Small Business Taxes & ManagementTM--Copyright 2012, A/N Group, Inc.
Introduction
The Health Care and Education Reconciliation Act of 2010 (HCERA, P.L. 111-152) contains a provision that will subject certain individuals to a 3.8% "unearned income Medicare contribution" tax beginning in 2013. The tax is on "net investment income" which includes interest, dividends, annuities, royalties, certain rents and certain other passive business income. The tax will apply to single taxpayers with a modified adjusted gross income (MAGI) in excess of $200,000 and married taxpayers with an MAGI in excess of $250,000 ($125,000 for married, filing separately). MAGI includes wages, salaries, tips, and other compensation, dividend and interest income, business and farm income, realized capital gains, and income from a variety of other passive activities and certain foreign earned income. Taxpayers with a MAGI below these thresholds will not be subject to the 3.8% tax. The tax is 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.
The impact of the tax will depend on how much net investment income you have and your modified adjusted gross income (MAGI). Because certain factors can boost your MAGI in one year enough to subject you to the tax, careful planning may be able to reduce the impact.
Net Investment Income
The definition includes:
That means, for example, if your MAGI is above the threshold, you could owe the 3.8% tax on capital gains from the sale of investment property as well as any other regular tax on the gain. For example, capital gains could be taxed at 18.8%; interest income at 38.8%.
As usual, things are not as simple as represented by the list above.
Net investment income is gross income from the above sources, reduced by otherwise allowable deductions allocable to the income or gain. For example, investment interest expense could reduce your net investment income. Interest, dividends, royalties, rents and gains derived in the ordinary course of a business that is not a passive activity to the taxpayer isn't gross income subject to the tax.
Investment income includes gross income from any passive trade or business. Thus, if you're a shareholder in an S corporation or a partner or member in a partnership or LLC and don't materially participate in the business, the income is investment income for purposes of the tax. (See below for more details.) It also includes a trade or business of trading in financial instruments or commodities.
Net gains are investment income for this tax only if they're included when computing your taxable income and the disposition is not related to property that is held in a trade or business that is not a passive business. For example, you sell at a gain 100 shares of Chatham Small Stock Fund. Assuming you meet the MAGI threshold, the tax applies. You sell your vacation home for a $175,000 gain. The tax applies. You're a 50% shareholder in Madison Inc., an S corporation. You materially participate in Madison's operations and during the year the business sells some used equipment for a $62,500 gain. The gain is not investment income. You're also a member in Shaker Products, LLC, but do not materially participate in the operations. It sells a building it used as a warehouse and there's a $225,000 long-term capital gain. The tax applies.
The sale of a principal residence will be taxed only on the amount above the exemption. For example, you sell your principal residence for a $575,000 gain. You and your spouse meet the ownership and use requirements resulting in an exemption for the first $500,000 of gain. Only $75,000 of the gain results in net investment income.
Computing the Tax
The tax owed is equal to 3.8% multiplied by the lesser of (1) net investment income or (2) the amount by which your MAGI exceeds the $250,000/$200,000 threshold. Two examples will make the application of the tax clearer.
Example 1--In 2013 Fred and Sue Flood have $195,000 of net investment income from capital gains and dividends. Their MAGI is $262,500 and they file a joint return. Their Medicare contributions tax is equal to the lesser of their net investment income or the amount by which their MAGI exceeds $250,000 (married, filing joint). While their MAGI is largely comprised of net investment income ($195,000 of the total MAGI of $262,500), their tax base is the amount by which their MAGI exceeds $250,000, or $12,500. In this case their liability for the tax is $475 (($262,500 - $250,000) X 3.8%).
Example 2--Mike and Denise have the same amount of net investment income, $195,000, but their MAGI is $526,000. They're also filing married, joint. Again, the tax base is the lesser of net investment income or the amount by which your MAGI exceeds the threshold. In this case their MAGI exceeds the threshold by $276,000, but their net investment income is only $195,000. Thus, their tax base is $195,000 and their liability for the tax is $7,410 ($195,000 X 3.8%).
Example 3--Paul and Kathy sell their principal residence for a $620,000 gain. They meet the requirements to exclude the first $500,000 of gain. Thus, $120,000 of the gain is included in their taxable income. They have salary income of $155,000; they have no other income. Their MAGI is $275,000, ($155,000 plus $120,000) and their tax base for the Medicare contributions tax is $25,000 (the lesser of the net investment income of $120,000 or the amount by which their MAGI exceeds $250,000 or $25,000).
Planning
Since the tax only applies to net investment income, if you have no investment income, the tax does not apply, no matter how high your MAGI. On the other hand, if your MAGI is high enough, as in Example 2, above, all your net investment income could be subject to the tax. On a large capital gain, that could be substantial.
The tax applies to passive income such as that from rental activities that are inherently passive or trade or business activities in which you do not materially participate. This will make tracking your participation in an S corporation, partnership, LLC etc. even more important. In the past whether or not you materially participated in the activity made little difference if all such activities in which you had an interest produced net income. All the income would be taxable as ordinary income. Now, if you can't show material participation, you could be subject to an additional 3.8% tax. Keep in mind that material participation is by activity, not entity. For example, you're a 50% member in Madison LLC. Madison provides lawn services to residential customers and manufactures aircraft parts for the military. You could be materially participating in the lawn service business; the manufacturing business; both; or neither. Talk to your tax adviser.
Avoiding the tax will be difficult. Staying below the $250,000/$200,000 threshold, if possible, is the only real approach. Smoothing out your income to stay below the threshold could allow you to avoid the tax. If you'll exceed the threshold on a regular basis, you'll have to work through the numbers for the best approach. Depending on your net investment income it might make sense to bunch income in some years. In other circumstances, stretching out the income by selling an asset on the installment basis, could be advantageous. There's no rule of thumb here.
Offsetting capital gains and losses is one way of reducing your exposure to the tax. Remember, capital losses can be carried forward, but capital gains are fully taxed immediately. Under most circumstances, the worst scenario is to have a large capital gain in one year and a large capital loss in the next. In that case you'll pay tax on the gain, but get no benefit for the loss unless it can be used in future years.
Tax exempt income from state and local bonds escape the tax and won't increase your MAGI. That makes the interest particularly attractive. As always, investment considerations should be your first concern.
You must take the tax into account when computing your estimated tax payments for the year.
The Medicare contributions tax applies to estates and trust. The tax is applied to the lesser of the (1) undistributed net investment income for the year, or (2) the excess of the trust or estate's AGI over the beginning of the highest tax bracket for the estate or trust for the year.
While salaries, IRA distributions, etc. are not subject to the tax, such amounts will increase your MAGI, which increases your chances of breaking the $250,000/$200,000 threshold. Again, timing income can produce savings.
Copyright 2012 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 06/11/12