Effective January 1, 2013, a new 3.8% Medicare tax is being imposed on certain transactions. This new tax is the courtesy of Sec. 1411 of the Patient Protection and Affordable Care Act, P.L. 111-148 (informally referred to as Obamacare) and the Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
While a 3.8% tax may seem insignificant to some, if the current Bush income tax rates are extended, this tax amounts to a 25% tax increase on dividends and long-term capital gains (LTCG).
Who will be subject to this tax? The tax will apply to single taxpayers who have Modified Adjusted Gross Income (MAGI) over $200,000 and married couples filing jointly with a MAGI over $250,000 who have certain types of income. Since the MAGI computation will likely be equal to the Adjusted Gross Income (AGI) for most taxpayers, for purposes of this blog we will focus on AGI. You can find your AGI on line 37 of your 2011 Form 1040. The IRS provides a worksheet in Appendix B of Publication 590 which can be found at www.irs.gov for those who wish to compute their actual MAGI.
The types of income that will be subject to this tax are classified as “net investment income” which is investment income reduced by deductions properly allocable to that income. Investment income include interest, dividends, capital gains from portfolios, annuities, income from passive activities (e.g., rents and royalties), and gains from sales of certain real estate transactions. Home sales can trigger the tax in one of two ways. First, a home sale may result in a capital gain that increases net investment income. Second, a home sale may result in a capital gain that increases a taxpayer’s MAGI. Fortunately for principal residences, the gain that is includable as net investment income must exceed the $250,000 gain exclusion for single homeowners and the $500,000 gain exclusion for married couples under the normal tax rules. Taxpayers who sell a second home (vacation, rental property) will find that the entire gain on such sales is subject to the surtax if the MAGI thresholds are satisfied.
In the case of a trade or business, the Medicare tax applies if the trade or business is a passive activity for the taxpayer or the trade or business consists of trading financial instruments or commodities. IRC Sec. 1411(c)(2)(A) defines a passive activity by reference to IRC Sec. 469. Under Sec. 469, business activities are treated as passive activities unless the taxpayer materially participates in the activity. A taxpayer will not be treated as materially participating in an activity unless his involvement in the operations of the activity is regular, continuous, and substantial. The current regulations treat a taxpayer as materially participating in an activity if he meets one of seven tests during the tax year. Perhaps the easiest of these tests is that the taxpayer spends more than 500 hours in the business during the tax year.
Sources of income exempt from this new tax include income subject to self-employment taxes, gains from sales of business assets where the business is not a passive activity of the taxpayer, qualified plan and IRA distributions, municipal interest, and life insurance proceeds.
For those who are subject to the tax, the amount of the tax owed will be equal to 3.8% multiplied by the lesser of (1) net investment income or (2) the amount by which their MAGI exceeds the above $200,000/$250,000 thresholds.
Type of legal entity may also impact net investment income. The gain from a sale of C Corporation stock is likely subject to the new tax, but a gain from the sale of partnership or S Corporation stock in which the partner or shareholder materially participated may not be includable in net investment income. An S Corporation shareholder who is active in the business would likely be considered as materially participating in the business. As a result, that shareholder’s K-1 income would not be considered investment income whereas dividends paid to a shareholder of a C Corporation would be considered investment income subject to the 3.8% Medicare tax. Perhaps C Corporation shareholders need to re-assess the advantages of electing to be an S Corporation.
How can you avoid or minimize this surtax? Work with your tax advisor to lower your AGI or convert income subject to this new tax to income that is exempt from the tax. Because of the interrelationship of some of these items, the tax advisor will likely want to do a “what if” analysis to compute the pro-forma tax savings. Ways to convert income that is subject to the surtax is to convert taxable corporate dividend income to municipal bond interest and to convert taxable portfolio investments to a variable universal life insurance policy. When attempting to lower your AGI, you need to realize that you need deductions that are “above the line” (line 37) and not “below the line”. Above the line deductions are normally found on lines 23-35 of Form 1040. Examples of such deductions include HSAs and self-employed retirement plan contributions. Below the line deductions which do not reduce AGI include real estate taxes, charitable contributions, mortgage interest, and other deductions found on Schedule A of Form 1040. For those business taxpayers with significant AGI, strategies could include Captive Insurance Companies, installment sales, using a defined benefit plan to reduce business earnings, and converting a C Corporation to an S Corporation. Another tax strategy that may appeal to some taxpayers is to sell appreciated assets in 2012 and repurchase those holdings before the new tax becomes effective. This would avoid the 3.8% surtax on the current unrealized gains and provide the taxpayer with a higher tax basis when a future sale is made.
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