How the new 3.8 percent tax may apply to selling a business

A new unearned income Medicare contribution tax, with an effective date of Jan. 1, 2013, was enacted as part of the healthcare act. That date has come and gone, and the tax is now applicable.

The new Medicare tax applies to net investment income of individuals whose modified adjusted gross income exceeds certain threshold amounts. The threshold amounts are $250,000 for married filing jointly, $125,000 for married filing separately and $200,000 for single taxpayers.

The tax also applies to undistributed net investment income of estates and trusts when adjusted gross income exceeds the highest estate and trust tax bracket.

Trade or business income

In the case of a trade or business, the Joint Committee on Taxation’s Technical Explanation of the provision says that the tax applies to business income if the trade or business:

  • Is a passive activity, with respect to the taxpayer, or
  • Consists of trading financial instruments or commodities

But the tax does not apply to other trades or businesses conducted by a sole proprietor, partnership or S corporation.

(Refer to Joint Committee on Taxation’s Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as amended, in combination with the “Patient Protection and Affordable Care Act,” March 21, 2010.)

Sale of business assets

Upon disposition of a business, only net gain or loss attributable to property held by the entity that is not property attributable to an active trade or business is subject to the tax. However, income, gain or loss on working capital is not treated as derived from a trade or business, so it’s taxable.

The tax applies to net investment income, including net gain (to the extent taken into account in computing taxable income), from the disposition of property other than property held in a trade or business. When a disposition of an active equity interest in a partnership or S corporation is made, rather than a disposition of the underlying assets, an exception also applies.

Sale of equity interests

An interest in a partnership or S corporation in most cases is not property held in a trade or business, according to the preamble to proposed regulations issued in November 2012. Therefore, gain or loss from the sale of a partnership interest or S corporation stock will be subject to the tax.

This generally is not the case when partners or S corporation shareholders materially participate in the business. So, dispositions of those interests should be closely reviewed for exemption from the tax.

Sale of partnership or LLC equity interests

A sale of equity interests in a partnership or limited liability company (LLC) is treated as a direct sale of partnership or LLC assets. Therefore, a net gain on the sale of partnership interests or LLC member interests by a partner or member who materially participates in the business is exempt from the tax. This result differs from the sale of interests in an S corporation, in which there is a strong distinction between stock and asset transactions.

Sale of S corporation stock

Absent further guidance, the sale of S corporation stock, even by a shareholder who materially participates in the business, would appear to be subject to the tax. Fortunately, the law itself provides an exception.

The Internal Revenue Code addresses gain in the case of a disposition of an interest in a partnership or S corporation. For purposes of the tax, gain is considered only to the extent of the net gain the seller would take into account if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of the equity interest.

Deemed asset sale election

The exception for a disposition of an active equity interest in an S corporation is inapplicable to the deemed asset sale and liquidation transactions that result from an election. The exception is unnecessary, since the exception for the sale of active business assets would apply directly.

Information reporting

The IRS requires information to verify a taxpayer’s eligibility for the exception for certain active interests in partnerships and S corporations. This information will be used to determine whether the amount of tax has been reported and calculated correctly.

The IRS specifically requests comments concerning whether the proposed collection of information is necessary for the proper performance of the IRS’s functions, including whether the information will have practical utility.

Payments for services, noncompete covenants and personal goodwill

In the context of selling a business, Form 8594, Asset Acquisition Statement Under Section 1060, asks – even for a stock sale – whether ancillary agreements were negotiated with the sellers in addition to the related stock or asset sale agreement.

Employment or consulting agreements may attract the new 0.9 percent Medicare tax. But they should not be subject to the 3.8 percent unearned income Medicare contribution tax because payments would not constitute net investment income. Noncompete payments should not be subject to either of the new taxes since they are neither self-employment income nor net investment income.

The sale of personal goodwill creates a capital gain that may be subject to the active trade or business exceptions to the 3.8 percent tax.

Deferred gain

If the sale of an S corporation would have avoided the tax under the active trade or business exception, a question comes to mind: Would that gain also be excluded from the new tax with a tax-free merger of the S corporation into a C corporation and reduce the ultimate net investment income on a taxable sale of the stock received in the merger? Nothing in the statute, Technical Explanation or proposed regulations addresses that issue.

