorable rates (15% or 20%). Also, the Pease limitation discussed above is not applied to attorneys and their clients in AMT. As such, attorneys and their clients in AMT may not see an increase in their tax rates unless they are subject to the 20% rate on capital gains and qualified dividends as well as the 3.8% NIIT.

Gift and Estate Tax Relief

The most expensive tax break in the Act, to the tune of about $368 billion over 10 years, is the permanent extension of the $5 million gift and estate exemption ($5,250,000 for 2013, as indexed for inflation). In fact, the only change to the generous provisions enacted as part of Congress's 2010 taxpayer relief is an increase in the marginal estate tax rate to 40% from 35%. Because Congress averted the expected decrease of the exemption to $1 million in 2013, attorneys and their clients may rest assured that there will not be a “clawback” of taxes for gifts already made in 2011 or 2012. The new Act also permanently enshrines “portability,” the ability of a deceased to transfer his or her unused exemption amount to the surviving spouse. Thus, in the case of decedents who transfer all of their assets to a surviving spouse at death, a surviving spouse will be able to take advantage of up to $10.5 million of exemption, as indexed for inflation. Congress's gift of certainty in the transfer tax arena will be surely be a welcome one as attorneys and clients engage in estate planning in 2013. In addition, the annual exclusion for gifts increased to $14,000 per donee as of Jan. 1, 2013.

Individual Tax Relief

The Act extended a host of exclusions, deductions, and credits that expired in 2012. Some of these provisions are permanent and some have been temporarily extended.

Permanent Provisions

Permanent provisions of the Act include the employer-provided educational assistance exclusion, which will benefit associates at law firms that pay for law school tuition. An employee may exclude up to $5,250 of education assistance per year from his or her gross income, even if the assistance is for graduate tuition. Unfortunately, this amount does not change with inflation.

Attorneys and staff who wish to adopt a child will be happy to know that the adoption expenses credit and employer-provided adoption assistance exclusion are now permanent under the Act. The adoption expenses credit allows taxpayers with adjusted gross income up to $229,710 (subject to a phaseout) to offset federal income tax and AMT by up to $12,650 of adoption fees, court costs, attorney fees, and other expenses paid or incurred to adopt a child. As a bonus, if a law firm chooses to pay some adoption expenses, employees with AGI less than $222,520 (subject to a phaseout) may exclude up to $12,170 of these payments from income.

To benefit working parents who must pay for child or dependent care in order to maintain employment, the Act permanently extended the dependent care credit at Bush-era rates. Thus, for taxpayers with AGI above $45,000, the credit will permanently be available at a rate of 20% of the first $3,000 of care expenses for a single dependent, or the first $6,000 for two or more dependents. This translates into maximum tax savings of $600 to $1,200 for each year that the dependents qualify.

As a revenue-raising provision that doubles as a useful retirement planning tool, the Act now allows all traditional 401(k) and 403(b) retirement plan participants (subject to employers amending their plans) to rollover all or some of their balance to a Roth 401(k) or 403(b) account within the same plan, and pay tax on the rolled-over funds. Previously, only participants who had already reached age 59' could make such in-plan Roth conversions. This could be advantageous for younger attorneys and staff who will now be able to pre-pay the tax on their retirement account balances and enjoy a greater share of tax-free retirement income in the future.

Temporarily Extended Provisions

To the relief of attorneys and their clients who continue to ride out an uncertain real estate market, Congress extended the exclusion of cancellation of indebtedness income for qualified principal residence indebtedness until the end of 2013. Taxpayers who acquired debt to buy, build or improve their primary home may exclude up to $2 million of income from debt discharged in foreclosure or forgiveness. Also extended through 2013 is the ability to include mortgage insurance premiums as part of the itemized deduction for qualified mortgage interest.

Another temporarily extended itemized deduction provision is the state and local sales tax deduction. For 2012 and 2013, attorneys and staff in states without state income taxes or whose sales taxes are higher than income taxes for the year may choose to deduct sales taxes paid as an itemized deduction.

