Planning for the 3.8 Percent Medicare Tax on Investment Income PART II by Karla Hopkins

With the potential for dramatic tax increases scheduled to go into effect in 2013, 2012 tax planning becomes imperative. The following taxes may be impacted:

• Not only are the Bush Administration tax cuts set to expire, but a new 3.8 percent surtax on investment income and a possible reinstated claw-back of itemized deductions could raise the tax rate on ordinary income to as high as an effective 44.6 percent for some taxpayers.
• Similarly, the tax rate on long-term capital gains could increase from 15 percent to 20 percent and the rate on qualified dividends from 15 percent to an effective 44.6 percent.
• Finally, if Congress doesn’t take action, the federal estate tax rate will increase from 35 percent to 55 percent and the exclusion amount will drop from $5,120,000 to $1,000,000.

Planning for these likely tax changes is a major undertaking and beginning the process now is prudent because it will allow you to become comfortable with the potential for a gifting process and provide you time to custom design trusts for your family.

Gain Harvesting

For many taxpayers it will make sense to harvest capital gains in 2012 to take advantage of the current lower rates. You would sell appreciated capital assets and immediately reinvest in the same or similar assets. You would then hold the new assets until you would otherwise have sold them, so there would be no change in your investment strategy.

Deciding whether to use the strategy is not as simple as it might appear on the surface, however, because the lower tax rates must generally be weighed against a loss of tax deferral. By harvesting the gains in 2012 you would be paying a lower tax rate, but recognizing the gains earlier. The greater the differential in tax rates and the shorter the time before the second sale the more favorable gain harvesting is.

In some cases, the correct decision will be clear without doing any analysis. If you are currently in the 0% long-term capital gains bracket, 2012 gain harvesting would always be favorable because it would give you a free basis step up. Gain harvesting would also be more favorable if you planned to sell the stock in 2013 or 2014 anyway. The time value of the tax deferral would be small compared with the future tax savings.

At the other extreme, if you are currently in the 15% long-term capital gain bracket and plan to die with an asset and pass it on to heirs with a stepped-up basis, there is no reason to recognize the gain now. You would be incurring tax now without any offsetting future benefit.

Nor would it make sense to harvest losses in 2012 to create additional capital loss carryovers. These loss carryovers would be better employed to offset capital gains in the future when rates are expected to be higher.

If you do not fall into one of these categories, you will have to do a quantitative analysis to determine whether 2012 gain harvesting would work for you. The decision could be thought of as buying a future tax savings by recognizing gain in 2012. By analyzing the decision in this way, you could measure a return on the 2012 investment over time. If this return on investment exceeds your opportunity cost of capital, gain harvesting would make sense.

Planning for the 3.8 Percent Medicare Surtax

For tax years beginning January 1, 2013, the tax law imposes a 3.8 percent surtax on certain passive investment income of individuals, trusts and estates. For individuals, the amount subject to the tax is the lesser of (1) net investment income (NII) or (2) the excess of a taxpayer's modified adjusted gross income (MAGI) over an applicable threshold amount.

Net investment income includes dividends, rents, interest, passive activity income, capital gains, annuities and royalties. Specifically excluded from the definition of net investment income are self-employment income, income from an active trade or business, gain on the sale of an active interest in a partnership or S corporation, IRA or qualified plan distributions and income from charitable remainder trusts. Modified adjusted gross income is generally the amount you report on the last line of page 1, Form 1040.

The applicable threshold amounts are shown below.

Married taxpayers filing jointly $250,000
Married taxpayers filing separately $125,000
All other individual taxpayers $200,000

A simple example will illustrate how the tax is calculated.

Example: Al and Barb, married taxpayers filing jointly, have $300,000 of salary income and $100,000 of Net Investment Income. The amount subject to the surtax is the lesser of (1) Net Investment Income ($100,000) or (2) the excess of their modified adjusted gross income ($400,000) over the threshold amount ($400,000 -$250,000 = $150,000). Because Net Investment Income is the smaller amount, it is the base on which the tax is calculated. Thus, the amount subject to the tax is $100,000 and the surtax payable is $3,800 (.038 x $100,000).

Fortunately, there are a number of effective strategies that can be used to reduce Modified Adjusted Gross Income and or Net Investment Income and reduce the base on which the surtax is paid. These include (1) Roth IRA conversions, (2) tax exempt bonds, (3) tax-deferred annuities, (4) life insurance, (5) rental real estate, (6) oil and gas investments, (7) timing estate and trust distributions, (8) charitable remainder trusts, (9) installment sales and maximizing above-the-line deductions.

Accelerating Ordinary Income into 2012

Another opportunity that should be noted is accelerating ordinary income into 2012. Perhaps the best way to do this would be to convert a traditional IRA to a Roth IRA in 2012, if a conversion otherwise made sense. Ordinary income could also be accelerated by selling bonds with accrued interest in 2012 or selling and repurchasing bonds trading at a premium. Finally, you might consider exercising non-qualified stock options in 2012.

