Taxpayers and their accountants are in the middle of “Busy Season” and one of the messages they are hearing is that even ignoring the unknown and potential income tax law changes that may come about later this year, clients need to plan for the “Medicare surtax” that will come into play in 2013. As you know Obamacare was in part funded by the passage of increased payroll and Medicare/income taxes that become effective in 2013.

For our business the most troubling aspect is the 3.8% net investment surcharge tax. Beginning in 2013, higher income individuals with net investment income will be subject to a 3.8 percent tax of the lesser of two amounts:

•Their net investment income, or
•the excess of the their modified adjusted gross income over a $200,000 (single) or $250,000 (joint filers) threshold amount

If their adjusted gross income is greater than the $200,000/$250,000 threshold, the excess becomes a limitation on the amount of net investment income exposed to the surtax. For example, if a joint return has a modified adjusted gross income of $280,000, the $30,000 excess becomes the limitation of the tax.

For most taxpayers modified adjusted gross income will be equal to or very close to their adjusted gross income which can be found on the bottom of page one on their individual income tax return.

The surcharge applies to their investment income which includes most forms of passive income including passive investment income passed through to taxpayers from business activities in which they do not materially participate. This includes capital gains, interest and dividend income (not muni income), rental income, some annuities, and royalties.

Some strategies that could be considered to reduce the impact of this tax include:

• Consider recognizing large capital gains in 2012 versus 2013. This could accelerate large liquidity events to 2012; as for example a sale of a business will be more expensive in 2013.
• Depending on one’s expected income, realizing bonuses and other income in 2012 that would push AGI over the income thresholds in 2013 if recognized in that year or beyond.
• While IRA/pension distributions are not subject to the tax they do increase AGI therefore exposing more investment income to the threshold of the tax. Therefore Roth conversions should be considered in 2012 as Roth’s do not have RMD requirements thereby reducing future year income. This has to be considered in light of the accelerated tax created by the conversion.
• Consider using “installment sales” in 2013 so as to spread out the income, if doing so keeps the taxpayer under the income threshold or otherwise minimizes the impact of the surtax.
• Plan pension and retirement income so as keep future year income under the thresholds.
• High value insurance plans become more attractive investments as the investment buildup is not subject to income tax or the surtax.
• Maximizing the use of high deductible retirement plans including defined benefit plans and confirming that all plans are fully funded. Use of deferred compensation plans could be more attractive as well.
• How the Kiddie tax is calculated could also impact the new tax, and as a result could impact overall planning.
• This provision also makes 529 and other education savings plans more attractive.

Thus planning includes watching and manipulating income and developing a strategy to smooth out income if possible so that the thresholds are not exceeded as well as planning the timing and form of investment income being realized.

These issues are actually even more critical for estates and trusts as the threshold for most trusts subject to tax is $12,000 for 2013.

These issues could all be compounded by potential income tax law changes that take place late this year.