2014-15 tax guide
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Your tax bill doesn’t end with income taxes. Additional taxes are levied against earned income and, starting in 2013, investment income.
The Federal Insurance Contributions Act (FICA) imposes taxes on earned income to fund Social Security and Medicare. These taxes are traditionally called “payroll” or “employment” taxes because they are funded by contributions from both employers and employees (you pay both shares on self-employment income, with a deduction for the employer share). The health care reform legislation of 2010 added a separate 3.8% Medicare tax on investment income, applicable for the first time in 2013.
There are now essentially three separate employment and investment tax bases:
- Social Security taxes: Social Security requires matching employee and employer contributions equal to 6.2% on earned income up to a yearly cap that is adjusted for inflation each year and is $117,000 in 2014 and $118,500 in 2015.
- Medicare tax on earned income: Medicare taxes on earned income are uncapped. They require matching 1.45% employer and employee contributions until earned income reaches $200,000 (single) or $250,000 (joint), when the individual rate share increases to 2.35%.
- Medicare tax on investment income: This 3.8% tax is imposed on net investment income (NII) to the extent modified AGI exceeds $200,000 (single) or $250,000 (joint).
Employment taxes apply to earned income. Earned income generally includes items like wages, bonuses, salaries, tips and self-employment income. If you are employed and your earned income consists of salaries and bonus, your employer will withhold your share of Social Security and Medicare earned income tax and pay them directly to the government. Your employer will also begin withholding at the 2.35% Medicare rate once earned income reaches $200,000, regardless of your filing status and whether you have other earned income outside of your employment. You will then have to calculate your total Medicare tax on earned income on your annual return and will be responsible for paying any difference from the amount withheld.
If you are self-employed, you must pay both the employee and the employer portions of employment tax, though you can take an above-the-line deduction for the employer portion of the tax.
Net investment income tax
The new 3.8% Medicare tax on NII was enacted as part of the 2010 health care reform bill and became effective for the first time in 2013. It applies a 3.8% tax on all NII once your AGI exceeds certain thresholds.
NII comprises the following:
- Capital gains
Any income from a trade or business that is a passive activity
There is an exception if the income is derived in the ordinary course of a trade or business in which you are not passive. But all income from a trade or business in which you are passive is NII, regardless of the type of income. For example, the ordinary income earned through your company’s business operations will generally be included in NII unless you work enough in the business to meet the significant or material participation standards. Plus, income from trading in financial instruments or commodities is always NII, regardless of whether you participate in the business.
NII doesn’t include qualified retirement plan distributions such as withdrawals from your IRA or 401(k). Income that is generally excluded under other provisions of the Internal Revenue Code, such as tax-exempt interest or certain gains from the sale of a principal residence, are also generally excluded from NII.
Use your deductions
The IRS allows you to reduce your NII by many common deductions that can be attributed to the income that gives rise to NII. Among the most common deductions you can allocate to NII are the following:
- Deductions attributed to rent and royalty income
- Penalties for early withdrawal of retirement accounts
- Investment interest
- Investment expenses such as investment management fees and investor publications
- Tax preparation fees
- State, local and foreign income taxes
- Certain fiduciary fees
Some taxes, such as investment interest, can be allocated fully to NII. Other deductions that can be partially attributed to NII, such as state taxes and tax preparation fees, are only partially allowable. The IRS allows you to allocate these deductions by any reasonable means. The simplest way is to use the ratio between overall AGI and investment income, but other methods may provide better results.
You don’t have to reduce your deductions on the income tax side by any allocation of these deductions to NII. The tax bases are separate, and the deductions are allowed against both taxes at the same time. However, you can deduct expenses against NII only to the extent the expenses are deductible for regular income tax purposes. So, the “Pease” phaseout of itemized deductions reduces some deductions for both regular income tax and NII tax purposes.
Beyond deductions, many other planning considerations can help mitigate the impact of the 3.8% tax on NII.
