What Happens if we go Over the Fiscal Cliff?

12/28/2012

Okay, we are now at December 28th and the President and Congress still can't seem to agree on anything.  Because of this stalemate, it is looking more likely that we may go over this thing that has come to be known as the "fiscal cliff."

There still may be hope for a last-minute, stop-gap solution—perhaps one in which Congress kicks the can further down the road just to buys itself time to formulate a comprehensive tax reform plan by deferring the sunsets for another year, patching the alternative minimum tax (AMT) again, and extending core expired or expiring tax provisions. However, with each day that passes, a stop gap solution becomes less likely.

So what is really at stake if we go over the fiscal cliff?  This blog is intended to outline what 2013 will look like under current tax law if Congress doesn't take action (or doesn't kick the can down the road with a stop gap measure).

The impact of Congressional inaction is outlined in a recent Congressional Budget Office (CBO) report on the budget and economic outlook. In general, if Congress doesn't change current law, governmental revenue will rise (because taxes will go up for just about everyone) and the deficit will drop substantially (because of mandatory spending cuts).  Some believe this could cause the economy to stall and possibly result in another recession.

Unless Congress acts, most of the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (commonly known as EGTRRA or the Bush tax cuts) and other subsequent tax acts will sunset.  This means the tax law will revert to what it was before EGTRRA which generally means higher taxes in 2013.

Here's a capsule review of what's in store for 2013 if the sunset does happen:

            a.     Tax Brakets.  Three fundamental changes occur with tax brakets:

      • The 10% bracket disappears (the lowest bracket is 15%);
      • The size of the 15% tax bracket for joint filers & qualified surviving spouses is 167% (rather than 200%) of the 15% tax bracket for individual filers;
      • The top four brackets rise from 25%, 28%, 33% and 35% to 28%, 31%, 36% and 39.6%.

                b.     Taxation of Capital Gain and Qualified Dividends.  Long-term capital gain is taxed at a maximum rate of 20% (18% for assets held more than five years). For lower-income taxpayers, the maximum rate will be 10% (8% for assets held for more than five years).  This is an increase from the 2012 maximum rate of 15% (and possibly 0% for lower income taxpayers).

Dividends paid to individuals are taxed at the same rates that apply to ordinary income as opposed to a maximum 15% rate for 2012.

             c.     Coverdell Education Savings Accounts.  A number of changes apply:

      • The annual per-beneficiary contribution limit drops to $500.
      • There's a lower phaseout range for married persons filing jointly.
      • A restricted definition of qualifying education expenses (e.g., only for higher education) goes into effect.
      • There are no special rules for special needs beneficiaries.
      • The rule permitting contributions for a tax year to be made as late as April 15 of the following year sunsets.

                 d.      Above-the-Line Student Loan Interest Deduction.  The deduction (1) phases out over lower modified adjusted gross income (AGI) ranges and (2) applies only to interest paid during the first 60 months in which interest payments are required.

             e.      Adoption Credit.  All of the following rules sunset: increase to $10,000 for maximum credit and maximum exclusion, special needs adoptions deemed to have $10,000 eligible expenses for purposes of credit and exclusion, increase in the beginning and ending points of phase-out range for credit and exclusion, and allowing the credit against AMT. 

                 f.      Standard Deduction.  The standard deduction for married taxpayers filing jointly (and qualified surviving spouses) is 167% (rather than 200%) of the standard deduction for single taxpayers.

             g.      Reduction in Itemized Deductions.  Most itemized deductions of higher-income taxpayers are reduced by 3% of AGI above an inflation-adjusted figure, but the reduction can't exceed 80%.

             h.      Phaseout of Personal Exemptions.  A higher-income taxpayer's personal exemptions are phased out when AGI exceeds an inflation-adjusted threshold.

                 i.      Earned Income Tax Credit.  There are multiple changes: the beginning of phaseout range for joint returns drops; phaseout of the credit is computed with reference to modified AGI (rather than AGI); earned income for EITC purposes includes exempt income; and EITC is reduced by the AMT.

              j.     Child Credit. The maximum credit drops from $1,000 to $500 and the credit is not allowed against AMT. Also, more restrictive rules apply to the refundable child credit.

                 k.     Estate, GST Tax and Gift Tax. The principal changes for the estate tax are as follows: The top rate is 55%. A 5% surtax on the wealthiest of estates phases out the benefit of graduated rates, with (1) a unified credit exemption equivalent of $1 million, (2) a reinstated Code Sec. 2057 deduction for family-owned businesses, and (3) a credit against State death taxes.

Various changes apply to the GST tax. The principal changes are that the top rate is 55%, and the GST exemption amount is set at $1 million (plus inflation adjustment). 

For gift tax, the top rate increases to 55%.

               l.     AMT.  Far more restrictive AMT rules already are in effect for 2012, and will remain so unless Congress passes a “patch” that amends the rules effective retroactively as of Jan. 1, 2012.  For individuals, the AMT exemption amounts for 2012 falls to $45,000 (joint filers & surviving spouses), $33,750 (unmarried individuals), and $22,500 (marrieds filing separately). By contrast, the AMT exemption amounts for 2011 were $74,450 (joint filers & surviving spouses), $48,450 (unmarried individuals), and $37,225 (marrieds filing separately).

              m.     Other Tax Rules That Expired at the End of 2011.  A host of favorable tax rules for businesses and individuals expired at the end of 2011. A deal on the fiscal cliff could revive some of them, retroactively effective to the beginning of 2012.  Following is a list of key tax rules that expired at the end of 2011 that will not apply for 2012 or thereafter unless an agreement is reached:

      • For Business:
        • Research credit.
        • 15-year writeoff for specialized realty assets, including qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.
        • 100% bonus first-year depreciation allowance for qualified property.
        • Increased $500,000 expensing election with $2 million investment ceiling.
        • Election to expense environmental remediation costs.
        • Work opportunity tax credit (WOTC) for non-veterans.
        • Credit for construction of new energy efficient homes.
        • Energy efficient appliance credit.
        • Enhanced charitable deductions for: contributions of food inventory; contributions of book inventories to public schools; and corporate contributions of computer equipment for educational purposes.
        • Empowerment Zone tax breaks.
      • For Individuals:
        • Election to deduct State and local general sales taxes in lieu of a state and local income tax deduction.
        • Above-the-line deduction for qualified tuition and related expenses.
        • Treatment of mortgage insurance premiums as deductible qualified residence interest.
        • Above-the-line deduction for up to $250 of certain expenses of elementary and secondary school teachers.
        • Nonbusiness energy property credit.
        • Tax-free distributions (up to $100,000 annually for taxpayers 70- 1/2 and older) from individual retirement plans for charitable purposes.