President Obama signed the American Taxpayer Relief Act of 2012 (2012 Tax Relief Act) on January 2, 2013, to avert the impending “Fiscal Cliff.” With the expiration of the American Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, many tax provisions originally enacted under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) were set to expire on December 31, 2012. The 2012 Tax Relief Act prevented the increase of individual income tax rates for all taxpayers, continued favorable tax rates for net capital gains and qualified dividends, and prevented the basic exclusion amount for the estate, gift, and generation-skipping taxes from reverting to $1 million. Thus, the 2012 Tax Relief Act was a necessity and provided taxpayers with much needed stability, especially in the context of the estate, gift, and generation-skipping taxes.

Although the 2012 Tax Relief Act provided stability to many areas of the tax law, not all the provisions of the 2012 Tax Relief Act are permanent. For instance, the 2012 Tax Relief Act extended the temporary education tax credits through 2017 provided by the American Opportunity Tax Credit (AOTC). Moreover, the 2012 Tax Relief Act reenacted less favorable provisions including limitations on itemized deductions and the phase-out rules for personal exemptions. Taxpayers should become familiar with an overview of the 2012 Tax Relief Act and its effect on income tax provisions, business tax provisions, education incentives, and transfer tax provisions.

Marginal Ordinary Income Tax Rates

The 2012 Tax Relief Act made permanent the 2012 marginal income tax rates and favorable capital gains and qualified dividends rates for Americans making less than $400,000 ($450,000 for married filing jointly), adjusted for inflation.

The 2012 Tax Relief Act did not increase the marginal tax rates or tax rates on capital gains and qualified dividends for middle-class Americans. The marginal tax rates for middle-class Americans will remain at 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent. However, the 2012 Tax Relief Act increased rates on ordinary income, capital gains, and qualified dividends for Americans that earn more than $400,000 ($450,000 for married filing jointly), indexed for inflation. The highest marginal rate for these taxpayers increased from 35 percent to 39.6 percent on ordinary income and from 15 percent to 20 percent on capital gains and qualified dividends. See Table 1.1 for a complete review of the schedule for joint and single tax filers for 2014. The marginal brackets are indexed for inflation and set to increase beginning in 2014.

The 2012 Tax Relief Act reinstated the “Pease” limitations on itemized deductions, although with slightly modified adjusted gross income (MAGI) threshold amounts. Americans with a MAGI above certain threshold amounts will have to reduce their itemized deductions by 3 percent of the amount their income exceeds the threshold amount. Deductions such as medical expenses are not subject to the limitations. Under the 2012 Tax Relief Act, taxpayers must also reduce their personal exemptions by 2 percent for every $2,500 that the taxpayer's MAGI exceeds a threshold amount.

Capital Gains Tax Rates and Qualified Dividends

The Tax Relief Act of 2012 extended the favorable maximum capital gains rate of 15 percent for all Americans making less than $400,000 ($450,000 for married filing jointly), indexed for inflation. For wealthier Americans, the maximum capital gains rate will be 20 percent. Similarly, the 15 percent rate on qualified dividends will apply to taxpayers making less than $400,000 ($450,000 for married filing jointly), indexed for inflation. For taxpayers with incomes above those thresholds, dividends will be taxed at 20 percent.

Educational Provisions

EGTRRA introduced many tax benefits for implementing an educational savings plan. With respect to the 2012 Tax Relief Act, additional benefits were enacted by extending the American Opportunity Tax Credit for Higher Education Expenses through 2017. This tax credit applies to all four years of an undergraduate college education. The amount of the tax credit is generally 100 percent of the first $2,000 in qualifying educational expenses. An additional 25 percent of the next $2,000 in qualifying educational expenses is allowed. The maximum credit is $2,500 (which assumes $4,000 in qualifying educational expenses). Qualifying educational expenses include tuition and related course materials, such as books, software, and lab supplies.

Business and Corporate Tax Relief

Under prior law, the business taxpayer was allowed to immediately deduct up to $500,000 of business property purchased during the calendar year. Prior law also allowed for 50 percent bonus depreciation for purchases of certain new property. These special tax incentives expired and were not addressed in the 2012 Tax Relief Act, but we anticipate that Congress may reinstitute similar provisions in the future due to their importance in providing economic stimulus. For the latest updates regarding tax law changes, visit the Resource Center at www.welchgroup.com; click on “Links,” then “Estate Book Updates.” Current law allows immediate expense deduction of up to $25,000 of business property purchased during the calendar year, with the balance subject to the depreciation rules.

Estate, Gift, and Generation-Skipping Transfers

Following years of uncertainty, the 2012 Tax Relief Act provided for a permanent unified transfer tax system. The exclusion amount enacted was $5 million indexed for inflation ($5,340,000 in 2014). The tax rate is 40 percent on estates exceeding the exemption amount (i.e., the “taxable” estate). Moreover, the 2012 Tax Relief Act permanently enacted so-called portability, which allows the surviving spouse to utilize a predeceased spouse's unused exclusion amount. Therefore, the applicable exclusion amount is now the basic exclusion amount of $5 million (indexed for inflation) plus a deceased spouse's unused exclusion (DSUE) amount.

