Individuals and trusts that will be subject to U.S. federal income tax in 2013 are facing a challenge remarkably similar to that of the protagonist in The Lady, or the Tiger, Frank Stockton’s famous 1882 short story. In the story, the hero must choose between two unmarked doors; behind one is a beautiful bride and behind the other is a hungry tiger. He has been offered some clues, but these clues as easily could be false as helpful. So it is for individuals and trusts attempting to structure their affairs in a tax-efficient manner at this time. The tax environment for 2013 is in a state of flux, and taxpayers cannot be certain whether their choice will result in tax savings or additional tax being paid. This Alert summarizes what can be said for certain, what issues are still open and some possible outcomes. And while we cannot predict the legislative conclusions, we will do our best to provide helpful clues.
As described in detail below, without additional action on the part of Congress and President Obama (or the next administration), in 2013, Social Security permanent tax increases will become effective and marginal federal income tax rates will increase significantly. Both of these events suggest that taxpayers may desire to accelerate taxable income in 2012. The benefits of any such acceleration transactions, however, must be weighed against the possibility of changes in the law.
I. What’s On the Books Now
We’ll begin with the Social Security tax changes. On June 28, 2012, the United States Supreme Court upheld the constitutionality of President Obama’s signature piece of legislation, the Patient Protection and Affordable Care Act, which was enacted on March 23, 2010 (Pub. L. No. 111-148) in combination with the Health Care and Education Reconciliation Act of 2010 (Pub. L. No. 111-152) (together, the “Health Care Act”) by a 5-4 majority decision. The Supreme Court decision clears the way for the implementation of the legislation.
The Health Care Act significantly changes Social Security tax obligations beginning in 2013.1 Approximately $210 billion towards funding the Health Care Act will be borne by higher income individuals, largely from taxes imposed through the Medicare Payroll Taxes and with an additional Social Security tax on “net investment income” (defined later). Revenues will also result from new limitations on individual taxpayers with respect to tax-advantaged accounts (such as flexible spending and health savings accounts) and on the itemized deduction used to pay for health care expenses.2
A. The ‘Payroll’ Taxes
The Health Care Act introduced two Payroll Taxes, but this is a misnomer because, for the first time, Social Security taxes are being imposed on income other than wages. Specifically, beginning in 2013, a new 3.8% Medicare Contribution Tax on “unearned income” (the “MC Tax”)3 and an additional 0.9% FICA Hospital Insurance Payroll Tax on “high earners”(the “HI Tax”) will be imposed.4
1. The 3.8% Medicare Contribution Tax on Unearned Income
The tax burden imposed on capital gains will become heavier by 3.8% as a result of the MC Tax pursuant to the Health Care Act.5 The term “net investment income” generally includes interest, dividends, annuities, royalties, rents, capital gains, passive activity income (as defined in Section 469 of the Internal Revenue Code of 1986, as amended (the “Code”)), and income from trading in financial instruments or commodities (as defined in Code § 475(e)(2)), minus allowable deductions that are properly allocable to the relevant income or gain.6 The MC Tax is NOT deductible as an expense from the individual’s federal income tax liability. Gain from a disposition of an interest in a partnership or an S corporation constitutes “net investment income” to the extent of the net gain that is attributed to the entity’s nonbusiness property.7 Conversely, net gain or loss attributable to property held by the entity that is attributable to an active trade or business, in which the taxpayer actively participated, is not taken into account in computing net investment income.
The MC Tax will be imposed only on taxpayers with specified levels of income. In the case of an individual, the tax will be imposed on the lesser of (a) the net investment income or (b) the excess of modified adjusted gross income (“MAGI”) over the threshold amount.8 The threshold amount is (i) $250,000 in the case of a couple filing joint return or in the case of a surviving spouse; (ii) $125,000 in the case of married individuals filing separate tax returns; and (iii) $200,000 for other taxpayers. Taxpayers who have net investment income, but whose MAGI is below these thresholds, will not be subject to the MC Tax on unearned income. In addition, taxpayers with income higher than these thresholds but with no net investment income (either because they had no gross income of the types described above or if the allocable deductions exceed the gross income) will not be subject to the MC Tax.
