The package of US health care reform laws imposes new taxes starting in 2013. These are not part of the so-called “fiscal cliff”. A solution to the “fiscal cliff” will probably not affect the taxes discussed in this article.
Part 1 – 3.8% Surtax On Certain Amounts and Kinds of Unearned Income
This new tax is found in new Internal Revenue Code sec. 1411. It was enacted as part of the “Health Care and Education Reconciliation Act of 2010” (PL 111-152, 3/30/10)
This is a new surtax on certain amounts and kinds of unearned income.
If “modified” AGI exceeds the “threshold amount”, which is either:
For married filing jointly – $250,000
For married filing separately – $125,000
For single individuals – $200,000
then, there is a flat surtax of 3.8% on the smaller of “Net Investment Income” (a new concept), or, the excess of “modified” AGI minus the threshold amount.[Special variant for estates and most non-charitable irrevocable trusts:
In the case of estates and most non-charitable irrevocable trusts, if regular AGI as normally computed for estates and trusts exceeds the estate or trust threshold amount
For estates and most non-charitable irrevocable trusts – the beginning dollar amount for the highest tax bracket (for 2013 possibly $11,351)
then, there is a flat surtax of 3.8% on the smaller of “Net Investment Income” that is trapped inside the estate or trust and hasn’t been distributed to beneficiaries or the excess of AGI as normally computed for estates and trusts minus the threshold amount for estates and trusts. In the end, estates and non-charitable irrevocable trusts are treated more harshly if they haven’t distributed out almost all of their Net Investment Income.
Many estates and trusts try to, and are even written to require, retaining capital gains for the remaindermen. The effect may be to penalize most estates and trusts that continue to operate in this way.]
“Modified” AGI is regular AGI modified to include the taxpayer’s net foreign earned income (if the taxpayer has any). Most individuals will not have worked abroad and will not have net foreign earned income; so, most individuals will just use regularly computed AGI.
AGI (Code sec. 62) is, essentially, gross income minus…
- various trade and business expense deductions,
- losses from the sale or exchange of property,
- deduction for alimony payments,
- deduction for self-employed or partner contributions to retirement plans,
- deduction for self-employed or partner payments for health insurance or health savings accounts,
- deduction for certain contributions to IRAs,
- deduction for moving expenses, and
- certain other tax-favored deductions.
Note that AGI excludes income that, itself, is excluded from “gross income” – e.g., tax exempt municipal bond income, Roth IRA distributions, unemployment insurance benefits, veterans benefits, parsonage rental allowance, etc.
(For a sense of adjusted gross income, see the 2012 US personal income tax return (Form 1040) at line 37 and above.)
“Net Investment Income” is a new concept. It includes –
- dividends, interest, capital gain distributions from mutual funds,
- net rental income unless derived from a business in which the taxpayer-recipient materially participates in performing work,
- net royalty income unless derived from a business in which the taxpayer-recipient materially participates in performing work,
- net capital gain from the sale of 2nd, 3rd, etc. homes,
- the amount of capital gain above what is excluded from income upon the sale of the principal residence,
- net gain from the sale of investments (stocks, bonds, mutual funds, ETFs),
- net gain from the sale of assets that are not active business assets (e.g., net gain from the sale of raw land held for investment),
- net income from investments in partnerships (including LLCs treated as partnerships) and S corporations in which the taxpayer-recipient does not materially participate in performing work,
- if a passive investment in a partnership (or LLC) or S corporation is sold the net gain as if the passive assets inside the entity had been sold individually and their gain allocated to the taxpayer,
- interest/dividends/capital gain distributions received by a child (under age 18 or under age 24 if a full-time student) that the parent elects under the Kiddie Tax rules to take on the parent’s own income tax return (Form 8814).
What’s not included in Net Investment Income – among other things:
- distributions from qualified retirement plans of all kinds,
- distributions from IRAs (regular and Roth),
- self-employment income subject to Medicare tax as a sole proprietor, partner or member of an LLC that is treated as a partnership,
- income from a partnership, LLC treated as a partnership or S corporation if the payee taxpayer materially participates in conducting the entity’s business,
- compensation for services paid by an employer that is not owned by the payee taxpayer,
- Social Security.
- Items that are excluded from “gross income” – e.g., tax exempt municipal bond income, unemployment insurance benefits, veterans benefits, parsonage rental allowance, etc.
Exception to the Exceptions: If a taxpayer is a sole proprietor, partner, member of an LLC treated as a partnership, or stockholder of an S corporation and if the business is the trading of financial instruments or commodities, then, all net income to the taxpayer from the business is included in Net Investment Income, whether or not the taxpayer materially participates in conducting the business.
Subtracted from Investment Income to reach Net Investment Income –
state and local taxes allocable to investment income,
investment advisory fees,
expenses related to rental and royalty income,
interest payments related to the purchase of investment assets.
in general, expenses that are properly allocable to the acquisition and management of investments.
