Monthly Archives: January 2013

Planning for the 3.8% Medicare Tax on Investment Income

The health care reform package (the Patient Protection and Affordable Care Act and the Health Care and education Reconciliation Act of 2010) imposes a new 3.8% Medicare contribution tax on the investment income of higher-income individuals. Although the tax does not take effect until 2013, it is not too soon to examine methods to lessen the impact of the tax.

Net investment income. Net investment income, for purposes of the new 3.8 percent Medicare tax, includes interest, dividends, annuities, royalties and rents and other gross income attributable to a passive activity. Gains from the sale of property that is not used in an active business and income from the investment of working capital are treated as investment income as well. However, the tax does not apply to nontaxable income, such as tax-exempt interest or veterans’ benefits. Further, an individual’s capital gains income will be subject to the tax. This includes gain from the sale of a principal residence, unless the gain is excluded from income under Code Sec. 121, and gains from the sale of a vacation home. However, contemplated sales made before 2013 would avoid the tax.

The tax applies to estates and trusts, on the lesser of undistributed net income or the excess of the trust/estate adjusted gross income (AGI) over the threshold amount ($11,200) for the highest tax bracket for trusts and estates, and to investment income they distribute.

Deductions. Net investment income for purposes of the new 3.8 percent tax is gross income or net gain, reduced by deductions that are “properly allocable” to the income or gain. This is a key term that the Treasury Department expects to address in guidance, and which we will update you on developments. For passively-managed real property, allocable expenses will still include depreciation and operating expenses. Indirect expenses such as tax preparation fees may also qualify.

For capital gain property, this formula puts a premium on keeping tabs on amounts that increase your property’s basis. It also puts the focus on investment expenses that may reduce net gains: interest on loans to purchase investments, investment counsel and advice, and fees to collect income. Other costs, such as brokers’ fees, may increase basis or reduce the amount realized from an investment. As such, you may want to consider avoiding installment sales with net capital gains (and interest) running past 2012.

Thresholds and impact. The tax applies to the lesser of net investment income or modified AGI above $200,000 for individuals and heads of household, $250,000 for joint filers and surviving spouses, and $125,000 for married filing separately. MAGI is AGI increased by foreign earned income otherwise excluded under Code Sec. 911; MAGI is the same as AGI for someone who does not work overseas.

Example. Jim, a single individual, has modified AGI of $220,000 and net investment income of $40,000. The tax applies to the lesser of (i) net investment income ($40,000) or (ii) modified AGI ($220,000) over the threshold amount for an individual ($200,000), or $20,000. The tax is 3.8 percent of $20,000, or $760. In this case, the tax is not applied to the entire $40,000 of investment income.

The tax can have a substantial impact if you have income above the specified thresholds. Also, don’t forget that, in addition to the tax on investment income, you may also face other tax increases proposed by the Obama administration that could take effect in 2013. The top two marginal income tax rates on individuals would rise from 33 and 35 percent to 36 and 39.6 percent, respectively. The maximum tax rate on long-term capital gains would increase from 15 percent to 20 percent. Moreover, dividends, which are currently capped at the 15 percent long-term capital gain rate, would be taxed as ordinary income. Thus, the cumulative rate on capital gains would increase to 23.8 percent in 2013, and the rate on dividends would jump to as much as 43.4 percent. Moreover, the thresholds are not indexed for inflation, so a greater number of taxpayers may be affected as time elapses. Congress may step in and change these rate increases, but the possibility of rates going up for upper income taxpayers is sufficiently real that tax planning must take them into account.

Exceptions. Certain items and taxpayers are not subject to the 3.8 percent tax. A significant exception applies to distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans. At the present time, however, there is no exception for distributions from nonqualified deferred compensation plans subject to Code Sec. 409A, although some experts claim that not carving out such an exception was a Congressional oversight that should be rectified by an amendment to the law before 2013.

