Arden Dale for the Wall St Journal writes: A new tax on investment income is raising red flags with some advisers as the tax season begins.
Congress enacted the 3.8% surtax on dividends, interest and other income back in 2010, but didn't make it effective until tax year 2013. Even though advisers have been studying the tax's rules, many still have some questions as they help clients report the tax for the first time.
Retirement income, state and local taxes, and investment advisory- and other expenses are a focus of concern. Tax experts want more direction from the Internal Revenue Service on how to report retirement income and calculate write-offs for state and local taxes and certain expenses that are also subject to the tax.
"It's the first time we have had to make a precise calculation of this tax," said Bill Fleming, managing director in PricewaterhouseCoopers Private Company Services practice, who added that there's "consternation" among accountants over the gray areas.
The general outlines of the tax are straightforward enough. It applies a 3.8% levy to investment income over modified adjusted gross income of $200,000 for individuals ($250,000 for couples). Many advisers spent significant time in 2013 helping clients estimate how much they were likely to owe in the near future, and came up with ways to reduce its effects.
For example, one strategy might involve selling appreciated stock in a year when someone is unemployed, so that capital gains don't put the taxpayer over the $200,000 threshold. Many estates and trusts are subject to the tax, as are capital gains, rental and royalty income, as well as interest.
But the devil is in the details for advisers as they start to work on hard numbers for clients. IRS rules, for instance, stipulate that non-qualified annuity distributions are subject to the tax but qualified pension distributions are not. Both kinds of income are reported on Form 1099-R with only a small notation to distinguish non-qualified annuity distributions.
Mr. Fleming, who is a financial planner and lawyer in Hartford, Conn., has many clients who receive pensions of between $20,000 to $90,000 a year, and a slip in reporting one of the distributions could cost $3,000 or more in unnecessary taxes.
In addition, even the experts could be confused by an IRS publication intended to help taxpayers report their 2013 taxes, he said. The document, Publication 17, says that non-qualified retirement distributions are subject to the 3.8% tax without noting the difference between non-qualified annuity distributions and non-qualified retirement distributions paid to former employees (which are reported on Form W-2 and not subject to the investment tax.)
Mr. Fleming also has clients who, as former mid- to upper-level corporate managers, got non-qualified pensions to supplement their 401(k)s or other qualified pensions. A few get more than $200,000 a year of income from these pensions. Someone in this situation could end up paying $7,000 or more in taxes on a distribution by reporting them as subject to the 3.8% tax, a mistake that could arise from reading the IRS guidance on filing 2013 taxes, he said.
The takeaway, Mr. Fleming pointed out: Taxpayers and their advisers should be very clear about what kind of pension and retirement income they have when handing over documents to an accountant working with Form 8960--which the IRS released last month to report net investment income. The one-page document and its lengthy draft instructions has been prompting questions among advisers and tax experts.
The IRS declined to comment for this article.
State and local income taxes, investment advisory and brokerage fees, and tax preparation and fiduciary fees are other potential problem areas. Taxpayers can deduct a portion of those expenses to offset the 3.8% tax but there's no set formula to do so.
James Guarino, a partner at New Wealth Advisors in Tewksbury, Mass., said IRS rules allow taxpayers to use "any reasonable method" to calculate these deductions. That gives tax advisers opportunities to explore different tax savings strategies for their clients. Mr. Guarino, whose firm manages around $100 million, has been telling clients there may be an initial trial and error period for the first year or so.
Many of financial planner Jim Holtzman's clients will face the question of how to calculate the state and local tax deductions because all of them will owe the 3.8% tax. Mr. Holtzman, who is also a certified public account, doesn't prepare tax returns, but does review them for clients. He said he needs to come up with a method for calculating the deductions, and envisions himself questioning some deductions claimed on client returns.
"I might say something like, 'I would anticipate the write off on state income taxes should be $5,000, not $1,000," said Mr. Holtzman, at Legend Financial Advisors, which manages about $313 million.
Anyone who expects to owe the 3.8% tax will probably have to wait at least until the end of this month to file the Form 8960 along with their other tax documents. That's partly because Form 1099 from brokerage houses--necessary to help calculate a taxpayer's net investment tax--won't come out until then. The wealthy routinely file their taxes on extension, but will still need to pay by April 15 the amount of investment tax they expect to owe.
Reid Schlotterbeck, an accountant who works as part of a wealth advisory team at Truepoint Inc. in Cincinnati, predicted that over time, advisers and the IRS will identify "gray areas" that exist in how to apply the tax.
"We'll see what works and what doesn't, and what modifications need to be made," said Mr. Schlotterbeck, whose firm manages about $1.2 billion.
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