I. From Washington
A rainbow of new federal income taxes arrived on January 1, 2014, led by the new 3.8 percent
“Medicare” tax imposed by IRC §1411. Although enacted as part of the health care legislation of President Obama, the new tax will actually augment the General Fund of the Treasury. In practice, the predominant effect of the Medicare tax will be to increase the capital gains tax rate on taxpayers to whom the 39.6 percent ordinary income rate applies, to 23.8 percent from 20 percent. A summary of major changes under the American Taxpayer Relief Act (ATRA):
¶ Marginal rates on taxpayers with over $400,000 of ordinary income ($450,000 for joint filers) will rise to 39.6 percent; marginal rates on other taxpayers will remain unchanged. These thresholds will be adjusted for inflation.
¶ The new 3.8 percent “Medicare”” tax will be imposed on “net investment income” of taxpayers whose AGI exceeds threshold levels.
¶ A new payroll tax of 0.9 percent will be imposed on wages above $200,000 ($250,000 for joint filers).
¶ Capital gains and dividend income will remain taxed at 15 percent for taxpayers not in the 39.6 percent bracket. The rate for taxpayers in the 39.6 percent bracket will rise to 20 percent.
¶ Itemized deductions as well as personal exemptions are phased out for taxpayers whose AGI exceeds certain thresholds.
¶ The Alternative Minimum Tax exemption amount has been increased and is now indexed for inflation.
¶ The gift and estate tax exclusion has been increased to $5 million permanently, and is indexed for inflation. The inflation-adjusted amount for 2014 is $5.34 million. The tax rate on gifts and estates once the lifetime exemption has been absorbed has risen from 35 percent to 40 percent. The concept of “portability,” intended to prevent the loss of one spouse’’s unused exemption, has been made permanent.
The upshot is that high income taxpayers will face significantly higher effective tax rates on earned income as well as investment income. The loss of itemized deductions for high AGI taxpayers will further increase effective federal tax rate by a few percentage points. Taxpayers whose taxable income is between $300,000 and $2 million will incur a state tax 6.85 percent; the rate for those whose taxable income exceeds $2 million is 8.82 percent of that excess. New York City imposes an income tax of between 3.53 percent and 3.876 percent. Mayor de Blasio is currently in disagreement with Governor Cuomo concerning the desire of Mr. de Blasio to increase the top NYC income tax rate to 4.41 percent.
As though it were not already apparent, high income NYC wage earners face a daunting effective federal and NYS income tax rate of 51 percent (39.6 + 6.85 + 3.65 + 0.9) which exceeds that of France (49 percent), Germany (45 percent), Norway (48 percent), and the UK (45 percent) but not that of the Netherlands (52 percent), Finland (53 percent) and Sweden (57 percent). Those taxpayers subject to the New York City Unincorporated Business Tax will pay an additional 4 percent. The UBT is imposed on any individual or unincorporated entity, other than a partnership, that is carrying on or currently liquidating a trade, business, profession, or occupation within New York City. City residents whose net self employment earnings are not more than $100,000 will not incur the tax. The 4 percent UBT is phased in for taxpayers whose self employment income is between $100,000 and $150,000.
The combined federal and state capital gains rate for NYC taxpayers in the 39.6 percent bracket (whose taxable income is not greater than $2 million) is now 34.3 percent (20 + 3.8 + 6.85 + 3.65). New York has what could be considered a ““long arm” residency statute which makes it relatively difficult to maintain ties to New York and still achieve nonresident status for income tax purposes.
