The ACA and NIIT: What High-Net-Worth Taxpayers Need to Know When Preparing 2014 Returns
High-income taxpayers and their CPAs were in for a rude awakening last year when new tax provisions under the Affordable Care Act first went into effect. Two new taxes in particular – the Additional Medicare Tax and Net Investment Income Tax (NIIT) – have had a significant impact on high-net-worth individuals' filing preparation and returns.
As we dive into tax season, now is an ideal time to recap lessons learned from last year, and what taxpayers and practitioners should keep in mind to yield the most beneficial 2014 returns.
Refreshing our Memories: Tax Changes Under the ACA
Effective January 2013, certain high-income individuals are subject to new taxes set forth by the Affordable Care Act and Health Care and Education Reconciliation Act.
The first is a 0.9% surtax to the existing Medicare tax on earned income. This tax applies to single taxpayers with earned income over $200,000, and married taxpayers who file joint returns with $250,000 or more in earned income (the threshold is $125,000 if they file separately).
The 3.8% Net Investment Income Tax is more complex, and applies to three different forms of investment income. Traditional portfolio income (e.g., interest, annuities, and dividends), trade and business income from passive investments, and gains from property dispositions each qualify as net investment income. The NIIT thresholds are $200,000 for single taxpayers, $250,000 for married taxpayers filing jointly, and $125,000 for married taxpayers filing separately.
Strategic Recommendations for 2014 Returns and Beyond
Now that any sticker shock over these new taxes has had time to dissipate, high-net-worth taxpayers should talk to their accountants and investment advisors about how to best navigate the 2014 filing process and 2015 planning. Individuals are not necessarily stuck with the same strategies they pursued last year. There are a few factors taxpayers can consider in order to start fresh and potentially minimize their taxable net investment income.
- Closely held business income: Income from closely held businesses structured as pass-through entities may or may not be subject to the NIIT, depending on how active the taxpayer is in the operation. If a taxpayer is already close to accruing the number of hours necessary (500) to qualify as an active participant in the business, he or she may consider purposefully crossing that threshold in order to avoid the NIIT. Note that work hours are just one way of achieving active participation, and this move might not make the most sense for all taxpayers. If the taxpayer is not active in the business, the income is passive and subject to the NIIT.
- Grouping: Under the Internal Revenue Code, taxpayers with multiple sources of passive activity income are allowed to group – or regroup – activities to lower their NIIT burden. Individuals with non-deductible passive activity losses may be able to group activities in such a way that future losses offset future gains, lessening their NIIT. Individuals with passive and non-passive income could group activities in order to avoid the tax altogether, assuming that the result of the grouping election is overall non-passive income. By grouping related activities, it will generally be easier to achieve active participation (such as the 500 hour threshold).
Passive activity income can be grouped based on a range of factors, such as similarity in industry, common ownership, geographic location, and interdependent operations. Keep in mind, however, that regrouping is a once-in-a-lifetime election, and will have permanent repercussions on future returns.
- State income tax: State income tax allocation deductions are another way to reduce the NIIT, so long as they're calculated properly. Because these allocations aren't automatically included in taxpayers' net investment income, it must be deducted against their gross investment figure as part of the tax calculation. One of the biggest challenges for tax practitioners last year was manipulating their systems to accurately determine clients' state income tax allocation — a glitch that should be smoothed out this season. Taxpayers can change allocation methods from year to year, so taxpayers are not locked into their 2013 allocation method.
- Trust distributions: Trusts pay the NIIT starting at about $13,000 taxable income, a much lower threshold than individuals. However, trusts only pay on undistributed income, so distributions to beneficiaries can lower the tax overall. Rather than make last-minute trust distributions in hopes of dodging the NIIT, high-net-worth taxpayers should pursue distributions policies that make personal and economic sense — both for the trusts and their beneficiaries. If taxpayers are in a position to distribute funds from their trusts to recipients who aren't susceptible to the NIIT, there's still time to include this income on 2014 filings. A longstanding IRC election allows distributions made up to 65 days after the first of the year to count toward the prior tax year.
It's Not What you Make — It's What you Keep
Before settling on any one strategy this season, high-income taxpayers should consult with their accountants, investment managers, and even attorneys to devise a sound plan. Any method that's undertaken to avoid or reduce the NIIT burden needs to be designed to preserve individuals' after-tax income.
If the last few years have proven anything, it's that increasing tax complexity is as certain as taxes alone. More change is on its way, such as the "Cadillac tax" on premium employer health plans slated to go into effect in 2018. Mastering the latest tax rules now will make it that much easier for taxpayers to plan for tomorrow.
Visit our Net Investment Income Tax resource page » to learn more about these tax changes and their effect on high-income individuals, estates, and trusts.