Tax impact

An additional 3.8 percent tax on top of a 20 percent capital gains tax amounts to a 19 percent surtax.

While it is appropriate to minimize the tax when possible, the Joint Committee on Taxation warned in March 2010 that the IRS will closely review transactions that manipulate a taxpayer’s net investment income to reduce or eliminate the amount of tax imposed.

Professional tax advice is strongly advised in applying the provisions of the unearned income Medicare contribution tax.

Affordable Care Act – What to expect in 2013 and 2014

In June 2012, the U.S. Supreme Court ruled in favor of the constitutionality of the Patient Protection and Affordable Care Act, often called Obamacare, clearing the way for the law’s implementation.

The Affordable Care Act, along with the Healthcare and Education Reconciliation Act, represents the most significant regulatory overhaul of the U.S. healthcare system since the passage of Medicare and Medicaid in 1965. Aimed at reducing the number of uninsured Americans and reducing the overall cost of health care, the act provides a combination of mandates, subsidies, taxes and credits to both employers and individuals to increase the insurance coverage rate.

Although the major non-tax-related changes of the act are yet to come, a few significant tax provisions will take place in 2013 and 2014.

Many people are aware of the Medicare payroll tax and the surtax on net investment income, but there are additional provisions that may affect taxpayers. These taxes are meant to alleviate the Medicare system’s financial difficulties as well as offset the cost of healthcare legislation. 

Effective Jan. 1, 2013 

Medical device tax

This excise tax of 2.3 percent is levied on medical device manufacturers or importers on the sale of any taxable medical device. Generally, it doesn’t apply to over-the-counter medical devices, such as eyeglasses, contact lenses, hearing aids and some prosthetics.

The tax mostly applies to medical devices used and implanted by medical professionals. The manufacturer or importer of the device is responsible for paying the tax using Form 720, Quarterly Federal Excise Tax Return, which is due at the end of the month following the last month of the calendar quarter. The first quarter 2013 return is due April 30, 2013. Semimonthly tax deposits may be due if the tax exceeds $2,500 for the quarter.

Medicare payroll tax increase and surtax

The Medicare Part A (hospital insurance) tax rate on wages will be increased by 0.9 percent (from 1.45 percent to 2.35 percent) on earnings over $200,000 for individual taxpayers and $250,000 for married couples filing jointly. The increased tax will be withheld by employers, similar to the existing Medicare tax.

In addition, a 3.8 percent surtax will be imposed on net investment income if the taxpayer’s modified adjusted gross income exceeds $200,000 for individual taxpayers and $250,000 for married couples filing jointly. Net investment income includes interest, dividends, annuities, royalties, rents and capital gain income.

Capital gain includes the gain from sale of a principal residence but only for that portion of the gain above the existing exclusion. Capital gains associated with an asset used in a business are not included in the definition of investment income.

Net investment income also includes trade or business income from a “passive activity” as defined in Internal Revenue Code Section 469 (and related regulations). Although some rental activities engaged in by a real estate professional are not passive activities, they may still be subject to the surtax. More guidance is needed in this area.

Net investment income is defined as gross investment income less deductions allocable to that income. Typically, investment-related deductions are certain itemized deductions subject to a number of thresholds and limits for regular income tax purposes, including the investment interest deduction, which has its own separate limitations. It appears these thresholds and limitations will apply in calculating net investment income.

The 3.8 percent surtax also applies to trusts and estates on income in excess of approximately $12,000.

Limit on flexible spending contribution

A new cap of $2,500 will apply to contributions by employees to a flexible spending account. The annual $2,500 cap will be indexed for cost-of-living adjustments for plan years beginning after Dec. 31, 2013. Under previous law, no limit applied to an employee’s contribution amount unless the employer imposed one.

Loss of employer retiree drug subsidy deduction

The federal tax deduction for employers who receive the Medicare Part D retiree drug subsidy coverage is eliminated. The retiree drug subsidy was established by the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 to encourage employers to continue offering prescription drug benefits to their retirees.

