FAMILY AND CHARITABLE PLANNING WITH RETIREMENT ACCOUNTS

Transcription

1 FAMILY AND CHARITABLE PLANNING WITH RETIREMENT ACCOUNTS 2014 ESTATE TAX and INCOME TAX 1 PLANNING STRATEGIES FOR THE 3.8% NET INVESTMENT INCOME TAX 11 Net Investment Income Defined 14 Strategies to Reduce the 3.8% NII Tax 26 LIFETIME CHARITABLE USES OF RETIREMENT ACCOUNTS Charitable IRA Rollover in 2014? 42 Loan from IRA to Charity; Life Insurance 52 PLANNING BEQUESTS FROM RETIREMENT ACCOUNTS 55 Required Distributions - Lifetime 55 Required Distributions - Inherited accounts - life expectancy tables 56 Required Distributions - Inherited accounts - terminology 57 Required Distributions - Inherited accounts - disclaimers 58 Required Distributions - Summary of Rules - table 59 Required Distributions - Inherited accounts - examples 63 FUNDING TRUSTS WITH RETIREMENT ASSETS AT DEATH 65 Checklist 65 Private Letter Rulings 67 USING CRUTS AS BYPASS TRUSTS and QTIP TRUSTS FOR RETIREMENT ASSETS 71 Case study - Mandatory Distributions To A 70 Year-Old Widow 75 Case study - Mandatory Distributions To An 80 Year-Old Widow 76 Charitable Remainder Trust as a Bypass Trust for IRD 78 PORTABILITY and ROLLOVERS 80 COMBINATION OF FEDERAL ESTATE AND INCOME TAXES ON IRD OVERCOMING OBSTACLES FOR CHARITABLE BEQUESTS FROM IRAs 90 Legal Authority 96 CHRISTOPHER R. HOYT Professor of Law University of Missouri - Kansas City School of Law Christopher R. Hoyt 2014 All Rights Reserved

2 RECENT DEVELOPMENTS WHAT IS GOING ON WITH THE FEDERAL ESTATE TAX? The 2010 and 2012 tax acts significantly increased the amount that a person s estate can have at death without being subject to estate tax. The estate tax was completely repealed in the year 2010 (with an option to have it apply at a $5 million level to obtain a stepped-up income tax basis in inherited property). The 2010 tax act provided a two year record high threshold of $5 million (indexed for inflation) for the estate tax, gift tax and generation skipping tax. The 2012 tax act made the $5 million threshold (indexed for inflation) permanent. The thresholds are summarized in the table below (changes are highlighted in bold): Lifetime Gift Estate Tax Highest Estate & Year Tax Threshold Exemption Amount Gift Tax Rate 2001 $675,OOO $675,OOO 55% (+5% surtax) $1 million $1 million 50% $1 m illion $1.5 million 48% $1 m illion $2 million 45% 2009 $1 m illion $3.5 million 45% 2010 $5 million Repealed! <<Carryover basis or $5 million $5 million <<Step-Up basis (35% tax rate) $5 m illion+ $5 million+ 35% - 40% 2014 $5.34 million $5.34 million 40% * The generation skipping tax threshold is also $5.34 million in 2014, indexed for inflation. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L. No , established an exemption amount of $5 million for 2010 and 2011 and indexed this amount for inflation for years after Section 101(a) and ( c) of The American Taxpayer Relief Act of 2012 made permanent the exemption provisions and raised the estate tax rate to 40%. 1

3 FEDERAL ESTATE TAX RETURNS RETIREMENT PLAN ASSETS AND ANNUITIES; CHARITABLE DEDUCTIONS TOTALS RETIREMENT PLANS/ANNUITIES CHARITABLE DEDUCTIONS Year # of Gross # of Value # of Value Filed Returns Estates Returns % (millions) % Returns % (millions) % (millions) ,412 $124,321 5, $ 6, , $14, ,031 $203,096 23, $13, , $19, ,718 $192,635 36, $17, , $14, ,112 $215,649 58, $18, , $ ,856 $173,798 45, $12, , $10, ,772 $117,735 30, $ 6, , $8, ,176 $ 98,850 22, $ 4, , $6, ,695 $ 77,997 14, $ 2, , $4, ,125 $ 59,805 11, $ 1, , $3, SOURCE: IRS Statistics of Income Bulletins. See web < Estate Tax Returns Filed in 2002: Estate Size and Charitable Deductions [All figures are estimates based on samples--money amounts are in thousands of dollars.] Size of Gross Estate Gross Estate Charitable deduction Average amt Number of returns Amount (in thous. $) Number of returns (%) of returns Amount (in thous. $) (%) of estate (in thous. $) All returns 98,359 $ 211,212,218 16,105 16% $ 17,828,921 8% $ 675,000 < $ 1,000,000 36,809 30,210,377 4,624 13% 683,015 2% 148 $ 1,000,000 < $ 2,500,000 46,361 68,575,863 7,688 17% 3,131,444 5% 407 $ 2,500,000 < $ 5,000,000 9,882 33,618,289 2,097 21% 1,819,776 5% 868 $ 5,000,000 < $10,000,000 3,439 23,598, % 1,749,224 7% 1,803 $10,000,000 <$20,000,000 1,198 16,187, % 1,523,675 9% 3,628 $20,000,000 or more ,021, % 8,921,787 23% 29,061 Taxable returns 44,407 $ 117,230,253 8,691 20% $ 11,509,315 10% $ 675,000 < $ 1,000,000 13,026 11,265,400 1,355 10% 34,765 0% 26 $ 1,000,000 < $ 2,500,000 22,993 33,795,007 4,576 20% 582,739 2% 127 $ 2,500,000 < $ 5,000,000 5,049 17,433,073 1,405 28% 702,587 4% 500 $ 5,000,000 < $10,000,000 2,101 14,544, % 1,062,025 7% 1,394 $10,000,000 < $20,000, ,250, % 908,359 9% 2,753 $20,000,000 or more ,941, % 8,218,840 27% 31,370 Nontaxable returns 53,952 $ 93,981,965 7,414 14% $ 6,319,606 7% $ 675,000 < $ 1,000,000 23,783 18,944,977 3,268 14% 648,250 3% 198 $ 1,000,000 < $ 2,500,000 23,368 34,780,856 3,112 13% 2,548,705 7% 819 $ 2,500,000 <$ 5,000,000 4,833 16,185, % 1,117,189 7% 1,614 $ 5,000,000 < $10,000,000 1,338 9,054, % 687,198 8% 3,304 $10,000,000 <$20,000, ,936, % 615,316 10% 6,837 $20,000,000 or more 187 9,080, % 702,947 8% 15,621 For this and other IRS statistics, see the IRS web cite < 2