The MC Tax also applies to estates and trusts. The application, however, is different than for individuals. In the case of an estate or trust, the tax is imposed at the same rate of 3.8% on the lesser of (a) undistributed net investment income or (b) the excess of adjusted gross income over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins ($388,350 for trusts and estates in 2012).
Example 1: Simple Computation
A married couple’s MAGI is $400,000 for the year 2013, and they also have a total of $100,000 of net investment income. In this case, the MC Tax is imposed on the net investment income; therefore, the MC Tax liability in this case will be:
3.8% x $100,000 = $3,800
If, however, the couple has $200,000 of net investment income, the MC Tax will be imposed on the excess of the couple’s MAGI over the applicable threshold; therefore, the MC Tax liability will be:
3.8% x ($400,000 - $250,000) = $5,700
Many items of income are included in both MAGI and net investment income. Specifically, capital gains, dividends, interest and certain types of passive business activity income will be included in both. As a result, taxpayers with such items of income and whose MAGI is beyond the above thresholds may suffer increased tax liability as a result of the new MC Tax in 2013 and thereafter.
Example 2: Application of the MC Tax to Capital Gains
For the couple in Example 1, any sale of a capital asset will result in the imposition of the 3.8% of the MC Tax. Specifically, if they sold stock that they held as a capital asset during 2013 for a gain of $100,000 (and this is their only net investment income item), the capital gain will be taxed at 20% (if the 15% maximum tax rate is not extended), and their MAGI will also go up to $500,000. The highest capital gains rate will effectively increase in 2013 by another 1.2% as a result of the return in 2013 of the phase-out of itemized deductions for high-income earners for an additional tax liability of $1,200.9 The MC Tax liability will be 3.8% x $100,000 = $3,800.
As a result, the couple will have a total tax liability of $25,000 (25.0%) from the sale in 2013, as opposed to a tax liability of $15,000 (15.0%) if they were to sell the stock before December 31, 2012.
Sales of homes with gain that exceeds the current $500,000 one-time exemption (for married couples filing jointly) will also be included in both MAGI and net investment income, which will result in the same MC Tax.10 Thus, if the above couple sells their home for $800,000 and their basis is lower than $300,000, the excess of the gain beyond $500,000 will be subject to the double tax. Obviously, if the selling couple is not eligible for the $500,000 exemption, the entire gain will be counted towards the MAGI and net investment income and the results will be the same as above.
Example 3: Application of the MC Tax to Qualified Dividends
The impact of the MC Tax combined with the expiration of the 2003 tax rate cuts on qualified dividends will be significant.11 Assume that instead of capital gains of $100,000, the couple from Example 1 receives a qualified dividend of $100,000 in 2013 and (i) the qualified dividend income rules are not extended and (ii) the top marginal ordinary rates go back up to 39.6%. In addition, as noted above, the highest marginal income tax rate will effectively increase to 40.8% due to the return in 2013 of the phase-out of itemized deductions for high-income earners. In 2013, the $100,000 dividend will be taxed as ordinary income and the couple will pay up to $40,800 in federal income tax, and $3,800 of MC Tax, for a total of $44,600 (44.6%), as opposed to $15,000 in total tax if the dividend is distributed before December 31, 2012. Thus, dividends may be taxed at almost three times more than the 2012 rate. Considering that the tax on dividends is added to the corporate tax imposed on the corporate income (35%), shareholders with income exceeding the above thresholds may be subject to an effective rate of 63.99%, starting in 2013.
It is worth noting that if the dividend is paid before December 31, 2012, to the extent that the dividend constitutes qualified dividend income, any subsequent loss on the sale of the stock will be treated as a long-term capital loss.
