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June 11, 2012
group 2012
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The following alert is from Desmond Sheridan

 

New 3.8% Medicare tax on investment income draws near

 

We wrote a couple of years ago about a new tax included in President Obama's health care legislation. The tax becomes effective in 2013, so it's time to revisit this subject. Wage earners and business owners have long been subject to a 2.9% Medicare tax on their incomes. The Medicare tax is rolled up with the Social Security tax (12.4%) for a total tax of 15.3%. The Social Security component burns off at $110,100 (in 2012) but the Medicare tax has no cap. Another note: In 2012, the Social Security tax is reduced to 10.4% but that's scheduled to go back to 12.4% in 2013. The health care law increases the earned income Medicare tax to 3.8% but also imposes a brand new tax on net investment income of higher income taxpayers. Here's the story on the tax and a few ideas:

 

Medicare tax on investment income. For tax years beginning after Dec. 31, 2012, a 3.8% tax will apply to net investment income of higher income taxpayers. The tax for individuals is 3.8% of the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount.

 

Threshold amount. The threshold amount is $250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 in any other case.

 

MAGI. MAGI is adjusted gross income adjusted for certain foreign income.

 

Only individuals with MAGI above the applicable threshold amount will be subject to the tax.

 

Example: For 2013, a single taxpayer has net investment income of $50,000 and MAGI of $180,000. He won't be liable for the tax, because his MAGI ($180,000) doesn't exceed his threshold amount ($200,000).

 

Example:

For 2013, a single taxpayer has net investment income of $100,000 and MAGI of $220,000. He would pay the tax only on the $20,000 amount by which his MAGI exceeds his threshold amount of $200,000, because that is less than his net investment income of $100,000. Thus, the tax would be $760 ($20,000 � 3.8%).

 

An individual will pay the 3.8% tax on the full amount of his net investment income if his MAGI exceeds his threshold amount by at least the amount of the net investment income.

 

Example:

For 2013, a single taxpayer has net investment income of $100,000 and MAGI of $300,000. Because his MAGI exceeds his threshold amount by $100,000, he would pay the tax on his full $100,000 of net investment income. Thus, the tax would be $3,800 ($100,000 � 3.8%).

 

Net investment income. For purposes of the Medicare contribution tax, "net investment income" means the excess, if any, of:

 

(1) the sum of:

... gross income from interest, dividends, annuities, royalties, and rents, unless those items are derived in the ordinary course of a trade or business to which the Medicare contribution tax doesn't apply (see below),

... other gross income derived from a trade or business to which the Medicare contribution tax applies (below),

... 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 Medicare contribution tax doesn't apply, over

(2) the allowable deductions that are properly allocable to that gross income or net gain.

 

Thus, the 3.8% tax doesn't reach tax-exempt bond interest and gain from the sale of a principal residence that is excluded. However, to the extent that gain from a sale of a principal residence doesn't qualify for the exclusion (e.g., the gain exceeds the $250,000/$500,000 limit on the exclusion), it would be subject to the 3.8% tax. Gain from the sale of a vacation home or other secondary residence also would be subject to the tax.

 

It should be borne in mind that the 3.8% tax is in addition to any regular tax or capital gains tax that may be imposed on the investment income item. Because higher income taxpayers may face increased regular taxes and capital gains taxes in the next few years, reducing the 3.8% tax takes on increased importance.

 

Trades and businesses to which tax applies. The Medicare contribution tax applies to a trade or business if it is a "passive activity" of the taxpayer. For a taxpayer that does engage in a passive activity, "net investment income" will include the above items, plus the net income from the passive activity.

 

The tax doesn't apply to other trades or businesses conducted by a sole proprietor, partnership, or S corporation. This type of income is subject to the Medicare tax anyway.

 

Exception for certain active interests in partnerships and S corporations. Gain from a disposition of an interest in a partnership or S corporation is taken into account as net investment income only to the extent of the net gain that the transferor would take into account if the partnership or S corporation had sold all its property for fair market value immediately before the disposition. A similar rule applies to a loss from a disposition of an interest in a partnership or S corporation. Thus, only net gain or loss attributable to property held by the entity that isn't property attributable to an active trade or business is taken into account.

 

Retirement plan distributions. Investment income does not include distributions from tax-favored retirement plans, such as qualified employer plans and IRAs.

 

While distributions from qualifying tax favored retirement plans are not investment income for purposes of the 3.8% tax, depending on the type of vehicle and the taxpayer's basis in it, they could be included in MAGI and thus help to push the taxpayer over the threshold thus causing other types of investment income to be subject to the tax.

 

An individual who has the means but is not contributing the maximum permissible amount to 401(k) plan or IRA should do so rather than invest the difference in a regular investment account. Not only will the individual get the income tax advantages of the qualified plan or IRA for the additional contributed amounts but, in the future, he may save some 3.8% tax that could have been triggered had the funds been invested in a regular investment account.

 

The 3.8% Medicare tax makes Roth IRAs a more attractive alternative for higher income individuals. Qualified distributions from Roth IRAs are tax-free and thus won't be included in MAGI (or be subject to the Medicare tax), whereas distributions from regular IRAs (except to the extent of after-tax contributions) will be included in MAGI (but won't be subject to the Medicare tax).

 

Taxpayers planning to roll over regular IRAs to Roth IRAs should consider doing so before 2013 to avoid winding up with higher MAGI as a result of the rollover. And for IRA-to-Roth-IRA conversions occurring in 2010, unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income this year; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012. 

 

What if the Health Care Law is Unconstitutional? The U.S. Supreme Court is considering the constitutionality of the health care law. It's possible the Court could find the central part of the law (the individual requirement to buy health insurance) unconstitutional but leave the rest of the law intact. In that case, the tax would go forward unless Congress acts to change it. There's no question that the tax itself is constitutional but it's also possible the entire law could be voided. In short, no one knows what's going to happen.

 

 
About the Writer

Desmond G. Sheridan is a partner in the Greensboro law firm of Isaacson Isaacson Sheridan & Fountain, LLP and is a certified public accountant.  His practice areas are business transactions, tax, corporations, limited liability companies, commercial real estate and estate planning.  Sheridan has served on the Board of Directors of the North Carolina Association of Certified Public Accountants and has been recognized as a "Best Lawyer in America," a North Carolina "Super Lawyer" and a member of the "Legal Elite" by Business North Carolina.  He has given numerous continuing education presentations to CPAs and attorneys.

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