OCTOBER 2012 NEWSLETTER

TAX PLANNING THE 2013 TAX CHANGES- ARE YOU PREPARED?

With the end of the year creeping up, soon enough the new 2013 tax rules reversing much of the Bush administration tax breaks will be coming to a forefront. One notable tax change is the Obamacare 3.8% Medicare tax on investment income under 26 U.S.C. § 1411. This is an additional tax on what is called “net investment income” for individuals who have income above specific thresholds.

What is Net Investment Income?

First, net investment income is defined in § 1411 to include: (1) interest, dividends, annuities, royalties, and rents except where derived from most active trades or businesses; (2) gross income from passive activities or a trade or business in financial instruments or commodities; and, (3) net gains 3 attributable to the disposition of property other than that property held in most trades or businesses. This is a fairly wide tax base which includes generally all but wage/salary income and income from active business activity.

However, there is the ability to exclude certain types of income and the use of deductions to offset such income. Income that is normally tax exempt or non recognizable is not included in net interest income. Further, this does not apply to the sale of a partnership interest or S corporation stock to the extent any gain is due to an active business activity that would not have been taxable otherwise. Last, a notable exception is that net investment income does not include distributions from ERISA plans including qualified pension plans, 401(k) plans, tax‐sheltered annuities, individual retirement accounts (“IRAs”), and 457 plans. However, Congress has explicitly left out nonqualified deferred compensation under 409A from the ERISA exception.

Further deductions are allowed to reduce net investment income to the extent “properly allocated.” While the term has not been specifically defined yet in regulations, this would likely include depreciation, operating expenses, investment expenses, interest on funds to purchase investments, advisor/broker fees, and other such related expenses.

What is a High Income Taxpayer and How are They Taxed?

The Medicare Tax applies only to a certain class of taxpayers with income in the excess of “the threshold income”. The tax amount is 3.8% multiplied by the lesser of “net investment income” or a modified aggregate gross income (“AGI”) in excess of the threshold amounts. These thresholds are $200,000 for individuals, $250,000 for joint filers, and $125,000 for those married but filing separately. However, for trusts and estates the threshold amount is the amount for the highest tax bracket and the current amount is $11,351.

The tax works such that if an individual taxpayer Andy has an modified AGI of $500,000 with net investment income of $100,000, the investment income is less than the excess over the $200,000 threshold. Thus, Andy would be taxed $3,800 on the $100,000. On the other hand, if Andy only had $220,000 of modified AGI, since the excess over the threshold is only $20,000, Andy’s extra tax would only be $760 (3.8% x $20,000). If either of these incomes were in trust, the tax would be $3,800 as the $100,000 of net investment income easily clears the difference between $11,000 and modified AGI.

How Does This Interact with Other Tax Changes?

This tax becomes more significant when put into perspective with the other tax changes for 2013. The highest two ordinary income tax rates of 33% and 35% are increasing to 36% and 39.6%, the dividends tax rate is increasing from capital gains treatment at 15% to the aforementioned ordinary income tax rates, capital gains taxes are to increase from 15% to 20%, and employers are to withhold an extra .9% for wages in excess of similar threshold amounts for the Medicare tax. Taken together, the 3.8% boosts the ordinary tax rates to 39.8% and 43.4% which is a significant percent of income for certain taxpayers especially considering these taxpayers were paying a maximum marginal tax rate of 4 35% in 2012.

How to Protect Oneself? 

There are a couple ways to minimize the impact from the investment tax, but no real silver bullet to avoiding this tax. First, is to have income characterized as ordinary non‐investment income. However, with this, wages are subject to the extra .9% of Medicare tax for amounts in excess of the threshold amounts. Further, this may convert a capital gain taxed at 20% to an ordinary gain at 39.6%.   One may consider accelerating income to year 2012 instead of 2013 before the tax is fully implemented. The issue is timing, however,  one may not want to dispose of the asset generally or prior to 2013 for other reasons.

Another way is to utilize the ERISA and qualified plan exception as distributions are not taxed. However, for most high income taxpayers, they have already maxed out the benefits of using qualified plans due to maximum benefit limitations. Last, is to look at tax exempt options which may make municipal bonds relatively more attractive. However, municipal bonds may not carry the same after‐tax yield as other taxable bonds.

Conclusion:

The 3.8% is another tax for certain successful risk taking individuals for redistribution purposes. The arguments for both sides have been heard with the coming election. Some argue the wealthy can easily afford and should take the redistributions with open arms. On the other hand it is argued that the Medicare tax is a spiteful nearsighted tax placing an unfair burden on business persons who drive the economy and will hinder future investments and employment. Whether it will help the economy or hinder it, no one has a crystal ball, but the tax is in place and is yet another tax that needs to be planned around.