On September 12, President Obama provided the legislative text for the “American Jobs Act” that he summarily described during a September 8 speech to a Joint Session of Congress. In terms of taxes, the following summarizes the primary items, all of which are described in this article:
The bill’s Title IV, entitled “Offsets”, contains the tax increases. Republicans and many Democrats have previously been unwilling to support some of these same ideas, so the wholesale passage of these tax increases is quite unlikely.
Proposed Section 401 limits itemized deductions for single taxpayers with incomes over $200,000, and those married filing jointly filers with income over $250,000 by capping the value of an itemized deduction at 28 cents for each dollar deducted. Under current tax rates, itemized deductions can be worth up to 35 cents for every dollar deducted.
The possible impact that this itemized deduction limitation might have on charitable contributions is of concern to both sides of the political aisle. Although certain politicians obtain favor by demonizing the “rich”, those with affluence do donate more. The limitation on charitable contributions may have unintended adverse consequences.
Previous versions of this provision in the president’s budget would have applied only to itemized deductions. The current proposal expands to cover many above-the-line deductions, including:
1. Self-employed health insurance
2. Domestic production activities deduction (Section 199)
3. Employee trade or business expenses, including the $250 deduction for K-12 teachers
4. Moving expenses
5. Contributions to medical and health savings accounts
6. Student loan interest
7. Higher education tuition and fees
The American Jobs Act also would also limit to 28% the benefit of certain exclusions, including (i) interest on state and local bonds, and (ii) foreign earned income excluded under Section 911. Interestingly, limiting the tax benefit of municipal bonds is a direct transfer of value from the municipalities issuing such bonds to the federal government. This occurs because the lower market interest rate paid by the municipalities directly reflects the federal tax treatment of the interest by the investors. In short, increased taxes on municipal bonds means increased interest paid by the municipalities.
Unlike earlier proposals, the 28% limitation in the American Jobs Act would also affect individuals subject to the alternative minimum tax.
As noted in the summary at the beginning of this article, the increase in upper-income taxation is by far the largest portion of how the President plans to pay for The American Jobs Act. President Obama’s proposal to limit deductions and other benefits for higher income individuals is not a surprise, since he previously proposed to limit itemized deductions for higher income taxpayers and has consistently made other proposals focused on this same group. Since these earlier proposals have not been passable, and there are limits to the federal debt ceiling, one must wonder how the federal government will pay for largest portions of the American Jobs Act.
Proposed Section 411 eliminates capital gains treatment (currently taxed at 15 percent) for partnership interests obtained through the provision of services (aka carried interests). Instead, this long-term income would be classified as ordinary income, which is currently taxed at 35 percent. This primarily affects organizers and operators of investment partnerships and hedge funds.
Proposed Section 421 would increase the depreciation life of “general aviation” aircraft from five years to seven years. Commercial aircraft are already depreciated over seven years. The White House estimates this would increase taxes by $300 million annually. In the scope of the U.S. Treasury’s problems, this is a pretty small amount.
Proposed Subtitle D is a lengthy section involving the repeal of most tax benefits for the oil & gas exploration industry. When first passed, these now-threatened incentives were intended to encourage domestic production and reduce dependence on foreign oil. The proposed changes apply to all involved in oil & gas activities, not just the large integrated oil companies. The changes include the following, all of which would be effective in 2013:
- Modify Section 199 (the domestic production activities deduction) to exclude revenues from the sale or disposition of oil and gas and primary products of oil and gas
- Require intangible drilling cost, and tertiary injectant costs to be capitalized and recovered over time as depreciable or depletable property
- Repeal percentage depletion for oil and natural gas, and require cost depletion to be used
- Repeal the passive loss exception for working interests in oil and natural gas properties
- Increase the geological and geophysical amortization period from 2 to 7 years for oil and gas producers
- Repeal the enhanced oil recovery credit
- Repeal the marginal well tax credit for production
- Modify the foreign tax credit rules applicable to dual capacity taxpayers, except where provided by treaty
- Create a separate foreign tax credit basket for taxes paid or accrued on certain oil and gas income
Tax Reductions Aimed at Increasing Employment
The tax breaks are focused on new job creation, with an emphasis on smaller businesses.
