Five Tax Planning Strategies For Minimizing The Additional 3.8% Obamacare Tax On Investment Income

[rico1]

http://www.forbes.com/sites/anthonynitti/2012/11/19/five-tax-planning-strategies-for-minimizing-the-additional-3-8-obamacare-tax-on-investment-income/3/

Like it or not, the Affordable Health Care and Patient Protection Act — or less formally, Obamacare – is here to stay, so it’s time to get proactive and start planning for its tax provisions. And since the enactment of Obamacare, no one element of the President’s signature legislation has spawned more country club consternation and misleading e-mails than the additional 3.8% Medicare tax to be imposed upon a taxpayer’s “net investment income” beginning in 2013.

As a quick primer, net investment income includes:

1. Income from interest, dividends, annuities, royalties, and rents, net of applicable deductions,

2. Income from a passive activity, and

3. Gain from the sale of property other than property held in a trade or business in which the taxpayer materially participates.

While that may seem relatively straightforward, as the ensuing discussion indicates, determining when the surtax applies is rarely as simple as it seems. What follows are five planning opportunities designed to minimize your exposure to the new tax and hopefully, clear up any confusion surrounding this oft-misunderstood provision.

Manage your income. If the Bush tax cuts expire at year-end, the top marginal tax rate will increase from 35% to 39.6%. As a result, savvy tax advisors have been urging wealthy taxpayers to accelerate year-end compensation and bonus income from 2013 into 2012.

But there’s a secondary motivation for keeping income out of 2013. The 3.8% Medicare tax applies only when your modified adjusted gross income, or MAGI (unless you have foreign earned income, this will be the same as your adjusted gross income) exceeds certain thresholds: $200,000 for a single taxpayer, $250,000 for a married couple filing jointly, and $125,000 for a married couple filing separately. Thus, the lower your MAGI, the less likely you are to incur the additional tax:

Example: Ted Striker, a single taxpayer, earns $195,000 in compensation and $30,000 of dividend and interest income during 2013. These are his only items of income or loss.

A taxpayer with both net investment income and MAGI in excess of the applicable threshold, like our friend Ted here, is subject to the 3.8% Medicare tax on the lesser of:

1. MAGI ($225,000) less the applicable threshold ($200,000) or $25,000, or

2. Net investment income, or $30,000.

Assume further that $25,000 of Ted’s 2013 income was a 2012 year-end bonus received on January 3, 2013. If Ted accelerates the receipt of the bonus to December 2012, he will owe the 3.8% tax in 2013 on the lesser of:

1. MAGI ($200,000) less the applicable threshold ($200,000) or $0, or

2. Net investment income of $30,000.

Despite the fact that there has been no change to Ted’s investment income, by accelerating his bonus into 2012 and reducing his 2013 AGI, he has avoided the 3.8% surtax and saved $950 ($30,000 *.038).

Harvest stock gains, rather than losses, prior to year-end. Taxpayers have long been trained to sell loss-generating stock prior to year-end in an effort to offset otherwise taxable capital gains. In the waning days of 2012, however, you should consider selling appreciated stock, not only to lock in the soon-to-expire 15% preferential rate currently afforded long-term capital gains, but to avoid the impending 3.8% Medicare tax as well.

Note, however, that net investment income does not include capital gains resulting from the sale of stock in an S corporation or an interest in a partnership in which the taxpayer materially participates. Thus, for example, if you participate full time in an S corporation (more on this later), the sale of the corporation’s stock will generally not be subject to the 3.8% surtax. All other sales of stock, however, will generally be considered net investment income for purposes of the additional tax.

If you’re worried about losing your investment position in the stock, fear not. The “wash-sale” rules of Section 1091 — which prevent a taxpayer from deducting a capital loss when they purchase the same stock 30 days before or after the sale – do not apply to gains. Thus, you can sell the stock for a gain and repurchase the same amount of shares the next day if you wish.

Example: Marcellus and Mia earn $600,000 per year in wages and hold appreciated publicly-held stock that would generate a $30,000 gain if sold. If the stock is sold during 2013, the entire $30,000 gain would be subject to both the tax rate in place at the time (20% if the Bush tax cuts expire) and the additional 3.8% Medicare tax.

If instead, Marcellus and Mia sell the stock in December 2012, the $30,000 gain will be taxed at only the 15% long-term capital gains rate. Because the wash sale rules don’t apply to capital gains, Marcellus and Mia can purchase the same stock immediately after the sale.

