Fiscal Cliff Averted? It All Depends.

Search the term “fiscal cliff averted” and you’ll get about 57 million hits in a quarter of a second.  Is that proof enough that we did, in fact, avoid a cataclysmic spill over a scary economic precipice?  As a nation, perhaps so.  But if you now find yourself approaching the highest income tax bracket, you may not feel as if you averted anything at all!

The newly enacted American Taxpayer Relief Act of 2012 preserved lower tax rates and other benefits for nearly all households.  But as household income increases, taxpayers may now be climbing a personal tax mountain that feels as daunting as the fiscal cliff the nation just dodged.  Here’s what you need to know. 

Payroll Tax Holiday Sunset

The consequence of the new tax law that affects the most people is actually not in the law at all.  For the past two years employees and self-employed workers have enjoyed the benefit of a two percent reduction in the Social Security tax rate.

The result was an average boost of about $2,200 for the typical taxpayer.  Because this reduction was not renewed for 2013, the Social Security rate returns to 6.2%, and, as a consequence, take home pay will go down.

$250,000 Income Threshold

Additional wage and investment surtaxes enacted with the 2010 healthcare reform legislation took effect at the beginning of this year.  This means that every dollar in wages over $250,000 is now subject to a Medicare tax of 0.9%.   

Once total income surpasses the $250,000 threshold any investment income – dividends, interest, rents, most capital gains and other types of unearned income – is now subject to a 3.8% Medicare tax.

These taxes are assessed on top of the taxes that ordinarily apply to wage and investment income.

$300,000 Income Threshold

At the $300,000 income level, you begin to give back certain tax benefits available to taxpayers at lower levels.  For example, itemized deductions such as charitable contributions, real estate taxes and mortgage interest can be reduced up to 80% of the otherwise deductible amount.

Additionally, the value of personal exemptions for you, your spouse and your children will gradually be phased out.

$450,000 Income Threshold

If your income exceeds $450,000, you will likely be subject to the new higher tax rates governing ordinary and capital gains income.  The top rate applying to ordinary income is now 39.6% (up from 35% last year), and the new capital gains rate is 20%.  A capital gains rate of 15% still applies if income is below $450,000.

Business Provisions

Since most businesses are organized as passthrough entities, (business income passes through the entity and is reported by its owners), the new individual tax provisions will have a major impact on business planning.

One encouraging development is the extension and expansion of tax rules that make it easier for businesses and owners to write off capital equipment purchases.  Retroactive to the beginning of 2012, businesses can deduct up to $500,000 in qualifying purchases during the year.

With top income tax rates approaching 40%, this provision represents a significant inducement for businesses to make infrastructure investments. The half-million dollar annual threshold remains in effect through the end of this year.

Is It A Cliff?  Is It A Mountain?

It’s impossible that any financial policy decision – let alone one with the potential impact of that scary fiscal cliff – results in consequences that are “all good” or “all bad.”   No matter how neatly the politicians try to wrap the package, there are always surprises, some welcome and others less so, that straggle out.

My advice for taxpayers is to do your own investigation, or enlist a trusted tax advisor, into what these changes will mean for you. Only then will you know if you’re falling over a cliff, climbing a mountain or resting easy…at least until the next crisis erupts. 

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Tax Planning for the Fiscal Cliff and Beyond- Business and Individual Planning

The holidays will soon be behind us and the new-year-new-you weight-loss ads will start to appear. That means it’s time to begin thinking – and planning – for year-end tax strategies to minimize the April 15th tax bite.

Traditional tax-reduction strategies for businesses include buying new equipment or computers that you can write off quickly, paying bills before year’s end (for those on the cash basis), awarding holiday bonuses to valued employees and setting aside funds for the retirement plan.

But tax planning this year might be a bit different. That’s because of the ongoing tax and spending stalemate in Washington. Known as the fiscal cliff, it refers to a package of Bush-era tax cuts slated to expire after 2012 and two new Medicare taxes targeting higher income taxpayers beginning in 2013. As a result, your deductions may be far more valuable next year.

As Congress and the White House continue to debate the fate of 2013 income taxes, here is what we expect will happen once the dust settles:

Marginal (Ordinary Income) Tax Rates

The marginal tax rate is the rate at which your last dollar of income is taxed. Currently, marginal tax rates range from 10% to 35%. However, it is expected that the tax rules will eventually incorporate marginal rates of 36% and 39.6% on income over $250,000. These rates could become effective as soon as next year.

