Last week, President Obama signed into law the Middle Class Tax Relief Act of 2010.  Bill Leary, a director in MFR’s Tax Services practice, provides an analysis of the new law’s provisions and their impact on taxpayers.  Bill has been involved in tax compliance and global business planning for public and private companies for more than 25 years. Bill can be reached via email or at 713.622.1120.

Pulled Out of a Hat:  A New Tax Law

Ten days after announcing a controversial compromise with the Republican leadership, President Obama signed into law the Middle Class Tax Relief Act of 2010 (the “Act”) on December 17th.  For the period 2011 – 2015, the Act adds $892 billion to the federal deficit.  With the exception of the extension of unemployment benefits, changes to estate and gift taxation, depreciation, and employment taxes, most taxpayers will not notice the changes. 

The addition to the deficit results from the way the cost of the Act is measured.  Had it not been enacted, numerous pro-taxpayer provisions would have expired.  The cost is a result of continuing the status quo for most taxpayers, largely measuring the government’s anticipated loss of future revenues.  Looking at it another way:  In 2011, without the Act, the economy would be tax-burdened by a large portion of the addition to the deficit; instead, the economy can continue its timid recovery without new tax costs.

Scope of the New Law

The Act extends for two years the so-called Bush-era tax cuts and retains favorable tax rates for long-term capital gains and qualified dividends, and provides significant estate and gift tax relief (measured against the rules that were to take effect in 2011), as well as a two-year alternative minimum tax (AMT) “patch.” It also contains new tax breaks, including 100% first-year write-offs of qualifying property placed in service after Sept. 8, 2010 and before Jan. 1, 2012, and a payroll/self-employment tax cut of two percentage points for 2011 for employees and self-employed individuals, which will appear as reduced withholding.  Plus, it extends a host of expired and expiring tax breaks for businesses and individuals as well as disaster relief provisions.

Under pre-Act law, changes enacted in 2001 and 2003 were scheduled to expire at the end of 2010 -- statutory tax rates on ordinary income, capital gains, and dividends would rise; the child tax credit would decline; and the 15 percent tax bracket would narrow for taxpayers.

The Act reduces the scheduled 2011 individual income tax rates on ordinary income except for the two highest tax rates that apply to taxpayers with adjusted gross income greater than $200,000 ($250,000 for taxpayers who file joint tax returns), increases the amount of the child tax credit, and expands the 15-percent tax bracket. The standard deduction for married taxpayers filing jointly (and qualified surviving spouses) remains at twice of the standard deduction for single taxpayers for two additional years, temporarily eliminating the “marriage penalty.”  Itemized deductions and personal exemptions will not be phased out under the Act in 2011 or 2012 for higher-income taxpayers.  The extending provisions also include the election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes.

For tax years beginning in 2010, an individual's qualified dividend income is taxed at the same rates that apply to net capital gain. Thus, an individual's qualified dividend income is taxed at no more than 15 percent. Under pre-Act law, for tax years beginning after 2010, dividends received by an individual were to be taxed at ordinary income tax rates.   Under the Act, adjusted net capital gain will be taxed at a maximum rate of 0/15% for two additional years, through 2012.   A qualified dividend paid to individuals will be taxed at the same rates as adjusted net capital gain through 2012.   As a result, taxpayers can briefly defer year-end strategies designed to ameliorate the scheduled increase in taxes.

Employees and self-employed workers will receive a reduction of two percentage points in Social Security payroll tax in 2011, bringing the rate down from 6.2% to 4.2% for employees, and from 12.4% to 10.4% for the self-employed.

The Act will also increase for two years, through 2011, the exemption amounts allowed under the AMT.  The two-year AMT “patch” for 2010 and 2011 will keep the AMT exemption near current levels and allow personal credits to offset AMT. Without the patch, an estimated 21 million additional taxpayers would have owed AMT for 2010.

Under pre-Act law, the estate tax and the generation skipping tax (“GST”) was repealed in 2010 only, and the estate tax and the GST tax would have been reinstated in 2011 and later years.  The estate tax under the Act is imposed at the top rate of 35-percent of the estate's value after the first $5 million.  For farmers, ranchers and small business owners, the $5 million floor is too low.  Despite its relatively small federal revenue impact, to its opponents, it was a politically unacceptable benefit for the “wealthy.” 

The Act extends the research credit for two years by striking the 2009 expiration date. (The cost of a permanent solution to the research and experimentation (R&E) incentive makes it very difficult for Congress to agree on a long-term incentive.)  Because the extension of the research credit is retroactive to include amounts paid or incurred after 2009, certain fiscal year taxpayers that have already filed returns for affected years should consider filing an amended return to claim the credit.

A work opportunity tax credit (WOTC) is available on an elective basis to an employer for a percentage of limited amounts of wages paid or incurred by the employer to individuals who belong to a “targeted group.”  The Act extends the WOTC for four months (for individuals who began work for an employer after August 31, 2011 and before January 1, 2012.  The taxpayer is eligible to get a credit for wages paid or incurred to that individual for one year (two years, in the case of long-term family assistance recipients) after the date that employment begins, even though that employment continues after 2011.

A Gamble?

Rather than letting the new Congress consider whether make or reject retroactive law changes, President Obama may have let down his supporters by accepting the compromise.  (He and his advisors may be betting on a recovery before the 2012 elections.  Good News: According to the Tax Foundation, the law could also benefit lower-income taxpayers.)   

It was a perfect compromise – something for everyone to like and to dislike, and offering a degree of uncertainty for all.  After relatively swift action by the Senate, the House was more contentious, advancing reluctantly to a vote after elaborate parliamentary wrangling.  The President quickly signed the measure into law. 

At the same time, a long-term funding measure for the federal government, filled with pork-barrel measures, died in the lame-duck session -- something more than a short-term solution is needed and will be one of the first challenges the new Congress. 

Deficit reduction options, confronting powerful lobby groups, have been placed on the upcoming legislative table by a special commission.  President Obama says he plans to take on fundamental tax reform next year.  The new Congress seems poised to take on the established norms in DC.  Who will take the lead next year?  Will anyone follow or will they just stick to their own agendas?  Serious players are not yet placing their bets.