New Supplemental Wage Withholding Rates

Supplemental wages include bonuses, commissions, stock option income, and other income earned outside of the normal payroll amounts.  Federal income tax withholding on supplemental wages is computed under one of three methods:

1.     Mandatory flat-rate method.  When supplemental wages exceed $1 million during a calendar year, federal income tax withholding must be at the highest ordinary income tax rate.  In 2012, this rate was 35%.  In 2013, the flat-rate rises to 39.6%.

2.     Optional flat-rate method.  For supplemental wages (paid separately from regular wages) of $1 million or less during a calendar year, federal income tax withholding must be at the third lowest ordinary income tax rate.  This rate is 25% for both 2012 and 2013.

3.     Aggregation method.  For supplemental wages of $1 million or less during a calendar year, the supplemental wages can simply be added to regular wages to determine the amount of federal income withholding for that payroll period.

In addition, back-up income tax withholding is required on payments to a person that had either a missing or an incorrect taxpayer identification number on a required information return filing (e.g., Form 1099).  The back-up withholding rate must be at the fourth lowest ordinary income tax rate.  This rate is 28% for both 2012 and 2013.

Some taxpayers with supplemental wages fall into the trap of thinking that the optional flat-rate withholding pays all of the federal income tax due on those wages.  For example, employees with nonqualified stock option income or bonus income may have had 25% in federal income tax withholdings, but much or all of those supplemental wages may be subject to higher ordinary income tax rates (e.g. 28%, 33%, 35%, or 39.6%).  Therefore, it is important that such individuals estimate what the total income tax will be on those supplemental wages and set aside any shortfall in order to have the cash needed to fully pay the total income tax when the tax return is filed.

Form 1099-K Reporting Issues

The Form 1099 series is used by the IRS to match income reported by payers to the income tax returns of taxpayers in an effort to combat under reporting.  There are 17 different types of 1099s, plus other information reporting forms such as W-2s, K-1s, 1098s, 5498s, etc.  For example, Form 1099-INT is used to report interest income and Form 1099-MISC is used to report payments to non-employees.  The IRS developed new Form 1099-K to be used for the first time in 2011.  Form 1099-K was developed to require merchant card companies (issuers of credit and debit cards) and third party e-commerce facilitators (e.g. PayPal) to report the gross receipts received by businesses from customers paying with credit or debit cards or engaging in e-commerce transactions.  The 2011 business income tax forms included a special line for businesses to report the portion of their receipts coming from credit or debit card charges.  Small businesses complained to the IRS about the heavy burden they would experience if they had to reconcile their gross receipts with Forms 1099-K.  In response, the IRS announced that the special reconciliation line on the 2011 income tax return forms for Forms 1099-K should be left blank, and that the IRS did not intend to require reconciliation on future income tax returns.

Nevertheless, Form 1099-K is still required to be completed by merchant card companies and e-commerce facilitators.  Form 1099-K does not need to be filed on a business if the total gross amount of payments during the calendar year to the business is $20,000 or less and if the total number of transactions is 200 or less.  Despite its assurances above, the IRS announced plans to establish a small compliance program in which it will send notices to some businesses to determine whether taxpayers are properly reporting all of their income.  Businesses should expect IRS scrutiny if total Form 1099-K receipts are higher or represent a high percentage of reported gross receipts.  Absent receiving a notice from the IRS, businesses do not need to reconcile the Forms 1099-K on their 2012 income tax returns.

Estate and Gift Tax Provisions of the American Taxpayer Relief Act of 2012

The ATRA was passed by Congress on January 1, 2013 and signed by Pres. Obama on January 2, 2013.  ATRA makes several important changes to the transfer tax system effective for individuals dying or making gifts after 2012, including the following:

1.     The exemption from estate, gift, and generation-skipping transfer tax is permanently set at $5 million (instead of the scheduled $1 million amount) as indexed for inflation after 2011.  The 2013 inflation adjusted exemption increases to $5.25 million, up from $5.12 million in 2012.  The permanent increase makes irrelevant the much discussed concern over the potential "clawback" of tax benefits associated with making a gift in an amount larger than the future estate tax exemption.

