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Sunset Fiscal Cliff

ATRA brings some permanency to key parts of our tax system, but upper-income filers face a number of increases.

Fiscal Cliff Legislation: Extenders, Increases, Modifications, and Strategies

  • 1/8/2013

Fiscal Cliff Legislation: Extenders, Increases, Modifications, and Strategies

The American Taxpayer Relief Act (ATRA) addresses some overdue 2012 tax provisions, and makes significant changes that begin in 2013. Understanding the changes can help inform both business and personal tax strategies.

2012 extenders

Each year, there are about 30 or more temporary provisions in the tax law that expire and must be renewed by Congress. As expected, ATRA renewed virtually all of these individual and business “extender” items. Provisions that expired on December 31, 2011 were renewed for both the 2012 and 2013 tax years. However, several issues deserve some explanation.

AMT patch made permanent

Every year or two, Congress must adjust the Alternative Minimum Tax (AMT) exemption to keep it coordinated with regular tax rates. Ordinary tax brackets are automatically inflation-indexed by law, but the AMT exemption needs specific Congressional action. This time around, Congress not only adjusted the exemption retroactively for 2012 (to $78,750 for joint filers and $50,600 for single filers), but also made those amounts permanent in the law with annual inflation indexing beginning in 2013.

“This will end the annual drama of awaiting an updated AMT exemption amount from Congress,” says Andy Biebl, a tax partner with CliftonLarsonAllen.

IRA-to-charity relief for retirees

Since 2006, an individual over age 70½ could directly transfer up to $100,000 per year from an IRA to charity. But as a routine extender, this provision expired on December 31, 2011. The ATRA legislation renewed the provision for 2012 and 2013, and also provided two work-arounds for the missed opportunity in 2012:

  • An eligible taxpayer may electively treat an IRA-to-charity transfer made in January of 2013 as if it occurred in 2012. This allows a taxpayer to catch-up the omitted transfer to charity, and strip up to $100,000 of future income out of their IRA in January 2013 using the 2012 limitation.
  • Any cash withdrawal from an IRA taken during December 2012 to be contributed to charity during January of 2013 can be electively treated as a direct IRA-to-charity transfer. Under this provision, an individual who took a December mandatory distribution from the IRA because the IRA-to-charity alternative was not available may now reverse that by writing a check to charity in January.

“High net worth, high-income individuals should give these January privileges special attention,” says Nick Houle, a private client tax partner with CliftonLarsonAllen. “With the income tax and estate tax rate increases starting in 2013, deferred income in an IRA is now a more costly asset to leave to heirs. Using an IRA to fund those charitable commitments is an efficient solution.”

2013 tax increases for upper income individuals, trusts and estates

Upper income individuals, trusts, and estates will face a number of tax increases beginning in 2013.

New 39.6 percent rate

The income tax rates have been stable, but temporary, for more than 10 years. These rates consist of six brackets (10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent). The new legislation makes those rates permanent and adds a seventh rate of 39.6 percent.

Filing Status

39.6 Percent Threshold (Taxable Income)



Head of household




Married filing separately


Beginning in 2014, the bracket thresholds for the 39.6 percent rate will be annually adjusted for inflation in the same manner as the other six tax rates. The 35 percent bracket has been eliminated for trusts and estates, replaced by the 39.6 percent rate. Trusts and estates with taxable income above approximately $12,000 are subject to the 39.6 percent rate.

“The 35 percent tier is very small for single filers — only about $2,000 of income,” says Chris Hesse, a tax partner with CliftonLarsonAllen. “Effectively, this means that single filers leapfrog from the 33 percent bracket to the 39.6 percent rate with only a small amount taxed at the 35 percent rate. For joint filers, the sixth bracket is more substantive — about $52,000 of income before the 39.6 percent rate kicks in on amounts over $450,000.”

Rates on long-term capital gains and qualified dividends move to 20 percent

Previously, capital gains and dividend income had been taxed at a top rate of 15 percent. Beginning in 2013, that rate continues for middle income taxpayers, but increases to 20 percent to the extent the income is within the 39.6 percent bracket. In applying these rates, ordinary income is considered to fill the lower tax brackets first, and capital gains and dividends are considered the upper element of a taxpayer’s annual income.

Example: Paul and Joan, joint filers, report total taxable income of $480,000 in 2013. This consists of $50,000 of capital gain and dividend income, and $430,000 of ordinary income (salary, investment, and business income, net of business and personal deductions). Their capital gain and dividend income is considered the top tier, increasing their ordinary income from $430,000 to total taxable income of $480,000. Of the capital gain income, $20,000 is taxed at the 15 percent rate ($450,000 threshold minus $430,000 of net ordinary income) and the upper $30,000 of capital gain income ($480,000 minus $450,000) is taxed at 20 percent.

