Even with the election now behind us, great uncertainty remains about what our taxes will look like in 2013 and how looming tax changes will affect companies and their employees. Between talk about the "fiscal cliff" and budget shortfalls, it is clear that Congress must act to move towards a balanced budget and reduce deficits. With "Taxmageddon" quickly approaching higher taxes for at least some Americans are inevitable in 2013. This article discusses the various potential tax changes and year-end deadlines for employers, as well as what companies can do now to plan and prepare.
Tax Rate Changes
Sunset of Tax Cuts
One major change set to occur at the end of 2012 is the sunset of the Bush tax cuts and the President Obama extension. Unless some form of tax cut extension is negotiated, most tax brackets will see a sizable rate increase. The chart below outlines the current tax rates and the tax rates that will go into effect if no action is taken by Congress.
President Obama has proposed a tax increase only for Americans earning more than $200,000 ($250,000 for married/joint filers). However, the ultimate outcome depends on if and how Congress compromises.
Also, the tax holiday for the employee portion of Social Security is scheduled to expire after December 31, 2012. Unless the tax break is extended, the employee portion of Social Security will revert back to 6.2 percent from 4.2 percent (subject to wage base limit). Capital gains and dividend tax rates are also scheduled to increase. The phase out of personal exemptions and itemized deductions for higher-income taxpayers is also planned for restatement, along with many other tax increases.
New Medicare Taxes
Historically, employees and employers have each paid a flat 1.45 percent Medicare tax on 100 percent of wages and salary income (earned income) and no Medicare tax on unearned income. The Patient Protection and Affordable Care Act (PPACA) included two key Medicare tax provisions that will affect higher-income taxpayers beginning in 2013.
Effective January 1, 2013, the first Medicare tax rate change will increase the employee's portion of Medicare tax by 0.9 percent from 1.45 percent to 2.35 percent for employees with wages and self-employed individuals with earnings in excess of $200,000 ($250,000 for a married/joint filer). Wage and salary earnings up to $200,000 ($250,000 for a married/joint filer) are still taxed at 1.45 percent.
The employer's portion of Medicare tax remains at 1.45 percent for all earned income. While this Medicare tax rate increase affects only the employee's portion of Medicare tax, the employer is responsible for withholding and remitting this additional tax from the employee's wages in excess of $200,000 in a calendar year (ignoring any spousal income). The 2013 Form 941 (Employer's Quarterly Federal Tax Return) will be revised to incorporate this additional tax withholding requirement. If too little or too much tax is actually withheld based on the proper withholding rules, the difference will be settled when the individual files his or her individual tax return.
The chart below summarizes the 2013 Medicare tax rate increase on earned income:
The second Medicare tax rate change is the first Medicare tax ever imposed on unearned income. Effective January 1, 2013, a 3.8 percent Medicare tax will be imposed on net income from interest, dividends, capital gains, annuities, royalties, rents and net gains from the disposition of property. The tax will apply to the lesser of the individual's net investment income (after deductions) or the individual's adjusted gross income in excess of $200,000 ($250,000 for a married/joint filer). The good news is that employers have no withholding or reporting obligation because this Medicare tax increase is imposed on unearned income.
Employer Considerations for the Sunset of Tax Cuts and for New Medicare Taxes:
- Consider accelerating bonuses or other income into 2012 to avoid the potentially higher tax rates. However, be careful not to run afoul of IRC Section 409A. Accelerating income may prove to be difficult with more formulaic plans, including plans designed to be exempt from the Section 162(m) limitation. Also, think about how changing the payment timing might affect the timing of your company's tax deduction.
- Consider specifically whether it makes sense to allow executives to accelerate recognition of defined-benefit-type nonqualified deferred compensation (for example, Supplemental Executive Retirement Plans, or SERPs) into 2012 for purposes of the Federal Insurance Contributions Act (FICA) under the special timing rule to avoid the additional Medicare tax. The acceleration would only affect the FICA taxation of the benefits, and the benefits would continue to be tax deferred with respect to both federal and state income taxes.
- For C corporations, declaring and distributing special dividends to shareholders in 2012 may prove beneficial because the top dividend tax rate is scheduled to increase dramatically in 2013. However, do not forget to think about the impact the special dividends will have on any outstanding employee equity awards. Equity awards will likely need to be modified, bringing about special tax and accounting considerations.
- Be sure your payroll department is prepared and ready to properly withhold on these potential tax increases at year-end. If Congress doesn't act until 2013, you must also be ready to make subsequent changes based on the new law. These potential tax increases will also affect supplemental wage withholding because the supplemental tax rates are tied to the applicable tax brackets. Therefore, payroll departments should also be ready for these changes, especially in light of the fact that many companies pay annual bonuses early in the year.
