In one of the most anticipated rulings in recent history, the Supreme Court upheld the constitutionality of the Patient Protection and Affordable Care Act (informally referred to as Obamacare).  Most of the public’s attention was focused on the major changes to our health care system resulting from the Act.  However, the Act also brought about a significant change in the tax law which will go into effect on January 1, 2013.  There will be a new tax for taxpayers to grapple with: the 3.8% “health care surtax.”  Additionally, a .9% surtax will apply on single taxpayer wages over $200,000 and joint wages over $250,000.

The new surtax of 3.8% will apply to the lesser of a taxpayer’s “net investment income” or the excess of “modified adjusted gross income” over the allocable threshold amount.  The applicable threshold amount is $200,000 for single taxpayers and $250,000 for joint filers.  Taxpayers with modified adjusted gross income under those thresholds should not be subject to the surtax.  Keep in mind that modified adjusted gross income does not account for any deductions, including itemized deductions.

Investment income, for purposes of the surtax, includes interest, dividends, capital gains, annuities, rents, royalties, and passive activity income.  Investment income does not include wages, active trade or business income, IRA or qualified plan distributions, or self-employment income.   For those business owners who participate in the business’ operations on a daily basis, any pass-through income (such as from a business organized as an LLC or an S corporation) should not be included as investment income for purposes of the surtax.

As an example of the application of the surtax, consider John and Jane Doe, who are the sole owners of Widgetbiz, Inc., an S Corporation.  The Doe’s income in 2013 is $300,000, comprised of:

Widgetbiz, Inc. wages                                    $180,000

Widgetbiz, Inc. income (from K-1)   $  50,000

Dividend income                                $  15,000 (investment income)

Interest income                                   $    5,000 (investment income)

Capital gain income                           $  50,000 (investment income)

Total income                                      $300,000

Because the Doe’s modified adjusted gross income is the same as total income ($300,000), the health care surtax threshold has been exceeded.  Investment income, as noted above, totals $70,000.  The surtax will equal 3.8% of the lesser of:

-        Net investment income ($70,000) or

-        The excess of modified adjusted gross income over the threshold amount ($300,000 - $250,000 = $50,000).

Therefore, the Doe’s will have a Health Care Surtax equal to $1,900 ($50,000 * 3.8%) in 2013.

The additional tax incurred in 2013 as compared with 2012 may not end with the surtax.  The “Bush tax cuts” are currently set to expire on December 31, 2012.  This means that qualified dividends that are taxable at a 15% federal rate in 2012 could be taxed at the highest ordinary income tax rate in 2013 of 39.6%.  Long term capital gain rates are set to increase in 2013 from 15% to 20% without a change in the law.  Keep in mind that these rates do not consider the surtax.  Given the certainty of the surtax and the potential for the elimination of the favorable tax rates found in the Bush tax cuts, advance tax planning is critical.

In our example, the Doe’s should consider accelerating the recognition of the capital gain so that it is taxable in 2012 instead of in 2013.  By doing so, the modified adjusted gross income in 2013 drops to $250,000; at this level of income, the surtax is avoided.  Also, the Doe’s would pay a maximum 15% federal capital gain tax rate as opposed to the potential higher rate in 2013.  The Doe’s should also take a close look at their investment mix – tax-exempt income, for example, is not subject to the surtax.

While business owners and individuals are considering the impact of Obamacare on their health plans, the new Health Care Surtax should also be granted attention.  It’s not too late to determine if action can be taken in 2012 to reduce exposure to the surtax in 2013.  If you’d like to discuss the surtax and its effect on your situation, please contact Deanna Salo or Karen Snodgrass from Cray, Kaiser Ltd. (630-953-4900), a strategic partner with the Chicago Family Business Council.

Deanna Salo CPA                                                       Karen Snodgrass CPA

Cray, Kaiser Ltd.                                                        Cray, Kaiser Ltd.

1901 S. Meyers Road                                                 1901 S. Meyers Road
Suite 230                                                                     Suite 230
Oakbrook Terrace, IL 60181                                      Oakbrook Terrace, IL 60181
Phone: (630) 953-4900 x210                                      Phone: (630) 953-4900 x248
Fax: (630) 953-4905                                                   Fax: (630) 953-4905

Email: dsalo@craykaiser.com                                   Email:  ksnodgrass@craykaiser.com

We are a full-service accounting and business advisory service with three offices in the Chicagoland area. With over 25 professionals on staff serving clients across the Midwest, we have the size to meet your needs and the personal service to exceed your expectations.

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