Guest Article

More on Decoding the Fiscal Cliff: The Power of Doing Nothing and Other Ruminations on Opportunities for Cliff Maneuvers Inherent in New Medicare Surtax and AMT Patch

By Alvin D. Lurie
December 21, 2012

Reach of The Tax Collector

This is a country of many taxes, surtaxes, excises, penalties, interest charges, fees, etc. imposed at alll evels of government. At the federal level alone the principal ones are income, payroll, Social Security, Medicare, sales, estate and gift, business, license and luxury imposts. Within many of these target turfs are discrete schemes of taxation reaching into different strata and populations of their respective universes, e.g., capital-gains-earning investors, alternative-minimum-tax candidates, pension distributees, social security recipients, disregarded entities, S-corporations, citizens working abroad, foreign athletes winning purses here, holders of bank funds in foreign tax havens, members of the clergy -- the list goes on and on. Where there is a dollar to be found in people's (figurative) pockets, Congress will find it -- even charges for government doing things its own laws require it to do, like fees to issue agency private rulings or to waive statutory prohibitions, and premiums for guaranteeing pension benefits. These all suck revenue out of respective target areas for deposit into the U.S. Treasury general funds (or into trust funds dedicated to particular governmental programs such as Medicare).

The goal each year is for Congress to pluck the most feathers from the ducks with the least squeals. This invoking of the animal kingdom is not by way of beginning an Aesop's Fable. It is very pertinent to a "Guest Article" by this author posted this past November 29 on BenefitsLink.com. The argument there was that a surprisingly large array of taxes already imposed on the "rich" (the President's term) that become operative in 2013 could be taken into account by the negotiating parties in accommodating Mr. Obama's insistence that, to avert the imminent "fiscal crisis," higher taxes be imposed on top-bracket taxpayers in 2013. The article suggested that approach as one way of overcoming what appears to be the chief stumbling block in the current crisis negotiations. I would now add to that argument that such taxes should be taken into account, not just as a means of mediating the differences between the negotiating parties, but because failing to do so undercuts the implied moral underpinning of the Obama position that one who does not pay a new, stipulated higher rate of federal ordinary income tax is not contributing his fair share to the public fisc, notwithstanding the payment of other new, higher federal taxes equivalently enhancing the fisc.

Survey of Opportunities For Cliff Negotiators

The previous piece cited a number of federal taxes that could satisfy the bill, including ordinary income, alternative minimum, Medicare, estate, gift, the "AMT patch," and certain new levies enacted in the Affordable Care Act. It is the purpose here to expand briefly on two of such alternate sources of tax revenue. One tax in particular introduced in the health care reform legislation is especially well suited to the proposition, a 3.8% tax on net investment income (misleadingly labeled in the law as a "Medicare contribution") that comes into force in 2013 at income levels matching exactly the $250k/$200k figures that have been the battle cry of Obama in the fiscal cliff war of words. That provision readily lends itself to Obama's demonstrating a significant rise in tax liability of high-bracket taxpayers in 2013 as deriving from the signature legislative achievement of his first term, that he can fairly claim as having stemmed from his initiative. At the same time, the Republicans can no longer credibly claim they will repeal the statute; so that segment of 2013 tax revenues is already baked into the cake.

The AMT "patch" also lends itself to being ready-made to contribute in much the same way to resolution of the current fiscal crisis deadlock. The patch is part of a year-end ritual that the Congress must customarily perform year-by-year in order to keep application of the AMT within some semblance of its origination as a means to prevent high-bracket taxpayers from avoiding, or greatly diminishing, their income tax liabilities. Whether or not the 2013 patch is formally part of the current crisis negotiations, it would be a relatively easy thing for the Republicans and Democrats each to claim to have served their bases well by the compromises agreed upon in respect of the patch in settling their differences concerning the fiscal cliff.

Reference should also be made to an early position staked out by Boehner in these negotiations that his side would never agree to raise individual tax rates, because its impact would fall heavily on business owners of corporations who conducted their companies under legitimate means for profits to flow through directly to the individuals, completely by-passing the corporate tax regime. But he did agree to raising the tax revenues from individuals by capping their allowable tax deductions. A ready means of accomplishing that result is at hand, distinct from the operation of the AMT patch, by utilization of section 67 of the Internal Revenue Code. That section imposes a threshold amount only above which the aggregate amount of certain itemized deductions can be claimed on Form 1040 return, i.e. 2 percent of the taxpayer's adjusted gross income. Obviously, the larger the taxpayer's AGI, the greater the lessening of those deductions.

