The Affordable Care Act created two new taxes for individuals whose income exceeds $200,000 ($250,000 for married couples filing joint returns). Employees must pay an additional 0.9% Medicare tax on wages in excess of these dollar thresholds. Individuals whose adjusted gross income exceeds the dollar thresholds also must pay a 3.8% tax on their net investment income.
Both taxes became effective in 2013, but high-income employees will pay the taxes for the first time next year, when they file their 2013 tax returns. Employers are required to withhold the 0.9% additional Medicare tax, and are liable for any amount they fail to withhold.
The IRS recently published a final regulation and an updated set of FAQs interpreting the additional Medicare tax. The IRS also published a final regulation, a new proposed regulation, and updated FAQs interpreting the tax on net investment income.
Additional Medicare Tax
Employers and employees each owe an old age, survivors, and disability insurance tax equal to 6.2% of the employee’s FICA wages up to the taxable wage base ($113,700 in 2013) and a hospital insurance (Medicare) tax equal to 1.45% of all FICA wages. The employer must withhold the employee’s share of the tax and pay it to the IRS. When an employer fails to withhold the proper amount, the employer is liable to the IRS for the employee’s share of FICA tax. In most cases, the employee’s share of FICA tax is paid exclusively by wage withholding: the employee is not expected to calculate the tax owed, declare it on a return, or pay it directly to the IRS (although the employee remains responsible for tax that the employer fails to withhold).
Starting in 2013, employees owe an additional 0.9% tax on FICA wages above a threshold amount: $250,000 for married couples filing jointly, $125,000 for married couples filing separately, and $200,000 for all others. Unlike the FICA taxable wage base, these dollar thresholds are not indexed for inflation. The additional 0.9% tax also differs from regular FICA tax in that it applies only to the employee: the employer does not pay a corresponding tax.
As is true of other FICA taxes, the employer must withhold the additional 0.9% tax from the employee’s wages, and the employer is liable to the IRS for any tax it fails to withhold. The employer must withhold 0.9% of all FICA wages above $200,000 that it pays to an employee, regardless of the employee’s filing status. The employer’s liability is reduced to the extent it can show that the employee paid any tax the employer failed to withhold.
In many cases, however, the employer’s withholding obligation will not cover the employee’s tax liability. For example, if an employee’s FICA wages are $190,000 and the employee’s spouse earns $180,000, the couple will owe the additional Medicare tax on $120,000 of combined wages above the $250,000 threshold; but because neither employee earns more than $200,000, neither employer is required to withhold the additional tax.
The additional Medicare tax is different from regular FICA tax in that the employee is required to determine and pay directly to the IRS the portion of the tax that is not covered by the employer’s withholding obligation. This additional tax liability becomes part of the employee’s obligation to pay estimated tax, and the employee might incur penalties if the employee fails to pay sufficient estimated tax to cover the liability. Alternatively, an employee may use IRS Form W-4 to request additional federal income tax withholding on wages paid by the employer, to reduce the need to make estimated tax payments to cover the additional Medicare tax liability.
A corresponding 0.9% SECA tax applies to the net earnings of self-employed individuals that exceed the dollar thresholds. A company’s outside directors, retired executives who provide consulting services as independent contractors, and other self-employed individuals are potentially liable for this tax, and must pay estimated tax to cover the additional tax liability. The additional SECA tax is non-deductible.
An employer generally may make an interest-free adjustment to correct errors in withholding the additional Medicare tax, but only if the employer discovers and corrects the errors in the year in which the wages were paid. Because the requirement to withhold the additional Medicare tax is new in 2013, employers might wish to check their payroll records for high-income employees before the end of the year to make sure the additional tax was properly withheld and to correct any withholding errors.
When deferred compensation vests during a calendar year, many employers include the vested amount in an employee’s FICA wages as of the last payroll period in the year. In some cases, the vesting of deferred compensation will cause an employee’s FICA wages to exceed the $200,000 withholding threshold for the first time. Employers might wish to make sure that their payroll systems will identify employees who are subject to withholding for the additional 0.9% Medicare tax and will withhold the tax as required from deferred compensation that vests in 2013.
In addition, although the IRS has confirmed that employers have no obligation to notify employees of the additional Medicare tax, employers might wish to remind employees, directors, and independent contractors of the requirement to pay estimated tax if wage withholding is not sufficient to cover their 2013 liability for the additional Medicare tax.
