Utah Pass-Through Entity Withholding Tax Rules

Utah defines a pass-through entity (PTE) as an entity whose income, gains, losses, deductions, and credits flow through (via a Schedule K-1) to its owners for purposes of paying income tax.  A PTE is subject to Utah withholding requirements if one or more of its owners is an entity or is a Utah nonresident individual.  Therefore, this withholding is not strictly a nonresident withholding tax.  Withholding is also required if the PTE has an entity owner, even if that entity-owner is located in Utah and is owned by Utah residents.

The PTE withholding tax began in 2009 and applied to general partnerships, limited partnerships, limited liability partnerships, limited liability companies (if classified as a partnership for federal income tax purposes), and S corporations.  Composite nonresident tax return filings were eliminated at that time.  Beginning in 2013, trusts and estates will also be classified as PTEs if they distribute (or are required to distribute) income to beneficiaries.  Entities that are disregarded for federal purposes are classified in the same manner as for federal income tax.

A PTE is required to withhold 5% on allocations to entity owners or nonresident individual owners of Utah business income and any non-business income derived from or connected with Utah sources.  Portfolio income is categorized separately from non-business income if the PTE owner is not required to include the portfolio income as Utah income.  Portfolio income is attributable to the state of the PTE owner's residency.  Portfolio income generally includes gross income from interest, dividends, royalties, capital gains, and certain other items if not earned in the ordinary course of the PTE's trade or business.

The withholding tax must be paid on or before the original due date (without extensions) for the PTE's tax return.  The PTE must provide a Utah Schedule K-1 to its owners showing the allocated withholding amount.

A PTE may elect a waiver of its Utah withholding requirement.  The waiver may be for one or more of its owners subject to withholding.  However, if the owner fails to file a Utah income tax return and pay its Utah tax, the PTE will be assessed the tax, including any interest and penalty.

A special rule applies if the PTE intending to elect a waiver is itself also owned by a PTE (a "downstream" PTE), and the downstream PTE is owned entirely by Utah resident individuals.  In this case, the waiver can only be elected if all of the downstream PTEs and Utah resident individuals file their tax returns and pay their Utah tax on or before the PTE's Utah tax return filing due date, including extensions.  This will require Utah resident individuals to file their extended tax returns one month earlier than otherwise allowed.  For example, assume XYZ, LLC operates a Utah business and is partially owned by ABC, Ltd. (a family limited partnership) that in turn is owned solely by Utah resident individuals.  Assume XYZ, LLC's and ABC, Ltd.'s tax return due dates are April 15th and that they have obtained five-month extensions (maximum extension period for partnerships) to September 15th.  Assume further that the Utah resident individuals have obtained six-month extensions (maximum extension period for individuals) moving the due date of their tax returns to October 15th.  In order for XYZ, LLC to be eligible to elect a waiver from the Utah withholding requirement applicable to the ownership interest held by ABC, Ltd., both ABC, Ltd. and all of its Utah resident individuals must file their Utah tax returns, and pay their Utah income tax, by September 15th, the filing due date for XYZ, LLC, even though the Utah resident individual income tax returns aren't due until October 15th.

Temporary Expansion of the Voluntary Worker Classification Settlement Program

On December 17, 2012, the IRS issued Announcement 2012-46 temporarily modifying the Voluntary Worker Classification Settlement Program originally established on September 21, 2011 (see prior post).  This is a program that reduces the penalties on employers who come forward to correct workers misclassified as independent contractors who instead should have been classified as employees.  There is not a bright-line test in properly classifying workers, and errors can be made.  In addition, workers classified as employees are much more costly to a business than if the workers were instead classified as nonemployees.  Examples of additional costs are payroll taxes, health insurance (if offered to employees), and retirement plan (if offered to employees) contributions.  Therefore, some businesses may have tended toward classifying workers as independent contractors.  If the IRS discovers that workers were misclassified, the IRS can impose years of back taxes, interest, and penalties on the employer.  In addition, the employer could be responsible for past overtime pay, retirement plan contributions, and other employee fringe benefits.  With potential penalties building up over the years, employers felt stuck with the problem without a low-cost way of correcting the misclassification. 

Under the 2011 settlement program, the employer was not eligible to participate if it had not issue all required Forms 1099 for their workers during the three prior years.  The modified program allows employers that did not file required Forms 1099 to participate in the settlement program, but only if application is made on or before June 30, 2013.  The cost of entering into the modified program is higher than the regular program. 

The modified settlement program enables eligible employers to obtain substantial relief from past taxes, penalties, and interest if they prospectively treat workers as employees. To be eligible, a business must:

 

1.    Have consistently treated the workers in the past as nonemployees,

2.    Not be currently under an employment tax audit by the IRS, and

3.    Not be currently under audit by the Department of Labor or by a state agency concerning the classification of these workers.

