As we wound our way through 2010, no one knew for sure whether sweeping tax law changes would result from a set of new laws or whether sweeping Tax Law changes would result from the expiration of a set of old laws. Either way, something big was going to happen.
On December 17, 2010 the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRA 2010) was signed into law by President Obama. While it extended many of the “Bush Era” tax laws, it also resulted in some significant changes. Many of these changes are retroactive to the 2010 tax year, not simply for 2011 and future years.
The IRS apparently bet on the expiration of the old income tax laws and lost. As a result, the IRS programmed their computers (and created some tax forms) for 2010 returns that must now be changed. The IRS is feverishly re-programming their computers and developing some new forms. The IRS has announced that these may not be available until mid-to-late February of 2011. Many taxpayers that like to file early will be prevented from doing so, including those who itemize their deductions on Schedule A, claim Higher Education Tuition and Fees Deduction, or claim Educator Expense Deductions. All of this will cause a spike in the blood pressure of taxpayers and tax preparers alike.
Here are some of the highlights of TRA 2010:
- Income Tax Rates and Brackets: TRA 2010 extends the 2009 Federal Income Tax Rates through 2012 and the Brackets to which the Rates apply are relatively unchanged.
- Capital Gain and Qualifying Dividend Rates: TRA 2010 extends the 2009 Federal Capital Gain and Qualified Dividend rates for 2 more years. The top Long-Term Capital Gain and Qualified Dividend rate will remain at 15% through 2012. The rates for taxpayers in the 10 or 15 brackets will remain at 0% through 2012. Please note that not all Capital Gains have or will get the benefit of these low rates. Capital Gains from the sale of collectibles and from recapture of accelerated depreciation will continue to be taxed at higher rates.
- Social Security Tax Rates:TRA 2010 gives a gift to employees in the form of reduced Social Security Tax Rates on 2011 payroll. Briefly, FICA is comprised of Social Security Tax and Medicare Tax. FICA is imposed on employees and employers (i.e. money comes out of the employee’s paychecks and employer’s must pay in a matching amount to the U.S. Treasury). For many years, the Social Security Tax Rate was 6.2% on each of the employee and employer, 12.4% total. TRA 2010 reduces the employee rate by 2% to 4.2% for wages earned in 2011. The employer’s portion remains at 6.2% for a combined 2011 Social Security Tax Rate of 10.4%. The Self-Employment tax rate for Self-Employed persons is also reduced. Medicare Tax Rates remain unchanged at a combined 2.9% (1.45% on employees and 1.45% on employers). This will increase employee’s paychecks in 2011 but might compromise the long-term viability of the Social Security System.
- Alternative Limited Tax: The Alternative Minimum Tax (AMT) is a “stealth” tax imposed on taxpayers. Every year, more and more taxpayers get hit by the AMT. TRA 2010 grants a higher AMT exemption for 2010 and 2011 which will reduce the AMT that taxpayers will have to pay.
- Standard Deduction: The higher standard deduction for people filing as “Married Filing Jointly” has now been extended through 2012.
- Itemized Deduction and Personal Exemption Phase-out: Generally, itemized deductions and personal exemptions phase-out as taxpayer’s income increases. This has the effect of increasing taxable income. These phase-outs were previously repealed (i.e. no phase-outs) for 2010 only. This repeal of the phase-outs has now been extended through 2012.
- Bonus Depreciation and Section 179: Bonus Depreciation and Section 179 provide an opportunity for taxpayers to get accelerated depreciation (i.e. faster deductions) on business machinery and equipment. TRA 2010 increases the amount of Bonus Depreciation from 50% to 100% for business property acquired and placed in service between 9/8/10 and 12/31/11. Bonus depreciation remains available until 12/31/12 but generally drops down to 50% for qualified property placed in service after 12/31/11. However, certain qualifying transportation and long-lived property may still be eligible for 100% Bonus depreciation if placed in service by 12/31/12.
- Credits: Tax Credits allow taxpayers to reduce their actual Income Tax, not simply the income subject to tax. Dollar for dollar, credits are much more powerful than deductions. Many credits allow a taxpayer a refund to the extent of the tax that they paid in during the year. Refundable tax credits are the most valuable of all since they allow taxpayers the opportunity to get refunds that exceed the tax that they paid in during the year. Unfortunately, many credits are only available to taxpayers whose income is below certain levels and get phased-out for higher income taxpayers.
TRA 2010 extends a wide range of Federal Tax Credits through 2012, including:
- The Child Tax Credit allows taxpayers a partially refundable credit of up to $1,000 for qualifying children under age 17.
- The Dependent and Child Care Tax Credit allows taxpayers up to $3,000 for one child and up to $6,000 for 2 or more children.
- The American Opportunity Credit (formerly known as the Hope credit) is a refundable tax credit of up to $2,500 for qualified undergraduate education costs.
- The Earned Income Credit can be calculated based upon up to 3 dependents.
- The Adoption Tax Credit is extended with higher limits.
- Federal Estate and Gift Tax (with an Income Tax “Twist”):
- Gift Tax Rules: The Gift Tax never went away (i.e. there was a Gift Tax even for gifts made in 2010). The 2010 Annual Gift Tax Exclusion ($13,000) remains the same for gifts made in 2011.
Federal Estate Tax Rules:
By way of background, early in the Bush Era, Federal Estate Tax laws were enacted as part of EGTRRA that had scheduled changes in the Estate Tax rules that kicked in every few years. The rules got better over time and culminated with no Federal Estate Tax under EGTRRA for those dying in 2010.
