PFS Planning Update Planning for the Net Investment Income Tax, also known as the Medicare Contribution Tax

Transcription

1 PFS Planning Update Personal Financial Services Planning for the Net Investment Income Tax, also known as the Medicare Contribution Tax Local disclaimer and copyright statements go here

2 Introduction The Patient Protection and Affordable Care Act (sometimes referred to as Obamacare) and The Health Care and Education Reconciliation Act of 2010 came with new taxes for higher income taxpayers. The legislation and corresponding taxes were recently upheld by the Supreme Court. Although the new taxes were enacted to alleviate the Medicare system's financial difficulties, they also represent a revenue-raiser to help offset the cost of health care legislation. One new tax takes the form of a 3.8% tax on various types of investment income received by individuals, trusts and estates (unearned income). This Net Investment Income Tax or NIIT (sometimes called the Medicare Contribution Tax), will be applied to net investment income in excess of certain thresholds. The other new tax represents a 0.9% tax added to the Medicare tax currently applied to earned income, i.e. employee compensation and self-employed earnings. This surtax increases the existing 1.45% employee Medicare tax to 2.35% and the 2.9% self-employed Medicare tax to 3.8% on compensation or self-employment income above certain thresholds. Neither surtax applies to distributions from qualified retirement plans or IRAs. Net Investment Income Tax (Medicare Contribution Tax) Overview The 3.8% Net Investment Income Tax (NIIT) applies to the lesser of (1) net investment income or (2) the excess of a taxpayer's modified adjusted gross income (MAGI) over an applicable threshold amount. The threshold amount for single taxpayers is $200,000 and for married taxpayers filing jointly is $250,000. For married individuals filing separately, the threshold is $125,000. The increased tax applies to trust income in excess of about $12,000 (where the maximum tax rate begins). Net investment income is gross investment income less deductions allocable to that income. Investment income includes interest, dividends, annuity income, royalties, rents, and capital gains from portfolio investments. Capital gains from the sale of a primary residence will be subject to NIIT but only for that portion of the gain above the existing exclusion. Capital gains associated with an asset used in a business are not included in the definition of investment income. Yet to be determined are what investment deductions can be used to determine Net Investment Income. Normally, investment related deductions are itemized deductions, and are subject to a number of thresholds and limits for regular income tax purposes. Separate limits apply to investment interest. Whether these investment-related thresholds and limits will also apply to the NIIT calculation, as well as the mechanical details associated with that process, have yet to be worked out. Certain types of income are excluded from the definition of net investment income: Self-employment income (subject to the 0.9% Medicare supplement tax) Active trade or business income (including sales of the business entity itself) Distributions from qualified retirement plans or IRAs Interest on municipal bonds Excludable portion of gain on primary residence sale The active trade or business income exclusion does not apply to "income, gain, or loss on working capital," which is characterized as net investment income. PwC Page 2 of 6

