Increased Tax Rates and the Net Investment Income Tax – A Galactic Collision of Forces
Researchers predict that the Andromeda Galaxy will collide with our very own Milky Way Galaxy in approximately four Billion years. When that happens, life on Earth will be eliminated for certain. “So what”, you say with a smile. Well, time sneaks up on all of us and as 2013 becomes only a memory, investment managers and investors will face a tax collision of galactic proportions on their 2013 income tax returns.
Last year at this time we were all warned that we would begin to feel the full weight of Obamacare and a budget that is simply out of control. Now as investment managers and investors face the prospect of paying income tax balances due for 2013 and estimated tax payments for 2014, the increased tax burdens will become a reality. A simple analysis of what has happened to upper middle income taxpayers should bring that reality into focus. The analysis illustrates the effects of the 2013 increase in federal income and employment taxes on married taxpayers filing joint returns with the same income and itemized deductions for 2012 and 2013.
In the first illustration, the married taxpayers are assumed to have $600,000 of income comprised of wages in the amount of $200,000, qualified dividends in the amount of $100,000 and long-term capital gains in the amount of $300,000.
In the second illustration, the married taxpayers are assumed to have $1,000,000 of income comprised of wages in the amount of $600,000, qualified dividends in the amount of $100,000 and long-term capital gains in the amount of $300,000.
In the third illustration, the married taxpayers are assumed to have $600,000 of income comprised only of wages.
In the fourth illustration, the married taxpayers are assumed to have $1,000,000 of income comprised only of wages.
|Case 1: MFJ w/ $600,000 in income||Case 2: MFJ w/ $1,000,000 in income||Case 3: MFJ w/ $600,000 in income||Case 4: MFJ w/ $1,000,00 in income|
|Long Term Capital Gain||300,000||300,000||300,000||300,000||–||–||–||–|
|Adjusted Gross Income||600,000||600,000||1,000,000||1,000,000||600,000||600,000||1,000,000||1,000,000|
|State and Local Income Taxes||60,000||60,000||100,000||100,000||60,000||60,000||100,000||100,000|
|Mortgage Interest Expense||20,000||20,000||20,000||20,000||20,000||20,000||20,000||20,000|
|AGI Floor Limitation||–||(9,000)||–||(21,000)||–||(9,000)||–||(21,000)|
|Total Itemized Deductions||105,000||96,000||145,000||124,000||105,000||96,000||145,000||124,000|
|Alternative Capital Gain Tax||75,816||80,558||188,390||216,142||–||–||–||–|
|Net Alternative Minimum Tax||31,084||28,952||30,510||22,668||19,170||11,580||5,170||–|
|High Income Hospital Insurance Tax||–||–||–||3,150||–||3,150||–||6,750|
|Medicare Investment Income Tax||–||13,300||–||13,900||–||–||–||–|
|Total Tax Due||106,900||122,810||218,900||255,860||158,900||161,960||270,900||301,292|
|Increase in Federal Income Tax from 2012 to 2013||15,910||36,960||3,060||30,392|
|Percentage Increase from 2012 to 2013||14.88%||16.88%||1.93%||11.22%|
As you can see, both married couples with investment income are paying significantly more federal income tax in 2013 on the same amount of income. The illustration does assume that the taxpayers somehow during their lifetime were able to build a fairly significant investment portfolio, perhaps through gifts from parents, an inheritance, previously exercised stock options, or just some very astute investing over many years.
However, the married taxpayers with $600,000 of wages and no investment income are paying only a small amount of additional federal income tax in 2013, but far more in federal income taxes than the taxpayers with $600,000 comprised of wages in the amount of $200,000, qualified dividends in the amount of $100,000 and long-term capital gains in the amount of $300,000.
Finally, the married taxpayers with $1,000,000 of wages and no investment income are paying significantly more federal income tax in 2013 on the same amount of income and they are also paying significantly more in federal income tax than the taxpayers with $1,000,000 of income comprised of wages in the amount of $600,000, qualified dividends in the amount of $100,000 and long-term capital gains in the amount of $300,000.
