As 2010 ends, taxpayers are confronted with the reality that scheduled increases in individual income tax rates, significant reductions in many popular tax incentives and more changes will occur when the calendar reads 2011. One year ago, it appeared highly unlikely that taxpayers would be faced with such uncertainty. Today, that uncertainty is generating many questions and few answers.
Temporary tax cuts
Nearly 10 years ago, Congress enacted the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which set in motion a gradual reduction in the individual income tax rates. In 2003, Congress passed the Jobs and Growth Tax Relief Act, which gradually reduced capital gains and dividend tax rates. When these laws were enacted, many lawmakers, tax professionals, businesses, and individuals assumed that Congress would either further extend the tax incentives or make them permanent before their expiration after 2010. To date, Congress has not acted; causing great uncertainty for tax planning.
Impact on individuals
The current individual tax rates of 10, 15, 25, 28, 33, and 35 percent are scheduled to expire after December 31, 2010. In their place, the pre-EGTRRA individual tax rates of 15, 28, 31, 36, and 39.6 percent will apply to tax years beginning after December 31, 2010, unless Congress acts to change this result that is otherwise required under the Tax Code. On top of these increases, the Making Work Pay credit, which further reduced income tax withholding for wage earners in 2009 and 2010, will expire after 2010. Additionally, the limitation on itemized deductions for higher-income taxpayers and the personal exemption phase-out for higher income taxpayers are scheduled to return after 2010.
Individuals with capital gains and dividend income will also see significant changes after 2010. The maximum rate of tax on the adjusted gain of an individual will revert to 20 percent (except 18 percent for gains on assets held over five years). Qualified dividends received by an individual for tax years beginning after December 31, 2010 will be taxed at ordinary income tax rates. Additionally, the current zero percent rate for capital gains for taxpayers in 10 and 15 percent tax brackets will expire to be replaced with a 10 percent rate (except eight percent for gains on assets held over five years).
Individuals liable for the alternative minimum tax (AMT) will also be hit with some surprises. Higher exemption amounts as part of an AMT “patch,” routinely enacted in past years, have languished in Congress. Under current law, the exemption amounts for 2010 and again for 2011 are $33,750 for unmarried individuals, $45,000 for married couples filing a joint return and surviving spouses, and $22,500 for married individuals filing a separate return. Comparing these amounts to higher exemption amounts for 2009 shows how drastic the reductions are. For 2009, the exemption amounts were $46,700 for single individuals, $70,950 for married couples filing a joint return and surviving spouses, and $33,475 for married couples filing a separate return.
Further down the road, a new 0.9 percent Medicare tax on earned income above $200,000 ($250,000 for married couples filing a joint return) and a 3.8 percent Medicare tax on the lesser of an individual’s net investment income for the tax year or modified adjusted gross income in excess of $200,000 ($250,000 for married couples filing a joint return) are effective for tax years beginning after December 31, 2012. All of these events will, unless altered by Congress, will significantly change the dynamic for many taxpayers.
After December 31, 2010, many popular but temporary tax breaks for individuals will revert to their pre-EGTRRA levels, unless Congress acts to prevent this result. One of the incentives taking the hardest hit is the child tax credit. For the 2010 tax year, the child tax credit is $1,000 for each eligible child. After December 31, 2010, the child tax credit is scheduled to plummet to $500 per qualified child. Other enhancements to the child tax credit also will expire after 2010.
Along with the child tax credit, individuals should also expect some reductions in the dependent care credit, the earned income credit, Coverdell Education Savings Accounts (ESAs), the student loan interest deduction, and more. Absent Congressional action, many other popular tax incentives, commonly called tax extenders, expired at the end of 2009. These include the state and local sales tax deduction, the higher education tuition deduction and the teachers’ classroom expense deduction.
Impact on businesses
Business owners who are taxed on their business income at the individual rates, such as sole proprietors, will also be hit with a tax increase if the scheduled pre-EGTRRA rates return. The top rate will increase from 35 percent to 39.6 percent for tax years beginning after December 31, 2010.
Among the tax extenders are a number of expired business incentives. At the top of the list is the research tax credit, which rewards businesses for investing in research for new products. The research tax credit expired at the end of 2009.
One tax rate that is not scheduled to change after 2010 is the corporate tax rate. The top corporate tax rate is 35 percent for 2010 and will remain 35 percent in 2011 and beyond, unless changed by Congress. Some unincorporated businesses may be eyeing corporate status as a way to reduce their taxes. However, changing status is a complex endeavor and has some special tax rules.
Congress returned to work on November 15 for a lame duck session. The first week of the lame duck session was spent electing leaders and making other organizational changes for the new Congress that meets in January. Congress took a week long Thanksgiving break and is now back at work. Legislation to extend the individual tax cuts, renew the tax extenders and pass an AMT patch and more has yet to be introduced. There are many proposals, ranging from making permanent all of the reduced rates to making permanent just the 10, 15, 25, and 28 percent rates. Increasingly, lawmakers from both parties are talking about a two or three year extension of the individual rate cuts. Few observers expect Congress to continue working past mid-December (unlike 2009 when lawmakers worked right up to year-end) so taxpayers may enter 2011 faced with continuing uncertainty.
We will keep you posted on developments.