– By Mark Battersby –
Many builders, contractors face two new taxes
Largely unnoticed, ignored or overshadowed by the talk about the “Fiscal Cliff,” higher tax rates, tax reform and the economy, many builders and contractors woke up on January 1, 2013, to face two new taxes. Thanks to the Health Care and Education Reconciliation Act of 2010, beginning in 2013, many individuals are subject to a 3.8 percent Net Investment Income NII) tax and a 0.9 percent Additional Medicare tax.
Although the NII tax applies to “investment” income, the operators of many rural building businesses may be surprised to learn how broad the term “investment income,” actually is. Furthermore, while both of these surtaxes are aimed at so-called: “wealthy” individuals, the floor isn’t all that high. The new taxes will apply to single taxpayers with a modified adjusted gross income in excess of $200,000 and married taxpayers with a MAGI in excess of $250,000 if filing a joint return, or $125,000 if filing a separate return.
Net investment income includes interest, dividends, annuities, royalties, and rents, other than the income derived in the ordinary course of a trade or business. It does, however, include income from a passive activity, or a trade or business trading in financial instruments or commodities. It does not include distributions from qualified plans such as pensions, profit-sharing, stock bonus plans, qualified annuity plans, or individual retirement plans net investment.
As mentioned, the NII surtax applies only if the building business is a so-called “passive” activity. However, an owner active in a business operating as a pass-through entity such as an S corporation, LLC or partnership, may discover that a portion of the flow-through income is actually subject to the NII tax.
Should the passive investor attempt to argue he or she is not passive in order to avoid the new tax they will end up being subject to self-employment tax. This is also the case with an investment in an LLC or a partnership.
To the ever-vigilant Internal Revenue Service, no compensation or unreasonably low compensation while claiming to be an active participant for S corporation employee/owners clearly constitutes a passive investment.
Within a pass-through business entity, any income, gain, or loss that can be attributed to an investment of working capital will be treated as not derived in the ordinary course of a trade or business. Interest, dividend, and royalty income earned in the normal course of a trade or business would not be subject to this surtax, but idle cash-producing investment income would.
When an interest in a partnership or S corporation is disposed of, only the gain attributable to the disposition of non-active assets would actually be subject to the NII tax. The owner of an interest in a building business may find that he or she has both an active trade or business and a passive activity housed within the operating entity. The determination of the portion of the gain subject to this tax would be based on an allocation of the fair market values of all the assets (active and passive) immediately before the disposition of the interest.
Although there is no definition for “working capital” in our tax laws, working capital may be invested in income-producing liquid assets, such as savings accounts, certificates of deposit, money market accounts, short-term bonds, and similar investments. The NII Tax on working capital can pose an unexpected liability for a business conducted by a sole proprietor, partnership or S corporation, which otherwise escapes the tax.
According to the IRS’s guidelines, income from working capital is subject to the surtax. Cash-intensive business using interest-bearing accounts, as well as businesses that park some excess funds until a project begins, should be alert to this “hidden” surtax in connection with an active business operation.
Also effective in 2013, a 0.9 percent Additional Medicare Tax applies to individuals’ wages, compensation and self-employment income over certain thresholds, although it does not apply to income items included in the NII. This new surtax may also result in complications for employers, as well as employees and the self-employed in addition to the regular Medicare rate of 1.45 percent on wages received by employees. The tax only applies to the employee portion of the Medicare surtax. The employer Medicare tax rate remains at 1.45 percent, and the employer and employee Social Security tax remain at 6.2 percent.
The 0.9 percent additional Medicare surtax applies only to employees, not employers. Employers must begin withholding the additional Medicare surtax once an employee’s wages exceed $200,000, even if the employee may not ultimately be liable for the additional tax such as an employee earning $210,000 and a spouse earning $25,000, filing a joint return.
On the other side of the coin, additional Medicare surtax may be owed on an employee’s income tax return where withholding is not collected. This might involve an employee earning $175,000 while the spouse earned $150,000. If an employer fails to withhold the 0.9 percent additional Medicare surtax, the IRS will not collect the tax from the employer although they remain subject to any applicable penalties or additions to taxes for failure to withhold.
The Medicare surtax on self-employment income for any tax year beginning after December 31, 2012, is increased by an additional 0.9 percent of self-employment income which exceeds the same thresholds as employees. The 0.9 percent surtax on earnings kicks in when income from a job exceeds a certain amount. For a single individual the threshold is $200,000 and $250,000 for married taxpayers who file a joint return.
Wages have been subject to a 2.9 percent Medicare tax for years. The amount is split, with the employee and employer each paying half, or 1.45 percent. Starting with your first paycheck in 2013, if your annual salary exceeds the threshold, you will pay 2.35 percent toward Medicare. There is no increase in the amount employers have to pay.
Consider John Doe, a single-filer, who has wages of $180,000 from his lucrative building business, and $15,000 of dividends and capital gains. His modified adjusted gross income is $195,000, which is less than the $200,000 threshold and he is not subject to the NII Tax. Depending on how much is earned in the form of wages and investments, the surcharge could apply to all, or only part, of an individual’s investment income.
On the other side of the coin, additional Medicare surtax may be owed on an employee’s income tax return where withholding is not collected. This might involve an employee earning $175,000 while the spouse earned $150,000.
Every builder or contractor who expects to be subject to the surtax in 2013 or thereafter is required to adjust their income tax withholding or estimated payments to account for the tax increase if they hope to avoid underpayment penalties.
Both sets of these new regulations are “proposed,” thus subject to a public comment and reassessment process before finalized. The IRS stated that taxpayers may rely on the proposed regulations until final rules are released sometime in 2013.
Mark Battersby is an expert in tax and financial matters. With more than 30 years experience in small business issues, he lectures and writes extensively on business topics. Contact him at MEBatt12@earthlink.net.