American Taxpayer Relief Act of UPDATED

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1 American Taxpayer Relief Act of UPDATED On January 2, 2013, the President signed the American Taxpayer Relief Act, thus ending the nation s brief stint over the fiscal cliff a confluence of expiring Bush- era tax cuts and the imposition of scheduled spending cuts but not the national debate over revenue and spending issues. The Act increases taxes for high- earners as well as trusts, and defers for two months significant automatic sequestration cuts that had been set to take effect on January 1, The cuts are now scheduled to begin on March 1, Importantly, the Act also creates two time- limited opportunities for IRA rollovers that older taxpayers may wish to consider taking advantage of this month (see Time- sensitive opportunity for IRA rollovers, below). Individual taxpayers will be most impacted by some of the tax provisions of the Act, which are permanent in that they are not set to automatically expire, and which: Extend income tax relief for taxpayers with taxable income below $400,000 (single) or $450,000 (married filing jointly [MFJ]). For taxpayers with income above this level, the top marginal tax rate will return to 39.6%. As anticipated, this income threshold is higher than the $200,000 $250,000 originally proposed by the President, but it is still lower than the $1 million proposed by a number of legislators. Raise the top long- term capital gain (LTCG) and qualified dividend rates to 20%. Capital gain and dividend rates will return to 20% for taxpayers above the $400,000/$450,000 income threshold. Qualified dividends will continue to be taxed at LTCG rates, but both gains and dividends will be

2 subject to the new 3.8% Medicare surtax (explained below), effectively subjecting both to a 23.8% rate. Restore the personal exemption phase- out (PEP). The personal exemption phase- out is restored for taxpayers with adjusted gross incomes (AGIs) higher than $250,000 (single) or $300,000 (MFJ). Restore the Pease limitations. The Pease limitations (the so- called 3% haircut ) on itemized deductions that existed in prior law are restored for taxpayers with adjusted gross incomes (AGIs) higher than $250,000 (single) or $300,000 (MFJ). This limitation reduces allowable itemized deductions by 3% of the amount by which a taxpayer s AGI exceeds the $250,000/$300,000 thresholds, but not by more than 80%. Not included are select items, such as medical expenses, casualty losses and investment interest expenses. For most high- income taxpayers, especially those in states with high income tax rates, this provision effectively results in a tax increase of roughly 1.2%. Despite much discussion, the Act did not impose any new limitations on key itemized deductions, such as the mortgage interest and charitable deduction. Index the AMT exemption to inflation. Prior to this legislation, lawmakers annually had to patch the AMT exemption amount to increase the exemption. From now on, the exemption will be indexed to inflation. The provision is effective as of December 31, Set estate/gift/generation- skipping transfer (GST) tax rates at 40%. Significantly lower than the 55% rate that had been set to go into effect on January 1, 2013, the new rate of 40% splits the difference between last year s 35% rate and 2009 s 45% rate. It also ensures that top transfer tax rates remain above top income tax rates. All three taxes (estate, gift and

3 GST) remain unified in their rates. Set estate/gift/gst tax exemptions at $5 million, adjusted for inflation. These exemptions are indexed for inflation, and all transfer taxes have the same exemption. The 2013 inflation- indexed exemption amount is expected to be $5.25 million, which is $130,000 higher than last year s $5.12 million. The inflation- adjustment provision may offer significant additional gifting opportunities over time. Extend portability of unused transfer tax exemptions. Portability allows surviving spouses (of couples married under federal law) to continue using their deceased spouses unused gift and estate exemptions if certain estate tax informational filing requirements are met, thus ensuring the gift and estate tax exemptions are really $10 million (indexed for inflation). The GST exemption is not portable. It is still worthwhile to consider using the lifetime exemptions. Extend the deduction for state death taxes. The Act replaced the scheduled estate tax credit with a deduction for state estate taxes paid. Effective estate tax rates may vary by state; for example, the effective estate tax rates (federal and state) of New York, Connecticut and Texas are 49.6%, 47.2% and 40%, respectively. Do not extend the payroll tax cut. The Act does not extend the 2% cut in payroll and self- employment taxes. Allow in- plan Roth conversions. This provision, which was included in the Act as a revenue raiser, expands the in- plan Roth rollover provisions to permit vested, otherwise undistributable amounts (e.g., 401(k) deferrals, employer matching or non- elective contributions, or earnings) from 401(k), 403(b) or 457(b) plans to be transferred to designated

