With the personal income tax filing deadline of April 15 just days away, the nation’s changing tax policies are top of mind for many Americans. Last year’s Fiscal Cliff debate and the resulting American Taxpayer Relief Act of 2012 have not only changed the scope of personal taxes in this country, but affected the landscape for corporate taxes as well.
While Bush-era tax cuts for the middle class were renewed, high income-earning individuals and families will see their taxes increase in 2013. All taxpayers have experienced a net decrease in their pay with the end of the payroll tax holiday. For businesses, certain tax extenders that effectively lower rates and research credits have been revived. The American Taxpayer Relief Act prevented across-the-board tax increases on all income groups, and ensured that tax-friendly treatment of capital gains and dividends continued as well. Yet, there remain many political obstacles for Congress to address in the coming months, such as reconfiguring the corporate rate, questions regarding taxation of offshore income, and the development of a tax policy that satisfies the needs of both multinational corporations and small businesses alike.
In this month’s feature, two tax industry experts speak with the Sellinger School to discuss changes to corporate and personal taxes in 2013. Walter Doggett, MSF ’02, MBA ’04, vice president of tax at E*TRADE, and David Einhorn, tax partner at KPMG in Baltimore, share their insights into this year’s tax season and potential changes to tax policy that may loom ahead.
How does the recent legislation that resolved the fiscal cliff debate impact business or individual tax payers in 2013?
On Jan. 2, President Obama signed into law the American Taxpayer Relief Act of 2012. The Act includes permanent extensions of certain 2001 and 2003 tax provisions for individuals with income below $400,000, and joint filers with income below $450,000. Highlights of the Act include the following provisions:
- Tax rate increase for higher-income taxpayers. For tax years beginning after 2012, a 39.6 percent tax rate will apply for income above $450,000 for joint filers and surviving spouses; $425,000 for heads of household; $400,000 for single filers; and $225,000 for married taxpayers filing separately.
- Personal exemption phase-out and itemized deduction limitations for higher-income taxpayers. For tax years beginning after 2012, the personal exemption phase-out and the limitation on itemized deductions is reinstated with a starting threshold for those making $300,000 for joint filers and a surviving spouse, $275,000 for heads of household, $250,000 for single filers, and $150,000 for married taxpayers filing separately.
- Capital gain and dividend rates increase for higher-income taxpayers. For tax years beginning after 2012, the top rate for capital gains and dividends will permanently rise to 20 percent (up from 15percent) for taxpayers with incomes exceeding $400,000 ($450,000 for married taxpayers).
- Transfer tax provisions kept intact with slight rate increase. The Act prevents steep increases in estate, gift, and generation-skipping transfer (GST) tax that were slated to occur for individuals dying and gifts made after 2012 by permanently keeping the exemption level at $5 million (indexed for inflation). However, the Act also permanently increases the top estate, gift, and rate from 35 to 40 percent. The Act also continues the portability feature that allows the estate of the first spouse to die to transfer his or her unused exclusion to the surviving spouse.
- Permanent AMT relief. The Act provides permanent alternative minimum tax (AMT) relief. Retroactively effective for tax years beginning after 2011, the Act permanently increases these exemption amounts to $50,600 for unmarried taxpayers, $78,750 for joint filers, and $39,375 for married persons filing separately. In addition, for tax years beginning after 2012, the Act indexes the AMT exemption amounts for inflation.
What are your thoughts on possible tax reform? What would a lower corporate tax rate mean for the United States? Can this make the U.S. more competitive in the global economy?
The need to strengthen the competitiveness of U.S. firms in the global marketplace—together with slow economic growth, a continuation of high unemployment rates, and projections of significant future budget deficits—have increased interest in tax reform as a way of promoting U.S. economic growth, controlling federal deficits, and spurring job creation.
The United States has the highest corporate tax rate among advanced economies. Including the average state and local levies on top of the 35 percent federal rate, the U.S. combined statutory tax rate of 39.1 percent is more than 50 percent higher than the 25 percent average statutory corporate tax rate of other Organization for Economic Co-operation and Development (OECD) countries in 2012. Both the president and House Republican leaders are proposing a corporate rate reduction that would be offset by “base-broadening” measures by limiting or repealing tax deductions, exclusions, credits, or preferences.
The present U.S. system of international taxation is in urgent need of reform. Many analysts believe the current tax system reduces the ability of American companies to compete effectively in foreign markets. The present system imposes a substantial tax barrier to repatriation of earnings back for use in the U.S. economy. Approximately $2 trillion in foreign earnings is held by foreign subsidiaries and cannot be invested in U.S. parent companies without being subject to U.S. tax.
The U.S. system of worldwide taxation also stands in contrast to the territorial tax systems employed by most other OECD countries. The United States also is one of a few developed countries to tax foreign earnings under a worldwide tax system. All other G-7 countries and 28 of the 34 OECD countries use territorial tax systems under which all or most foreign dividends are exempt from domestic taxation.
Let’s discuss personal taxes. What are some common pitfalls people make when preparing their individual tax returns? Is there any advice you have for those preparing their taxes?
