As the end of 2013 approaches, rumblings of major tax overhaul are again making their way through Congress. Sen. Max Baucus (D-Montana), chairman of the Senate Finance Committee, and Rep. David Camp (R-Michigan), chairman of the House Ways and Means committee, have both released draft proposals for comment. Most significantly, under the Camp proposal, the top corporate tax rate would be lowered from 35 percent to 25 percent, while the Baucus proposal suggests a rate of less than 30 percent.
As Camp begins his final year as committee chair due to term limits, the proposal represents reform that is two years in the making. However, the government’s tenuous implementation of the Affordable Care Act website and the partial government shutdown during the month of October have both severely strained political cooperation and financial resources– leaving little room to achieve any definitive reform before the end of the current year. Given that 2014 is an important election year, it is unlikely that tax reform will gain any momentum until after the midterms.
Two upcoming tax changes
While we can expect very few changes to current legislation before the end of the year, two major pieces of reform were passed. The Medicare surtax was effective Jan. 1, 2013, and the final repair regulations are effective for tax years beginning on or after Jan. 1, 2014. Both initiatives (detailed below) present opportunities where action should be taken before the end of this calendar year. Referenced at the end of this article are also additional provisions that can help improve your tax and cash flow position before the New Year arrives.
THE NEW 3.8% MEDICARE SURTAX
A major provision of the Affordable Care Act is the 3.8 percent Medicare surtax, commonly referred to as the Net Investment Income tax (NII tax). This tax is assessed on income earned beginning Jan. 1, 2013 and is imposed on the lesser of Modified Adjusted Gross Income (MAGI) over $250,000 for taxpayers filing a joint return or on Net Investment Income defined below.
Net investment income (NII) consists of three major categories of income: unearned income, passive activity income and net gain from disposition of property. Unearned income includes interest, dividends, royalties and most rents, while passive activity income includes any income in which the shareholder, partner or owner of the business activity is not a material participant.
The combination of the additional Medicare tax with the higher tax brackets imposed under the American and Taxpayer Relief Act could result in a combined marginal tax rate of 43.4 percent for many taxpayers.
For example, a taxpayer in the highest marginal tax bracket with $10,000 of short-term capital gain income will pay $3,960 of income tax (39.6 percent marginal tax rate) in addition to $380 of additional Medicare tax (3.8 percent flat rate) for a total tax of $4,340. In 2012, this same $10,000 short-term capital gain would have been assessed $3,500 income tax (35 percent marginal tax rate). The rate differential between 2012 and 2013 represents an 8.4 percent increase in total tax due.
For portfolio income items (dividends, interest, etc), there is not much that you can do. However, if you receive pass-through income from a trade or business, there might be some opportunity for savings.
The following questions would need to be considered:
Are you active in the trade or business?
The IRS has several rules to determine whether or not an individual is an active participant in a business activity. However, the rule relied upon most regularly is the 500-hour rule. Under this rule, any business activity from which you derive income but in which you participate less than 500 hours, is most likely deemed a passive activity and will therefore be subject to the 3.8 percent surtax.
If you know you are active, be sure the documentation of your hours and the type of activities you’ve carried out for the business is complete, accurate and readily available. Also note that any time spent in an investor role and not managing or operating the business activity cannot be included in the 500 hours.
Be aware that the IRS chose to defer guidance for business activities held by a trust. In the interim, there is case law that would indicate that you may look to the activities of the trustee or co-trustee to determine whether or not the income is active. This means that if that trustee does not, at a minimum, meet the 500-hour rule, the income from that activity will be characterized as passive and will be subject to the additional NII tax.
In addition to documenting the hours of the trustee, make sure to clearly document the nature of activities that are being carried out as trustee of the trust as opposed to as an employee of the business. If a functional distinction between employee and trustee cannot be made, the IRS may disqualify the time spent by the trustee from being counted toward the material participation requirements.
Can you combine activities to get a better outcome?
If you participate in several business activities, you may have the option of treating those different activities as a single group. By grouping or aggregating your activities at the individual taxpayer level, you can count any hours spent carrying out the business of the group for the 500-hour rule, instead of trying to reach the 500 hour threshold on an entity-by-entity basis.