4 Estate Tax Returns Filed in 2002: Retirement Plans, IRAs and Annuities [All figures are estimates based on samples--money amounts are in thousands of dollars.] Size of Gross Estate Total Estate Tax Returns IRAs, Retirement Plans & Annuities Average amt Number of returns Amount (in thous. $) Number of returns (%) of returns Amount (in thous. $) (%) of estate (in thous. $) All returns 98,359 $ 211,212,218 55,168 56% $ 17,498,702 8% $ 675,000 < $ 1,000,000 36,809 30,210,377 19,858 54% 3,340,282 11% 168 $ 1,000,000 < $ 2,500,000 46,361 68,575,863 26,887 58% 8,102,511 12% 301 $ 2,500,000 < $ 5,000,000 9,882 33,618,289 5,842 59% 3,448,768 10% 590 $ 5,000,000 < $10,000,000 3,439 23,598,243 1,673 49% 1,520,009 6% 909 $10,000,000 <$20,000,000 1,198 16,187, % 602,709 4% 1,039 $20,000,000 or more ,021, % 484,422 1% 1,472 Taxable returns 44,407 $ 117,230,253 21,093 47% $ 6,546,006 6% $ 675,000 < $ 1,000,000 13,026 11,265,400 6,399 49% 1,090,216 10% 170 $1,000,000 < $ 2,500,000 22,993 33,795,007 10,874 47% 2,945,366 9% 271 $2,500,000 < $ 5,000,000 5,049 17,433,073 2,518 50% 1,275,626 7% 507 $5,000,000 < $10,000,000 2,101 14,544, % 659,442 5% 832 $10,000,000 <$20,000, ,250, % 283,725 3% 939 $20,000,000 or more ,941, % 291,631 1% 1,416 Nontaxable returns 53,952 $ 93,981,965 34,075 63% $ 10,952,696 12% $ 675,000 < $ 1,000,000 23,783 18,944,977 13,458 57% 2,250,066 12% 167 $1,000,000 < $ 2,500,000 23,368 34,780,856 16,013 69% 5,157,145 15% 322 $2,500,000 < $ 5,000,000 4,833 16,185,216 3,324 69% 2,173,142 13% 654 $5,000,000 < $10,000,000 1,338 9,054, % 860,567 10% 978 $10,000,000 <$20,000, ,936, % 318,984 5% 1,152 $20,000,000 or more 187 9,080, % 192,791 2% 1,567 ("Taxable Returns" and "Nontaxable returns" -- Most non-taxable returns claim ed the m arital deduction to avoid the federal estate tax (typically the estate of the first spouse to die). For this and other IRS statistics, see the IRS web cite < Estate Tax Returns Filed in 2004: Retirement Plans, IRAs and Annuities -- Variations Based on Age and Gender (A) Percent of Returns that Report Any Retirement Plan Assets and (B) Percent of All Assets that are in Retirement Plan Accounts MALE FEMALE ALL 2004 RETURNS 23, ,300 18,493 75,621 ($ millions) ($ millions) % OF ALL RETURNS REPORTING RETIREMENT ACCOUNTS % of returns with retirement assets % o f al l assets % of returns with retirement assets % of all assets 47% 9% 31% 4% Under age 50 63% 7% 64% 10% Ages 50 to 65 69% 14% 62% 10% Over age 65 43% 8% 28% 3% Source: Brian G. Raub, Federal Estate Tax Returns Filed for 2004 Decedents, Figures B and G, IRS Statistics of Information Bulletin, available at < Percentage of returns is computed from 1998 data. 3

