Odds have now turned against those hoping that the health care law passed in 2010 will "just go away." The Supreme Court has spoken and legislative repeal seems more remote. On the other hand, President Obama has now indicated a willingness to improve the law and perhaps some of the more controversial provisions will work themselves out ... eventually.
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The Treasury, Internal Revenue Service and Department of Health and Human Services also have considerable administrative flexibility in how they interpret and apply many provisions. This may be especially true following the Supreme Court's Mayo decision, which appears to allow agencies more leeway in interpreting statutory requirements. That said, some health care law provisions are already in place and others are set to start in less than five months, beginning in 2013. When faced with these realities, dealing with the law as it now exists, and within the parameters of the limited guidance already released, appears to be an appropriate course of action.
One of the more pressing issues for many taxpayers is how to deal with one of the health care law's principal funding mechanisms -- the additional Medicare taxes imposed on higher-income taxpayers. The additional Medicare taxes come in two flavors: 0.9 percent and 3.8 percent.
In addition to the 1.45 percent employee portion of the HI (Medicare) tax imposed on wages, a 0.9 percent Medicare tax will be imposed on every taxpayer (other than a corporation, estate or trust) who receives wages with respect to employment during any tax year beginning after Dec. 31, 2012, in excess of $200,000 ($250,000 in the case of a joint return, $125,000 in the case of a married taxpayer filing separately). Deferred-compensation techniques and tax-free fringe benefits are among the standard tax planning strategies that may be used to reduce exposure to this tax. Also effective for tax years beginning after Dec. 31, 2012, a 3.8 percent Medicare tax is imposed on the lesser of an individual's net investment income for the tax year or modified adjusted gross income in excess of $200,000 ($250,000 in the case of joint filers and surviving spouses, and $125,000 in the case of a married taxpayer filing separately).
Modified AGI means an individual's AGI for the tax year increased by otherwise excludable foreign earned income or foreign housing costs under Code Sec. 911. Particularly with the 3.8 percent tax effective only a few months away, avoidance planning must start almost immediately. And it must be done under the disability of not having comprehensive guidance on the numerous issues that have been raised.
• Managing MAGI. In computing MAGI for purposes of the 3.8 percent threshold, gross income does not include items such as interest on tax-exempt bonds, veterans' benefits, and excluded gain from the sale of a principal residence, that are otherwise excluded from income. However, there are at least three non-re-occurring situations in which individuals may find themselves unexpectedly pushed over the $250,000 ($200,000) threshold by items that themselves may or may not be net investment income:
1. Gain over and above the $250,000 ($500,000) amount protected by the principal residence exclusion does increase MAGI as well as net investment income. Although complaints have been raised against this unexpected result for those many home owners not otherwise subject to the 3.8 percent tax, Congress so far has not acted to carve out an exception.
2. Lump-sum distributions from retirement plans, while excluded from net investment income, are included in computing MAGI. Required minimum distributions are also included, but generally will not create a one-year-only vulnerability of a retiree to the 3.8 percent tax that a lump-sum distribution would pose.
3. Converting traditional IRAs to Roth IRAs after 2012 will also increase MAGI by the amount of the converted amount. Those taxpayers potentially subject to these atypical increases in MAGI may consider accelerating into 2012 closing on a home sale, receiving lump-sum retirement distributions, or converting a traditional IRA to a Roth. Among the three, timing a Roth conversion likely presents the most flexibility.
• Managing net investment income. Code Sec. 1411(c)'s definition of "net investment income" for purposes of the 3.8 percent tax casts a wide net. It is "investment income" reduced by the deductions properly allocable to such income plus the sum of:
1. Gross income from interest (with the exclusion of interest on tax-exempt bonds), dividends, annuities, royalties and rents (other than income derived from any trade or business to which the tax does not apply);
2. Other gross income derived from any business to which the tax applies; and,
3. Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply.
This last part of the definition of investment income has raised questions over how to make the distinction between active versus passive business activities, not only within the controversial territory of investment partnerships, but also potentially within the operation of many plain-vanilla pass-through small businesses.
Code Section 1411(c) also taxes income earned on working capital. This will force pass-through entities such as partnerships and S corporations to segregate distributions of active trade or business income and passive, net gain attributable to property held by the S corp or partnership that is not property attributable to an active trade or business. Minority shareholders and minority partners may find themselves at a disadvantage, if the controlling shareholders or partners are not interested in distributing the additional cash that may be needed to cover the 3.8 percent tax.
Code Sec. 1411(c) complicates S corp and partnership planning further when there is a disposition of S corporate stock or partnership interest. In those situations, gain or loss is taken into account for determining net investment income only to the extent that gain or loss would be taken into account by the shareholder if the S corporation had sold all its properties for fair market value immediately before the disposition.
• Sunset of Bush-era rates. Measured alone, the 3.8 percent tax is substantial enough to be more than just a nuisance tax. When combined with the possibility of a sunset of the Bush-era rates for either capital gains, dividends or both, however, more of an effort toward post-November election contingency planning may be in order. Rather than a long-term capital gain rate of 18.8 percent, a rate of 23.8 percent or higher may be in force. Decisions based upon these outcomes include determining when to sell capital assets (before 2013 if qualified for long-term gain) or when to make special distributions in closely held businesses (before 2013 to qualify for the 15 percent dividend rate). Preparations might also be made to change the mix of investments by moving away from dividend-paying securities and investing in tax-free municipal bonds (for yields starting in 2013).
The higher cost of taxable investments might also tip the scales in favor of contributing more to a retirement plan from which eventual distributions are not subject to either the 0.9 percent or 3.8 percent tax. The traditional decision matrix of pre-tax contributions versus payouts at ordinary income tax rates therefore might need recalibration (which, of course, may also be higher when retirement is eventually taken).
The decision regarding whether to sell long-term capital assets in 2012 to recognize taxable gain, especially if the assets or a like-kind can be repurchased (and the overall investment preserved), hinges upon a number of factors. High on the list is the immediate loss in overall portfolio value from the cash set aside to pay the tax on the sale. If carryover losses are available to cover those gains, the case for a sale is more compelling.
Without offsetting losses, however, taxpayers will find themselves immediately poorer by the amount of tax immediately owed on the sale. The issue remains whether there will be a longer-term advantage when a sale otherwise taking place after 2012 would trigger taxable gain. The issue also remains whether to sell now or read the tea leaves as to the outcome of the November elections. If 2013 rates look like they are going up after the November elections, a selloff in certain markets might depress stock and other values to the extent that selling some assets now, to hedge against that possibility, might also be considered.
Estates and trusts not exempt. Estates and trusts also must pay a 3.8 percent unearned income Medicare contribution tax on the lesser of:
1. Their undistributed net investment income for the tax year; or,
2. Any excess of their AGI (as determined under Code Sec. 67(e)) over the dollar amount at which the highest tax bracket for estates and trusts begins for the tax year (currently at $11,650, but subject to inflation adjustment each year). Charitable remainder and other tax-exempt trusts are excluded. Since individual beneficiaries have the higher $250,000 ($200,000) threshold, distributing to estate or trust beneficiaries the assets that create net investment income might serve to avoid the 3.8 percent tax on some or all of the income.