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Absorbing Body Blows

Who would have thought a con-servative judge's vote would land high-earners new income taxes and business owners new burdens?  For the wealthy, wide-ranging are the implications of Chief Justice John Roberts's deciding vote that rendered constitutional the Patient Protection and Affordable Care Act.

What the U.S. Supreme Court ruled on, of course, was the controversial individual mandate: the requirement, beginning in 2014, that every American carry health insurance or pay a penalty. The levy can be up to 1% of income in 2014, rising to 2.5% by 2016, although the penalty can not exceed a figure estimated in 2016 to be as much as $12,500 for a family or $5,000 for an individual, according to the Congressional Budget Office.

Health-care reform may have a green light, but much of the law remains gray. For high-net-worth individuals and families, particularly those who run a business, guidance is in the offing. 

Then again, many provisions are crystal clear.

Beginning in 2013, two new income taxes, which estimated tax payments must account for, apply to joint filers with incomes above $250,000 and singles above $200,000-figures that won't be inflation-indexed. The taxes are assessed on the income that exceeds these thresholds.

The first is 0.9% on earned income such as salaries, commissions and self-employment profits. Often referred to as the Medicare Hospital Insurance Tax, the Internal Revenue Service called it the "Additional Medicare Tax" in an informative FAQ available at www.irs.gov.

Whatever its name, the tax is on household earned income. If one spouse's salary is $170,000 and the other's is $130,000, the couple will pay 0.9% on $50,000 ($300,000 household earning income, minus the $250,000 threshold).

Now here's the rub: Withholding doesn't begin until an employee hits the $200,000 mark. That means neither spouse in our example would have the tax withheld. The same holds true for a single client who earns, say, $125,000 from each of two different employers.

The opposite problem, over-withholding, can result in other cases. Take a married client with a $225,000 salary and a non-working spouse. The worker will have tax withheld on $25,000 even though the couple won't owe this tax since their combined earned income is under $250,000. The withholding would be credited to the couple on their Form 1040.
Happily for business owners, employers don't match this payroll tax. Self-employed individuals thus pay the same 0.9% rate employees do.

Surtax Rules
More concerning is the 3.8% Unearned Income Medicare Contribution Tax, frequently called the tax on investment income or the health-care surtax. It is 3.8% of whichever is smaller:  the client's net investment income, or the amount by which the client's modified adjusted gross income (MAGI) exceeds the $250,000-joint/$200,000-single threshold.

MAGI is adjusted gross income plus the client's net foreign earned income exclusion.

Net investment income includes many things. In the mix are taxable interest, dividends, annuities, rents, royalties, income from a passive activity, income from trading in financial instruments or commodities, and capital gains on non-business property such as portfolio securities or a second home. When profits on a principal residence top the tax-free amount ($500,000 for joint filers, $250,000 for singles), the taxable portion counts toward net investment income.

Because the surtax is assessed on the smaller of two figures, if either is zero, there is no surtax.

There exist but two ways to reduce, or increase the surtax: either change net investment income or change excess MAGI, which, in some slightly circular math, includes net investment income plus other income. One approach may have greater impact on the surtax than the other, depending on the facts.

Suppose a client with $50,000 of net investment income exceeds the MAGI threshold by $80,000, as Example 1 in the chart depicts. Reducing other income by $15,000 would lower the excess MAGI to $65,000, but the smaller investment income of $50,000 would continue to dictate the surtax. Other income would have to decrease by more than $30,000 to lower the tax, whereas any reduction in net investment income would do the trick.

What if income rises? When investment earnings drive the surtax, if it grows, so does the levy. "But you could add other income and it wouldn't affect the surtax," says Mitchell Drossman, the Manhattan-based national director of wealth planning strategies for U.S. Trust.

To manage investment income, shift from taxable bonds to municipal debt, says Leon LaBrecque, CEO of LJPR LLC, an independent wealth-management firm in Troy, Mich. Muni income is not subject to the surtax, LaBrecque says.

Or you might seek investments providing tax shelter, such as tax-deferred non-qualified annuities, real estate (when the rental income is offset by depreciation deductions), and cash-value life insurance, says CPA Robert S. Keebler, partner at Keebler & Associates LLP in Green Bay, Wis. Non-modified endowment contract insurance policies can provide clients with tax-free cash flow via policy loans and non-taxable basis recovery, Keebler points out.

Clients who take gains this year will need to carefully weigh installment sales, cautions LaBrecque. An installment sale spreads the gain into future years, which could be detrimental if the tax rate will be higher then. Clients with existing installment sales might consider negotiating an accelerated payment in order to realize gains ahead of 2013.  "We've discussed that with clients," says LaBrecque.

Different Situation, Different Strategies
Now consider Example 2, someone with $150,000 of investment income and $100,000 excess the MAGI.  With excess MAGI controlling the surtax, it can be reduced by lowering either of MAGI's constituent parts: investment income or other income. Likewise, increases in either type of income swell the surtax bill.

In addition to the strategies already discussed, these clients can make larger contributions to qualified plans to lower taxable wages and, in turn, MAGI and the surtax. Business owners can reduce MAGI by managing profits with year-end equipment purchases and careful customer billing, Drossman says.