5 ESTATE TAX, GIFT TAX & GENERATION SKIPPING TAX IN 2014 [from pages of the Overview of the Federal Tax System As in Effect for 2013, Joint Committee on Taxation, JCX-2-13R (Jan 8, 2013)] The United States generally imposes a gift tax on any transfer of property by gift made by a U.S. citizen or resident, whether made directly or indirectly and whether made in trust or otherwise. Nonresident aliens are subject to the gift tax with respect to transfers of tangible real or personal property where the property is located in the United States at the time of the gift. The gift tax is imposed on the donor and is based on the fair market value of the property transferred. Deductions are allowed for certain gifts to spouses and to charities. Annual gifts of $14,000 (for 2014) or less per donor and per donee generally are not subject to tax. An estate tax also is imposed on the taxable estate of any person who was a citizen or resident of the United States at the time of death, and on certain property belonging to a nonresident of the United States that is located in the United States at the time of death. The estate tax is imposed on the estate of the decedent and generally is based on the fair market value of the property passing at death. The taxable estate generally equals the worldwide gross estate less certain allowable deductions, including a marital deduction for certain bequests to the surviving spouse of the decedent and a deduction for certain bequests to charities. The gift and estate taxes are unified such that a single graduated rate schedule and effective exemption amount apply to an individual s cumulative taxable gifts and bequests.... A unified credit... is available with respect to taxable transfers by gift or at death. This credit effectively exempts a total of $5.34 million (for 2014) in cumulative taxable transfers from the gift tax or the estate tax. *1* The unified credit thus generally also has the effect of rendering the marginal rates below 40 percent inapplicable. Unused exemption as of the death of a spouse generally is available for use by the surviving spouse; this feature of the law sometimes is referred to as exemption portability. A separate transfer tax is imposed on generation-skipping transfers in addition to any estate or gift tax that is normally imposed on such transfers. This tax generally is imposed on transfers, either directly or through a trust or similar arrangement, to a beneficiary in more than one generation below that of the transferor. For 2014, the generation-skipping transfer tax is imposed at a flat rate of 40 percent on generation-skipping transfers in excess of $5.34 million. *1* - The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L. No , establishes an exemption amount of $5 million for 2010 and 2011 and indexes this amount for inflation for years after The American Taxpayer Relief Act of 2012 makes permanent the exemption provisions of the 2010 Act. 4

6 PORTABILITY OF UNUSED EXEMPTION BETWEEN SPOUSES [explanation from pages of the Technical Explanation of the Revenue Provisions in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010; Joint Committee on Taxation, JCX (Dec. 10, 2010)] Under the legislation, any applicable exclusion amount that remains unused as of the death of a spouse who dies after December 31, 2010 (the "deceased spousal unused exclusion amount"), generally is available for use by the surviving spouse, as an addition to such surviving spouse's applicable exclusion amount. The legislation does not allow a surviving spouse to use the unused generation skipping transfer tax exemption of a predeceased spouse. If a surviving spouse is predeceased by more than one spouse, the amount of unused exclusion that is available for use by such surviving spouse is limited to the lesser of $5 million or the unused exclusion of the last such deceased spouse. A surviving spouse may use the predeceased spousal carryover amount in addition to such surviving spouse s own $5 million exclusion for taxable transfers made during life or at death. A deceased spousal unused exclusion amount is available to a surviving spouse only if an election is made on a timely filed estate tax return of the predeceased spouse on which such amount is computed, regardless of whether the estate of the predeceased spouse otherwise is required to file an estate tax return. Example Assume that Husband 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election is made on Husband 1's estate tax return to permit Wife to use Husband 1's deceased spousal unused exclusion amount. As of Husband 1's death, Wife has made no taxable gifts. Thereafter, Wife's applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death. Example With Remarriage. Assume the same facts as in Example 1, except that Wife subsequently marries Husband 2. Husband 2 also predeceases Wife, having made $4 million in taxable transfers and having no taxable estate. An election is made on Husband 2's estate tax return to permit Wife to use Husband 2's deceased spousal unused exclusion amount. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2 s $1 million unused exclusion is available for use by Wife, because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion of the last deceased spouse of the surviving spouse (here, Husband 2 s $1 million unused exclusion). Thereafter, Wife's applicable exclusion amount is $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death.. 5

7 INDIVIDUAL INCOME TAX IN 2014 Federal Individual Income Tax Rates for 2014 [from Rev. Proc ] If taxable income is: Then income tax equals: Single Individuals Not over $9, % of the taxable income Over $9,075 but not over $36, $ plus 15% of the excess over $9,075 Over $36,900 but not over $89, $ 5,081 plus 25% of the excess over $36,900 Over $89,350 but not over $186, $ 18,194 plus 28% of the excess over $89,350 Over $186,350 but not over $405, $ 45,354 plus 33% of the excess over $186,350 Over $405,100 but not over $406, $117,541 plus 35% of the excess over $405,100 Over $406,750...$118,189 plus 39.6% of the excess over $406,750 Married Individuals Filing Joint Returns and Surviving Spouses Not over $18, % of the taxable income Over $18,150 but not over $73, $ 1,815 plus 15% of the excess over $18,150 Over $73,800 but not over $148, $ 10,162 plus 25% of the excess over $73,800 Over $148,850 but not over $226, $ 28,925 plus 28% of the excess over $148,850 Over $226,850 but not over $405, $ 50,765 plus 33% of the excess over $226,850 Over $405,100 but not over $457, $109,588 plus 35% of the excess over $405,100 Over $457, $127,962 plus 39.6% of the excess over $457,600 Special long-term capital gains and dividends rates For 2014, the maximum rate of tax on the adjusted net capital gain of an individual is 20 percent on any amount of gain that otherwise would be taxed at a 39.6 rate. In addition, any adjusted net capital gain otherwise taxed at a 10- or 15-percent rate is taxed at a zero-percent rate. Adjusted net capital gain otherwise taxed at rates greater than 15-percent but less than 39.6 percent is taxed at a 15 percent rate. These rates apply for purposes of both the regular tax and the alternative minimum tax. Dividends are generally taxed at the same rate as capital gains. [Note from Hoyt: If adjusted gross income is over $200,000 ($250,000 joint), then long-term capital gains and dividends are subject to an additional 3.8%% health care surtax. This brings the effective tax rate as high as 23.8% for taxpayers who are in the 39.6% tax bracket and 18.8% for taxpayers in lower tax brackets with modified adjusted gross income over $200,000 ($250,000 joint). Even higher if the phaseout of itemized deductions applies to the taxpayer] u HEALTH CARE SURTAXES - Adjusted Gross Income or Compensation Income over $200,000 ($250,000 married joint returns) * 3.8% Surtax on Net Investment Income when Modified AGI over $200,000 ($250,000 joint returns) Analyzed at length beginning on Page 11 of this outline. * 0.9% Surtax When Wages and Earned Income exceed $200,000 ($250,000 joint returns) Analyzed beginning on Page 8 of this outline 6

