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Posted: March 28, 2013

A new tax ...

... that's been around since 2010

Robert Keatinge

One of the most significant tax changes that came into effect on Jan. 1, 2013, wasn’t a part of the American Taxpayer Relief Act, the fiscal cliff compromise enacted in January, but was enacted in 2010 as part of the Affordable Care Act (ACA).

The change amounts to a 0.9  percent  increase in the hospital insurance tax on wages and self-employment income for taxpayers with combined wages and self-employment income over a threshold amount ($200,000 for individuals, $250,000 for married individuals filing jointly, and $125,000 for married individuals filing separately). Additionally, it includes a 3.8 percent tax on “net investment income” for taxpayers with adjusted gross income above the threshold amount and a 0.9 percent increase in employment and self-employment taxes.

While the questions surrounding the application of these ACA taxes are still being resolved, business people with income above the threshold amounts are subject to them now by exploring strategies to reduce the impact of these taxes or, at the least, make provisions for the additional taxes that will appear on next year’s tax return.

In one respect, the ACA taxes can be seen as leveling the playing field between those individuals who earn income from compensation (whether in the form of wages or self-employment income) and those whose income comes from other sources. Historically, compensation income was subject to a 2.9 percent Medicare Hospital Insurance Tax (the HI tax), while other income, including capital gains, dividends, interest, and income from passive investments was not subject to any tax.

Now, above the threshold amount, compensatory income will be subject to a combined HI tax of 3.8 percent while, with a couple of exceptions, other income of an individual with modified adjusted gross income (MAGI)  above the threshold amount will be subject to a new 3.8 percent tax on net investment income (NII Tax). MAGI is adjusted gross income increased by the foreign earned income.

NII, although given a complicated definition in the tax code, includes virtually all income of any character other than: wages and self-employment income, amounts excluded from income (such as the amount excluded on the sale of a personal residence and tax-exempt interest), and distributions from qualified plans.

The NII tax also does not apply to most non-compensatory income derived from most  active trades or businesses in which the individual is an active participant. This exception does not apply from income of a trade or business of trading in financial instruments or commodities or derived from working capital. Thus, a shareholder in an S corporation or a limited partner who actively participates in a limited partnership may be able to exclude the income of those entities from NII and HI (except to the extent that they constitute wages in the case of an S corporation).  While the ACA taxes were adopted in 2010, the first regulations interpreting them did not come out until last December and are still under study.

High-income individuals should factor this significant tax into their business planning, particularly if they have the ability to organize their business affairs to actively participate in a pass-through entity such as an S corporation of limited partnership.

Robert R. Keatinge is an attorney at Holland & Hart, where he provides seasoned and effective counsel to a wide variety of business organizations and their owners, including small start-up companies to publicly traded corporations. Reach Bob at 303.295.8595 or at rkeatinge@hollandhart.com

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