Timber Tax Advice

William L Hoover, PhD
Posted: December 29, 2010

Signed by President Obama on December 17, 2010

Although the press is referring to the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Relief Act) as a tax cut, this depends on the base used for comparison.  This Act continues the provisions that were in effect from 2001 or 2003 to 2010. On the other hand it does provide additional cuts targeted at accelerating economic growth. The extensions of the tax rates are in effect until December 31, 2012. The many extenders that have been renewed on a yearly basis are extended for 2011 only. This one year extension also applies to the  Alternative Minimum Tax relief and 100% bonus depreciation.

Although the 2010 Tax Relief Act doesn’t include specific timber provisions, the general provisions that affect all taxpayers are very important, and are summarized.

Ordinary Income Tax Rates

The tax rates for 2010, are shown in Table 1. Note that the marginal tax rates are 10%, 15%, 25%, 28%, 33%, and 35%. These rates will remain in effect for 2011 and 2012 tax years, as shown in Table 2. The 2011 tax table shows the normal increases in the tax brackets for inflation.

Table 1.–Federal Individual Income Tax Rates for 2010

If taxable income is: Then income tax equals:

Single Individuals
Not over $8,375, tax is 10% of the taxable income
Over $8,375 but not over $34,000, tax is $837.50 plus 15% of the excess over $8,375
Over $34,000 but not over $82,400, tax is $4,681.25 plus 25% of the excess over $34,000
Over $82,400 but not over $171,850, tax is $16,781.25 plus 28% of the excess over $82,400
Over $171,850 but not over $373,650, tax is  $41,827.25 plus 33% of the excess over $171,850
Over $373,650, tax is $108,421.25 plus 35% of the excess over $373,650

Heads of Households
Not over $11,950, tax is 10% of the taxable income
Over $11,950 but not over $45,550, tax is $1,195 plus 15% of the excess over $11,950
Over $45,550 but not over $117,650, tax is $6,235 plus 25% of the excess over $45,550
Over $117,650 but not over $190,550, tax is $24,260 plus 28% of the excess over $117,650
Over $190,550 but not over $373,650, tax is $44,672 plus 33% of the excess over $190,550
Over $373,650, tax is $105,095 plus 35% of the excess over $373,650

Married Individuals Filing Joint Returns and Surviving Spouses
Not over $16,750, tax is 10% of the taxable income
Over $16,750 but not over $68,000, tax is $1,675 plus 15% of the excess over $16,750
Over $68,000 but not over $137,300, tax is $9,362.50 plus 25% of the excess over $68,000
Over $137,300 but not over $209,250, tax is $26,687.50 plus 28% of the excess over $137,300
Over $209,250 but not over $373,650, tax is $46,833.50 plus 33% of the excess over $209,250
Over $373,650, tax is $101,085.50 plus 35% of the excess over $373,650

Married Individuals Filing Separate Returns
Not over $8,375, tax is 10% of the taxable income
Over $8,375 but not over $34,000, tax is $837.50 plus 15% of the excess over $8,375
Over $34,000 but not over $68,650, tax is $4,681.25 plus 25% of the excess over $34,000
Over $68,650 but not over $104,625, tax is $13,343.75 plus 28% of the excess over $68,650
Over $104,625 but not over $186,825, tax is $23,416.75 plus 33% of the excess over $104,625
Over $186,825 $50,542.75 plus 35% of the excess over $186,825

Table 2.–Federal Individual Income Tax Rates for 2011

If taxable income is: Then income tax equals:

Single Individuals
Not over $8,500, tax is 10% of the taxable income
Over $8,500 but not over $34,500, tax is $850 plus 15% of the excess over $8,500
Over $34,500 but not over $83,600, tax is $4,750 plus 25% of the excess over $34,500
Over $83,600 but not over $174,400, tax is $17,025 plus 28% of the excess over $83,600
Over $174,400 but not over $379,150, tax is $42,449 plus 33% of the excess over $174,400
Over $379,150, tax is $110,016.50 plus 35% of the excess over $379,150

