The 2012 “American Health Care Act – the Affordable Health Care Act” (Obama Care) [The Act] contains many provisions that affect both large and small businesses. The Act will have many ramifications, particularly for small businesses in determining if they are required to cover employees with health insurance and penalties for failure to do so. Even businesses that provide insurance today may get caught up under the mandate because they must offer coverage that meets the minimum requirements {Michael D. Tanner, “No [Obama Care]: It will Make It Harder For Small Firms to Grow”, The Wall Street Journal, August 19, 2013}. The Act affects individuals starting in 2014 and businesses starting in 2015, but there are still uncertainties regarding implementation of the Act because the IRS has not released final regulations.

This article will discuss the tax provisions enacted as part of the Act and its implications and hardships that will be created for businesses and individuals.

Tax Information Required to be Disclosed

The IRS regulations list information that may be disclosed to the U.S. Department of Health and Human Resources (HHS) to determine if a taxpayer is eligible to enroll in an exchange and is eligible for government assistance to pay for health care. The IRS can provide HHS with the following taxpayer information:

•  identity

•  filing status

•  number of personal exemptions claimed

•  adjusted gross income (AGI)

•  modified adjusted gross income (MAGI)

•  any foreign earned income exclusion

•  tax-exempt interest

•  amount of Social Security benefits included in AGI

•  whether a tax return had to be filed for the year

•  whether a tax return filed for the year reconciled advance assistance payments (Sec. 36C) with the amount of the credit to which the taxpayer was entitled to for the year.

[J.K. Lasser’s Monthly Tax Letter, September 13, 2013].

Major tax provisions included in the Act are the additional medicare tax on net unrealized income (NII), a 3.2% tax on medical appliances, taxes (penalties) on businesses that do not provide health care insurance for their employees, taxes (penalties) on individuals who do not purchase health care insurance, and tax credits (subsidies) on health insurance premiums for certain low-income people. Each of these and other financial provisions will be discussed.

Tax on NII

Background

One of the provisions in the Act imposes an additional Medicare contribution tax of 3.8% on NII for tax years beginning in 2013. This new surtax will apply to individuals, self-employed, estates, and trusts, and S corporations.

For individuals, the tax is imposed on the lesser of (1) NII (gross investment income less investment related expenses) for the tax year, or (2) any excess of modified adjusted gross income (MAGI) [AGI plus tax-exempt interest income] for the tax year over a threshold amount [Sec. 1411(a)(1)]. The IRS released a draft of form 8960 which will be used to compute the tax for individuals. There will be no withholding tax for NII tax. Taxpayers should review the form and consult with their tax adviser to determine if they need to adjust withholding and estimated tax payments for any additional tax resulting from the NII. For more information on the tax for estates and trusts see “Recent Developments in Estate and Trusts Planning: Part I” by Justin P. Ransome, J.D., MBA,

CPA, and Frances Schafer, J.D, The Tax Adviser,on line edition., September 1, 2013.

Threshold Amount for Individuals

The threshold MAGI where the tax begins to apply is $250,000 for joint return filers and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for all other taxpayers [Sec. 1411(a)(2)].

Threshold Amount for Estates and Trusts

The tax is imposed on the lesser of undistributed NII for the tax year or AGI over a threshold amount for the highest tax bracket ( $11,950 in 2013) for the tax year [Sec. 1411(a)(2)].

Gross Investment Income

Sect 14118 states this is the total of:

(1) interest, dividends, annuities, royalties, and rents other than income derived in the ordinary course of business that is not a passive activity or a trade or business that engages in trading financial instruments or commodities [Prop. Regs. 1.4111-4(a)(1)(I) and 1.411-4(b)]

(2) income from a trade or business that is a passive activity to the taxpayer under Sec. 469 that engage in trading financial instruments or commodities [Prop. Regs. Secs. 1.4111-4(a)(1)(ii) and 1.411-5] .

(3) net gain from the disposition of property other than property held in a trade or business that is not a passive activity or a business engaging in trading financial instruments or commodities. It also includes income attributable to an investment in working capital [Sect 1411( c)(3)]. Investment income does not include any income subject to self-employment tax [Sect 1411( c) (6)] nor distributions from qualified plans under Sects. 401(a), 403(b), 408(a), or 457(b) [Sect 1411(c)(5)].

