Limiting Deductions Could Be The New Tax Hike In Fiscal Cliff Avoidance
By Robert A. Green, CPA
Forbes version: "Limiting Deductions Could Be The New Tax Hike In Fiscal Cliff Avoidance".
Democrats view tax reform as starting from Clinton-era tax rates in 2013 on the upper-income and lowering tax rates back to Bush-era rates from 2012, in exchange for limiting deductions. In their view, that does not violate the tax-protection pledge signed by many Republicans and some Democrats, because tax rates are reduced in exchange for limiting tax deductions. Democrats figure the Bush-era tax cuts were passed in a reconciliation procedure with a required 10-year sunset provision, so therefore when the temporary tax cuts expire, it's not deemed a tax hike but a rather a return to sunrise tax policy. This is the key obstacle to making a deal to reduce the shock of the fiscal cliff in the lame duck session.
Even controversial Grover Norquist agreed that reducing tax deductions in exchange for lower tax rates is not a violation.
The fiscal cliff 2013 tax hikes are 5:1 vs. 2013 spending cuts
Barron's cover story "Shock Treatment" by Gene Epstein points out that the fiscal cliff is heavily stacked toward tax hikes in 2013 (he calculates $475 billion) vs. 2013 spending cuts of $111 billion; the often cited $1 trillion in cuts spans 10 years.
If passed, the 2012 AMT patch will trim $114 billion off the fiscal cliff. Perhaps Congress should only pass the AMT patch for the middle class. Extending the Bush-era tax cuts for everyone other than the upper income and will trim another $95 billion off the fiscal cliff. That’s around $200 billion of less fiscal cliff shock on the middle class, which surely affects the economy.
Extending Bush-era tax rates on the upper income but limiting their tax deductions will generate close to $50 billion of tax hikes on a static basis, and from growth, too. That new tax revenue helps the deficit. Ending the temporary payroll tax cut stimulus at year-end as scheduled will add back $120 billion in tax revenues. That's close to $170 billion of new 2013 tax revenues vs. $110 billion of 2013 spending cuts. This is good balance that should satisfy President Obama’s requirement. If Congress and the President don't like the automatic 2013 sequester with 50/50 non-defense vs. defense spending cuts, then find different spending cuts to replace them.
Negotiating through the media
President Obama won reelection, Democrats added to their majority in the Senate and Republicans retained safe control of the House. We’re left with the same leaders and negotiators to the fiscal cliff and upcoming debt-ceiling crisis. But President Obama feels he has an edge after the election and that honeymoon lasts through the lame duck session.
This past week after the election, the leaders started fiscal-cliff negotiations through the media — the new style set by President Obama. The President is pushing hard to let the Bush-era tax rates expire on the upper-income only, as promised. Obama has to start his post-election fiscal-cliff negotiations from that position, and he won’t surrender it easily, although he may to strike a deal in the lame duck.
In the president's public talk from the White House on Friday, he also seemed to leave the door open to tax hikes on the upper income through other means like reduced tax expenditures for the upper-income. The President said he is open to ideas from Republicans, who hinted at the same type of other means to raise new tax revenue on a static basis, not just through growth which is the preferred Republican approach.
Speaker Boehner seemed to strike a conciliatory tone this week, hinting he would agree to tax hikes on the rich on a static basis, and not just from growth through tax reform – with lowering tax rates. Speaker Boehner said he would obstruct tax rate hikes, meaning he won’t allow the Bush-era tax rates to expire on the rich only.
Both President Obama and Gov. Mitt Romney included a haircut on tax deductions for the rich in their tax plans, so there is common ground between the parties on this approach to tax reform. It was also advocated in Bowles Simpson and the Gang of Six in their deficit, spending and tax reform plans.
I think there is common ground here for striking a deal in the lame-duck session. Perhaps Speaker Boehner might accept President Obama’s idea of limiting itemized deductions to a tax rate of 28% (rather than 35%), thereby raising taxes on the upper income. It will probably take a bigger haircut for the math to add up.
If Congress reduces itemized deductions for 2013, it may be better for the upper income to accelerate their tax deductions into 2012 – provided there’s no AMT triggered on them — rather than defer itemized deductions into 2013. I suggest this in my last blog "Year-End Tax Planning with the Fiscal Cliff."
Speaker Boehner agreeing to the above itemized-deduction haircut on the rich would likely constitute his suggested "down payment" on tax reform, which should be hopefully completed in 2013.
Where does the President stand?
