The health care reform package (the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010) imposes a new 3.8 Medicare contribution tax on investment income of higher-income individuals. The 3.8 percent tax will apply to the lesser of net investment income or the excess of modified adjusted gross income over the threshold amount. The tax is effective beginning in 2013.

The tax applies to the lesser of net investment income or modified adjusted gross income (MAGI) above $200,000 for individuals and heads of household, $250,000 for joint filers and surviving spouses, and $125,000 for married couples filing separately. MAGI is the same as AGI for someone who does not work overseas.  The tax can have a substantial impact on taxpayers with income above the specified thresholds.

In addition to the tax on investment income, taxpayers also face other tax increases to take effect in 2011. The top two marginal income tax rates for individuals will rise from 33 and 35 percent to 36 and 39.6 percent, respectively. The maximum tax rate on long-term capital gains will increase from 15 percent to 20 percent. Dividends, which are currently capped at the 15 percent long-term capital gain rate, will be taxed as ordinary income. Thus, the cumulative rate on capital gains would increase to 23.8 percent in 2013, and the rate on dividends would jump to as much as 43.4 percent. Moreover, the thresholds are not indexed for inflation, so more taxpayers may be affected as time elapses. Some estimates forecast the total tax rate on high-income individuals to reach approximately 59 percent when federal tax increases are in place and state rates likely follow suit.

“Net investment income," includes interest, dividends, annuities, royalties, rents, and other gross income attributable to a passive activity. Gains from the sale of property that is not used in an active business, and income from the investment of working capital are treated as investment income. However, the tax does not apply to nontaxable income, such as tax-exempt interest or veterans’ benefits.

An individual’s capital gains income would be subject to the tax. This includes gain from the sale of a vacation home and your principal residence, unless the gain is excluded from income under Code Section 121 (generally your primary residence for two of last five years and gain is less than $250,000 ($500,000 joint filers)).  If you are considering sale of capital gain property, planning should be done to determine if a sale should be completed before 2013.

For capital gain property, this formula puts a premium on keeping tabs on amounts that increase the property’s basis. It also puts the focus on investment expenses that may reduce net gains: interest on loans to purchase investments, investment counsel and advice, and fees to collect income. Other costs, such as brokers’ fees, may increase basis or reduce the amount realized from an investment. One question is whether capital loss carryovers will reduce investment income and net gains (especially if derived from 2012 and earlier years).

Net investment income is gross income or net gain, reduced by deductions that are “properly allocable” to the income or gain. This is a key term that Treasury expects to address in guidance. For passively-managed real property, allocable expenses will still include depreciation and operating expenses. Indirect expenses such as tax preparation fees may also qualify.

Planning should also be done with respect to installment sales with net capital gains (and interest) running past 2012.

Higher-income individuals may also be taxed for Medicare after death, because the tax applies to estates and trusts.  The tax is on the lesser of undistributed net income or the excess of the trust/estate adjusted gross income (AGI) over the threshold amount ($11,200) for the highest tax bracket for trusts and estates, and to investment income they distribute. 

Certain items and taxpayers are not subject to the 3.8 percent tax. A significant exception is provided for distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans (although these distributions continue to be taxed as ordinary income rather than capital gains, even to the extent of investment earnings). There is no exception for distributions from nonqualified deferred compensation plans subject to Code Sec. 409A. However, distributions from these plans (including amounts deemed as interest) are generally treated as compensation, not as investment income.

The exception for distributions from retirement plans suggests that potentially taxable investors may want to shift wages and investments to retirement plans such as 401(k) plans, 403(b) annuities, and IRAs, or to 409A deferred compensation plans. Increasing contributions will reduce income and may help taxpayers stay below the applicable thresholds. Small business owners may want to set up retirement plans, especially 401(k) plans, if they have not yet established a plan, and should consider increasing their contributions to existing plans.

A counter-argument is that distributions from retirement plans after 2012 will increase AGI and push taxpayers closer to the threshold for taxing investment income. Thus, contributing to a Roth IRA would be especially valuable since distributions are nontaxable, will not increase AGI, and will not be subject to the investment tax.

An exception is provided for income ordinarily derived from a trade or business that is not a passive activity under Code Sec. 469, such as a sole proprietorship. Investment income from an active trade or business is also excluded. However, SECA (Self-Employment Contributions Act) tax will still apply to proprietors and partners. Income from trading in financial instruments and commodities is also subject to the tax. The tax does not apply to income from the sale of an interest in a partnership or S corp, to the extent that gain of the entity’s property would be from an active trade or business.

S corps may have an advantage over partnerships and limited liability companies (LLCs) because they generate active income that is not subject to the Medicare contribution tax and arguably is not subject to SECA tax.

The tax does not apply to business entities (such as corporations and LLCs), nonresident aliens (NRAs), charitable trusts that are tax-exempt, and certain non-taxable charitable remainder trusts.

Please contact your BC Engagement Executive or one of our tax partners if you have any questions.

Ronald J. Manse, CPA
Corporate Tax & Succession Planning

Scott T. Warburton, CPA/PFS
Corporate, Individual & Estate Tax Planning

Gregory F. McNulty III, CPA, JD
Individual Tax & Estate Planning

David L. Groves, CPA
Corporate & International Tax Planning

Daniel R. Riemenschneider, CPA, CMA
Corporate & Individual Tax Planning