Is The Tax Stalemate Finally Broken?

December 10th, 2010

In a news conference held December 7, and carried live by most major networks, President Obama discussed the tax agreement he had worked out with the GOP’s Congressional leaders the previous day.  Although there is some discontent with the agreement among some liberal Democrats, it is expected to pass Congress before year-end.  Keep in mind that this agreement – which primarily addresses tax cuts enacted in 2001 and 2003 (the “Bush era”) that have or will soon expire – has not yet become law and must first pass both houses of Congress, and there could be some modification to the original agreement.

Although there will be additional details to come, the following is a general overview of the agreement between the President and the GOP.

INDIVIDUAL PROVISIONS

Individual Tax Rates – For 2010, there are six individual tax brackets: 10, 15, 25, 28, 33, and 35 percent.  These rates were scheduled to return to the five pre-Bush era brackets of 15, 28, 31, 36, and 39.6 percent beginning in 2011.  Thus, the lowest bracket would have increased 5 percentage points and the highest bracket 3.6 percentage points.  Under the compromise agreement, the lower rates that apply to 2010 will continue through the end of 2012 (a two-year extension).

Capital Gains & Qualified Dividends – Long-term capital gains and qualified dividends are currently taxed at a maximum rate of 15 percent for taxpayers in the 25% and higher tax brackets.  The rate is zero to the extent a taxpayer is in the 10 and 15 percent income tax brackets.  The lower rates are scheduled to expire after 2010.  Under the compromise agreement, the lower rates that apply to 2010 will continue to the end of 2012 (a two-year extension).  This potential change could impact the decision by investors to sell off investments before the end of the year in order to take advantage of the lower capital gain rates in 2010.

Itemized Deduction Limitation – Prior to the Bush era tax cuts, itemized deductions where partially phased out for higher-income taxpayers.  This phase-out was gradually eliminated beginning in 2006 and is totally repealed for 2010.  However, the full phase-out was scheduled to return in 2011.  Under the compromise agreement, the repeal of the phase-out will continue for an additional two years through 2012.

Personal Exemption Phase-Out – As with itemized deductions, prior to the Bush era tax cuts, the personal exemptions were phased out for higher-income taxpayers.  This phase-out was gradually eliminated beginning in 2006 and is totally repealed for 2010.  However, the full phase-out was scheduled to return in 2011.  Under the compromise agreement, the repeal of the phase-out will continue for an additional two years, through 2012.

Marriage Penalty Relief – Prior to the Bush era tax cuts, the standard deduction for a married couple was not twice the amount of the standard deduction for a single individual.  Instead, it was only 167% of the single amount even though there were two people instead of one.   This was often referred to as the “marriage penalty.”  As part of the 2001 and 2003 tax cuts, the marriage penalty was eliminated and the standard deduction for a married couple filing jointly became twice the amount for a single taxpayer.  The marriage penalty also applies to the high-end cut-off point for the 15% tax bracket.

The marriage penalty was scheduled to resume in 2011.  Under the compromise agreement, marriage penalty relief would be extended for two years, through December 31, 2012.

Child Tax Credit – For several years, the maximum child tax credit has been $1,000 per qualified child, and, for 2009 and 2010, a portion of that credit was refundable for certain lower-income taxpayers.  The credit was scheduled to drop back to $500 per child and the refundable portion reduced.  Under the com promise agreement, the child tax credit will remain at $1,000 and the enhanced refund portion continued through 2012 (a two-year extension).

Earned Income Credit (EIC) – There have been a number of enhancements in the past several years including additional credit when there are three or more qualifying children and increased income beginning and end points of the EIC.  Under the compromise agreement, the EIC will retain its enhancements through 2012 (a two-year extension).

Dependent (Child) Care Credit – As part of the Bush era tax cuts, the maximum expenses qualifying for dependent care credit were raised from $2,400 ($4,800 for two or more qualifiers) to $3,000 ($6,000 for two or more qualifiers) and the income-based maximum credit percentage was raised from 30% to 35%.  However, these increases were scheduled to revert to the lower amounts in 2011.  Under the compromise agreement, the higher expenses limits and credit percentage will be retained through 2012 (a two-year extension).

