'2013 Federal Income Tax Update'

Overview

This may be the final year that the so-called Bush tax cuts remain in effect, unless Congress acts to further extend them. The Bush tax cuts, enacted in 2001 and 2003, were originally scheduled to expire for tax years beginning in 2011. However, President Obama signed legislation in late 2010 that temporarily extended the Bush tax cuts through 2012.

Many commentators agree that Congress is unlikely to extend the Bush tax cuts prior to the November elections, but uncertainty remains as to whether Congress will take action following the elections. Provided that Congress fails to extend the Bush tax cuts, many significant rate changes and other substantive changes will take effect in 2013. This article summarizes the major federal income tax changes that are scheduled take effect in 2013 if Congress allows the Bush tax cuts to expire, certain other changes scheduled to take effect independent of the Bush tax cuts, and planning strategies to reduce the impact of these changes. If you or your company would like to discuss any of these scheduled changes or planning strategies, please contact any member of the Tax and Employee Benefits Team.

Individual Income Tax Rates

If Congress allows the Bush tax cuts to expire, ordinary income tax rates will increase for most individual taxpayers beginning in 2013. As discussed below, qualified dividend income that is currently taxed at long-term capital gain rates will be taxed at these higher ordinary income rates. The following table sets forth the scheduled rate increases, using 2012 dollar amounts which will be adjusted for inflation in 2013.

Tax Brackets (2012 Dollar Amounts)

Marginal Rate

Unmarried Filers

Married Joint Filers

Over

But Not Over

Over

But Not Over

2012

2013

$0

$8,700

$0

$17,400

10%

15%

8,700

35,350

17,400

70,700*

15%

15%

35,350

85,650

70,700*

142,700

25%

28%

85,650

178,650

142,700

217,450

28%

31%

178,650

388,350

217,450

388,350

33%

36%

388,350

...

388,350

...

35%

39.6%

* In 2013, this dollar amount will decrease to 167% of the amount for unmarried taxpayers in the same bracket (which is $58,900 in 2012), rather than 200% of the amount for unmarried taxpayers under current law. This change will have the effect of putting more middle-income joint filers in the 28% bracket and increasing the "marriage penalty" for many taxpayers.

Long-Term Capital Gain Rates

The maximum rate on long-term capital gain is scheduled to increase from 15 to 20 percent in 2013. Individual taxpayers in the 10 and 15 percent ordinary income tax brackets currently pay no tax on long-term capital gain. These taxpayers are scheduled to be subject to a 10 percent long-term capital gain rate in 2013. An 18 percent maximum rate will apply to capital assets purchased after 2000 and held for more than five years. Additionally, the 3.8 percent Medicare contribution tax discussed below will increase the effective rate of tax on long-term capital gains for certain higher-income taxpayers to as high as 23.8 percent. The following table sets forth the scheduled rate increases.

Maximum Rates

2012

2013

2013 (including Medicare contribution tax)

Long-Term Capital Gain

15%

20%

23.8%

Qualified 5-Year Capital Gain

15%

18%

21.8%

Planning Strategies. If Congress fails to take action as the year-end approaches, investors who were otherwise considering selling appreciated stocks or securities in early 2013 should give additional consideration to selling in 2012 to take advantage of the lower rate, assuming they will have held the asset for longer than one year. Additionally, business owners who are considering selling their business in the near future should consult with their tax adviser to discuss whether electing out of the installment method for an installment sale in 2012 would be more advantageous from a tax planning perspective.

Dividend Income Rates

The Bush tax cuts created the concept of "qualified dividend income," which currently allows dividends received from domestic corporations and certain foreign corporations to be taxed at the taxpayer's long-term capital gain rate. Additionally, qualified dividend income earned by mutual funds and exchange-traded funds may be distributed to shareholders and treated as qualified dividend income by the shareholder. Prior to the Bush tax cuts, all dividend income was taxed as ordinary income. If Congress fails to extend these provisions, the qualified dividend income provisions will expire, and all dividends will once again be taxed as ordinary...