The Fiscal Cliff

1. The Fiscal Cliff Tax Policy Outlook for 2013

2. The Fiscal Cliff Agenda • Overview and Potential Impact • Expiring Tax Provisions • New Tax Provisions • Other Tax Issues (“Extenders”, Depreciation) • Candidate Proposals • Planning Ideas

3. The Fiscal Cliff Overview – What is the Fiscal Cliff? A convergence of several laws that are set to take effect on January 1, 2013 • Expiration of Bush and Obama tax cuts • Addition of new taxes (Health Care Act, etc.) • Reduction in government spending due to sequesters required by the Budget Control Act of 2011

4. The Fiscal Cliff Estimated Impact of the Fiscal Cliff • Taxes increase by over $500 billion in 2013 • Average tax increase of almost $3,500 per household • Tax increase to be felt by about 90% of Americans • Average marginal tax rates would increase by 5% on labor income, 7% on capital gains, and more than 20% on dividends

5. The Fiscal Cliff Federal taxes are scheduled to rise in 2013 for six reasons: • Expiration of Bush-era tax cuts from 2001 and 2003 • Expiration of Obama tax cuts from the 2009 and 2010 Tax Acts. • Many short-term tax breaks are set to expire if not extended by Congress. • Expiration of the payroll tax cut. • New taxes from the Affordable Care Act • Alternative Minimum Tax (AMT) more prevalent due to the above changes and the expiration of the patch in 2011.

6. The Fiscal Cliff Expiring Tax Provisions • Reduced tax rates – lowered for all brackets • Repealed the limitation on itemized deductions and the phaseout of personal exemptions • Doubled the child tax credit from $500 to $1,000 • Eliminated marriage penalty • Reduced taxes on capital gains • Reduced taxes on dividends • Payroll tax cut (Social Security tax cut 2%)

7. The Fiscal Cliff New Tax Provisions – Affordable Care Act • Additional 0.9% Medicare tax on wages above $250,000 for MFJ; $200,000 for single. • Increased the AGI threshold for deducting medical expenses from 7.5% to 10%. • Medicare Contribution Tax - 3.8% surtax on net investment income

8. The Fiscal Cliff The Medicare Contribution Tax • Calculated as 3.8% of the lesser of: • Net investment income; or • The excess of the taxpayer’s AGI over a threshold of $200,000 for single; $250,000 for MFJ. • No tax if no investment income

9. The Fiscal Cliff The Medicare Contribution Tax – Continued Net investment income is defined as the sum of: • Gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a business; • Income from a business in which the taxpayer does not personally materially participate; • Capital gains and other net gains from the disposition of property

10. The Fiscal Cliff The Medicare Contribution Tax – Continued Exclusions from definition of Net Investment Income: • Active business income • Qualified retirement plan distributions (Social Security earnings, IRA distributions, 401(k) distributions, etc.)

11. The Fiscal Cliff “Extenders” Tax Provisions Many short-term tax provisions that Congress regularly extends, known as “extenders,” have either already expired or will expire by the end of 2012. These are as follows: • Deductibility of state and local sales taxes • Deduction for qualified education expenses • R&D tax credits

12. The Fiscal Cliff “Extenders” Tax Provisions – Continued Depreciation Changes – severely hinder business owners’ ability to manage their tax liabilities. • Bonus depreciation allowed for immediate write-off of cost of qualifying property (new property only, could claim even if loss) • Section 179 also allows for immediate write-off (new and used property qualifies, cannot create a loss, phased out for larger taxpayers) • Both applicable for regular tax and AMT (i.e., no AMT trap)

13. The Fiscal CliffDepreciation Law Changes

14. The Fiscal CliffEstate Tax Comparisons

15. The Fiscal Cliff Example of Fiscal Cliff Impact • Single taxpayer • W-2 = $400,000 • Interest Income = $100,000 • Qualified Dividends = $100,000 • Long-Term Capital Gains = $100,000

16. The Fiscal CliffExample of Fiscal Cliff Impact

17. The Fiscal CliffComparison of Tax Law Changes

18. The Fiscal CliffComparison of Tax Law Changes

19. The Fiscal CliffTax Bracket Comparison - MFJ

20. The Fiscal CliffPresidential Candidate Proposals

21. The Fiscal Cliff Planning Opportunities Consider a grouping election to group passive activities with active businesses to exclude the income from the 3.8% Medicare Contribution Tax. • A passive activity is defined as a business activity in which the taxpayer does not materially participate, and any rental activity.

22. The Fiscal Cliff Planning Opportunities – Continued • Grouping Election – allowed if the activities are considered an appropriate economic unit • Example – Ronald owns two McDonald’s restaurant franchises, one in Peoria and one in East Peoria. Both are organized as separate S corporations. Ronald actively manages the Peoria McDonald’s but does not participate at all in the East Peoria McDonald’s; his son runs that restaurant. Without a grouping election, the East Peoria McDonald’s activity is passive, which means the income is subject to the 3.8% surtax and losses may not be deductible.

23. The Fiscal Cliff Planning Opportunities – Continued • Opportunity to also group active business with rental activity. • Effective in 2011, a written election is required for new groupings. • Consider a grouping election on the 2012 return

24. The Fiscal Cliff Planning Opportunities – Continued • Consider selling securities to maximize capital gains. Alternatively, defer security losses to 2013. • For business owners that are selling or sold their business in ‘12, consider electing out of the installment sale rules to accelerate capital gains at the lower rate.

25. The Fiscal Cliff Planning Opportunities – Continued • Maximize dividends to exploit favorable tax rates • Extract liquidity from closely held C corporations, including partial redemptions treated as dividends • S corporations should consider election to treat distributions as dividends of former C corporation earnings and profits. • Evaluate timing of IC-DISC dividends

26. The Fiscal Cliff Planning Opportunities – Continued • Consider exercising non-qualified stock options in 2012 to avoid the 0.9% Medicare tax and higher tax rates in 2013. • Consider gifting strategies to “lock in” the high exemption amount. Gift exemption is same as the estate exemption for 2012.

27. The Fiscal Cliff Questions?