The New Medicare Taxes

The Health Care Reform Legislation enacted in 2010 significantly broadens the Medicare tax base for higher-income taxpayers by enacting two new taxes.  Beginning in 2013, higher-income taxpayers will be subject to an additional 0.9% tax on earned income and a new 3.8% tax on investment income.

0.9% Tax on Earned Income

Effective for tax years beginning after December 31, 2012, an additional 0.9% Medicare HI tax is imposed on wages in excess of $250,000 for married taxpayers filing a joint return, $125,000 for married taxpayers filing separately, and $200,000 in all other cases (i.e., single or head of household).

An additional 0.9% tax is also imposed on net earnings from self-employment in excess of the above threshold amounts.

The additional tax on wages is imposed only on employees.  Unlike the regular Medicare HI tax, there is no employer match.  Although employers are not subject to the matching excise tax, they do have a withholding obligation and are liable for the tax if they fail to withhold the required tax from employees.  Employers are required to withhold the additional 0.9% Medicare HI tax on wages in excess of $200,000.  Wages received by a spouse are not considered in determining the appropriate withholding.  The withholding obligation applies only to wages in excess of $200,000, even though the tax may apply to wages at or below $200,000.

H and W are married and file a joint return in 2013.  W has wages of $250,000 and H has wages of $200,000.  W’s employer must withhold the additional 0.9% Medicare HI tax on the $50,000 of wages in excess of $200,000.  H’s employer is not required to withhold anything with respect to the 0.9% Medicare HI tax even though W and H combined wages are over the $250,000 threshold.  Employees are liable for the additional 0.9% Medicare HI tax to the extent it is not withheld by their employer and W and H must consider the tax in determining their 2013 tax liability.

Unlike the 1.45% Medicare HI tax, which is applied separately to wages earned by each spouse, the new 0.9% Medicare HI tax is imposed on combined wages in excess of $250,000 for married taxpayers filing a joint return.  Because the $250.000 threshold for married taxpayers is less than twice the $200,000 threshold for unmarried taxpayers, married taxpayers are potentially subject to a “marriage penalty.”

A and B each have wages of $200,000 in 2013, and are married and file a joint return.  C and D each have wages of $200,000 in 2013, and live together but are not married.  A and B earned income exceeds the $250,000 threshold for joint returns, and they are subject to an additional Medicare HI tax of $1,350 (($400,000 – $250,000) x 0.9%).  C and D, on the other hand, are not subject to an additional Medicare HI tax because neither of their wages exceeds the $200,000 threshold for unmarried taxpayers.

3.8% Tax on Investment Income

Effective for tax years beginning after December 31, 2012, higher-income taxpayers with investment income will be subject to a new 3.8% Unearned Income Medicare Contributions Tax (UIMCT) on their net investment income.  This tax is imposed on the lesser of (1) net investment income, or (2) the excess of modified adjusted gross income (MAGI) over a threshold amount.  The threshold amounts are the same as those used for the additional 0.9% Medicare HI tax ($250,000 for married couples filing a joint return, $125,000 for married couples filing separately, and $200,000 for all other taxpayers).  As is the case with the additional 0.9% Medicare HI tax, these threshold amounts are not indexed for inflation.

M an unmarried taxpayer, has MAGI of $220,000 and net investment income of $80,000 in 2013.  The tax is imposed on the lesser of MAGI over the threshold amount ($20,000), or net investment income ($80,000).  As a result, M is subject to an additional tax of $760 (3.8% x $20,000).

Taxpayers can be subject to both the additional 0.9% Medicare HI tax on earned income and the Unearned Income Tax in the same year.  Net investment income is defined as the excess of the sum of the following items less deductions properly allocable to such items:

  • Gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which the UIMCT tax does not apply.
  • Income from a trade or business to which the UIMCT tax applies.
  • Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the UIMCT does not apply.