In the last crisis round of negotiations over the debt ceiling and tax policy in mid-2011, President Obama insisted on delaying the debt ceiling and fiscal cliff crisis until after his reelection, which left little time to craft a deal in a lame-duck session. Now that President Obama has won his reelection, will the President keep his promise to end Bush-era tax rates for the upper income at year-end 2012? Or will the President blink in fear of a CBO-forecasted fiscal-cliff-induced recession, accept some tax revenue hikes through other means and extend the Bush-era tax rates for everyone into 2013? I think the President will make this type of deal if he can. But, I hope the President doesn’t spike the ball about breaking the tax protection pledge since that’s not clear and Democrats don’t want that label, either.
With whatever deal is forged in the lame duck session, I doubt Republicans will surrender their leverage of not de-coupling Bush-era tax rates — for the middle-class vs. upper-income — or giving the President a blank check on a debt-ceiling vote. Their starting point for negotiations is new tax revenue through tax reform and growth only. Republicans want to lower rates starting with the Bush-era rates, not the Clinton-era rates on the rich. They also want specific spending cuts and entitlement reform before they agree to new revenues and tax reform.
It’s impossible to negotiate and draft detailed legislation for entitlement reform and tax reform in the lame duck; that should be the job of the next Congress. It’s crazy to make last-minute significant changes to the tax code and then reform it in a material fashion just a few months later. The IRS will be spun into a real mess and taxpayers will face great cost and headaches in compliance.
I hope President Obama learned his lessons from the last breakdown in deficit, spending and tax talks and he read Bob Woodward’s book The Price of Politics. We don’t have time in the lame duck session for the President and other leaders to back track and not honor their negotiated points.
McConnell versus Reid in the Senate
Senate Minority Leader Mitch McConnell drew a hard line in the sand after the election against any new tax hikes in the fiscal cliff showdown. He did not play cute like the others distinguishing between tax-rate hikes vs. new tax revenue through other means. Will Senator McConnell accept a Boehner down-payment on tax reform which includes new static tax revenue on job creators, providing Bush-era tax rates are continued on everyone into 2013? Will Senate Leader Reid try to ice McConnell by threatening his right to use the filibuster? McConnell could face a primary challenge from the Tea Party in 2014 so that may color his stated posture.
Brinksmanship and holding hostage
Both party’s leaders are playing that game. Democratic leaders are threatening to go over the fiscal cliff and let all the Bush-era tax rates expire, not pass a 2012 AMT patch and seek to pass tax cuts retroactively to Jan. 1, 2013 (and hopefully the AMT patch retroactive to 2012). Republicans won’t de-couple Bush-era tax cuts or give the President a blank check on the debt ceiling. The American people should not stand for this political grandstanding, and although we don’t need a grand bargain now, we want a reasonable small ball deal in the lame duck to limit the damage of the fiscal cliff.
In "Year-End Tax Planning with the Fiscal Cliff." I guessed President Obama might not agree to extend the Bush-era tax rates for the upper income and Republicans wouldn’t decouple the middle-class Bush-era tax rates. With that potential outcome, I suggested taxpayers might want to accelerate income and expenses since tax rates would skyrocket higher in 2013, and tax deductions may be limited in 2013 with tax reform. Don’t take for granted that Washington can rebuild Humpty Dumpty after the new year, either.
I hope Congress and the President strike a post-election lame-duck deal to extend the Bush-era tax rates on everyone and, as Speaker Boehner suggests, do a down-payment on tax reform by limiting deductions in 2013 for the rich. If that works out to be the case, then upper-income taxpayers may want to defer income and accelerate expenses, which is typical year-end tax planning. Read our normal year-end tax planning on our Website.
Will spending cuts ever happen?
Senator John Kyl told CNBC’s Larry Kudlow they can easily find $55 billion of spending cuts over six months for a lame-duck punting deal and that is all they need to kick the can down the road. As Larry Summers said, 10-year spending promises are worthless, since Congress never honors them and changes things each new Congress or year, anyway. We’re not really taking about spending cuts, but rather reductions in spending growth.
Everyone has a different take on the fiscal cliff story. Some want to go over the fiscal cliff to avoid the inevitable long-term fiscal abyss. Isn’t the fiscal cliff the medicine that Congress and the President prescribed? Are the patient and doctor trying to skip bad-tasting medicine?
Why is the financial-market industry whining?
Financial markets are high vs. the meltdown prices in 2008, and Helicopter Ben Bernanke of the Fed is keeping unending quantitative easing to buttress asset and market prices. Can’t the markets absorb a modified fiscal cliff based on the above suggested deal?
Our CPAs are standing by to help our clients with year-end tax planning and we hope to see a fixed target rather than moving goal posts. This will get interesting! October 26, 2012
Year-End Tax Planning with the Fiscal Cliff
By Robert A. Green, CPA
Postscript after the election: Read our new blog dated Nov. 11 "Fiscal cliff, fiscal abyss or fiscal three-card Monte?".
Forbes version: "Year-End Tax Planning Before The Fiscal Cliff".