Take a hard look at tax-exempt bonds. Assuming the Bush tax cuts expire at year-end, wealthy taxpayers will pay tax on interest income at a maximum rate of 39.6% plus the 3.8% Medicare tax in 2013 and beyond. Net investment income, however, does not include tax-exempt income. As a result, if you reside in the highest tax bracket, a 3% tax-exempt bond will now earn you the equivalent after-tax return of a 7% taxable bond (3%/(1-.434)).

Meet the material participation test for your S corporation or partnership. In general, when a taxpayer is merely a passive investor in an S corporation or partnership, any loss allocated to the taxpayer cannot be used to offset non-passive income from other sources. As a result, taxpayers who are allocated losses from a flow-through entity will typically prefer that their involvement in the activity be considered non-passive, so they can offset the losses against other taxable income without limitation. In 2013, however, taxpayers with income from an S corporation or partnership will also have a vested interest in avoiding a passive classification, because as mentioned in the introduction, the 3.8% Medicare tax will apply to income earned from a passive activity, but not from a non-passive activity.

In simple terms, your interest in an S corporation or partnership is passive unless you meet one of seven “material participation” tests found in the Section 469 regulations:

1. You participate in the activity for more than 500 hours during the year,

2. Your participation in the activity constitutes substantially all of the participation by all individuals (including nonowners) in the activity for the year,

3. Your participation is more than 100 hours during the year, and no other individual (including nonowners) participates more hours than the taxpayer,

4. The activity is a significant participation activity in which you participate for more than 100 hours during the year and your annual participation in all significant participation activities is more than 500 hours. [A significant participation activity is generally a trade or business activity (other than a rental activity) that you participate in for more than 100 hours during the year but do not materially participate in (under any of the material participation tests other than this test),]

5. You materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years,

6. For a personal service activity, you materially participated for any three tax years (whether or not consecutive) preceding the current tax year, or

7. A generic facts and circumstances test.

In 2013, pumping a few extra hours into your S corporation or partnership activity could be the difference between saving or shelling out an extra 3.8% in tax on the resulting income.

Example: Danny Noonan, a single taxpayer, is employed full-time as caddy at a prestigious country club, where he draws a $200,000 annual salary. On the side, Danny also owns 50% of an S corporation that serves burritos outside of a local bar from 2-4 AM every Saturday night. The stand is quite profitable, generating $50,000 of flow-through income to Danny every year. During 2012, Danny put in 90 hours building and serving burritos. The other 50% shareholder, Tony, contributed only 70 hours. The S corporation has no other employees.

Assume Danny did not materially participate in the S corporation under any of the regulatory tests during 2012. In 2013, there is tremendous motivation for Danny to work an extra 10 hours at the burrito stand. Doing so would allow Danny to satisfy material participation test #3 because he would have 1) worked 100 hours, and 2) worked more hours than anyone else in the burrito stand activity.

By meeting the material participation test, Danny would remove the $50,000 of income allocated to him from the S corporation from the definition of net investment income, as the activity is no longer passive under the meaning of Section 469. As a result, Danny saves $1,900 in additional Medicare tax.

There are additional complexities when the activity is conducted through a limited partnership or LLC. Under Section 469(h)(2), an interest in a limited partnership as a limited partner is generally treated as a passive activity, regardless of the partner’s level of participation.

Until recently, this rule had been unilaterally been applied to members in an LLC, but in two recent court cases — Garnett v. Commissioner, 132 T.C. 639 (2009) and Thompson v. Commissioner, 87 Fed Cl 728 (2009) — the Tax Court and Federal Court of Claims, respectively, ruled that interests in an LLC were not automatically treated as passive. Rather, if state law grants the LLC member the right to participate in management, the courts concluded that the LLC more closely resembles a general partnership, and the members are permitted to look to the seven regulatory tests in order to establish material participation.

Thus, courtesy of Garnett and Thompson, an LLC member who materially participates in the partnership will not be treated as a passive investor, and as a result, will avoid the 3.8% Medicare tax on the resulting flow-through income.

Be advised, however, that if you materially participate in an LLC, it will likely sentence you to reporting any income as subject to self-employment tax. So in effect, you may be trading an additional 3.8% tax on a small portion of income for a 15.3% tax on a lot of income.