How does one group a set of businesses?
The following list sets out some criteria for consideration. Not every requirement on the list needs to be met, but the IRS may disqualify the group if it can determine that the group is not an appropriate economic entity. The more you can beef up the rationale for the group, the better.
1. Similarities or differences in types of trades or businesses
2. The extent of common control
3. The extent of common ownership
4. Geographical location
5. Interdependencies between or among the activities
The grouping of activities is a tax election. Once you’ve elected to group a set of business activities, that group must remain the same for all future tax years unless you are able to determine that the grouping was clearly inappropriate, or a material change in facts deems the grouping inappropriate.
If you have already established a grouping for your business activities, you may be eligible to change it. In November, the IRS announced final regulations allowing business owners to undergo a one-time regrouping if the income thresholds are met and if any net investment income is present. The grouping election must be made with the filing of your 2013 or 2014 tax return.
What about rental real estate?
This can cause a problem when it comes to the NII tax, since rental activities are generally treated as passive activities and would be subject to the 3.8 percent surtax. The regulations contain several exceptions to this rule, however, and some are left purposely vague.
For example, the rental income could be excluded if it is:
1) generated in the ordinary course of business and
2) is grouped in a set of business activities that, as a whole, are deemed active.
There are other tests specific to grouping real estate activities that also must be met.
Although a business and the real estate could be grouped under the passive activity rules, the NII tax regulations require that the real estate be a trade or business. Specifically, the regulations provide an example where the regulations deem the real estate not to be a trade or business and thus subject to the NII tax. The regulations do not provide the fact pattern for why it is not, but it is theorized that activity would be in a triple net lease situation which is common in this fact pattern.
Because the tenant effectively manages all facets of the real estate, the real estate entity could be deemed not a trade or business. Taxpayers in this situation might want to reconsider the activities of the real estate entity to determine if they could have enough activity to constitute a trade or business and then weigh that against the NII tax. Because these rules can be complex, real estate owners should seek out professional assistance in determining how to characterize the income.
In the rental real estate area the final regulations did provide one taxpayer favorable change in that they specifically allowed income from a real estate entity that is classified as a self-rental to be deemed not passive and thus not subject to the 3.8 percent tax. Commentators argued with the Service that failure to allow this as the proposed regulations ignores the true economics of the situation.
FINAL REPAIR REGULATIONS
On Sept. 13, 2013, the IRS released final repair/capitalization regulations, more commonly referred to as the repair regs. The rules contain several business-friendly provisions.
Most importantly, the regulations establish a de minimus safe harbor rule in which taxpayers are able to immediately expense, instead of capitalize, amounts paid for a unit of tangible personal property. Under these rules, taxpayers with audited financial statements are eligible to expense the entire amount paid as long as the cost does not exceed $5,000 per invoice (or per item). If the total invoice amount, including delivery and installation fees, exceeds the threshold amount, the purchase will not qualify for immediate expensing under the safe harbor rules and should be capitalized and depreciated.
Splitting up the cost of a single item among several invoices to avoid exceeding the invoice threshold is specifically prohibited. Any installation and delivery fees, however, will not count toward the threshold as long as they are not billed on the same invoice. You should work with your vendors to ensure that these additional costs are either billed separately, or, if they are included on the same invoice, ensure that these additional costs do not disqualify the entire purchase from immediate expensing.
If you do not have audited financial statements, the same rules apply, but the threshold for expensing is set lower: $500 instead of $5,000.
In order to take advantage of this provision, businesses are required to have a written accounting policy in place delineating the price points at which purchases are either capitalized or expensed. The written policy needs to be in place before you begin your first tax year on or after Jan. 1, 2014. This means that for calendar year taxpayers, the policy will need to be completed by December 31, 2013.
Another provision included in the final regulations allows businesses to deduct routine repair and maintenance costs on buildings. Safe harbor rules for this provision require that taxpayers reasonably expect for the repair to be made at least twice within a ten-year period. As long as the taxpayer uses a reasonable methodology in determining the expectation, taxpayers will not be penalized if the repair is only made once in the ten-year window.