A. New Medicare Surtax
Beginning January 1, 2013, a new 3.8 percent Medicare tax is imposed on the lesser of (i) ““net investment income” (gross investment income less allowable deductions) or (ii) the excess of the taxpayer’s AGI over a threshold amount, which is $200,000 for individuals, or $250,000 for joint filers. Thus, if no AGI “excess” exists, no Medicare tax liability will arise. Contrariwise, if AGI excess exists, then the tax will target the lesser of that excess or “net investment income.” (The statute actually references ““modified” AGI, which for the vast majority taxpayers will be identical to AGI.) Taxpayers subject to the Medicare tax include U.S. individual taxpayers (not nonresident aliens), as well as trusts and estates (except grantor trusts). Corporations are not subject to the tax (although S Corporate income will flow through to taxpayers who are subject to the tax). Net investment income includes income from the following sources:
(i) interest, dividends, royalties and rents;
(ii) trade or business activities of the taxpayer in which the taxpayer does not materially participate;
(iii) profits from trading in financial instruments (even if taxpayer materially participates); and
(iv) net gains attributable to the disposition of property that qualifies as a capital asset under IRC §1221, as well as gains from ordinary income that do not so qualify.
NOTE: Taxable gains arising from the taxpayer’s participation in a trade or business in which the taxpayer materially participates or income from rents or royalties arising from a trade or business in which the taxpayer materially participates, do not constitute net investment income (NII) if the income is a “core source” of income from the trade or business in which the taxpayer materially participates. Note also that interest which is deductible, as well as taxes arising from investment income, may reduce NII.
(i) Interest, dividends, royalties and rents. All generally NII. However, tax exempt interest is not NII. Interest, dividends, royalties and rents earned by an entity, such as an LLC or S Corporation in which the taxpayer has an interest will constitute NII, even if the taxpayer materially participates in the business.
Passive loss rules restrict taxpayer deductions arising from rental real estate activities. The regulations under IRC §1411 provide that a “real estate professional” will not be subject to NII provided (i) the IRC §469 passive loss rules are met and (ii) the rental real estate activity constitutes a trade or business of the taxpayer.
(ii) Trade or business activities of the taxpayer in which the taxpayer does not materially participate. IRC §1411 defers to the passive loss rules of IRC §469 for purposes of determining whether the taxpayer has met the material participation test such that the activity is not a passive activity.
(iii) Profits from trading in financial instruments (even if taxpayer materially participates). A “trader” is one who seeks to profit from “short term market swings” and whose trading is “frequent and substantial.” An investor, whose income is not NII, is a person who purchases and sells securities to realize investment income. The management of one’s own investments will not cause the person to become a trader, regardless of the extent of investments. IRC §1411(c)(2)(B); Reg. §1.1411-5(c).
(iv) gains from the sale or exchange of property (except those gains associated with a trade or business in which the taxpayer materially participates.) NII generally includes gains from the sale or exchange of property. However, an exception to this rule applies if the taxpayer materially participates. In addition, gains deferred or excluded under other provisions of the Code are deferred for purposes of IRC §1411 (e.g., like kind exchanges, IRC §121 exclusion, IRC §1033 involuntary conversions, and IRC §453 installment sales).
B. Payroll Tax Increases
Effective January 1, 2013, a new 0.9 percent Additional Medicare tax will be imposed on wages and other compensation in excess of $200,000 ($250,000 for joint filers). Employers are required to withhold the tax, but are not required to match it. Final regulations were issued in November.
C. The Affordable Care Act
The Affordable Care Act became law on January 1, 2014 and requires all taxpayers to obtain health coverage, or incur a penalty. On February 10, the Administration announced modifications to the employer mandate intended to ease the burden on large employers. Thus, companies employing 100 or more workers must now obtain health insurance for only 70 percent of workers by 2015, but by 2106 for 95 percent of workers. Medium sized companies employing between 50 and 99 workers must provide health insurance by 2016, and must certify under penalty of perjury that their payrolls were not reduced to avoid the health insurance mandate required for large companies.
Companies subject to the mandate are required to provide health insurance for employees who work 30 hours or more. Those companies which (i) fail to provide an “affordable premium” comprising no more than 9.5 of an employee’s income and (ii) fail to pay for 60 percent of the premium, will incur a penalty of $2,000 per employee for noncompliance. The penalty increase to $3,000 of an employee not offered coverage purchases a subsidized plan on a federal or state exchange. Small companies, which comprise 96 percent of all businesses, are exempt from the Affordable Care Act employer mandate. The individual mandate, which requires all individuals to obtain minimum essential coverage, was not delayed. However, individuals who experience a short delay in obtaining coverage will not be subject to the penalty. Under IRC §36B, individuals who obtain insurance on an exchange may be entitled to receive a refundable tax credit, depending upon their income.