Example 4: Application of the MC Tax to Interest
If instead of qualified dividends of $100,000, the couple receives interest income of $100,000 in 2013, and the top marginal ordinary rates go back up to 39.6% (plus the 1.2% resulting from the phase-out of itemized deductions), the interest will be taxed as ordinary income and the couple will pay $40,800 in federal income tax, and $3,800 of MC Tax, for a total of $44,600 (44.6%), as opposed to $35,000 in total tax if the interest is taxed before December 31, 2012. One important exception from the definition of “net investment income” is for interest on tax-exempt bonds. Thus, such exemption from federal income tax will become more valuable because it will not be included in either MAGI or “net investment income” for purposes of the MC Tax.
2. The 0.9% HI Tax on Excess Earnings
Beginning in 2013, the tax burden on individuals is increased by an additional payroll tax of 0.9% on wages received in excess of (i) $250,000 in the case of a married couples filing jointly; (ii) $125,000 in the case of a married individual filing a separate return; and (iii) $200,000 in any other case. This tax is added to the existing 1.45% Medicare tax on earnings below these thresholds.12 Thus, the payroll tax imposed on employees will increase from 1.45% to 2.35% for wage earners with income over the threshold amounts. In the case of a joint return, the additional tax is on the combined wages of the employee and the employee's spouse.13 As opposed to the Social Security Payroll Taxes that apply only up to a ceiling amount, there is no cap for Medicare Payroll Taxes, the result of which is that for taxpayers with significantly high wages, the combined 2.35% rate will be significant. In addition, the above threshold amounts will not be indexed for inflation. As a result, more and more taxpayers will be subject to this increased rate in the near future.
Example 5: Computation of the HI Tax
Assuming that the $400,000 earned by the couple from Example 1 now is solely from wages. The couple does not have any “net investment income.” Thus, this couple will not be subject to the 3.8% MC Tax. However, they will be paying 1.45% x 250,000 = $3,625 on their income below the threshold and another 2.35% x 150,000 = $3,525 on the income above the threshold, for a total Medicare Tax of $7,150.
3. Possibility of Repeal
It is unclear what will happen following the November elections. Both parties have expressed either support for the legislation or outright opposition to the Health Care Act. The difficulty in determining how this issue will be resolved rests with the elections and the challenges of the United States federal budget as well as how to make changes in the law without increasing the federal debt.
B. Expiration of President Bush’s Tax Cuts
There is a long list of tax breaks that may or may not be extended this year. First, beginning in 2013, itemized deductions again will be phased out under Code § 68 by the lesser of 3% of adjusted gross income and 80% of the amount of itemized deductions.14 Second, the top rate on long-term capital gains (currently at 15%) will increase to 20%. Third, since 2003, “qualified dividends” (defined later) were taxed at rates similar to long-term capital gains, but absent an extension, such preferred rates will expire and dividends will be taxed again as ordinary income (which could be up to 44.6%, if the current maximum rate of 35% is not extended).15 The combination of the new Payroll Taxes (discussed above) with higher income tax rates for capital gains and ordinary income will have a significant impact on many U.S. taxpayers.
There is a significant possibility that the current rate structure will be extended, at least through the end of 2013. Both President Obama and Speaker of the House John Boehner have stated they are looking at such a course of action. As of the writing of this Alert, however, it cannot be said with any degree of certainty as to whether the Bush tax cuts will be extended. It is also possible that the Bush tax cuts will expire at the end of 2012 and be reinstated in early 2013, possibly retroactive to January 1, 2013.