The rules also include a provision allowing small business owners to immediately deduct up to $10,000 of routine repair and maintenance expenses. A small business is defined as one with average annual gross receipts of $10 million or less over the three previous tax years, and a qualifying building is defined as having an unadjusted basis of $1 million less. The expenses cannot exceed the lesser of $10,000 threshold or 2 percent of the adjusted basis of the building.
OTHER YEAR-END PLANNING
In addition to both major changes outlined above, there are also blocking and tackling items that business owners should be considering.
â¢ Beware of AMT: Consider whether you will be subject to AMT in 2013. If you determine that AMT will apply for 2013, hold off on making your fourth quarter state tax estimated payment. Since state taxes are not deductible for AMT, you will receive no benefit from making the payment early. Delaying will move the deduction to a year in which there is potential tax benefit, and you can always use some extra cash for Christmas gifts.
â¢ Donate Stock, not Cash: 2013 has been a good year in the stock market. If you’re considering making a charitable donation, consider donating your appreciated publicly traded stock instead of cash. Your stock is deductible at the full fair-market value if the stock has been owned for more than 12 months. Reinvest the cash in the business or, better yet, buy more Christmas gifts!
â¢ Purchase New Equipment: If you’ve been planning to buy a new piece of equipment for your business, now is the time to do so. Absent further legislation, the 50 percent bonus depreciation deduction for purchases of almost all types of equipment is set to expire after 2013. Remember the equipment must be new and placed in service before the end of the year; used equipment does not qualify for the additional depreciation deduction.
â¢ Wait for the New Year: Consider your income position at the end of 2013. If you’re nearing the NII thresholds, consider delaying major business transactions until 2014. Good things don’t always come to those who wait, but this time the saying will hold true!
EXPIRING PROVISIONS FOR BUSINESSES TO CONSIDER
Year-end tax planning for businesses for 2013 will be impacted by several incentives set to expire at the end of the year. Similar to previous years, Code Sec. 179 and Code Sec. 41 (research and experimentation credit) are once again at the forefront of planning. There are also other favorable business provisions, such as the Work Opportunity Tax Credit (WOTC), that are newly up for expiration. As the year comes to an end, corporations and small businesses alike should be planning with these considerations top of mind:
â¢ Small Business Stock â Both investors and small business owners should be aware that the Small Business Stock exclusion, which allows individual investors to exclude capital gain from the sale or exchange of qualified small business stock from gross income, will meet its end this year. In order to still take advantage of this incentive, qualifying stock must be purchased by Jan. 1, 2014.
â¢ Research Tax Credit Despite being one of the few credits to receive bipartisan support, Code Sec. 41, also known as the R&D tax credit, is in a perpetual state of pseudo permanency. At the end of 2013, it will once again expire. However, tax professionals largely believe that it will be extended for 1 to 2 years. Research hubsâsuch as nonprofits and universitiesâas well as research contingent industriesâlike technology and manufacturingâare acutely impacted by this ongoing tax battle.
â¢ Section 179 Deduction Sees Major Decrease After tax year 2013, the expensing limit for this tax deduction, which allows businesses to deduct up-front, rather than depreciate the cost of equipment like computers, manufacturing machines and office furniture, will drop to $25,000 from $500,000.
â¢ Work Opportunity Tax Credit In order to reap any benefit from this expiring credit, business owners must hire qualifying employeesâindividuals who receive government benefits, supplemental Social Security Income, long-term family assistance and veteransâwho start before January 1, 2014. The credit may be equal to approximately 40 percent of the worker’s first-year salary or wage.
As the end of the year approaches, make a choice to reject the uncertainty of the talk of tax reform tossed around in the media and instead take hold of the few small suggestions we’ve made. These are in your control and, with careful planning and wise counsel, have the potential to make a large impact on your business.
The views expressed above are those of the author and are not necessarily those of BDO USA, LLP The comments expressed above are general in nature and not to be considered as any specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties. Readers are advised to consult with their professional advisers before acting on any items discussed herein. Daniel Fuller is a tax partner in the Grand Rapids, Mich., office of BDO USA LLP. He can be reached [email protected]