Reviewing Two ObamaCare Taxes Springing Up in 2013

We are beginning over here to re-review the tax aspects of ObamaCare after the Supreme Court’s decision last week. There are several tax changes, but today we will revisit the new investment income tax and the new earned income tax. These will happen in 2013, so let’s go over them.

Investment Income

If you are single, you will owe a new investment tax if your adjusted gross income (AGI) is over $200,000. If you are married, you will owe the new tax if your AGI is over $250,000. (I know, twice $200,000 is considerably more than $250,000. I did not write the law). If this is you, will owe a brand-new 3.8% tax on your investment income.

Let’s be clear: it is not necessarily ALL your investment income. Rather it will be on investment income over $200,000 or $250,000, as the case may be. If you are married and retired and your entire adjusted gross income of $250,000 is interest and dividends, you will owe no NEW tax. You will owe plenty of OLD tax, though.

What is investment income? Let’s go with the easy examples: dividends, interest, capital gains (short-term and long-term), royalties and annuities outside retirement plans

NOTE:  Net investment income is also defined to include income from a passive activity. This concerns me, as the rental of a duplex is a passive activity, as is passthrough income to a “passive” member in an LLC. Under Section 469, these activities were considered “trades or businesses,” although the activity could be further tagged as “passive” or “nonpassive.” They were not however tagged as “investment.” This new tax appears to use the language differently from Section 469 and equates “passive” with “investment.” The IRS unfortunately has yet to issue formal guidance in this area.

How can this tax surprise you? Here are a few ways:

(1)   You sell your business.

(2)   You get married.

(3)   You sell your principal residence, and the gain exceeds the $250,000/$500,000 exclusion.

(4)   You inherit and sell stock from a parent’s estate.

Earned Income

If you are single, you will pay an extra 0.9% Medicare tax on your earned income over $200,000. If married, that threshold changes to $250,000.

What is earned income? The easiest way is to ask whether you paid or will pay social security or self-employment tax on the income. If the answer is “yes”, you have earned income. Note that this definition excludes your pension, 401(k) and IRA distributions.

Let’s go over a few examples.

EXAMPLE 1: A married couple filing jointly has $360,000 of adjusted gross income—$240,000 of wages plus $120,000 of interest, dividends and capital gains. They have $110,000 of investment income` over the $250,000 threshold. They will owe an extra 3.8% of that $110,000, or $4,180, in tax.

EXAMPLE 2: In the following year, the same couple has $400,000 of income, the difference being a $40,000 bonus. All their investment income is now above the threshold amount. Their new investment income tax will be $4,560. In addition, since their earned income is now above $250,000 they will owe the new earned income tax of $270 ((280,000- 250,000) times 0.9%).

EXAMPLE 3:  After many years, you move from Purchase, New York. You sell your house for $920,000 and are single.  Your exclusion amount on the sale is $250,000 so the taxable gain is 670,000. Assuming that you earned income is over $200,000, the new investment income tax will be $25,460 ((920,000 – 250,000) times 3.8%).

We will discuss other tax changes in a future blog. Some are delayed (such as the employer penalty) and others are already in place but are somewhat esoteric (the prescription drug fee).

Taxation and Renouncing Citizenship: Part II

Let’s say that you were born in Brazil. Your family was wealthy. Due to safety concerns (such as the risk of kidnapping), they moved you to the United States when you were young. You grew up in a southern and international city – perhaps Miami. You went to Harvard. While there you met and bankrolled a cantankerous near-friendless computer genius who came up with the next great social media idea. He tried to boot you out of the fledging company, but after a lawsuit and hard feelings, you kept about 4% or so of the shares. Much to your delight, the company went recently went public and made you a multibillionaire. Prior to that, you met with high-powered attorneys and tax advisors. You renounced your U.S. citizenship and are now living in Singapore. Where is Singapore? Think Vietnam, and then turn south. It is a former British colony, and you like pasties and room-temperature beer. Seems a fit.

Why would you do this?