8 PHASEOUT ITEMIZED DEDUCTIONS & PERSONAL EXEMPTION - Adjusted Gross Income over $250,000 ($300,000 joint returns) [In 2014, the inflation indexed thresholds are $254,200 ($305,050 joint returns) ] To determine taxable income, an individual reduces AGI by personal exemption and dependent deductions and either the standard deduction or his or her itemized deductions. 3% Phaseout of Itemized Deductions In lieu of taking the applicable standard deductions, an individual may elect to itemize deductions. The deductions that may be itemized include State and local income taxes (or, in lieu of income, sales taxes), real property and certain personal property taxes, home mortgage interest, charitable contributions, certain investment interest, medical expenses (in excess of 10 percent of AGI), casualty and theft losses (in excess of 10 percent of AGI and in excess of $100 per loss), and certain miscellaneous expenses (in excess of two percent of AGI). The total amount of itemized deductions allowed is reduced by three percent ($0.03 for each dollar) of AGI in excess certain thresholds. In 2013 the thresholds were $250,000 (single), $275,000 (head-of-household), $300,000 (married filing jointly) and $150,000 (married filing separately). These threshold amounts are indexed for inflation (amounts for 2014 appear below). This rule is sometimes referred to as the Pease limitation. A taxpayer may not lose more than 80 percent of his or her deductions as a result of this provision. Personal Exemption Phased Out for AGI Between $250,000-$372,000 ($300,000-$422,000 joint returns) [In 2014, the inflation indexed thresholds cause a phase-out for AGI between $254,200-$376,700 ($305, ,550 on married joint returns) ] Personal exemptions generally are allowed for the taxpayer, his or her spouse, and any dependents. For 2014, the amount deductible for each personal exemption is $3,950. This amount is indexed annually for inflation. The personal exemption phase-out ( PEP ) reduces a taxpayer s personal exemptions by two percent for each $2,500 ($1,250 for married filing separately), or fraction thereof, by which the taxpayer s AGI exceeds $250,000 (single), $275,000 (head-of-household), $300,000 (married filing jointly) and $150,000 (married filing separately). These threshold amounts are indexed for inflation. In 2014, a taxpayer will have all personal exemptions completely phased out at incomes of $376,700 (single) and $427,550 (married filing jointly). HIGHEST 39.6% MARGINAL TAX RATE -Taxable Income (not AGI) over $400,000 ($450,000 joint returns) [In 2014, the thresholds have been increased to $406,750 ($457,600 for married taxpayers filing a joint return)]. These taxpayers also pay a higher 20% tax rate on qualified dividends and longterm capital gains (rather than the prior 15% threshold). 7

9 Medicare Surtax: 0.9% When Compensation Exceeds $200,000 ($250,000 joint) A. OVERVIEW: The 0.9% Surtax on Wages and Earned Income - Sec 3101(b) For remuneration received in taxable years beginning after December 31, 2012, the employee portion of the health insurance ( HI ) tax is increased by an additional tax of 0.9 percent on earned compensation received in excess of the specific threshold amount. 1 The threshold amount is $250,000 in the case of a joint return, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case (unmarried individual, head of household or surviving spouse). These threshold amounts are not indexed for inflation. For a married couple filing a joint return, the additional 0.9% tax is on the combined compensation/earned income of the employee and the employee s spouse. In the case of wages paid by an employer, the employer does not pay a matching 0.9% surtax, but is expected to withhold the employee s 0.9% tax once compensation income for an employee exceeds $200,000 for the year For self-employed individuals, the same additional HI tax applies to the HI portion of SECA tax on self-employment income in excess of the threshold amount. Thus, an additional tax of 0.9 percent is imposed on every self-employed individual on self-employment income in excess of the threshold. B. IRS Issues FAQs When are individuals liable for Additional Medicare Tax? An individual is liable for Additional Medicare Tax if the individual s wages, compensation, or selfemployment income (together with that of his or her spouse if filing a joint return) exceed the threshold amount for the individual s filing status: Filing Status Married filing jointly $250,000 Married filing separately Single Head of household (with qualifying person) Qualifying widow(er) with dependent child Threshold Amount $125,000 $200,000 $200,000 $200,000 1 Sec. 3101(b), as amended by the Patient Protection and Affordable Care Act ( PPACA ), Pub. L. No

