The Treasury Department and the IRS released proposed regulations for the new 3.8 percent tax on net investment income (NII) and the 0.9 percentage point increase in the section 3101 hospital insurance tax. The proposed regulations give taxpayers and practitioners needed guidance on how to apply the new statutory provisions, enacted as part of the 2010 health care reform law. Taxpayers may be subject to both taxes, but not on the same type of income.
While the NII tax goes into effect Jan. 1, 2013, the effective date of the proposed regulations is delayed until Jan. 1, 2014. However, the IRS stated that taxpayers may rely on the proposed regulations for compliance purposes until the effective date of the final regulations. The government expects to finalize regulations under section 1411 in 2013. A public hearing is scheduled for April 2, 2013.
Section 1411 imposes a 3.8 percent tax on the lesser of NII (which includes capital gains, dividends, annuities, royalties, interest, rents, and income from some trades or businesses) or the amount by which an individual's modified adjusted gross income (AGI) exceeds $200,000 ($250,000 for joint filers and surviving spouses). The tax was enacted in the Health Care and Education Reconciliation Act of 2010. We are in the process of analyzing the proposed regulations and will issue additional guidance in the coming weeks. The following are some key highlights we’ve noted for your consideration.
Fresh start granted for grouping activities
The regulations give taxpayers a one-time opportunity to regroup their activities regardless of how activities were grouped in prior years. Taxpayers may regroup in the first year beginning after Dec. 31, 2013, if their income is above the applicable threshold and they have NII. While this regrouping opportunity is a year away, taxpayers should work with their advisors now to plan for its impact and determine what flexibility is available to take advantage of this opportunity. Also, taxpayers may rely on the proposed regulations to regroup on 2013 returns.
Properly allocable deductions
The health care law provided that taxpayers can reduce their NII by properly allocable deductions. The proposed regulations provide that amounts such as investment interest expense, investment expense, and the penalty on the early withdrawal of savings can offset NII prior to calculating the 3.8 percent tax.
The proposed regulations also state that NII for any tax year may not be less than zero. Consequently, to the extent a taxpayer has certain loss carryforwards, those losses may offset NII in the tax year they impact adjusted gross income.
Under the proposed regulations, NII does not take into account a net operating loss (NOL) deduction because when an item becomes part of an NOL that is carried to another year, it generally is no longer properly allocable to a specific type of income. However, the NOLs will continue to be taken into account for determining a taxpayer's modified AGI, which is important since taxpayers are not subject to the NII when their modified AGI is below the threshold level.
Deemed sales of pass-through interests
Since an interest in a partnership or S corporation is not usually property held in a trade or business, gain or loss from the sale of such an interest will be subject to section 1411. The preamble to the proposed regulations states that Congress intended this section to put taxpayers who sell an interest in a partnership or S corporation in a similar position to taxpayers whose partnership or S corporation disposed of all of its properties passed through the resulting gain or loss to its owners.
However, the preamble also says the gain or loss upon the sale of an interest in the entity and the entity’s underlying properties will not always match, and parity must be achieved by applying section 1411(c)(4) on a property-by-property basis. The proposed regulations require the seller to compute the gain or loss from the sale of the underlying properties using a deemed asset sale method and determine if, based on the deemed sale, there is an adjustment for the seller’s gain or loss on the disposition of the partnership or S corporation interest for purposes of section 1411.
Applying the deemed sale rules under the regulations may impose a significant burden on the sellers of such interests; the impact will need to be reviewed carefully.
Additional Medicare tax
The Treasury and the IRS also issued proposed regulations for the increase in the Medicare hospital insurance (HI) tax under section 3101(b)(2). The statute increases by 0.9 percentage points the employee portion of the payroll tax on covered wages, compensation, and self-employment income in excess of $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately).
Employers required to withhold
Employers must withhold the additional (employee) Medicare tax from wages it pays to an individual in excess of $200,000 without regard to the individual’s filing status or wages paid by another employer.
Because of the differing thresholds, an individual may owe more than the amount withheld by the employer, depending on the individual’s filing status, wages, compensation, and self-employment income. For example, if each spouse makes $190,000 a year, their combined wages exceed the $250,000 married filing jointly cap, but neither of their employers would be required to withhold since neither of their wages exceed $200,000.
In that case, the individual should make estimated tax payments and/or request additional withholding using Form W-4, Employee’s Withholding Allowance Certificate. Any excess withholding will be treated as additional federal taxes paid on the employee’s personal income tax return.
For more information or any questions you might have on this topic, please contact your Baker Tilly advisor or send an e-mail to firstname.lastname@example.org.