Heads of Households
Not over $12,150, tax is 10% of the taxable income
Over $12,150 but not over $46,250, tax is $1,215 plus 15% of the excess over $12,150
Over $46,250 but not over $119,400, tax is $6,330 plus 25% of the excess over $46,250
Over $119,400 but not over $193,350, tax is $24,617.50 plus 28% of the excess over $119,350
Over $193,350 but not over $379,150, tax is $45,323.50 plus 33% of the excess over $193,350
Over $379,150, tax is $106,637.50 plus 35% of the excess over $379,150

Married Individuals Filing Joint Returns and Surviving Spouses
Not over $17,000, tax is 10% of the taxable income
Over $17,000 but not over $69,000, tax is $1,700 plus 15% of the excess over $17,000
Over $69,000 but not over $139,350, tax is $9,500 plus 25% of the excess over $69,000
Over $139,350 but not over $212,300, tax is $27,087.50 plus 28% of the excess over $139,350
Over $212,300 but not over $379,150, tax is $47,513.50 plus 33% of the excess over $379,150
Over $379,150, tax is $102,574 plus 35% of the excess over $379,150

Married Individuals Filing Separate Returns
Not over $8,500, tax is 10% of the taxable income
Over $8,500 but not over $34,500, tax is $850 plus 15% of the excess over $8,500
Over $34,500 but not over $69,675, tax is $4,750 plus 25% of the excess over $34,500
Over $69,675 but not over $106,150, tax is $13,543.75 plus 28% of the excess over $69,675
Over $106,150 but not over $189,575, tax is $23,756.75 plus 33% of the excess over $106,150
Over $189,575, tax is $51,287 plus 35% of the excess over $189,575
 

Capital Gains and Qualified Dividends Tax Rate
(Sec. 102 of the bill and Sec. 1(h) of the Code)

Capital Gains and Dividends

Qualified dividend income received by individuals will continue to be taxed at the same rate as capital gains. This applies to both the regular tax and the alternative minimum tax. Thus, an individual’s capital gains and qualified dividend income is taxed at a zero or 15 percent rate. The zero-percent rate applies to taxpayer’s in the two lowest brackets. The rate is 15% for higher brackets. As in past years, the Form 1099 from your broker will break out qualified and non-qualified dividends. Forest owners that sell timber will (should) get a Form 1099-S from the firm purchasing stumpage, whether a lump-sum or pay-as-cut contract is used.

Limitation on Itemized Deductions and Personal Exemption Phase-Out

The limitation on itemized deductions does not apply for two additional years, 2011 and 2012. In addition, the personal exemption phase-out does not apply for 2011 and 2012 tax years.

Extension of Alternative Minimum Tax (AMT) Relief and Exemption Amount

The Act provides that the individual AMT exemption amount for 2010 is (1) $72,450, in the case of married individuals filing a joint return and surviving spouses; (2) $47,450 in the case of other unmarried individuals; and (3) $36,225 in the case of married individuals filing separate returns.

The individual AMT exemption amount for taxable years beginning in 2011 is (1) $74,450, in the case of married individuals filing a joint return and surviving spouses; (2) $48,450 in the case of other unmarried individuals; and (3) $37,225 in the case of married individuals filing separate returns.

The increase in exemption amounts does not apply to 2012 unless Congress extends the rates in 2011 for the 2012 tax year.

Estate Tax Relief

The immediate impact is on executors of estates for decedents dying in 2010. In addition, many changes apply to estates of decedents dying in 2011 and 2012. Knowing what the law is two years out is helpful, but “permanent” provisions would be much better for development of estate plans. 