Capital Gains Rate

The tax rate that applies to long-term capital gains is currently 15%. Expect that rate to increase to 20% beginning in 2013. Most capital gains will also be subject to a new Medicare surtax on investment income discussed below.

Qualified Dividends Rate

Since 2003, dividend income has been taxed at a preferential rate identical to long-term capital gains. Many believe that dividend income will be taxed as ordinary income subject to the taxpayer’s effective marginal tax rate. That means an expected increase from 15% to as high as 39.6%. These dividends may also be subject to the new Medicare surtax on investments.

Medicare Surtaxes

A new Medicare tax of 3.8% that applies to the investment income of higher-income taxpayers could push the Federal tax on interest, dividends and other investment income over 40%.

Single taxpayers making $200,000 or more and married taxpayers making $250,000 or more are subject to this new tax beginning next year. Additionally, a new wage surtax of 0.9% targets wages over $200,000 ($250,000 for married taxpayers).

Itemized Deductions

Finally, lawmakers are also reviewing proposals to limit the deductions of higher income taxpayers as a way of broadening the income tax base. This limitation may take the form of a fixed percentage (one proposal limits the itemized deductions for high income taxpayers to 28% of income) or a fixed amount (another proposal limits itemized deductions to $50,000).

While it still may make sense to defer income and accelerate deductions, consider doing the opposite in order to achieve the greatest tax savings over time. Seek the advice of a skilled tax advisor to design and implement the best financial strategy to ensure the long-term health of you and your business.

Whether Uncle Sam falls over the cliff or is stopped short, you still need to start planning today.

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BP Deepwater Horizon Spill Settlement – Your Business May Qualify for Compensation

The new Deepwater Horizon Court-Supervised Settlement is now open and accepting claims. This new program is a dramatic shift from the prior Gulf Coast Claims facility headed by Kenneth Feinburg.  Your businesses may qualify even if not located on the coast or involved in tourism. The geographic area of the settlement includes all of Alabama, Mississippi and Louisiana as well as parts of Florida and Texas.

In most cases, the calculations are driven entirely by financial formulas, so there is no requirement to prove your loss was a direct result of the spill. Many businesses will be eligible without having to provide any information other than financial data. There are also provisions for failed and startup businesses which may not have been entitled to compensation under the prior settlement.

The new settlement facility is expected to be open through April of 2014; although it is possible the date may be extended.

We are currently assisting businesses with claims. If you would like to discuss your specific situation, please contact Mike Baker at 205-380-1895.

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Gulf Coast Property Owners Can Receive Over $1,000

Do you own a condo on the Gulf Coast?  If you owned it on April 20, 2010, you are eligible for a payment being administered by the U.S. District Court-Eastern District of Louisiana because of the Deepwater Horizon Economic & Property Damage Settlement. 

Under this settlement, no physical damage to your condominium is required.  This does apply to condominiums used personally.  For a condo with a 2010 tax assessor value of $350,000 the economic damage refund ranges from $1,239 to $1,859. 

For more information, please contact Dale Prosch at 205-871-1880 or dprosch@dentbaker.com.

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An Overview of the Medicare Surtaxes

As we wind down 2011, we are already beginning to take a look at 2013 with tax planning in mind. Why? Absent any legislative tinkering to the tax code in this upcoming election year, nearly all taxpayers can expect a big tax hike beginning in 2013. Here is a rundown of just a few changes that will result in heftier tax bills:

  1. A return of pre-2001 individual income tax brackets and rates
  2. An increase in capital gains tax rates from 15% to 20%
  3. An increase in dividends tax rates from 15% to rates up to 39.6%
  4. A sharp decline in the ability of businesses to claim first-year deductions for capital purchases

In addition to these changes, 2013 marks the first year of the Medicare surtaxes created by last year’s healthcare reform legislation. These surtaxes apply to wages, income from self-employment and investment income of taxpayers whose income exceeds certain threshold amounts. Here is how these taxes work.

Wage Surtax

This .9% surtax applies to wages and income from self-employment in excess of $250,000 for married taxpayers filing a joint return ($200,000 for single taxpayers). Employers are required to withhold the surtax tax once an employee’s wages exceed $200,000 (regardless of whether or not the spouse is also a wage earner.) Any additional surtax liability must be taken into account by quarterly estimated tax payments or by the original due date of the return.

Example: One spouse has wages of $275,000; the other spouse has wages of $125,000. They file a joint return. The total liability for the wage surtax is $1,350 [($400,000 – $250,000) x .9%]. Wage withholding represents $675 of that liability ($75,000 x .9%) while the remainder is due either as a component of estimated tax payments or by the original due date of the return.