Eligible employers must file Form 8952 with the IRS by June 30, 2013.  Employers accepted into the program will be required to electronically file all required Forms 1099 for the prior three years, in accordance with IRS instructions that will be provided once the IRS has reviewed the application and verified that the employer is eligible for the modified settlement program. 

Employers accepted into the temporary, modified program will pay a penalty of from 1.26% to 1.97% of wages (up from about 1% under the regular program) paid to the reclassified workers for the past year.  The IRS will not audit the employer for payroll taxes related to these workers for prior years. 

In addition to the reduced payroll tax penalty, a reduced penalty on the late filing of Forms 1099 will apply.  The amount of the penalty is based upon the total number of Forms 1099 that should have been filed during the three prior years.  The amount penalty is: 

1.     From 1 to 25 non-filed forms, the lesser of $500 or $50 per form.

2.     From 26 to 49 non-filed forms, the lesser of $3,675 or $75 per form.

3.     For 50 or more non-filed forms, the lesser of $10,000 or $100 per form.

This is a voluntary Federal program.  Participation in the program could be shared with states that may or may not have a voluntary compliance program of their own.  Note also that correcting worker classification may have an impact under the 2014 health insurance mandate for employers having 50 or more employees beginning in 2013.

New W-2 Reporting Duty for "Large" Employers

As the year 2012 draws to a close, employers will be busy preparing Form W-2 for their employees.  Form W-2 must be provided to employees no later than January 31, 2013.  Under the new health care reform law, employers that filed 250 or more W-2's for 2011 (prepared in January 2012) are classifed as "large" employers for this purpose and must report the aggregatge cost of employer-provided health insurance on W-2's for 2012 (prepared in January 2013).  Employers that filed less than 250 W-2's for 2011 do not have to report the cost of health insurance on the W-2, even if they have 250 or more W-2s for 2012.

The cost is to be reported in box 12 of Form W-2 using the code "DD."  The cost is for information reporting only; it is not taxable compensation to the employees and therefore should not be included with other compensation reported in boxes 1, 3, or 5 of Form W-2.

The "aggregate cost" of employer-provided health insurance follows these general rules.  Be sure to check IRS Notice 2012-9 for your specific circumstances.

1. Include premiums paid by the employer.
2. Include premiums paid by the employee (whether pre-tax or after-tax).
3. Include COBRA premiums of former employees and beneficiaries.
4. Exclude pre-tax employee contributions to health flexible spending accounts.
5. Exclude contributions to a health savings account.
6. Exclude coverage for long-term care.
7. Exclude the cost of separate policies covering dental or vision.

The IRS has reserved the right to lower the 250 W-2 threshold in the future, so smaller employers may yet have to deal with this paperwork requirement.

Major Changes to the Estate and Gift Tax Looming

With the "fiscal cliff" discussions centering on income tax rates and spending cuts, don't forget about the major changes to the estate and gift tax system that take place on January 1, 2013.  The chart below outlines several of these changes, absent any new legislation.

	2012	2013
Annual gift tax exclusion	$13,000	$14,000
Lifetime gift & estate tax exclusion	$5,120,000	$1,000,000
Lifetime generation skipping tax exclusion	$5,120,000	$1,430,000
Top gift & estate tax rate	35%	55%
Flat generation skipping transfer tax rate	35%	55%
Portability of deceased spouse’s unused exemption amount	Available	Unavailable

In addition to these statutory changes, Pres. Obama has proposed a variety of changes to reduce or eliminate the benefits of certain estate and gift tax planning strategies.  Whether any of the following proposals will be enacted remains to be seen.  If enacted, these proposals could increase gift and estate taxes much more than the taxes raised from reduced lifetime exemption amounts.

·       Eliminate valuation discounts for the transfer of closely-held businesses or gifts among family members.

·       Grantor-retained annuity trusts may be required to have at least a 10-year term and some minimum gift amount that effectively eliminates the benefits of a short-term, zeroed-out GRAT.

·       Sales of assets to “defective” grantor trusts could be rendered ineffective by requiring the value of assets in such trusts to be taxed as part of the estate.

·       Dynasty or descendants’ trusts might be limited to 90 years in duration at which time the generation skipping tax could apply.

Although there isn’t much time left before the end of 2012, be sure to consider the following gift and estate tax planning strategies to secure tax benefits for your family that might not be available in full after 2012.  Note that estate planning attorneys are becoming booked with appointments and it could be difficult to draft and implement any sophisticated strategies by year-end if you wait much longer.

 

·       Be sure to make annual exclusion gifts.  While the annual exclusion amount renews each calendar year, any unused exclusions from previous years do not carry over.  Remember that checks must be cashed by December 31^st, so consider using cashier’s checks.

