Updated January 4, 2013: The American Taxpayer Relief Act of 2012 restores the original 3 percent phaseout of itemized deductions for income above $300,000 for married taxpayers filing jointly and $250,000 for single taxpayers. The Act also restores the 39.6 percent top rate for income above $450,000 for married taxpayers filing jointly and $400,000 for single taxpayers.
Most readers are aware that many provisions of the tax law “sunset” or expire at the end of 2012 if nothing happens before the end of the year. One little-noticed provision could help both sides move beyond the current impasse.
Under IRC §68, there is a phase-out of itemized deductions known as the Pease phase-out, after its initial author. The law was amended in 2001 to phase out the phase-out over several years, but it springs back to life in 2013.
Here’s how it works: For every dollar of income above a certain threshold ($177,550 in 2012) itemized deductions are reduced by 3 percent of the additional amount up to 80 percent of itemized deductions. However, itemized deductions are never entirely recaptured because the allowable IRC §164 deduction for state and local income taxes or sales taxes almost always increases at a faster rate.
In effect, the phase-out simply increases the effective marginal tax rate on income above the threshold. For example, a taxpayer in the 33 percent bracket would pay a dollar more in tax for every three dollars of itemized deductions with every hundred dollars of income and so would pay an additional tax of about 1 percent.
This feature could prove useful because one side wants to increase the marginal tax rate on high-income taxpayers, but the other side doesn’t want rates to go up. The phase-out is a way of raising effective rates without raising nominal rates and it does so by limiting itemized deductions, which Republicans and some Democrats have talked about as a source of revenue.
A possible face-saving compromise might contain the following elements:
- Increase the threshold to $200,000 ($250,000 for married taxpayers) to meet the promise of no tax increase for 98 percent of taxpayers;
- Increase the phase-out rate from 3 percent to 5 percent to make up lost revenue; and
- Increase the top rate a token amount from 35 percent to 36 percent.
For taxpayers above the threshold, the effective tax rates would rise from 33 and 35 percent to 34.6 and 37.7 percent, comfortably between the current rates and the top rates of 36 and 39.6 percent scheduled to take effect in 2013.
Of course, both sides would have to compromise and they could just agree to raise the rates. But it might be worth a shot.
For much more coverage of coming tax law changes, including big changes ahead for the estate and gift tax, see the December issue of CEB’s Estate Planning & California Probate Reporter. Also check out CEB’s California Estate Planning, chaps 10–13.
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