Photograph by Thomas Barwick
Congress pulled off a narrow escape for the U.S. economy this week, averting a fall off the so-called fiscal cliff. The New Year’s Day deal includes bad news and good news for entrepreneurs: Despite its billing as a tax hike on the wealthy, the deal actually raises taxes on 77 percent of U.S. households, thanks to the expiration of a payroll “tax holiday” passed in 2011.
On the other hand, most self-employed people and small business owners (including owners of so-called pass-through entities, such as S corporations, who pay income taxes as individuals) will benefit from the permanent extension of the 2001 and 2003 Bush-era tax cuts for lower- and moderate-income taxpayers. And small businesses will get generous limits on bonus depreciation, further encouraging investment in capital purchases.
What exactly will the American Taxpayer Relief Act of 2012 mean for individuals who run their own companies (with and without employees)? Here’s the rundown:
Income taxes: Current income tax rates, established under President George W. Bush in 2001 and 2003, were set to expire this year and increase on everyone. Instead, those rates were made permanent for individuals earning less than $400,000 and couples earning less than $450,000. People who earn more than those thresholds will see an income tax increase from 35 percent to 39.6 percent.
Payroll taxes: A 2011-12 payroll tax holiday reduced the self-employment tax from 15.3 percent to 13.3 percent of net earnings and the employee rate from 6.2 percent to 4.2 percent. But the holiday is over for 2013, and the tax rate goes back up. The amount that employers contribute on behalf of their employees has remained at 6.2 percent and will not change.
Business tax incentives: Two widely used tax incentives, bonus depreciation and expensing, were extended. Through 2013, businesses will be able to claim 50 percent bonus depreciation on capital purchases and expense Section 179 expenditures (for equipment, office furniture, and other material goods) to a generous $500,000 allowance and a $2 million investment limit. The allowance was scheduled to be reduced to $25,000, with a $200,000 investment limit, in 2013.
Tax credits: Tax Code Section 45 production tax credits were extended for wind energy, biofuels, and energy-efficient appliances. In addition the research, work opportunity, new markets, and empowerment zone tax credits and incentives were extended through 2013, along with an employer wage credit for hiring military reservists.
Dividends and long-term capital gains: Rates go from 15 percent to 20 percent for high-earning individuals; the 15 percent Bush-era tax rate remains in place for middle-income Americans.
Estate taxes: If you’re one of the tiny sliver of Americans who will leave your heirs more than $5 million, you won’t be too happy with a 5 percent jump in the federal estate tax rate, to 40 percent from 35 percent. The rate was made permanent, a feature that estate planners will no doubt cheer, after several years in which the rate jumped around from zero to a scheduled 55 percent on estates over $1 million.
The AMT: The alternative minimum tax was never indexed for inflation and so had to be “patched” annually by Congress to avoid raising taxes on the middle class. The new legislation permanently fixes that problem, indexing the AMT for inflation.
Unrelated to the new tax legislation, an increase of 0.9 percent in Medicare taxes on the wealthy becomes effective in 2013 as part of the 2010 Affordable Care Act. The tax hike, to cover health-care costs, is on earned income of more than $200,000 for individuals and $250,000 for married couples. Employers will not pay the extra tax, but it will need to be withheld from employees’ wages. The tax may or may not apply to earnings from S corporations and limited partnerships, depending on how the earnings are treated for tax purposes. Check with your accountant on this one.
Obamacare also imposed a new 3.8 percent Medicare tax for 2013 on net investment income (from sources such as interest, dividends, and annuities) for individuals making more than $200,000 (and couples making more than $250,000). Passive income from a business and income derived from trading in financial instruments are both considered investment income.
The bottom line? Most everyone will owe a little more, and those at the top will owe a lot more, between the fiscal deal and new health-care taxes.