·       Direct payments of tuition to educational institutions and of medical expenses to health care providers do not count against either the annual or lifetime exclusion amounts.

·       Consider making a gift of the full $5.12 million to an irrevocable trust for your descendants.  A spousal lifetime access feature can be added if there is a concern about whether your spouse might need some benefits from these assets in the future.  The trust can also be designed to last for multiple generations without an estate tax being imposed at each generation.

·       Consider using a GRAT or a sale to a defective grantor trust as part of your estate planning.

Selected 2013 Inflation-Indexed Figures

Many contribution and deduction amounts in the tax law are indexed for inflation.  Many also have statutory adjustments.  While there remains substantial uncertainty about whether the “lame duck” Congress will enact any new tax laws before the end of 2012, some important 2013 inflation-adjusted figures have been released and are as follows:

·       The contribution amount for traditional and Roth IRAs is $5,500 (up from $5,000 in 2012).  For those who are age 50 and older in 2013, the additional “catch-up” contribution remains $1,000.

·       The modified adjusted gross income phase-out range for contributions to Roth IRAs is from $178,000 to $188,000 for joint filers (up from between $173,000 and $183,000 in 2012); and from $112,000 to $127,000 for single filers (up from $110,000 and $125,000 in 2012).

·       The contribution amount for traditional and Roth 401(k) accounts is $17,500 (up from $17,000 in 2012).  For those who are age 50 and older in 2013, the additional “catch-up” contribution remains $5,500.

·       The limit on the annual additions to a participant's defined contribution account is $51,000 (up from $50,000 in 2012).

·       The annual exclusion from gift tax is $14,000 per donee (up from $13,000 in 2012).

·       The personal exemption is $3,900 (up from $3,800 in 2012).

·       The Social Security tax wage base is $113,700 (up from $110,100 in 2012).

·       The maximum annual contribution to a health savings account is $3,250 (up from $3,100 in 2012) for an individual-coverage-only health plan, and $6,450 (up from $6,250 in 2012) for a family-coverage health plan.  For employees age 55 and older in 2013, the additional HSA "catch-up" contribution remains $1,000.

Planning with Non-Grantor Charitable Lead Annuity Trusts

The government’s intervention to artificially lower interest rates has created important gift and estate tax saving opportunities when using Charitable Lead Annuity Trusts.  The CLAT is an irrevocable trust that pays a specified amount at least annually (called a “lead”) to charity for a term of years (not in excess of 20) or for the life of designated individuals.  The balance in the trust (called the “remainder”) either reverts to the donor (a grantor CLAT) or is paid to one or more non-charitable beneficiaries (non-grantor CLAT) upon termination of the lead interest.  Since gift and estate and gift taxes are scheduled to increase after 2012, a non-grantor CLAT can be a powerful planning vehicle to transfer property to heirs and reduce gift and estate taxes.

The non-grantor CLAT best fits those desiring to make charitable donations and to transfer property to their heirs as part of their estate tax planning.  The value of the charitable interest is subtracted from the fair market value of the property contributed to the CLAT in determining the taxable gift amount for the remainder passing to heirs.  When interest rates are low, the present value of the charitable interest is higher, thus making the taxable gift lower.  The IRS valuation interest rate has never been lower in its history.

Unlike a charitable remainder trust, the CLAT is not exempt from income taxes.  Therefore, it doesn’t make sense to contribute appreciated property to a CLAT, and then have the CLAT sell the property.  The non-grantor CLAT is taxable on income and gains earned, but it also receives a charitable tax deduction for the amount paid to charity.  Unlike an individual, the charitable deduction for a trust is not limited to a percentage of adjusted gross income (AGI).  The payment to charity must be from “gross income” and be authorized in the trust agreement.  Income earned above the lead amount can be contributed to charity and also receive a deduction, but only if the excess contribution is permitted by the trust agreement.

The IRS §7520 valuation rate is 1.2% for October 2012.  The rate is adjusted monthly.  The donor may select the lowest interest rate for the period of the month the CLAT is established or the prior two months.  Since the interest rate was 1.0% in September 2012, that rate can be selected for CLATs established in October or November 2012.  If the property donated to the CLAT earns more than 1.0% a year over the life of the CLAT, there will be significant estate and gift tax benefits.

Example

David pays tithing to his church and is interested in estate tax planning.  He owns $1,000,000 of investments that produce a total return of 6% annually.  Assume that yield and capital gains are recognized only in sufficient amounts to pay 5% annually to charity (zero taxable income) with the balance of the total return constituting unrecognized appreciation.  David would like to give the investments to his heirs as part of his estate tax planning, but not for 20 years during which time his heirs will have had the opportunity to work and gain maturity.  If David establishes a 20-year, non-grantor CLAT in October 2012 with the investments, and the CLAT makes a $50,000 annual payment to his church, then the following results would occur:

·       At the end of 20 years the balance in the trust would grow to $1,367,856 and be transferred to his heirs for a gift tax value of only $97,720 today.  The gift value would be offset by any unused portion of David’s lifetime gift tax exemption.