2.     The top estate and gift tax rate is permanently set at 40% (instead of the scheduled 55%), up from 35% in 2012.

3.     The flat generation-skipping transfer tax rate is permanently set at 40% (instead of the scheduled 55%), up from 35% in 2012

4.     The portability election for a deceased spouse’s unused exemption amount is made permanent (instead of expiring).

5.     The gift and estate tax regimes are permanently reunified.

With respect to ordinary income (O.I.) tax rates applicable to trusts and estates, ATRA left the 2012 rates in place except that the top 35% rate is eliminated in favor of a top 39.6% rate.  Therefore, there isn’t an intermediate 35% trust and estate income tax rate bracket in 2013 as there is for individuals.

2012 Rate Bracket	2012	2013 Rate Bracket	2013
$0 to $2,400	15%	$0 to $2,450	15%
$2,401 to $5,600	25%	$2,451 to $5,700	25%
$5,601 to $8,500	28%	$5,701 to $8,750	28%
$8,500 to $11,650	33%	$8,751 to $11,950	33%
$11,651 and up	35%	$11,951 and up	39.6%

With respect to long-term capital gain and qualified dividend income tax rates applicable to trusts and estates, rules similar to individuals will apply.

LTCG and Qualified Dividend	2012	2013
15% O.I. rate	0%	0%
25% through 33% O.I. rates	15%	15%
39.6% O.I. rate	15%	20%

Alternative Minimum Tax Patch Expanded and Made Permanent

The non-corporate alternative minimum tax (AMT) is a tax system that runs parallel to the regular tax system.  It has its own definitions of income and deductions, and has its own exemption and tax rates.  For example, some tax-free municipal interest income (e.g. “private activity” bonds) is taxable, and itemized deductions for taxes and personal exemptions are not deductible.  The AMT has all of the long-term capital gain and qualified dividend tax rates used for regular tax, but it only has two ordinary income tax rates:  26% and 28%.  There is a fairly large exemption amount, but it phases out by 25% of the excess of AMT taxable income over certain threshold amounts.  If the calculated amount of the AMT exceeds the regular tax, then the excess becomes the AMT and is added to the regular tax amount.  Thus, the AMT is really a misnomer because it isn’t an “alternative” to the regular tax, it is mandatory; and it doesn’t “minimize” tax, it maximizes tax.

The AMT was originally enacted to catch 155 rich taxpayers who reportedly paid no income tax in 1966.  Now the AMT catches around 4 million taxpayers in its snare.  The main reasons for the expansion of the AMT are that its tax rate brackets, exemption amounts, and exemption phase-out threshold amounts have not been fully indexed for past inflation.  In addition, regular tax ordinary income tax rates were lowered under the “Bush” tax cuts (now made permanent except at the highest income bracket) while there was no corresponding reduction to the AMT ordinary tax rates.  In the past, Congress enacted temporary “patches” of the exemption amount to reflect recent inflation in order to prevent a wide expansion of the AMT.  For example, the 2012 patch prevents an additional 26 million taxpayers from becoming ensnared by the AMT.

Fortunately, the American Taxpayer Relief Act of 2012 permanently patches the AMT exemption amount for recent inflation, and in a significant change, also expands the patch so that starting in 2013, the exemption phase-out threshold and the 26% ordinary AMT tax bracket will be indexed for future inflation.  The relevant figures are shown in the table below.