3 Application to Pass-through Entities Earnings from pass-through business entities such as partnerships, LLCs, and S Corporations are reported on Schedule K-1 and are broken into component parts. The earnings at the business level retain their character as they are passed through to the shareholders or partners. It is not uncommon for a Schedule K-1 to have both business activity income and investment income. Different lines on the Schedule K-1 are earmarked for business activity income, while others are earmarked for investment related income (known as portfolio income). A specific line on the partnership Schedule K-1 reports earnings subject to self-employment tax. The NIIT applies to trade or business income that is from a "passive activity" under the passive activity rules of Internal Revenue Code section 469 (and related regulations). The NIIT also applies to income, gain, or loss associated with working capital. The NIIT does apply to trade or business income from trading financial instruments or commodities. The NIIT does not apply to trade or business income that is categorized as "material participation" income, aka not passive income. The practical issue for business earnings will be whether the NIIT categories will correspond with the existing business vs. portfolio categories on Schedule K-1. That would be the simple approach. Another approach would be to expand on the "income, gain, or loss on working capital" language in the statute and recharacterize some trade or business income from line 1 of Schedule K-1 to net investment income. One extreme change might be to create a new line on Schedule K-1 labeled "NIIT working capital investment income". The connection between NIIT and passive activities will also mean revisiting all the passive activity planning done in prior years. Often the prior planning objective was to be a "passive" activity for income generating operations, but be a material participation activity for loss generating operations. S Corporation Nuances Shareholder wage earnings are reported on Form W-2 and would be subject to the additional 0.9% Medicare tax. Material participation trade or business income from the S Corporation should not be subject to either the 3.8% NIIT or the self-employment tax (including the enhanced Medicare tax) under current rules. Passive trade or business income from the S Corporation would be subject to the 3.8% NIIT. Note that S Corporation earnings on "working capital" will be subject to the NIIT regardless (aka portfolio income). Partnership Nuances Many different legal forms of businesses file as partnerships, including, but not limited to, general partnerships, limited partnerships, limited liability partnerships, and limited liability companies. The special complication for partnerships is the distinction between material participation trade or business income and income subject to selfemployment tax. The application of the self-employment tax to the earnings of partnerships with limited liability features is not entirely clear (especially LLCs and LLPs). The IRS issued proposed regulations in but was forced to withdraw them by Congress. The central issue is whether all material participation trade or business income is also subject to the self-employment tax or whether some material participation trade or business income will escape both the 3.8% NIIT as well as the enhanced Medicare tax (similar to an S Corporation). This has been an area of uncertainty for many years. Passive Activity Rules The passive activity rules are murky and have been a battleground for years. The temporary regulations provide a series of material participation tests to determine a "passive" activity. Limited partners were originally categorized based on liability features associated with the business form but recent proposed changes would shift the focus to management activity. The multiple types of organizations and liability/management features associated with state law application have posed a significant challenge in applying the passive activity rules. The new 3.8% NIIT makes this even more important. An individual's classification as "passive" can change from year to year depending on the material participation tests. Further, activities can be grouped together for purposes of the material participation testing. Unless facts and circumstances change, activity grouping cannot be modified from year to year without IRS approval. PwC Page 3 of 6

4 Application to Rental Property The NIIT applies to rental income that is not associated with a trade or business. The trade or business category is most likely reserved for "real estate professionals" who can meet enhanced material participation standards and escape the "passive" activity classification. However, it isn't entirely clear whether it is possible to have a passive rental activity that isn't subject to NIIT by having normal material participation levels rather than the enhanced material participation real estate professional standard. Application to Trusts The NIIT applies to trusts as well as individuals. Income tax planning for trusts has usually focused on rate differentials between the beneficiaries and the trust. Trusts reach the highest tax bracket at about $12,000. The additional NIIT will place a greater emphasis on the tax bracket differential between the trust and beneficiaries. Income tax planning would suggest that income be distributed to beneficiaries in order to avoid the application of NIIT at the trust level. However, basic trust accounting rules will prevent most capital gains from being distributed out of the trust. Another issue for a trustee is the shifting of the income tax burden to the beneficiary and what additional costs or coordination issues are created. Many trusts are created for minor children. Often, the trust will pay tax on the earnings each year in order to keep the funds out of the hands of the child until later in life. Beginning in 2013, the trustee may choose to distribute trust income to the beneficiary in order to escape the NIIT. This may create a filing requirement for the minor child (where none existed before). The cost to prepare and file a child's return (and associated "kiddie tax" complications) may be greater than the NIIT savings. Further, many trusts are designed to preserve assets for generations and avoid estate taxes. Paying current year income to a beneficiary may save current NIIT, but may cause the assets to be subject to estate taxes as the income is accumulated and reinvested by the beneficiary in his or her own accounts. Finally, the application of the passive activity loss rules to trusts has been the subject of some disagreement. Whether to examine the activities of the trustee alone (the IRS position) or whether the activities of the beneficiaries must also be considered (a court position) is the debate. Material participation at the trust level should avoid the NIIT. Employee Medicare Surtax Currently, the Medicare tax is 2.9% of all earned income. Employees pay 1.45% of this tax, and employers also pay 1.45% of this tax. Self-employed individuals pay the entire 2.9%,but receive an income tax deduction for 1/2 of the tax. Beginning in 2013, the employee portion of this tax will be increased by 0.9%. Therefore, employees will have to pay 2.35% tax on their earnings, while self-employed individuals will have to pay 3.8% tax on their net selfemployment income. The deduction for self-employed individuals will not be increased by the additional 0.9% enhanced Medicare tax. The surtax only applies to earned income over $200,000 for single individuals and $250,000 for married couples filing a joint income tax return. This means that payroll providers must be alert for wages over the thresholds and begin to collect the surtax. Employees with multiple jobs and working couples create additional complexity. Further guidance on how to collect the enhanced Medicare tax in such cases is need. PwC Page 4 of 6