In addition, upper income filers also face a new 3.8 percent net investment income (NII) tax on all dividends and most long-term capital gains from the 2010 Affordable Care Act. The 3.8 percent tax affects those whose adjusted gross income (AGI) is more than $200,000 as a single filer or more than $250,000 as a joint filer. Thus, with the two changes combined, upper income taxpayers will find their dividend and capital gain rate effectively increased from 15 percent in 2012 to 23.8 percent in 2013. But these two increases apply unevenly: The 3.8 percent rate applies to those over the $200,000 income range, pushing the capital gain and dividend rate to 18.8 percent. At the $400,000 income level, the 5 percent increase applies, moving the total rate to 23.8 percent. For trusts and estates, the 20 percent capital gains rate and the 3.8 percent NII tax become effective at the same point — approximately $12,000 of taxable income.

“There are several tax elections for owners of S corporations that we can adopt retroactively to create some inexpensive 15 percent dividends within the 2012 tax year,” notes Hesse. “But it takes just the right facts: An S corporation that was formerly a profitable C corporation, and an expectation that the owner will be selling or liquidating in the next few years at new higher tax rates.”

Owners of closely held S corporations in those circumstances should contact their CliftonLarsonAllen tax advisor, Hesse adds.

Phase-out of itemized deductions and personal exemptions

An additional tax increase on upper income filers arrives in 2013 in the form of a phase-out of itemized deductions and personal exemptions. The starting point for these phase-outs is lower than the 39.6 percent bracket. It is based on AGI as follows:

Filing Status

AGI Phase-Out Threshold



Head of household




Married filing separately


The mechanics of these phase-outs are complicated, but the concept is simply to reduce itemized deductions (such as charitable contributions, real estate taxes, and home mortgage interest) and personal exemptions in a gradual manner, as income exceeds the AGI threshold. For the phase-out of personal exemptions, it takes $125,000 of income over the threshold to reduce personal exemptions to zero. For itemized deductions, the phase-out is generally over a greater base of income (depending on the magnitude of itemized deductions). The effect of these two phase-outs, however, is the same: as income exceeds the threshold amount (e.g., $300,000 for a joint filer), taxpayers won’t get the benefit of these deductions.

“For upper income filers, the combined effect of all of these increases will be harsh,” notes Biebl.

Expiration of 2 percent Social Security tax cut

To stimulate consumer spending in 2011 and 2012, Congress reduced the employee portion of the Social Security tax, as well as the self-employed Social Security tax, by 2 percent. The benefit was a significant increase in take-home pay. For example, a $50,000 salaried worker saved $1,000 per year in Social Security taxes. A top income worker paying the maximum on earnings of $110,100 in 2012 saved about $2,200 in payroll taxes. ATRA did not renew this 2 percent cut. As a result, every employee and self-employed taxpayer will revert to the full 6.2 percent employee share on Social Security or self-employment taxes, effective January 1, 2013.

Hesse says, “Workers will notice this 2 percent drop in take-home pay in their first January payroll check.”

Estate and gift tax modifications

ATRA preserves the unified gift and estate exemption at the $5 million per person level, subject to continued inflation indexing. As a result, the per person exemption increases from $5.12 million in 2012 to $5.25 million in 2013. However, Congress has raised the tax rate on transfers in excess of this exemption from 35 percent to 40 percent, effective January 1, 2013. Both the exemption amount and the increased rate are now permanent provisions and no longer subject to short-term expiration.

Business provisions, including extended depreciation incentives

During the recession, Congress enacted measures intended to provide short-term economic stimulus in the form of several enhanced first-year depreciation incentives for businesses. In 2012, a 50 percent first year bonus depreciation deduction applied for purchases of new (not used) assets other than real estate. Also, an enhanced $500,000 Section 179 first-year depreciation allowance applied for tax years beginning in 2011. ATRA continues both of these incentives. The 50 percent first-year bonus is extended one year and applies to eligible property acquired and placed in service within calendar year 2013. The enhanced $500,000 Section 179 limit was restored on a retroactive basis, applying for tax years beginning in 2012 and 2013. A corresponding adjustment increases the “too big to get it” asset addition limitation to $2 million for the Section 179 deduction.

“Profitable businesses with capital equipment needs will want to consider purchases in 2013,” notes Biebl. “When these temporary first-year depreciation incentives end, we’ll drop back to a Section 179 deduction that is likely be in the vicinity of $140,000.”