However, EGTRRA contained a ticking time bomb that was set to explode after 2010. That is, for those dying after 2010 the Federal Estate Tax rules were scheduled to return with a vengeance (i.e. 55% top tax rate and $1 million exemption). Most estate planning attorneys thought that the 2010 “no Estate Tax” rules would get changed before they ever took effect. However, 12/31/09 came and went without the Estate Tax being addressed. Throughout 2010, those same attorneys split their time between speculating on what the new laws would be and whether they would be retroactive to 1/1/10.
The new Federal Estate Tax laws enacted as part of TRA 2010 provide for 2 years of the most favorable set of laws since….well, since 2010 when there was no Federal Estate Tax. For those dying in 2011 or 2012 the top tax rates are reduced to 35% and the exemption is increased to $5 million (you may recall that for those dying in 2009, the exemption was $3.5 million). Further, surviving spouses can tack-on the unused portion of their deceased spouses’ $5 million exemption to their own (for a maximum possible $10 million exemption) if they file a Federal Estate Tax return (Form 706) for the estate of the first spouse to die on a timely basis and make the proper election. They do not have to pay an Estate Tax to get this benefit, just file the Form 706.
For many taxpayers, TRA 2010 is even better than the EGTTRA law applicable for those dying in 2010. You may ask, how can anything be better than no Estate Tax? Here is where the Income Tax laws intersect with the Federal Estate Tax laws. Briefly, “Basis” is used to determine the Income Tax gain or loss on the sale of an asset (Sale Price – Basis = Gain/ (Loss)). For those dying prior to 2010, there was an unlimited opportunity for the heirs to “Step-Up” the Basis of assets that they inherited to the Fair Market Value of those assets as of the date of the decedents’ death. This was true even if no Estate Tax return had to be filed and no Estate Tax had to be paid. This generally had the happy effect of reducing the potential Income Tax gain when the heirs sell the assets that they inherited.
The ugly side of EGTTRA was that for those dying in 2010 was that there were restrictions placed upon the amount of inherited assets that could be Stepped-Up for Income Tax purposes. This would tend to result in higher gains (and higher tax) for Income Tax purposes. Basically, EGTTRA said that taxpayers cannot have it both ways: If there is no Estate Tax then taxpayers will be limited as to how much of the inherited assets can be Stepped-Up for Income Tax purposes.
(Please note that while the term “Step-Up” is used to describe the re-setting of Basis, it does not mean that Basis always goes up. If the FMV was lower on the date of death than it was in the decedent’s hands, the Basis in the hands of the heirs would be that lower figure.)
TRA 2010 gives estates of those dying after 2010 a full Step-Up (as it had been prior to 2010 under EGTTRA). Further, TRA 2010 comes to the rescue for estates of those that died in 2010 by giving them an option. They can elect to either:
- Keep the EGTTRA 2010 No Estate Tax/limited Basis Step-Up rules; or
- Use the new TRA 2010 35% Estate Tax/$5 million exemption/unlimited Basis Step-Up rules.
TRA 2010 gives the IRS the authority to determine the method and timing in which estates can make this election. I would not be surprised if the IRS decides that no election is required unless estates want to be covered by the new TRA 2010 35%/$5 million exemption/unlimited Basis Step-Up rules (but we will have to wait and see).
Filing Deadlines For 2010:
Please note that the filing deadline for 2010 Income Tax returns of Individuals (Form 1040), Estates and Trusts (Form 1041) has been pushed out 3 days, to Monday, April 18, 2011. This is because April 15, 2011 fell on a District of Columbia holiday and called “Emancipation Day”. The extended due date for Individual Income Tax Returns is Monday, October 17, 2011.
Method of Filing:
The IRS has been “encouraging” taxpayers to file electronically rather than with paper copies of tax returns. The IRS is now going beyond mere encouraging. The law now requires that all tax preparers who reasonably expect to prepare more than 100 returns in 2011 must file their clients’ returns electronically.
Starting in 2012, the threshold for electronic filing will be dropped to those filing more than 10 returns. Filing Electronically requires that tax preparers go through a special registration process that takes a month or so to complete. They must also have software that handles electronic filing and clients that cooperate.
All tax advisors must study the TRA 2010 soon and carefully since it affects 2010 returns about to be prepared and filed. Some provisions will require clarification from the IRS to know, for sure, how the laws are to be interpreted.
The tax cuts (including the 2% Social Security Tax) will leave more money in the hands of taxpayers. This part of the equation is good. However, the government needs money to run on and pay bills. The hope is that the economy recovers enough to offset the lost revenue to the Federal Government and the Social Security system.
Some will say that we now have some certainty as to the tax laws allowing people to plan. However, most of these laws expire in 2 years, which is a short window for planning. Further, it is unlikely that the Federal Government will leave the tax laws alone, even for those 2 years.
Copyright ©, Keith B. Baker – 2011
This article is designed to be a public resource of general information. It does not constitute “legal advice” nor does it create a “client-attorney” relationship. While the information is intended to be accurate, this cannot be guaranteed. Tax laws are complex and constantly changing as a result of new laws, regulations, court interpretations and IRS pronouncements. Often, there are also various possible interpretations. Further, the applicable rules can be affected by the facts and circumstances of a particular situation. Because of this, some of the information may no longer be correct or may not apply to all situations. We are not responsible for any consequences or losses resulting from your reliance on such information. You are urged to consult an experienced lawyer concerning your particular factual situation and any specific legal questions you may have.
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