Planning for the 3.8% Medicare Tax on Investment Income

The Patient Protection and Affordable Care Act and the Health Care and Education Act of 2010 impose a new 3.8 percent Medicare contribution tax on the investment income of higher- income individuals.

The combination of the implementation of the health care reform legislation and the expiration of Bush-era tax rates (and/or the cap on itemized deductions, referred to as the Pease Limitation) can cause high-income taxpayers to experience tax increases ranging from 24% to 189%, depending on the type of income they receive.

Dividends that were taxed at the rate of 15% in 2012 may be taxed at the rate of 43.4% (39.6% +3.8%) for higher income taxpayers (an increase of 189%). Long term capital gains that were taxed in 2012 at 15% will be taxed at 23.8% (20% + 3.8%), an increase of 59% and passive income taxed in 2012 at a rate of 35% will be taxed at 43.4% (39.6% + 3.8%) an increase of 24%.

One of the funding provisions in the health care legislation imposes a Medicare contribution tax (Medicare tax) of 3.8% on certain unearned income for tax years beginning in 2013. This new tax applies to individuals, estates, and trusts. C corporations dodge this bullet.

The tax is imposed on the lesser of Net Investment Income(NII) for the year or the amount that NII exceeds the taxpayer modified adjusted gross income(MAGI) over $250,000 ($200,000 if single). For estates and trusts it the lesser of undistributed NII or adjusted gross income over $11,950 for 2013. For most taxpayers MAGI will be their normal Adjusted Gross Income (AGI).

WHAT IS NET INVESTMENT INCOME (NII)?

Includes three baskets of income less deductions properly allocable to such income (currently there is no guidance as to what properly allocable means.) Are NOL carry-forwards, or suspended losses carried forward and freed up in the current year properly allocable to K-1 income for that year?

The first basket consists of Interest, Dividends, Annuities, Royalties and Rent. If the above items are derived in the ordinary course of a trade or business they would be excluded. This would imply that such items passing through to shareholders or partners of S Corporations or Partnerships/ LLC (respectively) where the owners materially participate in the pass through entity would not be considered NII; the second basket includes gains attributable to disposition of property (other than property held in a trade or business which is not a Passive Activity); and, the third basket is income derived from a pass through entity which is a Passive Trade or Business.

Income excluded from the new tax includes tax exempt bond interest or dividends and any item taken into account in determining self-employment tax, i.e., if a member of an LLC does not materially participate, he could conceivably have income which is both subject to SE tax and the NII tax. Also, excluded from NII are IRA and Pension distributions. While, excluded from the NII tax IRA and pension distributions may cause AGI to increase above the thresholds subjecting the taxpayer to the tax on NII, unlike tax free investments, i.e. municipal bonds.

Life Insurance proceeds are not subject to the NII tax. And the buildup value inside the LI policy is not subject to the tax nor does it increase the threshold amount. Estates and trusts have lower thresholds than individuals ($11,950 vs. $250,000). Therefore, might be advantageous for estates and trusts to push income out to the beneficiaries.

Contact us to discuss tax planning to avoid the new 3.8% Medicare tax or at least reducing its impact.