II. Summary Chart
|Current Top Marginal Income Tax Rates||2013 Top Marginal Income Tax Rates||2013 Additional Payroll Taxes||2013 Additional Taxes from Reinstatement of Limitations on Itemized Deduction||2013 Top Combined Marginal Rate||Change (%) Between Current And 2013 Rate16|
|Long Term Capital Gain||15%||20%||3.8%||1.2%||25%||66.7%|
|Interest, Rents, Royalties, etc.||35%||39.6%||3.8%||1.2%||44.6%||27.4%|
|Wages (Including Payroll Tax)||36.45%||41.05%||0.9%||1.2%||43.15%||18.33%|
III. How to Prepare this Year for 2013?
Taxpayers whose marginal rates are expected to be at the top brackets (and obviously with income that will exceed the threshold MAGI for both the MC and HI Taxes) will be mostly affected and would be advised to prepare. There are planning techniques available to taxpayers to mitigate the impost of both the higher effective rates and the new payroll taxes.
A. Recognition of Capital Gains in 2012
To the extent that a taxpayer is holding an appreciated capital asset with significant built-in gain, the taxpayer may desire to assess whether to engage in transactions to trigger the built-in gain before December 31, 2012. In addition to traditional investment type capital assets, this includes (i) owners of closely-held equity interests in an entity that has a built-in gain, and (ii) home owners with a built-in gain above the exemption threshold that are considering selling and moving to a different home.
In addition, taxpayers with an open naked short position with a built-in long term capital gain (i.e., because the price of the underlying asset has dropped) should assess whether to close the short position at a gain this year. Furthermore, if a taxpayer holds a position in a derivative (i.e., forwards, options, futures or notional principal contracts) in which the underlying asset is capital, and the taxpayer currently has a built-in gain in the position, to the extent the contract allows for an early termination (and not so many derivative contracts allow for an early termination), the taxpayer is advised to consider actual or constructive terminations of such positions before December 31, 2012. Leveraged employee stock ownership plans (ESOPs) also provide opportunities to manage capital gains. In conclusion, taxpayers should consider dispositions of any positions with a built-in capital gain that can be disposed this year.17
B. Acceleration of Qualified Dividends Paid by Closely Held Business
To the extent that individual shareholders of closely held corporations are able to control payments of dividends during 2012, and assuming the corporation has sufficient earnings and profits to pay a dividend, it is advised for such shareholders to consider causing the corporation to pay the dividend before December 31, 2012, because the effective rate on dividends may almost triple in 2013.
To effect a dividend payment in 2012, the closely held corporation may also redeem shares of stock held by the owner in a transaction that is treated as a dividend. A stock redemption is taxed as a dividend if the proportionate ownership of the shareholder is not reduced. Leveraged recapitalizations, which enable the entity to make qualified dividend distributions this year; leveraged ESOPs and note dividends also provide opportunities to accelerate dividends.
C. Special Treatment for Extraordinary Dividends
Code § 1059 imposes special basis adjustment rules on investments in stock held by corporations. This rule has been extended to qualified dividend income. Under the extraordinary dividend rule applicable to individuals, if “extraordinary dividends” are received with respect to such stock, any gain or loss on the sale or exchange of the related shares will, to the extent of such dividends, be treated as long-term capital loss (rather than short-term).18 Extraordinary dividends for this purpose are generally defined as dividends in excess of ten percent of the holder’s adjusted basis in common stock (five percent on preferred stock), subject to special aggregation rules included in Code § 1059(c).
Generally, all dividends paid during an 85-day period (based on ex-dividend dates) must be aggregated in making the determination of whether the dividend is extraordinary. However, if dividends paid during a one-year period exceed 20% of a shareholder’s basis, then all of the dividends paid during such period must be aggregated and the applicable percentage for determining whether all such dividends are extraordinary is twenty percent rather than ten percent.19
The application of the extraordinary dividend rules to qualified dividend income is a non-event if the shares have already been held for more than one year. Careful planning will be required, however, if the shares have not been held for this length of time.
Beginning in 2013, the couple from Example 1 would have a 43.15% effective marginal tax rate (40.8% income tax plus 2.35% HI Tax) on wages, 44.6% on dividends and interest (40.8% income tax plus 3.8% MC Tax), and 25.0% on capital gains (21.2% capital gain tax plus 3.8% MC Tax). One important observation is that earning passive income will become less attractive in comparison with a trade or business income, as the additional burden of the MC tax will be felt on the former. Thus, taxpayers with closely held businesses should do everything possible to ensure that they satisfy the material participation test. When the taxpayer materially participates in a business, the income is treated as active business income and not as taxable investment income subject to the new 3.8% MC Tax.
