Budget deal or not, taxes are going up — at least for high earners.
As Republicans and Democrats joust over income tax rates, one certainty will be two new levies, a 3.8 percent surtax on investment income and a 0.9 percent additional tax on wages. Both were enacted in the 2010 healthcare law, and President Barack Obama’s re-election sealed their start on Jan. 1. That certainty is driving changes in the fiscal behavior of top- earning Americans, such as selling gains in investments.
“It’s going to be costly to many of our clients that are high income,” said Mark Nash, a tax partner in New York-based PricewaterhouseCoopers’ private company services practice, referring to the investment income surtax. “It’s a tax that nobody’s talking about deferring. It’s not in the fiscal cliff discussions.”
The so-called fiscal cliff is the metaphor Federal Reserve Chairman Ben S. Bernanke used to refer to more than $600 billion in spending cuts and tax increases set to take effect in January if Congress doesn’t act. The new taxes in the health law are separate and apply to individuals making more than $200,000 a year and married couples earning at least $250,000.
Together, the added tax on wages and the investment income surtax will raise an estimated $318 billion over the next 10 years, according to the Joint Committee on Taxation.
“These taxes hit right in the gut,” said Michael J. Grace, a tax attorney and managing director at Milbank, Tweed, Hadley & McCloy in Washington. “This really could change people’s behaviors.”
4.1 Million Households
An estimated 4.1 million U.S. households, or 2.4 percent, will be affected by one or both of the new taxes in 2013, according to the Tax Policy Center in Washington. The thresholds aren’t indexed for inflation so the percentage of people subject to them almost doubles by 2022.
A married couple with $300,000 in salary and $100,000 in investment income would pay the 3.8 percent tax on the unearned income, costing them $3,800, according to an example from the American Institute of Certified Public Accountants. The couple also would pay the 0.9 percent tax on $50,000 of their wages, for a combined tax increase of $4,250.
The taxes effectively may push the top marginal rate to as much as 43.4 percent next year for top earners if tax cuts enacted during George W. Bush’s presidency expire as scheduled. The investment tax captures a broad array of income including from capital gains, dividends, interest, rents, royalties and so-called passive activities. An exception is profits from active business, which aren’t affected by the new investment income tax. That is leading people to find ways to classify what they’re doing as active business income.
To accomplish this, clients who own a business and have been letting their employees run it while collecting income should participate more and keep track of their time, said Grace, who previously worked for the Internal Revenue Service and authored regulations on passive activities.
“Let’s make sure that we get those hours up above 500,” he said. “If it’s 501 hours then all the income from the year will be active and not subject to the 3.8 percent tax.”
Taxpayers also should review any investments they’ve grouped together for tax purposes if there’s a mix of active and passive activities, said Mitchell Drossman, national director of wealth planning strategies at U.S. Trust, a unit of Charlotte, North Carolina-based Bank of America Corp. That’s because the rules allow people a chance to regroup them, which may reduce the amount of income subject to the tax, Drossman said.
The regulations make clear that gains from hedge funds and private equity funds — including the share of profits known as carried interest — will be subject to the investment tax, said Jim Cofer, a partner in the tax group at Seward & Kissel LLP. The rules clarified that investing in offshore funds isn’t a way to avoid it, he said. When income is distributed from passive foreign investment companies, it’s subject to the tax, he said.
Investors with interests in offshore funds may elect to receive income from these companies at the same time they report gains for income-tax purposes, according to the regulations. “That’s not a taxpayer-friendly election, but it may save you a headache,” Cofer said of forgoing tax-deferred benefits.
Rental income will be subject to the 3.8 percent tax unless it’s received in the course of a trade or business in which the taxpayer is actively involved, such as a real estate company, said Nash of PwC. That means investors may have to use similar tax planning techniques for those properties as they would with partnerships and document their hours, he said.
“The casual rental of one or two properties is not going to get you there,” Nash said. “They are consciously trying to capture most rental income within the tax.”
The regulations clarified some misconceptions about how the 3.8 percent tax applies to home sales, said Tim Steffen, director of financial planning at Robert W. Baird & Co. in Milwaukee. The tax applies only to the extent the income would have been included after exclusions, such as $500,000 allowed for married couples selling a primary residence.
Profits from sales of second homes will be affected by the levy, he said.
The investment tax also applies to certain types of trusts at the top tax bracket for such entities. In 2012 that threshold is $11,650, or lower than the earnings level that qualifies individuals and couples. That means there may be more incentive next year to distribute some gains in trusts to beneficiaries if they make less than the $200,000- or $250,000-a-year thresholds, Steffen said.
Taxpayers with so-called charitable remainder trusts should consider realizing long-term gains before Jan. 1 to minimize the effect of the tax, said Drossman of U.S. Trust. These trusts distribute income to charities as well as non-charitable beneficiaries such as family members. While the regulations specify that money transferred by the trust to charities isn’t subject to the 3.8 percent tax, gains passed to others can be, he said.
“There’s an opportunity here,” Drossman said. “Sell appreciated assets in these trusts even if you’re going to buy them right back.”
Taxpayers also should keep close track next year of expenses including state and local taxes paid or penalties for an early withdrawal of a certificate of deposit, Drossman said. Those costs can offset investment income subject to the tax.
High earners should be aware that employers must start withholding for the other tax in the healthcare law — the 0.9 percent additional tax on wages — as soon as workers earn $200,000 in a year.
“They’re going to withhold as soon as you hit the $200,000 threshold on the presumption that your spouse will push you over the $250,000, even if your spouse doesn’t work,” said Steffen of Robert W. Baird. “Basically, the government gets an interest-free loan as a result.”
Married taxpayers who make less than $200,000 a year and with their spouse earn more than $250,000 may have to plan for additional taxes owed because their employers won’t automatically withhold extra, he said. Such taxpayers whose combined incomes exceed the threshold should make estimated tax payments or request additional income tax withholding using form W-4, according to the IRS.
Those who usually make estimated tax payments during the year may need to account for the two taxes as soon as the first quarter of 2013, said Cofer of Seward & Kissel. “Keep it in the front of your mind early in the year,” he said.
The regulations are proposals and open to public comment by March 5. Still, they represent the agency’s view and taxpayers can rely on them to prepare as the taxes will start applying Jan. 1, according to the IRS.
“The reality is beginning to set in,” said PwC’s Nash. “It’s going to take effect.”
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