Let’s go over several tax reasons. We need numbers in this conversation. Let’s use the following:

            Proceeds from IPO                          $ 4.0 billion

            Expected annual salary                     $ 7.5 million

            Expected annual dividends               $ 40 million

            Expected capital gains                      $ 25 million

What are your U.S. 2013 taxes if you remain a U.S. citizen?

(1)   Your salary may be taxed as high as 39.6% next year. Let’s say that it will be. The federal tax would be $7,500,000 times 39.6% equals $2,970,000.

(2)   If your dividends are “qualified” dividends, you would pay a 15% tax rate this year. The President’s proposed 2013 budget would increase this to 39.6%. In previous budgets, however, he has proposed 20%. What rate should we use? Let’s use 20%.  Your tax would be $ 40,000,000 times 20% equals $8,000,000.

(3)   The capital gains are a wild card. Let’s say that you will be selling stock periodically to fund your lifestyle. What amount? Let’s say $25 million annually. Let’s also say that your basis is so low that any sale is virtually all gain. The long-term capital gains rate is currently 15%, but everyone expects this rate to go up. Unless Congress acts, the rate will increase to 20% in 2013. Let’s use 20%. Your tax would be $5,000,000.

(4)   Starting in 2013, there is a new surtax on investment income if your income exceeds either $200,000 or $250,000, depending on filing status. You have clearly blown past that speed bump like Steven Tyler’s new Hennessey Venom GT Spyder. That new tax is 2.9% and will cost you $1,885,000.

(5)   Starting in 2013, there is a Medicare surcharge for persons earning more than $200,000. The surcharge is 0.9% and will cost you $67,500.

What are your 2013 taxes in Singapore?

(1) The top tax rate in Singapore is 20%. Taxes on your salary will be $1,500,000.

(2) Taxes on your dividends will be $8,000,000.

(3) There are no taxes on your capital gains.

OK, let’s look at the scorecard. A quick back-of-the-envelope calculation shows:

            United States              $ 17,922,500   

            Singapore                   $  9,500,000

Is there more? Well, yes.

(1) Let’s say that you invested in mutual funds to obtain those dividends. Chances are these funds will be considered PFIC’s (“pea-fics”) and carry some heavy U.S. tax disapproval.

The best you can do with a PFIC is make a QEF election and pay taxes every year on your share of income, whether distributed to you or not. This requires the PFIC manager to want to go to the trouble of assembling this information for you, as the PFIC tax is an American concept. A fund manager in Hong Kong, for example, might be less than interested in IRS mandates. In any event, the U.S. wants to accelerate your tax without regard to whether you received any cash.

If the fund manager is unwilling, you go to an ugly place in U.S. taxation. Without belaboring this, it may require you to go back and recalculate your prior year taxes on an “as if” basis. You will then write a real check to the IRS for that “as if” calculation. You also have to pay the IRS interest for not having paid taxes in the earlier “as if” tax year.

(2) Don’t forget your FBAR filing every June 30.

You have financial accounts overseas, so you will have an FBAR filing.

Penalties for failure to file an FBAR border can be severe. Penalties begin at $10,000 for each non-willful violation. If willful, the penalty goes to the greater of $100,000 or 50% of the account for each violation. Oh, each year is considered a separate violation. And the IRS gets to decide what is willful.

You got it: if the IRS considers your violation to be willful for two years, you have wiped-out the account.

(3)   You have to file the new Form 8938 disclosing foreign financial assets.

This is the FATCA and its reason for existing reads like a bad dream. In essence, the IRS felt that it was not getting enough information from the FBAR, and it really wanted more information. Think about this. The FBAR is mailed to the U.S. Treasury, and technically the IRS is part of the U.S. Treasury. One would think that the IRS and Treasury would speak, perhaps weekly for breakfast. Treasury did not upgrade the FBAR, nor did it replace the FBAR with the IRS Form 8938. No sir, the IRS created a new form and they kept both filing requirements. Well, it is one more opportunity to confuse the populace and maximize those penalty dollars. Brilliant!