The exception for distributions from retirement plans suggests that potentially taxed investors may want to shift wages and investments to retirement plans such as 401(k) plans, 403(b) annuities, and IRAs, or to 409B Roth accounts. Increasing contributions will reduce income and may help you stay below the applicable thresholds. Small business owners may want to set up retirement plans, especially 401(k) plans, if they have not yet established a plan, and should consider increasing their contributions to existing plans.

Another exception covers income ordinarily derived from a trade or business that is not a passive activity under Code Sec. 469, such as a sole proprietorship. Investment income from an active trade or business is also excluded. However, SECA (Self-Employment Contributions Act) tax will still apply to proprietors and partners. Income from trading in financial instruments and commodities is also subject to the tax. The tax does not apply to income from the sale of an interest in a partnership or S corporation, to the extent that gain of the entity’s property would be from an active trade or business. The tax also does not apply to business entities (such as corporations and limited liability companies), nonresident aliens (NRAs), charitable trusts that are tax-exempt, and charitable remainder trusts that are nontaxable under Code Sec. 664.

Please contact our office at (630) 665-4440 if you would like to discuss the tax consequences to your investments of the new 3.8 percent Medicare tax on investment income.

The Impact of the 2012 American Taxpayer Relief Act on You

The tax side of the “Fiscal Cliff” has been averted. The American Taxpayer Relief Act allows the Bush-era tax rates to sunset after 2012 for individuals with incomes over $400,000 and families with incomes over $450,000; permanently “patches” the alternative minimum tax (AMT); revives many now-expired tax extenders, including the research tax credit and the American Opportunity Tax Credit; and provides for a maximum estate tax of 40 percent with a $5 million exclusion. The bill also delays the mandatory across-the-board spending cuts known as sequestration.

The Act is nowhere close to the grand bargain as envisioned by the President and many lawmakers after the November elections. Effectively, it is a stop-gap measure to prevent the onus of the expiration of the Bush-era tax cuts from falling on middle income taxpayers. Congress must still address sequestration. Congress is likely to revisit tax policy and spending cuts when it tackles the expected increase on the nation’s debt limit in February. Slowing the growth of entitlements, such as through a “chained-CPI” is certain to be a controversial topic in upcoming debates.

The devil is in the details and we are still going through the new law carefully, but here are the major tax provisions:

• Individuals with incomes above the $450,000/$400,000 thresholds ($450,000 for joint filers; $425,000 for heads of household) will pay more in taxes because their tax rate rises to 39.6 percent income tax rate and a 20 percent maximum capital gains tax;

• All taxpayers will find less in their paycheck in 2013 because the Act did not extend the 2012 payroll tax holiday that had reduced social security taxes from 6.2 percent to 4.2 percent on earned income up to the wage base ceiling ($113,700 for 2013);

Marriage Penalty Relief
• The Act extends all existing marriage penalty relief;

Permanent AMT Relief
• The new law “patches” the Alternative Minimum Tax (AMT) for 2012 and subsequent years by increasing the exemption amounts and allowing nonrefundable personal credits to the full amount of the individual’s regular tax and AMT. Additionally, the Act provides for an annual inflation adjustment to the exemption amounts for years beginning after 2012. The legislation permanently increases the exemption amounts to $50,600 for single filers, $78,750 for joint filers and $39,375 for married taxpayers filing separately;

Capital Gains/Dividends Sunsets
• Dividends and long-term capital gains are taxed at 20% for individuals making over $400,000 ($450,000 for joint returns);

Personal Exemption Phase-Out
• The personal exemption phase-out is reinstated with a starting threshold of $300,000 for joint filers and a surviving spouse, $275,000 for heads of household, $250,000 for single filers, and $150,000 for married taxpayers filing separately. Under the phase-out, the total amount of exemptions that can be claimed by a taxpayer subject to the limitation is reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer’s adjusted gross income (AGI) exceeds the applicable threshold;

Itemized Deduction Phase-Out
• The itemized deduction phase-out is reinstated with a threshold of $300,000 for joint filers and a surviving spouse, $275,000 for heads of household, $250,000 for single filers, and $150,000 for married taxpayers filing separately. Under this phase-out, the total amount of itemized deductions is reduced by 3% of the amount by which the taxpayer’s AGI exceeds the threshold amount, with the reduction not to exceed 80% of the otherwise allowable itemized deductions;

Mortgage Insurance Premiums
• This provision treats mortgage insurance premiums as deductible interest that is qualified residence interest. The Act extends this provision through December 31, 2013.