·       The trust charitable deduction would offset the trust earnings and gains resulting in no income tax to the trust.  Because the trust is making the charitable donations, David cannot take the deduction on his personal tax return.  But in turn, he does not include the investment income and gains on his return either, thereby lowering his AGI.  A lower AGI often results in keeping more tax benefits that are phased-out based upon AGI levels.

·       The amount of the $50,000 charitable deduction would not be at risk of reduction (like it would be if made by David instead of the CLAT) if the Bush tax cuts sunset in 2013, and if certain proposed tax reforms of either presidential candidate are enacted.

Don't Lose Your Charitable Tax Deduction

Many years ago keeping canceled checks was often sufficient to prove a charitable deduction.  But the tax law was changed to require contemporaneous, written proof from the charity in order to deduct donations of $250 or more.  Not only must the charity provide a written receipt, but the receipt must contain the required information and statements in order to qualify the contribution as a deduction.  The receipt must contain the following elements:  

1.     State the amount of the contribution,

2.     Name the person making the donation,

3.     State the fact that either: i) no goods or services were provided by the charity in consideration for the contribution, or ii) provide a description and good faith estimate of the value of any goods or services provided by the charity,

4.     If the donor only received “intangible religious benefits,” then the receipt must explicitly state this, and

5.     The person seeking the deduction must receive the receipt no later than the due date of the original federal tax return (including any extensions obtained). 

If these five conditions are not met, then there is no tax deduction for the contribution.  These conditions have been strictly enforced by the IRS and by the court system with the result that some taxpayers have lost income tax deductions for very significant charitable contributions.

I have observed that some charities do not provide tax qualified receipts.  You should read your receipts to be sure that the required elements are contained.  If not, a corrected receipt must be obtained no later than the due date of your tax return. It is no longer sufficient just to be able to prove you made the donation.  You also have to prove that you received the tax-qualified receipt within the prescribed time limit. Substantial compliance is not good enough. S trict compliance with the rules is required. 

For non-cash donations, there are additional requirements, including the possible need for a qualified appraisal.  See Form 8283 and related instructions and also IRS Publication 526.

2013 Limits on Medical Deductions

Recent postings have reviewed the Affordable Care Act's (ACA) new Medicare taxes on net investment income and earned income.  A couple of other tax increases also occur in 2013.

Reduction in Itemized Medical Deductions.  Currently unreimbursed medical expenses must exceed 7.5% of adjusted gross income (AGI) to net an itemized deduction.  For tax years beginning after 2012, the ACA raises the threshold to 10.0% for taxpayers under age 65.  For those age 65 and older, the 10.0% threshold starts in 2017.

Reduction in Health FSA Contributions.  Currently, there is no upper limit on the amount of money that can be contributed on a pre-tax basis to a health care, flexible spending account, except as limited by the employer's cafeteria plan.  For plan years beginning after 2012, the maximum amount that can be contributed to a health care FSA is limited to $2,500; indexed for inflation after 2013.  This low limit will increase both income and FICA taxes on those who would like to contribute more than this amount to pay for their medical expenses.  Coupled with the increase of the AGI limit above, this change is a particularly effective means of raising taxes on sick people.

Increased 0.9% Medicare Tax Rate on Employee Compensation and Self-Employment Earnings

The Medicare tax rate on wages is currently 2.90%.  There is no upper ceiling on the amount of wages subject to Medicare tax.  The employee and the employer each pay one-half, or 1.45%.  Self-employed individuals pay both halves, and may deduct one-half of that amount on their income tax returns.  The Medicare tax rate on the employee’s share rises to 2.35% for compensation received in tax years beginning after 2012.  The increase is part of the Affordable Care Act and applies to wages exceeding $250,000 for joint; $125,000 for separate; or $200,000 for other tax return filing statuses.  The employer's tax rate remains at 1.45%.  Although the employer isn't subject to the tax rate increase, the employer must withhold the additional 0.90% tax once wages exceed $200,000 regardless of the employee's marital status.  Any shortfall or overage is reconciled on the employee’s income tax return.

The Medicare tax rate for the self-employed rises to 3.80% at the $250,000/$125,000/$200,000 income levels, but there is no increase to the income tax deduction.  If a person has both wages as an employee and earnings from self-employment, the amounts are combined against a single threshold amount for purposes of computing the tax. 

