Medicare Tax | Payroll Unlimited

The health care reform package (the Patient Protection and Affordable Care Act and the Health Care and education Reconciliation Act of 2010) imposes a new 3.8 Medicare contribution tax on the investment income of higher income individuals. Although the tax does not take effect until 2013, it is not too soon to examine methods to lessen the impact of the tax.

Net investment income. Net investment income, for purposes of the new 3.8 percent Medicare tax, includes interest, dividends, annuities, royalties and rents and other gross income attributable to a passive activity. Gains from the sale of property that is not used in an active business and income from the investment of working capital are treated as investment income as well. However, the tax does not apply to nontaxable income, such as tax-exempt interest or veterans’ benefits. Further, an individual’s capital gains income will be subject to the tax. This includes gain from the sale of a principal residence, unless the gain is excluded from income under Code Sec. 121, and gains from the sale of a vacation home. However, contemplated sales made before 2013 would avoid the tax.

The tax applies to estates and trusts, on the lesser of undistributed net income or the excess of the trust/estate adjusted gross income (AGI) over the threshold amount ($11,200) for the highest tax bracket for trusts and estates, and to investment income they distribute.

Deductions. Net investment income for purposes of the new 3.8 percent tax is gross income or net gain, reduced by deductions that are “properly allocable” to the income or gain. This is a key term that the Treasury Department expects to address in guidance, and which we will update you on developments. For passively managed real property, allocable expenses will still include depreciation and operating expenses. Indirect expenses such as tax preparation fees may also qualify.

For capital gain property, this formula puts a premium on keeping tabs on amounts that increase your property’s basis. It also puts the focus on investment expenses that may reduce net gains: interest on loans to purchase investments, investment counsel and advice, and fees to collect income. Other costs, such as brokers’ fees, may increase basis or reduce the amount realized from an investment. As such, you may want to consider avoiding installment sales with net capital gains (and interest) running past 2012.

Thresholds and impact. The tax applies to the lesser of net investment income or modified AGI above $200,000 for individuals and heads of household, $250,000 for joint filers and surviving spouses, and $125,000 for married filing separately. MAGI is AGI increased by foreign earned income otherwise excluded under Code Sec. 911; MAGI is the same as AGI for someone who does not work overseas.

Example. Jim, a single individual, has modified AGI of $220,000 and net investment income of $40,000. The tax applies to the lesser of (i) net investment income ($40,000) or (ii) modified AGI ($220,000) over the threshold amount for an individual ($200,000), or $20,000. The tax is 3.8 percent of $20,000, or $760. In this case, the tax is not applied to the entire $40,000 of investment income.

The tax can have a substantial impact if you have income above the specified thresholds. Also, don’t forget that, in addition to the tax on investment income, you may also face other tax increases proposed by the Obama administration that could take effect in 2013. The top two marginal income tax rates on individuals would rise from 33 and 35 percent to 36 and 39.6 percent, respectively. The maximum tax rate on long-term capital gains would increase from 15 percent to 20 percent. Moreover, dividends, which are currently capped at the 15 percent long-term capital gain rate, would be taxed as ordinary income. Thus, the cumulative rate on capital gains would increase to 23.8 percent in 2013, and the rate on dividends would jump to as much as 43.4 percent. Moreover, the thresholds are not indexed for inflation, so a greater number of taxpayers may be affected as time elapses. Congress may step in and change these rate increases, but the possibility of rates going up for upper income taxpayers is sufficiently real that tax planning must take them into account.

Exceptions. Certain items and taxpayers are not subject to the 3.8 percent tax. A significant exception applies to distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans. At the present time, however, there is no exception for distributions from nonqualified deferred compensation plans subject to Code Sec. 409A, although some experts claim that not carving out such an exception was a Congressional oversight that should be rectified by an amendment to the law before 2013.

The exception for distributions from retirement plans suggests that potentially taxed investors may want to shift wages and investments to retirement plans such as 401(k) plans, 403(b) annuities, and IRAs, or to 409B Roth accounts. Increasing contributions will reduce income and may help you stay below the applicable thresholds. Small business owners may want to set up retirement plans, especially 401(k) plans, if they have not yet established a plan, and should consider increasing their contributions to existing plans.

Another exception covers income ordinarily derived from a trade or business that is not a passive activity under Code Sec. 469, such as a sole proprietorship. Investment income from an active trade or business is also excluded. However, SECA (Self-Employment Contributions Act) tax will still apply to proprietors and partners. Income from trading in financial instruments and commodities is also subject to the tax. The tax does not apply to income from the sale of an interest in a partnership or S corporation, to the extent that gain of the entity’s property would be from an active trade or business. The tax also does not apply to business entities (such as corporations and limited liability companies), nonresident aliens (NRAs), charitable trusts that are tax-exempt, and charitable remainder trusts that are nontaxable under Code Sec. 664.