10 Will Additional Medicare Tax be withheld from an individual's wages? An employer must withhold Additional Medicare Tax from wages it pays to an individual in excess of $200,000 in a calendar year, without regard to the individual's filing status or wages paid by another employer. An individual may owe more than the amount withheld by the employer, depending on the individual's filing status, wages, compensation, and self-employment income. In that case, the individual should make estimated tax payments and/or request additional income tax withholding using Form W-4 Will I need to make estimated tax payments for Additional Medicare Tax? If you anticipate that you will owe Additional Medicare Tax but will not satisfy the liability through Additional Medicare Tax withholding and did not request additional income tax withholding using Form W-4, you may need to make estimated tax payments. You should consider your estimated total tax liability in light of your wages, other compensation, and self-employment income, and the applicable threshold for your filing status when determining whether estimated tax payments are necessary. Will individuals calculate Additional Medicare Tax liability on their income tax returns? Yes. Individuals liable for Additional Medicare Tax will calculate Additional Medicare Tax liability on their individual income tax returns (Form 1040). Individuals will also report Additional Medicare Tax withheld by their employers on their individual tax returns. Any Additional Medicare Tax withheld by an employer will be applied against all taxes shown on an individual's income tax return, including any Additional Medicare Tax liability. If my employer withholds Additional Medicare Tax from my wages in excess of $200,000, but I won't owe the tax because my spouse and I file a joint return and we won't meet the $250,000 threshold for joint filers, can I ask my employer to stop withholding Additional Medicare Tax? No. Your employer must withhold Additional Medicare Tax on wages it pays to you in excess of $200,000 in a calendar year. Your employer cannot honor a request to cease withholding Additional Medicare Tax if it is required to withhold it. You will claim credit for any withheld Additional Medicare Tax against the total tax liability shown on your individual income tax return (Form 1040). Are wages that are not paid in cash, such as fringe benefits, subject to Additional Medicare Tax? Yes, the value of taxable wages not paid in cash, such as noncash fringe benefits, are subject to Additional Medicare Tax, if, in combination with other wages, they exceed the individual's applicable threshold. Noncash wages are subject to Additional Medicare Tax withholding, if, in combination with other wages paid by the employer, they exceed the $200,000 withholding threshold. How do individuals calculate Additional Medicare Tax if they have wages subject to Federal Insurance Contributions Act (FICA) tax and self-employment income subject to Self-Employment Contributions Act (SECA) tax? Individuals with wages subject to FICA tax and self-employment income subject to SECA tax calculate their liabilities for Additional Medicare Tax in three steps: Step 1 Calculate Additional Medicare Tax on any wages in excess of the applicable threshold for the filing status, without regard to whether any tax was withheld. Step 2 Reduce the applicable threshold for the filing status by the total amount of Medicare wages received - but not below zero. Step 3 Calculate Additional Medicare Tax on any self-employment income in excess of the reduced threshold. 9

11 Example 1: Marty Graw, a single filer, has $130,000 in wages and $145,000 in self-employment income. #1.Marty's wages are not in excess of the $200,000 threshold for single filers, so Marty is not liable for Additional Medicare Tax on these wages. #2.Before calculating the Additional Medicare Tax on self-employment income, the $200,000 threshold for single filers is reduced by Marty's $130,000 in wages, resulting in a reduced self-employment income threshold of $70,000. #3.Marty is liable to pay Additional Medicare Tax on $75,000 of self-employment income ($145,000 in self-employment income minus the reduced threshold of $70,000). 22.Will I also owe the 3.8% net investment income tax on my income that is subject to Additional Medicare Tax? No. The new tax imposed by section 1411 on an individual's net investment income is not applicable to FICA wages, RRTA compensation, or self-employment income. Thus, an individual will not owe net investment income tax on these categories of income, regardless of the taxpayer's filing status. What form will individuals use to report the Additional Medicare Tax? The IRS has released the draft of Form 8959, which has been developed for the purpose of reporting the Additional Medicare Tax. EMPLOYER and PAYROLL SERVICE PROVIDER FAQs When must an employer withhold Additional Medicare Tax? The statute requires an employer to withhold Additional Medicare Tax on wages it pays to an employee in excess of $200,000 in a calendar year, beginning January 1, An employer has this withholding obligation even though an employee may not be liable for Additional Medicare Tax because, for example, the employee's wages together with that of his or her spouse do not exceed the $250,000 threshold for joint return filers. Any withheld Additional Medicare Tax will be credited against the total tax liability shown on the individual's income tax return (Form 1040). Is an employer liable for Additional Medicare Tax even if it does not withhold it from an employee's wages? An employer that does not deduct and withhold Additional Medicare Tax as required is liable for the tax unless the tax that it failed to withhold from the employee's wages is paid by the employee. Even if not liable for the tax, an employer that does not meet its withholding, deposit, reporting, and payment responsibilities for Additional Medicare Tax may be subject to all applicable penalties. If an employee's annual Medicare wages are expected to be over $200,000, will an employer withhold Additional Medicare Tax from the beginning of the year or only after Medicare wages are actually paid in excess of $200,000 year-to-date? An employer is required to begin withholding Additional Medicare Tax in the pay period in which it pays wages in excess of $200,000 to an employee. 10