Notice that the higher Medicare tax increases the cost of the so-called "marriage penalty" because the wages and self-employment income of both spouses must be combined.  A marriage penalty results when two-earner spouses do not receive the same tax treatment as two-earner, non-married couples.  In this case, a married couple receives only one $250,000 threshold amount whereas an unmarried couple receives two $200,000 amounts. 

The threshold amounts are not indexed for inflation.  Therefore, more taxpayers will become subject to the tax in the future. 

Example 1.  Joe earns $175,000 of wages and his wife Cathy earns $175,000 of wages.  Neither employer withholds the extra 0.9% Medicare tax because wages are less than $200,000 each.  Combined wages are $350,000.  Therefore, Joe and Cathy must pay the 0.9% increased Medicare tax on $100,000 of wages or $900.  If Joe and Cathy were an unmarried couple, they would not owe any additional Medicare tax. 

Example 2.  Joe earns $175,000 of wages and his wife Cathy earns $175,000 of wages.  They have $50,000 of net investment income and modified adjusted gross income of $400,000.  Neither employer withholds the extra 0.9% Medicare tax because wages are less than $200,000 each.  Combined wages are $350,000.  Therefore, Joe and Cathy must pay the 0.9% increased Medicare tax on $100,000 of wages and the new 3.8% Medicare tax (see prior posts) on all $50,000 of net investment income on their income tax return.  The extra Medicare tax is $900 on wages and $1,900 on investment income for a total tax increase of $2,800.  Estimated tax payments are necessary to avoid a penalty.

Planning for the New 3.8% Medicare Tax on Net Investment Income

Last week’s article reviewed in detail how the 3.8% Medicare tax on net investment income (NII) is calculated.  The new tax was enacted as part of the Patient Protection and Affordable Care Act and applies to certain “high income” taxpayers in tax years beginning after 2012.  This article presents a checklist of planning ideas that can reduce the amount of this tax on your NII.  Space does not permit a discussion of these ideas.  Therefore, be sure to consult your tax advisor before implementation.

In order to reduce the impact of the Medicare tax on NII, you must manage modified adjusted gross income (MAGI) and/or NII.  The following ideas reduce either MAGI, NII, or both.

1.     Close the sale of your business in 2012

2.     Diversify out of concentrated stock positions in 2012

3.     Close the sale of your second home, or the sale of your principal residence having gain in excess of the exclusion amounts, in 2012

4.     Accelerate investment income into 2012

5.     Convert a traditional IRA to a Roth IRA in 2012

6.     Exercise stock options in 2012

7.     Plan how to use the tax installment sale method:

a.      Elect out of the method for 2012 sales

b.     Use the method for post-2012 sales

8.     Don’t defer the first required minimum distribution from your retirement plan to April 1, 2013 if you attain age 70 ½ in 2012

9.     Use a November 30, 2012 fiscal tax year for the estate income tax return of recent decedents, and make the election to treat a qualified revocable trust as part of the estate income tax return

10.  Distribute NII of trusts and estates to beneficiaries

a.      Elect to treat distributions made during the first 65 days of 2013 as having been made on the last day of 2012

11.  Maximize deductible contributions to retirement plans

12.  Form family limited partnerships or limited liability companies to split income

13.  Use a non-grantor charitable lead trust for making charitable donations

14.  Defer compensation until retirement when your MAGI is lower

15.  Minimize sources of investment income by:

a.      Investing taxable account funds in tax-exempt bonds,

b.     Investing taxable account funds in low-yield, appreciating securities,

c.      Investing taxable account funds in tax-managed funds or accounts,

d.     Allocating retirement fund assets to tax-inefficient investments, such as higher yielding securities and funds or accounts with higher turnover ratios

16.  Use a charitable remainder trust for the sale of appreciated property

17.  Make investments in nonqualified annuities to defer investment earnings until retirement when your MAGI is lower

18.  Time capital gains to low-income years

19.  Make investments in cash value life insurance to fund future tax-exempt cash flow

20.  Harvest capital losses

21.  Increase the number of hours you work in a pass-through entity business that you own to avoid passive activity income

22.  Meet the tax definition of a real estate professional to exclude rental income from NII

23.  Use the like-kind exchange rules to defer gain recognition on the sale of business or investment property 

A couple of examples illustrate how advance planning with a Roth IRA can reduce the cost of the Medicare tax on NII. 

Example 1:  Larry is single and has $40,000 of NII and $190,000 of MAGI.  He withdraws $30,000 from his traditional IRA.  Although the IRA distribution is not NII, it does increase MAGI to exceed the $200,000 threshold for a single filer.  Therefore $20,000 of NII is subject to the 3.8% Medicare tax because of the distribution. 