Planning tip: Skirt the ‘kiddie tax’ by passing income to children
The new 3.8% tax on NII has resurrected a formerly popular planning strategy: passing investment income down to children to achieve a lower rate. The enactment of the kiddie tax virtually ended this practice in the past. Under the kiddie tax, a child’s income will generally be taxed under the parent’s rate, but only for income tax purposes. Fortunately, the kiddie tax does not include the tax on NII. So, the first $200,000 of your child’s income won’t be subject to the 3.8% tax even if it would have been subject to this tax had it been included in the parent’s income. Consider passing assets to children that generate dividends and capital gains (make sure to consider gift taxes and exemptions). The children’s income will be taxed at your rate only for income tax purposes. But be careful how you file. If you elect to report your children’s interest and dividends on Form 8814, this income will still go into your NII. Make sure your children instead claim this income on their own returns using Form 8615.
Participating in your business activities
The new tax on NII makes it more important than ever that income from your business activities isn’t passive. Your business income is generally passive unless you “materially participate” in the activity. IRS rules allow you to establish material participation in a business by meeting any one of seven tests. The most common test is to work in the business for at least 500 hours during the year. There are special rules for some kinds of income like rental income. Rental income is generally considered passive regardless of your participation unless special exceptions apply.
Generally, establishing your active participation is very important. If the business is producing income, active participation will typically provide an exception for Medicare tax. If the business is in the red, establishing your participation can allow you to take the losses against other types of income.
Planning tip: Avoid passive characterization with as little as 100 hours of participation
You may be able to avoid passive status with as little as 100 hours of participation. Income from an activity in which a taxpayer “significantly participates” may be recharacterized as nonpassive under the passive activity rules. The final regulations for the NII tax generally provide that if income is recharacterized under this rule, it is also nonpassive for purposes of the 3.8% tax.
To significantly participate, you must participate for at least 100 hours. However, the IRS is expected to scrutinize significant participation claims closely and will check if you treated the activity as a significant participation activity in past years. You must be able to document your activities and prove that your participation is not investor participation, and there is a special calculation to determine how much of your income is recharacterized under this rule.
Planning tip: Group your activities
If you have more than one trade or business activity, you may be able to group these activities to meet the material participation requirements and save yourself from the 3.8% Medicare tax that applies to passive income. This is especially helpful for taxpayers who can’t spend more than 500 hours per year on each separate business.
If you have never grouped your activities, you should consider doing so on your 2014 tax return. Taxpayers who have already grouped activities may consider a unique “fresh start” opportunity to regroup for the 2013 or 2014 year. Once you’ve made a grouping election, you’re generally not allowed to regroup without a material change in circumstances. But the proposed regulations on the Medicare tax allow one-time regrouping for either 2013 or 2014.
There is considerable flexibility in the grouping rules. Generally, the activities must represent an “appropriate economic unit,” and the regulations acknowledge there may be multiple acceptable ways to group a taxpayer’s activities. The regulations list five key factors the IRS will use to determine whether activities can be grouped:
- Similarities and differences in the trades or businesses
- Extent of common control
- Extent of common ownership
- Geographical location
- Interdependence between or among activities
But remember that grouping an activity so that it is no longer passive can prevent you from deducting accumulated passive losses when the activity is sold.
Document your activities
Participation includes almost any work performed in a business as an owner, manager or employee as long as it isn’t an investor activity. Investor hours spent on activities such as studying financial statements, preparing financial analyses or summaries, or monitoring the finances and operations, don’t count as participation. It’s important to document your activities so you can establish your participation activities. Neither the IRS nor the Tax Court will accept ballpark estimates made in hindsight. The regulations allow you to prove material participation “by any reasonable means” and do not necessarily require contemporaneous time reports, logs or similar documents. However, the burden of proof falls on the taxpayer, and the IRS has aggressively challenged taxpayer claims. Make sure you’re documenting the hours you’re spending with calendar and appointment books, emails and narrative summaries.
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