	2012 if no Patch	2012 Patch	2013 as Indexed
Exemption, MFJ	$  45,000	$  78,750	$  80,800
Exemption, MFS	$  22,500	$  39,375	$  40,400
Exemption, Single	$  33,750	$  50,600	$  51,900
Exemption, Trust & Estate	$  22,500	$  22,500	$  23,100
Start of Exemption Phase-out, MFJ	$150,000	$150,000	$153,900
Start of Exemption Phase-out, MFS	$  75,000	$  75,000	$  76,950
Start of Exemption Phase-out, Single	$112,500	$112,500	$115,400
Start of Exemption Phase-out, Trust & Estate	$  75,000	$  75,000	$  76,950
Top of 26% rate bracket, MFJ & Single	$175,000	$175,000	$179,500
Top of 26% rate bracket, MFS	$  87,500	$  87,500	$  89,750
Top of 26% rate bracket, Trust & Estate	$175,000	$175,000	$179,500

Provision for Direct IRA Distributions to Charity Extended with Tax Elections Available for Actions Taken in January 2013

The American Taxpayer Relief Act of 2012 (ATRA) was passed by Congress on January 1, 2013 and signed by Pres. Obama on January 2, 2013.  ATRA retroactively reinstated for 2012 and extended through 2013 the prior law provision enabling certain direct charitable distributions from an Individual Retirement Account (IRA).

Under the provision, those age 70 ½ or older may instruct their IRA custodian or trustee to pay a distribution of up to $100,000 per year directly to a public charity (e.g. the check cannot be made payable to the IRA owner) that is not a donor advised fund or a supporting organization.  Furthermore, no benefits can be provided by the charity to the IRA owner in exchange for the donation (e.g. dinner) or else the entire donation will not qualify for this provision.  A tax-qualified receipt must also be obtained from the charity.  The distribution is excluded from gross income but the donation is not counted as a charitable deduction (no double benefit).  This strategy provides two main benefits:  (1) excluding the distribution from gross income lowers the amount of adjusted gross income (AGI) upon which so many tax increases are based (e.g., taxable portion of Social Security benefits), and (2) the charitable distribution is counted towards meeting the required minimum distribution (RMD) for the year.  The traditional and the Roth IRA are eligible under this provision.  However, the SEP IRA and the SIMPLE IRA are not eligible.  Using a Roth IRA to make a direct charitable distribution usually does not make tax sense because qualified Roth IRA distributions are tax exempt.  Where individuals have made nondeductible contributions to their traditional IRAs, a special rule treats amounts distributed to charities as coming first from taxable funds, instead of proportionately from taxable and nontaxable funds, as would be the case with regular distributions.

Because this provision wasn’t extended until January 2013, a couple of special elections are provided to deal with the retroactive reinstatement to 2012.  However, action must be taken in the month of January 2013 if you intend to use one or both of these special elections!

1.     If you received an IRA distribution in December 2012 (e.g., in order to meet your 2012 RMD), you can make a cash donation of any portion of the distribution amount to charity by January 31, 2013 and elect to treat that portion of the December 2012 IRA distribution as if it were a 2012 qualified, direct charitable IRA distribution.

2.     You can make a qualified, direct charitable IRA distribution during the month of January 2013 and elect to treat the distribution as if it had been made on December 31, 2012.  This election could address situations where you were waiting for Congress to extend this provision before the end of 2012, and either you missed taking the full amount of your 2012 RMD (and would therefore be subject to a penalty) or you didn't make a 2012 charitable IRA distribution because the law expired in 2011.  Furthermore, another direct charitable IRA distribution can be made in 2013 for the 2013 tax year, effectively permitting a second charitable IRA distribution in 2013.

The IRS just provided some guidance regarding the impact of the second election.  If a January 2013 direct charitable distribution is made, and the election is made to treat it as having been made on December 31, 2012, then such distribution can only be counted towards satisfying your 2012 RMD and not your 2013 RMD.  However, for purposes of computing the amount of your 2013 RMD, the distribution must be subtracted from your December 31, 2012 IRA balance.