In a boon for attorneys and their staff who take public transit to work, the Act restores parity for employer-provided transit and parking benefits for one year. Thus, for 2013, law firms may provide tax-free money to employees for transit passes on a monthly basis up to the same dollar limit as tax-free parking benefits (currently $245, as indexed for inflation). There are various rules for administering and substantiating transit and parking benefit plans, so law firms that wish to offer this benefit for the first time should consult an employee benefits expert.

College tax breaks continue under the Act, including a five-year extension of the popular American Opportunity Tax Credit (AOTC) for college tuition. Although rarely used by higher-income families due to AGI limits, the return of the Personal Exemption Phaseout means that this credit deserves more attention in 2013. For attorneys with AGI over $250,000 single ($300,000 joint) who have limited benefit from personal exemptions, it may be more beneficial to simply forgo a dependency exemption and allow their college-enrolled children to take the credit against their own income tax instead (please note that the refundable part of the AOTC will still not be available as long as a dependent could be claimed). For some with AGI below $65,000 single ($130,000 joint), the above-the-line deduction for up to $4,000 of qualified tuition expenses may be a better deal. Congress extended the above-the-line deduction, which decreases to $2,000 for taxpayers with AGI of up to $80,000 ($160,000 joint), through Dec. 31, 2013. To get the highest benefit from these tax breaks, please consult your tax adviser.

Residential energy credits are back for a limited time, as well as a few other energy-efficiency and green energy credits. Through Dec. 31, 2013, attorneys and staff who purchase and install certain qualifying energy-efficient building components, water heaters, heat pumps or central air conditioners for a primary home can receive a credit for 10% of the amount paid, up to $500, or $200 for windows. The credit must be reduced by the amount of the credit from earlier years. Credits for two- or three-wheeled electric vehicles, the energy-efficient home credit for homebuilders, and credits for certain energy-efficient appliances are also available until Dec. 31, 2013.

Charitably minded attorneys and their clients who own historically or ecologically important real estate may benefit from the enhanced deduction for qualified conservation easements. For easements donated through Dec. 31, 2013, the carry-forward period for donations in excess of 50% of AGI is 15 years, versus five years for other donations to charity. Contributions with shorter time limits come first, so attorneys and their clients may take advantage of both their usual charitable giving and the deduction for conservation easements (up to the 50% AGI limitation) each year until it is used up.

Business Tax Relief

ATRA also extends many popular business tax breaks. 2013 may be a good year for law firms to consider capital improvements or fixed asset purchases. The Act extends for 2012 and 2013 the enhanced Section 179 expensing rules. Law firms can expense up to $500,000 of fixed asset additions with a $2 million investment limit. The 50% bonus depreciation was also extended through the end of 2013 as well as a 15-year straight-line depreciation period for qualified leasehold, restaurant and retail improvement property.

ATRA extends through 2013 the Work Opportunity Credit, which provides credits to employers that hire employees from certain targeted groups. The amount of the credit is generally 40% of the first year wages up to a maximum of $6,000. The credit for the hiring of a qualified veteran can be as much as $9,600.

Law firms operating as S corporations that were formerly C corporations may want to consider selling certain assets in 2013. The waiting period for built-in gains tax (entity level tax on S corporations that sell appreciated assets) has been fixed at five years for assets sales occurring in 2012 and 2013. Therefore, S corporations that converted in 2007 or earlier will not be subject to built-in gains tax on 2013 asset sales.

The Act also extended through 2013 the credit for Research and Development. This provision provides a credit for taxpayers who engage in qualified research activities.

Richard H. Stieglitz, CPA, a member of this newsletter's Board of Editors, is a Tax Partner and Martin Arking, CPA, is a Tax Manager in the New York accounting firm of Anchin, Block & Anchin LLP. They can be reached at 212-840-3456 or via e-mail at [email protected] and [email protected], respectively.