12 Coping and Planning Strategies for the 3.8% Net Investment Income Tax ( NIIT ) - Imposed on Individuals with Modified AGI over $200,000 ($250,000 jointt) I. Overview A. The big picture 2 Part of the 2010 Health Care legislation was the enactment of two surtaxes on the income of trusts, estates, and affluent individuals, commencing in the year The first surtax is a 0.9% surtax on individuals who have compensation income of over $200,000 ($250,000 on married joint returns). The second surtax is a 3.8% surtax imposed on the net investment income ( NII ) of certain trusts, estates and affluent individuals (those with income over $200,000; $250,000 on married joint returns). These thresholds are not indexed for inflation. Although enacted as part of the health care legislation, the 3.8% net investment income tax ( NIIT ) is not designated for the Medicare Trust Fund. 3 Individuals who are subject to the 3.8% NIIT are likely to ask their advisors how they can reduce the surtax. There are basically two ways to reduce the surtax: (1) get adjusted gross income ( AGI ) below the threshold amount, and/or (2) reduce the amount of net investment income while still maintaining the same lifestyle that they are accustomed to. There are basically two ways to reduce the amount of net investment income. The first is to convert NII into income that is not NII. The second: if the individual makes gifts to family or to charities, then shift the NII to family members and to charities who do not incur the 3.8% surtax. NII can be converted into non-nii by, for example, moving interest, dividends and capital gains from traditional investment accounts into qualified retirement plans. Distributions from qualified plans are not subject to the NIIT. This can be accomplished by, for example, making larger contributions to qualified plans where they work or by making Roth IRA conversions. 2 The Health Care and Education Reconciliation Act of 2010 (P.L , 124 Stat. 1029). Section 1402(a)(1) of that act added section 1411 to a new chapter 2A of subtitle A (Income Taxes) of the Code effective for taxable years beginning after December 31, The Preamble to the Proposed Regulations for the Section 1411 net investment income tax states: Amounts collected under section 1411 are not designated for the Medicare Trust Fund. The Joint Committee on Taxation in 2011 stated that [i]n the case of an individual, estate, or trust an unearned income Medicare contribution tax is imposed. No provision is made for the transfer of the tax imposed by this provision from the General Fund of the United States Treasury to any Trust Fund. See JCT 2011 Explanation, at 363; see also Joint Committee on Taxation, Description of the Social Security Tax Base (JCX-36-11) (June 21, 2011), at 24. REG , 77 Fed. Reg , at (12/05/2012). 11

13 NII can be shifted to family members who are in lower income tax brackets by making gifts of assets that generate NII (interest, dividends and capital gains) to these family members or to 4 trusts that will distribute all such income. NII can be shifted to charities by donations of income-producing assets to private foundations, donor advised funds and charitable lead trusts. Finally, individuals who are not subject to the surtax on net investment income because their income is too low should be alert for situations that could trigger the tax. First, they should plan for the future since the $200,000 and $250,000 thresholds are not indexed for inflation. Second, they should be alert for transactions that could cause an unusual spike in income that could trigger the tax, such as a large capital gain from the sale of a block of stock, a rental property, or a closely-held business. Tax strategies such as installment sales and using charitable remainder trusts can reduce the impact that a spike in income might otherwise have. B. Computation of the 3.8 surtax on net investment income Section 1411(a)(1) imposes a surtax of 3.8 percent on the lesser of: (A) an individual s net investment income (defined below) or 5 (B) the amount by which the individual s modified adjusted gross income exceeds the threshold amount of $250,000 (married joint returns; $125,000 if file separately) or $200,000 for all other returns (single or head of household). Trusts and estates are subject to the 3.8% NII tax at a much lower threshold amount: just $12,150 in the year text: 4 Since trusts are generally subject to the 3.8% NIIT, the tax would not be avoided by accumulating income in a trust. 5 Section 1411(d) defines modified adjusted gross income to be adjusted gross income increased by the excess of (1) the amount excluded from gross income under the foreign earned income exclusion of section 911(a)(1), over (2) the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section 911(d)(6) with respect to the amount excluded from gross income under section 911(a)(1). 6 Section 1411(a)(2) imposes a surtax of 3.8 percent on the lesser of (A) the estate s or trust s undistributed net investment income, or (B) the excess (if any) of (i) the estate s or trust s adjusted gross income (as defined in section 67(e)) for such taxable year, over (ii) the dollar amount at which the highest tax bracket in section 1(e) begins for such taxable year. In the year 2014, that amount is just $12,

14 II. Taxpayers Subject to the 3.8% Net Investment Income Tax - Individuals, Trusts & Estates A. Taxpayers subject to the NII tax 1. Individuals: U.S. citizens and residents with modified adjusted gross income over the threshold amounts of $200,000 ($250,000 married joint returns) who also have net investment income. 2. Trusts: The typical trusts described in Reg (a) with taxable income over $12,150 (in 2014) and with net investment income. A specific rule applies to an 7 ESBT (Electing Small Business Trust) that owns stock of an S corporation. 3. Estates with net investment income and with taxable income over $12,150 (in 2014). B. Taxpayers not subject to the NII tax 1. Corporations that are subject to the corporate income tax 2. Nonresident aliens Nonresident aliens are not subject to the net investment income tax. There are special rules for non-resident aliens who are married to U.S. citizens or U.S. residents who may elect to be treated as resident aliens on married-filing jointly 8 returns. 3. Charitable trusts, grantor trusts, and trusts that aren t trusts The following trusts are not subject to the Net Investment Income Tax: 9 a. b. Trusts that are exempt from income taxes (e.g., charitable trusts (e.g., private foundations Section 501(a)), qualified retirement plans (Sections 501(a) and 401(a)), and charitable remainder trusts (Section 664(c)). Thus, if a taxexempt trust incurs a tax liability for it unrelated business taxable income under Sections , it will not be liable for the additional 3.8% surtax on UBTI that may have been generated by investment income.. A trust in which all of the unexpired interests are devoted to one or more of the charitable and exempt purposes described in Section 170(c)(2)(B) (e.g., a 10 Section 501(c)(3) private foundation or a Section 4947(a) trust). 7 If a trust is an ESBT (Electing Small Business Trust) that owns stock of an S corporation, the $12,100 threshold amount that triggers the 3.8% NIIT is based on the total income of the trust rather than computed separately for the trust s S corporation income and the trust s other income. Reg (c)(1). 8 Section 1411( e)(1); Reg (a)(2). 9 Reg (b). 10 Section 1411( e)(2). 13