Example: Dignan, a single taxpayer, owns an interest in a LLC that conducts an active trade or business. Each year, Dignan is allocated $300,000 of income from the LLC, comprising all of his income. During 2012, Dignan worked 495 hours for the activity and did not meet any of the other material participation tests.

In 2013, assuming the state in which the LLC was formed permits members to participate in management; Dignan can establish that he materially participated in the LLC to avoid passive treatment of the $300,000 income.

If Dignan does not materially participate in the LLC, $100,000 of the LLC income ($300,000 – $200,000 threshold) will be subject to the 3.8% Medicare tax. As a result, Dignan will pay an additional $3,800 in tax. By not materially participating in the LLC, however, Dignan will likely take the position that the $300,000 of income is not subject to self-employment tax under the proposed Section 1402 regulations.

If instead, Dignan makes a concerted effort to work 500 hours in the activity during 2013, the LLC income will no longer be passive, and no portion of the income will be subject to the additional 3.8% Medicare tax. It will, however, become subject to self-employment tax of approximately $23,000.

Satisfy the real estate professional test. A taxpayer’s net rental income is generally subject to the 3.8% Medicare tax. The Obamacare legislation provides an exception, however, for net rental income that is earned in a trade or business that is not a passive activity. Unfortunately, pursuant to Section 469©(2), all rental activities are de facto passive. So if all rental activities are passive, but only-non passive rental activities can avoid the tax, what is a taxpayer to do?

The answer is found in Section 469©(7), which provides an exception to this default treatment of all rental activities as passive to certain “real estate professionals.” In the past, the benefit of this exception was that it allowed a taxpayer who spends substantially all of his time working in “real property trades or businesses” to use losses generated from those activities without restriction under the passive activity rules. With the advent of the 3.8% Medicare tax, however, there is now an additional reason to meet the standards of Section 469©(7): rental income earned by a real estate professional will not be subject to the additional surtax.

In order to be treated as a real estate professional, you must satisfy two tests:

1. More than one-half of the your personal services performed throughout the year must be performed in real property trades or businesses in which you materially participate, and

2. You must perform more than 750 hours of services during the year in real property trades or businesses in which the you materially participates.

These tests are designed to ensure that only those taxpayers who truly devote their time to their real estate activities and depend on them for income — such as developers, landlords, or brokers — are able to take advantage of the favorable treatment.

As a result, the court’s have repeatedly attacked the arguments of purported real estate professionals who were employed in non-real estate vocations, challenging the taxpayer’s contention that they worked more than half of their hours in a real estate activity. Looking at it logically, if you work full-time as say, an accountant, it’s nearly impossible to satisfy this first test. The average full-time employee works 2,000 hours per year; in order to meet the “more than half” test, you would have to spend 2,001 hours on your real estate activities, which isn’t particularly likely.

A hopeful real estate professional faces additional hurdles aside from the “more than half” test, however, as the courts have stringently applied the rules of Section 469©(7). A full discussion of all the potential pitfalls is beyond the scope of this post, but if you’re interested in reading more, click here, here, or here.

Assuming you can meet the standards, however, 2013 is the year to do it:

Example: Enrico Palazzo works 1,000 hours per year as an opera singer. He also owns and manages three rental properties that kick off significant rental income each year. In 2012, Enrico materially participates in each activity– spending 300 hours on property A, 300 on property B, and 300 on property C — but does not meet the standards of a real estate professional because he has not worked more than half of his total hours in his real estate activities (1,000 versus 900).

In 2013, if Enrico can find the time to devote an extra 101 hours to his rental real estate — or if he can spend less time in his opera business — he will qualify as a real estate professional under Section 469©(7). As a result, the net rental income generated by the properties will not be subject to the 3.8% Medicare tax. Even better, pursuant to Section 1402(a)(1), any rental income earned by a real estate professional will also not be subject to self-employment tax.

Hopefully, this discussion will have cleared up any misconceptions you may have had about the impending 3.8% surtax on net investment income. There are two other considerations worthy of note: first, the additional tax must be taken into account when preparing your required 2013 quarterly estimated tax payments. In addition, any income that is subject to self-employment tax — for example, your Schedule C activity from a sole-proprietorship — is not subject to the 3.8% surtax. In other words, the same income will never be subject to both SE tax and the additional 3.8% Medicare tax.

Edited November 21, 2012 by rico1