Background

As you know, the Bush tax cuts (from legislation enacted in 2001 and 2003) are scheduled to expire at the end of this year. But, you may not understand the full extent of what is in store if Congress allows the expirations to occur without making any changes.

Higher Income Tax Rates for All

Some clients may believe that only individuals in the top two federal income tax brackets will face higher rates when the Bush cuts expire. Not true! Unless Congress takes action and President Obama goes along, rates will automatically go up for everyone who pays taxes—not just “the rich.”

Specifically, the existing 10% bracket will go away, and the lowest “new” bracket will be 15%. The existing 25% bracket will be replaced by the “new” 28% bracket; the existing 28% bracket will be replaced by the “new” 31% bracket; the existing 33% bracket will be replaced by the “new” 36% bracket; and the existing 35% bracket will be replaced by the “new” 39.6% bracket. [See IRC Sec. 1(i) .] Appendix 1 shows income levels in each of these brackets for 2010 and 2011 assuming that there are no inflation adjustments between 2010 and 2011.

Outlook: The Administration has pledged to keep the three lowest brackets (the 10%, 15%, and 25% brackets) in place. The 28% bracket would be expanded to accommodate unmarried taxpayers with income (whatever that is determined to mean) below $200,000 and joint filers with income below $250,000. Only taxpayers with income above those levels would be affected by the new 36% and 39.6% rates. As stated above, however, Congress must make changes, and the president must go along for these things to happen. Right now, that is looking more problematic than a few months ago, and it now appears that Congress will not even bring up the subject until sometime after returning from its summer recess in August. To sum up, the only thing we know for sure is that tax rates will go up for everyone if Congress sits on its hands.

Marriage Penalty Will Get Worse

Right now, the 10% and 15% rate brackets for married joint-filing couples are 200% as wide as the 10% and 15% brackets for singles. Similarly, the standard deduction for joint-filing couples is 200% of the amount for singles. Right now, the 10% and 15% rate brackets for those who use married filing separate status are the same as the 10% and 15% brackets for singles. Similarly, the standard deduction for those who use married filing separate status is the same as the standard deduction for singles.

The Bush tax cuts put this relatively favorable framework for married individuals in place to reduce the so-called marriage penalty, which can cause a married couple to pay more federal income tax than if they were single. Note that the marriage penalty still exists for many married couples, but it’s not as harsh as before the Bush tax cuts. [See IRC Secs. 1(f) and 63(c) .] However, unless Congress makes changes and the president goes along, the marriage penalty will automatically get worse when the Bush tax cuts expire.

Starting next year, the new lowest bracket of 15% for Married Filing Joint (MFJ) couples will be only 167% as wide as the 15% bracket for singles—for Married Filing Separate (MFS) couples, it’ll be 83.5% as wide as the 15% bracket for singles. Similarly, the new standard deduction for joint-filers will be only 167% of the standard deduction for singles. For MFS status, it’ll be only 83.5% of the amount for singles.

Outlook: Presumably, the Administration’s pledge to keep things the same for lower and middle-income taxpayers includes extending the Bush tax cut elements that reduce the impact of the marriage penalty. However, extending those elements would require Congress to make changes and the president to go along. Will it happen? We don’t know, and neither does anyone else.

Itemized Deduction Phase-out Rule Will Return with a Vengeance

Before the Bush tax cuts, a nasty phase-out rule could eliminate up to 80% of affected itemized deductions for higher-income individuals. The phase-out rule covered the big-ticket deductions for mortgage interest, state and local taxes, and charitable donations. Deductions for medical expenses, investment interest expense, casualty and theft losses, and gambling losses were not affected. Thanks to the Bush tax cuts, the phase-out rule was gradually eased and finally eliminated this year. Next year, however, it will automatically return with a vengeance, unless Congress takes action and the president goes along.

If nothing changes, clients will lose $1 of affected deductions for every $3 of AGI in excess of the applicable AGI threshold (subject to the 80% disallowance limitation), starting next year. The threshold for 2011 is estimated to be $171,100 (or $85,550 for those who use MFS status). (See IRC Sec. 68 .)