Election for decedents who died in 2010

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) repealed the estate tax for decedents dying in 2010. It also eliminated the stepped-up basis, but provided a modified carryover basis. It authorized executors to allocate $1.3 million in basis to assets passing to any heir ($60,000 for nonresident alien decedents). In addition, up to $3.0 million in basis could be allocated to assets passing to a surviving spouse.  In all cases the allocated basis an asset could not exceed its fair market value on the decedent’s date of death. Otherwise the basis rules applicable to assets passed as gifts applied -- the basis of the asset in the hands of the decedent on their date of death carries over to the recipient with an increase for the applicable portion of any gift tax paid.
The 2010 Tax Relief Act in-effect reinstates the estate tax and step-up basis rules for estates of decedents dying in 2010 (2010 estate). However, the executor of such an estate can elect to apply the law that would have applied if the 2010 Tax Relief Act hadn’t been enacted. In other words, the executor of a 2010 estate must choose between no estate tax and modified carryover basis rules, or pay the estate tax due, if any, and have the stepped-up basis for all assets apply. Such an election will have no effect on the generation skipping transfer tax.

Reunification of Estate and Gift Taxes

Current law provides each person with a lifetime gift tax exemption of $1.0 million. The effective amount of the exemption is higher to the extent that the annual gift tax exclusion is used, currently $13,000. A couple with 10 grandchildren, for example, can give $260,000 each year without using-up any of the $1.0 exemption.
The 2010 Tax Relief Act reverts to the structure prior to 2002. This means that the $5.0 exclusion applies to the sum of the amount of lifetime taxable gifts and the amount passed by the estate. There will no longer be separate tax rates for taxable gifts and transfers through an estate.
The unified maximum tax rate will be 35 percent. This rate applies for taxable amounts exceeding $500,000.

Portability of unused exemption between spouses

Previously estate planners often had to go to great lengths to be certain that the amount of estate assets exempt from the estate tax, the so-called applicable exclusion amount of both spouses is used-up. The exclusion amount for 2011 and 2012 is $5 million. Thus, even without using by-pass trusts $10.0 million of assets can be taxed with no estate tax. For example, assume that father’s estate passes $3.0 million to children and $7.0 million to mother. The $3.0 million to the children uses-up $3.0 millionof father’s $5.0 million exclusion amount. This leaves $2.0 million unused. When mother dies assume she has the $7.0 million from father plus the earning on this, and $1.0 million of her own assets.  This makes the exclusion amount applicable to mother’s estate $7.0 million ($5.0 plus $2.0 unused by father’s estate). Mother’s estate is over $8.0 million, making $1.0 million subject to the estate tax. Proper planning can of course reduce mother’s estate by $1.0 million before she dies.

If a surviving spouse is predeceased by more than one spouse, the amount of unused exclusion that is available for use by such surviving spouse is limited to the lesser of $5 million or the unused exclusion of the last such deceased spouse.57 A surviving spouse may use the predeceased spousal carryover amount in addition to such surviving spouse’s own $5 million exclusion for taxable transfers made during life or at death.

Effective Date

The estate and generation skipping transfer tax provisions generally are effective for decedents dying, gifts made, and generation skipping transfers made after December 31, 2009 and before January 1, 2013. The modifications to the gift tax exemption and rate generally are effective for gifts made after December 31, 2010. The new rules providing for portability of unused exemption between spouses generally are effective for decedents dying and gifts made after December 31, 2010.

Temporary Extension of Increased Small Business Expensing

For taxable years beginning in 2012, the maximum amount a taxpayer may expense under IRC Sec. 179 instead of capitalizing and depreciating is $125,000 of the cost of qualifying property placed in service for the taxable year. The $125,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $500,000. The $125,000 and $500,000 amounts are indexed for inflation.

For taxable years beginning in 2013, and thereafter, the maximum amount a taxpayer may expense is $25,000 of the cost of qualifying property placed in service for the taxable year. The $25,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $200,000.

