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Posted on: March 12th, 2013
The American Taxpayer Relief Act of 2012 (ATRA), enacted January 2, 2013, settled much of the uncertainty tax practitioners had faced in the last decade.  The Bush-era income tax cuts were largely made permanent, and Montana’s farmers, ranchers and business owners can now take comfort in the estate and gift tax exemptions remaining at - at least for the time being - 2012 levels, indexed annually for inflation.  While Congress may choose to enact new laws in the future, the absence of any major sunsetting provisions looming on the horizon means that Montanans can plan with more certainty and make decisions with more confidence. 

               ATRA made permanent the federal gift, estate and generation-skipping transfer taxes.  The gift and estate exemptions will each remain at the 2012 level of $5,000,000 per person.  Taking into account the annual adjustment for inflation,[1] the expected 2013 exemption amount is $5,250,000 per person ($10,500,000 for a married couple).[2]  The generation-skipping transfer tax exemption will continue to be keyed to the estate and gift exemptions of $5,000,000, adjusted annually for inflation.  The tax rate increases from 35% to 40% on estates exceeding the exemption threshold of $5,250,000.[3] The annual gift tax exclusion amount -- the annual amount that an individual can give to another individual tax free -- has been inflation adjusted from $13,000 to $14,000.    
               With the annual exclusion and the exemption amounts indexed for inflation, the majority of Montanans will continue to be able to make large lifetime and death transfers tax free.  However, for persons with assets in excess of the estate tax exemption amounts, the higher 40% estate tax rate[4] exemplifies the need for practitioners to plan accordingly to meet the needs of their clients.. 
               Surprising to some, ATRA was silent on what many estate planning attorneys had coined “the endangered strategies.” Grantor trusts - including Intentionally Defective Grantor Trusts (IDGTs) and Irrevocable Life Insurance Trusts (ILITs) - are still available to reduce much or all of a client’s estate tax.  Discounts are still allowed on non-business interests and for transfers of minority interests.  As no ten-year minimum was enacted, the two-year rolling Grantor Retained Annuity Trusts (GRATs) are still available.  Dynasty trusts also remain an option, as no 90-year limit was enacted on the GST tax exemption.          
               The continued, historically-low interest rates have given practitioners the opportunity to effectively utilize certain estate planning tools, such as intra-family loans and selling property to a trust for an installment note.  When property is expected to appreciate substantially in the future, a grantor can sell the property to a trust for an installment note in order to “freeze” the value of the property in the grantor’s estate.  This will shift the future gain from the appreciation of the asset to the beneficiaries of the trust, usually the grantor’s children.  At the same time, the gain recognized to the grantor/seller is postponed for income tax purposes.[5] The low interest rates result in the grantor/seller experiencing limited interest income on the installment sale.  In January, 2013, money can be loaned or property sold for an installment note with 3-9 year rates as low as 0.87%. The § 7520 rate is 1%. 

