The Pease limitation, which restricts the amount of itemized deductions a taxpayer can claim, has been around for more than two decades; after briefly being phased out and repealed at the end of last decade, it has returned in full force for 2013 as a result of the American Taxpayer Relief Act of 2012. The reinstatement of the Pease limitation applies with the same rules that existed previously - phasing out itemized deductions by 3% of every dollar over the threshold - though the new rules did increase to the threshold to a new, higher amount.
Given how the Pease limitation is calculated though - as a percentage of income above the threshold, and not directly based on deductions - the reality is that the Pease limitation should actually more properly be viewed as a surtax on income, not a limitation on deductions. Although the amount of deductions does matter in certain limited circumstances - particularly with ultra-high-income taxpayers living in states with no state income taxes - for most, the Pease limitation simply lifts the top 3 tax brackets by about 1% - 1.2% without directly impacting the benefits of tax deductions at all!
This distinction of whether the Pease limitation is driven primarily by income or by deductions is important, as it affects the relative value of various income and deduction strategies. In fact, while the common conclusion from the media and some political pundits has been that the Pease limitation is a disincentive to tax deduction strategies like charitable giving, the reality is actually that there are only a few limited circumstances where the benefits of charitable giving may be diminished indirectly by the Pease limitation, and in the end the overwhelming majority of individuals who face the Pease limitation will actually still enjoy the full tax benefits of their charitable giving strategies!
Origins of the Phaseout of Itemized Deductions
The phaseout of itemized deductions for high-income taxpayers under IRC Section 68 - also known as the "Pease Limitation" after Congressman Donald Pease who authored the original legislation - originated in 1991 as a phaseout of itemized deductions for 3% of every dollar of income above $100,000 (of AGI), up to a cap of 80% of itemized deductions (excluding deductions for medical expenses, investment interest, casualty and theft losses, and gambling losses). The $100,000 threshold was indexed annually for inflation, and applied equally for individuals and married couples (the threshold for married filing separately was 50% of the amount for individuals and MFJ).
As a part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (i.e., the first "Bush tax cut") the Pease limitation was scheduled to be phased out over several years; the phaseout impact was reduced by 1/3rd in 2006 and 2007, by 2/3rds in 2008 and 2009, and was repealed entirely for one year in 2010. However, the Pease limitation repeal in 2010 was subject to the same "sunset" provision that applied to all of the 2001 tax legislation, and as a result was extended for 2 years in the fiscal cliff extension that was passed in late 2010 (the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010).
When the fiscal cliff issue was revisited at the end of 2012, and ultimately resolved with the American Taxpayer Relief Act of 2012, the repeal of the Pease limitation was unwound and the rule was reinstated with the same provisions - a phaseout of itemized deductions for 3% of every dollar of income above the threshold, up to a cap of 80% of itemized deductions - but the threshold itself was increased to $250,000 of AGI for individuals and $300,000 for married couples in 2013. The threshold remains indexed for inflation, and consequently will rise to $254,200 for individuals and $305,050 for married couples in 2014 as announced in Rev. Proc. 2013-35.
Pease Limitation As A Surtax On Income
While the Pease limitation is literally written into the tax code as a 'limitation on itemized deductions' in practice it would be better described as a surtax on income rather than a limit on itemized deductions, due to the way it is actually calculated. An example to show why this is the case may help:
Example 1. In 2013, a married couple is just above the $300,000 AGI threshold, which means they will likely be in the 33% tax bracket after deductions. If the couple earned another $1,000 of income, this would phase out another 3% x $1,000 = $30 of tax deductions, resulting in a total taxable income increase of $1,030 (the first $1,000 is the income, the last $30 is the lost deductions). At a 33% tax rate, this leads to another $339.90 of taxes, which is the equivalent of a $339.90 / $1,000 = 33.99% marginal tax rate. Thus, the net effect of the itemized deduction phaseout is to increase the marginal tax rate by 3% (phaseout) x 33% (tax bracket) = 0.99%. Notably, if the couple was subject to the 39.6% tax bracket, the net impact would be 3% x 39.6% = ~1.2% increase in the marginal tax rate, instead of just ~1%.
