Additional Medicare taxes went into effect Jan. 1, 2013, for high-income earners, but many may not consider these taxes until they start filing their 2013 returns — and writing the checks.
“You want to take the time to go through this now, and lay the groundwork, because the decisions you make will have ramifications for next year,” says Chris Paris, regional tax leader of the Greater Bay Area at Moss Adams LLP.
“We’re spending a considerable amount of time dealing with this. People are asking: How is this going to impact us? Is there anything we can do to structure around it?”
Smart Business spoke with Paris about the impact of these taxes and what you need to know.
What are the new Medicare surtaxes?
The Unearned Income Medicare Contributions Tax (UIMCT) is a 3.8 percent tax on net investment income for higher income individuals. The other surtax is a 0.9 percent tax increase on wages and self-employment earnings for higher income individuals, for a combined employer/employee tax rate of 3.8 percent.
The taxes are designed to help cover about half the cost of the Patient Protection and Affordable Care Act, passed in 2010.
How does the IRS define higher income individuals?
Both taxes apply to individuals that meet an income threshold of $200,000 or more, or those married and filing jointly that meet a threshold of $250,000 or more.
If a taxpayer earns wages in excess of $200,000, his or her employer is required to withhold the 0.9 percent, in addition to the 2.9 percent previously taken out (1.45 percent for the employer and 1.45 percent for the employee). However, the 3.8 percent on net investment income is a new type of tax that may take some by surprise.
What’s so unusual about the UIMCT?
This is the first time the government has taxed net investment income to pay for the cost of Medicare. Net investment income includes interest income, dividends, royalties, rental income, and income flowing through passive investments like private equity funds, hedge funds and venture capital funds.
Rental income is going to be a big factor because many higher income earners own a lot of real estate, don’t qualify as real estate professionals and will be subject to this tax. It also could impact middle market companies where the owner of the business owns the real estate, although there may be ways of grouping activities together to reduce the impact of the tax. Further guidance regarding these issues is anticipated in the final version of the tax regulations.
How can those affected by these taxes plan?
First, be cognizant of the fact that it’s happening, so you can factor it into your 2013 tax planning. Estimated taxes are usually based on what you owed the prior year, so your figures may now be too low.
Secondly, you can potentially reduce the impact of the UIMCT by recharacterizing passive income subject to the 3.8 percent tax to ‘Trade or Business’ income, which is not subject to the surtax. For example, an individual who owns multiple businesses or rental properties may be able to group the multiple activities into a single activity by making an election pursuant to Revenue Procedure 2010-13. However, the activities must also rise to the level of a trade or business, a requirement that currently lacks clarity in the proposed regulations. Further guidance may be provided when the final tax regulations are released. The grouping election is particularly attractive if you haven’t filed your 2012 extended return because you can put the IRS on notice now to be in a better position to potentially reduce the UIMCT next year.
Questions also remain about whether certain people qualify as a real estate professional — whose rental income may not be subject to the UIMCT— which is another reason to reach out to your advisers now.
In addition, it may be time to discuss choice of entity, how you operate your business. An LLC with two active owners in the maximum tax bracket could be looking at a combined 43.4 percent federal tax rate on income, whereas a C corporation has a maximum tax rate of 35 percent. However, any dividends from the C corporation would also be taxed, hence there could be double taxation. Further, tax consequences alone may not be enough of a reason to switch, and exit alternatives such as asset sales need to be considered.
Some taxpayers are exploring alternative investments, such as tax-exempt interest income like municipal securities, non-dividend paying equities in certain rapid growth companies, tax-deferred annuities and investments, as well as considering capital gain planning, loss harvesting, installment sales and more.
Whatever strategy you decide to undertake to help control what you pay, don’t wait to plan — or you may not have the most desirable result.
Chris Paris is Regional tax leader, Greater Bay Area, at Moss Adams. Reach him at (415) 677-8352 or firstname.lastname@example.org.
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