Tax on Net Investment Income
The Affordable Care Act also imposed a new tax on unearned income. The rate of tax is 3.8%, equivalent to the hospital insurance tax a self-employed person would pay on earned income (the sum of the regular 2.9% Medicare tax and the 0.9% additional Medicare tax). Although the statute labels the new tax an “unearned income Medicare contribution,” it is part of the federal income tax rather than the employment tax program that funds Medicare.
The 3.8% tax applies to the lesser of an individual’s net investment income or the amount by which his modified adjusted gross income (including both earned and unearned income) exceeds the dollar thresholds: $250,000 for married couples filing jointly and qualified widows or widowers with dependent children, $125,000 for married couples filing separately, and $200,000 for all others. For example, if an unmarried taxpayer has $100,000 of net investment income and $220,000 of modified adjusted gross income, he will pay the 3.8% tax only on the $20,000 of net investment income that exceeds the AGI threshold. A corresponding 3.8% tax applies to the net investment income of certain trusts and estates, although the income thresholds and rules for calculating the tax are different for these entities.
The investment income subject to the tax includes income from dividends, interest, annuities, royalties, and rents (unless derived in the ordinary course of a trade or business in which the taxpayer actively participates); other forms of gross income derived from passive business activities; and net gain from disposition of property, to the extent taken into account in computing taxable income (unless the property was held in a trade or business in which the taxpayer actively participates). The taxpayer is permitted to deduct certain investment-related expenses, such as margin interest, investment management fees, and an allocable share of state and foreign taxes, in determining net investment income.
The preamble of the regulation proposed in 2012 explained that an employee is engaged in the “trade or business” of being an employee. Because income derived from active participation in a trade or business (with the exception of trading in financial instruments or commodities) generally is not included in net investment income, amounts that are treated as wages for purposes of the federal income tax withholding rules in section 3401 of the Internal Revenue Code are not subject to the tax. The final regulation reflects this principle in the definition of “excluded income,” which states that “wages” are among the items of income that are not included in net investment income, although the regulation does not define “wages” for this purpose.
Because the 3.8% tax applies to unearned income, it has little direct effect on employers (although it might have a substantial impact on the tax position of executives, directors, small business owners, and other highly compensated individuals). Employers are not required to withhold the 3.8% tax or to report income potentially subject to the tax. Nevertheless, employers might wish to note the following points concerning the tax on net investment income:
Retirement Plan Distributions
- The net investment income tax does not apply to actual distributions or deemed distributions (such as defaults on plan loans) from tax-qualified retirement plans and individual retirement arrangements. This exclusion increases the relative tax advantage of these arrangements as retirement savings vehicles.
- The final regulation makes it clear that distributions from foreign retirement plans also are excluded from the net investment income tax.
- The final regulation confirms that dividends generated by shares held in an employee stock ownership plan and paid directly to the ESOP participants are treated as tax-qualified plan distributions, and thus are excluded from the net investment income tax.
- Amounts attributable to net unrealized appreciation in employer securities distributed from a tax-qualified retirement plan, when subsequently realized upon the disposition of the shares, also are treated as tax-qualified plan distributions and are excluded from the net investment income tax. In contrast, however, any amounts attributable to appreciation in the employer securities after they are distributed from the tax-qualified plan are subject to the net investment income tax upon disposition of the shares.
- Although tax-qualified retirement plan distributions are not subject to the tax on net investment income, taxable retirement plan distributions increase the employee’s modified adjusted gross income, and thus might cause the employee to exceed the threshold above which the tax applies to net investment income. In contrast, a distribution from a Roth account generally will not increase modified AGI (although conversion of a regular account to a Roth account will increase modified AGI in the year of the conversion).
- As explained above, amounts treated as wages subject to federal income tax withholding generally are excluded from net investment income. Accordingly, amounts realized on the exercise of a nonqualified option or the vesting of restricted stock and treated as wages subject to withholding are not subject to the net investment income tax (although these amounts are subject to the regular Medicare tax shared by the employer and employee and to the 0.9% additional Medicare tax borne solely by the employee). Once the vesting or exercise of the award concludes the compensatory portion of the transaction and transfers the shares to the employee, however, subsequent dividends and additional gain recognized on disposition of the shares are subject to the net investment income tax.
