In addition to the changes to tax rates and deductions from the “Fiscal Cliff” compromise, there is another tax many clients may be unaware of: A 3.8% tax on investment income to partially fund the Affordable Patient Care Act better known as “Obamacare”. How could this tax potentially affect you in 2013?
Who Is Subject To The Tax?
Citizens and residents of the United States, bona-fide residents of United States Territories, bankruptcy estates and certain types of trusts and estates (Section 1411(a)(2)). The threshold amounts for the application of the tax are:
- Married Filing Joint & Surviving Spouse: $250,000
- Married Filing Separately: $125,000
- Single & Head of Household: $200,000
The tax is computed on the lesser of net investment income or modified adjusted gross income (If a taxpayer has no foreign earned income, modified adjusted gross income will equal adjusted gross income).
What Type Of Income Is Subject To The Tax?
- Interest, dividends, capital gains, rent and royalty income, and non-qualified annuities
- Income and gains from passive activities
- Income and gains from businesses involved in the trading of financial instruments and commodities and
- Gains from the sale of interests in partnerships and S corporations to the extent the taxpayer is a passive owner.
If you own a sole proprietorship, are a disregarded LLC or own an interest in an S corporation or partnership, you need to pay special attention to make sure that income from those activities is not included in net investment income. The following four exceptions allow you to be sure the income will not be included net investment income:
- The activity is engaged in an active trade or business AND
- The income from the entities is earned in the ordinary course of that trade or business AND
- The income from the activity come from the ordinary course of that trade of business AND
- The activity is not “passive” for you. This means you must meet one of the following seven tests:
- You participate in the activity for more than 500 hours during the year,
- Your participation in the activity constitutes substantially all of the participation by all individuals (including non-owners) in the activity for the year,
- Your participation is more than 100 hours during the year, and no other individual (including non-owners) participates more hours than the taxpayer,
- The activity is a significant participation activity in which you participate for more than 100 hours during the year and your annual participation in all significant participation activities is more than 500 hours. A significant participation activity is generally a trade or business activity (other than a rental activity) that you participate in for more than 100 hours during the year but do not materially participate in (under any of the material participation tests other than this test),
- You materially participated in the activity for any five tax years (whether or not consecutive) during the 10 immediately preceding tax years,
- For a personal service activity, you materially participated for any three tax years (whether or not consecutive) preceding the current tax year, or
- A generic facts and circumstances test.
- The activity is not engaged in the trading of financial instruments.
By incorporating proper tax planning techniques into your business plan, much of the effect of the “Obamacare” tax can be mitigated by us and your other financial professionals. Putting those techniques in place, however, needs to begin now. Doing so can prevent a nasty surprise when you file your 2013 taxes.