The United States Congress and the North Carolina General Assembly have been busy over the past couple of years implementing significant tax reform for individual and corporate taxpayers. Understanding the impact of these various tax reforms is essential for individual and corporate taxpayers to properly budget their personal finances and potentially implement some tax planning strategies.
Federal Tax Reform
As part of the Patient Protection and Affordable Care Act ("Affordable Care Act"), which became effective on January 1, 2013, there were several items of federal tax reform. In particular, the Affordable Care Act created the federal net investment income tax ("NII Tax") and an additional Medicare tax as discussed below.
Net Investment Income Tax
The NII Tax is a new tax of 3.8% that applies to income generated from certain investment activities. However, the NII Tax applies only when a taxpayer has both "net investment income" and a modified adjusted gross income that exceeds a set threshold.
In particular, the NII Tax is imposed on the lower of:
- A taxpayer's modified adjusted gross income in excess of $200,000 for a taxpayer filing single and $250,000 for taxpayers filing jointly; or,
- The taxpayer's "net investment income."
"Net investment income" is income derived from one of the following three categories:
- Traditional portfolio income such as royalties, interest, and dividends;
- Income received from businesses in which the taxpayer does not materially participate; and,
- Capital gains realized in connection with the disposition of either traditional portfolio investments or a passive asset.
Therefore, if either you do not have net investment income or your modified gross income is less than the applicable threshold described above, then you are not subject to the NII Tax. When you are trying to determine whether the NII Tax applies to you, you should consider the following items:
- Have you materially participated in the investment activity?
- Material participation is an important, yet complex, test that assists in determining whether a particular business activity is a passive activity or a non-passive activity.
- If you can satisfy the material participation test, then any income you derived from the activity would not be considered to be net investment income and, therefore, will not be subject to the NII Tax.
- Can you group any of the investment activities together?
- Grouping of activities is another important concept that allows you to group certain activities together and then aggregate your participation in such activities to make it easier to meet the material participation rules and thereby make all of the grouped activities non-passive activities.
- However, for those activities that were not grouped together back in 2013, you will generally have to obtain consent from the IRS to re-group the activities.
Given the complexity of the NII Tax, you should consult with your tax attorney and accountant to discuss the potential tax consequences of an investment activity and any relevant tax planning strategies.
Additional Medicare Tax
The additional Medicare tax is a new tax of 0.9% that applies to any wages, compensation, and self-employment income of an individual taxpayer over certain thresholds. In particular, for tax years 2014 and beyond, you, as an individual taxpayer, are liable for an additional Medicare tax if:
- Your filing status is single and you have a modified adjusted gross income in excess of $200,000; or,
- You and your spouse, filing jointly, have a modified adjusted gross income in excess of $250,000.
Your employer must withhold the additional Medicare tax from your wages or compensation in excess of $200,000 in a given calendar year, regardless of your filing status or the wages paid to you by another employer. In addition, you may owe more than the amount withheld by your employer, depending on your filing status, wages, compensation, and self-employment income.
North Carolina State Tax Reform
In 2013, Governor Pat McCrory signed into law the Tax Simplification and Reduction Act ("Tax Reduction Act") that resulted in significant tax reform for North Carolina. Among the many changes, the most significant was the replacement of graduated personal income tax rates with a flat tax regime, along with the limitation on, and even elimination of, certain itemized deductions. In addition, substantial tax reform has been set into motion for corporate income tax rates.
The goal behind this reform is to gradually shift from a tax system where personal and corporate income taxes provide most of the state government's funding to a consumption-based tax system. As a result, the Tax Reduction Act has increased and expanded the scope of North Carolina's sales tax, which is beyond the scope of this article.
North Carolina Individual Income Tax Rate
Prior to the enactment of the Tax Reduction Act, individual taxpayers in North Carolina were subject to graduated tax rates ranging from 6% to 7.75%, depending on filing status and North Carolina taxable income. For 2014, with a flat tax system, all individual taxpayers in North Carolina are subject to the same single tax rate of 5.8% on their North Carolina taxable income regardless of their income. For most individual taxpayers in North Carolina, this will result in substantial savings, which will continue into 2015 with the tax rate further decreasing to 5.75%.
No More North Carolina Personal Exemption, But An Increased Standard Deduction
As part of the new flat tax system, the Tax Reduction Act completely eliminated the personal exemption for all individual taxpayers in North Carolina regardless of their filing status, which typically ranged from $2,000 to $2,500. This means that you, as an individual taxpayer, may no longer claim a personal exemption for yourself, your spouse, your children, or any other qualifying dependents.
Despite the elimination of the personal exemption, the Tax Reduction Act significantly increased the standard deduction for all individual taxpayers in North Carolina. For 2014, the standard deduction for individual taxpayers filing jointly increased from $6,000 to $15,000, while the standard deduction for an individual taxpayer filing single increased from $3,000 to $7,500. However, North Carolina no longer allows any additional standard deduction for individual taxpayers who are blind or 65 years of age or older.
New Limitations And Eliminations Of Itemized Deductions
In addition to the elimination of the personal exemption, the Tax Reduction Act included significant tax reform to North Carolina's itemized deductions. As a result, North Carolina's itemized deductions are no longer identical to the federal itemized deductions and are subject to certain limitations. In particular, the only itemized deductions you, as an individual taxpayer, can claim on your North Carolina tax return are:
- A maximum of $20,000 of real estate taxes and qualifying home mortgage interest; and,
- Charitable contributions (subject to the federal limitations).
This means that you, as an individual taxpayer, are no longer able to receive itemized deductions for items such as medical and dental expenses, personal property taxes, and job expenses. In addition, you are no longer permitted a deduction for contributions made during the taxable year to an account in the Parental Savings Trust Fund of the State Education Assistance Authority (i.e., North Carolina's College Savings Program).
North Carolina Corporate Income Tax Rate
The Tax Reduction Act also provided significant tax reform with respect to the corporate income tax rate. Prior to the Tax Reduction Act, corporate taxpayers in North Carolina were subject to a corporate income tax rate of 6.9%. However, for 2014, the corporate income tax rate was reduced to 6%, and will be further reduced in 2015 to 5%. The Tax Reduction Act contemplates additional reductions for the corporate income tax rate in 1% increments, to 4% in 2016 and 3% in 2017, if defined revenue collection goals are met based on projected economic growth. These changes will result in substantial tax savings for corporate taxpayers.
The many tax changes that have been implemented over the past couple of years may have a considerable impact on your taxes this year and for years to come. Therefore, it is important that you consult with your tax attorney and accountant to better understand these tax implications so that you can properly budget and strategically plan for the future.
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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.