Lost in the rhetoric about the fiscal cliff and whether all or any part of the so-called Bush tax cuts were to be extended beyond December 31 was the fact that, in any event, a significant number of individuals, trusts and estates will be subject to increased taxes in 2013 as a result of the revenue provisions contained in the Patient Protection and Affordable Care Act of 2010 (as amended by the Health Care and Education Reconciliation Act of 2010). Taxpayers with incomes above certain threshold amounts will be subject to additional taxes that will be imposed on net investment income and all forms of compensation, including wages, income from self-employment and taxable fringe benefits.
New Sections 3101(b)(2) and 1401(b)(2) of the Internal Revenue Code impose an additional Medicare tax of 0.9 percent on all forms of taxable compensation, including wages and income from self-employment, earned by any individual above a threshold amount and received on or after January 1. An individual is liable for this additional Medicare tax if wages or income from self-employment exceeds $250,000 for married individuals filing jointly or $200,000 for singles. For married couples filing joint returns, the compensation of both spouses is aggregated for this purpose.
Currently, all compensation is subject to a Medicare tax of 2.9 percent. In the case of wages, half (1.45 percent) of the tax is paid by the employer and half is paid by the employee. For self-employed individuals, the entire Medicare tax is paid by the individual. When the additional Medicare tax of 0.9 percent is added to an employee’s current share of the Medicare tax, the total employee portion of the Medicare tax will be 2.35 percent. The employer’s share of the Medicare tax will remain at 1.45 percent, thereby resulting in a combined tax rate of 3.8 percent. Again, self-employed individuals will be required to pay the entire 3.8 percent tax.
The additional Medicare tax must be withheld by employers together with all other employment taxes if paid to an individual who has earnings from that employer in excess of $200,000 in a calendar year, without regard to the individual’s filing status or compensation paid by another employer. An employer that does not withhold and remit additional Medicare tax as required is liable for the tax and all applicable penalties in the same manner as an employer that fails to withhold and remit Federal Insurance Contributions Act (FICA) and other employment taxes.
If an individual anticipates liability for additional Medicare tax in excess of the employer’s basic withholding obligation (e.g., a spouse may have income from self-employment), the individual may request that his or her employer withhold an additional amount of income tax on Form W-4. The additional income tax withheld will be applied against the additional Medicare tax liability. Alternatively, an individual can make estimated income tax payments that will also be applied against the additional Medicare tax liability. Conversely, a married individual who files jointly may earn wages in excess of $200,000 but less than $250,000 and will therefore be subject to withholding even if that individual may have no additional Medicare tax liability (i.e., where the individual’s earnings even when combined with the spouse’s earnings will be less than the $250,000 threshold). In such case, the individual will need to claim credit for the withheld amount against the individual’s total tax liability on Form 1040.
New Code Section 1411 also imposes a companion net investment income tax (NIIT) on certain net investment income of individuals, estates and trusts that have income above statutory threshold amounts. Like the additional Medicare tax, the NIIT goes into effect for tax years commencing on or after January 1. The NIIT is imposed at the rate of 3.8 percent on the lesser of: (1) the amount by which a taxpayer’s modified adjusted gross income exceeds a threshold amount; or (2) the taxpayer’s net investment income.
For married couples filing jointly, the modified adjusted gross income threshold is $250,000 and for single taxpayers, the modified adjusted gross income threshold is $200,000. Estates and trusts are also subject to the NIIT if they have undistributed net investment income and have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year (for tax year 2012, this threshold amount was $11,650). Charitable trusts and qualified retirement plan trusts that are exempt from tax under Code Section 501 and charitable remainder trusts exempt from tax under Code Section 664 are not subject to the NIIT. “Grantor” trusts are not subject to the NIIT, but the grantor of such a trust is subject to the tax.
In general, investment income for purposes of the NIIT includes interest, dividends, capital gains, rental and royalty income, nonqualified annuity income, income from businesses involved in the trading of financial instruments or commodities and income from passive business activities as described in Code Section 469. Tax-exempt municipal bond interest is not subject to the NIIT. The NIIT is imposed on gross investment income reduced by deductions that are properly allocable to such items of investment income. Examples of properly allocable deductions include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes properly allocable to items of investment income.
As stated above, capital gains that are not otherwise offset by capital losses are included in the determination of net investment income. Such gains may arise from the sale of stocks, bonds and mutual funds, capital gain distributions from mutual funds and gains from the sale of real estate or interest in partnerships and S corporations (to the extent the taxpayer was a passive owner). The NIIT will not apply to any amount of gain that is excluded from gross income for regular income-tax purposes. For example, any gain realized on the sale of a personal residence but excluded from tax pursuant to Code Section 121 will not be included in the determination of net investment income, but any gain in excess of the Code Section 121 exclusion amount will be included in net investment income.
For individuals, the NIIT will be reported on, and paid with, the individual’s Form 1040. For estates and trusts, the tax rate will be reported on, and paid with, the Form 1041. The NIIT is also subject to the normal estimated tax provisions applicable to income taxes. Therefore, individuals, estates and trusts that expect to be subject to the tax in 2013 should adjust their income-tax withholding or estimated quarterly tax payments to account for the tax increase in order to avoid underpayment penalties.
It is intended that an individual could be subject to both the NIIT of 3.8 percent and the additional Medicare tax of 0.9 percent, but not on the same items of income. However, in determining whether an individual has modified adjusted gross income above the applicable threshold amounts for purposes of the NIIT, all of the individual’s taxable income, including taxable compensation subject to the additional Medicare tax, must be included for purposes of that determination. For example, if a single taxpayer has $180,000 of wages and also receives $90,000 of net investment income, the taxpayer’s modified adjusted gross income is $270,000. The taxpayer would not be subject to the additional Medicare tax because compensation income does not exceed $200,000, but the taxpayer would be subject to the NIIT on the lesser of the taxpayer’s net investment income ($90,000) or the amount by which the taxpayer’s modified adjusted gross income exceeds $200,000 ($70,000). Therefore, the taxpayer would owe NIIT of $2,660 ($70,000 times 3.8 percent).
The IRS has recently issued proposed regulations for the implementation of the additional Medicare tax and the NIIT. In addition, the IRS has issued a set of questions and answers about these taxes intended for taxpayers and tax preparers. These Q&As can be accessed at www.irs.gov.
While much of the recent focus has been on the debate about possible increases on the marginal income-tax rate, elimination of deductions and modifications to the gift and estate tax, many people have lost sight of the new taxes imposed under the Affordable Care Act, which took effect January 1. For high earners and individuals with significant investment income, these taxes may serve to compound the additional tax burden that is likely to be imposed as a result of the resolution of the fiscal cliff issues.
Mark L. Silow is the firmwide managing partner of Fox Rothschild. He formerly was chairman of the firm’s tax and estates department. His work involves a broad range of commercial and tax matters, including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.