Several other provisions will interest business owners:

S corporation built-in gains tax

Normally, when a C corporation converts to S corporation status, it continues to be subject to a potential double tax for the first 10 years as an S corporation. However, prior legislation had temporarily shortened the reach of this tax to five years, effective for S corporation tax years beginning in 2011. The new legislation continues that shortened five-year rule for tax years beginning in 2012 and 2013. Further, if an installment sale originates in an S corporation tax year beginning after 2011, all payments collected under the installment note are either exempt from the built-in gains tax (if the entity has been an S corporation for five years) or are subject to the built-in gains tax (if the sale starts within the first five years of leaving C corporation status).

401(k) plan Roth rollovers

Businesses with a 401(k) elective deferral retirement plan will want to consider amending their plan to take advantage of a new feature. ATRA allows employees to internally convert pre-tax accounts to nontaxable Roth status. A conversion triggers taxable income, of course, but this opportunity allows important flexibility for workers who might want to shift their retirement savings to a permanently tax-free accumulation vehicle. This new flexibility is allowed for internal retirement plan transfers after 2012, but only if the employer plan has been modified to provide this Roth conversion feature.

Various business extenders

A variety of business tax credit and deduction privileges expired on December 31, 2011. Those were virtually all renewed for two years, and include important tax credits such as the research and development credit, and the work opportunity tax credit for hiring various categories of disadvantaged workers. Only two extenders dropped out of the tax law: An enhanced charitable contribution privilege for donating book inventories to public schools, and a similar provision for donating computer equipment for educational purposes.

Strategies for upper income filers

Business owners who use pass-through proprietorship, partnership, and S corporation entities are particularly exposed to the combination of rate increases. Comparing the top rate impact on the various categories of business owner income is illustrative:

Type of Income

Top Rate in 2013

Rate Components

Salaries, wages, and self employment

43.4 percent

39.6 percent ordinary plus 3.8 percent Medicare tax

Rental income

43.4 percent

39.6 percent ordinary plus 3.8 percent NII tax

S corporation income
(owner is active)

39.6 percent

Ordinary income rates

S corporation income
(owner is passive)

43.4 percent

39.6 percent ordinary plus 3.8 percent NII tax

C corporation dividends or capital gains

23.8 percent

20 percent rate plus 3.8 percent NII tax (but corporation earnings first exposed to 15 percent to 35 percent corporate tax rates)

Qualified retirement plan distributions

39.6 percent

Ordinary income rates

Sale of pass-through entity — active owner

20 percent

Capital gain rates

Sale of pass-through entity — passive owner

23.8 percent

20 percent rate plus 3.8 percent NII tax

“There’s no one-size fits all solution here,” says Hesse. “Business owners will want to visit with their CLA tax advisor to identify how this legislation affects their tax return and to develop some strategies for restructuring.”

For example, where property is held apart from an S corporation to produce rental income, it may make sense to drop that property into the entity to eliminate the rental income taxed at a higher rate. Instead, that profit would flow out as lower taxed S distributions.

Business owners might also benefit by operating as a C corporation rather than as an S corporation or partnership. Leaving taxable income in the C corporation will reduce the amount of individual income subject to 39.6 percent ordinary income tax, the 3.8 percent Medicare tax, and possibly higher state income taxes. It may be possible to operate only a segment of the business as a C corporation. But there are long-term ramifications of operating as a C corporation in the form of possible double taxation of those retained business earnings.

Some taxpayers near the $400,000/$450,000 threshold for the 39.6 percent rate or the lower $200,000/$250,000 threshold for the 3.8 percent NII tax will need to consider techniques to maintain stable income. Installment sales will become a better route than incurring a large capital gain in a single year. And retirees, who are required to take minimum distributions from retirement plans, will want to avoid spikes in those draws that could subject other investments to the 3.8 percent NII tax.


Investors exposed to the higher rates will find tax-exempt and tax-deferred vehicles more attractive. Real estate investments generating depreciation deductions may become more valuable to offset rental income and other passive income subject to the 3.8 percent net investment income tax. Like-kind exchanges that defer taxation on real estate and business properties will also become more efficient in view of the higher rates.


Trusts that accumulate their investment income, such as those with minors or disabled individuals as beneficiaries, are particularly hard hit due to the low $12,000 income level at which the 39.6 percent rate and the 3.8 percent NII tax apply. Trustees should consider distributions of income to beneficiaries, if allowed under the trust agreement, if the beneficiary will be taxed at a lower level. In many cases, trusts have until the first 65 days of the next tax year to make distributions that are treated as occurring on the prior December 31, allowing for the opportunity of post-year-end planning. Trust and estate taxation is extraordinarily complex; trustees should seek legal and tax counsel to determine their alternatives.

Chris Hesse, Tax Partner or 612-397-3071