Example 2:  Assume the same facts as above, except now the $30,000 withdrawal comes from his Roth IRA.  Again, the IRA distribution is not NII, but in addition, a qualified Roth IRA distribution is tax exempt and does not increase MAGI.  Therefore, none of Larry’s NII is subject to the 3.8% Medicare tax.  Ideally, if Larry had both a traditional and a Roth IRA, $10,000 would come from his traditional IRA and $20,000 from his Roth IRA.

Understanding the New 3.8% Medicare Tax

A new 3.8% Medicare tax is imposed on net investment income of certain taxpayers for tax years beginning after 2012.  The Medicare tax has historically only applied to earned income.  The new tax is part of Pres. Obama's "Patient Protection and Affordable Care Act."  The new tax will be assessed as part of the income tax returns of individuals, trusts, and estates.  The tax is 3.8% of the lesser of:

1.     Net investment income (NII) or

2.     The excess of modified adjusted gross income (MAGI) over the following threshold amounts:

a.      $250,000 for joint filers

b.     $125,000 for married filing separately

c.      $200,000 for individual filers

d.     $12,000 as estimated for trusts and estates (the start of the top income tax bracket as indexed for inflation)

Before defining the above terminology in detail, several observations are worth noting about the new tax:

1.     Only 3% of taxpayers have MAGI over $250,000, so this is really a tax on Pres. Obama's so-called "wealthy."

2.     The thresholds are not indexed for inflation, so over time more people will become subject to the tax.

3.     The threshold for married persons is not double the amount for single persons.  This increases the cost of the so-called marriage penalty.

4.     Coupled with the sunset of the Bush-era tax cuts, the top federal tax rate in 2013 will be 43.4% on ordinary investment income and 23.8% on long-term capital gains.  By contrast, the top tax rates in 2012 are 35.0% and 15.0% respectively.

5.     Trusts and estates can avoid the 3.8% tax by distributing the NII to beneficiaries.  The beneficiaries in turn would include the distributed NII in their calculation of the tax.  But a distribution for tax purposes might not be in accordance with goals of the trust or estate plan.

6.     Charitable remainder trusts are exempt from this tax.

7.     MAGI cannot be reduced with itemized deductions or personal exemptions because these deductions are taken after the calculation of MAGI.

8.     Investment expenses are typically claimed as itemized deductions which, while reducing NII, don't reduce MAGI.

9.     The tax is imposed on the full amount of NII only if MAGI exceeds the threshold amounts by at least the amount of NII.

10.  Estimated tax payments may be necessary to avoid an underpayment penalty.

NII equals investment income minus investment expenses.  MAGI equals AGI (the figure at the bottom of page 1, Form 1040) plus any foreign earned income and housing cost exclusions.

Investment income includes the following:

1.     Dividends and taxable interest income

2.     Short- or long-term capital gains (with certain exceptions)

3.     Royalties and the taxable portion of annuity payments

4.     Passive activity income which includes

a.      Rent net income

b.     K-1 income from partnerships, limited liability companies, and S corporations in which you do not materially participate.  Material participation generally requires working more than 500 hours in the business during the year.

5.     Income earned from the investment of business working capital allocable to K-1s.

6.     Hedge fund income

7.     Gain on the sale of a principal residence above the $250,000 (single) or $500,000 (joint) exclusion amounts

Investment income does NOT include:

1.     Wages and self-employment income (already subject to Medicare tax)

2.     Tax-exempt municipal bond interest

3.     Traditional IRA and qualified retirement plan distributions

4.     Roth IRA distributions

5.     Qualified annuity Section 403 plan distributions

6.     Deferred compensation Section 457 plan distributions

7.     Social Security and alimony income

8.     Gain on the sale of nonpassive business ownership interests, except to the extent the business holds investment property

9.     K-1 business income from partnerships, limited liability companies, and S corporations in which you materially participate

10.  The amount of gain excluded on the sale of a principal residence

A couple of examples illustrate how the tax is calculated.  My next blog article will discuss tax-reduction planning strategies.

Example 1:  Joe is a single individual with MAGI of $240,000, consisting of wages of $190,000 and NII of $50,000.  The new 3.8% Medicare tax applies to only $40,000 of his NII because his MAGI only exceeded the threshold by this amount.  His total tax increase is $1,520.

Example 2:  Joe and his wife earn $200,000 of wages, have K-1 income of $150,000 from an LLC in which they materially participate, and have $60,000 of investment income and $10,000 of investment expenses.  Their MAGI equals $410,000 and NII equals $50,000.  The new 3.8% Medicare tax applies to all $50,000 of NII and increases their tax by $1,900.

