An Overview of the Medicare Surtaxes

As we wind down 2011, we are already beginning to take a look at 2013 with tax planning in mind. Why? Absent any legislative tinkering to the tax code in this upcoming election year, nearly all taxpayers can expect a big tax hike beginning in 2013. Here is a rundown of just a few changes that will result in heftier tax bills:

1. A return of pre-2001 individual income tax brackets and rates
2. An increase in capital gains tax rates from 15% to 20%
3. An increase in dividends tax rates from 15% to rates up to 39.6%
4. A sharp decline in the ability of businesses to claim first-year deductions for capital purchases

In addition to these changes, 2013 marks the first year of the Medicare surtaxes created by last year’s healthcare reform legislation. These surtaxes apply to wages, income from self-employment and investment income of taxpayers whose income exceeds certain threshold amounts. Here is how these taxes work.

Wage Surtax

This .9% surtax applies to wages and income from self-employment in excess of $250,000 for married taxpayers filing a joint return ($200,000 for single taxpayers). Employers are required to withhold the surtax tax once an employee’s wages exceed $200,000 (regardless of whether or not the spouse is also a wage earner.) Any additional surtax liability must be taken into account by quarterly estimated tax payments or by the original due date of the return.

Example: One spouse has wages of $275,000; the other spouse has wages of $125,000. They file a joint return. The total liability for the wage surtax is $1,350 [($400,000 - $250,000) x .9%]. Wage withholding represents $675 of that liability ($75,000 x .9%) while the remainder is due either as a component of estimated tax payments or by the original due date of the return.

One additional note to consider is that self-employed individuals that generally get an income tax deduction for one-half of self-employment taxes paid will receive no such deduction for Medicare surtaxes paid on income from self-employment.

Investment Surtax

The investment surtax is a 3.8% tax applied to the lesser of investment income and adjusted gross income over $250,000 for married taxpayers filing a joint return ($200,000 for single taxpayers).

Example: A married couple files a joint return with $350,000 in income, $75,000 of which is derived from investments. The income exceeding the threshold amount is $100,000. Since investment income is less than $100,000, the 3.8% tax rate is applied to $75,000 of investment income for a Medicare surtax of $2,850.

Here is a list of income subject to the investment surtax:

1. Passive income
2. Interest
3. Dividends
4. Annuities
5. Royalties
6. Taxable capital gains

Some of this income, such as capital gains, may be triggered in 2011 and 2012 in order to dodge the surtax. Also, bear in mind that while the capital gain exclusion from the sale of a primary residence also serves to exclude the investment surtax, any gain that exceeds the exclusion amount ($500,000 for married taxpayers filing a joint return/$250,000 for single taxpayers) will be subject to capital gains tax and the investment surtax.

Our Take on the Herman Cain 9-9-9 Plan

Herman Cain and his 9-9-9 Plan have received considerable attention over the past several weeks. Cain’s plan has been lauded for its simplicity and transparency while at the same time derided for its lack of detail and the perception that it will be insufficient to collect the revenue of the taxes it would replace. The 9-9-9 Plan is intended to be a transition to the “Fair Tax”, a national sales tax that would replace all income, payroll, self-employment, estate and gift taxes. Here are the basics from Mr. Cain’s website:

9% Business Flat Tax

The business tax is assessed on the gross income of businesses minus purchases from U.S. located businesses, capital expenditures and net exports. Additionally, payroll deductions will be offered to businesses that employ workers in Empowerment Zones, or designated economically-distressed areas.

Our Take: The key selling features of Cain’s tax plan are simplicity, transparency, and neutrality.  With the business tax provision, these principles are compromised.

If gross income is defined as “revenue from operations”, then this element of the equation is relatively straightforward. The subtractions from gross income to compute the taxable base are less so. If a U.S. business purchases inventory from a U.S. distribution facility owned by a foreign manufacturer, does the taxpayer receive a deduction? What if the inventory is manufactured overseas but assembled and sold in the U.S.? This provision has the makings of an enforcement nightmare.

Additionally, Mr. Cain’s website chastises the current tax regime for picking winners and losers (which it does), but the 9-9-9 Plan favors inventory-driven businesses (via the purchases deduction) over service-oriented businesses whose largest expense, payroll, would be non-deductible unless the businesses are located in a designated Empowerment Zone.

