After all of the sand had run out of the hourglass, Congress finally passed (and the President signed) a compromise tax bill to avoid very substantial income tax increases on taxpayers with income under $400,000 ($450,000 for joint filers). The good news for our estate planning clients is the “permanent” extension of the current estate, gift, and generation-skipping transfer tax exemptions, and a slight increase in the tax rate from 35% to 40%. The American Taxpayer Relief Act of 2012 (the “Act”) did not include any other estate and gift tax provisions that have been proposed over the past several years, such as restricting the use of grantor retained annuity trusts or qualified personal residence trusts, nor does the Act include any restrictions on how family businesses are valued for gift and estate tax purposes.

The estate, gift, and generation-skipping transfer tax exemption for an individual in 2013 is $5,250,000, and it is indexed for inflation (meaning it should rise by more than $100,000 per year). Thus, an individual who fully utilized his or her gift tax exemption in 2012 will have an additional $130,000 of gift tax exemption this year. In addition, indexing has increased the gift tax annual exclusion amount from $13,000 per recipient to $14,000 per recipient for 2013.

Most of the bad news is found in the changes to income tax rules including:

• Top individual marginal federal income tax rate of 39.6% for taxable income above $400,000 ($450,000 for joint filers).
• Additional 3.8% healthcare surtax applied to net investment income for individuals with adjusted gross income (“AGI”) in excess of $200,000 ($250,000 for joint filers).
• Additional 3.8% healthcare surtax applied to net investment income of estates and trusts on AGI in excess of about $11,800.
• Top individual income tax rate on qualified dividends and long-term capital gains increased from 15% to 20% for taxable income in excess of $400,000 ($450,000 for joint filers); thus, for dividends and gains that are investment income, the top rate will be 23.8%.
• Revival of the 3% reduction in itemized deductions (other than medical expenses, investment interest, and casualty/theft losses) for AGI above certain thresholds ($300,000 for joint filers and $250,000 for individual). Itemized deductions include property taxes, state income or sales taxes, mortgage interest, and charitable deductions.
• Personal exemptions are also reduced by 2% for each $2,500 by which AGI exceeds the threshold amounts applicable to itemized deductions; for taxpayers filing a joint return, the exemptions are eliminated at $425,000 of AGI.
• A 0.9% increase in hospital insurance payroll tax for wages or self-employment income over $250,000 for joint filers and $200,000 for individual taxpayers.
• The 2% “tax holiday” for the employee portion of payroll taxes has expired and the employee portion is back to 6.2%.
• Finally, a somewhat complicated retroactive resurrection of the IRA charitable rollover rule is included in the Act. First, individuals who qualify (over age 70½) can direct a distribution to charity prior to February 1, 2013, and treat the amounts as having been directly transferred in 2012. Also, an individual who received a distribution from an IRA in December of 2012 can make a cash contribution to a charitable organization during January of 2013 and treat that amount as if it had been transferred directly from the IRA to the charity, and excluded from income.

Application of the top 39.6% income tax rate and the 3.8% healthcare surtax to trust and estate net investment income will have a significant impact. While the top income tax rate and the surtax do not apply until an individual taxpayer’s taxable income exceeds $400,000, these rates apply to investment income of a trust or estate above approximately $11,800. Thus, a trust with $100,000 of interest income or short-term capital gains would find all of that income in excess of $11,800 taxed at 43.4%. If half of that income was dividends or capital gains, that portion would be taxed at 23.8% and the interest and short-term gains would be taxed at 43.4%. In contrast, an individual with taxable income of $450,000 (or joint filers with $500,000 of taxable income), including $100,000 of investment income, would only find $50,000 of the investment income subject to the surtax. Thus, for most trusts, it will be even more important to consider distributions to cause some or all of the income to be taxed to individual beneficiaries. These rules do not impact grantor trusts because all of the income of the trust will be treated as income of the person who is considered the owner of the property under the grantor trust rules, and will be included on that individual’s return, subject to the rates and thresholds applicable to that individual.

If you have any questions, please feel free to contact one of the attorneys listed below.

To ensure compliance with requirements imposed by U.S. Treasury Regulations, Haynes and Boone, LLP informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

*Board Certified – Estate Planning and Probate Law and Tax Law by the Texas Board of Legal Specialization.