Last year ushered in many changes on the tax front resulting from the American Taxpayer Relief Act and the Patient Protection and Affordable Care Act. For family business owners, a better understanding of these tax law adjustments can help them plan accordingly.
Most successful business owners are puzzled by use of the word “relief” to describe new income tax rates. The title is especially apt with respect to transfer taxes, since it’s now possible to shift at least $5 million to the next generation free of federal transfer tax. The income tax picture, however, has become significantly more complicated.
Consider the business owner who is an employee of his business. In addition to the Medicare tax of 1.45 percent on all earned income, a new 0.9 percent Medicare surtax applies to earned income in excess of $250,000 if married filing jointly, less if single. As the business owner, he contributes a matching 1.45 percent for his and all employees’ earned income. There’s no employer contribution on the new surtax. Only if an individual’s income exceeds $200,000 is employer withholding required, despite the fact it must be paid.
Many may be surprised by the surtax this year. For example, assume Bob and Sue own and are employed by their print shop. Bob’s earned income is $180,000; Sue’s is $150,000. The 1.45 percent Medicare tax has been withheld, but Bob and Sue just received the draft of their 2013 federal income tax and noticed another $720 required for the surtax. Perhaps it’s not significant to them, but those with higher incomes will be affected more severely. The planning point: Avoid penalties by making sure overall withholding amounts are sufficient.
The other new — and more complicated — tax affects those with unearned income. The Net Investment Income Tax was signed into law under the PPACA too, but it isn’t earmarked to help the Medicare trust fund. It’s simply an additional tax on unearned income for those married filing jointly with modified adjusted gross incomes in excess of $250,000. Single filers’ threshold is $200,000. This tax will impact most successful business owners and is in addition to either ordinary income tax or capital gains tax, whichever applies.
Investment income includes capital gains, corporate dividends, rents, interest, royalties, taxable distributions from non-qualified annuities, net gain from a passive trade or business, and net gain from the business of trading financial instruments or commodities. Good news: Income from an active business is not considered for purposes of the NIIT. Pensions, IRAs and Roth IRAs are excluded. Losses are netted against gains, and the net amount is subject to an additional 3.8 percent income tax.
Consider Jane. She has a very successful insurance agency, and her husband, Ron, is a physician. Together, their employee earnings are $850,000; their net investments add $200,000 to their bottom line. Since they are over the threshold of $250,000, the Medicare surtax adds $5,400, but the NIIT adds $7,600.
1. The threshold for the Medicare surtax and the NIIT are not indexed for inflation, unlike ordinary tax brackets. As earned income and net investment income increase, more annual earned and unearned income will be exposed to the new taxes.
2. If a business owner doesn’t adjust withholding or make estimated tax payments quarterly, interest and penalties may apply in addition to the tax.
ATRA reinstated the 39.6 percent income tax bracket on married couples filing jointly whose adjusted gross income was $400,000 in 2013; this year, the inflation adjustments put that number at $457,600. Single filers will find themselves in the highest income tax bracket when their AGI is $406,750 in 2014, having been subjected to the higher bracket at $400,000 of income last year.
For taxpayers who are subject to the highest marginal rate on earned income, interest earnings are taxed at that same rate. Capital gains, which had been a mere 15 percent through 2012, are now 20 percent.
While the NIIT doesn’t apply to earnings from an active business, let’s consider Avery and Alice Abbot. They’ve operated a successful music store for the past 40 years and have just entered into an agreement to sell to a younger competitor, Zane. The agreed price is $4,780,000. The Abbotts have only a $100,000 cost basis remaining. Because they are in the highest income tax bracket, Avery and Alice will pay the 20 percent capital gains tax on $4,680,000 this year, which will amount to $936,000. The NIIT effectively turns the 20 percent capital gains tax into a 23.8 percent total, so their actual tax bill will be $1,113,840, leaving $3,666,160 to produce retirement income.
What strategies could have lessened Avery and Alice’s tax hit? There are at least two.
First, the Abbotts could have considered an installment sale. When the business is sold over time, both the payments and the tax are managed over that time period. The Abbotts would account for each payment as part recovery of their basis, part capital gain subject to the 20 percent capital gain and 3.8 percent NIIT, and the balance to interest earnings. Just as the Abbots receive payments over time, so does Uncle Sam. The risk: whether the buyer will be successful and able to continue making payments.
Second, the Abbotts could have planned ahead, created a charitable remainder unitrust, gifted their business to the CRUT, and later Zane could have bought the store from the CRUT. The Abbotts would receive income for life, which would be taxed in a fashion similar to the installment sale. Any funds remaining in the CRUT after the Abbotts are gone is paid to the charity of their choice. The greatest advantage is that 100 percent of the business value goes to work producing income for the Abbotts. Tax is paid over time, and their estate would receive a charitable estate tax deduction for the remainder of the CRUT payable to charity. Life insurance in trust is a helpful tool to replace the wealth for children that transferred to charity instead.
Lynne F Stebbins is a principal and legal consultant at Mercer H&B Executive Benefits and Private Client Life. Mercer is a wholly owned subsidiary of Marsh & McLennan Companies (NYSE: MMC), a global team of professional services companies offering clients advice and solutions in the areas of risk, strategy, and human capital. She can be reached at (212) 345-1297 or Lynne.Stebbins@mercer.com.