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.

Understanding Tax Issues of Employee Expense Reimbursement Plans

Employers will generally reimburse or provide advances to cover ordinary and necessary business expenses incurred by their employees for travel, meals, and entertainment.  Specific tax rules, including time limits, must be observed to avoid income tax pitfalls.  There are two tax categories of expense reimbursement plans:  accountable (tax favorable) and nonaccountable (tax unfavorable).

For an accountable plan, the employee must timely document the expenses to the employer and also timely return any excess reimbursement or advance to the employer.  The time requirements are as follows:

1. The employer may not provide an advance more than 30 days before the time the employee will incur the expense.
2. The employee must provide adequate documentation of expenses within 60 days after the expense was paid or incurred.
3. The employee must return any excess reimbursement within 120 days after the expense was paid or incurred.
4. If the employer gives periodic statements (at least quarterly) to the employee asking for an accounting of the expenses and a return of any excess reimbursement, then employee must comply within 120 days of the date of the statement.

The tax benefit of an accountable plan is that the expense reimbursement is not treated as taxable wages.

In lieu of actual expenses, per diem amounts for lodging and meals and incidental expenses, and mileage rates for driving a personal car for business may be used.  As long as the amounts do not exceed the rates published by the IRS, and the employee otherwise provides documentation, the employee is deemed to have met the accountable plan rules and any excess does not need to be returned to the employer.  See IRS Publication 1542 for per diems rates.  The business mileage rate for 2012 is 55.5 cents per mile.

A nonaccountable plan is an arrangement that does not meet the rules for an accountable plan.  Also, if the employee does not comply with the time requirements, then the expense reimbursements are treated as though paid under a nonaccountable plan.  The amounts paid under a nonaccountable plan are treated as regular taxable wages, subject to income and payroll tax withholdings, and are reported on Form W-2.  The employee may then deduct the business expenses, but they are miscellaneous itemized deductions.  Miscellaneous itemized deductions only provide tax savings to the extent the total exceeds 2% of adjusted gross income, if the employee has itemized deductions in excess of the standard deduction, and if the employee is not subject to the alternative minimum tax!  There are a lot of hurdles for an employee to clear to receive a tax deduction for business deductions under a nonaccountable plan, so it is advisable for the employee to comply with the accountable plan rules to avoid very negative tax results.

Observations from Tax Season

"Tax season" ended last week for 2011 income tax returns.  This season seemed particularly painful given the expanded reported requirements for sales of investments and the delay in receiving Forms 1099 from financial institutions.  Some of the tax returns also held surprises for some taxpayers.  Here are a few observations that may be of benefit to you.

1. A windfall of additional income does not belong 100% to you.  The government is your partner in every dollar you earn.  You cannot spend the extra income without first providing for income taxes or you may find that the money left over not sufficient to pay your partner!  If you are in the top Federal and Utah brackets, for 2012 the government will be at least a 40.0% to 42.9% partner.  In 2013, the government demands an even larger share, 48.4%.
2. Your choice of investments can greatly complicate your income tax return.  Although income taxes should not be the primary factor in choosing suitable investments, you should be aware of the tax reporting implications of those choices, which can add to the costs of preparation and delay the timing of when the tax return can be completed.
   
   For example, with the sharp decline in interest rates over the past several years, purchasing Treasury notes and CD's on the market rather than at original issue will result in the payment of premiums and accrued interest.  The financial institution's Form 1099 will report to the IRS the amount interest income earned according to the stated coupon rate, which greatly overstates the actual economic interest earned.  Tax elections and complicated calculations for premium amortizations and accrued interest adjustments are necessary to avoid overpaying tax.
   
   Another example relates to investments that are bought and sold by investment advisors as if the investment were shares of stock, but the investment is actually a tax partnership.  As an owner of a partnership you will receive a Schedule K-1 rather than a Form 1099 for the investment income or loss.  Tax partnerships are complicated!  Many times the K-1s are not even provided until September, requiring a six-month extension of your tax return.  Some of the partnerships invest in foreign entities that require expanded disclosures in your tax return.  Others hold property in a variety of other states that may require you to file tax returns in those states.  All of these consequences bring delays and added costs.  Therefore, an investment structured as a tax partnership should be a conscious choice because of its unique investment opportunities not otherwise available.
3. Tax planning beyond 2012 is difficult because of tax law uncertainty.  We know what most of the rules are for 2012.  We know what the tax laws are scheduled to be in 2013.  But we don't know what the outcome of the national elections will be this fall, and we certainly don't know what our elected politicians will do about the dramatic fiscal, debt, and tax problems this country is facing.  In the face of uncertainty, it is wise to be conservative and to use the tax benefits currently available.  Three of the most important benefits that are scheduled to disappear after 2012 are:  (1) the 15% Federal long-term capital gain tax rate, (2) the 35% top ordinary tax rate, and (3) the $5.12 million gift tax exemption amount.  You should plan to use these benefits where they fit into your overall financial and estate plan.  Consultations with your tax advisor this summer and again after the elections may prove particularly valuable this year.