Penalties can be rough: $10,000 for each failure to file. If you both fail to file the 8938 and fail to pay tax on the foreign income, there is a super-penalty of 40% on the tax underpayment. Don’t do that.

(4)   Should you leave family behind, gifting to them will certainly be a problem. These transfers will be picked up under the expatriation rules of Section 877 and trigger tax at the maximum gift tax rate. That rate is currently 35% but is expected to increase to 55% next year.

You read that right: Uncle Sam is your biggest beneficiary. More so than your mom, son or daughter. 

You may want to take them with you.  Singapore has no gift tax.

(5)   Should you remain a U.S. citizen, consider hiring an experienced tax attorney and/or CPA to navigate all this. It is another expense, but least you can write-off the professional fees on your taxes. Oh, wait. No you can’t. Chances are the fees will not exceed 2% of your income. If you are in the AMT, they will not be deductible in any event.

There are reasons other than taxation to renounce. There are many expatriates overseas who have no intention of returning to the U.S. They have lives, spouses, children, jobs and friends there. Perhaps they will return, but it will be at some unknown and distant date.

It is unfortunate to renounce citizenship over tax reasons. The U.S. does press your hand by taxing you on your worldwide income, irrespective of where you live, work or maintain family. The U.S. is virtually alone in the world with this type of taxation. If this ever made sense, does it still make sense? Leaving the U.S. doesn’t mean that you leave its mandates. You have to renounce.

What would you do?

Foreign Mutual Funds

Let’s talk about PFICs.

It is pronounced “Pea Fick,” and it is shorthand for a passive foreign investment company. We are continuing our “foreign” theme of late.

A PFIC is a foreign mutual fund. Think about your funds at Fidelity or Vanguard and relocate them to Bonn or London. That is all you have done, but with that act you have entered a twilight world of odd tax reporting.

Why? Treasury does not like foreign mutual funds. Why? That question has several possible answers, but I believe that a large part is because Treasury cannot control the taxation. A mutual fund in the United States is a “regulated investment company.” One of the requirements is that it has to pass along its taxable income to its investors in order to preserve its tax standing. Shift that fund to Bonn, and the German fund manager may not have the same level of concern in maintaining that “regulated investment company” status. The German fund manager may do something unconscionable, such as not declare dividends or distribute income to investors. That would allow the German fund to delay tax consequence to its U.S investors, possibly for many years. Why, the U.S. investor may eventually report the income as capital gain rather than ordinary dividend income. This is clearly an unacceptable scenario.

It didn’t use to be this way. The law for PFICs changed in 1986.

You are going to be specially taxed. You however can choose one of three methods of taxation:

(1)    The Excess Distribution Method

This is the default method and is found in Section 1291 of the Internal Revenue Code.

At first glance it sounds good. You pay no tax until you either sell or receive an “excess distribution.” When you do, the IRS presumes that the income was earned ratably over the years you owned the fund. You have to pay tax at the highest marginal tax rate. It does not matter what your actual tax rate was. What if the fund lost money for 8 years, had one great year that made up for all losses and then you sold at a profit. ? Doesn’t matter. The IRS presumes that your profit was earned pro rata over 9 years. Now you are late on your taxes (remember, you did not include the profit in your prior year returns because there WAS NO PROFIT). You now have to pay tax using the highest-marginal tax rates. For 9 years. And then there is interest on the late taxes.

Oh, you may not be allowed to claim the loss if you sell the PFIC at a loss.

 You really do not want to use this method.

(2)    The Mark to Market Method

This option was added to the Code in 1997.

You mark your PFIC to market every year-end. In other words, you pay taxes on the difference between the share price on January 1^st and December 31^st. Every year.

You forfeit capital gains and losses. Whatever income or loss you report is ordinary. Sorry.

The big requirement here is that the PFIC has to have published fund prices. If the prices are not published, you simply cannot use the mark to market method.

(3)    The Qualified Electing Fund

This is the method I have normally seen. The problem is that the fund has to provide certain information annually. As that information has meaning only to a U.S. taxpayer, the fund may decide that it is not worth the time and cost and refuse to provide it. In practice, I have seen these funds go through investment houses such as Goldman Sachs. Goldman can pool enough U.S. investors to make it worthwhile to the foreign fund manager, so the fund agrees going in that it will provide this additional information annually.

