Year-end tax guide: Employment and investment taxes

2015 Year-end tax guideIncome taxes tell only part of the story. For many business owners and executives, payroll and investment taxes are a very important part of the tax bill. Three separate tax bases are intended to fund Social Security and Medicare. Traditionally, these taxes were called payroll or employment taxes because they were levied only against earned income like wages or self-employment income. But beginning in 2013, a new tax on net investment income (NII) became effective. There are now essentially three separate employment and investment tax bases:
  • Social Security taxes: 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 $118,500 in 2015.
  • Medicare tax on earned income: Requires employee and employer contributions on earned income and is uncapped. The employee and employer shares are 1.45% until earned income reaches $200,000 (single) or $250,000 (joint), when the employee rate share increases to 2.35%.
  • Medicare tax on investment income: Imposes a 3.8% tax on an individual’s NII to the extent modified AGI exceeds $200,000 (single) or $250,000 (joint). There is no employer share.

Q: Can my income be hit with both employment and NII tax?
No income is ever subject to both at the same time, but you can pay each tax on different streams of income.

Q: Is there any income that avoids both?
There may be income that is not subject to employment or NII tax. An S corporation owner who is active in the business will typically pay employment tax only on salary and will not owe self-employment tax or NII tax on the rest of the S corporation’s operating income. In some cases, a limited partner who participates in the partnership’s business may also pay neither tax on the partnership’s operating income.

Q: Which tax would I rather pay?
The rules do not allow you choose one or another, but in general, self-employment taxes are preferable for the deduction on the employer share of tax.

Earned income taxes
Employment taxes apply to earned income, which 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 taxes 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.

Earned income employment tax rates for 2015
(click to view chart)

Net investment income tax
The new NII tax applies a 3.8% tax on all NII once your adjusted gross income (AGI) exceeds certain thresholds. So what is NII? NII comprises the following:

  • Rents
  • Royalties
  • Interest
  • Dividends
  • Capital gains
  • Annuities
  • 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 IRS tests. 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.

AGI threshold at which 3.8% tax on NII first applies
(click to view chart)

Example: How much will I pay on NII? (click to view chart)

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 discussed in Chapter 2 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. If you’re already paying self-employment tax on your pass-through income, you don’t have to worry about this new tax because self-employment income is exempt regardless of whether it’s passive.

If you have income that’s not subject to self-employment, you need to know if your business activity is passive to you. In the past, the passive activity rules usually mattered only to businesses in a loss position because the rules limited your ability to take losses against other kinds of income. Now, because all passive trade or business income will be hit with the tax, you have a strong incentive to make sure you aren’t passive.

Your business income is generally considered 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 considered passive, regardless of your participation unless special exceptions apply.

Generally, you want to be active. If the business is producing income, your participation can provide an exception for NII tax. If the business is in the red, establishing your participation can allow you to take the losses against other types of income.

Business perspective: Group your business activities
If you have more than one business activity, you may be able to group these activities together in order to meet the material participation requirements and save yourself from NII tax. This is especially helpful for taxpayers who can’t spend more than 500 hours per year on each separate business.

Unfortunately, there are limits. You generally cannot make a new grouping election unless you have a material change in facts, such as launching a new business activity or selling another off, or if you will be subject to the tax on NII for the first time.

If you are eligible for a new grouping election, there is considerable flexibility in the 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

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 in past cases. If you don’t keep a time log, make sure you’re documenting the hours you’re spending with a calendar and appointment books, emails and narrative summaries.

Planning tip: Avoid passive characterization with as few as 100 hours of participation
You may be able to avoid passive status with as few 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 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.

David Walser
T +1 602 474 3410

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