MoneyShow podcast interview with Robert Green about this blog: "Year-End Tax Planning for Traders".
Tax planning is very tricky this year with the fiscal cliff. Most people hope Congress and President Obama will act soon — after the November election and before year-end — to bring clarity to the fiscal cliff, especially making a decision about the crucial Bush-era tax cuts.
Consider accelerating income this year-end
Most years, taxpayers prefer to defer income and accelerate expenses, but this year is different.
Income tax rates are scheduled to skyrocket up in 2013 with expiration of the Bush-era tax cuts. Plus, the Affordable Care Act’s new Medicare tax of 3.8% on unearned income goes into effect on Jan. 1, 2013 for taxpayers making more than $250,000 for married filing joint and $200,000 for single. Trading income is subject to that Medicare tax and an S-Corp can’t help lower it. Read our "blog" on the subject. For regular year-end tax planning for traders, read our "prior content" on the subject.
If the Bush-era tax cuts are not extended for your marginal tax bracket, it’s probably a good idea to accelerate income of all kinds into 2012 — ordinary income, capital gains and dividend income. Consider selling investments with unrealized gains before year-end. While that’s easy with marketable securities, it’s more difficult with less liquid investments like real estate and private equity.
If you own a C-Corp, consider paying yourself qualifying dividends from retained earnings, as the 15% 2012 rate jumps up to 39.6% plus the Medicare tax of 3.8 percent in 2013 (if you are over the threshold). Deal with those built-up retained earnings now.
Tax gain selling
In most years, taxpayers engage in “tax loss selling” to prune their portfolio of losing positions and lower capital gains taxes. This year, consider the reverse — “tax gain selling.” Instead of avoiding wash sales, maybe wash sales can be your friend by accelerating income into this year and deferring losses until next year.
Deferring expenses may be unsafe
Generally, when it’s wise to accelerate income, it’s also wise to defer expenses, as it has the same effect on taxable income. But, this year is different and you should decouple those ideas: Accelerate income, but don’t defer expenses.
Itemized deductions and many other tax expenditures may be closed in 2013 as part of promised tax reform. Gov. Romney’s tax plan is to limit itemized deductions to $25,000 or similar amount for upper income taxpayers. Deductions could be reduced for the middle class too, even with Democratic plans. Most states are acting to limit itemized deductions. If you see a deduction allowed for 2012, take it. If it’s wiped out with AMT tax for 2012, then defer it.
Gov. Romney’s tax plan also includes zero income tax on portfolio income for taxpayers making under $200,000 per year, but it’s unlikely to pass Congress if Democrats retain a filibuster. You can make this call with the election results.
AMT patch not resolved
Even if Congress can’t agree on the Bush tax cuts, I hope they at least agree to pass the annual AMT patch for 2012. Otherwise, millions of additional taxpayers will be hit with a nasty AMT tax-hike surprise. AMT can give back some long-term capital gains rate benefit – since the AMT rate is much higher than the capital gains rate - and AMT doesn’t allow most itemized deductions.
Businesses get the golden (tax) goose
Business deductions for business traders and investment managers are safe because tax reform is focused on limiting itemized deductions, not business expenses. Just make sure you have business status in Q1 2013.
If you don’t qualify for trader tax status (business treatment) for 2012, and expect to qualify in Q1 2013, then defer business expenses to 2013. Alternatively, you can spend the money in 2012 and capitalize the amount into Section 195 startup costs to amortize in 2013. But, remember the expense provision of Section 195 is only $5,000 with the rest being amortized over 15 years using the straight-line method.
Conversely, if you qualify for trader tax status in 2012, but might not in 2013, take your expenses in 2012. If you have investor tax status, take your chances with a miscellaneous itemized deduction in 2012, rather than in 2013.
Business traders and investment managers should not defer charity to 2013. But businesses can defer equipment purchases to business deductions in 2013. I don’t have much faith in tax reform lowering rates much, so expense deferral is a good idea. Even if equipment expensing is scaled down with repeal of Bush-era tax cuts, there is plenty of room for 100% expenses with pre-Bush Section 179 depreciation allowances.
A Roth IRA or Mini 401k conversion is risk free
Consider a Roth IRA or Roth Mini 401k conversion in 2012. No matter what happens with the fiscal cliff, it’s a good idea under most scenarios and even if it turns out to be a bad idea, you can reverse it. A Roth IRA conversion comes with a free “recharacterization” feature. Up until the due date of your tax return the following year, you can reverse the Roth conversion. We will have details on this process in upcoming Webinars and it’s in "Green’s 2012 Trader Tax Guide", too.
Why not convert and check out your regular retirement accounts at lower Bush tax rates, and then trade your Roth IRA tax free for life? This will protect your trading gains from tax hikes in the future. Pass on these breaks to family members with estate planning, too.
