Fiscal Cliff Tax Deal: What Does It Mean for Small Business?
Money and Tax Return (Photo credit: 401(K) 2012)
For small and medium sized business owners there is good news and bad news in the deal to avoid the fiscal cliff. In addition, the deal strongly underscores the need for business owners to sharpen their own pencils to cut their taxes. NOTE – this article was first written after the Senate vote on the Fiscal Cliff deal but before the House has taken any action – the House has now passed the Senate bill without amendment and it is expected to be signed into law. The scores cited below are 10-year estimates from the Joint Committee on Taxation provided by the Senate Finance Committee.
First, let’s start with the good news. Greater certainty in taxes (although as you will read below, you may not like what is certain). More than any other issue I hear about from business owners and their accountants is the need for certainty in taxes. A recent study by the Mercatus Center highlights the economic drag of uncertainty in taxes.
The tax deal makes permanent a number of tax provisions (after making changes from current 2012 policy), including the tax rates on ordinary income; estate tax; dividends and capital gains – and best of all, the alternative minimum tax (AMT). NOTE: The payroll tax holiday was ended.
On AMT the current exemption of $33,750 individual and $45,000 married is increased to $50,600 single and $78,750 married and indexes the exemption and phaseout amounts. KEY – this new AMT fix is for tax years beginning after December 31, 2011 – i.e. the 2012 tax year. Happy day.
BUSINESS PROVISIONS EXTENDED (not permanent) – The most important tax credit for small and medium business owners – the Research and Development (R&D) tax credit was extended through 2013 and made retroactive for 2012 (see more below); Work Opportunity Tax Credit extended one year; Section 179 – keeps in place the 2010/2011 levels of a maximum amount of $500k and $2 million phase-out for 2012 and 2013; Accelerated Depreciation — the Senate deal provides for 50 percent expensing for qualifying property purchased and placed in service before January 1, 2014 (and January 1, 2015 for certain long-term assets and transportation).
Now, the bad news – the tax increases – and the hidden tax increases.
ORDINARY INCOME: While the tax deal increases the rates at a higher level than first proposed by the President ($200k single/250k married) – it does increase the rates from 35% to 39.6% at $400k single and $450k married (talk about a marriage penalty). From 2012 tax policy this is a tax increase of $396 billion over 10 years. Don’t forget, there is also the 0.9 percent tax increase on ordinary income over 200k/250k already set to begin in 2013 thanks to the health bill. Given that small and medium businesses are overwhelmingly organized as pass-thrus (LLC’s; S Corps; partnerships) – it is the ordinary income rate that hits these business owners – not the corporate rate (which was untouched in this deal).
CAPITAL GAINS/DIVIDENDS: Top rate increased to 20 percent (but not to 39.6 for dividends as proposed by the administration). Not a surprise that dividends didn’t increase to 39.6% given unpopular with many Democrats in the Senate as well as almost all Republicans. Still this increase to 20% raises over $56 billion over ten years from current 2012 tax policy – mostly from dividends. The top rate for dividends and capital gains starts at the $400k/$450k level. Note: this increase is in addition to the 3.8% add-on tax for capital gains and dividends included in the health bill. In addition, nothing done specifically on carried interest.
ESTATE TAX: Always of significant interest to family-owned businesses. Estate tax was a bit of a mixed bag – the $5 million dollar per person exemption was kept in place (and indexed for inflation continued) however the top rate is increased to 40 percent – effective date January 1, 2013. This change to 40 percent increased revenues from 2012 policy by $19 billion dollars. Other good news for estate planning – portability is kept in place and estate and gift remains unified – ie the $5 million stays in place for gift tax purposes as well. All permanent law — hallelujah.
HIDDEN TAX INCREASES — PHASE OUTS – One of the best things of the Bush tax cuts was the elimination of ”PEPS” and “Pease” – shorthand for phase outs of personal exemptions and certain itemized deductions. These are in effect hidden marginal rate increases. Unfortunately, the tax deal brings these bad policies back – albeit at a higher dollar level – hitting folks making $250k single and $300k married. It all sounds so very boring. Don’t be bored — this little understood and rarely discussed provision packs a womping tax hit of $152 billion dollars over current 2012 tax policy.
PLANNING OPPORTUNITIES FOR BUSINESS. The increase in the top rate, the AMT relief provided for 2012 tax year and the hidden tax increases – all combine to make it possible that many small and medium businesses that weren’t eligible for business credits thanks to AMT limitations in 2011 will now potentially be able to take advantage of these dozens of credits. In essence, a backdoor opportunity for small businesses — similar to when Congress expanded eligibility for credits for 2010. As mentioned above, the R&D tax credit remains the biggest business credit out there – but for reasons of self-censoring small businesses don’t take advantage of the credit. The time is now – before filing 2012 tax returns — for business owners to have a sit down with their accountants and focus on all of these business credits.
The other benefit that jumps out at me from this tax deal is IC-DISC. I’ve written on this in the past – this is a tremendous tax benefit for exporters (including computer software – software done here but sold overseas; architects, engineers – building designed here but built overseas). This tax benefit is for small and medium manufacturers who export — but also for businesses who manufacture a part, for example, an engine that goes on a plane that is exported. In a nutshell, the benefit is derived from getting dividend tax treatment for what would otherwise be ordinary income. Think big tax savings.
Given that the tax deal for the fiscal cliff kept a significant differential between the dividend rates (20% plus 3.8% health care) and top ordinary income rates (39.6% plus 0.9% health care) – and most importantly the rates are permanent – so there is no excuse — run, don’t walk, to take advantage of this major tax benefit – the IC-DISC. However, be eyes open – as I’ve mentioned in my articles, the IRS has recently put out audit guidance on IC-DISC – so you need to make sure you are doing it right.
Finally, the continuation of Section 179 and accelerated depreciation are a good incentive for considering more investments.
I welcome readers’ thoughts – especially all my smart accountants reading – of other planning ideas that business owners should consider under this tax deal.