"Now that's a fine mess you've gotten us into!"

Suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.
- Mark Twain, a Biography

The so-called “fiscal cliff” is looming, and I don’t see how we can avoid going over the edge. The election is now over, but nothing has really changed. Before the election we had Obama as President, a Democratic majority in the Senate, and a Republican majority in the House. Today, we still have the same thing.

The day after the election, Democratic and Republican leaders claimed to be willing to work towards a bi-partisan solution, but it sounds more like posturing than substance, and I don’t think there is enough time left before January 1, 2013 to avoid the tax calamity that will automatically happen on that date.

Though both sides agreed not to draw lines in the sand, congressional leaders did just that, staking out unchanged bargaining positions. Harry Reid, Senate Democratic leader, said he wanted to avoid the tax increases except for the wealthy and he would like to see substantial measures enacted during the lame-duck session of Congress that starts next week. Speaker John Boehner, Republican leader of the House, said that while he was open to tax reform, and saw considerable common ground on that, he continued to find tax increases unacceptable. Boehner repeated his previous objections to moving forward during the lame-duck session, except with temporary, stop-gap legislation to avoid the cliff. Vice President Joe Biden, saying the administration would like to move "right now," claimed "a clear, clear sort of mandate" on the tax issue, citing in particular doing "something on corporate taxes sooner than later".

It is thus apparent on the day after the election that the clarity it was supposed to have brought has yet to arrive.
 

Fiscal Cliff

So what is the “fiscal cliff”?

The fiscal cliff refers to the numerous tax increases and spending decreases that are scheduled to automatically occur on or before January 1, 2013. They include:

  • The 2001/2003 tax relief (the “Bush tax cuts) expires on 12/31/12.
  • There is currently no alternative minimum tax (AMT) patch in effect for 2012.
  • There are numerous tax provisions that have been extended annually for the last several years and they have not been extended yet for 2012.
  • Payroll tax relief expires on 12/31/12.
  • New Medicare taxes take effect in 2013.
  • Expanded unemployment benefits expire on 12/31/12.
  • Medicare physician payment rate falls on 12/31/12.
  • Sequestration under Budget Control Act of 2011 (BCA) in 2013.

The expiration of the 2001 / 2003 tax relief will have the following consequences:

  • Highest marginal income tax rates will rise to 36% and 39.6% from 33% and 35%
  • 10% rate bracket will be eliminated
  • Maximum rate on qualified dividends will rise from 15% to 39.6% (plus 3.8% Medicare tax for taxpayers with income above $250,000)
  • Maximum rate on long-term capital gains will rise from 15% to 20% (plus 3.8% Medicare tax for taxpayers with income above $250,000)
  • Phase-out’s of itemized deductions and personal exemptions will be reinstated for high-income individuals
  • Marriage penalty relief will expire
  • Child tax credit will decline from $1,000 to $500
  • Maximum estate tax rate will rise from 35% to 55%, and exemption will fall from $5 million to $1 million
  • Individuals with income over $250,000 (joint) or $200,000 (individual) face Medicare tax increases of: 0.9% on wages (on amounts exceeding threshold) and 3.8% on the lesser of: net investment income (e.g., interest, dividends, capital gains) or excess of modified AGI on amounts over the $250,000/$200,000 threshold.

Without Congressional action, the alternative minimum tax will affect an additional 27 million taxpayers in tax year 2012. AMT was originally designed to prevent high-income taxpayers from using exclusions, deductions and credits to minimize tax liability. AMT is not indexed for inflation, but it needed to be for it to be imposed only on the intended target. The "fix" has been a series of legislative patches, which have prevented its expansion to middle-income taxpayers. The most recent AMT patch expired December 31, 2011, and a new one has not been adopted for 2012 or beyond.

More than 60 business and individual tax extenders expired December 31, 2011. In prior years, tax extenders were generally passed as a package or, if allowed to expire, retroactively reinstated. The political and economic environment dims the prospects for extending these provisions. It is difficult to pass revenue losing tax provisions without identified revenue offsets. So, it may be that these extenders will only be “extended” as part of fundamental tax reform. It will be almost impossible to find a legislative vehicle for the extenders before the year-end. So, any extenders that get addressed may be in a piecemeal fashion. And it certainly looks now as if no extenders will pass or be retroactively reinstated this year.

Due to the 2011 failure of the Joint Select Committee on Deficit Reduction to agree on a deficit reduction plan, the BCA mandated $1.2 trillion of scheduled savings through an automatic spending cut process (sequestration). The BCA resulted in an initial $917 billion in deficit reduction from discretionary spending caps for FY 2012—2021. Sequestration is scheduled to begin in January 2013. Sequestration will be divided evenly between defense and non- defense spending. House of Representatives recently passed a bill to replace the sequester and generally protect defense spending. The Senate and Administration are opposed to the House bill. If Congress cannot agree on an alternative $1.2 trillion in spending cuts or added revenue over the next 10 years, sequestration will go into effect.

Likely Scenario

What happens if Congress cannot act before the end of the year?

Even if some sort of tax agreement or "tax reform" gets adopted retroactively, the IRS must administer the tax law as it exists. So, unless something happens before the due date (or the date returns actually get filed), everyone will have to pay their 2012 taxes based on the law then currently in effect. This could very likely mean that you have to file your 2012 return without any AMT relief and without any of the "extender" tax provisions. So, it is likely that you already have a tax increase on your 2012 income, and you might not even know it. If you end up owing the AMT, you may not have withheld or made quarterly deposits of enough to satisfy your 2012 tax liability. So, be prepared to write a check for your 2012 taxes.

Everyone will also owe a higher rate of tax in 2013. The withholding tables will reflect those higher rates. Even if tax reform occurs in 2013 and it is retroactive, the withholding tables will not reflect the "reformed" rates until the reform bill passes. So, you will have a reduced cash flow as if taxes were higher for 2013 even if the rates turn out to be lower by the end of the year.

Strategy

What should I do right now?

If nothing happens rates are going up:

  • Dividends: 15% to 43.4%
  • Capital Gains: 15% to 23.8%
  • Ordinary income: from 35% or 37.9% to 43.4%

I don’t think anything will happen before the year end. And, while any actual reform adopted in 2013 can be made retroactive, I don’t think that reform will touch the new Medicare tax increases. I also don’t see capital gains taxes going below 20% or dividends getting taxed at anything other than ordinary income rates. In other words, tax rates on individuals for dividends are probably at an historical low -- significantly so. Taxes on capital gains are also at a low that we may not see again, although the difference in the current and likely future rates is less drastic.

Usually, I would be encouraging my clients to defer income into later years and accelerate deductions into this year. This year, however, it may be wise to take the opposite course of action.

In particular, if you do business through a corporation and can pay taxable dividends, now may be the best time you will ever have to do that. Only if you have other plans in place to avoid any taxable dividends from ever being paid by the corporation might paying dividends now be a bad strategy. It’s simply hard to write that tax check when you could avoid it by not paying the dividend. You’re paying the "second" corporate tax, and you can’t take it back later.

Likewise, you should consider whether to trigger capital gains. The difference in rates is less drastic, but I don’t think you will ever see rates at less than 20% again. But with the smaller rate differential, it becomes a closer call as the time value of the deferral may still outweigh paying the lower tax now.
 

These are tough decisions. But the longer you delay, the less likely you'll be able to act when you make a decision to act.

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