(4) gross income from a trade or business that is a passive activity [when the owner is not actively and materially involved in managing the property] with respect to the taxpayer under Sec. 469 or a business that trades in financial instruments or commodities. Gross income from interest, dividends, annuities, royalties, and rents, other than these types of income derived in the ordinary course of a non passive trade or business and net gains on the disposition of property, other than property held in a non passive trade or business.

Any rules that allow carryovers of unused amounts for income tax purposes also apply for determining NII in future years [Preamble to Reg. 130507-11, 77 , Fed. Reg. at 72621]. Suspended passive activity losses, capital losses, and excess investment interest expense from pre-2013 tax years apply to determine a taxpayers MAGI and NII for post-2012 tax years [Prop. Regs. Secs. 1.4111-4(f)].

Net Investment Income of Individuals

NII is the gross investment income less investment related expenses: interest and fees incurred to purchase and sell securities, commodities and financial instruments, brokerage account fees, investment advice, costs incurred to maintain rental property, expenses related to earning self employment income, and other related charges [Sec. 1411(c)(1) ]. Additionally, investment deductions are those properly allocable to gross investment income [Sec. 1411(c)(1)(B)]. A NOL deduction allowed under Sec. 172 can not be used in computing NII for any tax year [Regs. Sec. 1.4111-4(f)(1)(ii) ].

Example of using a NOL

In year 1, an unmarried taxpayer has $60,000 wages, $20,000 investment income, a $70,000 loss from a sole proprietorship, and $30,000 of expenses allocable to investment income. There is no NII, but the taxpayer has a $20,000 NOL ($80,000 income less $70,000 loss and $30,000 of investment expenses. The taxpayer carries over the NOL to year 2. In year 2, the taxpayer has $200,000 wages, $100,000 investment income, $80,000 income from a sole proprietorship, and $10,000 of expenses allocable to investment income. The $20,000 NOL carryover is allowed in computing the taxpayer=s MAGI but not NII [ Reg. Sec. 1.411-4(b), Example 1].

Rental Activities

Example 1: A taxpayer rents a building in an arms-length transaction. Renting the building is not a trade or business and is not passive income from a trade or business that is a passive activity. However, it is NII because it is income from rents [Prop. Regs. Sec. 1.4111-5(b)(1)(2), Example 1].

Example 2. A taxpayer leases equipment in an arms-length transaction where the average period of customer use is seven days or less, which means the activity is not automatically passive. If the taxpayer materially participates in the activity and the activity otherwise constitutes a trade or business under Sec. 162, the rent is not NII. If the taxpayer does not materially participate, the rent will be NII [Prop. Regs. Sec. 1.4111-5(b)(1)(2), Example 3].

Effect of NII on S Corporations

The impact of the NII on unearned income can be reduced if their owners materially participate in its operations. If the owners materially participate, they will not be subject to the NII on their allocable share of the corporation’s income or distributions to them. But the exception doesn’t apply to passive shareholders or to S corporations that engage in trading financial instruments or commodities (passive investment activities). Shareholders should be cautious because the IRS can recharacterize S corporation dividends and salary if a shareholder’s salary is “unreasonably” low. The recharacterized amounts are subject to Social Security and Medicare taxes [Kiplinger’s Tax Newsletter, August 3, 2013].

Net Investment Income of Estates and Trusts

For details see “Recent Developments in Estate and Trusts Planning: Part I” by Justin P. Ransome, J.D., MBA, CPA, and Frances Schafer, J.D, The Tax Adviser, online edition, September 1, 2013.

Exclusions from NII

Social Security income, tax exempt interest, retirement income, alimony, or any item taken into account in determining self employment income for the tax year; however, a portion of these items may increase MAGI and cause more NII to be subject to the surtax.

Amount of Tax

A new, incremental 0.9% federal payroll tax, applies to earned income beginning in 2013, but the 0.9% tax and the 3.8% Medicare tax on NII can never be imposed on the same income item. The 0.9% tax has no corresponding employer portion that applies for other payroll tax purposes, but the employee portion is otherwise required to be withheld from wages and similar payments. For more on recent IRS guidance on the 0.9% tax, see IRS publication Guidance Issued on Additional Medicare Tax and IRS proposed regulations.

