B eginning in 2013, individual taxpayers considered

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1 Pension & Benefits Daily Reproduced with permission from Pension & Benefits Daily, 216 PBD, 11/08/2012. Copyright 2012 by The Bureau of National Affairs, Inc. ( ) New Medicare 0.9 and 3.8 Percent Taxes: Executive Compensation Year-End Tax Planning s directing income in to the few types of income exempt from either of the new taxes, or BY RUTH WIMER Overview B eginning in 2013, individual taxpayers considered to be high income will not only experience an increased rate of Medicare tax on wages and selfemployment income but also, for the first time in history, a Medicare tax of 3.8 percent 1 will apply to unlimited amounts of net investment income that exceeds certain thresholds. 2 Strategies for reducing the effect of the new Medicare taxes include: s accelerating income otherwise subject to either of the two new taxes in 2012, 1 Section 1411 of the tax code. 2 Both the increased Medicare tax on earned income and the new Medicare tax on unearned income are part of the 2010 health care reform legislation. Patient Protection and Affordable Care Act of 2010 (Pub. L. No , 5/23/10) and the Health Care and Education and Reconciliation Act of 2010 (Pub. L. No , 5/30/10). Ruth Wimer (rwimer@mwe.com) is a partner in the law firm of McDermott Will & Emery in Washington. She focuses her practice on matters related to executive compensation, including international issues, fringe benefits, and qualified and nonqualified deferred compensation. The author wishes to thank Joseph Urwitz, an associate in the firm s Boston office, for his help in preparing this article. s deferring income not receivable in 2012 and not exempt from the new taxes for as long as possible. There are numerous specific and detailed ways that these strategies can be applied to benefit executives in the workplace as discussed and explained in this article. Employers are responsible for withholding (but not paying) the new 0.9 percent tax on wages but, pursuant to Internal Revenue Service guidelines, may easily either over- or under-withhold resulting in individual estimated tax penalties. 3 On a positive note, however, any employer company that maintains a qualified retirement plan may provide to employees tax-free personal financial counseling on these new Medicare tax issues. 4 Understanding the New Taxes Earned Income Medicare Taxes: Wages and Self- Employment Income Employees and their employers must each pay a tax at a rate of 1.45 percent on the entire amount of the employee s wages, referred to as the Medicare tax, pursuant to the Federal Insurance contributions Act (FICA), in addition to a 6.2 percent tax on wages capped at $113,700 (2013). 5 Similarly, self-employed individuals must a pay a 2.9 percent tax on unlimited net earnings from self-employment (NEFSA), in addition to 12.4 percent on the first $113,700 (2013) (SECA taxes) 6 rates intended to equal the combined employer/employee 3 I.R.C. 3102(f)(1). See IRS Questions and Answers for the Additional Medicare Tax, at Small-Businesses-&-Self-Employed/Questions-and-Answersfor-the-Additional-Medicare-Tax. 4 Tax code 132(m) provides for tax-free personal financial planning pursuant to a qualified retirement plan, provided that the benefits are nondiscriminatory. There is no dollar limit on the value of the benefits that may be provided, but the benefits cannot include tax-return preparation, accounting, or benefits other than financial planning. 5 I.R.C The Middle Class Tax Relief and Job Creation Act of 2012 (Pub. L. No , 2/22/12) decreased the rate of payroll tax by 2 percentage points on the employee wage base for 2011 and I.R.C For 2011 and 2012, the payroll tax rate decreased by 2 percentage points. Id., Pub. L. No COPYRIGHT 2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN

2 2 rates for wages. Self-employed individuals are allowed a deduction from NEFSA equal to one-half of the SECA taxes in calculating their SECA tax (that is, selfemployed individuals can deduct the employerequivalent portion of FICA contributions), 7 and can deduct one half of the SECA tax from adjusted gross income (AGI) for federal income tax purposes. 8 Effective for employees in tax years beginning after 2012, an additional 0.9 percent Medicare tax is imposed on wages in excess of $250,000 for married taxpayers filing jointly, $125,000 for married filing separately, and $200,000 for single taxpayers. 9 Self-employed individuals also pay an additional 0.9 percent Medicare tax at the same thresholds. 10 There is no AGI or NEFSA deduction benefit for this additional 0.9 percent tax. 11 Unearned Income Medicare Tax Also effective for tax years beginning after 2012, taxpayers with income exceeding certain thresholds will pay a new tax on unearned income at the flat rate of 3.8 percent (unearned income Medicare or fake Medicare tax) (UIMT). 