The New 3.8 Percent Medicare Contribution Tax
by Jerri Hammer and Lu Liu
The new Medicare contribution tax contained in Internal Revenue Code (IRC) §1411 was enacted as part of the Health Care and Education Reconciliation Act of 2010. Also known as the net investment “surtax,” it was intended to pay some of the costs of the Patient Protection and Affordable Care Act of 2010, which had been enacted a few days earlier.
This new tax applies to the net investment income of high-income individuals and most estates and trusts. Generally, joint filers having adjusted gross income (AGI) over $250,000 and single filers over $200,000 become subject to this new tax. It applies to the lesser of (1) net investment income, or, (2) the excess of a taxpayer’s modified AGI over the threshold amount applicable to that taxpayer. Note that a child’s investment income included on the parent’s return for “kiddie tax” purposes is included in calculating net investment income.
Estates and trusts will be subject to the tax if they have investment income and taxable income above the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year (for 2013, $11,950). Note that this amount is much less than what you would think of as “high-income” for an individual taxpayer!
Trusts not subject to the new tax include tax-exempt trusts under IRC §501 and §664, grantor trusts under §§671–679, charitable trusts under §170(c)(2)(B) and entities not classified as trusts for federal income tax purposes (REITs and common trust funds).
Net investment income is gross investment income less deductions allocable to such income (§1411(c)). Investment income includes the following:
1. Portfolio income such as interest, dividends, rents, royalties and annuities, other than such income derived in the ordinary course of a trade or business not described in number two below;
2. Trade or business income from passive investments within the meaning of §469 and income from businesses that trade financial instruments or commodities; and
3. Net gains from the disposition of property including gains from the sale of portfolio investments, trade or business property used in passive activities and from the sale of a primary residence that is not excluded from taxable income under IRC §121.
Investment income is reduced by allocable deductions such as early withdrawal penalties, investment interest expense, brokerage fees, directly related rental and royalty deductions, and allocable state and local income taxes. Importantly, losses from one category of income do not reduce income from a different category. Also, loss or deduction limitations in other IRC provisions may impact deductions against investment income.
Wages, self-employment income, active trade or business income, tax-exempt interest, unemployment compensation, Social Security benefits, qualified retirement plan or IRA distributions, and the excludable portion of gain on a primary residence are excluded from the definition of net investment income. Also, rents derived by a qualifying real estate professional are not subject to the tax.
Planning for individuals may include maximizing contributions to retirement plans to reduce adjusted gross income and defer tax, Roth conversions, using tax deferred vehicles like 529 plans, cash value life insurance, or Health Savings Accounts, investing in tax-exempt investments or establishing charitable trusts if charitably inclined.
Earnings from pass-through entities such as partnerships, LLCs and S corporations reported on Schedule K-1 may include both business and investment income. This provides for planning opportunities such as the following:
1. Increasing participation in a pass-through activity so that there is material participation in a trade or business, which income would not be subject to the tax;
2. Reviewing/reclassifying current activity groupings in order to take advantage of the “fresh start” regrouping allowed by the Internal Revenue Service; or,
3. Using an S corporation or electing S status versus the partnership or LLC form in situations where the shareholder materially participates in the underlying trade or business.
Fiduciaries should consider planning options such as these:
1. Making “distribute or retain” decisions to reduce the tax impact overall between trusts/estates and beneficiaries, including distributing capital gains from pass-through entities or investment portfolios traditionally taxed at the trust level;
2. Increasing trustee participation or adding a special trustee for business operations to achieve material participation or qualified real estate professional status for real estate activities;
3. Allocating distributions from qualified plan or IRA assets between income distributed to beneficiaries and income not distributed, in order to reduce the tax burden overall.
In conclusion, taxpayers may be able to mitigate the new tax’s impact through timely planning strategies such as these and many others.