Deduction of State and Local Sales Taxes

The provision allowing taxpayers to elect to deduct State and local sales taxes in lieu of State and local income taxes is extended for two years (through December 31, 2011). Thus, the  provision applies to the 2010 and 2011 tax years.
 
Special Qualified Conservation Contributions Benefits Extended

The Act extends the special rule regarding contributions of capital gain real property for conservation purposes for two years for contributions made in taxable years beginning before January 1, 2012.

William L Hoover, PhD
Posted: October 26, 2010

The President signed P.L. 111-240 on September 27, 2010. Several of the provisions may impact family forest owners operating as a business or as a for-profit investment activity. Several will apply to timber buyers, and timberland owners receiving rental income.

Section 179 Expensing of Depreciable Property

Section 179 expensing is an existing deduction for the cost of qualifying property that would otherwise have to be recovered by depreciation. Qualifying property is in general tangible personal property. The Jobs Act, however, expands this definition to include qualified leasehold improvement property. Prior to the Jobs Act the maximum amount that could be expensed in 2010 was $250,000. The Jobs Act increases this to $500,000 per year for property placed in service in 2010 and 2011. The phase-out cap was increased from $800,000 to $2 million. Phase-out occurs on a dollar-for-dollar basis when the qualifying amount invested exceeds the cap. The income the Sec. 179 is deducted from must be from the active conduct of a trade or business. (P.L. 111-240, Sec. 2021, IRC Sec. 179)

Extension of First Year Depreciation Deduction

The Jobs Act extends the additional first- year depreciation deduction for one year. It now applies to property acquired and placed in service during 2010. The extension is until 2011 for certain long-lived property and transportation property. (P.L. 111-240, Sec. 2022, IRC Sec. 168(k)).

Increase in Amount Deductible as Start-Up Expenses

Start-up expenses are those that would have been deductible as a business expense if they had occurred after a business started. The Jobs Act increases the qualified amount from $5,000 to $10,000. The dollar-for-dollar phase-out cap is increased from $50,000 to $60,000. The increase applies to taxable years beginning in 2010.  (P.L. 111-240, Sec. 2031, IRC Sec. 195)

Form 1099 Required for Expense Payments for Rental Property

Generally every person engaged in a trade or business must file with the IRS and provide the payee a Form 1099 to any payee receiving $600 for goods and services. There was an exception for payments to corporations and for rental real estate activities not constituting a trade or business. The Jobs Act eliminates this exception for payments made after December 31, 2010. (P.L. 111-240, Sec. 2101, IRC Sec. 6041)

Increase in Penalty for Not Filing Information Returns

Information returns, Form 1099, are required for timber disposals, both pay-as-cut and lump-sum. There has been a penalty for not filing in a timely manner, or not filing at all. The penalty increases based on how long past due a return is or if not filed at all. The amount of the penalty goes from $15 to $30 per return for returns filed 30 days or less late. The maximum penalty per calendar year increases from $75,000 to $250,000. If filed more than 30 days late but before August 1 the penalty per return goes from $30 to $60 and the maximum from $150,000 to $500,000 per year. If filed on or after August 1 the penalty increases from $50 to $100 and the calendar year maximum is increased from $250,000 to $1.5 million. The penalty for intentionally disregarding the requirement to file goes from $100 to $250 per return required.  The effective date is for returns required to be filed on or after January 1, 2011. (P.L. 111-240 Sec. 6721, IRC Sec. 6722)

Posted: September 30, 2010
William L Hoover, PhD
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It’s too early to draw conclusions regarding what Congress and the President will do in terms of ordinary and capital gains tax rates for 2011. Congress is leaving town with taking action. We’re left to guess what a lame duck Congress will do to us. The President and Congressional majority leadership continue to insist that ordinary income tax rates and capital gains rates will be raised for “the rich.” Rich is being defined by the thresholds amounts of $250,000 for married filing jointly, $125,000 for married filing separately, and $200,000 for single or head of household. The capital gains rate may go to 20 percent, and dividends taxed as ordinary income.  If you are “rich” it may pay to accelerate timber income to this year and postpone deductions to next year.  Obviously there are tradeoffs involved and careful analysis should be undertaken for the range of possible scenarios.

