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Brace yourself for a sea change in the tax law

A number of tax law changes are making their way through Congress, and many more on the way. These changes will affect both individual and business taxpayers alike. In 2010, it is expected that Congress will address the federal estate tax, and is currently working on small business and jobs “relief,” as well as an extension of popular, but temporary tax incentives that expired at the end of 2009. This article provides a brief overview of what taxpayers can expect this year.

Individual and business tax extenders

Congress continues to debate the extension of a number of tax incentives for individuals and businesses that expired at the end of 2009. The tax breaks would be extended retroactively for one year, through December 31, 2010. A number of popular energy tax incentives and charitable deductions would be extended too. Among the individual incentives that would be extended are the popular additional standard deduction for real property taxes, the state and local sales tax deduction, and the higher education tuition deduction, as well as the teacher’s classroom expense deduction.

For business taxpayers, some of the tax incentives to be extended include the research tax credit, New Markets Tax Credit, differential pay credit, and the 15-year recovery period under the Modified Accelerated Cost Recovery System (MACRS) for qualified leasehold improvements, and qualified restaurant and retail improvement property.

A host of charitable and energy tax incentives would also be extended through 2010. The charitable extenders include the ability to make a charitable IRA contribution of up to $100,000 for individuals age 70 1/2 and older, and the tax deductions for contributions of real property, food inventory, computer and book inventory to public schools, and S corporation charitable contribution deductions.

Small business tax relief/”jobs” bill

The House has twice passed a package of small business tax incentives. The bills includes three major incentives for small business: (1) a 100 percent exclusion of gain from the sale of qualified small business stock, (2) an enhanced deduction for start-up expenses, and (3) penalty relief for taxpayers that failed to disclose transactions with the potential for tax evasion. The Small Business Jobs Tax Relief Act of 2010, passed by the House in June, would increase the exclusion for qualified small business stock sold by an individual from 75 percent to 100 percent for stock acquired after March 15, 2010 and before January 1, 2012.

Increased start-up expenses. The bill increases the deduction for qualified start-up expenses from $5,000 to $20,000. It also increases to $75,000 the threshold amount by which the $20,000 deduction would be reduced.

Decreased Code Sec. 6707A penalties. The legislation would also provide for lower penalties under Code Sec. 6707A for taxpayers who fail to disclose “reportable transactions” in which they participate. This change is intended to help ameliorate the impact of the penalty on small businesses, which can currently reach a maximum of $200,000 for businesses failing to report listed transactions and $50,000 for failing to report reportable transactions. Many businesses have been assessed these penalties for engaging in transactions they did not know were tax shelters.

New limits on GRATs. To pay for the small business tax incentives, the bill places new limits on grantor retained annuity trusts (GRATs), a popular estate and gift planning vehicle. GRATs would be required to have a minimum 10-year term, carry a remainder interest with a value greater than zero, and prohibit any decreases in annuity payments during the GRAT’s term. The new limits would be imposed for transfers after the date of enactment.

3.8 percent tax Medicare tax on investment income

The health care reform package (the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010) imposes a new 3.8 percent Medicare contribution tax on the investment income of higher-income individuals. The tax will apply to the lesser of net investment income or modified adjusted gross income above $200,000 for individuals and $250,000 for joint filers and surviving spouses, and $125,000 for married couples filing separate returns.

Although the tax will not take effect until 2013, it is important for individuals who will be affected by the tax to start examining ways to lessen the impact now.   Net investment income includes interest, dividends annuities, royalties, rents, and other gross income attributable to passive activities. Gain from the sale of property not used in an active business (for example, your personal residence) and income from the investment of working capital are also treated as investment income. The tax won’t apply, however, to nontaxable income such as tax exempt interest, or to veterans’ benefits. An individual’s capital gains income will be subject to the tax. This includes gain from the sale of a principal residence, unless the gain is excluded from income.

A significant exception to the 3.8 percent Medicare tax applies for distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans. These will not be subject to the tax.

Interplay with other tax changes. In addition to the 3.8 percent Medicare tax, taxpayers also face other tax increases taking effect in 2011. The top two marginal income tax rates for individuals will rise from 33 and 35 percent to 36 and 39.6 percent, respectively. The maximum tax rate on long-term capital gains is set to increase from 15 to 20 percent. Dividends, which are currently capped at the 15 percent long-term capital gains tax rate, will be taxed at ordinary income tax rates.

Estate tax fix

The federal estate tax does not apply to decedents dying after December 31, 2009 and before January 1, 2011. Also, beginning in 2010, the stepped up basis at death rules are replaced with modified carryover basis at death rules applicable to estates holding assets with unrealized capital gains of more than $1.3 million. In December 2009, the House passed the Permanent Estate Tax Relief Act, which would permanently extend the top federal estate tax rate of 45 percent with a $3.5 million exclusion ($7 million for married couples). The Senate, however, has failed to take up the House bill. Some action this year is expected. The estate tax will revert to a 55 percent tax rate beginning in 2011. Proposals in Congress range from setting the exemption level at $5 million for individuals and reducing the tax rate to 35 percent.