5 Planning for the New Taxes Many of the implementation details associated with the new taxes have yet to be determined. Additional guidance is particularly important to partnership investments of all types. Planning thoughts might include the following. Reacquaint yourself with the passive activity loss rules - Revisiting business activities and the business form (partnership or corporation) will be critical beginning in The categorizing of activities should be analyzed during 2012 and correctly grouped on the 2012 income tax filings. Note that individuals must now provide a statement concerning the grouping of activities with their tax return if the facts and circumstances change, if there are new activities, if there are new groupings, or if the prior grouping was incorrect. Prior to 2010, the grouping of activities was difficult to monitor since there was no statement required with the return. Further, recent changes to the passive activity rules make it especially important to review activities and groupings. Finally, it is possible that the S Corporation will replace the LLC as the business form of choice. Maximize contributions to your retirement plans (including after-tax IRAs) - Contributions to retirement plans provide tax-deferred earnings and distributions from retirement plans are not subject to the new 3.8% NIIT. While distributions are not directly subject to NIIT they are included in determining whether the NIIT threshold has been exceeded. Consider investing in municipal bonds - Municipal bond interest is exempt from both the federal income tax and the new 3.8% NIIT. The popularity of municipal bond investments may increase as a result and have an impact on borrowing costs for municipalities. Annuities and life insurance - Both these investments produce tax deferred earnings. Higher tax rates make them more attractive. Plan to hear more about insurance products in the years to come. Taxable distributions from the annuity or life policy would be subject to the 3.8% NIIT. Trigger portfolio long-term capital gains before It may make sense to trigger capital gains in 2012 ahead of the 3.8% NIIT if the securities might be sold in the next few years. This financial comparison also depends on the potential increase in long-term capital gain rates. Plan appropriately with a trust - The 3.8% NIIT will be a significant issue for trusts and trustees. Trustees need to begin learning about the beneficiaries' income levels and start the "distribute or retain" decision making process in advance of Trustees are especially vulnerable because saving income taxes is only one of many competing considerations associated with distribution decisions. Trusts with business activities should develop a strategy for classification as a material participation activity. Consider a charitable remainder trust - A Charitable Remainder Trust (CRT) has long been a favorite way to deal with highly appreciated property. The CRT pays an annual amount to the grantor/creator with the remainder passing to charity at the end of the trust. The 3.8% NIIT does not apply to investment income or gains by the CRT because it is exempt from tax. If a taxpayer contributed appreciated capital gain property to a CRT, the trust could sell the property and reinvest the proceeds without paying any 3.8% NIIT. Consider oil & gas investments - Depending on how the investment is structured, oil & gas investments can be categorized as passive or material participation activities. Oil & gas investments often produce losses in the early years (during the drilling phase), which can be passive activities (in limited partnership form). Income from that oil & gas investment would then produce passive income subject to the 3.8% NIIT. On the other hand, direct investment in working interests are not passive activities, which means no limit on passive losses in early years, but income subject to self-employment tax in later years. Employee deferred compensation plans - Deferring salary or bonus will not provide any escape from the enhanced Medicare tax. Medicare tax is imposed when the funds are earned even if those funds are deferred for payment later. PwC Page 5 of 6

6 Conclusion The 3.8% NIIT creates a new tax on certain types of income for those with income above the $250,000 (joint) and $200,000 (single) thresholds ($12,000 for trusts). Its application to normal investment or portfolio income is relatively clear. Further guidance is required for S Corporations and for entities treated as partnerships. The coordination of the 3.8% NIIT with the passive activity loss rules increases the impact of the "passive" category and should cause a reexamination of the planning around these activities. Business owners of all kinds need to begin examining the business form and their involvement in business activities. The enhanced 0.9% Medicare tax on employees and self-employed individuals will pose reporting and collection challenges for employers and the IRS. The ability to manage compensation and self-employment tax will be a factor in determining whether to choose the S Corporation or LLC form of operation PricewaterhouseCoopers LLP. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. PwC Page 6 of 6