State and Local Sales Tax Deduction
• The Act extends through 2013 the election to claim an itemized deduction for state and local general sales taxes in lieu of state and local income taxes;

Earned Income Credit
• The Act makes permanent or extends through 2017 enhancements to the earned income credit (EIC) in Bush-era and subsequent legislation.

Child Care Credit
• The Act extends permanently the $1,000 child tax credit. Certain enhancements to the credit under Bush-era legislation and subsequent legislation are also made permanent;

Adoption Credit/Assistance
•The Act extends permanently Bush-era enhancements to the adoption credit and the income exclusion for employer-paid or reimbursed adoption expenses up to $10,000 (indexed for inflation) both for non-special needs adoptions and special needs adoptions;

Child And Dependent Care Credit
• The Act extends permanently Bush-era enhancements to the child and dependent care credit. The current 35 percent credit rate is made permanent along with the $3,000 cap on expenses for one qualifying individual and the $6,000 cap on expenses for two or more qualifying individual;.

Employer-Provided Child Care Credit
• The Act extends permanently the Bush-era credit for employer-provided child care facilities and services;

American Opportunity Tax Credit
• The Act extends through 2017 the American Opportunity Tax Credit (AOTC). The AOTC is an enhanced, but temporary, version of the permanent HOPE education tax credit;

Deduction For Qualified Tuition And Related Expenses
• The Act extends until December 31, 2013 the above-the-line deduction for qualified tuition and related expenses. The bill also extends the deduction retroactively for the 2012 tax year;

Student Loan Interest Deduction
• The Act extends permanently suspension of the 60-month rule for the $2,500 above-the-line student loan interest deduction. The Act also expands the modified adjusted gross income range for phaseout of the deduction permanently and repeals the restriction that makes voluntary payments of interest nondeductible permanently;

Coverdell Education Savings Accounts
• The Act extends permanently Bush-era enhancements to Coverdell education savings accounts (Coverdell ESAs). These enhancements include a $2,000 maximum contribution amount and treatment of elementary and secondary school expenses as well as postsecondary expenses as qualified expenditures;

Employer-Provided Education Assistance
• The Act extends permanently the exclusion from income and employment taxes of employer-provided education assistance up to $5,250;

Teachers’ Classroom Expense Deduction
• The Act extends through 2013 the teacher’s classroom expense deduction. The deduction, which expired after 2011, allows primary and secondary education professionals to deduct (above-the-line) qualified expenses up to $250 paid out-of-pocket during the year;

Exclusion Of Cancellation Of Indebtedness On Principal Residence
• Cancellation of indebtedness income is includible in income, unless a particular exclusion applies. This provision excludes from income cancellation of mortgage debt on a principal residence of up $2 million. The Act extends the provision for one year, through 2013;

IRA Distributions to Charity
• The new law extends for two years, through December 31, 2013, the provision allowing tax-free distributions from individual retirement accounts to public charities, by individuals age 70 & 1/2 or older, up to a maximum of $100,000 per taxpayer per year;

Energy Credits For Individuals
• The credit is available to individuals who make energy efficiency improvements to their existing residence. The lifetime credit limit is $500 ($200 for windows and skylights) under the 2010 tax bill. The Act extends the credit at the $500 level through December 31, 2013;
• The Act permanently extends the inflation adjusted $5 million exemption for estate, gift, and generation-skipping transfer tax purposes. The top estate, gift and GST rate is increased from 35% to 40%;

