THE AMERICAN LAW INSTITUTE Continuing Legal Education

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1 41 THE AMERICAN LAW INSTITUTE Continuing Legal Education American Taxpayer Relief Act: What You Need To Know for Tax Planning and Compliance January 22, 2013 Video Presentation Service Issues Proposed Regulations under the New 3.8% Medicare Contribution Tax under Section 1411 By Fox Rothschild LLP Philadelphia and West Palm Beach

2 42 ALI CLE AMERICAN TAXPAYER RELIEF ACT: WHAT YOU NEED TO KNOW FOR TAX PLANNING AND COMPLIANCE VIDEO WEBCAST TUESDAY, JANUARY 22, 2013 (1:00 3:00 PM) Service Issues Proposed Regulations Under the New 3.8% Medicare Contribution Tax Under Section 1411 Fox Rothschild LLP Philadelphia, PA / West Palm Beach, FL In REG , the Service issued, on November 30, 2012, proposed regulations providing guidance under Section 1411 of the Internal Revenue Code. Section 1402(a)(1) of the Health Care and Education Reconciliation Act of 2010, P.L , 124 Stat. 209, ( HCERA ) enacted new Section 1411 to a new Chapter 2A of subtitle A (income taxes) effective for taxable years beginning after December 31, As with Section 1411, the proposed regulations pertain to subject individuals, estates and trusts. 2 The Section 1411 tax does not apply to a nonresident alien (on passive U.S. source income) or to a trust all of the unexpired interests of which are devoted to one or more charitable purposes set forth in Section 170(c)(2)(B). 3 The tax imposed by Section 1411 is not deductible in computing any tax under subtitle A (income or alternative minimum tax). 4 The government has also asked that comments be received on the proposed regulations by March 5, On November 29 th, the Service also released guidance on Section 1411 in question and answer format (20 Q&As in total) which is posted on its webpage. Section 1411 imposes on certain individuals a 3.8% tax on the lesser of such taxpayer s net investment income, i.e., capital gains, dividends, annuities, royalties, interest, rents, and income from some trades or businesses, or the amount by which an individual's modified adjusted gross income exceeds $200,000 ($250,000 for joint filers and surviving spouses). 1 At the same time proposed regulations on the 0.9 percentage point increase in the Section 3101 hospital insurance tax were also released. REG (a)(2)(application to estates and trusts). 1411(e). 4 See Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 111th Congress (JCS-2-11) (March 24, 2011), at 364 (JCT 2011 Explanation).

3 43 This outline will set forth the general rules to Section 1411 as amplified by the proposed regulations and further explained by the Preamble to the Proposed Regulations which Preamble is 36 pages in length. Obviously, the government is conceding that Section 1411 is not simple even though the statutory language is concise and relatively short. The proposed regulations state that the provisions apply with respect to taxable years beginning after December 31, 2013 but can be relied upon for reporting for taxable years beginning in Section 1411 applies to taxable years beginning after December 31, Amounts collected under Section 1411 are not designated for the Medicare Trust Fund. The Joint Committee on Taxation in 2011 stated that [i]n the case of an individual, estate, or trust an unearned income Medicare contribution tax is imposed. No provision is made for the transfer of the tax imposed by this provision from the General Fund of the United States Treasury to any Trust Fund. 6 The New Medicare Contribution Tax of 3.8% The 2010 HCERA imposes a new Medicare tax on passive or investment income, as compared with salaries, wages, or compensation for services, including a partner s of S shareholder s distributive share of net investment income, under Section 1411(a)(1). 7 The new Medicare Tax is 3.8% of the lesser of: (i) the taxpayer s net investment income or NII; or (ii) the excess of the taxpayer s annual modified gross income ( MAGI ) over (a) $250,000 for married taxpayers filing jointly, (b) $125,000 for married individuals filing separately; and (c) over $200,000 for all other taxpayers. The dollar floor limitations are referred to as the threshold amounts in Section 1411(b). The 3.8% Medicare Tax does not apply on distributions from a plan or arrangement described in Sections 401(a), 403(a), 403(b), 408, 408A or 457(b), 8 or with respect to U.S. 5 Prop. Treas. Reg (c). See also Preamble on effective date. 6 See fn 363. See also Joint Committee on Taxation, Description of the Social Security Tax Base (JCX ) (June 21, 2011), at 24 7 Under the Federal Insurance Contributions Act or FICA, a payroll tax is imposed on employers and employees up to a maximum wage base which is adjusted for inflation each year. Currently the FICA wage base is $110,100. The FICA tax has two parts: (i) the Old-Age, Survivor and Disability Insurance portion ( OASDI ) and the Medicare Hospital Insurance portion ( HI tax ). The HI tax rate is 1.45% on both the employer and employee while the OASDI tax is 6.2% each. However, under the Tax Relief Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the employee OASDI portion was reduced to 4.2% which benefit expires at the end of See also the Middle Class Tax Relief and Job Creation Act of The FICA taxes are subject to withholding. Self employed individuals are subject to FICA taxes on net earnings from self-employment. The selfemployment tax rate is 13..3% of the wage base amount, e.g., $110,100, of applicable net earnings and 2.9% HI tax on amounts in excess of $110, (a). The 13.3% rate incorporates the 2% reduction from the 15.3% rate under the Obama legislation reducing the employee s share of FICA taxes through Net income from selfemployment does not include capital gains, rental income, dividends, interest and royalties and other forms of investment income. Under 164(f), individuals are allowed to deduct ½ of the self-employment taxes paid as an above the line expense. The HI tax is 2.9% on the entire amount of self-employment income. This deduction reduces the effective tax rate on self-employment income. Partners are not treated as employees for federal employment taxes. Rev. Rul , C.B (c)(3). 2

