The New 0.9% Medicare Surtax and 3.8% Tax on Net Investment

The U.S. Treasury and the IRS recently released guidance in the form of proposed regulations and frequently asked questions on the new 0.9% Medicare surtax and the new 3.8% tax on net investment income. These two provisions were included in the Affordable Care Act (the “ACA”), which was enacted in 2010, but didn’t receive much attention until recently because: 1) the constitutionality of the ACA was challenged in the Supreme Court, and 2) these provisions don’t take effect until 2013. Since the U.S. Supreme Court upheld the constitutionality of the ACA and 2013 is now upon us, taxpayers must be aware of the impact of these new taxes. Both new taxes are designated as Medicare taxes, but none of the funds generated by these provisions are earmarked for Medicare or health care purposes.

While the income subject to tax under these new provisions is different, there is an overlap in the definition of taxpayers subject to these new taxes. The 3.8% tax on net investment income applies to unincorporated taxpayers (basically individuals, estates, and certain trusts) who have modified adjusted gross income (“MAGI”) in excess of certain threshold amounts: $250,000 in the case of married taxpayers filing a joint return or a surviving spouse; $125,000 in the case of a married taxpayer filing separately; and $200,000 for everyone else except estates and trusts, where the threshold is equal to the highest amount at which the maximum tax rate begins (projected to be $11,950 in 2013). The 0.9% Additional Medicare Tax applies to individuals at the same threshold amounts, but does not apply to estates or trusts. Neither of these new taxes applies to individuals who are treated as non-resident aliens for U.S. income tax purposes. Let’s look at each of these new taxes separately.

3.8% Tax on Net Investment Income

Perhaps no area has generated more activity from a year-end tax planning standpoint than the new tax on net investment income. This tax will apply to net investment income of taxpayers to the extent their net investment income and their MAGI, including their net investment income, is in excess of the threshold amounts discussed above. Proposed regulations take 159 pages to define “net investment income;” however, the term basically includes most dividends, interest, annuities, royalties, rents and the taxable portion of gains from the sale of property. Gains or losses from the disposition of partnership or S Corp interests are generally not subject to this tax, except to the extent the pass-thru entity would have generated gain or loss if it had sold all of its assets immediately before the sale of the pass-thru interest (the deemed sale rule). To the extent that rents and other income are treated as non-passive investment income under Code Sec. 469, they are not treated as net investment income subject to the 3.8% surtax. Qualified plan distributions and any income items subject to self-employment tax are not treated as net investment income subject to this surtax.

Most planning relating to this tax focuses on: 1) harvesting gains and other income subject to the tax before the tax takes effect next year, 2) deferring losses and deductions to next year so that the income subject to the surtax is minimized or the taxpayer will be under the threshold, 3) changing investment portfolios so that income generated will not be subject to tax (e.g., tax exempt bond interest, growth stocks instead of dividend paying stocks, annuities which will defer income until later years when the taxpayer will in a lower tax bracket), 4) maximizing deductions (e.g., depreciation, investment expenses, and other properly allocable deductions) that will reduce income otherwise subject to the tax, and/or 5) reorganizing or regrouping rental activities.

Additional 0.9% Medicare Tax

The additional 0.9% Medicare tax on wages and self-employment income is applicable only to income in excess of the threshold amounts discussed above, starting next year. The threshold and the amount of income subject to tax is based on the combined income of a husband and wife on a joint return. Thus, even if each is under the threshold amount individually, the couple will be subject to the tax to the extent their combined incomes exceed the threshold. In addition, in the case of wages paid to an employee, the surtax applies only to the employee’s share of the employment tax. Therefore, a single taxpayer with a salary of $300,000 would pay Medicare tax at a rate of 1.45% on the first $200,000 of salary received, but 2.35% on the $100,000 of salary received in excess of the $200,000.

Employers are required to withhold additional Medicare tax on wages in excess of $200,000 in a calendar year, without regard to the employee’s filing status or income from other sources. If an employer withholds the Additional Medicare Tax and no Additional Medicare Tax is due – for example, in the case of a married taxpayer who is under the $250,000 married filing jointly threshold but has wages in excess of $200,000 – the employer must withhold the tax and the employee will claim a credit for the withheld taxes on his or her income tax return for the year. If no tax is withheld – for example, if a husband and wife are each paid under $200,000 for the year, but their combined income exceeds the threshold amount – they should either request additional withholding or cover their additional liability for this tax by paying estimated tax.

A self-employed person will pay self-employment tax at a rate of 2.9% on self-employment income up to the threshold amount and 3.8% on income in excess of the threshold. These amounts are reduced, but not below zero, by the amount of FICA wages taken into account in determining the Additional Medicare Tax.

Self-employed individuals, as well as salaried employees, need to take both of these new taxes into account when determining estimated tax for 2013.

It should be evident that the rules applicable to these new taxes are extremely complex. We encourage you to meet with your CB&H tax advisor to explore ways that the impact of these new taxes, as well as the other tax law changes taking effect next year, can be mitigated. CB&H tax advisors have received extensive training on these tax law changes and how best to deal with them.