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Fast-Approaching “Fiscal Cliff” Could Mean Higher Taxes for Most Taxpayers

In the wake of the recent Presidential election, the focus of many politicians in Washington has turned to the fast-approaching “fiscal cliff,” a combination of federal spending cuts and tax increases designed to combat the growing federal deficit.  While it is still uncertain as to whether Congress will enact subsequent measures to avoid the “fiscal cliff,” it is important for taxpayers of all income levels to consider the potential impact these tax increases will have on both their businesses and their personal wealth.  In addition, as part of the Patient Protection and Affordable Care Act, sometimes referred to as “Obamacare,” a new 3.8% Medicare contribution tax on certain unearned income of individuals, trusts and estates (this may include interest, dividends, income from trades or business that are passive activities or that trade in financial instruments and commodities, and net gains from the disposition of property held in those trades or businesses) is scheduled to tax effect in 2013. This additional tax is scheduled to tax effect regardless of whether Congress taxes any action with regard to the “fiscal cliff.” As a result of these impending changes to federal tax policy, there are three areas of tax planning that we believe will be of particular concern to many of our clients: (1) long-term capital gains; (2) dividend income; and (3) individual income tax.

Long-Term Capital Gains

Currently, taxpayers in the 10% and 15% ordinary income tax brackets pay no tax on long-term capital gains and taxpayers in all other ordinary income tax brackets pay a 15% rate on capital gains.  Both of these tax cuts are scheduled to expire in 2013, with taxpayers in the 10% and 15% brackets becoming subject to a 10% long-term capital gain rate and all other tax payers seeing their long-term capital gains tax rate increasing from 15% to 20%.  In addition, an 18% long-term capital gains tax rate will apply to capital assets purchased after 2000 and held for more than five years.  It is worth noting however, that the additional 3.8% Medicare Contribution Tax discussed above will increase the effective tax rate for long-term capital gains for certain higher-income tax payers from 20% to 23.8% and 18% to 21.8%, respectively.  If no further action is taken by Congress, taxpayers considering selling appreciated stocks, securities and other capital assets in early 2013 may want to consider accelerating the sale of those assets to late 2012 to take advantage of lower tax rates, provided they have held the asset for more than one year to qualify as a long-term capital gain.  Similarly, private business owners – particularly founders of a business, who could gain a lot from a sale – may want to look into closing on the sale of their businesses before 2013 when the 23.8% effective tax rate on long-term capital gains will kick in.  If private business owners wait until 2013 to sell, the price received would need to be considerably higher to net the seller the same amount as they would receive this year in 2012 with the lower tax long-term capital gains rates.

Dividend Income

The “Bush” tax cuts also created “qualified dividend income,” which allowed dividends from certain corporations to be taxed at a taxpayer’s long-term capital gains rate.  Prior to the “Bush” tax cuts, all dividend income was taxed as ordinary income and, if Congress fails to act, dividends will once again be taxed as ordinary income beginning in 2013.  This means that taxpayers in the highest ordinary tax income bracket will see their tax rate on certain dividend income jump from 15% in 2012 to 39.6% in 2013.  In addition, similar to the long-term capital gains rates detailed above, the additional 3.8% Medicare Contribution Tax we have previously discussed will increase the effective tax rate for dividend income for certain higher-income tax payers from 39.6% to 43.4%.  As a result, owners of closely held corporations may want to consider declaring and paying a larger dividend this year in 2012, if the corporation has sufficient earnings to do so.

Individual Income Tax

The “Bush” tax cuts for individual income taxes (enacted in 2001 and 2003 and extended by President Obama in 2010), are scheduled to expire at the end of 2012.  If Congress allows the “Bush” tax cuts to expire, taxpayers at nearly every level of income will see their individual income tax rates increase in 2013.  The following chart illustrates the potential changes in marginal ordinary income tax rates for all taxpayers from 2012 to 2013 if no further action is taken by Congress:

Marginal Tax Rates

2012

2013

10%

15%

15%

15%

25%

28%

28%

31%

33%

36%

35%

39.6%

For more information on the “fiscal cliff” or the effect of any of these potential tax increases, please contact a member of Business Practice Team.

IRS Circular 230 Disclosure. To ensure compliance with U.S. Treasury Regulations governing tax practice, we inform you that any tax advice contained in the foregoing material was not written or intended to be relied upon, nor can it be used, by any taxpayer for the purpose of (i) avoiding tax penalties or (ii) promoting, marketing or recommending to another person any tax-related matter or transaction. This blog post is being provided for informational purposes only and you should consult your own tax advisor regarding your personal tax situation before making any further decisions.