               ATRA permanently extended the Bush-era tax cuts for all but higher-income taxpayers.[6]  However, because the Act did not extend the payroll tax holiday, the vast majority of Montanans will see a 2% reduction in their take home pay due to the restoration of the 6.2% payroll tax rate.  For higher-income households in Montana, there are three different amounts at which tax increases are possible. 
First, individuals with an annual income above $400,000 ($450,000 for married filing jointly) will be subject to a 39.6% tax rate and a 20% capital gains rate.[7]  For Montanans that do not reach the $400,000 threshold for yearly income ($450,000 for married filing jointly), the income tax brackets and long-term capital gains rates remain unchanged.  While Congress made permanent the anti-marriage penalty for taxpayers in the 15% tax bracket (discussed below), ATRA created a new marriage penalty for high income taxpayers.  With a top marginal tax rate of 39.6%, two unmarried individuals who each make $399,000 a year would pay significantly less tax than a married couple making $799,998 per year.  For taxpayers in this situation, there is a strong economic motivation to remain unmarried.   
Second, the Personal Exemption Phase-out (PEP) and Pease limits on itemized deductions will come into play for Montanans with an Adjusted Gross Income (AGI) above $250,000 ($300,000 for married filing jointly).[8]  These Montanans will lose the per person $3,900 personal exemption (including dependents) at a rate of 2% for every $2,500 ($1,250 for married filing singly) of AGI over the $250,000 threshold ($300,000 for married filing jointly).[9]  The $250,000 threshold ($300,000 for married filing jointly) will also impact taxpayers through the changes to the Pease limitation, i.e., for taxpayers with AGI above the thresholds, itemized deductions will be reduced by the lesser of: (1) 80% of the amount of itemized deductions otherwise allowable, or (2) 3% of the excess of AGI over the threshold amounts.[10]     
Third, the new 3.8% surtax on investment income and the Medicare payroll surtax will be levied on taxpayers who have an income in excess of $200,000 ($250,000 for married filing jointly).[11] The 3.8% surtax is more complicated than it initially appears.  It imposes a tax on the lesser of: (1) investment income, or (2) Modified Adjusted Gross Income (MAGI) in excess of $200,000 ($250,000 for married filing jointly).  The MAGI of a taxpayer is the taxpayer’s AGI plus their net foreign income exclusion amount.  The Medicare payroll surtax is increased by 0.9% for employment income in excess of $200,000 ($250,000 married filing jointly). 
               For Montana business owners, their choice of entity will become increasingly important.  The income splitting possibilities of S corporations and LLCs taxed as S corporations will make these entities increasingly attractive.  People who operate a business as a sole proprietorship, partnership, or LLC taxed as a partnership must pay self-employment tax on all income attributed to them from the business.  For taxpayers, the self-employment tax rate is 13.3% for the first $200,000 ($ 250,000 married filing jointly), and 14.2% for every dollar of income thereafter.  Business owners operating an entity as an S corporation or LLC taxed as an S corporation will experience a significantly lower tax burden by splitting their income from the business between wages (i.e. self-employment income) and profits, hence the term “income splitting.”  The taxpayer must pay themselves a “reasonable wage,”[12] and all money made by the business in excess of the “reasonable wage” is free of the 13.3% to 14.2% self-employment tax.  Furthermore, the amount paid to the taxpayer in excess of their “reasonable wage” will not be included in the definition of “investment income” for purposes of calculating the 3.8% surtax on investment income.
               The 3.8% surtax likely will not provide Montanans with sufficient incentive to classify their excess investment income as ordinary income.  Taxes collected on investment income remain at a significantly lower rate than taxes on ordinary income.  For an individual at the top marginal tax bracket, investment income will be subject to a federal tax at a cumulative rate of 24.592%, while ordinary income will be taxed at the rate of 41.292%.
               Trust income will remain an important consideration when drafting trust documents for clients.  Income allocated to a trust or estate will reach the highest marginal tax bracket at $11,900. According to the Joint Committee Council, the 39.6% tax rate will apply to trusts and estates. Thus, the 39.6% income tax and 20% capital gain rates apply to what was the entire 35% bracket range (i.e. trusts and estates with income exceeding $11,900). 

Layering of the Rates on Ordinary Income for the Top Marginal Tax Bracket (Earned Income)

  Single Head of Household Married Filing Jointly Married Filing Separately
0.9% Medicare Payroll Surtax $200,000 $200,000 $250,000 $125,000
Phase Out of Deductions $250,000 $275,000 $300,000 $150,000
39.6% Income Tax Rate $400,000 $425,000 $450,000 $225,000
Top Cumulative Marginal Rate 41.292% 41.292% 41.292% 41.292%