Proposed Section 101 would reduce both the employer and employee Social Security payroll
tax rate in half for calendar year 2012. For individual employees, the Social Security tax rate would be 3.1% for the full individual Social Security wage cap (which reached $106,800 in 2011, and is adjusted for inflation annually). The proposed 2012 reduction is more generous than the one-year 2011 reduction in the employee portion of the tax, which took the Social Security rate from 6.2% to 4.2%. In all cases, the Medicare tax is unaffected.
Employer Social Security taxes would also be reduced by the same amount, but only on the first $5 million in wages. Consequently, this provision benefits primarily small businesses.
Proposed Section 102 provides a 6.2% employer wage credit on the first $50 million in payroll increases over the prior year. The credit applies to the last quarter of 2011 and all of 2012. For the partial year of 2011, the credit is based on the increase in wages paid between October 1 and December 31 in 2011, compared to the wages paid over the same period in 2010. The employer receives a credit of 6.2% of any increase, up to $12.5 million. The full-year 2012 credit would be based on a year-over-year comparison with 2011, with a $50 million cap. The payroll tax credit is in addition to the 3.1% employer Social Security payroll tax savings described above, but could not reduce Social Security taxes below zero. This credit does not apply to self-employment income.
Self-employed taxpayers effectively receive both the employee and employer 2012 payroll tax holiday, lowering their rate a total of 6.2% on all self-employment income under the Social Security wage cap. The existing credit for a portion of the self-employment taxes would be reduced, thus making the net benefit smaller. Additionally, as with any employers with more than $5 million of payroll, self-employed taxpayers with other employees lose the “employer portion” of this rate cut once taxable payroll reaches $5 million of combined employee wages and self-employment income.
Proposed Section 111 would extend 100% bonus depreciation through the end of 2012. This 100% bonus depreciation allows a full expensing of depreciable property in the year it is placed in service. This treatment is currently available for property placed in service after September 8, 2010 through December 31, 2011. Absent this extension, property placed in service in 2012 would be eligible for 50% bonus depreciation. If this provision is enacted, taxpayers could continue to elect to accelerate alternative minimum tax (AMT) credits in lieu of claiming bonus depreciation. This alternative is already available under current law for both 2011 and 2012.
The bill would expand the existing work opportunity tax credit. Generally, this provides a credit of up to 40% of wages for workers employed for 400 hours or more as follows:
1. $2,400 for hiring veterans who have been unemployed at least 4 weeks,
2. $4,000 for hiring workers who have been unemployed at least 6 months,
3. $5,600 for hiring veterans who have been unemployed at least 6 months, and
4. $9,600 for hiring veterans with disabilities who have been unemployed at least 6.5 months
These credits are sufficiently small (when compared to the long-term total cost of an employee) that this will not have a substantial additional effect on hiring for employees who are not otherwise qualified.
Proposed Section 113 delays new rules that require 3% withholding on vendor payments paid by state, local, and federal governments. The withholding requirements were originally scheduled to begin in 2012, but were delayed administratively by the IRS until 2013. The bill delays the withholding further, to begin in 2014.
On September 19, President Obama unveiled an even larger tax increase proposal totaling $1.5 trillion. These larger tax proposals incorporate the same tax increases described above, but also:
- Adds about $800 billion from letting current tax rates expire for the affluent families and individuals that are the focus of the American Jobs Act tax increases, and
- Establishes a higher capital gains rate for those who make more than $1 million.
While Republicans could certainly support some of the changes in the American Jobs Act, passing an overall bill that does not add to the deficit will be nearly impossible. Nevertheless, it is important to understand the President’s current tax proposals in planning long-term tax positions.