Notably, this impact of the Pease limitation applies regardless of what the individual's actual charitable deductions added up to. Whether this client had $20,000 or $50,000 or $100,000 of deductions, the net result would be the same: someone with $301,000 of AGI loses $30 worth of deductions, because the phaseout is calculated solely based on income and is not actually based on deductions. In point of fact, it would have been far simpler to just increase the top 3 tax brackets - from 33%, 35%, and 39.6% to 34%, 36.1%, and 40.8% respectively (the increase is 3% of the tax bracket itself) - but given that the thresholds and adjustments to the top tax brackets were highly controversial during the fiscal cliff negotiations, bringing back the Pease limitation accomplished the same goal by a more indirect means.
Impact Of Pease On Charitable Giving
The reason why this distinction about whether the Pease limitation is really a reduction of deductions or a surtax on income is important, because it can impact the relative value of various income and deduction tax strategies. Accordingly, the fact that the Pease limitation is actually based on income and not deductions means that it is not actually a disincentive against deduction strategies like charitable giving, as shown in the example below:
Example 2a. In 2013, a married couple has $1,000,000 of AGI, which means they are a whopping $700,000 above the AGI threshold for married couples and consequently will phase out their itemized deductions by 3% x $700,000 = $21,000. With a state tax rate of 5%, the couple pays approximately $50,000 of state income taxes, and also pays $20,000 of mortgage interest on a remaining mortgage and $10,000 of property taxes, for deductions totaling $80,000. As a result of the Pease limitation, these deductions are reduced to $80,000 - $21,000 = $59,000. The client's total tax liability, with taxable income of $1,000,000 (AGI) - $59,000 (remaining itemized deductions) = $941,000 would be $320,282. Had the Pease not existed, the client's tax bill would have been $311,966. Thus, the lost $21,000 of deductions at a 39.6% tax rate indirectly results in an extra $8,316 of taxes due to the $700,000 of income over the AGI threshold, for a tax rate of $8,316 / $700,000 = 1.2%, and lifting the marginal tax rate to 39.6% + 1.2% = 40.8% for additional income.
Example 2b. Continuing the prior example, the client is considering whether to donate $50,000 to charity, but is concerned about the impact of the Pease limitation. If the Pease limitation did not exist, the client's total deductions would rise from $80,000 to $130,000, and the tax liability would fall from $311,966 to $292,166, for a tax savings of $19,800 (which is simply a $50,000 deduction at a 39.6% rate). With the Pease limitation, the client's itemized deductions go from $59,000 (after the partial phaseout) to $109,000, bringing the tax liability (with Pease impact) from $320,282 to $300,482; notably, the tax liability with the charitable deduction is reduced by the exact same $19,800, the equivalent of a $50,000 tax deduction at a 39.6% rate.
As the examples above illustrate, the client receives the entire benefit of the charitable deduction, regardless of the Pease limitation. The reason, in essence, is that the due to how it's calculated, the Pease limitation applies to the first deductions the client has already claimed and/or couldn't 'avoid' (e.g., state income taxes, property taxes, mortgage interest, etc.), such that at the margin choosing to make a charitable deduction still enjoys the exact same tax benefits that otherwise would have applied!
