Planning for the New 3.8% Medicare Tax on Unearned Income

Effective in 2013, the Health Care and Education Reconciliation Act of 20101 will subject some individuals to a 3.8% Medicare contribution tax on unearned income. This new tax will apply to single taxpayers with a modified adjusted gross income (MAGI) in excess of $200,000 and married taxpayers with a MAGI in excess of $250,000 if filing a joint return, or $125,000 if filing a separate return. The provision is contained in new Sec. 1411, Unearned Income Medicare Contribution. Congress added the provision as a means of raising revenue to pay for health care reform. It targets wealthier taxpayers, as can be seen by the thresholds at which the tax applies.

MAGI is defined as:

adjusted gross income increased by the excess of—

(1) the amount excluded from gross income under section 911(a)(1), over

(2) the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section 911(d)(6) with respect to the amounts described in paragraph (1).2

For most individuals, MAGI will be their adjusted gross income unless they are U.S. citizens or residents living abroad and have foreign earned income. The tax is equal to 3.8% of the lesser of net investment income or the amount by which MAGI exceeds the threshold.3

Net investment income includes interest, dividends, annuities, royalties, and rents, other than such income that is derived in the ordinary course of a trade or business, less allocable deductions.4 It also includes income from a passive activity or a trade or business of trading in financial instruments or commodities.5 It does not include distributions from qualified plans included in Secs. 401(a), 403(a), 403(b), 408, 408A, or 457(b).6 These sections refer to qualified pension, profit-sharing, and stock bonus plans; qualified annuity plans; annuities purchased by Sec. 501(c)(3) organizations or public schools; individual retirement accounts; Roth individual retirement accounts; and eligible deferred compensation plans, respectively. Net investment income also does not include tax-exempt interest.7

Net gain attributable to the disposition of property other than property held in an active trade or business is subject to this tax.8 Gains from trading in financial instruments or commodities are also included. The taxable gain on the sale of a personal residence in excess of the Sec. 121 exclusion would be included.9

Estates and trusts are subject to this tax on the lesser of undistributed net investment income or the excess of adjusted gross income in excess of the highest tax bracket in Sec. 1(e) for the tax year.10 The tax does not apply to nonresident aliens or a trust in which all of the unexpired interests are devoted to charitable purposes under Sec. 170.11 “The tax also does not apply to a trust that is exempt from tax under section 501 or a charitable remainder trust exempt from tax under section 664.”12

Although Medicare tax assessed on self-employment income is deductible, the Medicare tax on net investment income is not deductible when computing any tax imposed by subtitle A of the Code (i.e., income taxes).13 The tax is subject to the individual estimated tax provisions.14

Planning and Analysis

Wealthy taxpayers have approximately a year and a half to develop methods and strategies for avoiding or reducing the impact of this new tax on investments. A good portion of the implementation of plans to limit this tax may take place in the last quarter of the tax year ending on December 31, 2012. This would be a good time for taxpayers to analyze their investment portfolios and harvest any year-end gains, thereby limiting the 3.8% tax on top of the income or capital gain tax assessed on the gains. Given that the wash sale rules do not apply to gains, selling a security at year end and repurchasing it may make sense if the investment is still a good portfolio choice.

Investors and financial planners have had an increased interest in dividend-paying securities since the implementation of the qualified dividend tax rate that came into effect under the Jobs and Growth Tax Relief Reconciliation Act of 2003.15 Investors may want to pass on capturing dividends and look to investments providing long-term capital gain. Of course, this is a deferral tactic, but potentially an investor may be close to retirement or a career change, at which time there may be a decrease in income. This deferral could end up as a permanent tax savings if the taxpayer’s MAGI falls below the taxable threshold.

Taxpayers will have more reason to look at tax-exempt bonds. The analysis of these investments in comparison to taxable interest investments would have to factor in the new Medicare rate. Typically, a taxpayer could gross up the interest rate on a tax-exempt bond with the inverse of their tax rate. So a 4% tax-exempt bond grossed up at the inverse of a 35% tax rate would provide for a taxable rate of interest of 6.15% (4% ÷ 65%). The gross-up number of 65% would need to be reduced by 3.8% in factoring the total rate of tax, including income tax and the Medicare tax. Therefore, the grossed-up taxable rate to use in comparing a 4% tax-exempt rate to a taxable rate would be 6.53% (4% ÷ 61.2%).

Income from nonqualified annuities will be subject to this new investment tax. The opportunity to convert the annuity or its income into an investment that would be excluded from the tax is limited. A long-term investor looking for tax deferral may want to consider post-tax IRA investments versus annuities on a go-forward basis because income from an IRA is not subject to this tax. Maximizing investments into any qualified plan as an alternative to other investments will provide for future savings since the income withdrawn from a qualified plan will not be subject to the Medicare tax.

Investors may look to other insurance products to avoid the new tax. The inside buildup of life insurance cash surrender value is not subject to the new Medicare tax, nor are life insurance proceeds that are excluded from income tax.

