As of this writing, negotiations between the President and Republican-controlled House have not resulted in a deal to avert the so-called “fiscal cliff.” It is becoming increasingly likely that the government contracting industry as well as the public as a whole will be adversely impacted with sequestration and a wide array of tax increases and new taxes beginning Jan. 1, 2013.

This article will highlight how this fiscal cliff will impact your contracting business, as well as you, the taxpayer, should no deal be made.

Tax Increases and New Taxes Will Impact Everyone

Much of the attention and focus of the press has been on only one aspect of the fiscal cliff – that of individual income tax rate increases. What most people do not realize is that there are other aspects to the expiration of the Bush tax cuts that will impact every single taxpayer, whether you are a low-, middle- or high-income individual. These include:

• Individual income tax rates increasing from a range of 10% - 35% to a new range of 15% - 39.6%. This increase will affect every single taxpayer.

• The payroll tax holiday will expire. The FICA tax on wages will revert back to 6.2% from the current 4.2%. This will affect all employees and self-employed individuals.

“While the increase in the individual income tax rates will not be felt until (income) tax payments are due (either quarterly or April 15, 2014), the payroll tax increase will be seen on the very first paycheck in 2013.”

While the increase in the individual income tax rates will not be felt until tax payments are due (either quarterly or April 15, 2014), the payroll tax increase will be seen on the very first paycheck in 2013.

• Long-term capital gains rates will increase from 15% to 20%. This will impact all taxpayers with capital transactions.

• Lower-income taxpayers will also feel the reductions in the child tax credit, the amount of expenses eligible for the child and dependent care credit, as well as the earned income credit.

• Finally, upper-income families will be subject to the phase-outs of dependent exemptions and itemized deductions.

While all of these Bush-era tax reductions are set to expire, an entire new slew of taxes are set to begin that resulted from the passage of the Health Care Law. These include:

• Medicare tax on individual wages will increase from 1.45% to 2.35% for certain individuals. In addition, the employer must still match this at a rate of 1.45%.

• A surtax of 3.8% will be imposed on investment income such as interest, dividends, rents, royalties, capital gains, etc. This increase along with the capital gains rate increase has been the impetus for the sale of many government contractors prior to the end of the current calendar year.

• Finally, an increase in the hospital insurance tax, limits to the amounts employees can contribute into flex-spending health plans, as well as increasing the AGI threshold from 7.5% to 10% for medical deductions will adversely impact a significant percentage of the working population.

From an individual taxpayer perspective, everyone can expect to be hit in the pocketbook.

Sequestration Will Impact Your Business

There has been no indication by the government of what programs or contracts will be impacted by the mandatory cuts imposed by sequestration.

“The fiscal cliff scenario was designed to try and force Congress to work together to address the burgeoning budget deficit issue by creating a situation that neither Democrats nor Republicans would want to occur.”

While entitlements will not be subject to cuts, spending on defense and non-defense programs is expected to be decreased. We have already seen some of the effects of the possible sequestration in that:

• A significant increase in the number of procurements being protested has been occurring.

• The government has been increasingly utilizing the award model of lowest price technically acceptable. This is placing tremendous pricing pressure on contractors.

Conclusion

The fiscal cliff scenario was designed to try and force Congress to work together to address the burgeoning budget deficit issue by creating a situation that neither Democrats nor Republicans would want to occur. Unfortunately, their inability to address these difficult issues has brought us to this precipice.

Michael Smigocki, CPA, CVA is the Senior Managing Director of Federal Strategies Group, LLC in Rockville, MD. He provides government contract and management consulting, M&A advisory, litigation support and expert testimony to the government contracting industry. He can be reached via email at MikeS@FedStrat.com.