One additional note to consider is that self-employed individuals that generally get an income tax deduction for one-half of self-employment taxes paid will receive no such deduction for Medicare surtaxes paid on income from self-employment.

Investment Surtax

The investment surtax is a 3.8% tax applied to the lesser of investment income and adjusted gross income over $250,000 for married taxpayers filing a joint return ($200,000 for single taxpayers).

Example: A married couple files a joint return with $350,000 in income, $75,000 of which is derived from investments. The income exceeding the threshold amount is $100,000. Since investment income is less than $100,000, the 3.8% tax rate is applied to $75,000 of investment income for a Medicare surtax of $2,850.

Here is a list of income subject to the investment surtax:

  1. Passive income
  2. Interest
  3. Dividends
  4. Annuities
  5. Royalties
  6. Taxable capital gains

Some of this income, such as capital gains, may be triggered in 2011 and 2012 in order to dodge the surtax. Also, bear in mind that while the capital gain exclusion from the sale of a primary residence also serves to exclude the investment surtax, any gain that exceeds the exclusion amount ($500,000 for married taxpayers filing a joint return/$250,000 for single taxpayers) will be subject to capital gains tax and the investment surtax.

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Our Take on the Herman Cain 9-9-9 Plan

Herman Cain and his 9-9-9 Plan have received considerable attention over the past several weeks. Cain’s plan has been lauded for its simplicity and transparency while at the same time derided for its lack of detail and the perception that it will be insufficient to collect the revenue of the taxes it would replace. The 9-9-9 Plan is intended to be a transition to the “Fair Tax”, a national sales tax that would replace all income, payroll, self-employment, estate and gift taxes. Here are the basics from Mr. Cain’s website:

9% Business Flat Tax

The business tax is assessed on the gross income of businesses minus purchases from U.S. located businesses, capital expenditures and net exports. Additionally, payroll deductions will be offered to businesses that employ workers in Empowerment Zones, or designated economically-distressed areas.

Our Take: The key selling features of Cain’s tax plan are simplicity, transparency, and neutrality.  With the business tax provision, these principles are compromised.

If gross income is defined as “revenue from operations”, then this element of the equation is relatively straightforward. The subtractions from gross income to compute the taxable base are less so. If a U.S. business purchases inventory from a U.S. distribution facility owned by a foreign manufacturer, does the taxpayer receive a deduction? What if the inventory is manufactured overseas but assembled and sold in the U.S.? This provision has the makings of an enforcement nightmare.

Additionally, Mr. Cain’s website chastises the current tax regime for picking winners and losers (which it does), but the 9-9-9 Plan favors inventory-driven businesses (via the purchases deduction) over service-oriented businesses whose largest expense, payroll, would be non-deductible unless the businesses are located in a designated Empowerment Zone.

We also question the applicability of the business tax on entities, such as S corporations and partnerships, which pass through items of income, deduction and credit to its owners. The transition issues stemming from a conversion to this tax regime are too numerous to list.

9% Individual Flat Tax

The individual tax is assessed on gross income less charitable deductions. Additional deductions are allowed for taxpayers that live and/or work in designated Empowerment Zones.

Our Take: One could argue that the retention of the charitable contributions deduction is an example of the kind of tax handout that Cain criticizes. However, the feature that causes us the greatest pain is that a flat tax with no exemption amount (except as may be provided in the Empowerment Zones) is bad policy for lower income taxpayers. A 9% tax levy on a household that is struggling to meet basic needs has a far more negative impact on that household than the same percentage levy on a family living more comfortably. A progressive rate system with an exemption amount tied to poverty statistics would not overly complicate the system.

9% National Sales Tax

Mr. Cain’s website does not provide much detail on this provision, but we assume that the tax would be levied against business and individuals. Mr. Cain clarified in a recent interview that the tax would apply only to the purchase of new goods.

Our Take: A lower-income household outside of a designated Empowerment Zone that uses all of its income to cover basic needs will see a large percentage of its income diminished by a 9% individual income tax, a 9% national sales tax, and the prevailing state/county/local sales tax. In a high sales tax state like Alabama where combined sales tax rates are currently as high as 12%, an extra 9% is punitive. The “Fair Tax” does offer a prebate system that has the effect of exempting spending up to the poverty level. While not articulated on Mr. Cain’s website, his 9% national sales tax may contain a similar provision.

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