Rents are subject to the Medicare tax unless the rent is derived in the ordinary course of a trade or business. Investors in real estate would have more reason to look at the active real estate investors’ rules to determine if they could avoid this tax via the active classification. Active real estate investors need to spend more than one-half of their time specifically in the real property trades or businesses (out of their total trades or businesses). In addition, the materially participating taxpayer needs to perform more than 750 hours of services during the tax year in real property trades or businesses.16 Real estate investors need to consider the possibility of making an election to treat all interests in rental real estate as one activity, thereby aggregating all real property interests into one trade or business.17

In the case of a trade or business, the tax applies if the trade or business is a passive activity. Active business ownership within a sole proprietorship, limited liability company (LLC), partnership, or S corporation would not lend itself to this tax. A passive investor in a trade or business housed within one of these flowthrough entities is not subject to self-employment tax under Sec. 1401 because the investor is not active in the business. Therefore, if a passive investor attempts to construct an argument that she is not passive to avoid the Medicare tax, she will end up being subject to self-employment tax. This is the case for an investment housed within an LLC or a partnership. Under present rules, investors in a trade or business housed within an S corporation can avoid the investor’s Medicare tax on their flowthrough income if they can argue that they were actually active and not passive investors and still not be subject to self-employment tax. Even so, there are the implications of no compensation or unreasonably low compensation while claiming to be an active participant for S corporation employeeowners.18 Sec. 1411 includes a special rule whereby it excludes from the definition of net investment income any item taken into account in determining self-employment income under Sec. 1401.19 Thus, a taxpayer should never pay both self-employment tax and the new Medicare tax on the same stream of income.

An owner of a passthrough active trade or business may find that a portion of the flowthrough income is actually subject to the Medicare tax. Any income, gain, or loss attributable to an investment of working capital will be treated as not derived in the ordinary course of a trade or business. Interest, dividend, and royalty income earned in the normal course of a trade or business would not be subject to this tax, but idle cash-producing investment income would.20

Upon the disposition of an interest in a partnership or an S corporation, only the gain attributable to the disposition of nonactive assets would be subject to the Medicare tax. 21 An owner of an interest in a business may find that it has both an active trade or business and a passive activity housed within the operating entity. The determination of the portion of the gain subject to this tax would be based on an allocation of the fair market values of all the assets (active and passive) immediately before the disposition of the interest.22

An interesting twist on an investment within a flowthrough entity occurs when a taxpayer is invested in a hedge fund. Of course, a hedge fund yields the exact type of income that the new tax was meant to capture—interest, dividends, and capital gains. However, most hedge funds are considered to be active trades or businesses and not passive. Specifically, Temp. Regs. Sec. 1.469-1T(e)(6) states that “[a]n activity of trading personal property for the account of owners of interests in the activity is not a passive activity.”23 Some taxpayers may argue that their investment is an active trade or business based on this regulation and thereby not subject themselves to the Medicare tax. It appears that Congress expected an argument such as this; Sec. 1411(c)(2) specifies trades and businesses to which this tax applies, and subparagraph B lists “a trade or business of trading in financial instruments or commodities.”24

A working interest in an oil and gas property that a taxpayer holds through an entity that does not limit the taxpayer’s liability, or one held directly, is not considered a passive activity.25 Therefore, arguably royalties from this type of investment would not be subject to the tax. This may be an area where the IRS needs to provide clarification. Oil and gas production payments, royalties, or other income arrangements would be subject to the Medicare tax if the investment was not a working interest.

For the most part, a wealthy taxpayer with investments that produce income is going to be subject to this tax. The new law does not take effect until tax years beginning after December 31, 2012. This provides a somewhat lengthy window of opportunity for a taxpayer to plan potential minimization strategies.

Footnotes

¹ Health Care and Education Reconciliation Act of 2010, P.L. 111-152.

² Sec. 1411(d). Sec. 911(a)(1) refers to the exclusion from income of foreign- earned income for citizens or residents of the United States living abroad. Sec. 911(d)(6) refers to the disallowance of any deduction or exclusion from gross income to the extent that such deduction or exclusion is properly allocable to or chargeable against amounts excluded from gross income under Sec. 911(a).

³ Secs. 1411(a)(1)(A) and (B).

⁴ Secs. 1411(c)(1)(A) and (B).

⁵ Sec. 1411(c)(2).

⁶ Sec. 1411(c)(5).

⁷ Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as Amended, in Combination with the “Patient Protection and Affordable Care Act” (JCX-18-10), p. 135 (March 21, 2010).

⁸ Sec. 1411(c)(1)(iii).

⁹ Joint Committee on Taxation, Technical Explanation (JCX-18-10), at 135.

¹⁰ Secs. 1411(a)(2)(A) and (B).

¹¹ Secs. 1411(e)(1) and (2).

¹² Joint Committee on Taxation, Technical Explanation (JCX-18-10), at 135.

¹³ Id.

¹⁴ Id.

¹⁵ Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27.

¹⁶ Secs. 469(c)(7)(B)(i) and (ii).

¹⁷ Sec. 469(c)(7)(A) (flush language).

¹⁸ See, e.g., David E. Watson PC, 714 F. Supp. 2d 954 (S.D. Iowa 2010), in which the IRS successfully litigated unreasonably low compensation for the shareholder of an S corporation.

¹⁹ Sec. 1411(c)(6).

²⁰ Sec. 1411(c)(3) and reference to Sec. 469(e)(1)(B).

²¹ Sec. 1411(c)(4)(A).

²² Id.

²³ The example under Temp. Regs. Sec. 1.469-1T(e)(6)(iii) specifically states that interest, dividends, and capital gains derived from a partnership that is a trader of securities are not passive income.

²⁴ Sec. 1411(c)(2)(B).

²⁵ Sec. 469(c)(3)(A) and Temp. Regs. Sec. 1.469-1T(e)(4)(i).

EditorNotes

Karl Fava is a principal with Business Financial Consultants, Inc., in Dearborn, MI. Ken Rubin is a partner with RubinBrown, LLP, in St. Louis, MO. Both authors are members of the AICPA’s Individual Income Tax Technical Resource Panel. For more information about this article, contact Mr. Fava at kfava@bfcinc.com or Mr. Rubin at ken.rubin@rubinbrown.com.