by Bob Rywick
Both collectibles gain and Section 1202 gain of non-corporate taxpayers are taxed at a maximum rate of 28 percent. What is usually referred to as 28 percent rate gain equals the sum of collectibles gain and Section 1202 gain, over the sum of:
● Collectibles loss;
● Net short-term capital loss; and,
● The amount of long-term capital loss carried over to the tax year from the prior year.
Collectibles gain or loss is gain or loss on the sale of a collectible as defined in Internal Revenue Code §408(m). Under that section, collectibles include works of art, rugs, antiques, any metals or gems, stamps, coins and alcoholic beverages.
Section 1202 gains generally mean the 50 percent of the gain on the sale of qualified small business stock held for more than five years that is subject to tax.
Rate at which 28 percent
rate gain is taxed
The maximum rate at which 28 percent rate gain is taxed is, of course, 28 percent. However, the actual rate at which 28 percent rate gain is taxed depends on the other items of income that a taxpayer has.
It’s possible for 28 percent rate gain to be taxed at a rate a low as 10 percent. This would happen if the taxpayer has little other income, or most of the taxpayer’s other income consists of items taken into account when computing adjusted net capital taxed at a maximum rate of 15 percent (20 percent if taken into account before May 6, 2003).
Example 1: Your client and his wife will file a joint federal income tax return in 2003. His business as a sole proprietor operated at a loss in 2003. To make ends meet, he sold an antique cabinet for $60,000 that he bought in 1988 for $5,000. His gain on the sale of $55,000 is collectibles gain taxed at a maximum rate of 28 percent.
You expect your client’s taxable income after deductions to be $45,000, including the collectibles gain of $55,000 and adjusted net capital gain of $10,000 taken into account after May 5, 2003. Thus, your clients’ net capital gain of $65,000 (collectibles gain of $55,000 and adjusted net capital gain of $10,000) is $20,000 more than his taxable income of $45,000.
You first compute your clients’ tax on the greater of:
● Taxable income less the net capital gain ($0 for your clients, since net capital gain is more than their taxable income in 2003); or on the lesser of:
● The amount of taxable income taxed at a rate under 25 percent ($56,800 for a couple filing a joint return in 2003); or,
● Taxable income less adjusted net capital gain ($35,000 [taxable income of $45,000 less adjusted net capital gain of $10,000]).
Thus, you compute tax at regular income tax rates on $35,000 (the balance of the collectibles gain after taking deductions into account). This tax is $4,550 ($1,400 [(10 percent of $14,000 for a married couple filing a joint return], plus $3,150 [15 percent of $21,000]).
The tax on the adjusted net capital gain is $500 (5 percent of $10,000, since the gain was taken into account after May 5, 2003, and would be taxed at a rate under 25 percent if it were ordinary income).
Your clients’ total tax for 2003 will be $5,050 ($4,550 on collectibles gain, and $500 on adjusted net capital gain).
Suppose the sum of a taxpayer’s ordinary income and net short-term capital gain for a tax year is less than the taxable income that is taxed at a rate under 25 percent. In that case, part of the 28 percent rate gain will also be taxed at a rate under 25 percent, i.e., at a rate of 10 percent or 15 percent.
Example 2: Your client, a single woman, has taxable income of $35,000 in 2003, which is the sum of ordinary income of $30,000, collectibles gain of $10,000, and adjusted net capital of $8,000 taken into account after May 5, 2003, less itemized deductions and a personal exemption totaling $13,000. You first compute her tax on $27,000 (taxable income of $35,000 less adjusted net capital gain of $8,000) since this is more than:
● Taxable income less net capital gain of $17,000 ($35,000 less $10,000 of collectibles gain, and less $8,000 of adjusted net capital gain), but less than,
● The maximum amount of taxable income taxed at a rate under 25 percent for a single taxpayer in 2003 ($28,400).
The tax on $27,000 computed at regular income tax rates for a single person is $3,700, i.e., $700 (10 percent of $7,000), plus $3,000 (15 percent of $20,000). In effect, the collectibles gain of $10,000 is taxed at a rate of 15 percent.
The tax on the adjusted net capital gain of $8,000 is $1,060, i.e., $70 (5 percent of $1,400 [the amount of adjusted net capital gain that would be taxed at a rate under 25 percent if it were ordinary income ($28,400, less $27,000)]), plus $990 (15 percent of the $6,600 balance of adjusted net capital gain).
