[IMGCAP(1)]I remember the tax-cutting years in previous political eras. Those were the good old days. Now it’s easy to get the impression we have higher income taxes and an extra tax on investment earnings. But analyzing taxes and the reasons behind them are not that simple. Some brackets are actually lower today, and some taxpayers are paying at a higher rate while others are paying at a lower rate.
Taxes have come up recently in political banter, comparing today to the 1980s. The discussion quickly polarized along party lines. CNN reported that annual federal tax receipts of over 30 years ago averaged 18.2 percent of the gross domestic product, a little above where they are today at their 40-year average.
When you directly compare times in which presidents were trying to guide the country out of recessions, revenues compared to GDP were 17.5 percent 30 years ago and 14.9 percent today.
Through the years, several administrations increased spending on military build-ups and wars, resulting in the need to pay for them. Income taxes were also cut several times, but it didn’t feel like it to taxpayers because inflation pushed them into higher tax brackets, the so-called bracket creep. Presidents have also adjusted taxes by eliminating some popular tax loopholes for the wealthy and corporations.
Today taxes are higher for the wealthy; capital gains and self-employment taxes have increased and now we have the 3.8 percent “Net Investment Income Tax” over a certain income level to pay in part for social programs.
The point about the changing tax policy is that administrations react to the situation on hand while following their own philosophies. Governments will continue to change tax policy; therefore taxpayers need to make their own adjustments in order to avoid paying what they may deem to be extra taxes.
Doing the Tax Dance
The federal income tax didn’t pay for the Revolutionary War, the War of 1812, the charge up San Juan Hill or anything else up until World War I. From 1791 to 1802, the government supported itself by taxing booze, horse-drawn carriages, sugar, tobacco, property sold at auction and the slave trade.
There are many ways tax revenue can be adjusted higher or lower and as many reasons for the changes. Brackets can be changed, rates adjusted and preferences eliminated or enhanced. Taxes are often played with when revenue has plunged due to recession and spending has increased.
There are also misguided tax cuts because they were implemented for a particular cause and had an unintended effect. For example, there is give and take when a tax is cut for Social Security and it changes unemployment benefits.
Today, taxpayers with investments, particularly trusts, are spending a lot of time trying to figure out how to avoid the Net Investment Income Tax. The NIIT goes like this: Portfolio, non-trade or business income is subject to this additional 3.8 percent tax over a certain income level. That is $200,000 for individuals, or $250,000 for married filing jointly.
Because the tax is based on portfolio types, taxpayers are trying to avoid the tax by converting investment income into trade or business income. When they do this, they need to be concerned about other taxes that could affect them, such as creeping into self-employment taxes and higher passive income brackets.
It is also not easy to qualify income as part of a trade or business. A complete review of passive loss rules must be performed. If you are a trustee of a trust, you may need to think twice about how and when distributions from the trust occur, and make sure they are in accordance with the trust instrument.
The trust tax on net investment income starts at a very low amount. If income is distributed to beneficiaries, it is probable that the beneficiaries will not have the level of income that causes net investment income to be taxed. For example, tax starts on a distribution at $11,950 (2013), versus the $200,000 (individual) for the net investment tax. Based on trustee discretion, either method can be applied and might be one way to avoid the 3.8 percent net investment tax. One should remember that this is a separate tax on a separate form that hits on top of every other tax.
Self-employment Tax Strategy
As the taxpayer thinks about net investment income and perhaps argues that it is trade or business income, now he or she has to think about being subject to the new higher self-employment tax. The additional Medicare rate associated with self-employment income has been increased to 3.8 percent, or 2.9 percent plus an additional 0.9 percent. So the key is to avoid both the investment income and self-employment tax.
If the interest is held in a limited pass-through entity, some of the limited partners may not meet the tests that require them to be subject to self-employment tax but may still be deemed to be in a trade of business for other purposes. As a result, they may be able to have trade or business income and no self-employment income. Consideration should be given to see if these tests can be met.
Limited partners apply certain rules to determine if they are subject to self-employment taxes. These include various tests listed in the regulations, including control over certain aspects of the business. If they don’t meet these tests, they would not have self-employment tax on that income. However, they might argue that they meet the tests to be deemed to be in a trade or business. Since it may not be treated as passive, there might be no NIIT. You can bet that more rules will be coming out on this in the future to try and eliminate these perceived inconsistencies.
As you can see, taxation and policy come with the times. Taxes seem higher today but may not be relative to history. As always, there are always changing strategies to help avoid extra taxes.
Mira Finé, CPA, is the national director of tax operations for Hein & Associates LLP, a full-service public accounting and advisory firm with offices in Denver, Houston, Dallas and Orange County. She specializes in succession planning and can be reached at email@example.com or (303) 298-9600.