Following is a list of select provisions that could affect your estate planning:

• The 2012 Tax Relief Act raised the maximum estate, gift, and generation-skipping rates to 40 percent (from 35 percent). The 2012 Tax Relief Act also permanently established the amount of assets that are not subject to estate, gift, and generation-skipping taxes at $5 million, indexed annually for inflation (see Table 1.2).
• Portability is now a permanent feature of estate planning. A decedent's applicable exclusion amount is now the basic exclusion amount of $5 million plus the DSUE amount. Congress intended that portability would simplify estate planning. However, as discussed later, merely relying on portability is not the most prudent planning strategy.

The 3.8 Percent Tax on Net Investment Income

In 2010, Congress passed the Health Care and Reconciliation Act (HCRA), which amended the Patient Protection and Affordable Care Act. Section 1402 of the HCRA imposed a new 3.8 percent surtax on net investment income (NII), which became effective in 2013. The new tax is found in Section 1411 of the Internal Revenue Code. The effect of the tax is that taxpayers in the highest income brackets (39.6 percent for ordinary income and 20 percent for net capital gains) may be subject to an additional 3.8 percent tax on income that meets the definition of NII.

To be subject to the 3.8 percent tax on NII, two initial requirements must be met: (1) the taxpayer's income must be above the “threshold amount,” and (2) the taxpayer must have income that meets the definition of NII.

For individual taxpayers, the 3.8 percent tax will apply only if the taxpayer's MAGI exceeds the threshold amount. For individuals, the threshold amount is as follows:

• Unmarried taxpayer: $200,000
• Married taxpayer filing jointly: $250,000
• Married taxpayer filing separately: $125,000

The threshold amount for estates and trusts is the dollar amount at which the highest marginal taxable rate applies—in 2014 an amount of $12,150. The 3.8 percent tax is imposed on the undistributed NII of estates and trusts. However, the rules for individuals apply to trusts that are treated as “grantor trusts” for income tax purposes.

Once a taxpayer's MAGI exceeds the threshold amount, the taxpayer must have income that meets the definition of NII. There are three potential types of NII:

• Category 1: The gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business that is not a passive activity or is not derived from the trade or business of trading in financial instruments.
• Category 2: Gross income other than interest, dividends, annuities, royalties, and rental payments that is derived from a trade or business that is either (1) a passive activity under Section 469 or (2) the trade or business of trading in financial instruments. This “other income” is subject to the 3.8 percent tax if the income is derived from a trade or business that is either a passive activity or is the trade or business of trading in financial instruments.
• Category 3: The net gain from the disposition of property if the gain is derived from property held in a passive trade or business.

The 3.8 percent tax is imposed on the lesser of (1) the taxpayer's total NII or (2) the difference between the taxpayer's MAGI and the threshold amount. The 3.8 percent tax does not apply to a taxpayer who does not have net investment income or who has an adjusted gross income below the threshold amount. For example, assume that an individual taxpayer is married and files a joint income tax return with the taxpayer's spouse. The taxpayer's MAGI is $1 million, which is composed of a qualified dividend in the amount of $800,000 and $200,000 of ordinary income. In addition to the 20 percent of tax imposed on the qualified dividend, the 3.8 percent tax is imposed on $750,000 (the lesser of the difference between the taxpayer's MAGI of $1 million and the threshold amount of $250,000 or the total NII of $800,000). As a result of the 3.8 percent tax, the taxpayer will pay an additional $28,500 in tax (3.8 percent × $750,000). The dividend results in a total tax of $188,500 (20 percent × $800,000 + 3.8 percent × $750,000).

The 3.8 percent tax is applicable at much lower income levels for trusts. Assume the same facts in the preceding example except that the taxpayer is a trust that receives an $800,000 dividend, which is the trust's only income. Assume that the trust makes an income distribution to its beneficiary of $200,000. The trust will be subject to the NII tax on $587,850 (the lesser of the amount of the undistributed NII of $600,000 or the difference between the trust's AGI of $600,000 and the threshold amount of $12,150).

Although the NII tax is harsh, there are some planning opportunities to minimize the tax. Individuals that own an interest in a trade or business should consult their tax professionals to ensure that the requirements of active participation are satisfied. For instance, an individual will generally materially participate in the business if the individual spends more than 500 hours a year on activities related to the business. Distributing NII from trusts will lower the amount of the NII tax imposed on trusts. Thus, if the beneficiary's MAGI is less than the threshold amount (taking into account the distribution from the trust), distributing the NII will avoid the tax. However, there may be nontax reasons to not distribute the income to a beneficiary—for instance, to protect the distribution from creditors or provide incentive to the beneficiary.

If you feel your estate is not large enough to take advantage of any of these strategies, be clear that, at a minimum, you need at least a basic estate plan, which would include a will, durable power of attorney, and an advanced health care directive.

In this chapter, we have provided an overview of the current estate tax laws as well as actions you should consider taking now. In our next chapter, we will delve deeper into the importance of developing your estate plan and planning opportunities under the 2012 Tax Relief Act.