If the Bush tax cuts do expire, pundits expect the market to sell off with calamity on the horizon. Why not cash out your investment positions before others try to do the same? After your conversion to the Roth IRA, you can trade and make new investments at lower prices as the markets recover.
Part II – The Political Intrigue (further reading for those interested in the politics of tax negotiations)
The great divide on taxes
For invaluable additional insight into how the negotiations may play out, read Bob Woodward’s best-selling book “The Price of Politics.” He makes one thing very clear: President Obama is dead set on raising tax rates on the rich, which means letting the Bush-era tax rates expire for the upper class. Obama says time and again he will not agree to balance budget cuts on the middle class and poor, without the rich paying their fair share. Senate Majority Leader Harry Reid and House Minority Leader Nancy Pelosi are on the same page.
On the other side of dysfunctional government negotiations is the Republican mantra to defend their tax-protection pledge not to raise taxes in any means other than through growth. Republicans swept the House in 2010 with Tea Party ascendance and the Young Guns are committed to growth through tax and spending reforms. Republicans certainly can’t throw their new power and mandate under the bus.
In “The Price of Politics”, President Obama carried on five different negotiations over the debt ceiling, deficit and taxes, and Woodward paints a picture of the President impeding negotiations by throwing curve balls, not facing the reality of Republican mantra and trying to use the media too much. We ended up with sequestration and negotiation failure. In the third and final presidential debate over foreign policy, President Obama said defense spending sequestration will not happen. And, how won’t it happen?
Just guessing the Bush tax cuts will expire
Republicans won’t decouple and allow the Bush-era tax cuts to expire on the rich only, as they will then lose all leverage going forward on spending and tax reform and the debt-ceiling.
The Washington Post recently reported that Obama threatens to play his power card — to veto any legislation that allows the Bush-era tax cuts to continue for the upper income. He said he is prepared to allow the Bush-era tax cuts to expire as scheduled for everyone and then rush through tax cuts for the middle class in 2013. Republicans will insist on tax reform and they won’t agree to greater progressivity with tax hikes on the rich and job creators.
Whether Obama wins or loses the election, I don’t think he will allow Congress to extend the Bush-era tax cuts for the upper income again. For the President, it’s a matter of principle and it will be part of his legacy. It’s been the cornerstone of his tax plan starting with his 2008 presidential campaign and it’s been included in every one of his annual budgets. I think President Obama is prepared to go out with bang based on his principles, and he won’t want to cave into George W. Bush and his tax cuts! Democrats often assail ‘unpaid for tax cuts for the rich, which never produced jobs or trickle-down benefits to the middle class.’
If President Obama wins re-election, he might take his chances with a potential blow to the economy from going over the fiscal cliff. Let’s get serious, we are going over the long-term fiscal cliff anyway. President Obama may not be that concerned with a stock market drop, as that affects rich people the most and Helicopter Ben (Bernanke) just passed unlimited QE to save the stock market. Obama may be more concerned with the economy and he doesn’t believe tax hikes on job creators hurts jobs. He is more focused on future negotiations over the debt ceiling, spending and taxes, including tax reform. He may figure that he can do better starting from higher Clinton tax rates, giving him more room to maneuver, and more leverage. He can blame the tax hikes on Republicans.
The path to making a tax deal is mired in pitfalls
Democrats need new tax revenue without growth, since CBO won’t score growth. Republicans won’t agree to tax rate hikes; they will only agree to tax revenue increases through growth. That’s dead-end number one.
Democrats want to make the tax code more progressive, to have the rich pay more (a fairer share). They view tax reform as a Republican Trojan horse to lower rates and close deductions, which mean less progressivity and a tax hike on the middle class. Republicans view tax reform as being integral to overall government reform including spending reform. They want simplification, fewer government candy bars and fiscal policy handouts, and lower rates for job creators, on par with lower corporate rates, to be competitive around the world. Republicans argue that if you want more taxes, grow the economy and jobs and that generates more tax payments. Tax reform is dead-end number two.
With these two dead-ends, don’t expect taxes to help solve the next debt-ceiling showdown, either. It will be all about spending again, which is just what Republicans want.
So, isn’t the wise move for Obama to let the Bush tax cuts expire and get it while he can? Who can blame Obama for getting the Clinton rates back? If it’s good for the goose (Clinton), it’s good for the gander (Obama).
Tax reform is a mirage and red herring
Tax reform is a red herring, since it means more progressivity to Democrats and less progressivity to Republicans. Democrats will agree to roll back Clinton rates to Bush rates for the rich, but they have to give up deductions a la Romney’s plan. Romney wants rates dropped to 25%, not 35%.