A QEF is basically like a partnership. It passes-though its income to the U.S. investor – whether distributed or not – and the U.S. investor pays taxes on it. Ordinary income is taxed at ordinary rates, and capital gains at capital gains rates. What changes is that Treasury does not wait for a distribution.

A QEF should be elected in the first year you own the QEF. If so, you avoid the “excess distribution” regime altogether. If you make the election in a later year, then there is a procedure to “purge” the earlier PFIC treatment.

The QEF election is made fund by fund.

Yes, there is a special form to use with PFICs. It is Form 8621 “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.” It can be an intimidating three pages of tax-speak.

I saw PFICs a few years back, as we had several well-heeled clients. What I generally saw was a K-1, perhaps from a hedge fund. That fund in turn invested, and some of its investments were PFICs. The fund K-1 would arrive with its booklet of information, explanation and disclosures. The PFICs inside would further swell the page count. I remember these K-1s going on for 30 or 40 pages. These K-1s are not for young tax accountants.

As I said, Treasury really does not like foreign mutual funds.

The New InvestOhio State Tax Credit

The recent Ohio biennial budget bill included an income tax credit for investments in qualifying small businesses.  This was a late addition, and it was made in response to some rather depressing statistics about Ohio business over the last decade:

·         Ohio has lost more jobs than any state other than California and Michigan

·         Ohio has ranked in  the bottom 10 states for population growth

·         Ohio’s economy has ranked in the bottom 5 states

The new tax credit is referred to as “Invest Ohio.” The credit will run for two years (Ohio has biennial budgets), and the state estimates that the program will cost $100 million. The state hopes to stimulate at least 30,000 jobs, at which number the state anticipates to breakeven.

The credit is nonrefundable. You need to have an Ohio income tax to make this worthwhile.

Let’s go through the steps:

(1)    This is an income tax credit. More specifically, only taxpayers with income taxes will be able to use it. You may recall that Ohio C corporations pay a Commercial Activity Tax (or “CAT”) in lieu of income taxes, so this credit is not for C corporations. Rather it is for individuals, passthroughs, trusts and estates.

(2)    You have to be an eligible small business.

a.       Your total assets are $50 million or less OR your total sales are $10 million or less

                                                               i.      Because of the “or,” you must meet one of the two tests to qualify.

b.      You must have enough presence in Ohio to qualify. There are two alternative tests:

                                                               i.       More than half your employees are in Ohio.

1.       It doesn’t matter how many employees you have. Just one (yourself) is enough.

                                                             ii.      You have more than 50 full-time equivalent employees in Ohio.

1.       This does not need to be more than half.

NOTE: Let’s go over this, as it may not be clear. If you have 2 employees and both are in Ohio, you qualify. If you have 274 employees, of which more than 50 are in Ohio, you qualify. Technically, this second test is done by full-time equivalents rather than employees, but you get the idea.

(3)    Fresh money is going into the business as equity.

a.       This fresh money is going to acquire, increase or maintain an equity interest.

                                                               i.      You are not playing banker here. This is not a “Loan from Owner.”

                                                             ii.      You are receiving shares, units – something- that indicate ownership.

                                                            iii.      An easy example is someone who becomes a new shareholder in an S corporation by investing $25,000. This is fresh money and he/she has acquired an ownership interest.

1.       What is you already own 100%? You cannot go over 100%.

a.       Answer:  this will count.

(4)    You have to spend the money in an approved way.

a.       You have to buy tangible personal property.

                                                               i.      Desks, a copier, computer monitors or a business van will qualify.

b.      You can buy real property, as long as it is in Ohio. Ohio will not subsidize that Florida condo.

c.       You can buy intangibles, such as patents, copyrights or trademarks.

                                                               i.      The one that occurred to me was enterprise software or a website.

d.      Compensation for new or retrained employees for whom the business is required to withhold Ohio income tax.