The chief enemy to utilizing any of these tactics is time. Less than two weeks remain until the new year, as this is written -- and, with a Christmas break, fewer working days -- for Congress to do its work for the year. That and the urgent necessity of dealing with fiscal cliff legislation before year-end will almost certainly foreclose actual legislation to effectuate any of the foregoing outcomes. That will require creative documentation by the negotiators, possibly letters of intent outlining the legislation agreed to, rather than actual enactments, with the latter held over until early 2013 following the swearing in of the new Congress.

New 3.8% Medicare Surtax

The caption immediately above this sentence notwithstanding, the new 3.8% surtax is not a Medicare tax. The caption is employed here only to enable the reader to relate what follows under this caption to the 3.8% tax that has received so much notoriety in the trade and financial journals as one of the principal revenue raisers under the Affordable Care Act -- perhaps second only to the penalties imposed on individuals under that Act related to the much publicized "insurance mandate," and the companion levy on employers for failing to provide qualifying health insurance meeting the Act's standards. The fact is that the new 3.8% tax is in every respect a full-fledged income tax, making it especially suited to serving as a surrogate -- as this piece suggests -- for the elevated income tax rates on high-bracket taxpayers that are at the core of what has separated the contestants in the fiscal cliff debates.

One wouldn't know this from reading the statute; and it might be surmised that cloaking it in Medicare garb was not accidental. The provision is found (with difficulty) in the second of the two statutes that together make up what is now collectively called the Affordable Care Act. The major portion of the law is contained in the statute called the Patient Protection and Affordable Care Act. The 3.8% tax is part of the statute called Health Care and Education Reconciliation Act, enacted one week after the Affordable Care Act proper. (This breaking up of the law into its two constituent parts was also not accidental, but that's another story.) The statutory language imposing the tax is included under the Title of the statute called "Coverage, Medicare, Medicaid, And Revenues," under which is a heading, "Unearned Income Medicare Contribution," which brings you to the 3.8% tax. How could one not have concluded that it was a new Medicare tax? In talks at tax institutes and articles in print, that is reasonably how it has been labeled.

The awakening for this author (and I suspect for many other practitioners) occurred with the publication last month of proposed Treasury regulations on the statute, whose heading reads "Net Investment Income Tax." That was a clue, but easily missed if one was conditioned to thinking it was a Medicare tax, and had not yet been required to come to grips with the provision, since it was not to become effective for almost three years after enactment. The first jolt came on the fifth page of the introductory "background" material of the proposed regulation, stating that the tax "is subject to the estimated tax provisions." That was immediately followed by the assertion that it "is not deductible in computing any tax imposed by subtitle A of the Code." But the real shocker came in the next paragraph, that "Amounts collected under section 1411 are not designated for the Medicare Trust Fund." The regulation supports that with a quotation from the Explanation of the law by the Joint Committee on Taxation, that "No provision is made for the transfer of the tax imposed by this provision from the General Fund of the United States Treasury to any Trust Fund."

The same background material calls attention to the income thresholds of adjusted gross income at which the 3.8% tax kicks in for the several categories of individual taxpayers, as well as estates and trusts. For example, for marred joint filers, it is over $250,000. For trusts, it is over the dollar amount at which the highest tax bracket begins. But, in case of individuals, the tax base is net investment income, if less. As noted above, the taxable amount must be included in the quarterly estimated amounts of tax to be reported and paid on the applicable dates for each quarter. The NII tax reads like an income tax, from which it borrows heavily. One significant distinction: the person who owns an interest in a business in which he is "passive" (as determined for income tax purposes) must include the income for NII tax purposes; but the active business owner does not.

There are doubtless many other such disparities that will emerge. But, as a generality, there are sure to be many overlaps that would justify crediting NII tax payments against any elevated rate of income tax that might result from the fiscal cliff negotiations. That is not to be confused with the above-mentioned prohibition against deducting the NII tax against any Subtitle A tax. Subtitle A is the Income tax title of the Internal Revenue Code. That supports the argument of this paper, which is obviously not for crediting the 3.8% tax against one's income tax liability, but rather against any raised rate of tax that might otherwise been imposed under the fiscal cliff settlement. The better way of expressing that is, if the top tax bracket were to rise to 39.6 percent, any federal income tax otherwise payable above the present 35 percent level would be deemed satisfied by any other federal taxes that shall be designated as qualifying for such treatment (for example, the three tax items discussed in this paper).

