If you haven’t heard this word yet, you soon will. The term was coined by congressional aides and is their own, and others’, bleak prophecy of what could transpire on January 1, 2013. Think of it as a perfect storm that will abruptly and sharply raise taxes while also cutting government spending.
Certain aspects to this scenario might draw applause from either political party and could reduce our deficit, but in combination, their degree could result in another recession. Obviously, neither party desires this result, but the key variable making such a situation feasible is that the events will be automatically triggered, barring legislative compromise and action.
The tax repercussions in such a scenario are significant.
There are several groups of legislative tax cuts that are set to expire at the end of the 2012 calendar year: the Bush-era tax cuts, a group of various provisions that are routinely renewed called “extenders,” and some of the remaining 2009 stimulus provisions. These events will affect both corporate and individual taxpayers.
Corporations alone will see nearly 30 credits and deductions revised unfavorably. The most notable is the elimination of the research and experimentation credit and the decrease in favorable depreciation rules. The research and experimentation credit allows a 20 percent credit for certain research expenses and is part of the extenders package that may not be renewed.
Additionally, the favorable depreciation rules that have been in effect for several years are scheduled to expire on December 31, 2012. Included in this are the elimination of the 50 percent bonus depreciation allowance on new equipment and the reduction of the current section 179 expensing limits on new and used equipment from $139,000 in 2012 to $25,000 in 2013.
Although corporations will clearly be affected, the majority of the tax hikes hit individuals. In terms of revenue, the most significant of the potential changes comes through the expiration of the payroll tax cut, non-renewal of the AMT patch, and increase in individual marginal tax rates, respectively.
The payroll tax cut affects the payroll taxes of employees and self-employed individuals by reducing their portion of payroll taxes withheld or paid by 2 percent on compensation or self-employment net income up to $110,100. The next two items require a little more explanation.
The Alternative Minimum Tax (AMT) sets a minimum tax rate on businesses and individuals who fall within certain income ranges. It was a response to wealthier taxpayers’ taking advantage of too many loopholes. Essentially, the AMT works by eliminating some of taxpayers otherwise deductible expenses (i.e. state income taxes, property taxes, etc.), allowing a uniform exemption amount and taxing the resulting amount by a flat 26 percent or 28 percent rate.
The exemption is what keeps the AMT tax from affecting the unintended target of the middleclass. However, the exemption is not adjusted for inflation and requires legislative action to be raised, hence the name the AMT patch. If there is no patch, the exemption will be reduced from $74,450 to $45,000 and is estimated to affect 28.5 million households, up from 4 million. The non-patched AMT will especially affect taxpayers in states with high income and property tax rates.
The third largest tax hike in the Taxmageddon scenario is the increase in individual marginal tax rates. If no changes are made starting in 2013, the 10 percent bracket would be eliminated and the highest tax bracket would increase from 36 to 39.6 percent.
Other notable changes adding to Taxmageddon:
· Estate tax exemption decreases from $5 million to $1 million and the top rate increases to 55 from 35 percent
· Elimination of state and local sales tax deduction
· Maximum capital gains rate will increase from 15 to 20 percent
· Qualified dividends maximum rate will increase from 15 percent to the taxpayer’s ordinary income tax rate (up to 39.6 percent)
· Maximum child tax credit will decrease from $1,000 per child to $500
· Expiration of marriage penalty provisions
· Reinstatement of phase-outs for itemized deductions and personal exemptions for high-income taxpayers
· Reductions in tuition expenses/credits and student loan interest deductibility
· Reductions in the dependent care tax credit
Although nobody wants Taxmaggedon, the current political climate does not guarantee its resolution and time is running short. The fact that these mechanisms trigger automatically is the scary part to this perfect storm.
Although the consensus is that most parts will be extended for another year, as some of them routinely are, most also agree that Taxmaggedon is possible. Given the uncertainty of the situation, now would be an opportune time to contact your accountant or tax advisor to understand the effect that these expiring provisions could have on you and your business.