Your client’s total tax for 2003 is $4,760 ($3,700 plus $1,060).
If a taxpayer’s taxable income, less adjusted net capital gain, is more than the maximum amount taxable at a rate under 25 percent, but would be less than that amount if 28 percent rate gain were not included, part of the 28 percent rate gain could still be taxed at a rate of 10 percent or 15 percent.
Example 3: The same facts apply as in Example 1, except that your clients’ collectibles gain is $85,000 and their taxable income is $75,000. They still have $10,000 of adjusted net capital gain taken into account after May 5, 2003. In effect, $65,000 of your clients’ collectibles gain is taxed ($14,000 at a rate of 10 percent and $42,800 at a rate of 15 percent). See Example 4, below, for the rate at which the $8,200 balance of the collectibles gain is taxed. The adjusted net capital gain is taxed at a rate of 15 percent since it would be taxed at a rate of 25 percent if it were ordinary income.
When 28 percent
means 28 percent
Twenty-eight percent rate gain may be taxed at a rate of 28 percent even if it would be taxed at rate of only 25 percent if it were ordinary income.
We’ve seen that 28 percent rate gain is taxed at a rate of 10 percent or 15 percent if the taxpayer’s taxable income, less adjusted net capital gain, puts him in a tax bracket under 25 percent. If the taxpayer is in a 25 percent bracket, i.e., if any part of collectibles gain would be taxed at a rate of 25 percent if it were ordinary income, it will still be taxed at a 28 percent rate. The same, of course, is true for Section 1202 gain.
Example 4: The same facts apply as in Example 3. The part of the collectibles gain that is not taxed at a 10 percent or 15 percent rate ($8,200) is taxed at a 28 percent rate even though your clients’ total taxable income only puts them into a 25 percent bracket. (Taxable income between $56,800 and $114,650 is taxed at a rate of 25 percent for married couples filing a joint return for 2003.)
Thus, they will pay a tax of $2,296 on this gain (28 percent of $8,200). Your clients’ total tax on $75,000 of taxable income will be $11,616, i.e., the sum of the following:
● $1,400 (10 percent of $14,000 of collectibles gain);
● $6,420 (15 percent of $42,800 of collectibles gain);
● $1,500 (15 percent of adjusted net capital gain of $10,000); and,
● $2,296 (28 percent of collectibles gain of $8,200).
You do have the alternative of computing the tax due on the total taxable income at regular income tax rates without using the maximum rates for capital gains. If the only items making up net capital gain were 28 percent rate items (collectibles gain and Section 1202 gain), this would result in a lower tax, if your clients’ total income didn’t put them into a tax bracket above 25 percent.
On the other hand, if some of your clients’ income consists of adjusted net capital gain (always taxed at a lower rate than it would be taxed at if it were ordinary income), or if your clients are in a higher bracket than 25 percent, then you have to run the figures to see which method of computation would result in the lower tax.
Example 5: The same facts apply as in Examples 3 and 4. If your clients’ federal income tax were computed at regular rates on $75,000 of taxable income, the tax would be $12,370, or $754 more than the tax they would pay using the maximum rates on adjusted net capital gain and 28 percent rate gain.
The benefit of paying 10 percent less on $10,000 of adjusted net capital gain (15 percent instead of 25 percent) exceeds the detriment of paying 3 percent more on $8,200 of collectibles gain (28 percent instead of 25 percent).
Example 6: The same facts apply as in Examples 3 and 4, except that your clients’ have no adjusted net capital gain, and their taxable income is $65,000 instead of $75,000. If their tax were computed using the maximum tax on 28 percent rate gain, their total tax would be $10,116, i.e., the same tax as in Example 5, less the $1,500 of tax on $10,000 of adjusted net capital gain.
However, the total tax on taxable income of $65,000 at the regular income tax rate is only $9,870, or $246 (3 percent of $8,200) less than the tax using the maximum tax on 28 percent rate gain.
Observation: When the tax bracket immediately above the 15 percent bracket was 28 percent (i.e., before the Economic Growth and Tax Relief Reconciliation Act of 2001), you didn’t have this strange situation of 28 percent rate gain being taxed at a higher rate than it would be taxed at if ordinary income.
It may have been simply an oversight by Congress in not amending the provisions relating to the 28 percent rate gain to provide that the tax on that gain could never exceed what the tax would be if the gain were ordinary income.