AMT Patch

As noted, the affixing of a patch to the operation of the AMT for a given year is an annual ritual performed by Congress, typically at the end of the applicable calendar years, rarely even in the following year but retroactive to the preceding year. It has not yet occurred in 2012. The AMT patch for any year is as much a part of the taxes levied in that year by joint action of Congress and the President as any other tax enactments. As a generalization, the difference is that, in enacting a revenue act for any year, the provision remains in force without further action by Congress until Congress amends or repeals it, or for the shorter duration prescribed in the provision. By contrast, with so-called "extenders" -- that is, provisions which only remain in force if Congress specifically extends their life year by year -- the provision dies if not affirmatively extended.

While not yet officially enacted for 2012, it is considered foregone that the 2012 patch will occur, although its specifics are not presently known. According to recent remarks by former IRS Commissioner Schulman (as reported in Politico), IRS has already programmed its computers to include the 2012 patch, on the assumption that Congress will so act, as it has consistently done in the past. (It is noteworthy that the Congressional Budget Office regularly builds its revenue projections on the assumption that Congress will treat "extenders" as it customarily does.) The IRS Acting Commissioner, Steven Miller, has recently spelled out in a letter to the Finance Chairman of the Senate the acute problems for taxpayers and the Service if Congress fails to act on the 2012 patch by the end of this year: IRS letters required to be mailed to tens of millions of taxpayers advising of delays in the tax filing season; and no tax returns filed and no tax refunds received before late March 2013, if even then. The likelihood Congress would break its pattern, letting the 2012 patch actually expire, leaving millions of taxpayers (many in the middle class) caught up in the jaws of a "patchless" AMT, is too farfetched to contemplate.

It is very significant, in the context of this discussion of the potential for using the AMT patch to support elimination of the fiscal crisis, that Congress has not yet acted on the issue of the AMT 2012 patch, because that means that whatever it does in respect of 2012 directly affects the impact of the AMT on high-bracket taxpayers in 2013. Since extension of the patch for 2012 requires an affirmative action by Congress, by default -- that is, inaction -- the patch will die. Its effect will be that Congress will have imposed a tax increase under the AMT for 2012 on those not exempted from the tax, just by virtue of its not having extended the patch. The consequence would then appear to be that nothing Congress subsequently did in respect of the 2013 patch would enable resort to the patch to demonstrate an increase in the tax burden of high-bracket taxpayers in 2013. To again not give patch relief to "rich" taxpayers in 2013 would not satisfy the requisite of showing a greater tax burden on them in 2013 than in 2012, by virtue of the patch.

By contrast, if, as expected, the patch is applied across the board for 2012 (hence including the top-bracket population in 2012), but then disqualifying that group for patch relief in 2013, the required demonstration of a year-over-year higher AMT rate will have satisfied its use in support of the Obama cliff settlement condition insofar as the AMT contributes to satisfying that condition. Of course, the Obama condition would require the ability to forecast during the current cliff negotiations the AMT patch for 2013. Doubtless no formal actions will be taken in respect of the 2013 patch for a year or more. Congress would have a tabula rasa during all that time, and could at any time within 2013 (or, for a limited time, even after) decide whether it will raise taxes under the 2013 AMT simply by doing nothing; or it could fine-tune the AMT for 2013 by confining eligibility for the patch to specified classes of taxpayers, or by jiggering the AMT exemptions for different brackets of taxpayers, or enlarging the list of excluded itemized deductions and other tax preference items, or any combination thereof.

I would think it is theoretically possible to incorporate an outline of AMT changes for 2013 into a memorandum of understanding among the principals negotiating the fiscal cliff package, although realistically there is little time to accomplish that if the cliff negotiations are to be concluded before year-end. However, there is, one would suppose, nothing to prevent the principal negotiators, all of whom will presumably be occupying their same positions in the next Congress, and, of course, the President in the White House, to agree, as part of the cliff settlement package, that they will take up the issue early next year.

The latest signals, as these lines are written, are that the parties have finally gotten serious about getting the job done. In that environment, nothing is impossible.

Copyright 2012, A. D. Lurie

Alvin D. Lurie is a practicing pension attorney. He was appointed as the first person to administer the ERISA program in the IRS National Office in Washington. He is general editor of Bender's Federal Income Taxation of Retirement Plans (LexisNexis), a 2-volume treatise, and he is also editor of the annual compendium of articles published under the title New York University Review of Employee Benefits and Executive Compensation (LexisNexis). Mr. Lurie is the first recipient of the Lifetime Employee Benefits Achievement Award sponsored by the Employee Benefits Committee of the American Bar Association Tax Section. He can be contacted at Alvin D. Lurie, P.C. in Larchmont, New York, at (914) 834-6725 or via email: <allurie@optimum.net>. He is also of counsel to The Wagner Law Group in Boston.

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