New Medicare Tax Goes Into Effect January 2013: Year-End Tax Planning For Employers

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Year-End Tax Planning for Employers

The Employee Benefits and Executive Compensation team at Polsinelli Shughart have analyzed the potential implications of the new Medicare Tax to their clients' businesses and can provide direct and practical advice on your company's compensation planning.

A new Medicare tax goes into effect on January 1, and employers should review their deferred compensation arrangements to identify possibilities for tax savings by early payment of taxes in 2012. Additionally, a new Medicare surtax will be applied to all net investment income beginning in 2013. Compensation arrangements should be reviewed to minimize the affect of the new surtax charge.

Background

Enacted as part of the health care reform law, beginning in tax years after 2012, a new additional .9 percent tax applies to FICA wages exceeding the following thresholds:

Filing status

Threshold

Married filing jointly

$250,000

Married filing separately

$125,000

Single, head of household or qualifying widow(er) with dependent child

$200,000

The new tax applies only to employees, not employers, although employers have withholding obligations. The same legislation also subjects unlimited amounts of net investment income that exceeds specified thresholds to a Medicare tax of 3.8 percent. The 3.8 percent Medicare Surtax applies to the lesser of (1) net investment income or (2) the amount by which modified adjusted gross income exceeds the threshold amounts in the chart above.

Tax Strategies

Before December 31, employees and employers should consider tax strategies for reducing the effect of the new Medicare taxes including:

  • Accelerating income to 2012 that would otherwise be subject to the new tax rate in later years
  • Redirecting income to the few types of income exempt from either of the new taxes
  • Deferring for as long as possible income receivable after 2013 and not exempt from the new taxes. There are many possible approaches to minimizing the effect of the new Medicare tax. Highlighted below are some simpler concepts companies may want to consider.

Accelerating compensation income in 2012

Employers and employees may want to consider opportunities to accelerate wages and bonuses so that they are paid in 2012, rather than 2013. Not only will these wages and bonuses escape the additional Medicare tax, but will be subject only to the maximum 35 percent federal income tax versus a possible maximum of 39.65 percent in 2013, depending on Congressional and Presidential action in the coming weeks.

Early inclusion of deferred compensation for FICA

An alternative to early payment of bonuses or other deferred compensation is early payment of FICA. For example, 2012 bonuses which are paid early in 2013 could be electively included in FICA income for 2012 so long as the bonuses are vested, and the bonuses are paid by March 15, 2013 and so long as the elective early inclusion for FICA income relates to all employees covered under the plan.

Early payment of FICA taxes for defined benefit plans

Deferred compensation is not generally subject to Medicare until it is vested and ascertainable. For defined benefit plans, this means that Medicare tax often is not paid until an employee terminates employment, when the total value of the plan benefit is ascertainable. For defined benefit deferred compensation plans that currently have vested and accrued benefits, the employee can electively pay FICA taxes presently for vested, accrued benefits on an estimated basis. If such early elections are made in 2012, the additional Medicare tax can be avoided for amounts accrued and vested this year. Early FICA inclusion will also exempt the future value of that amount from any additional FICA tax, including the additional .9 percent rate applicable to years after 2012.

Early vesting of 457(f) plans

For deferred compensation plans of tax-exempt and governmental employers, subject to Code Section 457, early vesting in 2012 can avoid future increased Medicare tax rate. The general rule is that once an employee is vested in an amount payable under a 457(f) plan, those amounts are subject to full taxation, including income and FICA, even when the employee is not entitled to a distribution. An employer could choose to accelerate vesting of 457(f) amounts (though payment may not be accelerated), to enable the employee to pay 2012 Medicare and income tax rates.

The following chart shows how the new Medicare tax can affect the taxation of employee benefits and executive compensation:

Type of Income

Subject to New Medicare Tax?

 

Earned Income

Unearned Income

Wages

Yes

No

Fringe Benefits subject to FICA

Yes

No

Fringe Benefits not subject to FICA

Yes

No

Deductible employee contributions to qualified plans

Yes

No

Employer contributions to qualified plans

No

No

Roth contributions

Yes

No

Vested nonqualified deferred compensation

Yes

No

Restricted stock –vested or subject to 83(b) election

Yes

No

Stock option exercise

Yes

No

Nonqualified deferred compensation paid

No

No

Tax-exempt income, such as life insurance proceeds, state or municipal bonds veterans’ benefits

No

No

Roth distributions

No

No

Interest, dividends, annuities, rents, royalties

No

Yes

Capital gains (not sale of trades or businesses)*

No

Yes

Limited partnership trade or business income*

No

No

S corporation trade or business income*

No

No

Passive activity, working capital, business of trading in financial instruments income

No

Yes

Controlled foreign corporation, passive foreign investment company, qualified electing funds

No

No

Net self-employment income

Yes

No

* Other than from sale of trades or business, provided that it is not a passive activity or trading in financial instruments

Note that the IRS is drafting proposed regulations on these new Medicare taxes, and that could possibly affect executive and deferred compensation plans and arrangements. Polsinelli Shughart will continue to keep you updated on developments in this area.

For More Information

If you would like to discuss any of the items covered in this e-Alert, or discuss other matters, please contact one of the members of Polsinelli Shughart's Employee Benefits and Executive Compensation group.