- If an employee makes a section 83(b) election when he receives a grant of restricted stock, any dividends paid or appreciation occurring after the election (and, in the case of appreciation, later recognized on the disposition of the stock) is not treated as wages. Accordingly, a section 83(b) election potentially exposes dividends paid and appreciation occurring between the election date and the vesting date to the 3.8% tax on net investment income, which is borne entirely by the employee. In contrast, without a section 83(b) election, the pre-vesting dividends and appreciation would have been treated as wages, and the employer would have paid a share of the tax (1.45% of the total 3.8%) on the dividends when paid and on the appreciation when the shares vested. (This effect will not necessarily outweigh the tax advantages of a section 83(b) election, but it is a point employees might wish to consider before they make the election.)
- An employee does not recognize income under the regular federal income tax rules (and therefore does not owe the 3.8% tax on net investment income) when the employee exercises an incentive stock option. Presumably the gain on a qualifying disposition of the ISO shares is included in net investment income and is potentially subject to the 3.8% tax.
- It is less clear how a disqualifying disposition of ISO shares is treated for purposes of the tax on net investment income. When an employee makes a disqualifying disposition of ISO shares, the employee recognizes ordinary income equal to the excess of the fair market value of the shares on the exercise date over the exercise price; any remaining appreciation from the date of exercise through the date of disposition is treated as capital gain. The amount treated as ordinary income is excluded from “wages” for FICA purposes, and a special exemption in the statutory option provisions relieves an employer from any obligation to withhold federal income tax on this amount. Even though a disqualifying disposition of ISO shares does not result in federal income tax withholding, however, the ordinary income that an employee recognizes upon a disqualifying disposition of ISO shares is compensation reportable on Form W-2 and deductible by the employer. Because the tax on net investment income generally does not apply to income received as compensation for services, ordinary income recognized on a disqualifying disposition of ISO shares probably is exempt from the 3.8% tax.
Nonqualified Deferred Compensation
- Nonqualified deferred compensation generally is subject to FICA tax (including the regular and additional Medicare taxes) when it vests. After the vesting date, hypothetical interest or other investment returns on the vested balance are not subject to further FICA tax, as long as the returns do not exceed a reasonable interest rate or the rate of return on one or more predetermined actual investments. When the deferred compensation is distributed to the employee, the entire amount (including the post-vesting investment return) is included in income and is subject to income tax withholding. As explained above, wages subject to income tax withholding generally are excluded from the 3.8% tax on net investment income. Accordingly, the hypothetical investment returns credited to a deferred compensation account between the vesting date and the distribution date are excluded from regular FICA tax (as long as they meet the reasonableness standard described above), and all hypothetical investment returns credited to the account (whether reasonable or not) are excluded from the 3.8% tax on net investment income. (The preamble of the regulation proposed in 2012 confirms this conclusion.)
- Although trusts generally are subject to the 3.8% tax on their net investment income, the regulation confirms that the income of grantor trusts (such as “rabbi” trusts established in connection with deferred compensation arrangements) is attributed to the grantor for this purpose, as it is for other federal income tax purposes. Because corporations are not subject to the 3.8% tax, the tax will not apply to the net investment earnings of a rabbi trust with a corporate grantor.
- Trusts that are exempt from tax under section 501 of the Internal Revenue Code also are exempt from the 3.8% tax on net investment income. This exclusion applies, for example, to trusts that hold the assets of tax-qualified retirement plans, and to voluntary employees’ beneficiary associations (“VEBAs”).
- The income of tax-exempt individual trusts and accounts, such as IRAs, health savings accounts, and Archer MSAs, is exempt from the tax on net investment income.
- The summary plan description for a tax-qualified retirement plan usually includes a description of the federal tax consequences of plan distributions. Employers also distribute a notice (called a “section 402(f) notice”) describing the federal tax consequences of eligible rollover distributions. Employers might wish to consider whether it would be appropriate to update any employee communications concerning the tax treatment of retirement plan distributions to address the 3.8% tax on net investment income.
- Employers that deliver a prospectus in connection with stock option, restricted stock, and other equity compensation plans might wish to consider whether to update the tax description in the prospectus to reflect both the 0.9% additional Medicare tax and the 3.8% tax on net investment income.
- The 3.8% tax is included in an individual taxpayer’s estimated tax obligation. High-income employees might need to increase their rate of tax withholding or to pay estimated tax to cover this obligation. In addition, high-income employees that sell employer stock in connection with their year-end tax planning will potentially be subject to the 3.8% tax on any net gain they recognize. Although employers are under no obligation to communicate information to their employees concerning the tax on net investment income (apart from specific disclosure obligations such as those discussed in the two preceding paragraphs), some employers might wish to remind their executives of the 3.8% tax in connection with the executives’ year-end tax planning.