Although the tax law is modified each year, the types of taxes we pay remain relatively constant. These include taxes on sales, income, property, estate/gift, social security, unemployment, etc. However, beginning in 2013, there is an introduction of two new taxes, which are part of the Affordable Care Act: Net Investment Income Tax and an additional Medicare Tax on wages and self-employment income.
Net Investment Income (NII) Tax
As the name suggests, this is a tax on investment income. For the purposes of this law, investment income includes interest, dividends, capital gain, net income from rental and royalties, and income from business activities where the owner is considered to be a “passive” participant (does not materially participate in the business operations). Although this may seem straightforward, there are a number of gray areas regarding its application. The IRS has addressed many of these in regulations as well as Q & A sections on its website.
For NII tax purposes, income NOT subject to this tax includes: wages, unemployment compensation, operating income from a business that is not passive to the taxpayer, alimony, tax-exempt interest, self-employment income, and distributions from qualified retirement plans, such as IRAs.
A particularly confusing topic regarding this tax is the treatment of rental activities where those activities are treated as non passive under the passive activity rules. The current IRS position is that rental activity, which does not rise to the level of being considered a trade or business, will be included as income subject to this tax. An example of a rental activity that qualifies as a business and is therefore NOT subject to this tax, would be a taxpayer whose full-time job is managing the rental properties he or she owns.
However, the IRS appears to expect very few rentals to qualify for this exclusion. When final regulations were issued November 26, 2013, the IRS made a significant concession to taxpayers by deeming rentals to a business in which the taxpayer is a material participant to be a trade or business. The IRS also established a safe harbor for real estate professionals where the rentals will be a trade or business if the taxpayer spends more than 500 hours on the rental activities.
The NII tax is assessed at a 3.8 percent rate and is applied to the lesser of (1) net investment income, or (2) the excess of modified adjusted gross income for the year over a threshold amount. These applicable thresholds are $250,000 for married taxpayers filing a joint return or a qualified surviving spouse, $125,000 for a married taxpayer filing a separate return, and $200,000 for anyone else. Therefore, for this tax to affect you, you must have a certain level of income and net investment income included in that amount.
So what are some strategies that could be used to lessen this new tax for you? In addition to taking your rental to the level of a business, or increasing your participation in other activities to avoid the “passive” taint, you can shift the mix of your investments to assets that produce income not subject to the tax (i.e. municipal bonds, annuities, or life insurance).
Another strategy could be to smooth out income from year-to-year in order to stay under the gross income threshold mentioned above in order to avoid spikes in any one year that could make you subject to the tax. If you are planning to sell your stock in a closely held C corporation, arranging the financing of the sale as an installment sale (to be received over a number of years) may be a tax planning tool.
Additional Medicare Tax
Wages and/or self-employment income in excess of the same thresholds as the NII tax will be taxed at a 0.9 percent rate. This tax is more straightforward and tax planning more difficult. However, one possibility is for taxpayers to plan ahead to defer income such as bonuses and remain under the income thresholds.
The problem is that the definition of wages for the calculation of this tax is “Medicare Wages” which makes 401(k) deferrals still subject to this tax and tax will be imposed on deferred compensation when the income vests to the employee. A tax adviser can help you understand how the wage base is determined.
Employers also are required to withhold this tax when wages for the year exceed $200,000. If the withholding exceeds the actual tax owed, or vice versa, the difference is resolved on the employee’s tax return.
These new taxes clearly add to the complexity of the federal tax system and require consideration from both businesses and individuals. As with any complex issue, you should consider seeking help from a tax adviser familiar with the applicable law.