Democrats won’t close itemized deductions for the middle class, the middle class needs their housing, charity and (blue) state tax deductions. Republicans will never throw capital gains rates under the bus, which is what Democrats want in tax reform. Tax reform is at best hopeful and it will take six to 12 months per the Woodward book. The 2013 government is expected to be filibuster-proof, so either side can block tax reform in 2013. Republicans will never agree to just a promise of tax reform for a debt-ceiling increase and tax reform must be revenue neutral in their book. So, how can it be part of the upcoming debt-ceiling showdown by early 2013?
Defense versus non-defense spending
For Republicans, taxes are the third rail of politics and for Democrats, entitlement reform is the third rail. The last debt-ceiling showdown had to exempt taxes and punt the Bush-era tax cuts to this year-end, after the election — an absolute must of President Obama.
Negotiations were sure to fail with all of President Obama’s heavy-handed monkey wrenches thrown into every behind-your-back negotiation. The only possible outcome was sequestration, with equal parts spending cuts on non-defense (Democrats) and defense (Republicans).
Don’t wait too long
Don’t wait until holiday time to sell stocks and do year-end planning. Contact us now early in Q4 and consider a Roth IRA conversion early on. A Roth conversion plan takes plenty of time with your accountants and it’s usually wise to include your insurance agents and tax attorney for estate planning. By the way, the estate taxes will come back with a vengeance when the Bush tax cuts expire.
Even if you never worked with your accountant before for tax planning, you really should this year. General year-end tax planning content is great, but it’s not enough. You should crunch the numbers with us on 2012, and have us estimate for 2013 and beyond. We factor in your facts, circumstances, plans and assumptions. Plus, your current and future cash flows. The savings can be in the hundreds of thousands of dollars over time. Let us help you save a fortune in taxes. September 5, 2012
High-income traders are hit with ObamaCare’s 3.8% Medicare tax on investment income
Important Postscript: See our new blog "The IRS needs to fix their proposed regulations for the Net Investment Tax", dated May 1, 2013. The IRS proposed regulations throw a significant monkey wrench into this tax treatment.
Important Postscript: See our new blog "Post fiscal cliff tax planning for traders", dated Jan. 5, 2013. Excerpt: In an earlier blog (“High-income traders are hit with ObamaCare’s 3.8% Medicare tax on investment income”), I argued that an S-corporation trading company doesn’t reduce the ObamaCare 3.8% Medicare tax on unearned income, because unearned income passes through on the K-1. While that statement is still true, our new idea is different, carving out fee income into an earned-income related S-corporation. The ObamaCare 3.8% Medicare tax applies to “net” unearned income and this administration fee reduces the net trading income in the trading business partnership or S-corporation tax return.
This primer for traders and investment managers offers planning tips surrounding the new Medicare taxes.
By Robert A. Green, CPA
The Patient Protection and Affordable Care Act (ObamaCare) makes a big political point of raising taxes on the rich — defined as individuals with adjusted gross income (AGI) exceeding $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately) — and on the investor class, too. On Jan. 1, the first revenue raisers — the Medicare tax hikes on earned and unearned income — kick in. (The more contentious health-insurance mandate or tax penalties don’t start until 2014.)
The current Medicare tax rate of 2.9 percent applies to all earned income. But if you’re in one of the previously stated income groups, a new 0.9 percent Medicare hospital insurance tax raises this rate to 3.8 percent.
The more significant ObamaCare tax issue is this: Starting in 2013, the 3.8-percent Medicare tax will be applied to unearned income, too, for individuals exceeding these income thresholds. (Technically, it’s modified AGI, which means U.S. residents abroad must add back any foreign earned income exclusion reported on Form 2555.)
Unearned income includes investment or portfolio income (interest, dividends, most capital gains, and annuity distributions), royalties (net of oil and gas depletion expenses), rents (net of depreciation), and passive activity income, as well as gains from the sale of property not used in an active business.
The 3.8-percent Medicare tax on unearned income doesn’t apply to wages and self-employment income, tax-free municipal bond interest income, IRA and qualified plan distributions (retirement plans), or income from the disposition of, or pass-through from, active (earned-income related) LLCs, partnerships, and S-corps, among other revenue sources. If you sell your company for a capital gain and you have been active in the company, that capital gain is exempt from this Medicare tax. But if you have been passive in the company, it is subject to the Medicare tax on unearned income. The Medicare tax also applies to taxable income in trusts (and estates) with undistributed net income in excess of the dollar amount at which the highest tax bracket for trusts begins (this amount is $11,650 in 2012). You can reduce that trust-level Medicare tax by making DNI distributions, but that moves the potential tax trigger to the beneficiary level.