Employers who received the subsidy also were allowed to deduct the entire cost of the benefits. The healthcare act retains the drug subsidy but eliminates the employer�s ability to deduct the amount of the subsidy.

Medical itemized deduction threshold increased

The adjusted gross income (AGI) threshold for claiming medical expenses increases from 7.5 percent to 10 percent of AGI for taxpayers 64 and under. Taxpayers 65 and older can continue to use the 7.5 percent threshold through 2016.

Effective Jan. 1, 2014

 

Penalty for not having medical insurance

For individuals who do not have health insurance coverage, a penalty will be assessed at the greater of $95 a year or up to 1 percent of income. The penalty increases to the greater of $325 or 2 percent of income by 2015, and the greater of $695 or 2.5 percent of income by 2016.

For families, the penalty will be capped at 300 percent of the annual flat dollar amount.

The requirement can be waived for several reasons, including financial hardship or religious beliefs. If the tax would exceed 8 percent of your income (in 2014), you are exempt. Some religious groups are also exempt. The tax cannot exceed the cost of a “bronze plan” bought on the exchange.

While some states, including Alabama, Wyoming and Montana, have passed laws to block the requirement to carry health insurance, those provisions do not override federal law.

For businesses with more than 50 full-time employees who do not offer health insurance coverage to all employees, a penalty of $2,000 per employee will be assessed. The first 30 employees are not counted in the calculation of this penalty.

Enhanced Small Business Health Insurance Credit

For businesses with fewer than 25 employees that pay an average wage to their employees of less than $50,000 per year and pay for more than 50 percent of the employees’ health insurance premiums, a credit is currently allowed equal to 35 percent of the cost of the health insurance. Starting in 2014, the credit jumps to 50 percent for employers who participate in a health exchange. 

Federal agencies strive to counter identity theft

There are always plenty of reasons to speed up the process of filing your individual return.

The primary reason has always been that, if you’re expecting a refund, you shouldn’t wait any longer than necessary to receive it.

Well, you can add identity theft to your reasoning now.

Identity thieves have found ways to fraudulently prepare tax returns and steal refunds from taxpayers, and they’re doing it at exponential rates. Many times, these stolen numbers have been those of deceased individuals, children or those not otherwise required to file tax returns. However, anyone can be targeted.

Many families have suffered the passing of a loved one only to find that the decedent’s tax refund was stolen by identity thieves. Ironically, much of the information used by identity thieves is received from the federal government.

Every year the Social Security Administration releases the names and Social Security numbers of individuals when it learns of their deaths in a Death Master File. The file is meant to be confidential, but it has proven to be easily accessible. In a 2012 letter to the Office of Management and Budget, Senator Bob Casey (D-PA) called on the administration to finalize rules that would bolster privacy protections and better protect Americans’ Social Security numbers.

The method of delivery of the fraudulent refunds also facilitates the theft. Direct deposit and debit cards are often used by identity thieves.

Unfortunately, the Internal Revenue Service was found not to be in compliance with direct deposit regulations that require tax refunds to be deposited to an account only in the name of the individual listed on the tax return. In just one case, there were 590 direct deposits to the same bank account totaling over $900,000.

In July of this year, the Treasury Inspector General for Tax Administration (TIGTA) issued an audit report on this subject. The agency was established in 1999 to provide independent oversight of IRS activities.

While the problem of identity theft and fraudulent tax returns has been around for a while, it seems to have exploded for the tax years 2010 and 2011, and it looks like 2012 may be even worse. Florida has been an epicenter, where gang activity actually declined in some areas during January and February because the thugs found fraudulent tax return filing more profitable than drug deals.

In analyzing 2010 tax returns filed in 2011, the most recent TIGTA report found that the IRS may have delivered more than $5 billion in fraudulent refunds in addition to what it had already detected.

During the 2011 filing season, the IRS reported that it prevented $6.5 billion in fraudulent returns (938,664 tax returns). Even more troubling, the TIGTA report estimates that the IRS could issue approximately $21 billion in fraudulent tax refunds over the next five years.

