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Bar News - February 22, 2013

Tax Law: New Medicare Surtax Could Have Broad Impact


Many lawyers are unaware of the new Medicare surtax on unearned income, which could increase the federal taxes their clients pay on passive gains and most investment income in 2013 and beyond.

Effective Jan. 1, 2013, Section 1411 of the Internal Revenue Code imposes a new 3.8 percent Medicare Contribution Tax on unearned income received by individuals, trusts, and estates. For US residents, the tax is payable on the lesser of (a) Net Investment Income (defined under the Code as income or gains from passive investment or passive business activities, or from a trade or business that actively trades financial instruments or commodities); or (b) the excess (if any) of Modified Adjusted Gross Income (MAGI) over the statutory threshold amount, currently $200,000 for single filers or $250,000 for joint filers.

To illustrate the effects of the new tax on individual taxpayers, letís consider hypothetical, married taxpayers, Jack and Diane.

Letís assume that in 2013, Jack and Diane own and actively work in a business together that does not trade in financial instruments or commodities, is incorporated under state law, and has made a valid S-Corporation election. Assume that Jack and Diane pay themselves reasonable wages of $60,000 each and have combined S-Corporation income of $200,000. Jack and Diane also own dividend-paying stock in ABC Corp. For 2013, Jack and Diane receive dividend income from ABC Corp. of $15,000.

Example 1
Jack & Dianeís 2013 Income
Combined Wages: $120,000
S-Corp. Income: + $200,000
ABC Corp. Dividends: + $15,000
MAGI $335,000
As shown in Example 1, because Jack and Dianeís net investment income ($15,000 in dividends from ABC Corp.) is less than their MAGI, Jack and Diane would pay a surtax of $570 ($15,000 x .038) on their Net Investment Income of $15,000. The surtax is payable in addition to the taxes otherwise payable, if any.

Critical to our analysis of Jack and Dianeís potential Medicare Contribution Tax liability is whether Jack and Diane are "active" in their S-Corporation. In our example above, we assumed that Jack and Diane were active in their business; however, in the real world, we would have to apply the passive activity principals under ß 469 to determine whether Jack and Diane materially participated in their business during the taxable year. In simple terms, generally, if a person materially participates (1) more than 500 hours during the year; (2) more than 100 hours during the year, provided that no one else participates for more hours during the year; or (3) the personís participation constitutes substantially all of the participation in such activity, the IRS will consider the personís activity "active."

Consider the following example, where application of the ß 469 passive activity rules result in a situation where Medicare Contribution Tax liability arises.

Fred, an angel investor and commodities speculator, purchased a small stake in Jack and Dianeís S-Corporation in a tax year prior to 2013. Fred actively trades commodities, does not materially participate in Jack and Dianeís S-Corporation, and receives other stock dividends during 2013.

Example 2
Fredís 2013 Income
Commodity Trading Income: $300,000
Passive S-Corp. Income: + $ 10,000
Other Dividends: + $ 40,000
MAGI $350,000
Here, all of Fredís income for 2013 would be considered Net Investment Income as Fredís commodity trading income, passive S-Corporation income and other dividends are expressly defined in ß 1411 as Net Investment Income. Fredís Medicare Tax Contribution liability, therefore (exclusive of other tax liability), would be $13,300 ($350,000 x .038).

Fortunately, not all investment income is subject to the Medicare Contribution Tax, and Congress allows certain allocable deductions.

Examples of specifically excluded items from the definition of Net Investment Income are: any distributions from qualified pension, stock bonus, or profit-sharing plans described under ß 401(a); qualified annuity plans; and IRAs and Roth IRAs. Also excluded from Net Investment Income is any gain that is not immediately subject to income tax in the taxable year. Examples include gains deferred or excluded, such as the sale of a principal residence, qualified small business stock, installment sales, and like-kind exchanges subject to ß 1031. Finally, Congress excluded from Net Investment Income any item of income subject to self-employment tax, such as the reasonable wages S-Corporations pay to their shareholders for work performed.

Examples of allocable deductions from gross income and net gain include investment interest expenses, investment expenses, and ß 164 items, such as state income taxes.

Finally, to demonstrate that the Medicare Contribution Tax is assessed on the lesser of Net Investment Income or MAGI, please consider the following example.

In 2013, Jen and Robert, two Florida retirees living on an $85,000-per-year qualified pension distribution, decide to reside part of the year in New Hampshire. To purchase a new condominium near Lake Winnipesaukee, they sell certain property (not otherwise subject to the Medicare Contribution Tax) resulting in a capital gain of $200,000. Other than their pension income and the capital gains realized on the property sale, Jen and Robert have no other income.

Example 3
Jen & Robertís 2013 Income
Pension Income: $ 85,000
Capital Gains: + $200,000
MAGI $285,000
MAGI $285,000
Threshold Amount (joint): - $250,000
Subject to Medicare Surtax $ 35,000
Here, Jen and Robertís MAGI is calculated using their pension and capital gains income. Since Jen and Robertís MAGI is greater than the threshold amount for taxpayers filing jointly, Jen and Robert incur a Medicare Contribution Tax liability of $1,330 ($35,000 x .038).

We have entered a period of low investment yields and higher taxes. Interest rates and dividends are at historic lows, yet with the inclusion of the 3.8 percent Medicare Contribution Tax, the 0.9 percent Medicare Tax on earned income, and the increase of the top individual rate to 39.6 percent, top earners can now expect to pay a federal marginal rate of up to 44.3 percent.

Including the Medicare Contribution Tax, capital gains and qualified dividends to individual recipients are now taxable at 23.8 percent.

The 2013 goal for tax counsel is to become familiar with these new taxes in order to work with clients to craft strategies that minimize their impact.

Mark W. DellíOrfano is vice president and counsel at Sector Capital Group, LLC, a Manchester, NH-based private equity firm. He may be reached at 603-627-0416, ext. 226, or via e-mail.

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