We also question the applicability of the business tax on entities, such as S corporations and partnerships, which pass through items of income, deduction and credit to its owners. The transition issues stemming from a conversion to this tax regime are too numerous to list.

9% Individual Flat Tax

The individual tax is assessed on gross income less charitable deductions. Additional deductions are allowed for taxpayers that live and/or work in designated Empowerment Zones.

Our Take: One could argue that the retention of the charitable contributions deduction is an example of the kind of tax handout that Cain criticizes. However, the feature that causes us the greatest pain is that a flat tax with no exemption amount (except as may be provided in the Empowerment Zones) is bad policy for lower income taxpayers. A 9% tax levy on a household that is struggling to meet basic needs has a far more negative impact on that household than the same percentage levy on a family living more comfortably. A progressive rate system with an exemption amount tied to poverty statistics would not overly complicate the system.

9% National Sales Tax

Mr. Cain’s website does not provide much detail on this provision, but we assume that the tax would be levied against business and individuals. Mr. Cain clarified in a recent interview that the tax would apply only to the purchase of new goods.

Our Take: A lower-income household outside of a designated Empowerment Zone that uses all of its income to cover basic needs will see a large percentage of its income diminished by a 9% individual income tax, a 9% national sales tax, and the prevailing state/county/local sales tax. In a high sales tax state like Alabama where combined sales tax rates are currently as high as 12%, an extra 9% is punitive. The “Fair Tax” does offer a prebate system that has the effect of exempting spending up to the poverty level. While not articulated on Mr. Cain’s website, his 9% national sales tax may contain a similar provision.

Tax Summary: The American Jobs Act

Last week President Obama unveiled The American Jobs Act, a multi-faceted plan to boost the nation’s employment. Here are the tax provisions included in the proposal:

Employer Payroll Tax Cut
For 2012, the American Jobs Act would cut the employer Social Security tax rate from 6.2% to 3.1% on wages up to $5 million. Additionally, any increase in wages from 2011 (up to a maximum of $50 million) would be completely exempt from Social Security taxes.

Employee Payroll Tax Cut
The employee Social Security tax rate, typically 6.2%, is currently 4.2%. The American Jobs Act would further reduce this percentage to 3.1% for 2012.

Bonus Expensing Extension
100% expensing of qualifying business equipment purchases is scheduled to expire at the end of 2011. The American Jobs Act would extend this provision until the end of 2012.

Targeted Employer Credits
$4,000 for hiring long-time unemployed workers
$5,600 for hiring long-time unemployed veterans
$9,600 for hiring long-time unemployed veterans with service-related disabilities

Additionally, the proposal includes non-tax provisions that include infrastructure modernization, wireless internet expansion, and unemployment insurance expansion. The Obama Administration estimates the price tag to be $447 billion. This will add to the $1.5 trillion in deficit reductions that the Congressional “super committee” is tasked with identifying. Obama’s stated intent is for this proposal to be paid by big business and high income individuals.

2011/2012 Year-End/Year-Round Tax Planning Guide

At Dent, Baker & Company, LLP, we are committed to being your most trusted advisor. Our tax professionals are dedicated to providing comprehensive methods for determining tax-saving strategies, helping you accomplish your financial goals and preserve your family’s wealth. To that end, enclosed please find our 2011/2012 Year-End/Year-Round Tax Planning Guide.

As you read through this guide, you’ll find helpful explanations of the current federal tax rules, tax tables and even worksheets. Use these tools to make a preliminary estimate of your 2011 taxable income and make note of the dozens of tips for lowering your personal and business taxes.

The tax-saving ideas in this booklet are offered as suggestions only. As you begin to consider your individual and business tax planning needs, we encourage you to contact us concerning your specific situation before choosing any of the methods outlined.

Dent, Baker welcomes the opportunity to provide you with guidance and help you maximize your income through effective implementation of tax-saving strategies. Please contact our office if you have questions or wish to review your specific tax situation and determine whether a particular planning strategy is right for you.

The general information in this publication is not intended to be nor should it be treated as tax, legal, or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purpose of avoiding tax penalties.