Estate Tax Provisions

The estate tax exemption is currently $5,120,000 per person and will revert to $1,000,000 on January 1st, 2013 unless Congress acts. The President is suggesting a $3,500,000 exemption. The potential reduction in the estate tax exemption is resulting in many taxpayers making large gifts, in trust, for their family. In some instances the trusts are for the spouse, children and grandchildren and in others just for children and younger generations. Most experts would define the savings at 35%, 45% or 55% of the amount gifted over $1,000,000. On a $5,000,000 gift the savings would be $1,800,000 ($4,000,000*45%).

Planning for the 3.8 Percent Medicare Tax on Investment Income PART I by Karla Hopkins

The recently enacted health care reform package imposes a new 3.8% Medicare contribution tax on the net investment income of higher-income individuals. Although the tax does not take effect until 2013, it is not too soon to understand what it means and to examine strategies to lessen the impact of the tax.

Net investment income: Net investment income, for purposes of the new 3.8% 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. Income from trading in financial instruments and commodities is subject to the tax. An individual's capital gains income will be subject to the tax. This would include gain from the sale of a vacation home.

It may be prudent to realize gains in 2012 instead of waiting until 2013.

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 of $11,200 for the highest tax bracket for trusts and estates, and to investment income they distribute. This is a very low threshold so the impact to trusts is significant.

Deductions: Net investment income for purposes of the new 3.8% 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 at a later date. 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 reduce the amount realized from an investment. You may want to consider avoiding installment sales with net capital gains (and interest) running beyond 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% 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 current administration that could take effect in 2013. The top two marginal income tax rates on individuals would rise from 33 and 35%t to 36 and 39.6%, respectively. The maximum tax rate on long-term capital gains would increase from 15 to 20%. Moreover, dividends, which are currently capped at the 15% long-term capital gain rate, would be taxed as ordinary income. Thus, the cumulative rate on capital gains would increase to 23.8% in 2013, and the rate on dividends would jump to as much as 43.4%. Because the thresholds are not indexed for inflation, 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 your tax planning must take them into account.

Exceptions: Certain items and taxpayers are not subject to the 3.8% tax. A significant exception applies to distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans. 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, such as a sole proprietorship.

Investment income from an active trade or business is also excluded.

Self-Employment tax will still apply to proprietors and partners as it has in the past.

The tax does not apply to nontaxable income, such as tax-exempt interest or veterans' benefits.

It also 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.

The first step in any tax plan is to determine if the law applies to you. The second step is to review transactions that you may be considering to determine the timing of them to avoid the increased tax and thirdly to the extent that the tax cannot be avoided, gear up to understand what it means to your cash flow for estimated income tax payment and withholdings.

NEW REPAIR AND MAINTENANCE REGULATIONS by Karla Hopkins

The IRS recently released tangible property regulations (1.263S-3(T)), commonly referred to as “repair” regulations. The significant areas of the regulations include standards for Unit of Property definitions (UOP) for real and personal property, improvements to property, and modifications to the rules or dispositions of property. The regulations provide a general framework for determining whether an expenditure is an improvement to property or a deductible repair. A taxpayer must initially determine the UOP and then apply a series of tests to determine if the expenditure is a capital improvement or deductible repair.

The regulations make the UOP smaller, especially for buildings. As a general rule, the larger the UOP, the more likely the expenditure will be a deductible repair because they are proportionately smaller compared to a larger UOP. As the UOP gets smaller, more expenditures become capital improvements to the smaller UOP.

In the case of a building, an expenditure is treated as a capital improvement if it improves the building structure or any individual “building system”. Building systems include water, electrical, heating, ventilation, air conditioning, gas, plumbing, elevators, escalators and fire protection and security systems. For example if changes are being made to an elevator, they are considered in relation to the elevator system and not the total building itself to determine whether to capitalize it.

Under the new regulations, where an expenditure is incurred on any building system, the expenditure must be assessed against the respective building system to determine whether the expenditure is a deductible repair or capital improvement.

The regulations outline three tests to determine if an expenditure for personal property results in a betterment, restoration or adaptation to a UOP that requires capitalization. Characterizing an expenditure as an improvement requiring capitalization depends on the facts and circumstances in each case. The regulations themselves contain over 150 examples of how to interpret and apply the new rules and should be referred to during the preplanning phase of any significant repair or restoration project.

PAYROLL RELATED POINTS TO CONSIDER by Karla Hopkins

Outsourcing your payroll processing:

Remember that even though you have outsourced your payroll processing, you are always responsible for the payroll taxes. Payroll taxes accumulate quickly. Therefore, take the following steps to ensure that you are within the legal line with the company that processes your payroll:

• Make sure that the payroll company is bonded
• If you have a payroll company that files all taxes and returns, make sure that you verify that the filings are being completed by logging into the federal and state websites periodically
• Do not allow a hired individual to sign your tax returns, have them prepared for your signature and filing
• Make sure that all payroll correspondence goes directly to you and not the payroll service provider
• Request a transcript of your filings from the IRS and State periodically

When paying an employee’s final wages:

When you terminate an employee you generally have to pay them their final check at the time of termination. It’s easier to write a manual check for them and reconcile it with the payroll company later than to face possible legal action from the terminated employee. If a person in Massachusetts quits on their own, they are due their wages by the next business day.