If you are active in rental real estate, that income is free of the self-employment (SE) tax and the Medicare tax on unearned income. It’s not 100 percent clear yet if the exclusion on the sale of a primary residence is exempt from this Medicare tax. Certainly, the taxable portion of the capital gain on the sale of a primary residence is subject to the Medicare tax.
While the Medicare tax on earned income is 50 percent tax deductible, it is not deductible on unearned income. Employers pay half the 2012 Medicare tax and withhold the other half from employees’ paychecks. Investors have to pay the tax on unearned income through estimated taxes and with their tax balance due.
Planning tips: Selling profitable investment positions before year-end 2012 and accelerating other unearned income could be a wise tax move if you know you are going to be over the $200,000/$250,000 income threshold in 2013, triggering the Medicare tax. Plus, if Bush-era tax cuts expire, ordinary, qualifying dividend, and capital gains tax rates will rise in 2013, too.
As is the case with self-employment tax calculations, the Medicare tax on unearned income is assessed on net investment income. That’s defined as net trading gains — proceeds minus cost basis on securities — less “properly allocable” expenses. For traders and investors, these allowable expenses include trading expenses. For business traders, all trading expenses are deducted on Schedule C or on a pass-through entity tax return. For investors lacking trader tax status, Section 212 investment expenses don’t include education, home office, and some other expenses.
Social security taxes are limited to a base amount; Medicare taxes are not
Historically, social security and Medicare taxes were limited to a social security base amount on earned income only. The 2012 social-security-base amount is $110,100. Congress raises the base every few years by around $3,000 or more. The base was $76,200 in 2000, $51,300 in 1990 and $25,900 in 1980. That’s a serious tax hike on the middle class. Benefits have risen too with the inflation index.
In 1994, Congress untethered Medicare taxes from the social security base, applying them to unlimited earned income. While Congress failed in passing universal health care reform during the first Clinton administration, it did pass this Medicare tax hike which was intended to pay for that health care reform. Go figure.
Medicare costs are spiraling upwards and Congress seems bent on raising Medicare taxes to pay for these runaway costs. There seems to be credence to the popular saying that “spending equal tax hikes.”
An important proposal in Obama’s 2008 presidential campaign was his social security tax plan. To use the regular social security tax base and have the base return again on earnings over $250,000 in an unlimited manner. This proposal seems to be a precursor to ObamaCare’s Medicare tax hike on incomes over $250,000.
Traders can’t avoid the tax with an S-corp
Even though the Senate’s recent attempt to repeal the S-Corp self-employment (SE) tax loophole on earned income failed, taxpayers won’t be able to avoid the Medicare tax by operating their trading activities in an S-Corp. Initial suggestions in the media and tax webinars have indicated otherwise: In the Wall Street Journal tax report “About That Investment Tax,” a CPA suggested the loophole might work to avoid Medicare taxes on investment income. However, our tax research clearly shows these advisers are wrong.
Our tax attorney Mark Feldman, JD, says recent articles covering the loophole are referring to S-corps that engage in active businesses, such as cleaning carpets, not businesses trading financial instruments. Feldman says that even though active income normally is not subject to the unearned income Medicare contribution tax but is subject to SE tax, in the case of these active S-Corp businesses, the active income is subject to neither.
According to Feldman’s research, Temp. Regs. Sec. 1.469-1T(e)(6) states, “An activity of trading personal property for the account of owners of interests in the activity is not a passive activity.” Some taxpayers may argue that their investment is an active trade or business based on this regulation and thereby Medicare tax doesn’t apply to them. Feldman says Congress expected tax advisers to try this loophole and specifically ruled it out in the new law. ObamaCare specifically lists businesses to which this tax applies, including “a trade or business of trading in financial instruments or commodities.”
Here’s how the S-corp SE tax loophole works: Underlying earned-income businesses conduct their activities within an S-corp. S-corps do not pass through SE taxable income from earned income activities as LLC partnership returns do. The IRS requires S-corps to pay “reasonable compensation” to officers/owners. This area of the law is under challenge and the IRS is becoming more aggressive. In the past, 25 percent of income could be attributable to officers’ compensation, but the factors are much more complex and beyond the scope of this article. Check with a tax adviser before you proceed.
The marriage penalty is back
If the Bush-era tax cuts expire as scheduled at the end of December 2012, for either everyone, or as President Obama proposes, for taxpayers making more than $200,000 (single) and $250,000 (married), the significant marriage tax penalty will return. Plus, it will be even greater with ObamaCare’s Medicare tax on unearned income.
Many taxpayers don’t remember the significant marriage tax penalties from before the Bush-era tax cuts 2001 in 2003. Read about the history of the marriage tax penalty.
Consider this scenario. One unmarried partner could report the couple’s unearned income on a tax return filing single, and the other partner could report a high wage job on a second tax return filing single. That would save significant income and Medicare taxes versus filing as a married couple.