Watch our website for an update on the implications of returning to the estate and gift tax laws in effect in 2001. It unbelievable the Congress hasn’t dealt with the reinstitution on the estate tax with a $1.0 million excludable amount and 55% maximum tax rate, but it is so. This edition of the manual, dated September 2010, assumes that the carryover basis with a partial step-up for property received through estates of those dying in 2010 will be permanent.

Unearned Income Medicare Contribution Tax
Effective on January 1, 2013
IR Code Sec. 1411 add by P.L. 111-152 (Health Care and Education Reconciliation Act)[1]

The President’s health care package will be paid for in part by a “Medicare contribution tax” on unearned income.  Individuals, estates, and trusts will be subject to this tax (Code Sec. 1411, added by Reconciliation Act Sec. 1402(a)).  Individuals will pay 3.8 percent of the lesser of either (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount (Code Sec. 1411(a)(1)).

Under current law adjusted gross income (AGI) includes investment income. MAGI is adjusted gross income (AGI) increased by the amount excluded from income as foreign earned income under Code Sec. 911(a)(1), net of the deductions and exclusions disallowed for the foreign earned income (Code Sec. 1411(d)).

The threshold amount is $250,000 for a joint return or surviving spouse, $125,000 for a married individual filing separately, and $200,000 for all others (Code Sec. 1411(b)). The Committee Report states that for this purpose, gross income doesn't include excluded items, such as interest on tax-exempt bonds, veterans' benefits, and excluded gain from the sale of a principal residence.

The tax will be levied on income from interest, dividends, annuities, royalties, rents, and capital gains. The Medicare contribution tax is in addition to the 1.45 percent Hospital Insurance (HI) tax on employee's wages and on self-employment income in excess of applicable threshold amount.  Forest landowners who have both high wages or self-employment income, and high investment income from selling timber will pay both taxes. Note that the tax will not apply to capital gains on timber if the gain is considered to be business income and the taxpayer’s interest in the business is not passive.

Examples

Example 1.  A married couple in 2013 has joint income from earnings of $150,000, and a capital gain of $80,000 from a timber sale reported on their Form 1040, Schedule D.  They have no adjustments to make for foreign income. This makes their MAGI $230,000. Their excludable amount is $250,000. Since their MAGI is less than their excludable amount they do not owe any Medicare contribution tax.

Example 2. A married couple has joint income from earnings of $210,000 in 2013. They also sell timber producing a net long-term capital gain of $90,000, reported on Schedule D, Form 1040. Their MAGI is $300,000 and their excludable amount is $250,000. The $90,000 of investment income puts them over their excludable amount by $50,000 ($300,000 - $250,000 = $50,000). The Medicare contribution tax on their joint return is $1,900.

Example 3. A single taxpayer has MAGI of $380,000, which includes net investment income of $150,000 from a timber sale reported on Schedule D, Form 1040. His MAGI exceeds his threshold amount by $180,000 ($380,000 - $200,000). The taxpayer would pay the Medicare contribution tax on the $150,000 gain because it is less than the amount by which his MAGI exceeds his threshold amount.  This would make the Medicare contribution tax $5,700 ($150,000 × 0.038). This would be in addition to the capital gains tax paid on the $150,000 gain.

Example 4. A couple filing jointly has combined earnings from their employers of $260,000. They also own and operate a fast food franchise which provided them with business income in 2013 of $120,000. Since their MAGI does not include any investment income they do not owe a Medicare contribution tax.

Example 5. Ms. Smith is the sole owner of a lumber business structured as a single member LLC. The LLC has $300,000 of net income from the lumber business. In addition, it has a net long-term capital gain of $75,000 on timber cut subject to a Section 631(a) election.  Although her MAGI is $375,000 she does not owe any Medicare contribution tax because all of her income is from her business.

