Think you know your 2013 marginal tax rate?
It may be higher than you expect. The rates on upper-incomers can be far greater than the ones listed in the new income tax brackets. The same goes for tax-favored dividends and long-term capital gains.
Phaseouts of tax benefits are one culprit.
They actually are stealth rate increases, pushing your marginal rate above the 39.6% bracket in the new law. That rate applies to taxable income over $400,000 for singles and $450,000 for marrieds.
The cutback in itemized deductions adds up to 1.19% to your marginal rate. After 2012, these write-offs are reduced by 3% of the excess of adjusted gross income over $250,000 for singles … $300,000 for couples. The total haircut can’t exceed 80% of total itemizations. Medicals, investment interest and casualty losses are exempt. Note that the phaseout is based on the amount of your AGI and not taxable income … what’s left after itemized deductions. Filers with extremely large itemized deductions on Schedule A can start to feel the effects of this phaseout in the 28% bracket.
The loss of personal exemptions adds as much as 1.05% per exemption to your true rate. Personal exemptions are trimmed by 2% for each $2,500 of AGI over the $250,000/$300,000 thresholds we just noted. They disappear once AGI exceeds $372,500 for singles and $422,500 for joint filers. So a family of four in the phaseout zone can have a 4.2-percentage-point hike in its marginal rate.
Two other brand-new taxes for 2013 can increase your marginal rate:
The 0.9% Medicare surtax on high-earners. Singles owe it once earnings top $200,000 … couples, over $250,000. It hits wages and self-employment income.
And the 3.8% Medicare surtax on net investment income … gains, interest, dividends, royalties and passive rental income. This levy starts to bite single filers with adjusted gross income over $200,000 and married couples above $250,000.
Marginal rates on long-term gains and dividends can be higher than expected. If you are in the 10% or 15% tax brackets this year, gains and dividends are tax free until they push you into the 25% bracket … $72,500 of taxable income for couples and $36,250 for singles. Then they are taxed at 15% until your gains and dividends bump you into the 39.6% tax bracket, when the 20% top rate kicks in on the excess.
The 3.8% surtax raises the effective rate on tax-favored gains and dividends to 18.8% for filers below the 39.6% tax bracket and to 23.8% for upper-incomers.
The marginal rate can be even greater for high-incomers who owe the AMT.
Nominally, the 15% and 20% rates on gains and dividends also apply for the AMT. But for filers in the phaseout zones for the minimum tax exemptions … from $150,000 to $473,200 of AMT income for couples and $112,500 to $320,100 for singles … the marginal rate is 6.5 or 7 percentage points more. So most filers hit by this cutback pay a marginal rate of 22% on their gains and dividends. And a good chunk of them end up owing the 3.8% Medicare surtax on top of that, boosting the rate to 25.8%.
Let’s continue our review of the new tax law:
The 2013 withholding tables are out, reflecting the new 39.6% top bracket. The Revenue Service issued them Jan. 3, the day after the president signed the bill. See www.irs.gov/pub/irs-pdf/n1036.pdf for a copy. If an employer did not realize that the Social Security tax rate for employees has returned to 6.2% for 2013, the firm should adjust workers’ pay as soon as possible, but not later than March 31.
The withholding rate on bonuses over $1 million rises to 39.6% for 2013.
Trusts and estates will bear a higher income tax burden this year.
The 39.6% top tax bracket will kick in on taxable income over $11,950, replacing the old 35% maximum tax rate that applied in 2012. The next-lowest rate for 2013 is 33%.
Trusts and estates will be hit by the 3.8% Medicare surtax as well if their AGI exceeds $11,950 and they have any undistributed net investment income.
The AMT exemptions were increased retroactively for 2012 … to $78,750 for joint filers and $50,600 for singles and heads of household. In upcoming years, the exemptions will be adjusted for inflation, so the AMT rolls won’t grow dramatically. For 2013, the exemptions are set at $80,800 for couples and $51,900 for single filers and household heads. Our projection for couples in the Jan. 4 Letter was $50 low.
The adoption credit for 2013 is higher than we first reported. It can be taken on up to $12,970 of costs, IRS says, $200 above our estimate. And the phaseout zone starts at a higher level of AGI this year … $194,580. The credit goes away at $234,580.
The exclusion for company-paid adoption aid also increases to $12,970.
The tax credit for energy-saving home improvements was revived for 2012 and 2013. The credit remains at 10%, with a $500 maximum, and any credits taken in previous years are counted against the $500. No more than $150 can be claimed for furnaces and water heaters, $200 for windows and $300 for biomass fuel stoves.
Two special rules affect direct transfers from IRAs to charity. The new law restored for 2012 the rule that folks 70½ and older can directly transfer up to $100,000 free of tax from their IRAs to charity. The provision now is set to expire after 2013.
Payouts that IRA owners took in Dec. 2012 can qualify for tax free treatment as long as cash is transmitted to a charitable organization prior to Feb. 1, 2013.
And direct transfers made in Jan. 2013 can be treated as made in 2012.
The mass-transit-pass cap for 2012 was retroactively hiked to $240 a month, up from $125. Ditto for van pools. IRS recently issued guidance on FICA tax refunds and W-2 adjustments for firms that gave transit benefits of more than $125 a month. Employers that treated the excess as wages can make adjustments for all of 2012 on their fourth quarter Form 941 and on W-2 forms. But they’ll have to first reimburse their employees for the overcollected FICA tax before utilizing this special option.
The start of this year’s filing season will be delayed to Jan. 30, IRS says. Congress is to blame, since it did not finalize the income tax rules for 2012 until Jan. 1, 2013. IRS postponed the opening so it could reprogram its computers.
However, many filers will have to wait until late Feb. to file, at the earliest.