The IRS disagrees with this determination. It believes the filters it recently added to prevent some of this fraud were not taken into consideration in the estimate.

There are several problems contributing to this situation. For one, the IRS allows refunds to be issued before matching data used to verify the numbers are submitted.

For example, someone could file a tax return requesting a refund on Jan. 16, while the wages and related federal income tax withholding shown on that tax return are not reportable to the IRS on a W-2 form until Jan. 31.

Another problem is the level of the refund. Even if a filter is in place to flag a return as potentially fraudulent, a refund that is small enough often gets through. The IRS simply does not have enough resources to investigate all of these occurrences.

Any tax refund that is stolen from a taxpayer will ultimately be refunded to a taxpayer once the IRS is convinced of a taxpayer’s identity (see www.irs.gov/uac/Identity-Protection). But this can be a long and arduous process.

The better news is that the IRS has recently issued Form 14039, which is available to taxpayers who have been or may be victims of identity theft. The form essentially puts the IRS on notice of a taxpayer’s identity (or a decedent’s if the taxpayer is an executor).

After a taxpayer files Form 14039, the IRS will not send refunds, etc., to the addresses of others claiming the same identity. The form is filed with appropriate photocopies of identification.

To lessen the chance of stolen refunds, the following actions are recommended:

�         File individual returns, especially those with large anticipated refunds, as soon as practicable.

�         Don’t ignore an IRS notice that indicates you’ve received wages from a job you’ve never held.

�         File Form 14039 if you have been an actual victim of identity theft.

�         File Form 14039 if you feel you are a potential victim of identity theft, e.g., if you’ve had a lost or stolen purse or wallet or questionable credit card activity.

�         File Form 14039 if you’re the executor for a decedent with a potential refund, and recommend that this action be taken for friends and loved ones who have recently died.

If taxpayers fall victim to identity theft, they may feel that their IRS information is safe and refunds are not at risk. And if taxpayers don’t feel the need to share identity theft issues with their accountants, opportunities to protect refunds may be missed.

In addition to helping identity theft victims clear up problems with their IRS accounts, the IRS works proactively to help ensure that these taxpayers do not encounter delays in processing their future returns.

In January 2011, the IRS launched a pilot program for Identity Protection Personal Identification Numbers (IP PIN). The IP PIN is a unique identifier establishing that a particular taxpayer is the rightful filer of the return. This program continues to be in place.

There has been a 200 percent increase in ID theft phone calls, reported Peggy Bogadi, the commissioner of the IRS Wage and Investment Division, at the November 2012 National Tax Conference of the American Institute of CPAs in Washington. She also said that the IRS will issue more than 600,000 IP PINs for filing 2012 returns.

In December 2012, the IRS will mail IP PINs to ID theft victims to be used in filing their 2012 tax returns. The IRS provides answers to some frequently asked questions about IP PINs on its website at www.irs.gov/individuals/article/0,,id=249368,00.html.

Taxpayers who use these IP PINs when filing their 2012 returns should not have any processing issues. If anyone tries to file a tax return without the IP PIN, the refund will not be issued without further investigation, according to Bogadi.

For those who receive an IP PIN, it’s critical that they put it in a safe place so they will have it for their tax return preparation.

All victims of identity theft should let their tax advisers know as soon as possible.

Additional Medicare tax looms on the horizon

If you and your spouse have self-employment earnings or wages in excess of $250,000, you should be aware of the new tax increase starting in 2013.

The Health Care and Education Reconciliation Act of 2010, which was signed into law on March 30, 2010, created two methods of raising revenue by increasing Medicare taxes by 0.9 percent on wages and self-employment income and by 3.8 percent on net investment income (as discussed previously in the Sept./Oct. issue of Federal Tax Watch).

Prior to 2013, wages were subject to a Medicare tax of 2.9 percent – half (1.45 percent) paid by the employee and the other half paid by the employer. In addition to Social Security tax, self-employment earnings were subject to the 2.9 percent Medicare tax, which equaled the combined rate. Starting in 2013, an additional 0.9 percent tax will be assessed on wages and self-employment income in excess of certain limits, depending on filing status.

