It looks as though the Internal Revenue Service is finally convinced, like the rest of us, that it is going to have to deal with the new Medicare contribution taxes coming into effect in 2013. One month before they come into effect, the IRS issued extensive proposed regulations addressing many of the uncertainties surrounding these new surtaxes. The guidance also included sets of frequently asked questions. While the regulations are not expected to be finalized until well into 2013 for the 2014 tax year, the IRS stated that taxpayers may rely on the proposed regulations for compliance purposes for 2013.
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The proposed regs address both the 0.9 percent additional Medicare contribution tax on earned income and the 3.8 percent Medicare contribution tax on net investment income. These apply to modified adjusted gross incomes in excess of $200,000 for single filers and $250,000 for joint filers, with the thresholds for estates and trusts being much lower, tied to their highest income tax bracket.
Many of the questions that practitioners have been asking are addressed in these regs. What constitutes a business of trading in financial instruments or commodities? How will the material participation standard be applied? When are items properly allocable to income and gains? What is the treatment of nonqualified deferred compensation plans? How will the estimated tax rules be applied?
NET INVESTMENT INCOME
The majority of the questions surrounding the new Medicare contribution taxes related to the tax on net investment income under Code Sec. 1411, since that is new territory for a Medicare tax. By and large, the proposed reliance regulations seek to borrow as much as possible from existing definitions and distinctions in the tax law -- except where the IRS feels variations are necessary to prevent abuse of the rules. In addition to expanding upon how the rules apply to individuals, the proposed regulations discuss their application to estates and trusts in some detail.
Categories of net investment income include income derived from trades or businesses that are passive activities with respect to the taxpayer, or trading in financial instruments or commodities: The regulations expand upon both concepts. Another category of net investment income relates to income and gains from investments of working capital, and the regulations also expand upon that concept. Other areas addressed include dispositions of interests in partnerships and S corporations, distributions from certain qualified plans, and controlled foreign corporations and passive foreign investment companies. The regulations also delve into the items to be taken into account in determining self-employment income. Also hailed as a welcomed election for certain individuals with multiple activities, the regulations permit taxpayers to regroup passive activities for determining net investment income.
In general, gain that is not recognized for ordinary income tax purposes will not be recognized for net investment income purposes under Code Sec. 1411. However, in order to prevent what the IRS perceives as a possible avenue for abuse, substitute interest and dividends will be treated as interest and dividends for net investment income purposes. Also, certain distributions excluded from gross income are identified as being included in net investment income.
The regulations discuss how to handle joint returns where one of the spouses is a nonresident alien not subject to the surtax unless an election is made. Residents of U.S. territories are also addressed, with distinctions between territories with mirror tax systems and those without.
In the discussion of estates and trusts, a number of particular situations are discussed, including tax-exempt trusts, grantor trusts, electing small-business trusts, charitable remainder trusts, foreign estates and trusts, and bankruptcy estates. Generally, pass-through and accumulated income principles already applicable to these entities are applied for purposes of the surtax.
A significant portion of the regulations are devoted to defining net investment income, covering such issues as annuities, the ordinary course of business exception, other trade or business gross income, net gain, and properly allocable deductions. A passive trade or business discussion addresses material participation, real estate professionals, rental activity exceptions, and the Code Sec. 469 grouping rules.
ADDITIONAL TAX ON EARNED INCOME
The proposed regulations with respect to the additional 0.9 percent tax on earned income address such issues as self-employment contribution taxes, estimated taxes, interest-free adjustments of employment taxes, claims for refund of employment taxes, the employer's obligation to withhold, and the employee's and self-employed person's obligations to report and pay. The proposed regulations also cover the application of this new surtax to railroad employees under the Railroad Retirement Tax Act. Many of the issues with respect to the Medicare contribution tax on earned income relate to how the $200,000/$250,000 threshold will be applied.
FREQUENTLY ASKED QUESTIONS
For net investment income, the frequently asked questions cover the basic issues and include examples of the calculation of the tax and how it applies to the sale of a principal residence. The more extensive FAQ on the additional Medicare tax addresses how withholding is to work, how estimated taxes are to be handled, multiple employers, two spouses working for the same employer, non-cash fringe benefits, tips, and a combination of wages and self-employment income. Many of these questions and answers deal with issues surrounding the threshold amounts.
The extensive new proposed regs on the Medicare contribution taxes should help taxpayers cope with the new requirements. It would have been helpful had they come out a little earlier. When finalized, the regulations will apply starting in 2014. The proposed regulations may be relied upon, however, for dealing with the current 2013 tax year. Practitioners will want to make sure that their clients are setting up procedures to comply with these regulations as soon as possible.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.