IRS Releases Guidance on Additional Medicare Tax on High-Income Earners

On June 11, 2012, the Internal Revenue Service (IRS) released new guidance, in a 20 questions and answers (Q&A) format, on the 0.9% additional Medicare tax scheduled to go into effect in 2013. The Q&As are intended to assist employers and payroll service providers in adapting systems and processes that may be affected by the new tax.

Background:

As a result of the enactment of the Affordable Care Act (ACA), effective for wages paid on or after January 1, 2013, the Medicare tax rate increases from 1.45 percent to 2.35 percent on wages earned above $200,000 for single filers and $250,000 for joint filers ($125,000 for a married individual filing separately). This increase only applies to the employee Medicare portion of the Federal Insurance Contributions Act (FICA) tax. Consequently, employers do not have to match the increased Medicare tax amount from employee’s wages. However, employers are still responsible for the withholding and reporting obligations with respect to the increased employee Medicare tax. If an employer fails to withhold and deposit the additional Medicare tax amount AND the employee pays it with his or her tax return, the employer will not be required to pay the missed amount, but the employer will be subject to penalties for the failure to withhold the tax.

NOTE: The employer is required to withhold the increased amount from all workers with wages exceeding $200,000 regardless of the marital status claimed on the employee’s Form W-4. Over and under withholding for the employee will be reconciled upon the filing of his/her tax return.

Some of the highlights of the Q&As are as follows:

All wages that are currently subject to Medicare tax are also subject to the additional Medicare tax if they are paid in excess of the applicable threshold for an individual’s filing status (see above). (Q&A 4)

The additional Medicare tax also applies to employees who are nonresident aliens and U.S. citizens living abroad if their wages exceed the applicable thresholds. (Q&A 6)

An employer must begin withholding the additional Medicare tax once an employee’s wages are over the threshold, even if the employee may not ultimately be liable for this tax. For example, consider a situation where one spouse earns $210,000 and the other spouse earns $25,000, and the couple files a joint return. Although the employer would be required to withhold on the higher earner’s wages to the extent they exceed $200,000, the couple would not be liable for the additional Medicare tax because their combined income is less than the applicable $250,000 threshold. Any excess additional Medicare tax withheld will be credited against the total tax liability shown on the employee’s personal income tax return. (Q&A 7)

An employer is not required to notify an employee when it begins withholding the additional Medicare tax. (Q&A 8)

Although an employee can’t request additional withholding specifically for the additional Medicare tax, an employee who anticipates being liable for it may request that his employer withhold an additional amount of income tax withholding on Form W-4, which will be applied against all taxes (including any additional Medicare tax liability) shown on the employee’s income tax return. (Q&A 10)

An employer begins withholding the additional Medicare tax in the pay period in which it pays wages to the employee exceeding the $200,000 threshold and not earlier, even if the employee’s annual wages are expected to exceed the threshold. (Q&A 11)

If an employee receives wages from an employer in excess of $200,000 and the wages include noncash fringe benefits, the employer calculates wages for purposes of withholding the additional Medicare tax in the same way that it calculates wages for withholding the existing Medicare tax. The employer is required to withhold additional Medicare tax on total wages, including noncash fringe benefits, in excess of $200,000. The value of noncash fringe benefits must be included in wages and the employer must withhold the applicable additional Medicare tax and deposit the tax under the rules for employment tax withholding and deposits that apply to noncash fringe benefits. (Q&A 13)

To the extent that tips and wages exceed $200,000, an employer applies the same withholding rules for additional Medicare tax as it does currently for the existing Medicare tax. An employer withholds additional Medicare tax on the employee’s reported tips from wages it pays to the employee. If the employee does not receive enough wages for the employer to withhold all the taxes that the employee owes, including additional Medicare tax, the employee may give the employer money to pay the rest of the taxes or the employee may need to make estimated tax payments to cover any shortage. (Q&A 14)

If an employee receives third-party sick pay, wages paid by the employer and by the third party need to be aggregated to determine whether the $200,000 withholding threshold has been met. (Q&A 16)

If an employee has amounts deferred under a nonqualified deferred compensation (NQDC) plan, the employer calculates wages for purposes of withholding additional Medicare tax on the NQDC in the same way that it calculates wages for withholding the existing Medicare tax. (Q&A 17)

For a copy of the IRS FAQ’s, please click on the link provided below:
http://www.irs.gov/businesses/small/article/0,,id=258201,00.html