Business Tax Provisions of the American Taxpayer Relief Act of 2012

The ATRA was passed by Congress on January 1, 2013 and signed by Pres. Obama on January 2, 2013.  ATRA retroactively reinstated for 2012 certain expired business tax provisions and extended others including the following:

1.     The Section 179 expensing limit is increased to $500,000 for tax years beginning in 2012 (up from $139,000) and 2013 (up from $25,000).  The Section 179 deduction phases-out dollar for dollar as total eligible Section 179 property purchases during the year exceed $2 million for tax years beginning in 2012 (up from $560,000) and 2013 (up from $200,000).  In addition, up to $250,000 of the $500,000 expense amount can be for the cost of qualified leasehold improvements, qualified restaurant improvements, new restaurant buildings, and qualified retail improvements.  Finally, the special rule permitting off-the-shelf computer software to be expensed under Section 179 is extended to tax years beginning in 2012 and 2013.

2.     The 50% bonus depreciation for “new” property (and for qualified leasehold improvements) placed in service in 2012 is extended to property placed in service in 2013.

3.     The research and experimental tax credit expired December 31, 2011.  It is reinstated for expenditures made in 2012 and extended through 2013.

4.     The 100% exclusion of gain on the sale of certain small business stock held for more than five years is retroactively reinstated so that stock acquired from September 28, 2010 through December 31, 2013 is eligible for the 100% exclusion instead of the regular 50% exclusion.

5.     The shorter depreciation period (15 years instead of 39 years) for qualified leasehold improvements, qualified restaurant improvements, new restaurant buildings, and qualified retail improvements expired December 31, 2011.  It is reinstated for property placed in service during 2012 and 2013.

6.     The special rule limiting the reduction of S corporation stock basis to the tax basis of appreciated property donated to charity (instead of a higher reduction for fair market value) is reinstated for donations made in tax years beginning in 2012 and 2013.

7.     The reduction in the S corporation built-in gain recognition period (e.g. for C corporations electing S status) from 10 years to 5 years is extended to sales of assets in 2012 and 2013.

8.     The penalty tax rate on C corporations that are subject to the accumulated earnings tax or to the personal holding company tax rises from 15% for tax years beginning in 2012 to 20% for tax years beginning in 2013.

9.     The prior, temporary repeal of the collapsible corporation tax rules is now made permanent.

Most businesses are now organized as “pass-through” entities (PTE), meaning that business net income is allocated to the owners for purposes of paying income tax.  A regular or “C” corporation is not a PTE and pays its own income tax.  The top C corporation tax rate remains 35%, although some proposals have been made to lower the rate.  With the ATRA tax rate increases on individuals, the top PTE tax rate is 39.6%.  In addition, new Obamacare taxes begin in 2013 and will add to the top income tax rate of PTE owners, adding as much as 3.8% for a total of 43.4%.  Obamacare taxes do not apply to C corporations so its top rate remains 35%.  Nevertheless, a PTE will often remain the entity of choice for small business owners due to the potential for double taxation that can apply to C corporation shareholders (e.g. dividends, sale of assets and liquidation) resulting in an effective combined top federal tax rate of 50.5%.  The gap in between a PTE's single tax rate and a C corporation's double tax rate has been significantly narrowed in 2013.  Therefore, the decision of whether to select a C corporation as your business entity warrants a closer inspection, particularly when certain other C corporation tax advantages (e.g. nontaxable fringe benefits) are considered.

Individual Tax Provisions of the American Taxpayer Relief Act of 2012

The ATRA was passed by Congress on January 1, 2013 and signed by Pres. Obama on January 2, 2013.  ATRA retroactively reinstated for 2012 certain expired provisions, and then raised income taxes on higher income individuals beginning in 2013.

Important changes to 2012 tax law (affecting 2012 income tax returns) include the following:

1.     The alternative minimum tax (AMT) exemption amount has been permanently “patched” for past inflation.  The 2012 exemption amounts are increased to $78,750 for joint filers; $50,600 for single filers; and $39,375 for married filing separately.  The increase insulates about 30 million taxpayers from the AMT.  The exemption will be indexed for inflation after 2012.