• The new law makes permanent “portability” between spouses. Under the portability rules, the estate of a decedent who is survived by a spouse can elect to apply any unused exclusion amount to the surviving spouse’s own transfers during life and at death.  The portability provision was made permanent by this legislation;

State Death Tax Credit/Deduction
• The Act extends the deduction for state estate taxes;
Payroll Taxes
• The payroll tax holiday for the Social Security tax was allowed to expire. Consequently, the employee-share of social security taxes reverts back to 6.2% (from 4.2%);

Bonus Depreciation
• The Act extends 50 percent bonus depreciation through 2013. Some transportation and longer period production property is eligible for 50 percent bonus depreciation through 2014.  It now generally applies to property placed in service before January 1, 2014 (January 1, 2015, for certain property with longer production periods);

Section 179 Small Business Expensing
• The Act extends through 2013 enhanced Section 179 small business expensing. The Section 179 dollar limit for tax years 2012 and 2013 is $500,000 with a $2 million investment limit.  Before the Act, expensing limit was set at $139,000.  The rule allowing off-the shelf computer software is also extended;

Research Tax Credit
• The Act extends through 2013 the research tax credit, which expired after 2011. The incentive rewards taxpayers that engage in qualified research activities with a tax credit;

Work Opportunity Tax Credit
• The Act extends through 2013 the Work Opportunity Tax Credit (WOTC), which rewards employers that hire individuals from targeted groups with a tax credit;

Qualified Leasehold/Retail Improvements, Restaurant Property
• The Act extends through 2013 the 15-year recovery period for qualified leasehold improvements, qualified retail improvements and qualified restaurant property;

Energy tax incentives extended by the Act through 2013, include:
▪ Credit for energy-efficient new homes;
▪ Credit for energy-efficient appliances;

More Business Tax Extenders
A number of other business tax extenders expired after 2011 and they are extended through 2013 under the new law.

They include, among others:
▪ 100 percent exclusion for gain on sale of qualified small business stock;
▪ Reduced recognition period for S corporation built-in gains tax;
▪ Enhanced deduction for charitable contributions of food inventory;
▪ S corporations making charitable donations of property;

Not extended. Certain business provisions were not extended by the Act. These include:
▪ Enhanced deduction for corporate charitable contributions of book inventory;
▪ Enhanced deduction for corporate charitable contributions of computers.

Rest assured as we meet with you to discuss your 2012 taxes, we will outline more specifically how the new tax law will impact you directly.  If you have questions, please give us a call at (630) 665-4440.

Update on the Healthcare Reform Law

Beyond the current discussions in Washington concerning the fiscal cliff, taxes and government spending are going to be on the agenda in Washington throughout 2013. Where does that leave health care reform, the legislation passed in 2010 overhauling the health care system in this country?

Here’s a quick update that covers provisions in the health care legislation that have already gone into effect and those that, absent any changes made in the coming months, will go into effect in 2013 and thereafter.
The following provisions have already taken effect:

• A 10% tax is assessed on indoor tanning services.
• Small businesses with fewer than 25 full-time employees may qualify for a tax credit for the cost of purchasing health insurance for their employees.
• Children can remain on their parents’ insurance policies up to age 26. Private lending for student loans is replaced with loans directly from the federal government, cutting loan fees.
• A 50% discount on brand-name drugs for those with Medicare drug coverage helps to offset costs  in the “donut hole.”
• Over-the-counter medications can no longer be paid for with funds in health savings accounts (HSAs), flexible spending accounts (FSAs), and health reimbursement accounts (HRAs).
• The additional tax on nonqualified distributions from health savings accounts (HSAs) increases from 10% to 20%.
The provisions that will take effect in 2013 include the following:

FSA limits
• The amount that can be contributed to a health flexible spending account (FSA) is limited to $2,500 per year, indexed annually for inflation.
Medical expense deduction
• The 7.5% income threshold for deducting unreimbursed medical expenses increases to 10% for those under age 65. Those 65 and older may continue to take an itemized deduction for medical expenses exceeding 7.5% of adjusted gross income through the year 2016.

