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Closely Held Business Issues:

Recent legislation has brought change for closely held businesses and their owners. Increases to the Medicare tax, the new tax on net investment income, and compliance with healthcare reform are all issues that are new in 2013. Following is a summary of some of the many changes that go into effect this year. Please contact us if we can help you in understanding how these changes will impact you for 2013 and beyond.

Major Changes:

3.8% Medicare Contribution Tax: Taking effect on January 1, 2013 the Medicare surtax is imposed on a taxpayer’s “net investment income” (NII). However, the Medicare surtax does not apply to income derived from an active trade or business, or from the sale of property used in an active trade or business. The Medicare surtax is based on the lesser of the taxpayer’s NII or the amount of “modified” adjusted gross income (MAGI) (AGI with foreign income added back) above a specified threshold. The MAGI thresholds and the components of NII are detailed in the 12/13/12 Closely Held Business posting.

Additional 0.9% Medicare Tax on Earned Income: Effective January 1, 2103, higher income individuals are subject to an additional 0.9% Medicare tax. The additional Medicare tax means that the portion of wages and self-employment income received in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately) is subject to a 2.35% Medicare tax rate. The additional Medicare tax is imposed on individuals and does not apply to corporations, estates, or trusts.

Proposition 30 Rate Increases: The passage of Proposition 30, which is aimed primarily at funding education, will have tax implications for the following:

  • California composite returns: Tax imposed on nonresident individuals participating in composite returns filed by corporations and pass-through entities is imposed at the highest marginal tax rate, which is now 12.3% for the 2012—2018 tax years.
  • Sale of real property: Withholding on the sale of California real property can now be calculated based on the reportable gain from the sale rather than on a percentage of the total sales price. The applicable withholding rate is the highest marginal tax rate of 12.3%.

Updates on Limitations:

Bonus Depreciation (Extended): Bonus depreciation is 50% for 2013. Bonus depreciation is for new capital assets only, with a recovery period of 20 years or less.

  • California: No bonus depreciation.

Section 179 Deduction (Extended): The deduction limitation is $500,000 for 2013. These deductions are phased-out if property is purchased in excess of $2,000,000. Section 179 is for newly purchased new or used capital assets.

  • California: Deduction is limited to $25,000 and is phased-out for property purchases in excess of $200,000.

Retirement Contributions: Below are the limitations for retiremment plans:

  • Traditional and Roth IRA maximum contribution (due April 15, 2014)
    $5,500 with $1,000 catch-up for 50+ years (not to exceed taxable income, subject to AGI limitations)
  • SEP IRA maximum contribution (due by extended due date)
    Lower of $51,000 or 25% of employee’s salary
  • Simple IRA maximum contribution (due by extended due date)
    $12,000 with $2,500 catch-up for 50+ years
  • 401(k) maximum contribution (due by extended due date)
    $17,500 with $5,500 catch-up for 50+ years

Other Planning Ideas:

  • Business owners might consider setting up their business entity as an S-Corp, rather than as a partnership, so that the entity’s income allocable to owners is not treated as earned income.
    • If an entity is operating as a partnership, LLC, or single member LLC, the owners could convert it to an S-Corp when the tax first takes effect. (If the shareholder materially participates in the business, income from an S corporation is also not subject to the 3.8 percent Medicare contribution tax on investment income, which also starts to apply in 2013.)
    • Another consideration would be to move an S-Corp to a C-Corp if you have many passive shareholders to avoid the Medicare tax.
    • If business owners activtely participate in the management or provide services to a S-Corp they must take “reasonable compensation” for services rendered. Determing “reasonable compensation” is a facts and circumstances determination based on the services performed, the owner’s training and expereience, among other factors.
      • While the income passed through the S-Corp is not considered earned income, the compensation for services performed for the S-Corp is considered earned income.
  • Extended Business tax incentives:
    • Research tax credit
    • Work opportunity tax credit
    • 15-year recovery period for leasehold, restaurant & retail improvement property
      • California: 39-year recovery period
  • Small employer health insurance credit (Updated):
    • Employers with 25 or fewer full-time employees paying average annual wages of not more than $25,000 may be eligible for a maximum tax credit of 35 percent on health insurance premiums paid
    • A full-time employee is defined as 32 hours or more per week.
    • Applicable for tax years beginning in 2010 through 2013
    • Reporting of employer sponsored healthcare coverage on W-2 (Updated)
    • Mandatory starting in 2012
    • Starting in 2014 all small businesses with more than 50 full-time employees will be subject to a $100 per day per employee penalty for not offering health insurance
    • $2,500 minimum tax if there are one or more penalties not corrected by the date a notice of examination is sent.

California Tax Credits

New Jobs Credit: Nonrefundable credit for qualified small business hiring new qualified full time employees.

  • Qualified Small Business: no more than 20 employees on the last day of the prior tax year.
  • $3,300 for each net increase in qualified full-time employees hired during the tax year.

Enterprise Zone Credit:

  • Credit for hiring a qualified employee in a designated Enterprise Zone.
  • Credit amount: 50% of qualified wages (cannot exceed 150% of the minimum wage) paid to a qualified employee in the employee’s first year of employment and 40%, 30%, 20% and 10% of qualified wages in the second through fifth years, respectively.
  • Qualified Employee:
    • Hired after area designated an enterprise zone.
    • At least 90% of the employee’s services in an enterprise zone related to the conduct of the taxpayer’s trade or business.
    • At lease 50% of the employee’s services are performed in an enterprise zone.
    • Employee meets the criteria of certain targeted groups.

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