2.     Certain regular tax credits can reduce the AMT.  This provision expired December 31, 2011 but is reinstated for 2012 and made permanent.

3.     The $250 above-the-line deduction for certain expenses of elementary and secondary school teachers expired December 31, 2011.  It is reinstated for 2012 and extended through 2013.

4.     The deduction of mortgage insurance premiums expired December 31, 2011.  It is reinstated for 2012 and extended through 2013.

5.     The option to deduct state and local sales taxes (instead of state and local income taxes) expired December 31, 2011.  It is reinstated for 2012 and extended through 2013.

6.     The above-the-line deduction for qualified college tuition and related expenses expired December 31, 2011.  It is reinstated for 2012 and extended through 2013.

7.     The provision for those age 70 ½ or older to make tax-free direct IRA distributions of up to $100,000 per year to public charities expired December 31, 2011.  It is reinstated for 2012 and extended through 2013 with special transition rules.  A subsequent blog article will address this subject in more detail.

8.     The residential energy credit with a lifetime limit of $500 (of which only $200 can be used for windows and skylights) expired December 31, 2011.  It is reinstated for 2012 and extended through 2013.

Important changes to 2013 tax law include the following:

1.     The lower “Bush” ordinary income tax rates are made permanent after 2012 except that a new 39.6% rate applies to taxable income above certain thresholds.  The thresholds are $450,000 for joint filers; $400,000 for single filers; $425,000 for head of household; and $225,000 for married filing separately.  These thresholds are indexed for inflation after 2013.  The estimated taxable income brackets for a married taxpayer filing a joint return are:

2012 Rate Bracket	2012	2013 Rate Bracket	2013
$0 to $17,400	10%	$0 to $17,850	10%
$17,401 to $70,700	15%	$17,851 to $72,500	15%
$70,701 to $142,700	25%	$72,501 to $146,400	25%
$142,701 to $217,450	28%	$146,401 to $223,050	28%
$217,451 to $388,350	33%	$223,051 to $398,350	33%
$388,351 to $450,000	35%	$398,351 to $450,000	35%
$450,001 and up	35%	$450,001 and up	39.6%

 

2.     The lower “Bush” long-term capital gain and qualified dividend income tax rates are made permanent after 2012 except that a new 20% rate applies to such income above certain thresholds.  The thresholds are $450,000 for joint filers; $400,000 for single filers; $425,000 for head of household; and $225,000 for married filing separately.  These thresholds are indexed for inflation after 2013.  For taxpayers whose ordinary income (O.I.) tax rate is below 25%, the special 0% rate is made permanent for long-term capital gains and qualified dividends.  For taxpayers whose O.I. tax rate is from 25% to 35% (e.g. having income below the threshold at which the 39.6% rate applies), the top rate of 15% will apply to long-term capital gains and qualified dividends.  The special five-year, super-long term holding period tax rate of 18% that was to start in 2013 no longer applies.

LTCG and Qualified Dividend	2012	2013
10% and 15% O.I. rates	0%	0%
25% through 35% O.I. rates	15%	15%
39.6% O.I. rate	15%	20%

3.     After 2012, the deduction for personal exemptions phases-out (PEP) by 2% for each $2,500 (or portion thereof) by which adjusted gross income (AGI) exceeds a threshold amount.  For married filing separately, the PEP is 2% for each $1,250 (or portion thereof) by which AGI exceeds the threshold amount.  The threshold amounts are $300,000 for joint filers; $250,000 for single filers; $275,000 for head of household; and $150,000 for married filing separately.  All of the personal exemptions will be phased-out once AGI exceeds $122,500 above these threshold amounts.  The marginal tax rate on income earned in the phase-out range increases by approximately 1.0% point per personal exemption.  PEP is now a permanent provision and the thresholds are indexed for inflation after 2013.