It’s important to note that the 0.9 percent additional tax is imposed on the employee only, not on the employer. Accordingly, self-employment income is subject to 0.9 percent, not 1.8 percent. Self-employment income is generally income earned by owners of sole proprietorships and partners in a trade or business partnership.

For those who are self-employed, a deduction of one-half of the self-employment tax (Social Security and Medicare portion) is allowed in determining adjusted gross income on page 1 of their tax return. Note that the new 0.9 percent tax on wages/self-employment income is not eligible for the 50 percent deduction in calculating adjusted gross income.

The structure of the new tax also imposes a marriage penalty because it is assessed on the joint wages in excess of $250,000. Thus, if each spouse earns $200,000, the tax will be paid on the excess wages of $150,000 ($400,000 – $250,000). But if they had remained single and each had earned $200,000, no additional tax would have been due.

Taxpayers may be subject to underpayment penalties in addition to the new tax. This factor is of particular importance when the taxpayer has investment income that is subject to the previously mentioned additional 3.8 percent tax. Employers are required to withhold the new tax only on wages they pay in excess of $200,000. Therefore, a married couple’s earnings may be subject to the additional tax, but their respective employers may not withhold the extra amount.

For example, if each spouse earns $200,000, no withholding would be incurred, but their additional liability would be $1,350 ($400,000 – $250,000 = $150,000 * 0.9% = $1,350).

The same result occurs when an individual changes jobs or has multiple employers. According to the withholding requirements, only wages paid by the specific employer are subject to the additional tax regardless of other employment.

As with many other items in the recent tax changes, the tax thresholds are not subject to inflation adjustments, so the tax burden will increase as time and inflation march on.

Where do you live – for state tax purposes?

Dual state residency issues are becoming more frequent audit issues as states seek to increase their revenue.

In the digital data-sharing world, it’s very important to maintain good tax records. If you own property such as a vacation home in a state where you work, and you reside in another state, you may find yourself in a tax dilemma. Your records may or may not assist you in proving your “tax” residency is accurate.

Your residency is defined by tax law or statute, which in most states is based on how many days you spend in the state and whether you maintain a living space. If you own a house and work in New York but believe that you reside in a neighboring state, you may be subject to dual residency taxes. Dual residency would mean you owe taxes in two states on your entire income, with no offsetting tax credit for taxes paid to another state.

If your EZ-pass, credit card statements, cell phone and other records do not support your being out of the state for more than the statutorily defined period, you may find yourself in a tax problem. Alternatively, if your records show you were in a state for the required number of days, you are also in a tax dilemma.

In the case of New York, you’re considered a resident even if you are domiciled outside New York but maintain a permanent place of abode in New York and spend 184 or more days there. Generally, a permanent place of abode is a residence you or your spouse maintains, whether you own it or not, that is suitable for year-round use. The residence must have basic facilities, such as for cooking, bathing, sleeping, etc.

If the living quarters cannot be used all year, they may not be considered a “residence.” A few examples are given in New York State Tax Bulletin TB-IT-690, “Permanent Place of Abode.” As an example, consider an individual who owns a fishing cabin in the mountains. If the cabin is suitable for use only during the warmer months of the year because it doesn�t have adequate insulation or heating for winter use, it isn’t judged to be a permanent place of abode.

Alternatively, even if someone doesn’t own or lease premises within the state, it’s possible for the individual to be judged a resident by virtue of “maintaining” the property.

The state provides an example: Lisa lives in a condominium with Mark during the workweek. Although only Mark’s name is on the lease, Lisa regularly gives Mark money to pay for her share of the household expenses. Lisa has lived in the apartment for three years. Since Lisa makes monetary contributions to maintain her living arrangement in the apartment, the apartment would be considered a permanent place of abode for Lisa.

A corporate apartment suitable for permanent year-round use may also be considered a person’s permanent place of abode if the dwelling is principally available to that person. Even if others use the apartment on occasion, it may still be defined as the person’s permanent place of abode.