I just took an important tax update CPE class with RIA and the instructor suggested that divorce would be good tax planning. Isn’t that a little extreme, and have we come to that? Certainly, some taxpayers may think twice about getting married sooner, rather than later.
Although business traders work hard, they generate unearned income
Many of our clients are full-time business retail traders, combining hard work, skill and capital within the investment arena. Most put in more sweat equity than capital, and they use leverage and volume to make up for insufficient trading capital. They are certainly not coupon-clippers in the rich investor class.
Many aspiring business traders changed careers involuntarily through downsizing, while others pursue their dreams in trading. Some want a business from their home location to fit their lifestyle or family needs. Few online traders make over the $200,000/$250,000 from trading and many traders appreciate ObamaCare.
Even though many traders work full time, their trading gains are still considered unearned income — business-related “portfolio income.” Under the “trading rule” in Section 469, trading gains and losses are exempt from passive income or loss treatment. That’s good news. Trading losses are deductible in Section 212 (investment up to $3,000 per year against ordinary income) or Section 162 (trade or business) if other tax-treatment elections for ordinary loss treatment are in place, like Section 475 MTM for securities or Section 988 for forex. Congress didn’t want taxpayers with suspended passive losses to invest in hedge funds to easily generate passive income.
Ordinary trading losses (Section 475 and 988) are much more powerful than capital loss limitations of $3,000. The ordinary loss reduces both MAGI and net investment income (NII), and both of them can affect the Medicare tax on unearned income calculation. You pay the tax on the lower of the NII or the excess over MAGI, so always try to lower your MAGI, too. Roth IRA distributions don't generate MAGI, but RMD from traditional retirement plans do.
A few types of business traders have earned income subject to SE taxes:
-Futures traders who are full members of futures or options exchanges generate earned income — otherwise called SE income — on their trades executed through their exchange membership (Section 1402i in the SE rules).
-Investment management advisory fees — including management fees and incentive fees — are considered SE and earned income. Carried interest or profit allocation which is a share of portfolio income is not SE income, and that's one reason it's considered a tax loophole when it replaces incentive fees.
-Proprietary traders who trade the firm’s capital rather than their own as retail traders are sometimes paid as independent contractors and issued a Form 1099-Misc. for non-employee compensation, which is considered SE and earned income.
These traders with SE income have the tax benefit opportunity of AGI deductions for retirement plans and health insurance premiums, both of which require earned income. These income tax savings can outweigh SE tax costs.
Business traders who do not generate SE income start with the earned income glass empty, generally a nice thing. If these traders want AGI deductions for retirement plans and health-insurance premiums to put net tax savings in their pockets, they need to form an entity to financially engineer earned income. They use an administration fee in an LLC/partnership and a salary in an S-Corp. These business traders can also save more in income taxes than they pay in SE taxes.
Planning tips: Business traders affected by the Medicare tax in 2013 have more incentive to form an entity to convert trading gains to earned income with a fee or salary to increase retirement plan tax deductions. If they are going to pay Medicare tax on unearned income, they may as well have AGI deductions to offset that tax cost. Consider a defined benefit plan with a maximum contribution allowed up to $200,000 for 2012. That’s far higher than a defined contribution plan deduction of $50,000.
Trading within a retirement plan is already a good idea for saving income taxes — retirement plan earnings and distributions are exempt from the Medicare tax on unearned income — and now it can help save the additional Medicare tax on unearned income, too. When trading in a Roth IRA or Roth qualified plan, the income and Medicare tax savings are permanent. Conversely, in traditional retirement plans, income taxes are only deferred until retirement, when Required Minimum Distributions must start (no later than age 70½).
With the advent of online trading accounts for retirement plans and brokers making commissions competitive, more traders are self-directing their retirement funds into active trading. Some traders simply trade within their retirement plans, avoiding “early withdrawals,” which trigger ordinary tax rates and 10-percent excise taxes before age 59½ in IRAs and age 55 in qualified plans. We recommend business traders set up a qualified plan and then use a qualified plan loan to fund their business trading accounts. Factoring the Medicare tax on unearned income into the mix, some traders may prefer trading more inside of their retirement plans rather than taking distributions or plan loans.
We understand well that many of our trader clients count on trading gains to pay their bills and support their families. Trading is their job and living. Switching to trading retirement plan funds is simply not feasible for them. Others just haven’t accumulated much retirement capital. Plus, it’s risky to put retirement plan assets at risk and those funds are meant to provide income in retirement and to be a safety net.
We think Roth conversions are better than ever because they will help save this Medicare tax on unearned income. Remember, if the conversion is a mistake with subsequent losses, you can always recharacterize the conversion after year-end. We also recommend making non-deductible IRA contributions each year.