D. Reinstatement of Phaseout of Itemized Deductions
Beginning in 2013, itemized deductions will again be phased out. Three factors determine the phaseout: First, the “threshold” amount which, for single filers, is $250,000. Second, the percentage limitation, which is 3 percent for all taxpayers, regardless of filing status. Third, the taxpayer’s adjusted gross income (AGI). The reduction in itemized deductions equals three percent of the difference between AGI and the threshold amount. To illustrate, single taxpayer has AGI of $750,000 and $100,000 in itemized deductions. The difference between AGI and the threshold amount is $500,000, three percent of which equals $15,000. The taxpayer’s itemized deductions would be limited to $85,000.
E. Reinstatement of Phaseout of Personal Exemptions
In a manner similar to that which determines the phaseout of itemized deductions, Congress has imposed the same “thresholds” for determining the phaseout of personal exemptions. For single taxpayers, the threshold is $250,000. Again, the difference between the taxpayer’s AGI and the threshold amount is the starting point for determining the phaseout. The taxpayer will forfeit 2 percent of the allowable exemption for every $2,500 of that difference. For example, assume the single taxpayer’s AGI is $250,000. The phaseout will not apply. However, if single taxpayer’s AGI is $450,000, the difference between AGI and the threshold amount is $200,000. Personal exemptions are phased out to the extent of 2 percent of every incremental $2,500 “difference” between AGI and the threshold amount. $200,000 divided by $2,500 equals 80. Therefore, the taxpayer would lose all of his personal exemptions. A difference between AGI and a threshold amount of $125,000 or more will extinguish all of the taxpayer’s personal exemptions (i.e., $2,500 x 50). Note: The $125,000 differential between the threshold amount and AGI is the same regardless of whether the taxpayer is a single filer, files jointly, or files separately. The threshold amounts are higher for married filers.
F. Alternative Minimum Tax
The AMT exemption amounts have been increased beginning in 2013, and are now indexed for inflation.
G. Estate & Gift Taxes
The feature of “portability” has become permanent. Gift and estate taxes are again unified. The lifetime exemption amount in 2013 is $5.25 million, and for 2014 is $5.34 million. The exemption is now indexed for inflation. The rate of tax once the lifetime exemption has been exhausted (either during life or at death) has been increased from 35 to 40 percent.
II. From Albany
Governor Cuomo, facing reelection this November, and apparently with ambitions for higher office, recently unveiled his proposed $137 billion budget for the 2015 fiscal year starting April 1. Mr. Cuomo maintains that under his administration, New York has gone from an $8 billion deficit to a $2 billion surplus. Mr. Cuomo is currently enjoying a resurgence in popularity; his approval rating stands at 54 percent, with two-thirds of those polled viewing him favorably, and 57 percent inclined to re-elect him. While most residents favor the legalization of marijuana, they disagree with the method which Mr. Cuomo has chosen to accomplish that objective. Governor Cuomo has attempted to begin legalization through quasi- administrative fiat. Most New Yorkers polled prefer a state referendum, which is the procedure used in other states that have legalized marijuana. New York’s higher personal tax rate was extended for three years, from 2015 through 2017. The highest rate imposed on individuals, now 8.87 percent, had been slated to revert to 6.85 percent.
Budget Proposals of Governor Cuomo
Mr. Cuomo’s budget divides the state into two regions: “upstate” and the rest of the New York. Upstate comprises all of New York except Long Island, New York City, Westchester, Rockland, Orange, Putnam, and Dutchess counties. Most if not all tax incentives intended to benefit businesses target only upstate, thereby excluding the city and above-referenced regions. Proposals intended to help individual taxpayers are less skewed: Citing property taxes that are among the highest in the U.S., Mr. Cuomo proposed “freezing” real property taxes for two years, thus providing $1 billion in tax relief. An important proviso to this relief is that local governments must reign in tax increases as well. Citing the 3.3 million persons who rent their homes, Mr. Cuomo proposed a refundable tax credit available to renters whose incomes are below $100,000. This measure would, according to the Governor, provide more than $400 million in tax relief to the 2.6 million taxpayers who rent homes.