15 c. d.. Trusts classified as grantor trusts under Sections Instead, the income is taxed to the owner of the trust.. Trusts that are not classified as trusts for federal income tax purposes (e.g., real estate investment trusts and common trust funds). Although these trusts will not incur the NIIT, distributions of income from these trusts to beneficiaries can subject the beneficiaries to the NIIT. For example, distributions from a charitable remainder trust to a beneficiary can carry out that 11 trust s interest, dividends and capital gains. There is a special exemption for distributions from a charitable remainder trust: only the income that the trust earned after 2012 is subject to the 3.8% NIIT. A distribution of income that was accumulated in the charitable remainder trust before 2013 is exempt from the 3.8% NIIT. 12 III. Net Investment Income Defined A. Overview The statute groups net investment income into four categories: 13 (1) interest, dividends, annuities, royalties, and rents (2) profits from a trade or business where the taxpayer does not materially participate (a passive activity ), 11 Reg (d)(2). The computation is made in a manner consistent with the four-tier system for charitable remainder trust distributions contained in Section Reg (d)((1)(iii) and (d)(2), Example (1) 13 Section 1411(c) Net investment income For purposes of this chapter (1) In general The term "net investment income" means the excess (if any) of (A) the sum of (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2), (ii) other gross income derived from a trade or business described in paragraph (2), and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2), over (B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain. (2) Trades and businesses to which tax applies A trade or business is described in this paragraph if such trade or business is (A) a passive activity (within the meaning of section 469) with respect to the taxpayer, or (B) a trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2)). 14

16 (3) profits from a trade or business of trading in financial instruments or commodities, even if the taxpayer does materially participate, and (4) taxable net gain from the disposition of property (e.g., capital gains from stock sales as well as mutual fund capital gain distributions, etc.), but not gains from selling property held in a trade or business where the taxpayer materially participates. If, however, such income (such as royalties, rent or gains on sales) is a core source of income from a trade or business in which the taxpayer materially participates, it will not be subject to the % NIIT. A principal exception applies to profits from a trade or business of trading in financial instruments or commodities, since the statute expressly includes such income in the definition of net investment income. B. Interest, dividends, annuities, royalties 1. Interest a. Interest is generally taxable. 15 b. Tax-exempt interest from a state or local bond is not subject to NIIT c. Self-charged interest is not subject to NIIT. Self-charged interest typically occurs when the owner of an active business (e.g., an S corporation) lends money to the business where he or she works. 2. Dividends Annuities: taxable annuity income from a non-qualified annuity (an annuity that is not from a qualified retirement plan, described below), including the gain from a sale of an annuity contract. The gain from the sale of an annuity contract is classified as annuity income up to the surrender value, and any excess is classified as a gain. An 19 annuity paid by an employer as compensation is not be subject to the 3.8% NIIT. 14 For example, if A, an individual, is engaged in a trade or business that is not described in section 1411(c)(2) and the trade or business has gross income (for example, royalties), such gross income is derived in A s trade or business, and therefore A meets the first part of the ordinary course of a trade or business exception. Part 5.A.vi of the Preamble to the Proposed Regulations (REG , 77 Fed. Reg , at (12/05/2012)). 15 Section 1411(c)(1)(A)(i), Reg (d)(6). 16 Reg (d)(4)(i). 17 Reg (g)(5). 18 Section 1411(c)(1)(A)(i), Reg (d)(3). 19 Reg (d)(1) provides: The term gross income from annuities includes the amount received as an annuity under an annuity, endowment, or life insurance contract that is includible in gross income as a result of the application of section 72(a) and section 72(b), and an amount not received as an annuity under an annuity contract that is includible in gross income under section 72(e). In the case of a sale of an annuity, to the extent the sales price of the annuity does not exceed its surrender value, the gain recognized would be treated as gross income from an annuity However, if the sales price of the annuity exceeds its surrender value, the seller would treat the gain equal to the difference between the basis in the annuity and the surrender value as gross income from an annuity and the excess of the sales price over the surrender value as gain from the disposition of property included in section 1411(c)(1)(A)(iii) The term gross income from annuities does not include amounts paid in consideration for 15

17 4. Royalties Pass-through entities (partnerships & S corporations): Interest, dividends, annuities, royalties. Even if a taxpayer is working full-time and materially participates in a business operated by a partnership, LLC or S corporation, the business income from interest, dividends, annuities and most royalties that are allocated to the owner will retain their character as net investment income that could be subject to the NIIT. C. Rents 1. General rule Net rental income is generally considered investment income that can be subject to the 3.8% NIIT. Example: A, an unmarried individual, rents a commercial building to B for $50,000. A s rental activity does not involve the conduct of a Section 162 trade or business. Under section 469(c)(2), A s rental activity is considered a passive activity. Because the activity does not rise to the level of a trade or business, A s rental income of $50,000 will constitute investment income from rents that can be 21 subject to the 3.8% NIIT. 2. Exception: self-charged rent to a business where the owner of the rental property materially participates. 3. Real estate professional Although the Section 469 passive loss rules generally provide that a real estate 22 rental activity is a passive activity, there is an exception for a real estate professional. Such a services rendered. For example, distributions from a foreign retirement plan that are paid in the form of an annuity and include investment income that was earned by the retirement plan does not constitute income from an annuity within the meaning of section 1411(c)(1)(A)(i). 20 Section 1411(c)(1)(A)(i). The term gross income from royalties includes amounts received from mineral, oil, and gas royalties, and amounts received for the privilege of using patents, copyrights, secret processes and formulas, goodwill, trademarks, tradebrands, franchises, and other like property. Reg (d)(11). 21 Taken from Reg (b)(3), Example (1). 22 For purposes of the passive loss limitation (as opposed to the NIIT), A taxpayer qualifies as a real estate professional if (a) more than half of the personal services performed in trades or businesses by the taxpayer during the year are performed in real property trades or businesses in which the taxpayer materially participates; and (b) the taxpayer performs at least 750 hours in real property trades or businesses in which he or she materially participates. Section 469(c)(7)(B). This is more than the 500 hours that is usually required to demonstrate material participation in a trade or business. 16