U.S. Supreme Court Upholds Affordable Care Act

The U.S. Supreme Court upheld the constitutionality of the Patient Protection and Affordable Care Act in a ruling issued June 28, 2012.  The ruling consisted of three primary components:

1. The Court allowed the mandate that requires individuals to purchase health insurance or else pay a penalty (beginning in 2014).  The Court concluded that the penalty could reasonably be considered a tax and that Congress has the power to impose taxes.  However, in order to be able to rule on this issue, the Court first had to determine that the penalty was not a tax because the Anti-Injunction Act prohibits a court challenge of a tax before it is paid.  The mandate first applies to 2014 tax returns filed in 2015.  The Court reasoned that since Congress never called the required payment a tax, but rather a "shared responsibility payment" (or penalty), that it wasn't a tax for this purpose.  Therefore the Court could proceed with a decision.  Then 18 pages later, the Court called the payment a tax in order to uphold the law!
2. The Court limited the Commerce Clause of the Constitution stating that Congress could not regulate economic inactivity, like a decision not to purchase health insurance.  This holding would have invalidated the law except for the tortured reasoning above.
3. The Court restricted Federal power to punish States choosing to opt out of expanding Medicaid, ruling that the Federal government could not cut off Federal funding of current Medicaid programs.  Only new Federal funding of the expanded Medicaid program could be withheld from non-participating States.

Chief Justice Roberts, who wrote the majority opinion, added this observation at the end of his opinion:  "But the Court does not express any opinion on the wisdom of the Affordable Care Act.  Under the Constitution, that judgment is reserved to the people."  The opposing political parties will be taking their cases to the American people, as national elections are on November 6, 2012.

Now that the Supreme Court has ruled, it is time to get serious about the implications of the looming tax increases and administrative burdens on individuals and businesses.  Future blog posts will examine these taxes and responsibilities, and suggest planning ideas for coping with the Affordable Care Act.

Tax Armageddon: Planning for Long-Term Capital Gains & Qualified Dividends

Unless extended, the tax cuts of 2001 and 2003 expire after 2012.  The Federal top long-term capital gain (LTCG) rate will increase from 15% to 20% (ignoring the special, super-long-term 18% rate for assets acquired after 2000 and held for more than five years).  For qualified dividends (QD), the top tax rate will increase from 15% to 39.6%.  In addition, for single and joint taxpayers having modified adjusted gross income in excess of $200,000 and $250,000 respectively, a new and additional 3.8% Medicare tax will apply to net investment income after 2012 as part of the Affordable Care Act currently under review by the U.S. Supreme Court.  Furthermore, a return of the phase-out of itemized deductions for taxpayers having AGI above certain limits will effectively add another 1.2 percentage points to the tax rate.  Consider the following planning ideas to help reduce post-2012 income tax on your LTCGs and QDs:

1. Harvest capital losses.  Capital losses are deductible to the extent of capital gains.  Excess capital losses may offset up to $3,000 of ordinary income, with the balance carried forward to future tax years with no expiration until death.  Capital loss carryforwards are a shelter against future capital gain taxes.  Given the volatility of the financial markets, you may be able to recognize capital losses throughout the remainder of 2012.  Harvesting need not wait until the end of the year.  When reinvesting sale proceeds, be aware of the "wash sale" rule.  That rule disallows losses if the purchased security is substantially identical to the security that was sold for a loss, and it is purchased during the 30-day period before the date of sale or the 30-day period after the date of sale.  Therefore, to maintain your asset allocation,  reinvest your proceeds in similar but different securities.  The IRS even looks through to IRA holdings to apply the wash sale rule to your taxable account transactions.
2. Diversify your concentrated asset position before 2013.  Some individuals hold concentrated equity positions that they haven't sold because of capital gain taxes.  It is risky to hold a large percentage of your net worth in a single stock.  Many advisors believe that capital gain tax rates are at the lowest point they will be in the future.  Diversifying before 2013 could reduce your capital gain taxes significantly.
3. Sell your business or major asset before 2013.  If you are selling your business or a major asset for cash, close the transaction before 2013.  If a portion of the sale price will be paid in the future and the sale qualifies for the tax installment method, consider electing out of the installment method in order to recognize all of the tax gain in 2012 rather than having it spread out into future years when the tax rate is higher.
4. Accelerate deferred gain from prior year sales.  If you sold your business or major asset in a prior year on a deferred-payment promissory note for which you are using the tax installment method, consider taking steps to cause the gain to be accelerated into 2012.
5. Pay dividends from closely-held C corporations.  If you own a taxable C corporation with excess cash, the corporation could be at risk to the personal holding company penalty tax or the accumulated earnings penalty tax.  Paying a dividend to the shareholders before 2013 could lower the exposure to these penalty taxes, and bail out the excess earnings at favorable tax rates.  In addition, if the C corporation has strong cash flow, low debt, and currently pays dividends, it may make sense to borrow in order to prepay future dividends.
6. Elect to pay dividends from certain S corporations.  If you have an S corporation that generates lots of investment income, and it has earnings and profits from a previous C corporation status, the corporation is at risk to a penalty tax and loss of the S election.  In this situation, consider making the special election to distribute the C corporation dividends before distributing S corporation earnings.  Purging the S corporation of prior C corporation earnings and profits before 2013 will eliminate the risk of the excess net passive income penalty tax and loss of the S election at a lower QD tax rate.