Example 6. Assume the same Ms. Smith in Example 5, but now the timberland is not titled to the LLC. She is a passive investor with regard to all timberland activities. Her manager sells timber on the stump resulting in a net long-term capital gain of $75,000.  Her MAGI is again $375,000, which exceeds her threshold amount by $175,000. She pays the Medicare contribution tax on her $75,000 of timber gain since it is investment income.

Estates and Trusts

For an estate or trust, the Medicare contribution tax is 3.8 percent of the lesser of either: (1) undistributed net investment income, or (2) the excess of AGI (as defined in Code Sec. 67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins. (Code Sec. 1411(a)(2)) The Medicare contribution tax shouldn’t apply to simple trusts or grantor trust because they are required to distribute all income currently.

Net investment income defined

Net investment income is investment income reduced by applicable deductions. Investment income is the sum of: (1) gross income from interest, dividends, annuities, royalties, and rents (other than income derived from any trade or business to which the tax does not apply); (2) other gross income derived from any trade or business to which the tax applies; and (3) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply. (Code Sec. 1411(c)(1)) Business income isn’t included.

In the case of a trade or business, the tax applies if the trade or business is either a passive activity with respect to the taxpayer or the trade or business consists of trading financial instruments or commodities as defined in Code Sec. 475(e)(2)(Code Sec. 1411(c)(2)). The Committee Report states that the tax does not apply to other trades or businesses conducted by a sole proprietor, partnership, or S corporation. Thus, for a taxpayer that doesn't engage in a passive activity or a financial instrument or commodities trading business, “net investment income” will include non-business income from interest, dividends, annuities, royalties, rents, and capital gains, minus any allowable deductions.

In the case of the disposition of a partnership interest or stock in an S corporation, gain or loss is taken into account only to the extent gain or loss would be taken into account by the partner or shareholder if the entity had sold all its properties for fair market value immediately before the disposition. Thus, only net gain or loss attributable to property held by the entity which is not property attributable to an active trade or business is taken into account. (Code Sec. 1411(c)(4))

NOTE: The discussion below is included only to reduce confusion between this provision and the Unearned Income Medicare Contribution Tax discussed above.

Additional Hospital Insurance (HI) Tax on Employee Portion of HI Tax

Effective on January 1, 2013

Employees currently pay a share of the old age, survivors, and disability insurance (OASDI) tax, and a hospital tax (HI) on their earnings. The former is 6.2 percent and the later is 1.45 percent. There’s an annual cap on total wages subject to OASDI, but all earnings are subject to the HI tax. Their employers pay an equivalent amount for both taxes, making the total 15.3 percent. Individuals receiving self-employment income pay an equivalent 15.3 percent tax.

The Act imposes an additional 0.9 percent HI tax to be paid by an employee. Starting on January 1, 2013 the employees HI tax will be 2.35 percent. This additional tax will be paid on earnings above the threshold amount of $200,000 for individual taxpayers, $250,000 for married filing jointly, and $125,000 for married filing separately. This additional HI tax applies only to earnings above these threshold amounts. In the case of married filing jointly their earnings are combined in determining if the threshold amount has been reached.

The additional 0.9 percent HI tax also applies to self-employment income. This will make the total self-employment tax 16.2 percent of income from self-employment.

Economic Substance Doctrine

IRS Notice 2010-62 provides guidance on how the IRS will implement the codification of the economic substance doctrine included in the Health Care and Education Reconciliation Act. This long-standing doctrine holds that any transaction undertaken only to achieve a tax benefit without any benefit to the taxpayer other than lower taxes is suspect. A transaction has economic substance only if (1) It changes the taxpayer’s economic position in a meaningful way (apart from federal taxes); and (2) The taxpayer has a substantial purpose for entering into the transaction (apart from federal taxes). Existing case law requires only one of these two conditions to be met. Under the codified law both conditions must be met. If a transaction is disallowed on the basis of lack of economic substance and the transaction at issue is not fully disclosed to the IRS, the accuracy-related penalty increases from 20 to 40 percent. The notice also announces that if the IRS will not issue rulings on specific transactions being considered by a taxpayer.