4 Roth accounts in the same plan. Previously, participants could only convert to Roth accounts money they could take out of the plan as a result of reaching age 59½ or separating from service. This conversion is only possible if plan documents provide for it. Time- sensitive opportunity for IRA rollovers In addition to the provisions described above, some other provisions afford taxpayers a time- sensitive opportunity to make IRA rollovers to charity. The Act restores and extends for two years a provision allowing direct rollovers of up to $100,000 per taxpayer, per year, from IRAs to qualified public charities (note that this does not include donations to private foundations or donor- advised funds). Taxpayers can fulfill both their RMD requirements and charitable intentions without generating any income. The provision is effective from December 31, 2011, to December 31, Due to this retroactive timeframe, the Act includes two special relief provisions that expire on January 31, 2013: 1) Individuals making a qualified direct distribution in January 2013 are permitted to deem the distribution as though it had been made on December 31, ) Individuals who took a distribution in December of 2012 can contribute that amount in cash to a qualified charitable organization before February 1, 2013, and have it count as an eligible charitable rollover to the extent it otherwise meets applicable requirements. In both cases, such qualified distributions would count toward minimum distribution requirements, but not toward AGI (potentially keeping the taxpayer in a lower tax bracket). Such charitable contributions also would not be subject to the Pease limitations on itemized deductions. (Please note that only taxpayers over the age of

5 70½, whether original IRA owners or IRA beneficiaries over the age of 70½ prior to the distribution, can take advantage of these provisions.) Medicare tax Although not part of the American Taxpayer Relief Act, the Supreme Court s decision to uphold the Affordable Care Act last summer means that the Medicare tax is in effect for 2013 for high- income taxpayers (defined as single filers whose AGI is over $200,000 or joint filers whose AGI exceeds $250,000). This translates to an additional surtax of 90 bps on earned income and 3.8% on unearned income in excess of the threshold. This 3.8% tax also applies to trusts and estates on the lesser of undistributed net investment income 1 or AGI over the threshold at which the highest trust and estate bracket begins. It looks unlikely that the President would sign (or that Congress would override a veto of) any new law changing the Medicare tax. The new 3.8% tax on unearned income does not apply to nonresident aliens or fully charitable trusts. Trusts and estates Generally, for non- grantor irrevocable trusts or estates with undistributed net income, the top 39.6% tax rate applies to all fiduciary income over the presently projected $11,950 threshold, with no fiduciary income taxed at a 35% rate. As a result, the brackets for estates and non- grantor trusts will jump from 33% for income between $8,750 and $11,950, and 39.6% for income above $11,950. Furthermore, as noted above, the new Medicare 3.8% surtax applies to estates and non- grantor trusts and is imposed on the lesser of: (i) undistributed net investment income, or (ii) the excess of adjusted gross income over the dollar amount at which the highest bracket begins (in other words, undistributed trust income above $11,950 is also subject to the new Medicare surtax). Pease limitations on itemized deductions will not apply to fiduciary income of non- grantor trusts and estates.

6 Not addressed Various proposals to restrict use of grantor retained annuity trusts (GRATs), grantor trusts, valuation discounts and dynasty trusts, were not included in the Act. Furthermore, despite much discussion, the taxation of carried interest as ordinary income was not addressed by the Act. These issues may be revisited in the next couple of months in the context of debt ceiling and deficit reduction discussions. To that point, although many provisions discussed above are supposedly permanent, that just indicates they are not scheduled to expire automatically, so keep in mind that any of the above provisions can be amended by further legislation. Strategies to follow We have appended the chart below showing the highest tax rates resulting from both the American Taxpayer Relief Act of 2012, as well as the Medicare tax provisions from the Affordable Care Act. The Advice Lab will be issuing an In Your Interest later in the month describing planning opportunities and considerations arising from this new legislation. [1] Net investment income includes interest, dividends, royalties, rental income, gross income from a trade or business involving passive activities and net gain from disposition of property (other than property held in a trade or business) reduced by deductions connected to that income.

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