The good news: The new law cancels income tax increases that would have resulted in added misery. It also makes several provisions permanent, which will result in less uncertainty.
The bad news: Higher-income folks will face higher tax rates, starting this year. And there are a couple other new taxes kicking in this year (not part of the new law), which may take you by surprise.
This article summarizes some of the most important changes.
Employee Benefit Provisions
• Favorable rules for employer-paid adoption expenses made permanent: The Bush tax cut legislation increased the cap on tax-free employer adoption assistance payments and raised the income phase-out ranges to allow more employees to benefit. However, tax-free treatment for adoption assistance payments was scheduled to expire at the end of 2012. The new law makes the Bush tax cut provisions permanent for 2013 and beyond.
• Employer educational assistance plans made permanent. Section 127 of the Internal Revenue Code allows employers to set up plans that provide up to $5,250 in annual federal-income-tax-free educational assistance to each eligible employee. Both undergraduate and graduate school costs can be covered by the plan, and the education need not be job-related. The employer can deduct the cost as an employee benefit expense. This taxpayer-friendly deal was scheduled to expire at the end of 2012, but the Act makes it permanent for 2013 and beyond.
• Qualified retirement plan balances can be transferred into plan designated Roth accounts: Some qualified retirement plans [typically 401(k) plans] allow participants to make salary-reduction contributions to designated Roth accounts. These accounts are similar to Roth IRAs, but they are operated by the retirement plan.
Previous legislation also allowed a plan participant to roll over amounts that are eligible for distribution from the “regular” part of the plan into his or her designated Roth account. The Act extends the concept by allowing participants to transfer amounts into designated Roth accounts without the requirement that such amounts be eligible for distribution. This favorable change is available for transfers after December 31, 2012.
Key Point: For the plan participant, the federal income tax impact of transferring an amount into a designated Roth account is the same as receiving the amount as a plan distribution and then rolling it over into a Roth IRA, thereby effecting a Roth conversion with respect to the transferred amount. In other words, the taxable portion of the transferred amount must be included in the participant’s gross income—just like with a garden-variety Roth conversion transaction.
• Alternative minimum tax patch: It had become an annual ritual for Congress to “patch” the AMT rules to prevent millions more households from getting hit with this add-on tax. The patch consisted of allowing larger inflation-indexed AMT exemption amounts and allowing various personal tax credits to offset the AMT. Thankfully, the new law makes the patch permanent, starting with 2012. As a result, about 30 million households a year will be kept out of the AMT zone.
The new law increases AMT exemption amounts for 2012 to $50,600 for single taxpayers; $78,750 for married joint filers; and $39,375 for married taxpayers filing separately. (For 2013, these amounts are projected to be $51,900, $80,750 and $40,375, respectively.)
•Larger child tax credit: The $1,000 maximum credit for each eligible under-age-17 child was made permanent. Without the new law, the maximum credit would have dropped to only $500 for 2013 and beyond. In addition, provisions that allow the child credit to be refundable for more households were extended through 2017.
The payroll tax holiday is over
For 2011 and 2012, the Social Security tax withholding rate on an employee’s salary was temporarily reduced from the normal 6.2 to 4.2 percent. If you’re self-employed, the Social Security tax component of the self-employment tax was reduced from the normal 12.4 to 10.4 percent. Last year, this payroll tax holiday could have saved one person up to $2,202 (up to $4,404 for a married couple with two incomes). Unfortunately for working folks, the new law does not extend the payroll tax cut through 2013.
Key Point: For this year, the Social Security tax can hit up to $113,700 of salary at a 6.2 percent rate and up to $113,700 of self-employment income at a 12.4 percent rate.
• Qualified small business corporation stock: The Act retroactively restores the temporary 100 percent gain exclusion (within limits) for sales of qualified small business corporation (QSBC) stock issued in 2012 and extends the deal to cover eligible shares issued in 2013.
Note: QSBC shares must be held for more than five years to be eligible for the gain exclusion privilege.
• S corporation built-in gains: When a C corporation converts to S corporation status, the corporate-level built-in gains tax generally applies when built-in gain assets (including receivables and inventories) are turned into cash or sold within the recognition period. The recognition period is normally the 10-year period that begins on the conversion date.
Previous legislation established an exception for built-in gains recognized in S corporation tax years beginning in 2011 if the fifth year of the recognition period had gone by before the beginning of the tax year beginning in 2011. Gains that fall under this exception were not hit with the built-in gains tax.
The American Taxpayer Relief Act retroactively restores the five-year exception for tax years beginning in 2012 and extends it for tax years beginning in 2013. In other words, for gains recognized in those years, the built-in gains tax won’t apply if the fifth year of the recognition period has gone by before the start of the year. The Act also clarifies the treatment of installment sale gains for purposes of qualifying for the five-year exception.
• Favorable rule for S corporation donations of appreciated assets. The Act retroactively restores for tax years beginning in 2012 and extends through tax years beginning in 2013 the favorable shareholder basis rule for stock in S corporations that make charitable donations of appreciated assets. For such donations, each shareholder’s tax basis in the S corporation’s stock is only reduced by the shareholder’s pro-rata percentage of the company’s tax basis in the donated assets.
Without the extended provision, a shareholder’s basis reduction would equal the passed-through write-off for the donation (a larger amount than the shareholder’s pro-rata percentage of the company’s tax basis in the donated asset). The extended provision is taxpayer-friendly because it leaves shareholders with higher tax basis in their S corporation shares, which is almost always beneficial to shareholders.
• Corporate election to claim credits in lieu of bonus depreciation: Previous legislation allowed corporations that are otherwise eligible to claim bonus depreciation to elect to forego bonus depreciation and instead “free up” otherwise unusable minimum tax credit carryovers. Credit carryovers freed up by this election are refundable (meaning they can be collected even if they exceed the electing corporation’s tax liability).
The Act allows the election with respect to bonus depreciation on qualified assets that are placed in service by December 31, 2013, or by December 31, 2014, for certain assets that have longer production periods including transportation equipment and aircraft. Therefore, additional freed-up credits can be claimed in lieu of bonus depreciation deductions that would have otherwise been allowed by the law. Special rules apply to taxpayers that have previously taken advantage of this election.
Keep in mind that making the election does not result in any lost depreciation deductions. It just postpones depreciation deductions for affected assets.
• Biodiesel and Renewable Diesel Fuel Credits: The new law retroactively restores the income tax and excise tax credits for biodiesel and renewable diesel fuels for 2012 and extends it to cover qualifying fuels produced, sold, or used through 2013.
• Alternative Fuel Credits: The Act retroactively restores the alternative fuel and alternative fuel mixture excise tax credits for 2012 and extends them to cover qualifying fuels sold or used through 2013.
EDITORS NOTE: Selwyn Gerber is a principal in Gerber & Company, a CPA firm in Century City, California. He can be reached at 310- 432-4382, or sg@GerberCo.com