The moral from these illustrations? Maybe we should not work as hard as we do and hope we have rich parents who will bequeath to us a significant investment portfolio. And maybe those rich kids with the significant investment portfolio should not bellyache about the amount of additional taxes they are paying. Is all of this fair? It depends on where you sit. But one thing is certain; the seat was a lot more comfortable for most taxpayers in 2012.
Increases in the highest federal income tax rates for ordinary income from 35% to 39.6% and increases in the federal income tax rates on net long-term capital gains from 15% to 20% have a lot to do with the additional tax imposed on investment managers and investors. However, the greatest impact may come from the new 3.8% percent tax on unearned income to fund Medicare. This new tax, part of the Obamacare legislation, is dubbed the “net investment income tax”.
The net investment income (“NII”) tax will likely have the greatest long-term impact on investment managers and investors since it does not discriminate in favor of any type of passive income. Dividends, interest, short-term capital gains, long-term capital gains and even a non-materially participating limited partner’s share of partnership profits from a bona fide trade or business activity are subject to the tax. The Internal Revenue Service recently issued final regulations for NII tax. These regulations resolve a number of concerns expressed by tax practitioners and perhaps create a few more.
One very interesting loophole exempting certain limited partnership income from both the self-employment tax and the NII tax remains intact. If a limited partner materially participates in the business activities of the limited partnership, the limited partner’s share of partnership income is excluded from both the self-employment tax and the NII tax. Only a limited partner’s guaranteed payments for services rendered to the limited partnership are subject to self-employment tax. Thus, as if almost by design, the NII tax statute fails to close the glaring loophole that has permitted materially participating limited partners the ability to avoid self-employment tax for many years on their share of partnership profits. Investment managers should think carefully about the benefits of this loophole and if their management companies are organized as limited liability companies they should consider the prudence of restructuring their management companies as limited partnerships. The applicability of this seemingly timeless loophole to limited liability companies is now even more suspect than it was before.
The proposed regulations did not permit losses to offset gains for traders since gains and losses were computed separately and losses could never be less than zero. The final regulations make it clear that both traders and investors in securities will be able to net gains against losses in computing NII. Thus, it was possible for a trader to have an NII tax attributable to gains even though losses exceeded the gains. The final regulations provide that a trader making a mark-to-market election may offset mark-to-market losses against other categories of NII. Thus, the mark-to-market election provides yet one more benefit to investors in a trader fund that has not fared well.
One curious result under the proposed regulations for the NII tax has been confirmed in the final regulations. The deductions allocable to a materially participating partner in a trader fund are first applied against other self-employment income of that partner and any deductions in excess of self-employment income can then be applied against NII for that partner. This regulation may not be consistent with the self-employment statute which seems to indicate that in computing net earnings from self-employment only deductions attributable to the income that is includable in computing in net earnings should be taken into account. The obvious impact of this regulation is an overall increase in federal income tax since a deduction against net earnings reduces the self-employment tax, which is 50% deductible by a taxpayer. There is no similar deduction for the NII tax. On the other hand, these deductions could prove to be valuable for an investment manager who has had a bad year. Assuming the investment manager’s NII is below the threshold for taxation ($250,000 for taxpayers filing joint returns), the investment manager will at least be able to use the deduction to reduce self-employment tax that is attributable to management fee income without any other adverse effect.
The final regulations for the NII tax also provide guidance for a number of other transactions affecting investment managers and traders. Draft instructions for completing the new Form 8960, Net Investment Income Tax – Individuals Estates and Trusts were only first issued on January 6, 2014. Complications are sure to arise when tax preparers compute this tax for the first time.
2013 was a very good year for many hedge fund managers. The illustrations above are only the tip of the iceberg for 2013’s most successful investment managers and investors and their tax collision may be far worse. Higher federal income tax rates and the net investment income tax will probably be with us for a very long time. They may not survive the collision of the Andromeda Galaxy with the Milky Way, but neither will we! Until then, we must continue to navigate around the many tax meteors that Congress throws our way.