Executive pay limit
• The compensation deduction for certain health insurance companies is limited to $500,000 per year for high-level executives.

Medicare tax increase
• The payroll Medicare tax will increase from 1.45% of wages to 2.35% on amounts above $200,000 earned by individuals and above $250,000 earned by married couples filing joint returns. The income threshold levels are not indexed for inflation.
• A new 3.8% Medicare tax will be imposed on unearned income for single taxpayers with income over $200,000 and married couples with income over $250,000. Examples of unearned income: interest, dividends, royalties, rental income.

Medical device tax
• A 2.3% excise tax is imposed on the sale of certain medical devices.
Provisions scheduled to take effect in years after 2013 include the following:

Coverage required starting in 2014
• Individuals who are not covered by Medicare, Medicaid, or other government health insurance are generally required to maintain health insurance coverage or pay a penalty. Penalties are calculated using a percentage of the taxpayer’s income or a flat dollar amount. Subsidies and tax credits are available to help lower-income taxpayers pay for coverage.
• Health insurance exchanges are established by states to enable people to comparison shop for coverage.
• Large employers generally must provide coverage for employees or face penalties.
• Tax credits increase from 35% to a maximum 50% of premiums paid by qualifying small businesses that provide coverage for their workers. The credit available to nonprofit employers increases from 25% to 35%.

Health industry fee in 2014
• An annual fee is assessed on the health insurance industry, starting at $8 billion in 2014 and increasing over the following years.

Tax on “Cadillac plans” in 2018
• Insurance companies will be assessed a 40% excise tax on health insurance plans with annual premiums exceeding $10,200 for individual coverage and $27,500 for family coverage. An increase in the threshold amount is allowed for retired persons who are age 55 or older (an additional $1,650 for single coverage and $3,450 for family coverage). These increased thresholds also apply for plans that cover those engaged in high-risk occupations.
Certain provisions in the original health reform legislation have already been changed or repealed. For example, the law originally required Form 1099 reporting for payments over $600 made to corporations. That requirement has been repealed, and reporting is again generally required only for payments over $600 made to unincorporated businesses.

Congress may amend or repeal provisions in the health care reform law, either before their scheduled effective date or retroactively. Or the law may survive largely intact. Clearly, the massive law will affect every taxpayer. For guidance in your individual and business tax planning under the often-complicated health reform legislation, contact our office.

Post Election Tax Planning

President Obama has been re-elected and the potential for continued gridlock between the House of Representatives and the Senate is as prevalent as before the election.  This results in considerable uncertainty for taxpayers with respect to their income and estate tax planning.

Income Tax
On the income tax side, the significant increases in rates already programmed into the law for January 1st may actually occur. This could be a significant burden upon single individuals who earn more than $200,000 per year and married couples who earn more than $250,000 per year.

The scheduled income tax increases include a highest bracket of 39.6% instead of the present 35%, an increase in the capital gains tax rate from 15% to 20%, taxing dividends as ordinary income and a new 3.8% tax on interest, dividends, net rent, and other passive income to the extent that the taxpayer has total earnings exceeding the $200,000 and $250,000 thresholds.

Actions To Consider Before Year-end
Income tax planning steps that might be worth considering include the following:
• Analyzing when to take deductions and losses. Although the general rule of thumb is to accelerate tax deductions and losses, because of the possible tax rate rise, the opposite approach might sometimes be advisable. Thus, many taxpayers will benefit from deferring income tax deductions and losses until 2013 when higher marginal tax rates will make these deductions and losses more valuable. But it’s not automatic. If restrictions on specific deductions are enacted, then it may only prove worthwhile deferring deductions that themselves are not restricted or eliminated. The reinstatement of the 3% AGI phase out of itemized deductions may make many deductions of little or no value next year regardless of changes in marginal tax rates.
• If rates will be higher next year, then accelerating capital gains into 2012 will prove advantageous. This could avoid the income tax at higher rates in 2013 as well as the Medicare surtax. Avoiding the increase in long-term capital gains and the health care surtax by harvesting gains this year will sound appealing, but it will not always prove advantageous. You must evaluate the trade-off between paying lower taxes and the loss of tax deferral by trigging the gain.
• Bonus depreciation and Section 179 deductions are important to consider as you plan asset acquisitions near year end. If you buy a new car should you buy it now or in January 2013 when income tax rates are higher and you may qualify for a Section 179 deduction?
• If you can get paid this year the income may be taxed at a lower rate than next year.