To manage MAGI in future years, planners suggest Roth conversions. Their non-taxable distributions don't get included in MAGI, whereas distributions from traditional retirement accounts do. A Roth conversion today can stop required distributions-and surtax-later, LaBrecque tells wealthy clients. Convert in 2012, he adds, so that the conversion itself predates the surtax while benefiting from the low Bush-era ordinary rates, which are currently set to expire at year end.

For Fiduciaries
Trusts and estates are subject to the Medicare surtax and for these entities, tripping the threshold is easy because it's low.  The surtax is computed on the smaller of (1) the trust's undistributed net investment income or (2) the amount of AGI that falls in the highest tax bracket for trusts and estates, which in 2013 is expected to be income exceeding about $12,000. "For trusts and estates the threshold is indexed," says Drossman.

Practically speaking, a non-grantor trust that does not make any distributions will be subject to the surtax on its investment income above the lowly threshold, according to Drossman.  "Distributions reduce the trust's AGI and shift the income to the beneficiary, who may or may not be taxable on it depending on his personal situation.  This is one more thing for a trustee to consider when making a distribution," Drossman says.

Regarding recent deaths, executors should bear in mind that the surtax only applies to years beginning on or after January 1, 2013, says Keebler.  An election to end the estate's fiscal year on, say, November 30, 2012, would effectively place the first 11 months of 2013 in a pre-surtax year and avoid the levy for that period.

Health-Care Reform And The Business Owner
Clients with businesses may face many significant new requirements, and equally serious penalties for non-compliance, although some of the most onerous provisions apply only to larger employers.

"Business owners should immediately focus on the costs that health-care reform will bring to their organizations," advises Steven J. Roper, president of Roper Insurance & Financial Services, a consulting firm in Englewood, Colo.  Because the costs will not be trivial for many employers, they need to understand what's coming down the pike as they prepare budgets and business plans.

Also deserving immediate attention is a new document required of plan sponsors, the Summary of Benefits and Coverage (SBC).  Beginning September 23, employers must distribute the SBC to new hires at initial enrollment, as well as annually during open enrollment to all employees, if they work an average of 30 hours per week or more. This includes employees who do not participate in the health plan.

The SBC gives workers a side-by-side comparison of the benefits provided by different plans, along with a glossary of key terms, explains Roper, who serves on the board of the Colorado Health Benefit Exchange, created by the reform legislation to provide coverage to high-risk individuals.

Also coming to plan sponsors this fall is the assessment formerly known as the Comparative Clinical Effectiveness Research Fee, although princely it is not.  Now called the Patient-Centered Outcomes Research Institute (PCORI) Fee, it is $1 times the average number of covered lives (i.e., spouses and dependents as well as employees) for plan years ending before October 1, 2013. After that this nuisance fee doubles. It ceases after 2019. Several methods are available for calculating the average number of participants.

Provide Coverage Or Pay A Penalty
Especially worrisome to business owners is the employer mandate. As Roper explains, starting in 2014, employers with at least 50 full-time equivalent employees will have to make available a minimum level of insurance to employees who average 30 or more hours per week, or pay a penalty of $2,000 per employee excluding the first 30 workers.

Employers providing coverage that's deemed unaffordable under the rules are subject to a penalty of $3,000 per year, per employee who obtains federally subsidized coverage on an exchange, adds attorney Sarah Millar, a partner at Drinker Biddle & Reath LLP. 

Frankly, some business owners will probably just pay the fine, says attorney Bruce Howell, a shareholder at Schwabe Williamson & Wyatt, PC, in Portland, Ore.

Figuring out who is full time can be a mind-numbing exercise. "What if the client has several separate corporations each with 10 or 15 full-time employees? We've had that question," Howell says.

With the test based on full-time equivalency, businesses with a substantial part-time workforce could be subject to the rule, Millar observes.

Clients with growing businesses that have fewer then 50 full-time employees need to understand the requirement so they appreciate the implications of adding staff.  "The cost won't be just wages and employment taxes. It's going to include health coverage or a penalty for not providing coverage," Millar says.

Another unwelcome rule hits business owners with more than 200 full-time workers. These employers will be required to automatically enroll full-time employees in the company's health plan (with a waiting period of up to 90 days).  Employees must be given a chance to opt out, Millar says. Originally scheduled for 2014, this requirement won't take effect until the Department of Labor issues final regulations, which are not expected by 2014, according to Millar.

Not effective until 2018 is a nondeductible excise tax on employers who offer high-value, or "Cadillac," plans. The tax applies to plans with a value in 2018 greater than $10,200 for single coverage or $27,500 for family coverage.  It is 40% of the value above these thresholds, says Raymond Paolini, a professional-services advisor at Roper Insurance & Financial Services.

For private wealth advisors, the wide net of health-care reform means beaucoup opportunity to serve clients.  As LaBrecque says, "Besides the Affordable Care Act, they could have called this the Affordable Compensation Act for Advisors, because it's keeping us pretty busy."

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