                                                               i.      I am not sure my firm has clients that would incur employee “retraining.”

                                                             ii.      A new employee will count.

1.       There is a big EXCEPT here: the employee cannot be an owner, manager or officer.

                                                            iii.      The Ohio tax withholding becomes an issue for the border residents. For example, I live in northern Kentucky but work in Cincinnati. I do not have Ohio withholding because of the reciprocal tax agreement.  As I read this, I would not qualify.

(5)    You have to spend this new money within six months.

(6)    The credit is 10 percent.

a.       There is a maximum however.

                                                               i.      The maximum credit is $1,000,000 per taxpayer.

1.       If you are married, this becomes $2 million.

b.      My understanding is that this $1 million limit is for the first credit period, which is two years. If the credit is renewed, my understanding is that you will get a brand new $1 million limit.

(7)    Tax credit period

a.       The first period of the program runs from 7/1/2011 to 6/30/2013 (remember: biennial budget).

b.      The timing of this credit is odd.

                                                               i.      You have to wait until the period is up (6/30/13) before you can claim the credit.

1.       So an investment in 2011 gets no payoff until 2013.

2.       At least you can use it in the same year the period expires.

c.       You then get 7 years to use up the credit. More specifically, an investment in 2011 would get to use its credit in tax years 2013 to 2019.

d.      IF THE PROGRAM IS CONTINUED IN 2013 …

                                                               i.      Then the waiting period becomes five years rather than two. That is a long time to it for a credit to kick-in. An investment in 2014 would have to wait until 2019 before using the credit.

(8)    You have to keep the money invested for the credit qualifying period.

a.       That is, you cannot put money in and take it right back out.

b.      But, then again, the first period is only two years. This is not a long time.

(9)    Paperwork

a.       There is paperwork for …

                                                               i.      The application and qualification,

                                                             ii.      The certification, and

                                                            iii.      A pledge not to dispose of the investment before the end of the holding period

b.      In short, the business and its owner will have paperwork. This makes sense, as Ohio wants (at a minimum) to keep track of how many people are using the program.

c.       The program is being administered by the Ohio Department of Development. They are your contact, not the Department of Taxation.

(10) Owners of passthrough entities will claim the credit based on their distributive or proportionate share of the entity.

Rick Kruse and I agree that the key point to this credit is the fresh cash. Perhaps the cash is funded by savings, by borrowings, or perhaps by a circular transaction, but somehow new money has to enter the picture. The problem may be getting the fresh cash in the owner’s name.

Think about the following examples:

(1)               The S corporation buys a truck. There is a down payment and a term note for the balance. Even if the shareholders sign on the note, there has been no fresh cash into the business, so there would be no tax credit.

(2)               The LLC wants to buy shop equipment. There are three members. Only one of the members is willing (or able) to start the required “fresh cash” sequence.  Perhaps he/she is the only one with enough savings, enough credit or enough collateral to borrow.  Therefore, only one of the members can initiate the “fresh cash” cycle. This situation may be more about member dynamics than tax planning.

(3)               The partnership constructs a building. The construction loan is signed by the partners. Under this loan, the draws are disbursed directly by the bank to the contractors and suppliers.  Whereas one can argue “fresh cash,” there has been no increase in equity. There has been only an increase in debt.  

Here is one that intrigues me:

(4)               A key employee is awarded 50 shares under a stock bonus program. The stock vests, so the employee recognizes taxable income on his/her personal return. The business in turn purchases equipment within the requisite six month period. Do we have a "fresh cash” cycle?

BTW, the instructions and directions for this credit are virtually nonexistent as I write this. For the time being there are questions with no answers. For example, can one set up a new company in order to qualify as an “eligible small business” or will the new company being aggregated with an existing company?  This is a basic technique – and therefore a basic question - for any tax practitioner.

If your business qualifies as an Ohio eligible small business, you simply must consider this credit in your tax planning. If you will be buying equipment, or trucks, or software, or hiring ANYWAY, why not plan for the credit? If you can’t make it work then you can’t, but at least consider it.