Estate Tax
In the estate tax arena the chips are even higher, as the present $5,120,000 gifting and estate tax exemptions would drop to $1,000,000 on January 1!  This is why many clients have been working with us to make gifts exceeding $1,000,000 make use of all or part of the $5,120,000 temporary gifting allowance, an opportunity which may never exist again.  In addition to this, the estate tax rate, which is now only 35%, would go up to 55%!

Many clients have a concern that if they gift too much away they could run out of assets.  Popular solutions to this have been (1) have a spouse as a beneficiary of the trust and assume that as long as the spouse is alive the donor can derive indirect benefit by being supported by the spouse while the spouse is being supported by the trust, and (2) forming the trust in an asset protection jurisdiction, since the IRS has ruled in at least one case that the contributor can be a discretionary beneficiary and actually receive the benefit of trust assets if and when needed.

Another option is to consider putting an irrevocable trust into place that can hold assets that would not be subject to federal estate tax, but would be considered as owned by the grantor for income tax purposes.  This is because two very important estate and gift tax provisions that presently exist for these trusts would be eliminated if President

Obama’s February 2012 budget suggestions are adopted, which are as follows:
1. Presently the grantor can pay the tax on dividends, interest and other income earned by such a trust, which accelerates the growth of the assets that would pass free of estate tax.
Under President Obama’s proposal, this type of trust would be subject to estate tax on the death of the grantor.  Trusts existing before the end of this year probably would be grandfathered.  The effect of paying the income tax on trust earnings and selling assets or discounted family interests to the trust in exchange for a low interest note has an incredible mathematical value.

2. Presently this type of trust can be used to avoid estate tax not only at the grantor’s level, but also at the level of generations of descendants going for as long as 360 years if the trust is formed in Florida.

President Obama’s proposal would limit this “generation skipping dynasty” trust effect to 90 years.

In addition, many clients are selling family business ownership interests to these types of trusts before year-end because we can presently value non-voting or minority interests in family entities using discounts.  President Obama’s 2012 budget proposal would eliminate discounts.

The Republican House of Representatives may be able to resist having some of these new restrictive estate tax provisions enacted, but what will the trade-off be for raising the estate tax exemption above $1,000,000 per taxpayer?  President Obama’s February 2012 budget called for a $3,500,000 per taxpayer estate tax exemption but did not address the gifting exemption.  Since many wealthy individuals have probably used their $5,120,000 gifting exemption in 2011 and 2012, we may not see significant resistance to allowing the gift tax exemption to go down to $1,000,000.

So what are people to do between now and December 31, 2012?

If In Doubt Gift It Out! – Many clients with a net worth in the $2,000,000 to $4,000,000 range have stopped annual gifting in the hopes that the $5,120,000 exemption will continue.  Since that now seems highly unlikely, it may be a good idea to complete normal 2012 year end gifts to make maximum use of the $13,000 per person annual exclusion.

Also, remember that the Obama budget proposals would largely curtail grantor retained annuity trust planning by requiring a minimum 10 year term and a positive remainder interest.

Hopefully, there will be a political compromise with respect to both income and estate taxes between now and year-end. But most experts believe that this will likely not be sorted out until 2013, with the compromise to be retroactive to January 1, 2013.

Please contact us if you have any questions or if we can be of assistance between now and year end.