A corporate apartment may not be considered a permanent place of abode for the taxpayer if the primary purpose or use of the corporate apartment is other than as living quarters of the taxpayer or the taxpayer’s family. An example would be making the apartment available on a first-come, first-served basis to exec­utives, salesmen or important clients when they’re visiting the corporation.

Tax Impact of Health Care Reform Law

Dear Client,

 

Many clients (like yourself) have asked us about the tax impact of the health care reform law now that the U.S. Supreme Court has indicated that the law is largely constitutional. The following paragraphs provide a broad outline of some of the key individual tax provisions in that law.

 The Personal Responsibility Tax Penalty

 The U.S. Supreme Court found that the personal responsibility “penalty” is a tax and thus constitutional. This tax provision is found in Section 5000A of the tax code. It starts in 2014 and “ramps up” (increases) quickly. In 2016, the penalty is equal to the greater of $695 or 2.5% of household income (a family cap of $2,085 applies). This provision applies to all clients irrespective of income level.

 The personal responsibility penalty tax is aimed at individuals who fail to maintain health insurance coverage. To avoid the penalty, the individual must maintain minimum essential coverage.

 Medical Deduction

 It is very hard to obtain an itemized deduction for out-of-pocket medical care costs. Under current law, a taxpayer must exceed a 7.5% of AGI (adjusted gross income) threshold to obtain a deduction. Under the health care reform, a 10% of AGI threshold will apply.

 This rule will generally come into effect in 2013. However, individuals age 65 and older will be able to use the existing 7.5% through 2016.

 Health FSA Cafeteria Plan Contributions 

The new law limits health flexible spending account contributions to $2,500 in 2013. This significantly restricts these benefits for individuals.

 Remember, the pre-tax nature of a health FSA contribution is a major benefit to individuals. Many individuals work for companies that sponsor “cafeteria plans” (pre-tax plans) that contain such pre-tax health FSA type benefits.

 Other Individual Tax Provisions In The Affordable Care Act 

  • Individuals who take a non-qualified distribution from a health savings account (HSA) (or Archer MSA) will incur a 20% (up from a 10%) additional tax (effective 2011).
  • In 2018, the new law imposes a 40% excise tax on “cadillac” health care policies (health coverage). It is an “indirect tax.” The excise tax is imposed on the insurers on a pro rata basis. Thus, either policies will be modified to avoid the tax or there will be higher costs for these types of policies. Stay tuned. 
  • There are other provisions that may directly or indirectly impact a particular individual client. For example, there is an excise tax on manufacturers and importers of certain medical devices. This cost may be passed on to the individual consumer. 

Please contact our CPA firm if you have any questions regarding the tax impact of the Affordable Care Act.

Estate planning with trusts: Availability limited?

With the looming expiration of the $5 million estate and gift tax exemptions and the current favorable top tax rate of 35 percent, estate tax planning has become a significant area of focus among many tax advisers.

Possible expiration of these provisions has fueled the emphasis on the importance of addressing the impact on individuals and on the transfer of assets to future generations.

Many advisers have focused on employing grantor trusts to help meet clients’ objectives. Grantor trusts have been the target of legislators over the years, and current proposals would eliminate many of the benefits of using these trusts in estate planning.

Most commentators agree that it is highly unlikely that current proposals will be adopted. However, their approval would close the window on these estate tax planning opportunities, making it crucial to act now if you could benefit from these techniques.

To create a grantor trust, a donor transfers property to a trust but retains powers that cause the grantor to be treated as the trust owner under the grantor trust rules. The trust is disregarded as an entity under federal income tax law, and the grantor must account for all items of income and deduction attributable to the trust property.

Because the grantor is required to pay this tax, it is not treated as a gift to the trust, and the grantor effectively transfers additional wealth to trust beneficiaries without affecting the exemption amount or incurring additional gift tax.

In addition, due to differences in the grantor trust and the estate and gift tax rules, as long as the transfer is properly structured as a completed gift, the property will be excluded from the grantor’s estate for estate tax purposes.

When the trust document is drafted as a trust that purposely invokes the grantor trust rules, it is commonly referred to as an intentionally defective grantor irrevocable trust. Although this can be achieved in a number of ways, one of the more aggressive and complicated planning strategies involves structuring an installment sale to a grantor trust.