Layering of the Rates on Investment Income for the Top Marginal Tax Bracket

  Single Head of Household Married Filing Jointly Married Filing Separately
3.8% Medicare Payroll Surtax $200,000 $200,000 $250,000 $125,000
Phase Out of Deductions $250,000 $275,000 $300,000 $150,000
20% Capital Gains Rate $400,000 $425,000 $450,000 $225,000
Top Cumulative Marginal Rate 24.592% 24.592% 24.592% 24.592%
The following are some of the provisions that Title 1 of the ATRA extended:
·        The Act permanently extends the $1,000 child tax amount allowed against regular tax and alternative minimum tax.[13]
·        The Act permanently extends the adoption credit and employer provided adoption assistance exclusion.[14]
·        The Act permanently extends the dependent care credit for children under 13 and disabled dependents.  The dependent care credit gives taxpayers a credit for an applicable percentage of eligible care expenses.[15]
·        The Act permanently extends the credit of up to $150,000 per year for constructing, acquiring, rehabilitation, or expanding property used for a child care facility, and for the operation of such facility.[16] 
·        The Act permanently eliminates the marriage penalty inherent in basic standard deduction for married couples filing jointly and phases out the marriage penalty inherent in the 15-percent bracket.[17]  The Act also eliminates the marriage penalty for earned income credit.[18]
·        The Act permanently extends the $2,000 allowed annual contribution amount for education expenses and the expanded definition of education expenses (includes elementary and secondary school) for education individual retirement accounts.[19]
·        The Act permanently extends the $5,250 exclusion from gross income and employment tax per year of employer-provided education assistance.  The covers graduate and undergraduate courses.[20]
·        The Act permanently extends the above-the-line deduction for up to $2,500 of interest expenses paid on qualified education loans.  The deduction is phased out at $50,000 through $65,000 income levels.[21] 
·        The American Opportunity Tax Credit of up to $2,500 of tuition costs and related expenses is extended through 2017.[22] 
·        The Act extends the child tax credit for 5 years.  15% of earnings above $3,000 instead of above $10,000 are allowed as a credit to reduce federal income tax for certain lower income taxpayers who have qualifying children under the age of 17.[23]
·        The Act extends for 5 years the increased earned income tax credit of 45% for a working family’s first $12,750 of earned income, if the family has three or more children. The Act also increased the beginning point of the phase-out range for all married couples filing a joint return.[24]
               ATRA extended several tax relief provisions, some of which impact Montanans more than others.  Owners of large tracts of land will continue to benefit from increased contribution limitations and carryover periods of IRC § 170(b)(1)(E) and (b)(2)(B) for charitable contributions of certain qualified conservational easements.[25]  Under ATRA, corporate farmers, ranchers, and landowners will continue to benefit from the extended contribution limitation and carryover periods for contributions of conservation property made in taxable years on or before December 31, 2013. 
               Taxpayers will continue to have the election of itemizing costs of mortgage insurance on a qualified personal residence.[26]  The deduction begins to phase out for taxpayers with an AGI over $100,000, and is unavailable for taxpayers with an AGI in excess of $110,000. 
               Taxpayers who are older than 70 ½ will continue to make tax free distributions to charities from their IRAs and Roth IRAs, up to $100,000 per year per taxpayer.[27]  Under Title 9 of ATRA, account rollovers are allowed from a § 401(k), § 403(b), or § 457(b) account to a Roth account.[28]  The transfer will be treated as a qualified rollover contribution, and the converted amount will be taxable.[29]  Montana taxpayers with these retirement accounts will have the opportunity to optimize the timing of Roth conversions based on changing tax rates, individual circumstances, and anticipated minimum distributions.  This will also allow for planning opportunities with standalone retirement trusts.
The following are some of the individual tax extensions in ATRA: 
·        Deduction for certain expenses of Elementary and Secondary school teachers, giving them an above the line deduction of $250 for professional expenses.[30]
·        The Discharge of Qualified Principal Residence Indebtedness exclusion was extended, which excludes the forgiveness of debt in a foreclosure proceeding and the write down of principal on a mortgage from taxable income.[31]