Form W-2 Reporting for Health Benefits and Other Provisions of PPACA
As part of PPACA, employers that sponsor health plans must now report the aggregate cost of "applicable employer-sponsored coverage" in a new box on the Form W-2 with the Code "DD." With the hopes of increasing awareness about health care coverage costs, this reporting is informational only and does not affect whether health benefits are taxable. These reporting requirements are optional for small employers (with fewer than 250 Form W-2's filed for previous calendar year) until further guidance is released.
"Applicable employer-sponsored coverage" generally means group health plan coverage that is excludable under Section 106 from an employee's gross income. Generally, both the employer-paid and employee-paid portions of health coverage should be reported on the Form W-2. Employers must keep records of coverage on an individual-by-individual basis.
PPACA also added two new sections to the Internal Revenue Code to establish a trust fund, which will fund the Patient-Centered Outcomes Research Institute. The purpose of the Institute is to help the medical community make informed decisions by advancing the relevance and quality of evidence-based medicine. To fund the trust, a fee is applied to fully-insured and self-insured health plans starting with plan years ending on or after October 1, 2012. For plan years ending prior to October 1, 2013, the fee is $1 times the average number of covered lives for the plan year. The fee then increases to $2 times the average number of covered lives for plan years ending prior to October 1, 2014 (indexed thereafter to national health expenditures). As it now stands, this fee stops in 2019.
Although this is considered a fee, it is treated as a tax for tax administration purposes. Companies subject to these rules will need to pay the fees and file a Form 720 (Quarterly Federal Excise Tax Return). Unlike other excise taxes reported quarterly on the Form 720, these fees will only need to be reported annually by July 31 of the calendar year following the last day of the plan year according to the proposed regulations.
Employer Considerations for Other PPACA Provisions:
- Determining the "value" of the health benefits to be reported on the Form W-2 can be complicated. Make sure you are properly determining the value under an acceptable methodology. Otherwise, your company will be noncompliant with the reporting rules.
- Companies have a few options for how to determine "average number of covered lives" for purposes of the Institute fee. The tax department should work with human resources to determine the proper number of covered members in order to correctly remit and report the amounts on Form 720.
- Once again, the payroll department must be ready to implement all of these changes in a timely manner.
Internal Revenue Code Section 409A
It is common in today's business environment to condition severance and other termination-related compensation payments upon an employee executing a release of claims or similar arrangement, like a non-competition agreement. Many arrangements that provide for such releases may be subject to Section 409A, which governs the taxation of nonqualified deferred compensation. Section 409A contains harsh penalties (20 percent excise tax, interest and acceleration of income) for not complying with the complicated requirements. Releases of claims can run afoul of Section 409A if the employees are able to control the year of payment (and therefore the year of taxation) by how fast or slow they execute the releases of claims.
For example, if a company promises to pay severance under a Section 409A agreement within seven days of a terminated employee executing a release of claims after his December 1, 2012, termination date, then this arrangement violates Section 409A because the former employee could execute the release of claims immediately to receive his severance in 2012 or he could delay in order to receive his severance in 2013.
Notice 2010-80 permits eligible companies to tighten up the payment timing related to releases of claims and similar arrangements through December 31, 2012, for arrangements that were in effect on December 31, 2010. As corrective measures, the company could either provide that the payment will be made on a fixed date or provide that any payment that could extend over two years will be made in the second tax year regardless of when the release of claims is executed. Either of these corrective amendments avoids the situation where the employee could exercise control over the tax year of the payment. Employers that amend arrangements under Notice 2010-80 must attach a short information statement describing the correction to their federal income tax return for the year of the amendment. However, the employee does not have the same requirement for his or her personal tax return.
Employer Considerations for Compliance with Section 409A:
- Immediately determine if your company is eligible for the corrective measures under Notice 2010-80 if you have arrangements with non-compliant payment timing provisions.
- If so, start the amendment process now because December 31, 2012, is fast approaching. Usually, your company will need employee consent to change these arrangements and potentially even approval from your board of directors, especially with executive compensation arrangements.
Alvarez & Marsal Taxand Says:
Unless the Mayans were right about the world ending in 2012, tax and payroll departments need to be prepared for a whirlwind of a year-end. With numerous tax increases on the horizon and the potential for last-minute changes, companies must plan for numerous possible outcomes. However, in the midst of planning for change, year-end compliance like Form W-2 reporting and Section 409A corrections cannot be neglected either.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.