Notably, the circumstances are slightly different in situations where the client actually does reach the Pease deduction cap, as shown below:
Example 2c. Continuing the earlier examples, assume the married couple lived in a state with no state income taxes (e.g., Texas), and only pays a property tax bill and mortgage interest of $20,000 total. Their $1,000,000 AGI would result in a $21,000 phaseout of itemized deductions, but the phaseout is capped at $16,000 (which is 80% of their total itemized deductions), which would put their taxable income after deductions at $1,000,000 - $20,000 + $16,000 = $996,000 and a net tax liability of $342,062. However, if the couple chooses to contribute $50,000 to charity, their total itemized deductions would rise to $70,000, bringing their deductions more than high enough to clear the 80% Pease cap; as a result, their Pease limitation would essentially increase from $16,000 to $21,000, and their taxable income would be $1,000,000 - $70,000 + $21,000 = $951,000, and a tax liability of $324,242. Thus, the net benefit of the $50,000 charitable deduction would be only $45,000 (a $50,000 deduction less another $5,000 of deductions lost via Pease), and the net tax savings would be only $17,820 (which is a $45,000 tax deduction at the 39.6% tax bracket).
Even in the scenario shown above, though, where the Pease limitation is impacted by the amount of deductions (increasing the 80% cap threshold), the consequences are modest; the end result was that a $17,820 tax savings was still available, amounting to a 35.6% tax savings relative to the $50,000 original contribution. In other words, even with the Pease limitation affecting the charitable deductions directly, it didn't impact much. In fact, even at extreme high levels of income, the consequences of the Pease cap are still limited!
Example 3. Assume the married couple noted earlier has not $1,000,000 of AGI but $10,000,000 of AGI instead (perhaps due to high income plus a huge capital gain on the sale of a business all in the same year). Now, they are a whopping $9.7M of income over the AGI threshold, resulting in a phaseout of $291,000 of deductions. Of course, with only $20,000 of actual deductions, the Pease limitation is still capped at $16,000, allowing for net deductions of $4,000. If the couple decides to donate $50,000 to charity, increasing their total deductions to $70,000 and their Pease cap to $56,000, for a net deduction of $14,000 (which means the couple's total itemized deductions will rise by $10,000. With a 39.6% tax bracket, this still results in a tax savings of $3,960, for a marginal tax savings of 7.92% on the original $50,000 contribution. In other words, for a client that is capped before and after the charitable deduction, the effect of the Pease limitation is to reduce the value of the deduction to 20% of its original value (7.92% is actually 20% of the 39.6% tax bracket).
As this last example shows, when income is high enough, eventually the Pease limitation can have a more material impact on the benefit of a client's charitable deductions. However, this scenario only applies when income is so high (and/or deductions are so low) that the client is still facing the 80%-of-itemized-deductions Pease cap before and after the charitable giving, which takes a very high level of income and/or very low deductions. After all, it only takes a 3.6% state income tax rate to cause itemized deductions to rise as fast as the Pease phaseout itself (in the last example, a 3.6% tax rate would have resulted in $360,000 of state income tax deductions, which alone would have put deductions over the 80% Pease cap, such that the client would have enjoyed the entire benefit of their charitable deduction); in addition, the reality is that other itemized deductions also tend to rise at higher income levels. So at worst, the Pease limitation is really only an issue in scenarios with extremely high income and little or no state income taxes and not enough other itemized deductions to trigger the situation! For those who "merely" have several hundred thousand dollars of income, up to perhaps $1M of income (per example 2c earlier), the potential Pease cap effect is modest or irrelevant altogether, and the full value of charitable deductions remains.
In any event, the bottom line is that while the Pease limitation is framed as "a reduction of itemized deductions" as long as it is actually calculated based on income (over the threshold) and not directly on deductions themselves, its existence is not a disincentive for charitable giving (or other deduction strategies) except in extremely unbalanced income/deduction scenarios with ultra-high-income clients. Instead, it should be treated as a surtax on income, and clients with income high enough to face the Pease limitation should plan around the consequences of income (e.g., bonuses, deferred compensation, capital gains, IRA withdrawals or Roth conversions, etc.), and not avoid deductions. And although the situation is somewhat more complex when the AMT is involved, the end result is still the same: in most situations, the Pease limitation should not be viewed as a reason to avoid charitable giving!