12 The UIMT is imposed on the lesser of (1) net investment income, or (2) the excess of modified AGI exceeding the same threshold amounts applicable to the increased tax for employee wages and self-employed earnings. Modified AGI is adjusted gross income (the number at the bottom of the front page of Form 1040), plus any excluded foreign earned income, and is not reduced by 7 I.R.C. 1402(a)(12). 8 I.R.C. 164(f)(2). 9 I.R.C. 3101(b)(2). 10 I.R.C. 1401(b)(2). 11 I.R.C. 164(f)(1). 12 I.R.C itemized deductions. For most individuals, modified AGI is the same as AGI. Estates and trusts are also subject to the UIMT on the lesser of (1) undistributed net investment income, or (2) the excess of the estate or trust AGI exceeding the dollar amount at which the highest tax bracket begins for trusts, $11,650 for The threshold amounts are not indexed for inflation for individuals for either the increased tax on earnings or the UIMT. A taxpayer may be subject to both the increased Medicare tax on wages and self-employment tax and the UIMT tax all in the same year. Example: In 2013, David, a single taxpayer, has modified AGI of $900,000, wages of $300,000, and net investment income of $500,000. David will pay the increased Medicare tax of 0.9 percent on $100,000 of wages, and pay the new UIMT tax of 3.8 percent on his $500,000 of investment income, for a total of $19,900 additional taxes, as compared to 2012 Medicare tax liability. The chart below displays the treatment of different types of income as subject to the new taxes, and also whether it is included in modified AGI. Note that income not subject to the new Medicare taxes that is, however, included in modified AGI can lead to application of the Medicare tax to other income by causing the applicable modified AGI thresholds to be exceeded. For example, a single taxpayer with $200,000 of distributions from a qualified plan that is exempt from the Medicare tax will pay Medicare tax on all capital gain or dividend income, because his modified AGI threshold was already reached. Stated differently, a taxpayer does not have to pay Medicare tax until his modified AGI limit is reached. 13 I.R.C. 1411(a)(2). NEW MEDICARE TAX Type of Income Included in Modified Earned Income Unearned Income* AGI Wages Yes Yes No Fringe benefits subject to FICA, e.g., personal Yes Yes No use automobile Net self-employment income Yes Yes No Fringe benefits not subject to FICA, e.g., No No No qualified personal financial planning Deductible employee contribution to qualified No Yes No plans Employer contributions to qualified plans No No No Roth contributions Yes Yes No Nonqualified deferred compensation becomes No Yes No vested Restricted stock vested or subject toi.r.c. Yes Yes No 83(b) election Stock-option exercise Yes Yes No Nonqualified deferred compensation paid Yes No No COPYRIGHT 2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN

3 3 Tax-exempt income, such as life insurance No No No proceeds, state bonds, municipal bonds, veterans benefits, excluded gain from sale of primary residence Roth distributions No No No Interest, dividends, annuities, rents, and Yes No Yes royalties Capital gains (other than from sale of Yes No Yes trades or business, provided that it is not a passive activity or trading in financial instruments) Limited partnership trade or business income Yes No No (other than passive activity, working capital, or business of trading in financial instruments income) S corporation trade or business income Yes No No (other than passive activity, working capital, or business of trading in financial instruments income) Passive activity, working capital, business Yes No Yes of trading in financial instruments income Controlled foreign corporation (I.R.C. Subpart F), passive foreign investment company, qualified electing funds Yes No Likely No * Note that, although the total Medicare tax on both earned and unearned income is the same 3.8 percent rate, earned income results in an overall slightly lower total rate of total taxes, approximately 0.5 percent, as compared to unearned income. This is because the UIMT is applied to the gross amount of unearned income, while the earned income Medicare taxes are applied on income that does not effectively include approximately 0.5 percent of the total FICA or SECA tax liabilities (excluding the new 0.9 percent tax), and additionally, federal income tax is owed only on taxable income excluding approximately one-half of the total FICA or SECA tax (again, not excluding the new 0.9 percent tax). Overview of Year-End Tax Planning for Executive Compensation Bearing in mind that there are two different new taxes to contend with, the