Outlook: The Administration has said it wants the phase-out rule back, but at higher AGI thresholds of $250,000 for married joint-filing couples and $200,000 for other taxpayers. However, raising the AGI thresholds would require Congress to take action and the president to go along. Don’t bet the house on it.

Personal Exemption Phase-out Rule Will Return with a Vengeance

Before the Bush tax cuts, another nasty phase-out rule could eliminate some or all of a higher-income individual’s personal exemption deductions. Thanks to the Bush tax cuts, this phase-out rule was gradually eased and finally eliminated this year. Starting next year, it will automatically return with a vengeance, unless Congress takes action and the president goes along. [See IRC Sec. 151(d)(3) .]

If nothing changes, taxpayers need to be ready for yet another bite out of their wallets if their 2011 AGI exceeds the applicable threshold. The phase-out thresholds for 2011 are estimated to be $256,700 for MFJ; $171,100 for singles; $213,900 for heads of households; and $128,350 for MFS.

Outlook: The Administration has said it wants the phase-out rule back, but at different AGI thresholds: $250,000 for married joint-filing couples, $200,000 for unmarried individuals, and $125,000 for those who use married filing separate status. Since this is pretty close to what will happen without any making changes, it would not be surprising if Congress chooses to do nothing.

Higher Capital Gains and Dividends Taxes for All

Right now, the maximum federal rate on garden-variety long-term capital gains and qualified dividends is 15%. (As you know, a 25% maximum rate applies to unrecaptured Section 1250 gains, and a 28% maximum rate applies to long-term gains from collectibles.) Starting next year, the maximum rate on garden-variety long-term capital gains will increase to 20% (or 18% on gains from assets held for over five years). Starting next year, dividends will once again be taxed at ordinary income rates. So, the maximum rate on dividends will balloon to a whopping 39.6%.

Right now, a 0% federal rate applies to garden-variety long-term capital gains and qualified dividends collected by folks in lowest two rate brackets of 10% and 15%. Starting next year, folks in the “new” lowest bracket of 15% will have to pay 10% on long-term gains (or 8% on gains from assets held for over five years) and 15% on dividends (since dividends will be taxed at ordinary income rates). Again—these things will happen automatically, unless Congress takes action and the president goes along. [See IRC Sec. 1(h) .]

Outlook: The Administration has repeatedly said the current 0% and 15% rates on long-term capital gains and qualified dividends will be left in place except for married couples with income above $250,000 and unmarried individuals with income above $200,000. For this to happen, however, Congress must take action and the president must go along. A few months ago that looked likely, but now it looks more problematic. In particular, we think the odds are rising that dividends will once again be taxed at ordinary rates (of up to 39.6%), starting next year. We hope we are wrong.

Some Bush Tax Cuts Are Likely to Be Continued

Some elements of the Bush tax cuts have gained bipartisan support and become “extenders.” They will probably be continued, despite the scheduled demise of the Bush tax cuts. Examples include inflation-indexed AMT exemption amounts, the ability to use nonrefundable personal tax credits to offset individual AMT liabilities, the above-the-line deduction for qualified higher education tuition and fees, and the increased Section 179 deduction. We also think the current versions of the child tax credit, earned income credit, dependent care credit, and adoption credit are also likely to be continued, despite the scheduled demise of other elements of the Bush tax cuts. (The Bush tax cut legislation liberalized these credits, and later legislation liberalized them even more).

Conclusions

Despite what some people think, the Bush tax cuts don’t just help “the rich.” They help just about anyone who pays federal income taxes, including people who only file returns to collect free money from the government thanks to refundable tax credits. The scheduled demise of the Bush tax cuts next year will hurt lots of people, unless Congress makes changes and the president jumps on board.

Our Washington politicians don’t seem to be in a big hurry to resolve the many tax uncertainties that we have summarized here. Even worse, it appears the odds are increasing that we may not see resolution until after the November election.