Let the count down begin to the “wholesale” expiration of the “Bush Tax Cuts” on December 31, 2012. The majority of our writing the rest of this year will focus on this major event which will potentially change the tax landscape permanently. In addition to this major tax event, the beginning tax components of “Obamacare” take effect in 2013 (assuming the Supreme Court doesn’t reject the health care reform legislation in its entirety) .
The health care reform legislation enacted in 2010 significantly broadens the Medicare tax base for higher-income taxpayers by enacting two new taxes. Beginning in 2013 higher-income taxpayers will be subject to an additional 0.9% tax on earned income and a new 3.8% tax on investment income.
Effective for tax years beginning after Dec. 31, 2012, an additional 0.9% hospital insurance (HI) tax is imposed on wages in excess of $250,000 for married taxpayers filing a joint return, $125,000 for married taxpayers filing separately, and $200,000 in all other cases (i.e., single or head of household). An additional 0.9% HI tax is also imposed on an individual’s net earnings from self-employment (NEFSE) in excess of the above threshold amounts.
The additional tax on wages is imposed only on employees. Unlike the regular HI tax, there is no employer match. Although employers are not subject to the matching excise tax, they do have a withholding obligation and are liable for the tax if they fail to withhold the required tax from employees. Employers are required to withhold the additional 0.9% HI tax on wages in excess of $200,000. Wages received by a spouse are not considered in determining the appropriate withholding. The withholding obligation applies only to wages in excess of $200,000, even though the tax may apply to wages at or below $200,000.
The threshold amounts for the additional HI tax are not adjusted for inflation. Therefore, it is likely that more taxpayers will become subject to this tax in the future.
Effective for tax years beginning after Dec. 31, 2012, higher-income taxpayers with investment income will be subject to a new 3.8% unearned income Medicare contributions tax (UIMCT) on their net investment income. HI tax has traditionally been imposed only on wages and NEFSE. The UIMCT extends HI tax to investment income for the first time.
The UIMCT is imposed on the lesser of (1) net investment income, or (2) the excess of modified adjusted gross income (MAGI) over a threshold amount. The threshold amounts are the same as those used for the additional 0.9% HI tax ($250,000 for married couples filing a joint return; $125,000 for married couples filing separately; and $200,000 for all other taxpayers). As is the case with the additional 0.9% HI tax, these threshold amounts are not indexed for inflation.
The UIMCT applies to a trade or business that is a passive activity with respect to the taxpayer, and the trade or business of trading in financial instruments or commodities. As a result, business income from an activity that is passive with respect to the taxpayer is considered investment income for purposes of the UIMCT.
The tax does not apply to active trade or business activities conducted by a sole proprietor, partnership, or S corporation. Distributions from the retirement plans are excluded from net investment income.
Tax planning techniques
We are beginning to plan for the UIMCT now in order to minimize its impact in 2013. The UIMCT, combined with the increase in the top marginal tax rate, will significantly increase the marginal tax rate that our higher-income taxpayers pay on investment income.
The UIMCT applies only to taxpayers with both MAGI above the threshold amount and net investment income. As a result, taxpayers can minimize its impact by minimizing either MAGI or net investment income (or both). Tax planning strategies include:
- Income recognition and deferral planning. Items of income that are excluded from income reduce both MAGI and net investment income. This provides higher-income taxpayers potentially subject to the UIMCT additional incentive to structure transactions that result in either tax-exempt or tax-deferred income.
- Higher-income taxpayers can minimize the UIMCT by including non-dividend paying growth stocks, which do not increase MAGI or create investment income until sold, in their investment portfolio.
- Tax-deferred annuities and related investments will also minimize liability for the UIMCT, and may become more popular.
- Because tax-exempt income is not included in either MAGI or investment income, higher-income taxpayers will have increased incentive to invest in exempt state and local obligations.
- Capital gain planning. Investment income includes net gain (to the extent taken into account in computing taxable income) from the disposition of property. Tax planning strategies that reduce or defer capital gain income will also reduce or defer net investment income for purposes of the UIMCT.
- Using the installment method of accounting to report gain on the sale of property sold on an installment basis, for example, will minimize the impact of the UIMCT because it avoids a large increase in both MAGI and investment income in the year of sale. Taxpayers selling property on an installment basis in 2012, however, should consider electing out of the installment method and recognizing the entire amount of the gain before the UIMCT goes into effect.
- Retirement income planning. Because distributions from qualified retirement plans are not included in net investment income, the UIMCT provides taxpayers with additional incentive to maximize retirement plan contributions. Although retirement plan distributions are not included in net investment income, distributions that are included in income (such as those from a traditional IRA or 401(k)) increase MAGI. This increase in MAGI may increase the amount of other investment income subject to the UIMCT.
- Retirement plan distributions that are not included in income (such as those from a Roth IRA or Roth 401(k)) do not increase MAGI. This provides higher-income taxpayers with incentive to contribute to Roth-type retirement plans, rather than traditional plans. Contributions to traditional retirement plans reduce MAGI in the year of contribution, while contributions to Roth plans do not. Taxpayers with MAGI near the threshold level may be able to avoid or reduce current year’s UIMCT by contributing to a traditional plan and reducing MAGI below the threshold.
- Passive activity loss planning. We are also having to consider the UIMCT in planning for passive activities. Passive income is investment income for purposes of the UIMCT. Classifying income as passive is generally advantageous for taxpayers with sufficient passive losses to offset the passive income. For taxpayers with net passive income, however, the UIMCT increases the tax rate on passive income.
- Estate planning. The UIMCT provides higher-income taxpayers with an incentive to consider the use of family limited partnerships and related estate planning techniques. Investment income transferred from parents with significant MAGI and investment income to children with MAGI below the applicable threshold amount through the use of family limited partnerships will not be subject to the UIMCT. Although investment income transferred to children through a family limited partnership may be taxed at their parent’s rate under the “kiddie tax” rules, the children will be subject to the UIMCT only if their income (including income from a family limited partnership) exceeds the applicable threshold.
- Tax planning for estates and trusts. Estates and trusts with undistributed net investment income will be subject to the UIMCT whenever their adjusted gross income exceeds the dollar amount at which the top marginal tax rate begins. Because the top marginal rate for estates and trusts begins at a relatively small amount of income ($11,650 in 2012), the UIMCT is of particular concern to estates and trusts and should be considered in both distribution and investment decisions. Estates and trusts are subject to the UIMCT only if they have undistributed net investment income. Estates and trusts can reduce undistributed net investment income and thereby minimize or eliminate the UIMCT by distributing income to beneficiaries. Any distribution will increase the beneficiary’s net investment income and potential liability for the UIMCT. However, the threshold amount for individuals is much higher than that for estates and trusts, and the UIMCT can be eliminated if the beneficiary’s MAGI remains below the threshold amount. Estates and trusts should also consider the UIMCT in making investment decisions. The UIMCT increases the already existing incentives estates and trusts have to invest in tax-exempt and tax-deferred investments.
If you have any questions regarding this new law, its impact on your tax situation or how to plan for its impact, please do not hesitate to contact us.