January 31, 2014
By: Andrew Aldridge Tax Director, US Tax & Financial Services
When Congress passed President Obama’s healthcare reform, also known as the Affordable Care Act, which guaranteed a minimum amount of health coverage for all Americans, it was received with mixed reviews. For those living overseas such as the United Kingdom, who have access to the National Health Service (NHS), it seemed an obvious step in the right direction. For others, it raised more questions as to how this medical coverage would be funded and how it would be implemented in a real world scenario amid the long standing US health insurance practices we had all been accustomed.
One of the ways this coverage will be funded is through a 3.8% Medicare tax which specifically targets individuals, estates and trusts through a surtax on net investment income (NII).
When does this surtax kick in?
This tax kicks in when your Modified Adjusted Gross Income (MAGI) reaches $200K, $250K if Married Filing Joint (MFJ) and $125K if Married Filing Separately (MFS) and if you have “net investment income”. Modified AGI means that those who are claiming the foreign earned income exclusion/ foreign housing deduction under Section 911 will have to add this back for purposes of calculating MAGI.
What is included in “net investment income”?
NII includes gross income from interest, dividends, royalties, rents and capital gains less the appropriate deductions attributable to such income. It will also include the gain from the sale of your home less the $250K exclusion ($500K if MFJ). NII will also include income from a foreign pension which will be discussed below.
I pay tax in my country of residence on all my investment income. Can’t I just take a foreign tax credit on my US return?
Probably not. You can take a foreign tax credit for taxes defined under Section 1 of the Internal Revenue Code. However, the NII tax falls under Section 1411 which is not eligible for the foreign tax credits. Whether this was intentional is unknown. A number of commentators acknowledge this problem but “suggest” that an argument can be made under some Income Tax Treaties that a foreign tax credit could be available. But even the most aggressive commentators note that their arguments are tenuous.
What did Congress intend? As there is no discussion of foreign tax credits in any of the background material, it is probable that Congress just did not consider the matter. We will just have to wait and see whether the IRS or Congress address this matter at some point in the future.
However, in recent conversations with the IRS by various interest groups it is clear that the IRS is aware of the problem and does not intend to propose any changes.
What does this mean for my 2013 tax return? Can you give me an example?
For those of you living overseas who have traditionally not owed any income tax on your returns, you may find yourselves with a tax bill in 2014 even though you have paid all applicable taxes in your country of residence.
An even greater number of people will be subject to this surtax although it has been commonly grouped with taxes which will affect “higher income taxpayers” (i.e., those falling within the 39.6% bracket on ordinary income and 20% on qualified dividends/capital gains).
If you are married to a non-American spouse and have been filing separately, your threshold will kick in sooner than the rest at $125K (see example below).
Patty is married to a British citizen and files MFS on her US returns. She had the following income in 2013:
She also had a rental property which generated $18,000 of rent and $12,000 of expenses for a net income of $6,000.
The 3.8% surtax will apply to the lower of:
• Her net investment income of $7250. ($500 of interest plus $750 of dividends plus $6k of rental income), or
• The excess of her MAGI ($150K) over the threshold amount of $125K which equals $25K.
Her Medicare surtax for 2013 will be $275.50 (3.8% of $7250).
Jim is single and earned $175,000 in 2013. He also received a bonus of $50,000. He has no other income. He is claiming the Foreign Earned Income Exclusion (FEIE).
Wages plus bonus: $225,000
Less FEIE: ($97,600)
Adjusted Gross Income: $127,400
In this scenario, Jim’s MAGI is $225,000. His FEI exclusion was added back for the calculation. Although he is above the $200K threshold, he will not be subject to the NII surtax as he has no investment income.
What about for high net worth taxpayers who fall into the 39.6% tax bracket? What level of tax could I be paying?
For those taxpayers in the highest bracket, your combined tax rates on long term capital gains and qualified dividends could be 23.8% and 43.4% on ordinary income and short term gains.
Is there anything I can do before the end of the year to avoid this tax?
If possible, try to keep your income below the NII thresholds ($200K/$250K/$125K) by spreading it over a number of years.
Analyze all net investment income for exposure to NII surtax. Recognizing loss producing assets could reduce the gains that would be subject to the surtax.
You could also consider investing in US tax exempt bonds, life insurance and tax deferred annuity products. (We do not give investment advice, please consult with an investment advisor.) Also, please consider the impact of these investments in your country of residence. What is tax efficient in the US may not be tax efficient in your country of residence.
Is there anything else I need to consider?
Another aspect that will be affected by the NII tax of which you may not have been aware is income from a foreign pension.
Foreign pension plans are not US qualified plans and therefore any income or gains in the plan during the tax year are included in taxable income.
There is an option to treat the pension similar to a US qualified pension under many of the US income tax treaties and therefore enjoy the deferral of tax until distribution. As the income from a pension will be considered net investment income, it will be subject to the surcharge from 2013 if you fall above the threshold. The looming question is whether the treaty will provide protection from this treatment. As with the issue of foreign tax credits, some commentators are arguing that there may be relief under the various income tax treaties currently in force. Whether this is ultimately the case, we will have to wait and see how the IRS will respond. In any event, this will add yet another layer of complexity (and cost) in determining your tax exposure for 2013. Furthermore, it may find you owing tax for the first time.
It will be important to determine if there will, indeed, be a liability as payments will need to be made by April 15th, 2014 to avoid any additional penalties and interest. For those who file after April, it may make sense to file sooner in 2014 rather than extending, in case this tax will apply to you.
As each tax situation is unique, please contact us to discuss your particular facts and circumstances.
About the author: Andrew Aldridge is an Estates and Trusts Tax Director out of the London office of US Tax and Financial Services. He specializes in Individuals, Trusts, Expatriation, Estate/Gift. He is an LL.M, attorney with 35 years’ experience including 17 years tax counsel for a Fortune 50 Company; 3 years Head of Tax US-based finance company; 13 years with US Tax & Financial Services.