4 44 source income (passive) of a non-resident alien. 9 NII is comprised of passive forms of income directly realized by an individual, trust or estate or as indirectly realized through ownership of an interest in a pass through entity such as a partnership or S corporation HCERA introduced, for the first time, that investment income of a taxpayer was subject to FICA taxes, i.e., the HI type tax for Medicare contributions. The 2010 legislation also increased the Medicare portion of the self employment tax and on the HI tax by.9% to 3.8% on net income from self-employment or wages in excess of $250,000 for a married taxpayer filing a joint return, $125,000 for married taxpayers filing separate returns and more than $200,000 for other taxpayers. The New Medicare Tax Is 3.8% on Net Investment Income In Excess of the Threshold Amount Under Section 1411(c)(1)(A), NII is the sum of (i) an individual s taxpayer s gross income from interest, dividends, annuities, rents, royalties, other than income derived in the ordinary course of a trade or business, plus (ii) the amount of net gain, to the extent taken into account in computing taxable income, attributable to the sale or other taxable disposition of property other than net gain from property held in a trade or business, less the allowable deductions which are properly allocable to such income or net gain. 10 Income, including net gains from property dispositions of a trade or business is subject to the 3.8% tax if the taxpayer is over the threshold amount for the year per Section 1411(b), and provided the income as to such taxpayer is passive for purposes of Section 469 (including the regulations) or is income from a trade or business trading in financial instruments or commodities per Section 475(e)(2). In the case of an individual, Section 1411(a)(1) imposes a tax (in addition to any other tax imposed by subtitle A) for each taxable year equal to 3.8 percent of the lesser of (A) the individual's net investment income (per Prop. Reg ) for such taxable year, or (B) the excess (if any) of (i) the individual's modified adjusted gross income ( MAGI per Prop. Reg (c)) for such taxable year, over (ii) the threshold amount (per Prop. Reg (d). 11 Section 1411(b) provides that the threshold amount is: (1) in the case of a taxpayer making a joint return under Section 6013 or a surviving spouse (as defined in Section 2(a)), $250,000; (2) in the case of a married taxpayer (as defined in Section 7703) filing a separate return, $125,000; and (3) in any other case, $200,000. Section 1411(d) defines modified adjusted gross income as adjusted gross income increased by the excess of (1) the amount excluded from gross income under Section 911(a)(1), over (2) the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under Section 911(d)(6) with respect to the 9 11 See 7701(b), 1411(e)(1) and 7701(a)(31) Prop. Reg (b). 3

5 45 amount excluded from gross income under Section 911(a)(1), the foreign earned income exclusion). Example. During 2013, A, an unmarried U.S. citizen, has MAGI (per Prop. Reg (c)), which includes $50,000 of NII (per Prop. Reg ). A s Section 1411 liability for 2012 is $0 since the threshold amount (per Prop. Reg (d)(1)(iii)) for a single individual is $200,000. In 2014, A s MAGI were to increase to $220,000, which includes $50,000 of net investment income, then A would incur a Section 1411 tax of $760 (3.8 x $20,000). the individual has a Section 1411 tax of $760 (3.8 percent multiplied by $20,000). In the case of an estate or trust, Section 1411(a)(2) imposes the Medicare Contribution tax (in addition to any other tax imposed by subtitle A) for each taxable year equal to 3.8% of the lesser of (A) the estate's or trust's undistributed net investment income, or (B) the excess, if any, of the (i) the estate's or trust's adjusted gross income (as defined in Section 67(e)) for such taxable year, over (ii) the dollar amount at which the highest tax bracket in Section 1(e) begins for such taxable year. 12 Prop. Reg (b) provides generally that all references to an individual's adjusted gross income are to be treated as the same term is defined under Section 62 and references to an estate's or trust's adjusted gross income (for purposes of applying Section 1411) shall be treated as references to adjusted gross income per Section 67(e). Section 1411(c)(1) provides that net investment income means the excess (if any) of (A) the sum of (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which the tax does not apply, (ii) other gross income derived from a trade or business to which the tax applies, and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply; over (B) the deductions allowed by subtitle A which are properly allocable to such gross income or net gain. Section 1411(c)(1)(A) defines net investment income ( NII ), in part, by reference to trades or businesses described in Section 1411(c)(2). A trade or business is described in Section 1411(c)(2) if such trade or business is (A) a passive activity (within the meaning of Section 469) with respect to the taxpayer, or (B) a trade or business of trading in financial instruments or commodities (as defined in Section 475(e)(2)). Income on the investment of working capital is not treated as derived from a trade or business for purposes of Section 1411(c)(1) and is subject to tax under Section Prop. Treas. Reg (estates and trusts subject to income tax under part 1 of Subchapter J, under chapter 1 of subtitle A of the Code) (c)(3). Section 1411 does not define ordinary course of a trade or business, and the proposed regulations do not provide guidance on the meaning of ordinary course. However, other regulation Sections and case law provide guidance on whether an item of gross income is derived in the ordinary course of a trade or business. See, for example, Lilly v. Comm'r, 343 U.S. 90, 93 (1953), rev'g 188 F.2d 269 (4th Cir. 1951), aff'g 14 T.C (1950) (holding that expenses incurred regularly and arising from transactions that commonly or frequently occur in the type of business involved are ordinary ); T(c)(3)(ii) (providing rules for determining whether certain portfolio income is excluded from the definition of passive activity gross income). See Higgins v. Commissioner, 4