The situation of each taxpayer is unique, and multi-year tax projections should be made before implementing the above ideas.  In some situations, even a sale of stock followed by a repurchase in order to pay tax now at a lower rate in order to avoid a future tax at a higher rate could make sense.

Consider also the following potential pitfalls to your planning:

1. Triggering the alternative minimum tax (AMT).  Recognizing additional income in 2012 to beat the tax rate increases could cause the AMT to apply, reducing the expected tax benefits.
2. Making a bad investment decision.  Selling an asset before its full value has been realized in order to save some income taxes may be a bad financial decision.
3. Taking action too early or too late.  If Congress and the President enact a further extension of the Bush tax cuts during the last days of 2012, will you have made a bad decision by implementing a strategy earlier in the year under the assumption that tax rates would increase?  On the other hand, if you wait to see if the Bush tax cuts will be extended and they aren't before December 31st, will you have made a bad decision by waiting too long to pull the trigger?
4. C corporations don't have a favorable LTCG rate.  Be careful of selling capital assets owned by a C corporation in order to save taxes because C corporations do not have a favorable LTCG rate and their tax rates are not scheduled to increase after 2013.  Furthermore, net capital losses of C corporations can only be carried forward five years.

Be sure to consider all the potential ramifications of implementing tax planning.  That is a very challenging assignment given all of the political and economic uncertainties in the world.  All you can do is the best that you can and to have a rational basis for what you plan to do in response to Tax Armageddon!

Are You Ready for Tax Armageddon?

Armageddon appears once in the Bible and relates to the final conclusive battle between the forces of good and evil.  The word, Armageddon, has also become a general term that denotes any disastrous "end of the world" event.  With the looming tax law changes, the popular press has coined a new phrase, "Tax Armageddon" or "Taxmageddon" for short.  Assuming that the world survives the end of the Mayan calendar on December 21, 2012, then we face the largest tax increase in history on January 1, 2013!  The tax increase is estimated to be $500 billion for 2013 alone.  However, even this historic tax increase won't pay for half of the projected Fiscal 2012 budget deficit of $1.3 trillion!  To pile on, the federal debt ceiling will likely be reached around this same time.  To pile even higher, the failure of the "super committee" last fall requires $1 trillion in spending cuts over 10 years, beginning January 1, 2013, divided half between military and social spending.  This nation truly has severe budgetary problems, and failure to solve these problems is the true Armageddon that must be avoided.

Just what taxes are increasing and what can you do about them?  This post outlines the major categories of tax increases.  Future articles will explore the increases in more detail and outline available planning opportunities.  We expect that Congress may act to prevent some of these increases, but what can we really count on from Congress?

1. The so-called Bush tax cuts of 2001 and 2003, originally set to expire at the end of 2010 are now set to expire at the end of 2012.  Significant cuts included the lowering of all of the ordinary tax rates, including the top rate from 39.6% to 35.0%.  The top long-term capital gain rate was cut from 20% to 15% and the qualified dividend rate cut from 39.6% to 15.0%.  In addition, a host of other cuts were made including eliminating the loss of itemized deductions and personal exemptions based upon income levels, increasing a variety of personal and education tax credits, and reducing the so-called marriage tax penalty.
2. The exemption from estate and gift tax in 2012 is $5.12 million.  The exemption declines to $1.0 million in 2013.  In addition, the top estate and gift tax rate increases from 35% to 55%.
3. The alternative minimum tax exemption amount declined from $74,450 and $48,450 for joint and single filers in 2011 to $45,000 and $33,750 in 2012.  This decline will increase taxes on 30 million taxpayers unless the exemption is once again "patched" with a new temporary increase.
4. The employee portion of the Social Security tax was reduced from 6.2% to 4.2% for 2012.  The rate will revert to 6.2% in 2013.
5. Business 100% bonus depreciation on the purchase of new equipment in 2011 declined to 50% in 2012 and then is eliminated in 2013.
6. New Medicare taxes are imposed on compensation and investment earnings in 2013 as part of the so-called Obamacare tax provisions.  Compensation above certain thresholds will suffer an extra 0.9% tax.  Investment income of taxpayers having modified adjusted gross income above certain thresholds will, for the first time, be subject to Medicare tax, at a rate of 3.8%.  The U.S. Supreme Court is expected to issue its ruling on the constitutionality of the Affordable Care Act by the end of June 2012.  Whether this ruling will impact the Medicare tax increase remains to be seen.