This will affect taxpayers who use several popular forms. Among them: Form 4562 for depreciation. Form 5695 for residential energy credits. Form 8582 to report passive losses. Form 8839 for the adoption credit. And many forms used for business credits, such as Form 5884 for the work opportunity tax credit.
Farmers who claim depreciation are in a bind. Estimated tax penalties for 2012 are waived if they file by March 1. But Form 4562 may not be ready by then. If the filing delay stretches into March, it’s likely that the IRS will provide them relief.
IRS loses again on levying FICA taxes on severance pay for laid off workers. The 6th Circuit Court of Appeals has refused to reconsider a 2012 decision that payments made in conjunction with a reduction in force aren’t subject to FICA.
Odds favor a Supreme Court appeal. A different Appeals Court OK’d the tax. And IRS estimates refund claims could top $1 billion if it doesn’t ultimately prevail.
A worker can be both an employee and an independent contractor of a firm, the IRS says privately in the case of a consultant who is engaged on separate projects. In such cases, the Service will examine each role independently, and FICA taxes apply only to the portion of pay attributable to an employer-employee relationship.
An IRS attempt to reclassify payments to an S firm owner is partially rebuffed. An S corporation paid its co-owner $60,000, but treated only $2,400 of it as wages. The balance was ostensibly reimbursement for cash advances he made to employees to cover their business expenses. IRS classified $55,000 as salary subject to FICA. The Tax Court agreed that $2,400 was too low a salary. But, because part of his pay was used to reimburse workers, the Court said his average pay for the past five years … $30,000 … was appropriate for payroll tax purposes (Herbert, TC Summ. Op. 2012-124).
Selling and buying back a business can sometimes generate a tax break. After suffering a brain aneurysm, a CPA sold his practice for $900,000. Less than five months later, the buyer had a seizure and sold it back to the CPA for $900,000. Since the firm’s assets consisted of goodwill and other intangibles, the CPA amortized the repurchase cost over 15 years. IRS balked at the write-off, but the Tax Court OK’d the amortization deduction, finding in this case that the sale and buyback were separate and unrelated transactions (Fitch, TC Memo. 2012-358).
Replacing private disability pay with Social Security is bad for your tax health. A disabled worker got tax free benefits under an insurance policy. However, he also was required to apply for Social Security disability and turn over the benefits to the insurer. The Tax Court ruled that he owes tax on the Social Security benefits, even though they are a substitute for nontaxable payments (Brady, TC Memo. 2013-1).
Bad news for a man who financed the purchase of a home and adjoining land:
Interest on borrowings over $1.1 million isn’t deductible, the Tax Court says. He paid $1.8 million for the property, intending to subdivide it and develop a portion of the land. But the purchase contract didn’t allocate the cost between the residential and nonresidential portions. He can deduct the interest on $1.1 million of indebtedness as mortgage interest … $1 million of acquisition debt plus $100,000 of home equity debt. He can’t write off the balance as investment interest (Norman, TC Memo. 2012-360).
Giving a family member a break on rent won’t always nullify a like-kind swap, the Tax Court decides. A landlord exchanged one rental home for another property that needed substantial renovations. His son, who had home building experience, fixed up the place and moved in with his family. The son paid below-market rent because he continued renovating the home during the four years he lived there. Thus, the low rent won’t nix like-kind-exchange treatment (Adams, TC Memo. 2013-7).
The tax implications of home foreclosures depend on the type of loan used. If a mortgage is nonrecourse, so the owner isn’t personally liable on it, the waived debt is included when figuring gain or loss on the transfer, the Revenue Service says. For primary homes, no loss is allowed, and only the portion of gain over the $250,000 or $500,000 exclusion is taxed. On a recourse mortgage, the forgiven debt is treated as income, unless the homeowner is insolvent right before cancellation. And if the loan is on the main residence, up to $2 million of debt forgiveness is deemed to be tax free.
The 2012 audit rate fell to 1.03% for individuals, one out of every 97 returns. 2011’s rate was 1.11%. The number of enforcement staff dropped nearly 6%, partly due to budget cuts. And many agents were detailed to work identity theft cases.
Filers with incomes of $1 million or more continued to get the most scrutiny. The Service audited 12.14% of these filers. That’s one out of every eight tax returns. Exams of folks with lower incomes declined in proportion to the drop in the audit rate.
Audits of all classes of business returns rose last year to 0.71%. That reflects an effort by IRS to check more S companies, partnerships and regular corporations. Exam rates ranged from 17.78% for returns by corporations with assets of $10 million or more to 1.12% for small corporations, 0.48% for S firms and 0.47% for partnerships.
IRS isn’t doing enough to police noncash donations, Treasury inspectors say. Too many tax returns that claim noncash charitable contributions of more than $500 are slipping by without a Form 8283. So the agency will start flagging such returns and asking filers to send in the missing form before allowing the charitable write-off.
Filers will have a simplified option for claiming the home office deduction, beginning with returns for 2013, which will be filed in 2014. Their write-off can be based on a standard rate of $5 per square foot of space used for business, with a maximum deduction of $1,500. This way, they avoid allocating actual costs and figuring depreciation on the 43-line Form 8829. Of course, the requirement that the office be used exclusively for business still applies, no matter which method is used.
Don’t believe the talk that the 2013 tax hikes nail only the highest earners.
Lower- and middle-incomers are hit because of the payroll tax cut’s repeal. The effect of the expiration of the two-percentage-point drop in employees’ share of Social Security tax is being felt this month, as many workers see lower paychecks. An employee making $50,000 this year owes an additional $1,000 in payroll taxes, lowering his or her paycheck by about $19 a week. Individuals making under $100,000 wind up bearing more than 60% of the burden of this year’s payroll tax increase.
By contacting us, we can tailor a particular plan that will work best for you.