American Opportunity Tax Credit (AOTC) – For 2009 and 2010, the Hope education credit was replaced by an enhanced AOTC.  The AOTC provides a maximum credit of $2,500, of which up to 40% can be refundable, whereas the Hope credit maximum is $1,800 and the credit can only be used to offset tax liability (i.e., is not refundable).  Without extension, the AOTC expires after 2010 and reverts to the lower Hope credit levels.  Under the compromise agreement, the AOTC would be retained for two additional years through 2012.

Other Education Issues – With the limited amount of information available on the details of the tax deal agreed to by the administration and the GOP leaders, the fate of the higher education tuition deduction and the Coverdell education account is unclear.  The higher education tuition deduction, which allowed up to a $4,000 above-the-line deduction, expired at the end of 2009.  The Coverdell education account was expected to revert from the current $2,000 maximum annual contribution to a $500 maximum contribution in 2011.

Alternative Minimum Tax (AMT) – For several years, Congress has failed to permanently resolve the nagging issue of the AMT, and instead, each year has applied a one-year patch without which an estimated 28 million taxpayers would be hit with this punitive tax.  Even though the year is almost over, a patch for 2010 has not been made by Congress.  Under the compromise agreement, a patch would be applied for 2010 and 2011.  In a letter to the IRS commissioner in November, the Congressional bipartisan tax policy leaders committed themselves to legislation that will allow the personal credits against the alternative minimum tax (AMT) and set the AMT exemption amounts for 2010 at $47,450 for individuals, $72,450 for married taxpayers filing jointly, and $36,225 for married taxpayers filing separately.

Other Individual Tax Incentives – There are a number of other temporary individual tax incentives that expired at the end of 2009, including the $250 above-the-line teacher classroom expense deduction and the state and local sales tax deduction. Their fate is unknown at this time.

Unemployment Compensation – Under the compromise agreement, federal unemployment benefits will be extended through 2011.

Making Work Pay Credit – The Making Work Pay credit, which was part of the 2009 stimulus package, provided a credit of up to $400 ($800 for married couples filing jointly), subject to income limitations, and expires after 2010.  The credit was not extended under the compromise agreement and was replaced by a reduction in payroll taxes (Payroll Tax Reduction below).

Payroll Tax Reduction – For 2011 only, the compromise agreement provides for a 2 percentage point reduction in the employee’s portion of the payroll tax (OASDI) from 6.2% to 4.2%.  The reduction applies to all wage earners regardless of income.  The employer’s share of the payroll tax is unaffected.  For wage earners with payroll in excess of the $106,800 payroll tax cap, their savings for the year will be $2,136 (2% of $106,800).  There has been no indication if this reduction will also apply to self-employed individuals.

Federal Estate Tax – The Bush era tax cuts slowly phased out the federal estate tax and abolished it altogether for decedents dying in 2010 and replaced it with a modified carryover basis regime.  Just about everyone assumed Congress would reinstate the estate tax for 2010.  However, that did not happen and the estate tax was scheduled to return in 2011 with only a $1 million exemption and a tax rate of 55%.  Congress has been debating what to do for individuals dying in 2011, and there have been proposals of an estate tax exclusion of between $3.5 and $5 million. Under the compromise agreement, the estate tax rate for 2011 and 2012 will be 35% with a $5 million exclusion.

BUSINESS PROVISIONS

Bonus Depreciation – Generally, business assets cannot be written off in the year of purchase and must be depreciated over their useful life.  As an incentive to jump start the economy and promote business investment, in recent years Congress has allowed bonus depreciation of 50% of the cost of the investment in equipment and certain leasehold improvements.  Under the compromise agreement, the bonus depreciation will be increased to 100% for qualified investments made in 2011.  This generally provides a tax break for large businesses and others that can’t take advantage of the Section 179 expensing deduction because of income limitations.

Research Tax Credit – The Code Sec. 41 research tax credit expired at the end of 2009.  The compromise agreement includes a temporary two-year extension of the credit.

Now all we can do is wait and see if Congress passes the compromise.  Watch for further developments.

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