To discourage older residents from retiring in Florida and elsewhere, Mr. Cuomo proposed phasing out the estate tax over six years, with the eventual aim of reconciling the state exemption with the federal exemption by 2019. The maximum rate of estate tax would also be reduced to 10 percent within four years. Although not mentioned by the Governor in his January 8 State of the State Address, rumors have surfaced of an effort to reinstate the New York gift tax. Since New York has an estate tax with an exemption of only $1 million, wealthy New York residents may reduce potential New York estate tax liability by making large gifts. This change would impede this strategy.
Mr. Cuomo also proposed reducing the corporate tax rate to 6.5 percent, which would be the lowest such rate since 1968. The proposal would also provide a refundable tax credit to upstate businesses equal to 20 percent of a company’s annual property taxes, and would eliminate corporate income tax entirely for upstate manufacturers. Mr. Cuomo believes these measures would provide $346 million in annual tax relief. The cost of these tax incentives, including estate tax relief, would be significant: Revenues would decline by $381 million in fiscal year 2016, by $627 million in fiscal year 2017, and by $772 million in fiscal year 2018. The hope of Mr. Cuomo is that these short-term revenue losses would be offset by increased revenues from attracting capital into the State and retaining the wealth of affluent taxpayers who would otherwise depart.
New York is also expected to benefit from Washington’s largesse, courtesy of higher federal taxes. Medicaid revenues are expected to increase by 4.6 percent to $58.2 billion; and federal aid to schools is expected to increase by 3.8 percent to $21.9 billion. Mr. Cuomo is apparently in disagreement with Mayor Bill de Blasio concerning who will pay the $1.5 billion needed to provide statewide prekindergarten programs and to expand after school programs. While Mr. Cuomo would like New York to provide funding, Mr. DeBlasio would like the funds to be provided by a new income tax imposed on wealthy New York City residents.
New Laws as of January 1, 2014
The following new laws took effect in New York on January 1, 2014:
¶ Small businesses will benefit this year from tax reductions totaling $35 million.
¶ The New York State corporate tax imposed on manufacturers will be reduced by 10 percent, providing about 13,000 manufacturing companies with $30 million in tax relief.
¶ Under the “Family Tax Relief” program, a state Republican initiative, families with at least one dependent whose household income is between $40,000 and $300,000 will receive $350 in tax relief.
¶ The “Start-up NY Economic Development Program” will create tax-free areas near state universities and colleges. Businesses relocating to these area will be exempt from virtually all corporate, income, sales, use and property taxes for 10 years (provided their businesses do not compete with existing businesses in these areas).
¶ New York’s minimum wage has been increased to $8 from $7.25.
Tax Losses From Nonresident Trusts
Former Comptroller Carl McCall, heading a state tax commission, has proposed to limit the tax losses New York is incurring by wealthy residents using out of state nongrantor trusts. Trusts established jurisdictions which permit “self-settled” trusts have been used principally for asset protection proposes. Although the degree of asset protection these trusts provide is debatable, because of the IRS ruling which permits the use of nongrantor trusts in tax-free jurisdictions, New York is losing an estimated $150 million per year in tax revenues. Such trusts, most commonly formed in Delaware, Nevada or South Dakota, are attractive since Nevada imposes no personal income tax, and Delaware imposes no income tax on out of state beneficiaries. It is possible, because of a fairly recent IRS ruling, for a New York resident to establish trusts in those jurisdictions and thereby avoid New York income tax. Thus, if the assets of a business generate no New York source income, if all of the corpus of the trust is outside of New York, and if no trustees reside in New York, the trust, even though settled by a New York resident, will not be subject to New York income tax. Legislation by New York limiting the use of such trusts would most likely be challenged — perhaps successfully — under the Full Faith and Credit clause of the Constitution.