As Congress prepares for its August recess, the Democrat-led Senate and Republican-led House are unveiling proposals to address the expiring Bush-era tax cuts. While both political parties appear to be sensitive to the potentially damaging impact of the so-called “fiscal cliff” in 2013, there are some key differences on how each would address the issues.

The bills summarized

“The Middle Class Tax Cut of 2012” (S.3412), was introduced by Senate Majority Leader Harry Reid (D-NV).

This bill:

  • Extends lower tax rates into 2013 for taxpayers with incomes under $200,000 ($250,000 for married couples filing jointly)
  • Increases marginal tax rates for higher-income taxpayers (the 33% bracket increases to 36%, the top marginal bracket of 35% increases to 39.6%)
  • Provides that taxpayers earning income above the $250,000 threshold would be subject to a 20% tax on long-term capital gains and qualified dividends
  • Restores phaseouts for itemized deductions and personal exemptions for higher-income taxpayers
  • Extends certain tax credits such as the American Opportunity Tax Credit for educational expenses, the enhanced child tax credit, and the increased earned income tax credit
  • Increases the Alternative Minimum Tax exemption for tax year 2012 to prevent an additional 25 million+ taxpayers from being subject to AMT (2012 AMT exemption amount for single filers would be $47,450 and for joint filers would be $72,450)

An earlier version of the bill (S.3393) called for a return to the 2009 estate tax regime — an estate tax exemption of $3.5 million with a top marginal tax rate of 45%.

“The Job Protection and Recession Prevention Act” (H.R.8) was introduced by Ways and Means Chairman Dave Camp (R-MI).

This bill:

  • Extends the Bush-era tax cuts for all taxpayers for one year
  • Sets the maximum tax rates on long-term capital gains and qualified dividends at 15% (0% tax rate would still be in effect for taxpayers in lowest two brackets)
  • Eliminates income phaseouts for itemized deductions and personal exemptions
  • Maintains the estate tax at 2012 levels ($5 million estate, gift and generation-skipping transfer tax exemptions, 35% top marginal tax rate) and extends the portability provision on unused exclusion amounts
  • Extends certain education-related tax benefits such as the deduction for student loan interest and the $2,000 contribution limit on Coverdell savings accounts
  • Extends the increased child tax credit
  • Prevents the marriage penalty from returning in 2013
  • Provides AMT relief for tax years 2012 and 2013 to prevent a severe expansion of the AMT to an additional 25 million taxpayers

What are some key takeaways?

While it is difficult to predict whether any compromise will occur between the parties to stave off the fiscal cliff in 2013, there appears to be a framework for a year-end deal. These proposals provide some clarity on certain areas of concern for many investors — the AMT, future tax rates on dividends, and the estate tax.

If there is an agreement, it appears that the AMT situation will be addressed, at a minimum for tax year 2012.

Many investors are concerned that dividends may revert to being taxed at a rate of 39.6% in 2013 (43.4% if the Medicare investment surtax of 3.8% is included). Considering both proposals, one may conclude that the highest potential tax rate on dividends for 2013 will likely be 20% (23.8% including Medicare surtax).

While there has also been concern about an expansion of the estate tax next year with a return to a $1 million exemption amount and a maximum 55% tax rate. Neither political party is supporting those levels. The worst-case scenario for taxpayers on the estate tax would appear to be a $3.5 million exemption amount with a maximum tax rate of 45%.

While some type of compromise is likely given the economic impact of a fiscal cliff, the outcome remains uncertain. In the interim, clients need to be prepared for managing tax issues in 2013. While the debate continues, it is an opportune time to discuss tax-smart strategies.