IRS Provides Guidance for Executors of Estates of 2010 Decedents

Timber Tax Management for Family Forest Owners, 2010 edition explains in some detail how the carryover basis and partial stepped-up basis rules apply to the estates of individuals dying in 2010. Executors of larger estates are burdened with reporting to the IRS the date of death basis of assets in the hands of the deceased and how the allowable stepped-up basis is allocated to assets passed through the estate. The IRS has posted on its website FAQs about the New Tax Rules for Executors for 2010, must reading for anyone involved in an estate settlement, including heirs receiving property from an estate. The url is  http://www.irs.gov/businesses/small/article/0,,id=224519,00.html

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Several acts comprise the legislation generally known as the Health Care Act. The focus in this discussion is on relevant revenue provisions of the Patient Protection and Affordable Care Act (P.L. 111-152), and Health Care and Education Reconciliation Act of 2010 (P.L. 111-152). We collectively refer to these as “ Act.” The provisions discussed here are not effective until 2013. This gives you time to adjust your affairs to minimize the impact of the new Medicare tax on investment income and increases in existing taxes.

As promised by Pres. Obama the tax increases apply to “the rich.” You’ll be happy to know that there is now an official definition of “rich” for purposes of the Act. The Act uses  “threshold income” of $200,000 for a single taxpayer , combined income of $250,000 for married filing jointly, and $125,000 for married filing individually. “Threshold amount” means that s given tax applies when modified adjusted gross income (AGI) exceeds these amounts. The impact of the Act on family forest owners comes in two forms. First, your family forest income may push you over the threshold amount thereby triggering a tax liability. Second, if your income is over the threshold amount without the forest income the additional income will result in an additional tax liability. We start with the new tax that is likely to cost you the most.

“New”  3.8% Medicare Contribution Tax on “Investment Income”
(Internal Revenue Code Sec. 1411, new, effective for tax years beginning after Dec. 31, 2012.)

The existing Medicare Tax is withheld by employers and paid by the owner on self-employment income. The Act creates a new additional “Medicare contribution tax” of 3.8% on “investment income.”  This new tax applies to the lesser of

(1)net investment income, or

(2)amount by which AGI  exceeds the threshold amount, 

demonstrated by Examples 1 and 2.

Example 1. Norma Spangler is a widow with 2013 annual income of $45,000 from her former employer’s retirement program, $4,000 of taxable social security income, and $12,000 from her stock fund.  She has a net long-term capital gain from a timber sale of $120,000. She reports the gain on Form 1040, Schedule D because the forestland is an investment, not a business. This makes her adjusted gross income $181,000. Since this is below the threshold of $200,000 she does not owe any Medicare Contribution Tax on the timber.

Example 2. John and Joyce Bergman are married filing jointly. John’s W-2 earnings total $110,000 and Joyce’s are $90,000. Their family forest is an investment, not a business. They report gains on their infrequent timber sales on Form 1040, Schedule D. Their net long-term capital gain on a timber sale is $80,000. It is their only investment income. Their adjusted gross income without the timber sale is $200,000. With the timber sale it is $280,000.  Comparing $30,000 ($280,000 - $250,000) and $80,000 the lesser amount is $30,000. This results in a $1,140 Medicare Contribution Tax triggered by the timber sale.

Adjusted Gross Income. A “modified adjusted gross income” applies for purposes of the Medicare Contribution Tax.  Adjusted gross income determined under current law is increased by a combination of excluded foreign earned income and foreign housing allowances (IRC Sec. 911). We provide no further details on this adjustment.