18 person can deduct losses from the real estate rental activity without being subject to the passive loss limitation that generally applies to losses from real estate rental activities. Does this rule carryover to the 3.8% NIIT? Can a real estate professional avoid the 3.8% NIIT when real estate rental properties produce income rather than a loss? The final regulations indicate that there are two tests for a real estate professional to avoid the 3.8% NIIT: the individual must qualify as a real estate professional and the real estate rental activity must also 23 rise to the level of a trade or business within the meaning of Section 162. The regulations offer a safe-harbor: a real estate professional s gross rental income from a rental activity will be deemed to be derived from a trade or business if the real estate professional (a) meets the definition of a real estate professional under the passive loss statute [Section 469(c)(7)(B)] and (b) he or she participated in one or more rental real estate activities either (i) for more than 500 hours during the year or (ii) for more than 500 hours in any five of the preceding ten taxable years. Furthermore, if these tests are met, the gain from the sale of the 24 rental property will be exempt from the 3.8% NIIT. See also the discussion below in Parts VI.B and VI.C.2. Although a sole proprietor generally reports trade or business income on Schedule C and pays the self-employment tax on net income, it may be possible for a real estate professional to avoid both the self-employment tax (15.3 % on the first $117,000 of earned income in 2014) and the 3.8% NIIT on real estate rental income property. 25 D. Trade or Business where not materially participate (a passive activity ) A taxpayer who owns a business, either as a sole proprietorship or as part of a passthrough entity (partnership, LLC or S corporation), and who does not materially participate in the business is deemed to own an interest in a passive activity. For taxpayers with MAGI over $200,000 ($250,000 joint), income from a passive activity will generally be subject to the 3.8% 26 NIIT. Whether an activity is a passive activity or not is determined under the provisions of the 27 Section 469 passive loss limitation. Under those rules, the owner must generally engage in over 500 hours of work in order for the activity to qualify as non-passive. 23 The Treasury Department and the IRS do not believe that every real estate professional is necessarily engaged in the trade or business of rental real estate. Part 5.E.iii of the Preamble to the Final Regulations (REG , 78 Fed. Reg , at (12/02/2013)). 24 Reg (g)(7). 25 See Todd Keator, Rental Real Estate and the Net Investment Income Tax, JOURNAL OF TAXATION (August 2013). See also Randy Schwartzman and Patricia Brandstetter, New Sec Brings Difficulty Defining Real Estate Trade or Business, THE TAX ADVISOR (May 1, 2013), available at Section 1411(c)(1), Reg (a)(1) and 5(b). Id. 17

19 Example: Ken U. Diggit, single, owns a partnership interest in a hardware store where he does not work. His share of profits is $10,000. The $10,000 profit is net investment income from a passive activity. If Ken s modified AGI is over $200,000, the $10,000 of profit could be subject to the 3.8% NIIT. His share of gain from the hardware store s sale of property used in the business was $2,000. For similar reasons, the $2,000 of gain could be subject to the 3.8% NIIT. E. Gains on Sales Compare: If Ken worked at the hardware store for over 500 hours, the $10,000 of profit would not be considered net investment income and would not be subject to the 3.8% NIIT. See the analysis below at Part V.A. Similarly, the $2,000 of gain could escape taxation from the 3.8% NIIT. See the analysis below at Part IV.E.2 for gains on sales. 1. General Rule Net investment income includes net taxable gain attributable to the disposition of property (other than property held in a trade or business where the taxpayer 28 materially participates). Included are gains from the sales of stocks, bonds, mutual funds, investment real estate or a vacation home, and capital gain distributions from mutual funds. Also included are taxable gains attributable to cash distributions to partners or to S corporation shareholders that are greater than their basis in their partnership interests or S corporation stock. Gains that are deferred or exempt under other income tax statutes are also deferred or exempt for purposes of the 3.8% NIIT. Examples include gains deferred or excluded under Section 453 (installment sales), Section 1031 (like-kind exchanges), Section 1033 (involuntary conversions), and Section 121 (sale of 29 principal residence)). 2. Exemption for gains on sales from a trade or business If a taxpayer materially participates in a business, gains from the sale of property used in the business are exempt from the 3.8% NIIT. Similarly, a portion of the gain from selling that taxpayer s ownership interest in the business (stock, LLC interest, or partnership interest) can be exempt from the 3.8% NIIT. A real estate professional may be able to avoid paying the 3.8% NIIT on the gain from the sale of the rental property. The rules are explained below in Part V.C.1 of this outline. 28 Section 1411(c)(1)(A)(iii), Reg (d). 29 Part 2 of the preamble to the proposed regulations (REG , 77 Fed. Reg , at (12/05/2012)). 18