               Title III of the Act extends many favorable depreciation and cost recovery provisions.  Most notable is the extension of increased expensing limitations for § 179 property that was acquired during the tax year. 
Generally, § 179 property is tangible property or computer software used in the taxpayer’s trade or business and subject to the allowance for depreciation under § 167.[32]  ATRA will continue to allow small businesses to expense up to $500,000 of § 179 property, with a phase out threshold beginning after the acquisition of over $2,000,000 of § 179 property.[33]
                 ATRA temporarily extends the 100% exclusion of gain on certain small business stock.[34]  “Qualified small business stock” is stock from a C corporation that meets a specific active business requirement, and the business has gross assets that do not exceed $50,000,000.  Non-corporate taxpayers who hold qualified small business stock are eligible to exclude the greater of $10,000,000 or 10 times the taxpayer’s basis in the stock from gain on sale of the stock.  The stock must have been held for more than five years prior to sale.
               The Act also extends for one additional year the § 168(k) 50% bonus depreciation provision that applied to qualified property acquired during the tax year.[35]  The property must be placed in service before January 1, 2015, to be eligible for bonus depreciation. 
The following is a list of some of the ATRA business tax extensions:
·        ATRA extended the § 45A Indian employment credit for employing members of Indian tribes.[36]
·        Military housing allowances are not considered for purposes of eligibility for the low-income housing credit.[37]
·        The new markets tax credit national designated investment limitation is extended.[38]
·        Railroad track and maintenance credit was extended.[39]
·        Extended 20% credit given for costs spent in training mine rescue team members.[40]
·        Employer wage credit, if employees are active duty members of the uniformed services.[41]
·        Work opportunity credit extended.[42]
·        Extended the 15-year, straight-line cost recovery for qualified retail improvements, qualified leasehold improvements, qualified restaurant buildings and improvements.[43]
·        Business Property on an Indian reservation will continue to benefit from accelerated depreciation.[44]
·        Contributions of “apparently wholesome” food from a taxpayer’s trade or business will continue to be subject to a special charitable deduction rule under IRC § 170(e)(3)(C).[45]
·        Extension of election to expense mine safety equipment.[46]
·        Extended the modification that certain payments made to an exempt organization by a controlled organization shall be treated as business income.[47]
·        Extends the exemption of certain dividends from the 30% withholding tax imposed on dividends received by foreign individuals.[48]
·        Extends the inclusion of regulated investment companies inclusion in “qualified investment entity” when determining if a distribution is subject to FIRPTA tax and withholding.[49]
·        Active financing income will continue to be exempted from current inclusion under the subpart F rules.[50]
·        S corporation shareholders will continue to receive a basis reduction for charitable contributions of property equal to their pro-rata share of the contributed properties adjusted basis.[51]
·        The reduction in S corporation recognition period for built-in gains tax has been extended.[52]  Built-in gains arise in the S corporation context when there was gain that arose prior to the corporation’s conversion from C to S corporation status. 

               ATRA extended a number of energy credits.  The majority of the extensions of the energy tax provisions are now due to sunset at the end of 2013 instead of 2012.  The following is a partial list of the energy provisions of ATRA: 
·        The extension of the credit for energy-efficient existing homes allows an individual to claim a credit for qualified energy efficiency improvements installed during the year and for the amount of the residential energy property expenditures incurred by the taxpayer.[53]
·        The credit for alternative fuel vehicle refueling properties was extended.[54]
·        The production tax credit for qualified wind and open-loop biomass production facilities was extended for one year to January 1, 2014.[55]
·        The credit for electric scooters and 3-wheeled vehicles was extended for taxpayers purchasing a qualifying vehicle before January 1, 2014.[56] 
·        The production credit for Indian coal facilities was extended by one year for facilities that were placed in service before 2009.  The credit remains at 2012 level of $2.00 per ton produced.[57] 
·        The credit available for energy-efficient new homes was extended by year to include qualifying homes acquired in 2012 as well as those homes acquired by December 31, 2013.[58] 
·        Energy-efficient appliance manufacturers will enjoy a credit for qualifying appliances produced in 2012 and 2013.[59] 
·        A special depreciation allowance for cellulosic biofuel plant property was extended by one year.[60]
·        The definition of a “qualifying electric transmission transaction” was extended for qualified electric utilities through 2013.[61]
·        Alternative fuels excise tax credits was extended by the Act for qualifying fuels sold or used before December 31, 2013.[62]

Ultimately, ATRA works to preserve most of the tax laws from 2012.  With the exception of the expiration of the 2% payroll tax cut and tax increases for high income Montanans, the majority of people in our state will see very little change from their 2012 tax situation.  The good news for practitioners is that tax planning strategies which have been developed and used in recent years will, for the most part, continue to be available to meet the needs of clients. With a more certain playing field, new strategies can be developed.  However, the possibility always exists that new legislation will alter the current tax structure, and taxes will always be a central point of discussion with clients.  For the time being, however, there does not appear to be much change on the horizon…at least until we find ourselves looking over the edge of another fiscal cliff.