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Example, involving sale of a principal residence. Assume that the taxpayer files a joint income tax return with spouse. His basis in his principal residence is $600,000 and he sells it for $1,400,000. Taxpayer’s and spouse’s other Net Investment Income (apart from gain on sale of principal residence) is $100,000. Taxpayer’s and spouse’s (modified) AGI is $425,000.
Gain from sale of principal residence in excess of exclusion: $1,400,000 – basis of $600,000 – exclusion of $500,000 for married filing jointly = $300,000.
Net Investment Income = other Investment Income $100,000 + gain from principal residence sale that exceeds exclusion $300,000 = $400,000
3.8% surtax is computed on the lesser of Net Investment Income ($400,000) or the excess of (modified) AGI over Threshold Amount ($425,000 – $250,000 = $175,000).
3.8% x $175,000 = $6,650.
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The new surtax is also subject to payment by means of estimated taxes. Therefore, if the taxpayer is using the safe harbor of 100% of the current year’s income tax, for 2013 the safe harbor will be 100% of the regular income tax + 100% of the new surtax. If, in 2014, the taxpayer is using the safe harbor of 90% of the previous year’s income tax, for 2014 the safe harbor will be 90% of the sum of the regular income tax + new surtax in 2013. Additional W-2 withholding can also be used to cover the new surtax.
Part 2 – 9/10 of 1% Medicare Surtax
The Patient Protection and Affordable Care Act of 2010 (PPACA, PL 111-148), has added a 0.9% (90 basis points) medicare surtax, in addition to the regular medicare tax, on employee wages and self employment income in excess of the following thresholds:
For single individuals – employer-paid earned income above $200,000
For married individuals filing jointly – employer-paid earned income above $250,000
For married individuals filing separately – employer-paid earned income above $125,000
The “regular” medicare tax (employee’s share, only) below these thresholds remains at 1.45%.
Thus, the combined medicare tax (employee’s share) above the thresholds is 2.35%.
The new medicare tax is imposed only on the employee (or self-employed worker). The “employer’s share” (even for self-employed workers) is not affected.
Like all FICA taxes, the medicare surtax is to be withheld by the employer and deposited with the IRS as part of the employer’s regular employment tax withholding and deposits.
However, the employer must begin withholding the medicare surtax once the employee’s “wages” for medicare tax purposes exceeds $200,000 – even if later, when the employee figures out his taxes, he may end up not owing the medicare surtax. (For example, assume the employee is married and files a joint return with his spouse, the employee’s own “wages” are $205,000 and his spouse’s “wages” are $40,000, so that combined “wages” total only $245,000. Although the joint return “wages” are less than the $250,000 threshold for married taxpayers filing jointly and although, for the year, no medicare surtax is actually due, nevertheless, the employee’s employer must begin withholding the medicare surtax once the employee’s wages exceed $200,000. In that case, the excess withholding is available to be applied against any income tax shortfall for the year or to be refunded).
There is a corresponding medicare surtax on the self-employment income of sole proprietors, partners, and members of LLCs that are treated as partnerships – also for self-employment income above the same thresholds.
Note that the allocable share of all partner and LLC member income – even if not distributed to the partner or member – is considered “self-employment” income for medicare tax purposes. That is not true for S corporation shareholders, who are not subject to self-employment tax.
It is possible for the same individual to be subject to both the 3.8% surtax on Net Investment Income and, also, the medicare surtax, but they will be imposed on different kinds of income.
Example. Assume taxpayer “A” is married and he and his spouse (“B”) file a joint income tax return. “A” is employed and earns $250,000 per year; and “B” is employed and earns $175,000 per year. At the same time, the couples’ modified adjusted gross income = $500,000 and their Net Investment Income = $75,000. In that case, $175,000 of the couples’ “wages” (A’s wages of $250,000 + B’s wages of $175,000 – $250,000 threshhold = $175,000) would be subject to the 90 basis point medicare surtax ($175,000 x .009 = $1,575). Also, the excess of their modified adjusted gross income over their threshold amount ($500,000 – $250,000 = $250,000) or, if less, their Net Investment Income ($75,000) would be subject to the 3.8% surtax ($75,000 x 3.8% = $2,850). The taxpayer’s employer should have begun the medicare surtax withholding when the taxpayer’s “wages” exceeded $200,000. The balance of the medicare surtax could have been funded by additional withholding. The 3.8% surtax could have been funded by additional estimated taxes and/or additional withholding.
CAUTION – It is not possible to “earmark” additional requested withholding to the medicare surtax. Rather, additional withholding will be allocated among the taxpayer’s US tax liabilities in general for the tax year. Hopefully, the taxpayer will have made a sufficiently accurate projection of tax liabilities to be able to cover anticipated medicare surtax (as well as the 3.8% surtax on Net Investment Income).]
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The IRS has issued helpful and detailed “Q&A’s” about the two new surtaxes. These are appended to this article.
This Article is intended only to provide generalized information. It is not intended to provide information or advice with respect to specific situations. To address real life, specific situations you should obtain appropriate professional assistance.
Under the rules of the Supreme Judicial Court of Massachusetts this Article may be considered attorney advertising.