The Looming Medicare Surtax of 2013

By: Michael C. Burt, CPA (Aug, 2012)

With a fear for the future concerning Medicare funds the Supreme Court approved a measure to bolster the kitty.  Starting with tax years beginning on or after January 1, 2013 as part of the Patient Protection and Affordable Care Act (as amended by the Health Care and Education Reconciliation Act of 2010) a .9% Medicare surtax will be wielded against high-income individuals and a 3.8% surtax has been slated to assail high-income households.

The first wave is the additional 0.9% Medicare surtax high-income individuals will have to pay on their earned income.  The 0.9% Medicare surtax is applied to single taxpayers with wages and self-employment income in excess of $200,000.  It applies to married taxpayers filing jointly with wages and self-employment income in excess of $250,000.  This tax burden rests solely on the shoulders of the individual taxpayers as there is no employer match on the 0.9% surtax.

The second wave is a 3.8 % Medicare surtax.  This Medicare surtax does not just line up individual taxpayers in its crosshairs, the surtax may also apply to estates and trusts.

For individual taxpayers it is equal to 3.8% times the lesser of the net investment income, or the excess (if any) of the Modified Adjusted Gross Income over the threshold amount.  For estates and trusts it is equal to 3.8% times the lesser of the undistributed net investment income for the taxable year, or the excess (if any) of the Adjusted Gross Income (as defined in Internal Revenue Code 67) over the threshold dollar amount at which the highest tax bracket in section 1(e) begins for that taxable year.

The term net investment income includes taxable interest income, dividends, annuity income, passive royalties, rents, income derived from a passive activity, as well as net capital gains from the disposition of property.  Net investment income does not include salary, wages, bonuses, exempt interest (such as tax-exempt bonds), active royalties, IRA distributions, qualified plan distributions (such as 401(k) distributions and pension income), required minimum distributions, social security income, as well as other items normally excluded or exempt from the income tax law such as veterans benefits and capital gain excluded under Internal revenue Code section 121.  Also excluded from net investment income is any income taken into account for self-employment tax purposes and any gain on the sale of an active interest in a partnership or S corporation.

No official guidance has been issued yet as to the treatment of rents for materially participating real estate professionals or for deferred compensation.  Special care should be taken with non-passive pass-through activities where the ordinary trade or business income would be excluded for net investment income purposes, but the interest and dividend income will be included.

The word net in net investment income is exceedingly important.  Investment expenses can be netted against the net investment income.  These investment expenses include margin interest and investment brokerage fees.  Investment interest expense carryovers should not be overlooked as they may also reduce the net investment income.

The thresholds for the 3.8% Medicare surtax are the same as the 0.9% Medicare surtax with single taxpayers at $200,000 and married taxpayers at $250,000.  For estates and trusts the threshold amount currently is $11,650 which is the top income bracket in 2012 (this may change for 2013).

For individuals the Modified Adjusted Gross Income is the amount compared to the threshold amount to determine what may be subject to the surtax.  Caution should be taken as the term Modified Adjusted Gross Income for purposes of this calculation under Internal Revenue Code section 1141 are different from other definitions of Modified Adjusted Gross Income found elsewhere in the Internal Revenue Code.  For this calculation Modified Adjusted Gross Income equals the taxpayers Adjusted Gross Income (example: Form 1040, line 37 for 2011) plus the net foreign earned income exclusion.

Some strategies for reducing net investment income may include shifting an investment portfolio to be more heavily invested in municipal bonds, utilizing tax-deferred annuities, as well as life insurance products.  With rental real estate investments, depreciation can be utilized to reduce rents.  With oil and gas investments, drilling costs may be depreciated over five years.  For estates and trusts timing of distributions are critical.  Care must be exercised whether to have includible undistributed income taxed at the fiduciary rates, or distribute it to individuals subjecting them to the possible Medicare surtax.

One pitfall for estates and trusts are that capital gains subject to the 3.8% surtax are normally trapped at the trust or estate level.  One strategy to help mitigate the first year impact of the 3.8% surtax would be to consider the election of the accounting tax year end.  By electing an 11/30/12 year end any capital gains realized in the 12/1/12 to 11/30/13 period will fall under the old rules not subject to the new 3.8% surtax as it is applicable only for tax periods beginning on or after January 1, 2013.  

Some strategies for reducing the Modified Adjusted Gross Income for individuals may be looking into possible Roth IRA conversions, or structuring sales as installment sales for the smoothing effect of taking income over multiple years instead of claiming it all in one year.  For trusts, creating charitable remainder trusts or non-grantor charitable lead trusts may help.

This new legislation will hit those hardest who remain passive.  With proper tax planning this new legislation may not be as burdensome as originally envisioned.  To properly guard against this new barrage against taxpayers one should contact their Dermody, Burke & Brown tax advisor early to avoid any surprises and properly plan for the future.


The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.

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