2009 Jefferson County Occupational Tax Refund Update: Employer Reporting Extension Granted

According to The Birmingham News, the judge presiding over the 2009 Jefferson County Occupational Tax refunds has granted an extension for employers to report the employment data required by the Special Administrator to compute employee refunds. The extended deadline is September 15th. For additional information on the employer reporting requirements, please refer to our previous post regarding the settlement guidelines.

The Tax Case for Investing in Your Business Now

Businesses can deduct most asset purchases over periods ranging from 3 to 15 years. However, in recent years, businesses have been able to deduct most, if not all, of the cost of these same assets in Year 1 thanks to two key tax provisions – the Section 179 business expensing election and bonus depreciation. After next year, these “Year 1” deductions will pretty much be a thing of the past.

Section 179 of the Internal Revenue Code allows businesses to offset current year income with an immediate deduction for qualifying asset purchases up to a certain threshold amount. In 2011, this amount is $500,000. What this means is that if you pay tax at the highest federal rate of 35%, then $175,000 of the $500,000 in asset purchases is funded by tax savings.

Section 179 is an effective way to invest in a growing business while minimizing taxable income in those high growth years. However, beginning in 2012, the expensing availability declines significantly to $125,000 and then again in 2013 to $25,000.

Bonus depreciation allows a business to write off a certain percentage of the asset’s cost “off the top” prior to regular depreciation. Since roughly the fourth quarter of 2010 and continuing through the end of this year, the write off percentage is 100%, which means a business can use bonus depreciation to fully deduct the cost of a qualifying asset purchase in the first year. This percentage falls to 50% in 2012. In 2013, bonus depreciation is eliminated.

There are a few of key differentiators between Section 179 expensing and bonus depreciation:

• Bonus depreciation is applicable to new asset purchases only. Section 179 expensing applies to new and used asset purchases.
• Bonus depreciation can create a tax loss which may be carried back to recover tax dollars paid in a prior year. Section 179 expensing is limited to current year income and, thus, cannot be used to create a loss.
• Section 179 expensing is subject to an investment limitation above which the expensing amount is reduced dollar for dollar ($2 million in 2011). Bonus depreciation has no investment limitation.

Since the tax benefits of these two tax provisions will soon be significantly curtailed, we recommend businesses evaluate their capital expenditure needs now. If certain capital expenditures will be necessary within the next three to five years, the shorter recovery of those tax benefits this year and next might make an acceleration of those purchases more attractive than waiting.

Individual and Business Income Tax Overhaul Taking Shape

As the debate continues over raising the federal debt limit, lawmakers have also turned their attention to how individual and business income taxes can be overhauled to reduce the federal deficit. As usual, these discussions will center on who pays and how much.

Currently, individuals pay tax across six rate brackets ranging from 10% to 35%. A proposal currently garnering bipartisan support would collapse the six brackets into three – 12%, 22%, and 29%. These new rates are consistent with the recommendation of President Obama’s deficit reduction panel.

On its face, this appears to be a big win for supporters of low taxes and tax simplification; however, this same plan proposes a limitation on certain deductions that, for many taxpayers, would drive effective tax rates up. The primary targets are mortgage and home equity loan interest and charitable contributions of high income taxpayers. Additionally, this plan would lower the annual deductible amount of retirement plan contributions.

On the business tax side, the story is the same – reduced tax rates and broadened tax base. The top corporate rate, currently 35%, would fall to between 23% and 29%. This rate reduction would be funded by the elimination of the Domestic Production Activities Deduction (DPAD), less favorable depreciation rules, and a scale back or elimination of the R&D credit. These concessions will certainly set off a fight between small businesses that benefit greatly from DPAD, generous depreciation, and the R&D credit and large corporations that view a lower corporate tax rate as essential to effectively competing in the global marketplace. We discussed this dynamic in greater detail back in March.

Bear in mind that any overhaul in individual and business income tax will result in greater revenue to the Federal government. Also bear in mind that the Federal government will collect this additional revenue from those with the greatest ability to pay – high income taxpayers. The silver lining is that no legislator would dare push through a big tax increase ahead of an election, so we are probably looking at a 2013 implementation at the earliest.