January 2nd, 2013
Charitable Implications of the Fiscal Cliff Deal from Alliance for Charitable Reform
On New Year’s Eve the Senate passed a bill, the American Taxpayer Relief Act of 2012 that would avert the tax components of the fiscal cliff, and delays for two months the massive spending cuts set to take effect as part of “sequestration.” The House passed that bill later by a vote of 257 to 167, and it is now on its way to President Obama for his signature. Here is a quick recap of what the bill will do and what is of interest to the charitable giving community:
H.R. 8 permanently raises the income tax to 39.6% for individuals making more than $400,000 a year and families making more than $450,000
Permanently raises capital gains and dividends tax rates to 20% for the same $400,000/$450,000 earners
Permanently sets the estate tax at 40% with a $5.12 million per indidivual and a $10 million per married couple exemption
Includes the set of “tax extenders” that the Senate Finance Committee approved last summer, which includes a one-year extension the IRA Charitable Rollover provision
The good news is the bill does not include a much discussed cap on itemized deductions. However, it does reinstate the smaller “Pease” limitation on itemized deductions for those making $300,000 or more. Pease is a provision that progressively decreases the value of itemized deductions on those earners over $300,000. The Pease limitation was repealed under President George W. Bush as part of the 2001/2003 tax cuts and was set to be reinstated January 1, 2013.
More on Pease
The new tax law also reinstates a limitation on itemized deductions for higher income taxpayers, but the thresholds have been changed. The provision, known as the Pease limitation (named after the Congressman from Ohio who authored it originally) raises the effective tax rate of affected taxpayers by reducing the amount of their allowable deductions.
Here’s how it works. If a taxpayer’s income exceeds a certain amount, and he or she itemizes deductions, an amount equal to 3 percent of the excess over the threshold is disallowed. However, no more than 80 percent of the taxpayer’s deductions can be lost and several deductions, including the medical expense deduction, are exempt from the cut.
The threshold depends on whether the taxpayer is filing a joint return, or is single. For joint returns, it is $300,000, and it is $250,000 for single taxpayers. For taxpayers with incomes below these levels, the new limitation will have no effect.
This limitation is best illustrated by example.
Suppose for 2013 that you are filing a joint return and you and your spouse have income of $400,000. Also assume you have itemized deductions (mortgage interest, state taxes, and charitable contributions) that total $100,000. The Pease limitation is computed by first figuring the excess of your income over the threshold. In this case, the threshold is $300,000 because it is a joint return. So the excess is $100,000 ($400,000 less $300,000). Three percent of $100,000 is $3,000, so this is the amount of the limitation, and this amount is subtracted from the otherwise allowable itemized deductions. So, instead of having deductions of $100,000, you can write off only $97,000. Assuming you are in the 33 percent tax bracket, this new limitation would cost you $990 in extra federal taxes.
As a second example, suppose you are single and wealthy and have an income in 2013 of $2 million. Let’s say you also have itemized deductions totaling $600,000, comprised of $300,000 in state taxes and $300,000 in charitable contributions.
The limitation in this case is computed by subtracting the $250,000 threshold (the single threshold) from your $2 million income amount. The result is $1,750,000. Three percent of this amount is $52,500. Thus, your deductions will have to be reduced by this amount, and after subtracting, would be $547,500. Since with this amount of income and deductions, you would be in the new top tax bracket of 39.6 percent, your taxes would increase by $20,790 because of this limitation.
The Pease limitation is not new. It was first enacted in 1990, but it was gradually phased out by the tax cut that was passed in 2001. However, this new version of Pease will hit taxpayers at higher levels of income than the earlier version of the limitation.
On To Tax Reform
Shortly after Congress passed the fiscal cliff bill – H.R. 8 — leaders of both parties and the Congressional tax-writing Committees reaffirmed their intentions to proceed to comprehensive tax reform in 2013. House Ways and Means Committee Chairman Dave Camp (R-MI) urged his Republican colleagues to consider H.R. 8 as “just the first in a series of tax and budget skirmishes leading up to the ultimate goal of comprehensive tax reform.” Senate Finance Committee Chairman Max Baucus (D-MT) was also optimistic about the prospect for tax reform this year, noting that many issues – like deductions and credits – were not addressed in H.R.8. The charitable deduction and other incentives to give could be back on the table in tax reform so it is important we continue to work with Congress and the Administration on these important issues.