Given the Supreme Court’s decision to uphold the Patient Protection and Affordable Care Act and the recent election results, several Medicare-related tax law changes will almost certainly kick in for wealthier Americans starting in 2013. Haven’t paid much attention to these? That’s probably because more attention has been paid to whether the Bush income tax cuts for higher income taxpayers will expire after the election results are in. (For more on the expiring tax cuts, see “Companies May Want to Think Twice About Paying Bonuses Before Year-End to Avoid Tax Rate Increases,” Executive Pay Matters, October 15, 2012.)
But, the coming Medicare-related increases are real and may influence the behavior of executives in ways that — dare we say it? — have unintended consequences. This seems par for the course when it comes to taxes and executive compensation. Yet, there are so many unanswered questions about how some of these changes will apply to many elements of executive compensation that it’s difficult to offer definitive guidance on how companies and executives may want to respond.
Following is a brief overview of the new taxes, along with highlights of the interpretational issues.
Medicare Hospital Insurance (HI) Tax Increase
This tax increase is fairly straightforward and should not be the cause of too much interpretational angst. Beginning January 1, 2013, the employee-only portion of the Medicare hospital insurance part of the payroll (FICA) tax will increase by 0.9% (from 1.45% to 2.35%) on wages in excess of:
- $250,000 for joint filers (or surviving spouses)
- $200,000 for single filers
- $125,000 for married individuals filing separately.
Employers are responsible for withholding on the added tax only on wages above the single filer threshold and can ignore filing status and spousal income. They must report the additional tax withholding on amounts over the single-filer threshold on the employee’s Form W-2, box 5 (“Medicare wages and tips”). Employees are responsible for any additional tax owed that’s not withheld by the employer.
Potential influences: Keep in mind that the same rules currently in place for the timing of FICA/HI taxes will continue to apply after this tax change takes effect, posing implications for voluntary deferrals into employer qualified and nonqualified plans. Because FICA/HI taxes generally apply to deferred compensation as of the date deferred (if fully vested), deferring payment of compensation until a later date will not avoid the increase tax liability.
FICA/HI taxes generally apply to non-account-balance deferral plans (e.g., a traditional final-pay SERP) only when a participant retires, but sponsors are permitted to recognize the value of these benefits for FICA/HI tax purposes at an earlier date. Some employers have been considering whether to take advantage of this early-recognition rule in 2012 before the HI rate increase goes into effect.
New Medicare Tax on Unearned Income
High-income taxpayers also will be subject to a new Medicare tax on unearned income beginning in 2013. This new tax will carry a fairly hefty rate of 3.8% and will apply to many, but not all, items of “net investment income.” The rules for how this tax is triggered are complex, but understanding them is important before we can examine how they apply to executive compensation.
The starting point is to calculate net investment income, which generally is the sum of:
- Gross income from interest, dividends, annuities, royalties and rents derived from an investment, rather than from a business
- Passive income from some trades or businesses, including those that trade financial instruments or commodities
- Net gain attributable to the disposition of property that generates passive income.
Once the net investment income is determined, taxpayers must determine if their modified adjusted gross income (MAGI1) exceeds the high-income threshold, which, not coincidentally, is set at the same level as the HI tax discussed above:
- Over $250,000 for joint filers (or surviving spouses)
- Over $200,000 for single filers
- Over $125,000 for married individuals filing separately
If the taxpayer’s MAGI does not exceed these thresholds, there’s no need to worry about this tax. For taxpayers with MAGI above these levels, the 3.8% tax applies, but only to the lesser of:
- The amount by which MAGI exceeds the applicable threshold, or
- The amount of net investment income.
As shown in Figure 1, those whose MAGI is only slightly in excess of the income threshold will have their tax limited even if they have a large amount of net investment income. In contrast, those with substantially higher MAGI levels could have all of their net investment income exposed to the new 3.8% tax.
Application to Executive Compensation
As a general matter, net investment income excludes elements of executive compensation that are not taxed as gross income during the year. It’s unclear, however, whether this tax could apply to elements of executive compensation, like equity and nonqualified deferred compensation, where gains build up over time and are taxed as distributions.
Is non-qualified deferred compensation covered? The starting point here is an exception in the statute that excludes from net investment income distributions from the following retirement plans: qualified plans, qualified annuities, IRAs, Roth IRAs and deferred compensation plans of state and local governments and tax-exempt organizations. It’s not clear whether this would mean that other deferred compensation paid to executives from voluntary plans or SERPs would be considered net investment income because of the absence of a specific exception.
- Argument against: The 3.8% tax on unearned income happens to be the exact same amount as the increased HI tax (2.35% employee share + 1.45% employer share), so to further taxing deferred compensation that already is subject to the HI tax would be double taxation.
- Argument for: The FICA/HI tax regime for defined contribution deferrals applies when they vest so that any earnings growth is not subject to FICA/HI again at distribution. But, these earnings are those that would otherwise be considered net investment income if they were credited outside of a nonqualified deferred compensation plan. If these earnings were exempt, executives could avoid the 3.8% tax by deferring significant amounts into a company-sponsored nonqualified deferred compensation program. This logic would not apply to many SERPs because they often are subject to FICA/HI tax near the executive’s retirement, at which time the combined 3.8% FICA/HI tax would be applied. If this interpretation is correct, perhaps net investment income would be calculated on the difference between the amount paid at the time of distribution minus the amount previously subjected to FICA/HI tax.
The bottom line is that we just don’t know the correct interpretation of this issue and hope the IRS provides more guidance soon.
Is equity compensation covered? Another troublesome question is whether increases in the value of equity-based compensation from grant date until it’s taxed will be counted as net investment income. We suspect the answer is no, especially since increases in the value of unvested stock or unexercised options are subject to the full FICA/HI tax at the same time they are included in gross income. This makes it different than nonqualified deferred compensation whose earnings buildup is not subject to FICA/HI tax at distribution, although we are not sure this is correct either.
Figure 2 provides additional guidance on other elements of executive compensation and our reactions on possible impacts and complications.
1For those familiar with the O. Henry story, The Gift of the Magi, this is a lot like those gifts.
Steve Seelig and Russ Hall are executive compensation experts in Towers Watson’s Research and Innovation Team in Arlington, Virginia and White Plains, New York. Email email@example.com, firstname.lastname@example.org or email@example.com.