The much-discussed “fiscal cliff” facing the United States is the result of federal tax and spending policy changes that will become effective January 1, 2013, caused largely by the following: 1) the expiring “Bush tax cuts,” 2) the Patient Protection and Affordable Care Act (often called “Obamacare”), and 3) the Budget Control Act (passed in 2011 to increase the debt ceiling).
1) Expiring “Bush Tax Cuts”
The Economic Growth and Tax Relief Reconciliation Act of 2001, or EGTRRA, substantially modified portions of the Internal Revenue Code, including, among other things, income tax rates (including capital gains and dividend tax rates), and effective estate & gift tax exclusions. All the 2001 tax cuts were set to expire at the end of 2010 but were mostly extended until January 1, 2013 by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Tax Relief Act of 2010”).
Unless Congress passes legislation similar to Tax Relief Act of 2010, which the President also signs into law, the following income, capital gains, & dividend tax rates will become effective January 1, 2013:
| 2012 Tax Rates | 2013 Tax Rates | 2012 Long-Term Capital Gains Tax | 2013 Long-Term Capital Gains Tax | 2012 Dividend Tax | 2013 Dividend Tax |
|---|---|---|---|---|---|
| 10% | 15% | — | 10% | — | 15% |
| 15% | 15% | — | 10% | — | 15% |
| 25% | 28% | 15% | 20% | 15% | 28% |
| 28% | 31% | 15% | 20% | 15% | 31% |
| 33% | 36% | 15% | 20% | 15% | 36% |
| 35% | 39.6% | 15% | 20% | 15% | 39.6% |
The expiration of EGTRRA will also substantially change the effective estate & gift tax exclusions. The estate tax exclusion will drop from $5.12 million to $1 million, which will result in the imposition of a 55% federal tax on estates in excess of $1 million. The lifetime effective federal gift tax exemption will also be reduced from $5.12 million to $1 million, which will result in a similar imposition of a 55% federal tax on total gifts exceeding $1 million during a person’s lifetime, excluding gifts in amounts less than the annual exclusion.
The non-partisan Congressional Budget Office (“CBO”) estimates that the expiration of the Bush Tax Cuts will result in a tax increase of approximately $500 billion in 2013.
2) The Patient Protection and Affordable Care Act
The Patient Protection and Affordable Care Act will impose a 3.8% surtax on some types of income, subject to certain thresholds beginning in 2013. The applicable thresholds and the manner in which the surtax is calculated vary widely depending upon whether the taxpayer is an individual or an estate or non-exempt trust.
In general, the 3.8% surtax is applicable to net investment income, which is the sum of investment income in excess of allowable investment expenses. For estates and non-exempt trusts, the surtax is only applicable to net investment income received but not distributed in a tax year. For individuals, the surtax is applicable to net investment income received by the taxpayer in a tax year.
For individuals, the income threshold amounts depend on the filing status of the taxpayer and are $250,000 for married couples filing jointly, $125,000 for married couples filing separately, and $200,000 for all other individuals. For estates and non-exempt trusts, however, the effective threshold will likely be about $12,000.
3) The Budget Control Act
In order to raise the so-called “debt ceiling” and stave off a default by the United States on its debt obligations, Congress passed the Budget Control Act in 2011. This Act requires, among other things, a minimum total reduction in federal spending of $1.2 trillion through 2021.
The Budget Control Act prescribes a procedure that Congress and the President must follow to reduce the budget in order to avoid sequestration, i.e. automatic across-the-board budget cuts beginning January 1, 2013. If sequestration occurs, the automatic cuts will reduce the 2013 budget by about $110 billion. About half of the cuts will be defense-related and the other half will be split among Medicare provider payments and insurance plans, farm price supports, and other programs. Some expenditures, however, are exempt from sequestration, i.e. Social Security, Medicaid, Food Stamps, and Supplemental Security Income (“SSI”).
The Fiscal Cliff
The Congressional Budget Office ("CBO") estimates that the expiration of the Bush Tax Cuts, the 3.8% Medicare surtax, and sequestration will reduce the federal budget deficit from about $1.1 trillion in 2012 to about $641 billion in 2013. As a result, the CBO estimates the economic growth in the U.S. will decline by about 0.5% and result in around 9% unemployment.
This brief overview of some important considerations associated with the Economic Growth and Tax Relief Reconciliation Act of 2001, the Patient Protection and Affordable Care Act, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 1010, and the Budget Control Act is by no means comprehensive. Always seek the advice of a competent professional when making important legal and financial decisions.
