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Now that we’ve traded “Taxmegeddon” for the regular D.C. budget crisis of the week, it’s a good time to talk about the add-on tax (surtax) that begins in 2013 as a means of funding some of the new Affordable Care Act (ACA).
This surtax applies only to “high income” taxpayers, which is defined as adjusted gross income (AGI) in excess of $200,000 if you are single or $250,000 if you are married filing jointly. The surtax rate is 3.8 percent and it applies to “investment income.”
For those affected, the surtax seems to be Public Enemy No. 1 among the recent tax-law changes affecting higher-income individuals. So let’s start with the basics and then discuss the issues that are currently creating some anxiety.
First, the surtax applies only to investment income above the AGI threshold. So if you are single with AGI of $200,000 or less, this tax is of no concern. If AGI is $202,000, the tax might apply to as much as $2,000 of investment income.
Second, the basic definition of investment income is easy, and includes things like dividends and interest. It even includes interest from working capital of a business if that interest is reported on the personal tax return.
Third, investment income is not taxable distributions from a retirement plan, including qualified plans, qualified annuities, IRAs, deferred compensation plans, and taxable (nonqualified) Roth IRA distributions.
Capital gains are generally included as investment income. However, if the capital gain comes from the sale of business property it may be exempt, but only if the taxpayer “materially participates” in that business. In fact, any “active” business income is exempt.
Now whether you realize it or not, I just walked us into a tax quagmire. The law does not always make it clear when a taxpayer will be able to extricate himself from this quagmire. Late last year the Treasury Department issued proposed regulations to help map out the quagmire.
Proposed regulations are just that — proposed. They will not be effective until Jan. 1, 2014, after they have been amended to take into account comments received from tax practitioners and other interested parties.
The proposed regulations seem to only add more muck to the quagmire. They will change — somehow — but who knows how, and they are all we have for now.
Because most people would like to avoid this surtax, an easy recommendation is to show (1) that your income comes from a trade or business and (2) that you materially participate in this business. But there is no big red “easy” button for this task.
The proposed regulations say that the meaning of “trade or business” is “well settled.” The tax accountants who just read that statement are now probably picking themselves up off the floor and trying to recover the pens from their pocket protectors.
You might think you are in a business, but the IRS might say that you have an investment. When it comes to the surtax, these are not just words. The former may be surtax exempt, the latter surely not.
If you are in business, you still must “materially participate.” This is fancy language from regulations interpreting the 1986 Tax Reform, and it requires that you track your hours of participation each year. It might help to have a log of your hours of participation, by day — seriously.
Now let’s say that you sell a business equity interest, maybe a partnership interest or stock in an S corporation. The regulations say that you will have to make believe that you sold each individual asset of the business.
Business asset gains may be exempt, again if you materially participated. But you’ll have to do a make-believe computation of the gain on the make-believe sale of each asset, and then attach a (real) statement to your return to show you did it. No statement, no surtax exemption.
Treasury officials stuck with dealing with practitioner reaction to the proposed rules may wish they could follow the advice of Hall of Fame manager Casey Stengel, “The secret of managing is to keep the guys who hate you away from the guys who are undecided.” But I think all the tax guys have already decided.
James R. Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.
