The 2013 tax year is coming to a close, but business owners, most of whom pay taxes on business profits on their personal returns, may be unaware of some new tax laws that can increase their tax bill for this year.
Make sure you aren’t caught off guard and have the new tax laws into account when figuring income tax withholding (if you and/or your spouse receive wages) and estimated taxes so you won’t be penalized.
Familiarize Yourself With The New Tax Laws
1. Additional Medicare Tax on Earnings
If your earned income is high enough, you’ll pay an additional 0.9% Medicare tax. This is on top of the Medicare tax paid as part of FICA or self-employment tax.
The tax applies to earned income over a threshold amount (modified adjusted gross income of $250,000 for joint filers; $200,000 for singles). Thus, if you take a salary of $100,000 from your S corporation, you won’t pay this tax.
But if you have a sole proprietorship that shows a profit over your threshold amount, you’ll pay 0.9% on the excess (e.g., if you’re single and your profit is $225,000, you’ll pay $225 [0.9% of $25,000]).
There is no employer matching for this tax. Self-employed people pay a single 0.9% tax; it’s not doubled as in the case of self-employment tax.
2. Additional Medicare Tax on Net Investment Income
Investment income minus investment-related expenses may be subject to a 3.8% additional Medicare tax, the first time that Medicare tax has been applied to anything other than earned income. This is called the net investment income (NII) tax and it applies to the lesser of net investment income or modified adjusted gross income (MAGI) over a threshold amount for your filing status. The same threshold amounts for the additional Medicare tax on earnings applies to the NII tax.
When it comes to business income, if you materially participate in your company’s activities, then distributions aren’t treated as investment income. But if you’re a mere investor, distributions may be subject to this tax. Whether the tax applies to gains on the sale of a business depend on how the business is organized and your participation in it.
3. Phase-Out of Personal Exemptions
There is a personal exemption phase-out (called the PEP limitation) that can cause you to lose some or all of the exemptions for you and your dependents. Personal exemptions are phased-out by two percentage points for each $2,500 ($1,250 for married persons filing separately) that your adjusted gross income (AGI) exceeds a threshold amount.
The threshold amount varies according to your filing status. Say in 2013, you and your spouse have two dependents. Ordinarily you’d deduct $15,600 ($3,900 x 4). But if your AGI is high enough, you lose this write-off entirely.
4. Reduction in Itemized Deductions
Called the Pease limitation after the Congressman who initially created the rule years ago, it means you can lose up to 80% of your itemized deductions if your AGI is high income. The limitation means that your itemized deductions are reduced 3% of the amount by which your AGI exceeds the same threshold used for the PEP limitation.
The only break: medical expenses, investment interest, casualty and theft losses, and wagering losses are not subject to this limitation. But your deductible taxes, other interest, miscellaneous deductions, and charitable contributions may be reduced.
5. Higher Tax Rate
For more than a decade, the top tax rate on individuals has been fixed at 35%. What’s more, you paid no more than 15% on long-term capital gains and qualifying dividends. For 2013 and beyond, that has changed.
The top rate is 39.6% once your taxable income exceeds a threshold amount that varies with your filing status. Sure, the threshold is high, but a great business year can put you over it and trigger the high rate on ordinary income as well as on long-term capital gains and qualified dividends.
What To Do About The New Tax Laws
Meet with your tax advisor to review your tax picture and find out which of these new tax laws, if any, applies to you.
Then explore strategies you can use to minimize or avoid the new tax laws and keep your tax bill as low as possible.
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