Net Investment Income. A little “interpretation” is required on our part to apply the definition provided in the Act to the variety of circumstances of family forest owners. The Act provides that net investment income includes your gross income from

The tax does not apply, however, if such income is realized in the conduct of a trade or business. It does apply if your interest in the business is passive. It’s passive if you do not materially participate in the business in a given year.  See Examples 3 and 4.

Example 3.  Joe Pride is retired from a business he started many years ago. He no longer materially participates in the business, but he still receives a distributed share of its income. His main income is a 401(k) fund from which he withdraws $120,000 per year. His annual distributed share of passive income from the business is $100,000. He also received $35,000 in dividends and gains on stock sales in his portfolio. This account is not part of a retirement program for tax purposes. He and his brother are equal members of an LLC that operates a 1,200 tree farm.  It generates $10,000 in rent from a hunting club lease and $60,000 in net timber revenue. Joe’s AGI is $290,000 (sum of $120,000 $100,000, $35,000, $5,000 (50% interest in tree farm),  $30,000 (50% interest from timber sale). His invest income for purposes of the MCT is $135,000, consisting of $100,000 passive income from his business and $35,000 from his investment portfolio.  All other income is from a business or retirement fund.

Example 4.  Janice Jones and her husband have combined W2 wages of $220,000. They inherited 1,500 acres of forest and open land several years ago. Their children keep them very busy so they rent out the land to a group of hunters that do all the management. They report $40,000 of rental income less property taxes on Form 1040, Schedule E. Their AGI is $260,000 and the $40,000 is investment income. Thus, they owe $83 MCT on $10,000 ($260,000 - $250,000).

Investment income also includes net gains on the disposal of property that is not part of a trade or business, see Examples 1 and 2.

Our interpretation of net investment income in the case of gains from timber are that gains reported by a business are not included unless the business is a passive activity. Gains reported under IRC Sec. 631(a) and (b) would not be included. These gains are reported on Form 4797 and are discussed in our Manual.  Gains from timber reported on Form 1040 Schedule D would be included. Our interpretation of Congressional intent is that net gain from involuntary conversions reported on Form 4797would not be investment income even if the property is not held as part of a trade or business.

Estates and Trusts.  Estates and trusts pay the 3.8% MCT on the lesser of (1) undistributed net investment income, or (2) the excess of adjusted gross income over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins. This amount is $11,200 for 2010. If trusts and estates distribute their income to beneficiaries the MCT is determined on each beneficiaries’ tax return.

Worst Case Scenario

We hope that the follow scenario would never occur to any of our friends, and it is highly unlikely, but consider your bachelor rich uncle George who hates tax advice. He’s in the highest income tax bracket and reports $100,000 in timber income as ordinary income. His taxable income without the timber sale income is $350,000. This makes his marginal tax rate 35%. The income tax on the timber is $35,000. If he had to pay the 15.3% self-employment tax this would add $15,300. He’s over the $200,000 threshold making him liable for the new 3.8%Medicare Tax, adding $3,800. He could also be subject to the additional 0.9% Hospital Tax, adding $900. If there’s an income tax in his state of residence we need to add it. Assume that the marginal state tax rate is 2.5%, adding $2,500. This makes his total tax $57,500. We’ll let you decide if leaving $42,500 after-tax timber income is unfair.

Tax Management Implications

The obvious implication is to explore options to reduce your AGI below the applicable threshold amount. Any adjustments must reflect how much current income you can afford to give up by reducing pretax salary with contributions to 401(k)’s or similar retirement funds. If timber sale income would throw you over the threshold consider selling with an installment sale contract.

The passive loss rules will affect the treatment of both expenses and income starting in 2013. Currently they restrict the ability of owners not “materially participating” in the family forest business to deduct expenses against current income from other sources. Passive losses can be written off against passive income for the year, if any, and otherwise must be carried forward until passive income is realized. Now, timber gains from passive businesses may incur the new Medicare Contribution Tax.