[1] Title 1 – General Explanation of the American Taxpayer Relief Act of 2012.
[2] http://www.bloomberg.com/news/2013-01-11/irs-increases-exemption-from-estate-tax-to-5-25-million.html
[3] Title 1 – General Extensions of the American Taxpayer Relief Act of 2012.
[4] IRC §§ 2001, 2010
[5] IRC § 453
[6] IRC § 1 and Title 1 of the American Taxpayer Relief Act of 2012
[7] Id.
[8] IRC §§ 68, 151  and Title 1 section 101 – General Extensions of the American Taxpayer Relief Act of 2012.
[9] IRC § 151
[10] IRC § 68
[11] This surtax was enacted as part of the Health Care and Education Reconciliation Act of 2010.
[12] The Tax Court noted that the traditional standards used under §162(a)(1) in determining reasonable compensation in the C corporation context also apply to S corporations.  Some of the factors to determine "reasonable compensation" are the shareholder-employee's qualifications, the services actually performed by the shareholder-employee, the prevailing compensation rates in the corporation's industry, and the size of the business.  See, e.g., Mayson Mfg. Co. v. Comr., 178 F.2d 115, 119 (6th Cir. 1949); Rocco v. Comr., 57 T.C. 826, 831 (1972) (acq.); Roob v. Comr., 50 T.C. 891, 898 (1968).
[13] IRC § 24
[14] IRC §§ 23, 36C, 137
[15] IRC § 21
[16] IRC § 45F
[17] IRC §§ 63, 1
[18] IRC § 32
[19] IRC § 530
[20] IRC § 127
[21] IRC § 221
[22] IRC § 25A
[23] IRC § 24
[24] IRC § 32
[25] IRC § 170 and Section 206 of the American Taxpayer Relief Act of 2012.
[26] IRC § 163 and Section 201 of the American Taxpayer Relief Act of 2012.
[27] IRC § 408 and Section 208 of the American Taxpayer Relief Act of 2012. 
[28] IRC § 402A and Section 902 of the American Taxpayer Relief Act of 2012.
[29] Id.
[30] IRC § 62 and Section 201 of the American Taxpayer Relief Act of 2012.
[31] IRC § 108 and Section 202 of American Taxpayer Relief Act of 2012.
[32] IRC § 179(d)
[33] IRC § 179 and Section 315 of the American Taxpayer Relief Act of 2012.
[34] IRC § 1202 and Section 324 of the American Taxpayer Relief Act of 2012.
[35] IRC § 168 and Section 331 of the American Taxpayer Relief Act of 2012.
[36] IRC § 45A and Section 304 of the American Taxpayer Relief Act of 2012.
[37] IRC § 142 and Section 303 of the American Taxpayer Relief Act of 2012. 
[38] IRC § 45D and Section 305 of the American Taxpayer Relief Act of 2012.
[39] IRC § 45G and Section 306 of the American Taxpayer Relief Act of 2012. 
[40] IRC § 45N and Section 307 of the American Taxpayer Relief Act of 2012.
[41] IRC § 45P and Section 308 of the American Taxpayer Relief Act of 2012.
[42] IRC § 51 and Section 309 of the American Taxpayer Relief Act of 2012. 
[43] IRC § 168 and Section 311 of the American Taxpayer Relief Act of 2012.
[44] IRC § 168 and Section 313 of the American Taxpayer Relief Act of 2012.       
[45] IRC § 170 and Section 314 of the American Taxpayer Relief Act of 2012.
[46] IRC § 179 and Section 316 of the American Taxpayer Relief Act.
[47] IRC § 512 and Section 319 of the American Taxpayer Relief Act.
[48] IRC § 871 and Section 320 of the American Taxpayer Relief Act.
[49] IRC §§ 897, 1445 and Section 321 of the American Taxpayer Relief Act.
[50] IRC §§ 953, 954 and Section 322 of the American Taxpayer Relief Act.
[51] IRC § 1367 and Section 325 of the American Taxpayer Relief Act.
[52] IRC § 1374 and Section 326 of the American Taxpayer Relief Act.
[53] IRC § 25C and Section 401 of the American Taxpayer Relief Act of 2012.
[54] IRC § 30C and Section 402 of the American Taxpayer Relief Act of 2012.
[55] IRC § 45 and Section 407 of the American Taxpayer Relief Act of 2012.
[56] IRC § 30D and Section 403 of the American Taxpayer Relief Act of 2012.
[57] IRC § 45 and Section 406 of the American Taxpayer Relief Act of 2012.
[58] IRC § 45L and Section 408 of the American Taxpayer Relief Act of 2012.
[59] IRC § 45M and Section 409 of the American Taxpayer Relief Act of 2012.
[60] IRC § 168 and Section 410 of the American Taxpayer Relief Act of 2012.
[61] IRC § 451 and Section 411 of the American Taxpayer Relief Act of 2012.
[62] IRC §§ 6426, 6427 and Section 412 of the American Taxpayer Relief Act of 2012.

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