Medicare Surtax on Net Investment Income

William J. Killory, CPA, Partner (Jan, 2014)

Back in 2010, Nancy Pelosi infamously stated “we must pass this bill to find out what’s in it.” Four years later that bill, the Affordable Care Act, now appears to be a cross between Murphy’s Law and the law of unintended consequences.  A new component of the law will appear on your tax returns this filing season.  Section 1411 was added to the Internal Revenue Code and imposes a 3.8% tax on net investment income for taxpayers over a certain threshold.  Regulations were first promulgated in late 2012 to give guidance as to how to determine what was included in the definition of net investment income.  These regulations were revised in late November of 2013 that solved some of the more troublesome aspects of the initial regulations.

Before you continue too far with this article, if you are married with an adjusted gross income (the last number on page one of Form 1040) under $250,000 or single with an adjusted gross income under $200,000 this surtax will not apply to you. If you file separately then the threshold is $125,000 and if you have a trust, where the threshold is $11,950, you may still want to pay attention if you are over those limits and have investment income.

The definition of net investment income is fairly straightforward, but has a few twists that complicate matters.  Gross income from interest, dividends, annuities, royalties, and gains from the sale of securities and property are under this broad umbrella.  Income from tax exempt state and local bonds as well as income from qualified retirement plans is excluded.  Income from passive activities will be part of the equation, however, income from an active trade or business will not be.

Where things get a bit cloudy for our clients is the closely held business.  The theory behind the additional tax is to impose the Medicare tax on wealthy taxpayers on a broad array of sources of income.  Married wage earners that make above $250,000 face the same 3.8% tax.  There is the employee’s withholding of 1.45%, the employer’s match of 1.45% and the surcharge of 0.9% above the $250,000 that is either withheld from your paycheck or paid on your return, depending on individual circumstance.  Those that are self-employed face the same surcharge as wage earners.  Income that escapes this additional tax (for now) is earnings from the S-Corporation where you actively participate.

This still leaves a few areas that needed clarification and the November 2013 regulations provided some taxpayer-friendly guidance concerning rental property, the sale of business assets and, most importantly, the sale of an interest in a closely held business.

Rental activity is a per se passive activity as defined by the Internal Revenue Code.  There is an exception for those who are real estate professionals.  They are in effect deemed to be in the trade or business of rental real estate.  There are fairly substantial tests in order to meet this designation, but once met you are not subject to passive loss rules for rental activities.  You are not subject to self-employment tax on the income you receive from the rental activity, even though this is your business.  The regulations clarified that you are also not subject to the 3.8% surcharge on net investment income from these activities.

Many of our clients have real estate used in their business that is separately owned.  Because they can control the income or loss this activity is subject to recharacterization.  It is considered a passive loss if you lose money, but is considered non-passive if you make money.  The IRS wins if it’s heads and you lose if it’s tails.  They also clarified in the most recent regulations that if you elect to group your rental activity with your active business interest then the rental income will not be subject to the surtax.  This is true even if you have a triple net lease and the level of rental activity is minimal.  This is something that must be determined at the individual level as you must be actively involved in the related business in order to qualify.  You should consider your individual circumstance as well.  If you have a passive loss, but have passive gains from unrelated activity then you may want to offset that income with the related party loss.  Each circumstance is unique and does deserve thoughtful planning.

The other important area that gave taxpayer’s relief is the treatment of the sale of business assets and particularly an interest in a business that you actively participate.  The original regulations would have had you go through very complicated calculations based on information that you may not be able to readily obtain.  For the majority of transactions any sale of business assets or interests where you were actively involved won’t be subject to this additional tax.  This includes payments received in an installment sale that stretches out over several years.  The interest portion of the installment sale however will be included in the formula for net investment income.

The tax is on net investment income, which implies that you can offset expenses against the income.  Investment losses can be utilized to offset gains so it increases the planning opportunities when disposing assets.  You will be able to deduct investment fees, investment interest expense and a portion of your state taxes allocable to investment income.  This is another layer of tax on top of regular income tax, alternative minimum tax and normal employment taxes.  It illustrates the growing complication of the Internal Revenue Code and the difficulty in planning and properly calculating what is due to the government.

Those of you who may be subject to this tax and have active business interests will need to make elections this year on your return to group activities together.  The analysis will include your level of activity and the nature and timing of income to properly group activities that minimize your tax exposure.  As always, your Dermody, Burke & Brown tax professional is available to assist you through this process. 

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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