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The Affordable Care Act has been a hot topic for several years. We hope the following Q&A will be helpful in determining how some of the new tax laws that went into effect January 1, 2013, may impact you as a taxpayer:
Q: Okay, so cut to the chase, will this increase my taxes?
A: Maybe. If you are self-employed, the Medicare portion of your self-employment tax will increase by 0.9%, from 2.9% to 3.8%. This increase in tax is on earnings in excess of $200,000 (single) or $250,000 (married filing jointly).
Q: So what if I'm not self-employed?
A: Unfortunately, this law may still cause you to owe more tax. In addition to the 0.9% increase on self-employment earnings, "high-income households" could owe a 3.8% tax on "net investment income." To put this into perspective, the highest marginal rate increased from 35% for 2012 to 39.6% in 2013. The additional 3.8% tax further increases the marginal rate to 43.4%, resulting in a significant rate increase for certain taxpayers.
Q: Whoa, that could be a big jump in my taxes. But you gave me quite a few ambiguous terms. Can you clarify what you mean?
A: "High-income households" are taxpayers who have over $200,000 (single) or $250,000 (married filing jointly) of "modified adjusted gross income."
"Modified adjusted gross income" is line 37 on your Form 1040 (or your adjusted gross income) increased by foreign income less foreign exclusions.
"Net investment income" is the sum of interest, dividends, annuities, rents, royalties, other income derived from a passive trade or business, and net gain attributable to the disposition of property held in a passive trade or business, less deductions related to such income and gain.
You would be taxed on the lesser of your excess modified adjusted gross income over the threshold amounts or your "net investment income."
Q: Will the new tax legislation only impact individual taxpayers?
A: No, trusts and estates will also be taxed. Their additional tax liabilities are 3.8% times the lesser of undistributed net investment income or excess adjusted gross income over $11,950.
Q: Ouch, this doesn’t sound good. Is there anything I can do to avoid this tax?
A: There are several planning opportunities available, but every situation is unique. However, one thing to think about is your level of involvement in passive activities. Ensuring you meet the material participation standards to qualify as a non-passive member or shareholder of your business could reduce your ultimate tax liability.
Q: I heard there were certain rules for real estate professionals. Is that true?
A: Sort of. The recently issued final regulations provide a safe harbor for real estate professionals. If the real estate professional spends more than 500 hours on the activity, the activity will not be subject to the 3.8% tax.
Q: How many other areas would this affect?
A: Gain treatment from dispositions of partnership or S corporation interests are affected, as well as gains from installment sales, dispositions of other property (including goodwill)…the list goes on. And if that weren't enough, controlled foreign corporations and passive foreign investment companies are impacted by the tax as well. The details of this are quite complicated so be sure to ask your tax advisor if you have questions.
Q: Where can I find additional information?
A: Section 3101 of the Internal Revenue Code discusses the additional 0.9% tax on self-employment income. Section 1411 lays out the framework of the new 3.8% tax. The IRS issued final regulations for Section 1411 on November 26, 2013, and added some new proposed regulations as well. Although the IRS has issued drafts of new federal forms for the new NII, we're still waiting on final forms and instructions for the 2013 tax year.
Q: What if I am still confused?
A: We're here to help. Feel free to contact us at Delap at (503) 697-4118 or reach out to us online. As you consider year-end planning strategies, we'd be happy to help you understand the potential impact of the recent tax law changes to your personal situation.