A lump of coal may show up in some stockings this holiday season. This lump of coal is part of the funding mechanism for the Affordable Care Act or, as it has become known, Obamacare. Final regulations for this were issued the week of Thanksgiving. Many were preoccupied with the healthcare.gov website issues and the Thanksgiving holiday to take much notice.
The funding mechanism that is the lump of coal is the Medicare Net Investment Income Tax or the NII. This is intended to tax certain income of taxpayers that earn high amounts of investment or passive income. In the past, the Medicare tax was only a wage-based tax tied to the social security wage base (this was changed in 1993, when the Medicare wage base was decoupled from the social security wage base). With the adoption of Obamacare, certain revenue raisers were enacted, which included the medical device excise tax, the penalty for not purchasing health insurance, and an additional Medicare tax (.9 percent) on certain high-wage or self-employed earners.
The NII tax rate is 3.8 percent. This is in addition to any regular tax or alternative minimum tax liability a taxpayer may already be subject to. The NII tax is assessed on income earned for tax years beginning Jan. 1, 2013 (and after) and is imposed on the lesser of modified adjusted gross income over $250,000 for taxpayers filing a joint return or on the amount of net investment income.
Net investment income includes three major groups of income, including unearned income, passive activity income and net gain from disposition of property. Unearned income includes interest, dividends, royalties and most rents. Passive activity income includes any income in which the shareholder, partner, or owner of the business activity is not a material participant in the business activity. The net gains category includes gains related to dispositions of property in the unearned income and passive activity categories.
This tax will surprise many if it has not been considered in estimated tax payments for 2013. The tax will add to the top ordinary income marginal tax rate of 39.6 percent or the long-term capital gains and qualified dividend rate. The combination of the additional NII tax with the higher ordinary income tax brackets imposed under the American and Taxpayer Relief Act results in a potential combined marginal tax rate of 43.4 percent for many high income taxpayers. State income taxes also increase the tax burden to taxpayers.
An example of the impact can be illustrated in an example. A taxpayer in the highest marginal tax bracket with $10,000 of rental income will pay $3,960 of income tax (39.6 percent marginal ordinary income tax rate) and an additional $380 of addition NII tax (using the 3.8 percent rate), for a total tax of $4,340 in 2013. In 2012, this same $10,000 rental income would have been assessed $3,500 income tax (35 percent marginal tax rate). The rate differential between 2012 and 2013 represents an 8.4 percent increase in tax rates and a nearly 25 percent increase in actual cash taxes paid.
For portfolio income items (dividends, interest, etc.), there is likely not much a taxpayer can do in the remaining days of 2012. However, if a taxpayer receives pass-through income form a trade or business activity, there may be some opportunities.
A taxpayer who believes he/she is active should keep documentation of the hours and the type of activities carried out for the business and take steps to ensure the documentation is complete, accurate and readily available. Also note that any time spent in an “investor role” does not count for the hours test as active, as the IRS considers these activities not related to managing or operating the business activity.
If you participate in several business activities, you may have the option of treating those different activities as a single group. By grouping or aggregating your activities, you can count any hours spent carrying out the business of the group for the 500-hour rule, instead of trying to reach the 500-hour threshold on an entity-by-entity basis.
If a taxpayer participates in several business activities, taxpayers may have the ability of treating the different business activities as a single group of related activities. Many taxpayers may operate several business activities as separate legal entities for legal and other commercial purposes. By grouping or aggregating the several activities, a taxpayer can count any hours spent carrying out the business of the group of activities for the 500-hour rule, instead of trying to reach the 500-hour threshold on an activity-by-activity basis.
The analysis for the new NII tax is complex, and making one’s way through the large number of pages of regulations is tedious. Obtaining the advice of a tax adviser will assist in evaluating the impact of the tax and what planning can be accomplished to mitigate and manage any tax that may be due. Taking time to review and plan for the NII tax may not turn the lump of coal into a diamond, but may at least allow for making the tax more tolerable.
Bill Roth is a tax partner with the local office of BDO USA LLP. The views expressed are those of the author and not necessarily of BDO. The comments are general and not to be considered specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties. Readers are advised to consult with their professional advisers before acting on any items discussed herein.