Using this strategy, the donor sets up a trust in which he retains the power to replace trust assets with assets of equal value. The transaction is structured as a combination gift and sale.

The grantor first makes a gift to the trust, usually cash, and then sells an appreciating asset to the trust in exchange for cash and a promissory note providing for installment payments over time. The interest is based upon the required minimum IRS interest rate.

Because the grantor is treated as the owner of the trust, no gain or loss is recognized on the sale of the asset to the trust or on the note’s interest.

A grantor retained annuity trust (GRAT) is another type of grantor trust. It can provide a unique estate planning opportunity because of the manner in which the remainder interest is valued for gift tax purposes.

To establish a GRAT, the grantor transfers appropriate property to an irrevocable trust. The grantor retains the right to receive an annual payment of a fixed amount for a specified term of years. Then the property passes to the remainder beneficiaries.

The creation of the GRAT is treated as a taxable gift to the extent of the present value of the remainder interest, which can often have de minimis, or minor, value. The trust property is assumed to appreciate at the federally established rate, while the property in the trust is expected to appreciate at a higher rate.

Proper planning should result in the value of the property received by the trust beneficiary substantially exceeding the value on which the donor was required to pay gift tax.

Although these trusts can be an effective planning tool for some taxpayers, they are not appropriate for everyone. If your estate is less than $10 million joint ($5 million single), you can likely accomplish your planning goals through lifetime gifts and less complicated trusts.

With the help of your CPA, you should assess your long-term objectives, personal and financial situation, and the assets that will be held by the trust to determine the most suitable approach. After this assessment, if you believe that a GRAT or grantor trust may be appropriate, you should consider the advantages and disadvantages of each.

IRS guidance: Is it a tip or a service charge?

 The IRS recently issued guidance on the difference between a tip and a service charge.

The distinction is important because service charges are considered revenue of the establishment. To the extent that the service charges are, in turn, paid to the employees, that amount is compensation, subject to all payroll taxes and withholdings.

The employer’s calling the payment a “tip” is not conclusive. Customer payments are considered tips when all of the following requirements are met:

1. The amount must not be determined by the employer.

2. The customer has full discretion to determine the amount of the payment.

3. The payment must be freely made.

4. The customer can generally decide who receives the payment.

The IRS believes that the absence of any of these components suggests that the payment is a service charge instead of a tip.

This is an important clarification because the amount of com­pensation paid to employees affects not only the computation of payroll and withholding taxes due but also the calculation of other benefits based on compensation. In addition, service charges are not eligible for the employer tip credit.

In Announcement 2012-25, the IRS advises all businesses to make any needed system or procedure changes to fully conform to these rules by Jan. 1, 2013.

New Medicare investment tax adds layer of taxation

With the Supreme Court’s finding that the 2010 federal healthcare act is constitutional, it’s time to consider one of the revenue-raising provisions of the act and the ways it may affect next year’s tax situation.

As a generalization, the net investment income of taxpayers with total income over a certain threshold is subject to a new Medicare investment tax of 3.8 percent beginning in 2013.

As with almost any tax provision, the devil is in the details, and the details start with the definitions. The additional tax applies only to married couples with modified adjusted gross income over $250,000 (over $125,000 for married couples filing separately). Single filers face a threshold of $200,000.

For this purpose, modified adjusted gross income means total income on page 1 of your Form 1040, plus the foreign earned income exclusion. So, unless you have worked outside the United States and qualify for the exclusion, the threshold is based on the amount at the bottom of page 1 of your Form 1040.

This means that all income is included and only certain deductions apply, such as self-employed retirement contributions and health insurance. Items such as charitable contributions reduce your taxable income on page 2 of your 1040, but they do not reduce the exposure to this investment tax.

Net investment income is income from interest, dividends, royalties, annuities and certain other income. Net rents after expenses are included but not for real estate professionals. Flow-through income from trusts, LLCs, partnerships and S corpora­tions is included if the income is considered passive to the recipient. Gains on the sale of investment assets are generally included in net investment income as well.