Whether you trade taxable accounts individually, in a pass-through entity like a general partnership, LLC or S-Corp, or through estates and trust accounts, keep in mind the unearned income passes through to your individual return and it’s subject to this new Medicare tax if you exceed the income thresholds.
C-Corps are bad for trading activities, but maybe they can help
The 2013 tax rates on individuals are scheduled to move higher when the Bush-era tax cuts expire. At the same time, Congress is talking about reducing the corporate tax rates. In 2012, the top rates are both 35 percent, but in 2013, individual rates could approach 44 percent (39.6 percent plus phase outs and the 3.8-percent Medicare tax) and corporate rates could drop below 30 percent. Tax advisers then suggest using corporations to report income. But, don’t forget to factor in double-taxing including on the state level: The entity pays taxes on income, and the individual pays taxes on dividend payments from the entity.
Generally, trading in a C-corp is a bad idea. Trading losses are trapped in corporations and it’s better for individuals to use pass-through entities, utilizing the losses on their individual tax returns. Especially when they’re fully deductible as ordinary losses, like with Section 475 MTM on securities and Section 988 on forex. C-corps also can’t get lower Section 1256 60/40 tax rates on futures and other Section 1256 contracts.
Planning tip: One strategy is to house your earned income activities in a C-corp and grow accumulated earnings before double taxation on the individual level. Conduct your trading activities in pass-through entities and try to keep your AGI under the higher tax rate thresholds. Caution: The preferential qualifying dividends tax rate (15 percent) expires with the Bush-era tax cuts, and all dividends return to the ordinary income tax rate.
While tax planning is uncertain based on expiration of Bush-era tax cuts and promised tax reform, the ObamaCare Medicare tax changes are on the books and traders should adjust their tax planning accordingly. Even if a new Congress reverses some of ObamaCare, will they reverse these new Medicare taxes? Not if you look to 1994 as a precedent.
A version of this article appears in Active Trader’s November issue, on newsstands in October. June 28, 2012
Supreme Court upholds health care mandate as a tax
By Robert A. Green, CPA
I guessed it.
The Supreme Court reclassified the health care mandate as a tax, which is what many people said it was from the start. It was always going to be charged and collected on income tax returns. Had Chief Justice Roberts said it was unconstitutional, the whole bill would have collapsed and there would have been great disarray and wasted cost. President Obama didn’t sell it as a tax to avoid tax hike dissent and politics.
As tax preparers, we will have to deal with this health care tax on annual income tax returns. We deal with all sorts of taxes, and the list is growing, unfortunately. Income, FICA, Medicare and now health care taxes.
In addition to this health care tax, 2013 will bring the health care act's other tax — the Medicare Surtax, otherwise labeled the Medicare Hospital Insurance ("HI") tax. The Supreme Court left all the Act's tax provisions in place. This Medicare surcharge applies to wages and self-employment income in excess of $200,000/$250,000 (married couples). The surtax rate is 0.9 percent on top of the existing Medicare tax rate of 2.9 percent — a combined rate of 3.8 percent. Remember, unlike with FICA, Medicare taxes apply on unlimited earned income; there is no social security tax base of $110,100. (Click here for more information.)
There's a bombshell for our trader clients, too. For the first time in many decades, as part of the Affordable Care Act, Congress was able to break through the Chinese Wall to subject investment and passive income to this otherwise earned-income-related Medicare tax. That's bad news for our profitable trader and investor clients.
Like other tax hikes President Obama supports, this tax hike applies to higher-income folks. First, calculate adjusted gross income in excess of $200,000 (single) or $250,000 (married filing joint). Next, determine your total income from interest, dividends, capital gains, rents and passive income. The Medicare Surtax will apply to the lessor of these two calculations.
2013 is shaping up to be a year of great tax change and related uncertainty and disarray. In addition to these health-care taxes, the other big bombshell — the Bush-era tax cuts — is scheduled to expire at year end 2012. The estate tax is scheduled to come back with a vengeance, too.
All of these tax changes — AND TAX HIKES — will throw tax planning upside down. It's wise to consult with us about it before year-end.
To see the math on how tax rates will explode higher after expiration of the Bush-era tax cuts, see Green's 2012 Trader Tax Guide, Chapter 9 Tax Planning & Tax Law Changes.
Watch my latest video on why Congress should immediately extend the Bush-era tax cuts for everyone now. With tax reform promised in 2013, it's crazy to crash the tax code with sweeping changes from Bush-era tax cut expiration, only to change it again with major reform shortly thereafter.
What's the lesson? You can't keep making major changes last minute and causing great uncertainty. We all spend way too much time, effort and money dealing with change and it's counterproductive. That's probably why Judge Roberts took the easy way out — just call it a tax.