Many individuals and trusts will be affected by these tax hikes, and the number of affected taxpayers will increase over the years. There are many actions, such as those discussed herein, that taxpayers can take this year to reduce the burden.
ï1 According to the Joint Committee on Taxation, the Act’s revenue generators are projected to increase federal revenues by about $ 392 billion over 10 years.
2The revenue raisers borne by health insurers, plan administrators and health companies in the form of taxes and fees are not covered in this article.
3Code § 1411; The Joint Committee on Taxation estimates that the 3.8% MC Tax will raise $123 billion over a 10-year period. This, it is expected to raise almost one tenth of the total revenues to support the Health Care Bill.
4FICA stands for the Federal Insurance Contribution Act. According to the Joint Committee on Taxation , the 0.9% HI Tax is projected to raise $ 86.8 billion over a 10-year period.
5Code § 1411(a)(1).
6Net investment income will not include tax-exempt interest and distributions made by qualified pension, profit-sharing, and stock bonus plans, qualified annuity plans, annuities purchased by Code 501(c)(3) organizations or public schools, individual retirement accounts, Roth individual retirement accounts, and eligible deferred compensation plans.
7Code § 1411(c)(4)(A). A similar rule applies to a loss from a disposition of an interest in a partnership or S corporation. See Code § 1411(c)(4)(B).
8Code § 1411(d). For most individuals, MAGI will be their adjusted gross income unless they are U.S. citizens or residents living abroad and have foreign earned income.
9In accordance with Code § 68, itemized deductions must be reduced by a specified percentage of the amount by which adjusted gross income (AGI) exceeds a specified threshold. This reduction does not apply for the tax year 2012 but, unless such a relief is extended, will return in 2013. The reduction in 2013 will equal the lesser of (i) 3% of that excess AGI over the threshold or (ii) 80% of the itemized deductions (e.g., charitable contributions).
10Gains from the sale of a home up to $250,000 for single taxpayers and $500,000 for married couples filing jointly are excluded from income tax if the taxpayer has lived in the house for at least two out of five and has owned the house, also for two out of five years. This exclusion can be used every two years.
11Currently, an individual's “qualified dividend” income is taxed at the same rates that apply to net capital gain, subject to several limitations and restrictions. The dividend must be payable by either a U.S. corporation or a foreign corporation from certain listed treaty jurisdictions. For common stock, the shareholder must hold the stock for at least 61 days unhedged, which holding period should begin 60 days before ex-dividend date (holding period must be longer for preferred stock paying dividends attributable to periods of more than 366 days).
12Currently, employers and employees each pay a payroll tax of 1.45% (for a total of 2.9%) to finance Medicare Hospital Insurance. This rate will continue to apply to taxpayers whose income does not meet the threshold.
13The additional HI Tax will be withheld by the employer in the same way as other Payroll taxes are withheld. Married employees will have to make the determination as to their combined wages with their spouses.
14Code § 68.
15Ordinary income is currently taxed at a top marginal income tax rate of 35%, which will rise to 39.6% (with an additional bracket at 36%) in 2013. We have added the 3.8% MC Tax and 1.2% “stealth” tax resulting from the itemized deduction limitation to get to the rate shown in text.
16The ratio of the 2013 combined rate to the current rate.
17We note that the taxpayer can immediately repurchase the asset because the “wash sale” rules do not apply to gains, only to losses.
18Code § 1(h)(11)(D)(iii).
19The shareholder may elect to use the share’s fair market value as of the day before the applicable ex-dividend date instead of the adjusted basis for determining whether the threshold is met. Fair market value is based on the closing price of the stock the day before the ex-dividend date.