Update on Fiscal Cliff and the Charitable Deduction: Phase-out a Concern

Last week, Congress passed legislation  that is meant to help steer the country out of the “fiscal cliff” combination of tax increases and spending cuts. The bill may have many Americans breathing easier because its tax increases are not as far-reaching as earlier proposals:

  • The marginal tax rate increase from 35 percent to 39.6 percent will affect individuals earning over $400,000 and joint filers earning over $450,000 (rather than the proposed $200,000 and $250,000 limits);
  •  The top estate and gift tax rate will rise from 35 percent to 40 percent for those above the exemption amount, which will stay at its current level of $5 million per individual ($10 million for joint filers); and
  • Capital gains and dividends rates will rise from 15 percent to 20 percent for individuals earning over $400,000 and joint filers earning over $450,000.

In terms of the charitable deduction, the legislation does not de-couple the deduction from a donor’s marginal tax rate and cap it at 28 percent or 35 percent, as had been proposed by President Obama, nor does it set a fixed cap on total deductions as some Republicans had proposed.

However, the bill does restore the itemized deduction phase-out under Section 68 of the Internal Revenue Code (which had been suspended since 2009, but comes back into effect due to the sunset provision of 2001’s Economic Growth and Tax Relief Reconciliation Act). This provision, sometimes referred to as the Pease provision (after the late Rep. Donald Pease), eliminates up to 80 percent of deductions for joint filers above the $300,000 threshold and individuals over $250,000. It affects almost all deductions, including the charitable deduction, and effectively adds about one percentage point to the top tax rate.  This Chronicle of Philanthropy article highlights that this limitation also could pose a threat to charitable giving, because it provides a lessened incentive to donate the higher a taxpayer’s income grows.

Other notable aspects of the bill:

  • It extends tax-free distributions of up to $100,000 to charity from IRAs held by someone age 70.5 or older;
  • It permanently “patches” the alternative minimum tax by putting in place a permanent inflation adjustment (rather than continuing to patch it on a year-by-year basis);
  • It extends the state sales tax deduction in lieu of state income taxes;
  • It does not extend the 2 percent reduction in employees’ share of Social Security tax (put in place as part of the stimulus package), so paycheck amounts will be reduced right away; and
  • It phases out the personal exemption beginning at $300,000 for joint filers and $250,000 for individuals.

The spending cut piece of the puzzle has largely been delayed for two months, and House Republicans who allowed the measure to pass did so largely on the expectation that spending will be cut in the near future, so discussions on this point will continue.

Both the Wall Street Journal and Forbes have additional information on the legislation.

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