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Medicare related taxes will sneak up on many in
We are all in the midst of dealing with our personal income taxes. Nothing seems to remain the same from one year to the next. More tax surprises are in store for 2013.
One surprise is not dependent on extending the Bush-era tax cuts or enacting any current tax proposal. The surprise was already enacted (in 2010). Little attention has been focused on the changes to date, as the impact doesn’t hit the affected taxpayers until 2013.
The tax increases at issue were enacted as part of the Patient Protection and Affordable Care Act signed into law in 2010 (commonly known as “Obamacare”). In fact, many may have missed these changes within all the fine print of the legislation.
The two tax changes to be addressed in this discussion (one an increase and one a brand new tax) will affect many higher-income taxpayers in 2013. The changes increase the Medicare Tax in 2013 on wages and add the new Medicare Tax on investment income (MTII).
The Medicare Tax has been around since the 1960s when Medicare was first enacted and is currently assessed as a payroll tax on both employers and employee. The employee wage withholding for Medicare will increase .9 percent — from 2.9 percent to 3.8 percent — for certain higher-income individuals in 2013 if their wages or self-employment income exceeds $250,000 if married and $200,000 if single. Perhaps the good news is that employers are not subject to the additional levy for their share of the new Medicare tax (at least for now).
As mentioned, the Medicare Tax is a tax on wages and self-employment income. The MTII will apply to non-wage income. The tax base to assess it will include investment income. It will apply to taxpayers with adjusted gross income of more than $200,000 for single taxpayers and $250,000 for married taxpayers filing a joint tax return. The thresholds are not currently scheduled to be indexed for inflation.
These additional Medicare-related taxes are in addition to any tax changes that may occur with the expiration of the Bush-era tax cuts also scheduled for 2013.
This new tax on investment income is a surprise to many retirees who don’t currently have wage income, as the Medicare tax in the past was payable only on employment-related income. The MTII is assessed on many items of investment income, including interest, dividends, annuities, royalties and rents, other than such income which is derived in a trade or business. Deductions are allowed that are properly allocable to such gross investment income or net gain.
The MTII is important to the health care legislation. It is, after all, the single biggest tax revenue raiser included in the 2010 health care legislation.
There is some concern about how to determine the exact base of income to which the tax applies. The actual statute was a bit ambiguous as to what it may cover, and so the IRS recently stated that it will ask for comments as it attempts to draft regulations to fill in some of the gaps. The hope is that this will enable the IRS to provide clearer guidance to taxpayers on the application of this new tax.
It is a broad-based tax. More than dividends and interest is taxed under the MTII. Also taxed is income from business activities that are considered passive activities under section 469 of the Internal Revenue Code. Section 469 was added to the Code in 1986 to restrict the ability for certain taxpayers to deduct losses from passive activities. So, for many, the income reported on partnership or S corporation Schedule K-1 may be subject to MTII.
The tax also applies to any gains attributable to the sale or disposition of the assets deriving the income to generate the investment income or passive activity income. So the gains may be subject to tax at the capital gains tax rates plus the MTII tax. If the capital gains rate for long-term gains sunsets to the 20 percent rate in 2011, the addition of the MTII (3.8 percent) will result in long-term capital gains being taxed (for federal tax purposes) at 23.8 percent rather than the current enacted rate in 2012 of 15 percent. This change is obviously a significant increase in the rate of tax on capital gains.
It will be interesting to see if taxpayers realize gains on certain assets (such as marketable securities) and then repurchase the assets in the latter part of 2012 in an effort to minimize the impact of the tax increases for post-2012 tax years.
For many owners of rental real estate, the impact of the rules may be a big surprise. Current rental income may be sheltered by interest expense and depreciation costs. Therefore, the MTII may not be significant until a sale of the real estate. The gains realized from the sale of the rental property may be subject to both income tax and the MTII.
There are other items that may be impacted by the MTII. The passive activity rules referred to earlier generally treat real estate activities as passive without regard to whether the owner materially participates in the actual rental activity. Certain rules allow for real estate activities to be treated as non-passive income if the owner of the real estate is considered a real estate professional by spending at least 750 hours a year on real estate activities and meeting other requirements. The application of the tax to real estate professionals is not clear, as the statute does not have specific details for various situations where it may apply. Other areas where the application of the statute is not clear include how carried interests for investment, private equity and hedge funds may be treated. It is expected that these and many other items will be addressed in regulations to be issued sometime in late 2012.
As guidance is issued in regulations later this year, there may be some differences in the application of the tax based on how an entity is organized (S corporation, LLC/partnership or sole proprietorship). All those affected by the MTII will need to watch for when this guidance is issued to better determine its actual impact on their individual situations.
The tax debate continues to heat up during this campaign season. Taxes will become more of a hot topic this fall as the extension of the Bush-era tax cuts will need to be considered. The debate around extending the Bush cuts and the possible “Buffett Rule” proposals should consider the impact and the actual amounts of additional taxes that will be paid by the many taxpayers subject to the MTII. This tax will sneak up on many in 2013, and many may not realize it even exists until they need to pay it.
Bill Roth is a tax partner with the local office of BDO USA LLP. The views expressed are those of the author and are not necessarily of BDO. The comments are general in nature and not to be considered specific tax or accounting advice. Readers are advised to consult their professional advisers before acting on items discussed.