Example:  Bob and Mary are married with two dependent children.  The 2013 personal exemption amount is estimated to be $3,900 per person.  The total amount of personal exemptions is $15,600.  Assume AGI is $403,000.  The amount in excess of $300,000 is $103,000.  Dividing $103,000 by $2,500 equals 41.2.  The percentage phase-out is 2% times 42 equals 84%.  The amount of disallowed personal exemptions $15,600 times 84% or $13,104.  Therefore, the deductible portion equals $2,496.

4.     After 2012, the deduction for certain itemized deductions (e.g. state and local income, sales, or property tax; home mortgage interest; charitable contributions; and miscellaneous itemized) is reduced by the amount equal to 3% of the excess of AGI over a threshold amount.  The total reduction cannot exceed 80% of the total.  The reduction does not apply to itemized deductions for medical expenses; investment interest expense; or casualty, theft, or wagering losses.  The provision for reducing itemized deductions is sometimes called the “Pease” limitation, named after the Congressman who originally proposed this provision that started back in 1991.  The amounts are $300,000 for joint filers; $250,000 for single filers; $275,000 for head of household; and $150,000 for married filing separately.  The marginal tax rate on income earned in the phase-out range increases by approximately 1.2% points at the top ordinary rate.  The Pease limitation is now a permanent provision and the thresholds are indexed for inflation after 2013.

Example:  Assume Bob and Mary have itemized deductions from taxes, home mortgage interest, and charitable deductions totaling $60,000 and that their AGI is $403,000.  The amount in excess of $300,000 is $103,000.  Multiplying $103,000 by 3% equals $3,090.  The itemized deduction equals $60,000 minus $3,090 or $56,910.

5.     The American Opportunity tax credit, which provides a more generous tax credit for certain expenses of the first four years of college, was to expire December 31, 2012.  It is extended through 12/31/2017.

6.     The exclusion for the discharge of qualified principal residence indebtedness of up to $2 million was to expire December 31, 2012.  It is extended for discharges through December 31, 2013.

7.     Retirement plans may adopt a permanent provision allowing employees to make a direct Roth conversion (after 2012) of a traditional 401(k), 403(b), or 457(b) governmental plan amount to a designated Roth 401(k), Roth 403(b), or Roth 457(b) governmental plan account in the same retirement plan.  Previously, a direct conversion was only possible if the employee had a right to withdraw money from the plan (e.g. because of attaining age 59 ½ or separation from service).

8.     The enhanced child tax credit of $1,000 is permanently extended past 2012.

9.     The marriage penalty relief pertaining to the standard deduction and the 15% ordinary rate bracket is permanently extended past 2012.  However, the ATRA thresholds for the top rate brackets and deduction limitations make the marriage penalty worse.

10.  The enhanced Coverdell Education Savings Account annual contribution limit of $2,000 is permanently extended past 2012.

11.  The expanded exclusion of up to $5,250 for employer-provided educational assistance is permanently extended past 2012.

12.  The expanded student loan interest deduction of $2,500 is permanently extended past 2012.

13.  The expanded dependent care tax credit is permanently extended past 2012.

14.  The increased adoption tax credit and the adoption assistance program exclusion are permanently extended past 2012.

15.  The Social Security tax rate for employees was temporarily reduced from 6.2% to 4.2% for 2011 and 2012.  The rate permanently returns to 6.2% in 2013.  For those with wages at or above the 2013 Social Security tax ceiling of $113,700; this will be a $2,274 tax increase.

Finally, don’t forget the Obamacare 2013 tax increases that come on top of the ATRA increases.  These are an additional 0.9% tax on compensation above certain thresholds, and an additional 3.8% tax on net investment income when modified AGI exceeds certain thresholds.  See my blog posts of July 13, 2012 and August8, 2012 for the details.