There are many common mistakes made by individuals when preparing their Form 1040 tax returns. Some of the more costly oversights are listed below:
- Underreporting cost basis. Taxpayers often report excess gain from the sale of mutual fund shares by forgetting that they paid tax on distributions of capital gains and dividends in previous tax years.
- Overlooking carry-forward items from previous tax returns. Remember that $3,000 of capital losses from a prior tax year may be carried forward to offset capital gains in the current tax year.
- Failure to claim excess social security withholding. This applies when you worked for more than one employer during the year and earned in excess of the gross income limit for FICA.
- Failing to pay and report domestic payroll taxes. Taxpayers employing household workers, such as a house cleaner, an in-home caregiver, or a nanny, must pay and report payroll taxes for those individuals when the payments exceed certain threshold amounts.
- Choosing the wrong filing status. Remember to file as head of household if you are single with a dependent.
- Failure to claim a dependent. Specifically, the failure to claim an elderly parent or other relative whom you support.
- Failure to claim the earned income credit. Note that taxpayers must have a qualifying amount of earned income to claim the Earned Income Credit.
- Failure to itemize. Many taxpayers simply claim the standard deduction when itemizing would entitle them to greater tax deductions.
- Failing to sign and date the tax return. Taxpayers must sign and date their return under penalties of perjury. If the return is not signed, it will not be accepted as filed by the IRS. Both spouses are required to sign a joint return.
What were some of the major changes to tax policy for 2013?
Much of the Fiscal Cliff debate and eventual American Taxpayer Relief Act legislation from the Fiscal Cliff focused on tax cuts for individuals. The changes to personal income tax levels and capital gains are what received the most media coverage.
An important part of this legislation that did not receive as much coverage or isn’t as well-known by most is a one-year extension of certain tax extenders for corporations through 2013. A special tax extension rule for U.S. corporations with foreign subsidiaries was extended for the treatment of certain deemed dividend income.
Can you explain more about the special rule for dividend income of corporations?
The general rule is that U.S. corporations with foreign subsidiaries do not pay taxes on their foreign subsidiaries’ income if the cash is kept overseas for tax purposes, unless an exception applies. One exception to the general rule relates to passive income that a foreign subsidiary receives, such as dividends from its subsidiaries. Generally, passive income of foreign subsidiaries is taxable to the U.S. parent corporation as a deemed dividend. The Taxpayer Relief Act extended an exception to the exception by not treating a dividend from one foreign subsidiary to the other as passive income. Rather, the exception generally allows the recipient to look through to the foreign subsidiary and treat the dividend as active income.
This “look through” rule expired at the 2011, but the Fiscal Cliff legislation retroactively extended this rule through 2013. From the standpoint of corporations, this makes for easier tax planning knowing that rule will remain in place.
There have been calls for reducing the US corporate income tax rate. Why would this be necessary?
One of the reasons U.S. corporations keep their money “permanently invested” in foreign subsidiaries is due to the very high U.S. corporate tax rate of 35 percent. Comparatively, the corporate tax rate in the United Kingdom is 24 percent, and in countries viewed as corporate tax havens, such as Ireland, the corporate tax rate is as low as 10 percent. If the U.S. parent company had the foreign subsidiary repatriate their earnings, the U.S. parent would face a significant tax burden due to the higher U.S. tax rates. The rather complicated U.S. foreign tax credit rules may prevent the U.S. parent from claiming a credit for the foreign taxes that the foreign subsidiary has already paid. This could result in double taxation.
While the U.S. corporate tax rate is 35 percent, it can be much lower than that. Through different tax breaks, energy and research credits, reductions for stock options, etc., must corporations don’t end up paying the full 35 percent. The largest corporations often generate the most news when it comes to tax loopholes.
This said, in light of the recent high profile tax disputes between European countries and Starbucks, for example, there is a movement afoot for corporations to look beyond the details of tax savings. The concern in corporate tax policy used to be almost always about following the existing rules. Although these tools that corporations use to pay lower effective tax rates are legal and proper, they can have a global impact on customers and perception. More corporations are asking themselves if they want to wake up in the morning and read about their tax strategies in the news.
Do you foresee any more changes to corporate tax policy in the near future? What other considerations are currently under discussion?
It’s hard to imagine that a serious political solution to tax policy is imminent. Both parties have their ideological reasons for taking their positions in the debate about how to grow the U.S. economy. I tend to think that the way U.S. foreign subsidiaries are taxed, considering the amount of unremitted earnings they currently have outside the US, will need to be addressed. However, the debate over corporate tax policy in relation to growing the U.S. economy raises questions that the parties seem to take opposite sides on: should there be a U.S. corporate tax rate cut and how should the U.S. tax earnings of foreign subsidiaries? Specifically on the question of taxing foreign subsidiaries, there are different opinions on when to tax them: 1) when cash is repatriated using the current exceptions; 2) immediately; or 3) exempt them from US tax altogether or tax them at a very low rate.
The unfortunate reality is that right now, proposed changes have very little chance at becoming law—although it is known that on the macro level, some spending cuts and tax reform are going to be needed to minimize deficits and balance budgets.