Itemized Deductions Limits for NII

[Donald T. Williamson, J.D., LL.M., CPA “Planning for the ‘Parallel Universe’ of the NII Tax”, The Tax Adviser, August 2013].  Deductions subject to the 2% floor on miscellaneous itemized deductions are determined before the overall limitations on itemized deductions limited by AGI that exceeds certain amounts [Prop. Regs. Sec. 1.4111-4(f)(3)(ii)].

Example

An unmarried taxpayer has $2 million AGI in year 1 comprised of $1,600,000 wages and $400,000 interest. He has itemized deductions of $70,000 investment expenses, $30,000 job-related expenses (miscellaneous itemized), $120,000 state income taxes, of which $20,000 is directly allocable to investment income. His 2% floor is $40,000 (2% x $2 million) and the overall phase-out of itemized deductions begins at $200,000 AGI, resulting in $54,000 disallowed itemized deductions (3% of the excess of $2 million over the $200,000 threshold). Considering the 2% floor, his miscellaneous itemized deductions (investment and job-related) are limited as follows:

Investment expenses: 70,000 x (70,000 + 30,000 – $40,000) / (70,000 + 30,000) = 42,000

Job-related expenses: 30,000 x (70,000 + 30,000 – $40,000) / (70,000 + 30,000) = 18,000

The deduction for state income tax and investment interest is not subject to the itemized deductions phase-out, leaving the following subject to the overall phase-out:

Investment expenses 42,000

Job-related expenses 18,000

State income taxes 120,000

=180,000

The amount of deductible investment expenses, state income taxes directly allocable to investment income and deductible state income taxes indirectly allocable to investment income is shown below.

investment expenses: 42,000 x (180,000 – 54,000) / 180,000 = 29,400

state income taxes: 20,000 x (180,000 – 54,000) / 180,000 = 14,000

state income taxes not allocable to investment income: 100,000 x (180,000 – 54,000) / 180,000 = 70,000

Total allocable deductions offsetting investment income are

Investment interest 80,000

Investment expenses 29,400

State income taxes 14,000

=123,400

EXCEPTIONS TO the NII Tax

Non passive owners of S Corporations

Day to day material participation (often referred to as “active participation”) is necessary under Sec. 469 to avoid the passive activity characterization. For a non passive owner or shareholder of an S corporation, the taxpayer’s distributive share of income does not currently appear to be subject to the new 3.8% Medicare tax. This applies to the taxable income reported in Box 1 of the shareholder’s Schedule K 1, including any subsequent distributions of that income. For further detail on the new NII tax with respect to S corporations, see Wechter, “Using S Corporations to Avoid the Medicare Tax,” Tax Insider, June 14, 2012.

2. Rental Real Estate Professionals

A taxpayer qualifies as a real estate professional if more than one half of the personal services the taxpayer performs in a trade or business during the tax year are performed in a real property trade or business in which the taxpayer materially participates, and the performs more than 750 hours of services during the tax year. Generally, income derived from rental activities will be characterized as passive and subject to the 3.8% NII tax. Even if the taxpayer qualifies as a real estate professional under Sec. 469(c)(7) so that his rental activities are not passive , the taxpayer must still be considered to be engaged in a trade or business within the meaning of Sec. 162 and Prop. Regs. Sec. 1.411-4(b) to exclude any rental profits from the surtax [Donald Willamson, J.D., LL.M., CPA “Planning for the Universe of the NII Tax”, The Tax Adviser, August 2013].

The key benefit for real estate professionals is their income is considered non passive by definition. For this reason, rental income received by rental real estate professionals is not considered part of NII when calculating the 3.8% NII tax, as long as the rental real estate activities are conducted as part of a trade or business under Sec. 162. Real estate professional taxpayers should consider making “grouping elections” [Reg. 1.469 9(g)], which combines all rental activities into a single rental real estate activity. This may help taxpayers meet the material participation requirement for all their rental properties [Donald Willamson, J.D., LL.M., CPA “Planning for the Universe of the NII Tax”, The Tax Adviser, August 2013].

See Part 2

In accordance with Circular 230 Disclosure