A new tax is looming for 2013 returns. It’s known as the Unearned Income Medicare Contribution, a 3.8 percent surtax on net investment income — interest, dividends, rents, capital gains, royalties and annuities.
The tax was installed to help pay for the Patient Protection and Affordable Care Act, otherwise known as “Obamacare.” The tax applies to single filers with a modified adjusted gross income, or MAGI, above $200,000, and joint filers with a MAGI exceeding $250,000.
The new tax also applies to trusts and estates.
The federal Joint Committee on Taxation estimates that the surtax will raise $123 billion from 2013 through 2019. The Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution, estimates more than 86 percent of the new tax will be paid by the top 1 percent of earners.
In Northwest Arkansas, home to several Fortune 500 companies, that means plenty of people will be affected. High earners are also facing phase outs of certain personal exemptions and certain limitations on itemized deductions.
Accountants and financial planners say there’s no need to panic. While the new tax — coupled with the maximum rate on long-term capital gains increasing from 15 to 20 percent — and new regulations can look daunting, the health care levy can be mitigated in a variety of ways.
Don Fitzpatrick, a CPA with Beall Barclay & Co. in Rogers, and his colleagues have been aggressive in their treatment of the new tax.
“Beall Barclay is proactively engaging in face-to-face meetings and communicating to clients through in-house newsletters and emails,” Fitzpatrick said. “We are discussing both the fundamentals of the surtax and also engaging in tax/investment planning to reduce the impact of the tax.”
Since Beall Barclay represents a large number of closely held businesses, including those held by married couples and families, the capital gains surtax is very much in play.
Owners of small businesses are advised to establish their own qualified retirement plans and realize reduced income through deferral. Pre-tax contributions to a 401(k) decrease the amount of wages used to determine MAGI.
For Fitzpatrick, retirement plans are true problem solvers.
“I love the concept of taking money from one pocket, putting it in another and getting a tax deduction,” he said.
While a 3.8 percent tax definitely equates to money, the tax in and of itself is not enough to derail a carefully constructed, long-term financial plan, he said.
“We don’t want people to sell stock just to keep from paying 3.8 percent,” he said, referring to advice he gave to clients in 2012. His stance hasn’t changed since last year.
“We try to maintain the course on the investment side,” Fitzpatrick said. “We’re not letting taxes lead the way.”
The new tax is implemented on the lesser of either net investment income or the excess of MAGI over the threshold.
Based on an example provided by the IRS, here’s how the tax works: A single filer reports $180,000 in wages and $90,000 in net investment income, for an adjusted gross income of $270,000, which exceeds the threshold for single filers by $70,000. The filer is taxed on the $70,000 and would owe $2,660.
Another IRS example shows a single filer with $180,000 in wages and another $15,000 in investment income, for a total of $195,000. Since that amount does not cross the threshold, the 3.8 percent would not be assessed.
Here in Northwest Arkansas, the 3.8 percent is expected to have an effect. A look at the recent trend in the region’s investment landscape shows why.
On Sept. 17, 2010, Wal-Mart Stores Inc. shares opened at $53.17 and by Sept. 17, 2013, closed at $75.15.
At J.B. Hunt Transport Services Inc., shares opened at $35.07 on Sept. 17, 2010, and closed three years later at $73.98.
The recent trajectory of Tyson Foods Inc. stock shows a similar story. On Sept. 17, 2010, shares opened at $17.02 and three years later closed at $30.27.
Shareholders who invested back in 2010 and have sold or will sell this year could realize a sizeable windfall, and, if the threshold is crossed, face the 3.8 percent tax.
John Ervin, tax partner with Frost PLLC in Fayetteville, said the time has come to accept the new tax.
“It’s here,” he said. “You need to expect it.”
There are a couple of things a client could do, Ervin said. If they sold an immensely valuable piece of property and realized a large capital gain, they could opt for an installment sale, which means the proceeds of the sale are paid through installments, which could lower revenue in a given year.
Gains could also be offset at the end of the year by selling bad stocks at a loss and thereby reducing MAGI — a process known as tax harvesting.
The new surtax is in addition to the recent increase in the maximum long-term capital gains rate to 20 percent, and on top of that is the effective Arkansas rate of 4.9 percent, bringing the total rate on capital gains to 28.7 percent for Arkansas taxpayers in the highest income bracket.
On more than a few occasions, Ervin has had to be the bearer of bad news.
“The response is, ‘I took all the risk, I didn’t know the IRS was a partner, and they’re getting a third of the profit,’” Ervin said. “No one likes paying tax, and this is a pretty good hit.”
Passive vs. Active
For Rogers accountant Mark Lundy of BKD LLP, the new surtax presents interesting challenges.
He said it’s not uncommon for a high-powered executive and a spouse to own rental properties such as duplexes or apartment complexes, or even a commercial piece, to generate investment income. If the properties generate little or no income, however, then the new surtax doesn’t come into play. But if the real estate performs, the new surtax could become an issue.
The goal is to show that the executive or the spouse materially participates in the generation of revenue from the properties, that participation is regular, continuous and substantial. There is one big test, among others, that must be passed to make that case. Does the executive or spouse participate in the venture for more than 500 hours in a tax year? If so, then the revenue could be deemed active and therefore not subject to the 3.8 percent tax.
“We’re talking to our clients about how you’re going to document your non-passive role in a passive activity,” Lundy said.
Other tax issues regarding real estate involve self-rentals, when someone owns both the business and the building where it operates; and real estate professionals, who make more than half their personal service income in real estate and who work at it more than 750 hours in a tax year.
While the surtax is structured in a way that most property owners will not have to deal with it in the event they sell their primary residence, the same is not true for the sale of properties such as vacation homes and multifamily dwellings. Gains from the sale of such properties could be subject to the tax.
The National Association of Realtors presents a scenario in which that happens. A person inherits an apartment complex. He eventually sells it, realizes a total gain of $1.4 million and winds up paying over $53,000 in new taxes.
The 3.8 percent tax on net investment income is a major issue, but even bigger, Fitzpatrick said, is the increase to 39.6 percent for the rate paid by single filers with income of more than $400,000 and joint filers with income of more than $450,000.
Though income figures that high might seem rare, Fitzpatrick said, there are more people in this region who fit that profile than most might think.
In a dynamic economy like the one in Northwest Arkansas, someone might work for a Walmart vendor one year, and by the next, own his own business and start climbing up the tax brackets.
For those individuals and couples, tax and investment planning, done in conjunction with one another, is the best way to go, Fitzpatrick said.
It’s also a good idea to start planning in the third and fourth quarter, when larger financial patterns are discernable, Fitzpatrick said.
Confronting a 3.8 percent surtax on investment income and an additional 39.6 percent tax can have a jarring “psychological impact” on a business owner. And that’s what will happen without proper planning.
“If you keep going straight down the road, you’ll pay the maximum amount of taxes,” Fitzpatrick said.