strategies for the new taxes generally would fall in to the following general categories: s accelerating income otherwise subject to either of the two new taxes in 2012; s creating types of income exempt from either of the new taxes; or s after 2012, deferring income eventually subject to the taxes. IRS is working on extensive proposed regulations on these new Medicare taxes. It is possible that the regulations could affect the conclusions in this article. It is probable that guidance will focus on the definition of income subject to the new unearned income Medicare tax rules for wage and self employment income are well defined by statute. I. Accelerating Compensation Income in 2012 A. Wages and bonuses paid in 2012 rather than 2013 will not only escape the additional 0.9 Medicare tax but will be subject to the maximum 35 percent 14 federal income tax rate rather than possibly percent in 2013 and thereafter. A simple way to reduce tax for an executive is to pay 2012 bonuses at the end of 2012 rather than pay them in B. Deferred compensation is subject to Medicare tax when both vested and ascertainable, not when paid. 15 For defined benefit plans, this means that the tax is often deferred until the executive separates from service, when the total value of the plan benefit is then known. A simple strategy for defined benefit deferred compensation plans that are in place in 2012 and have vested accruals is to elect to subject, on an estimated bases, the accrued balance to Medicare tax in 2012 rather than at a later point in time. This has the benefit of permanently exempting the future value of that amount from any additional FICA tax, including the additional 0.9 percent rate applicable to years after C. Bonuses for 2012 paid in early 2013 would be subject to the additional 0.9 percent rate of Medicare tax when paid in However, under the deferred com- 14 I.R.C I.R.C. 3121(v)(2). ISSN BNA

4 4 pensation portion of the FICA regulations, 16 an employer can elect to include in income for FICA tax purposes, vested compensation paid within 2.5 months of the subsequent year as long as the election is for all employees under the plan. D. Restricted Stock is subject to federal tax and Medicare tax when vested 17 or when the executive makes a Section 83(b) election to include the value in income upon receipt. 18 Restricted stock that will vest based on services and/or performance after 2012 can be granted now, permitting the executive to make a Section 83(b) election and pay taxes at 2012 lower rates. Executives should be aware that, if the stock is eventually forfeited, negative tax consequences could occur. 16 I.R.C (v)(2)-1(b)(3)(iii). 17 I.R.C. 83(a). 18 I.R.C. 83(b). E. Unrealized capital gain in assets at the end of 2012 can be sold and subject to 2012 capital gain rates and also exempt from the new 3.8 percent on net investment income. For example, the following illustrates an executive with employer stock and other assets with a tax basis of $10 million and a current value of $13.2 million, selling in 2012 and paying tax at today s 15 percent capital gain rate, reinvesting, and selling again later after further appreciation. That strategy is contrasted in the second illustration to not selling and locking in at today s rates and instead selling at a future point in time at a capital gain rate of 20 percent, as well as the new 3.8 percent Medicare tax. The examples factor in the total after-tax value to the executive, including the lost growth on tax paid on an accelerated basis alternatively with growth rate assumptions of zero, 25 percent, and 50 percent. Sell Now, Lock In Gain, and Reinvest: Sell Later, After Tax Increase: Total $13.2M Fair Market Value $13.2M Fair Market Value $10M Basis $10M Basis $3.2M Capital Gain Less $0.48M Taxed at 15 Percent 2013 $12.72M Basis $10M Basis Growth: Initial Sale in 2012 Initial Sale in percent $12.72M-no tax=$12.72m $13.2M-$10M=$3.2M-tax $0.76M=$12.44M 25 percent $15.9M-$12.72M=$3.18M-tax $16.5M-$10M=$6.5M-tax $0.76M=$15.14M 50 percent $19.08M-$12.72M=$6.36M-tax $1.51M=$17.57M $1.55M=$14.95M $19.8M-$10M=$9.8M-tax $2.33M=$17.47M II. Creating Types of Income Exempt From Either of the Two Taxes A. Roth IRA and 401(k) conversions and contributions are unique in that these actions will create future income that is both exempt from any Medicare 19 or UIMT, 20 but the distributions will also not be included in modified AGI 21 and therefore potentially allow up to 19 IRA distributions are not wages within the meaning of I.R.C Section 401(k) distributions are exempt under 3121(a)(5). 20 I.R.C. 1411(c)(5). 21 I.R.C. 1411(d). $250,000 in net investment income to escape the UIMT. Roth qualified plans 22 and IRAs 23 are retirement plans wherein contributions are subject to tax but the earnings, when distributed, are free from federal tax. An added feature is that, unlike non-roth plans, Roth plans are not subject to minimum distribution requirements 24 and therefore the earnings may be accumulated and retain the tax benefits for a longer period of time. Example: 22 I.R.C. 402A(a), (d). 23 I.R.C. 408A(a), (d). 24 Treas. Reg A-6, Q&A 14; I.R.C. 408(a)(5). Remain non-roth Convert to Roth $1,000,000 $1,000,000 $650,000 0 percent increase $1,000,000 $650,000 After 0 percent increase $566,000 $650, percent increase $1,250,000 $821,500 After 25 percent increase $707,500 $821, percent increase $1,500,000 $975, COPYRIGHT 2012 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN

5 5 After 50 percent increase $849,000 $975,000 B. Qualified plan investments are specifically exempt from the new UIMT tax. 25 This means that non-roth qualified plan distributions remain subject only to regular federal income tax 26 on distribution (Roth distributions are exempt from all federal tax). 27 Key points are: s Establish and contribute to qualified plans to the maximum extent possible to build up balances that grow completely tax-free and are distributed free of the UIMT. Employers that only have 401(k) plans may, to the extent feasible given discrimination testing, increase contributions to the existing plans and/or establish defined benefit plans. s Employer contributions to qualified plans are exempt from the new 0.9 percent tax. s Deductible employee contributions to plans are exempt from modified AGI. C. S corporations have long presented a unique situation regarding tax advantages. S corporations, unlike C corporations, provide tax only at the shareholder level and the business entity is not individually taxed, in this regard similar to partnerships. A shareholder who also provides services to the S corporation business receives a salary reportable on a W-2 and subject to the Medicare tax (as well as all other employment taxes). However, earnings of the S corporation that are not paid out as salary are distributed to the shareholder free from Medicare tax and exempt from UIMT, provided that the earnings are not related to working capital, passive income, or business income that relates to trading in financial interests or commodities. D. Limited partnership income is received free from Medicare tax or other self-employment tax, although the definition as to exactly what income qualifies for this treatment is unclear. The new UIMT is defined in the new statute, but exactly what partnership income will be subject to the new UIMT tax is unclear. Key points are: s Income subject to the earned Medicare tax is not subject to the UIMT. 25 I.R.C. 1411(c)(5). 26 Treas. Reg (a), I.R.C. 3121(a)(5)(A). 27 I.R.C. 408A(d), 3121(a)(5)(A). s Passive activity income, working capital, and income as a result of trading in financial instruments are subject to the UIMT. s There is uncertainty concerning whether it is possible to be a limited partner, and at the same time, not have income considered to be passive activity income. E. Tax Exempt Income. A straightforward strategy to avoid the new tax is to direct resources to tax-exempt, income-producing investments that do not increase modified AGI and are also not subject to the new tax. Such investments include life insurance proceeds, interest on state or local bonds, veterans benefits, and excluded gain from sale of principal residence. 28 III. Deferring Income Subject to the Tax for as Long as Possible It is a fundamental principle of the income tax rules that deferring the time at which tax is paid creates a higher after-tax amount if rates do not increase. Accordingly, once the higher rates are applicable in 2013, deferring the time at which the taxes are paid allows the executive to build assets on a tax-favored basis. Strategies for deferring income include: s spending down assets outside of qualified plans before spending qualified plan money, s delaying recognizing capital gain income through tax-free exchanges, and s generally delaying recognition of income by delaying sale of assets. Conclusion Executives can reduce their tax liabilities for future years in some simple ways such as increasing qualified plan contributions, receiving pay in 2012, making Section 83(b) elections, and electing Roth conversions. The executive is well-advised to run projections that take in to account his or her specific financial positions, such as future income tax brackets, other sources of income, and marital status. Employers can provide detailed financial planning to executives under a qualified retirement planning services plan under Section 132(m), and if done on a nondiscriminatory basis, the value of the benefit will be free of income tax and free of the new Medicare taxes. 28 I.R.C. 1411(d). ISSN BNA