Investment income does not include income from tax-exempt municipal bonds, distributions from qualified plans or IRAs, or income or distributions from flow-through entities in which the investor materially participates.

 The tax also applies to trusts and estates if they have income that has not been distributed and the income is in excess of the highest tax bracket in that year. These tax brackets are quite short. For 2012, trusts and estates are generally at the top tax bracket with only $11,650 of income. Charitable trusts are exempt.

Example 1

John, a single filer, has $175,000 of salary and $75,000 of net investment income. His modified adjusted gross income is $250,000, less the $200,000 single-taxpayer threshold, leaving $50,000 of income in excess of the threshold. The lower of net investment income and excess income is $50,000. At a 3.8 percent tax rate, Medicare investment tax of $1,900 is due, in addition to any other tax.

Example 2

Misty and David are married and have $200,000 of combined salary, $50,000 of interest and dividend income, and $100,000 of net rental income from an investment partnership. Their modified adjusted gross income is $350,000, less the $250,000 threshold for a married couple filing jointly, leaving $100,000 of income in excess of the threshold. The lower of net investment income and excess income is $100,000. Medicare investment tax of $3,800 is due.

This investment tax is actually a third income tax system, separate from the regular federal income tax and the alternative minimum tax (AMT). It can be seen as a separate system because you can owe the investment tax without owing either the regular income tax or the AMT.

For example, you could have significant income yet also have large deductions and credits that eliminate your income tax liability. However, you could still owe this Medicare investment tax.

Consider some planning ideas for this new tax:

  • Shift savings and investment strategy to tax-exempt invest­ments and tax-deferred retirement assets.
  • If rents are a major source of your net investment income, a cost segregation study might increase your depreciation expense and reduce your net rental income.
  • If you have significant unrealized capital gains in your portfolio, consider selling those assets in 2012 before the new tax takes effect.
  • Consider using a charitable remainder trust, both to shelter a large gain from net investment income and to prevent a large one-year bulge in your total income subject to the MAGI threshold.
  • Plan for your installment-sale strategy. For sales beginning in 2012, you might consider electing out of the installment method, reporting all of the gain in 2012 and avoiding the tax on the gain from installments collected in future years.
  • If you are considering a Roth IRA conversion, converting a traditional IRA to a Roth IRA this year would be wise in plan­ning for the investment tax. If you wait until 2013, although your IRA income is not considered net investment income, the bump in income from the conversion will increase your modified adjusted gross income subject to the threshold.
  • Shift investment assets to children with lower investment income. The so-called “kiddie tax” will remove much or all of the income tax savings, but the investment tax savings may remain.
  • Trusts should reconsider the amount of distributions paid out to avoid paying this tax at the trust level.

Talk with your tax adviser about how the Medicare investment tax will affect your tax situation in 2013. But remember, in the end, this is only an additional 3.8 percent tax. While that amount may be sub­stantial in certain circumstances, the cost of this tax may not offer a sufficient reason to make dramatic changes in your affairs.

Project the expected effect of this tax on your tax picture first, determine how much of it can be avoided with certain changes, and then consider whether the net savings truly justifies the changes.

Small employers not claiming health care credit, IRS says

The volume of claims for the Small Business Health Care Tax Credit has been lower than expected, according to a Treasury Inspector General for Tax Administration audit released Nov. 7, 2011.

As of mid-May 2011, only 228,000 taxpayers out of an estimated potential pool of 4.4 million taxpayers have made claims for the credit. Less than 15 percent of the expected $2 billion of credit for tax year 2010 was claimed.

The credit is generally available only to small employers who pay at least half the cost of health insurance coverage for their employees. The credit is refundable to tax-exempt organizations but only to the extent it does not exceed the total amount of income tax and Medicare tax withholding from employees’ wages and the employer share of Medicare tax.

To qualify for the credit, an employer must have fewer than 25 full-time equivalents for the taxable year and have average annual wages for its employees for the year of less than $50,000 per FTE.

Employers with more than 10 but fewer than 25 FTEs or average wages of more than $25,000 but less than $50,000 may qualify for a reduced credit amount.