The UIMCT applies to a trade or business that is a passive activity (as defined in Section 469) with respect to the taxpayer, and the trade or business of trading in financial instruments or commodities (as defined in Section 475(e)(2)).  As a result, business income from an activity that is passive with respect to the taxpayer is considered investment income for purposes of the UIMCT.  The tax does not apply to active trade or business activities conducted by a sole proprietor, partnership, or S corporation.  Income from active business activities, however, is included in Self-Employed NEFSE and therefore subject to the additional 0.9% Medicare HI tax.

Investment income includes income from the investment of working capital.  In the case of the disposition of an interest in a partnership or S corporation, gain from the disposition is included in net investment income only to the extent of the net gain the transferor would take into account if the partnership or S corporation sold all of its assets for fair market value immediately before the disposition.

Distributions from the following retirement plans are excluded from the definition of net investment income:

  • Qualified pension, profit-sharing, and stock bonus plans under Section 401(a).
  • Qualified annuity plans under Section 403(a).
  • Qualified annuity plans for tax-exempt organizations under Section 403(b).
  • Individual retirement accounts under Section 408.
  • Roth individual retirement accounts under Section 408A.
  • Deferred compensation plans of state and local governments and tax-exempt organizations under Section 457. 

Investment income does not include items that are otherwise excluded from income, such as life insurance proceeds, interest on state or local bonds, veteran’s benefits, and gain from the sale of a principal residence excluded from income under Section 121.  Gain on the sale of a principal residence in excess of the Section 121 exclusion amount ($500,000 for married taxpayers filing a joint return and $250,000 for other taxpayers), however, is included in investment income.

M, an unmarried taxpayer, has the following items of investment income and expense in 2013:

  • $60,000 net schedule C income from a single-member LLC that M materially participates in.
  • $1,000 of interest income from the investment of working capital from the single-member LLC that M materially participates in.
  • $20,000 distributive share of business income from LP limited partnership, an activity that M does not materially participate in.
  • $15,000 distributive share of business income from GP general partnership, an activity that M materially participates in.
  • $14,000 distributive share of dividends from GP general partnership, an activity that M materially participates in.
  • $12,000 of dividend income from ABC Corporation.
  • $10,000 of interest income from a corporate bond.
  • $8,000 of interest income from a municipal bond.
  • $1,000 of fees paid for investment advice.

M’s investment income is $56,000, calculated as follows:

Interest income from investment of working capital                                            $                1,000
Distributive share of passive income from LP partnership                                                  20,000
Distributive share of dividends from GP partnership                                                           14,000
Dividends from ABC Corporation                                                                                        12,000
Interest income from corporate bond                                                                                  10,000
Less deductions properly allocable to investment income                                                   (1,000)
Net investment income                                                                                        $              56,000

The business income from M’s single member LLC and the general partnership that he materially participates in are not investment income (but are NEFSE subject to the additional 0.9% Medicare HI tax).  The $8,000 of municipal bond interest is excluded from net investment income because it is tax-exempt.  The $1,000 Tom paid for investment income because it is allocable to investment income.

Estates and trusts are subject to the UIMCT.  In the case of an estate or trust, the tax is imposed on the lesser of (1) undistributed net investment income, or (2) the excess of the estate or trust’s adjusted gross income (as defined in Section 67(e)) over the dollar amount at which the highest tax bracket begins.  Because the highest tax bracket for estates and trusts begins at a relatively low level of income ($11,650 for 2012), the UIMCT is of particular concern to them.

The AB Trust has adjusted gross income of $200,000 and undistributed net investment income of $180,000.  The UIMCT is imposed on the lesser of AGI over the amount at which the highest tax bracket begins ($200,000 – $11,650 = $188,350), or undistributed net investment income ($180,000), and the AB Trust is subject to an additional tax of $6,840 (3.8% x $180,000).  An individual taxpayer with the same income as the AB Trust would not be subject to the UIMCT because his or her adjusted gross income is less than the $200,000 threshold amount.

The UIMCT applies only to the undistributed net investment income of an estate or trust.  If an estate or trust makes a distribution to beneficiaries, its undistributed net investment income (and potential liability for the UIMCT) decreases, while the beneficiary’s net investment income (and potential liability for the UIMCT) increases.  However, because the threshold amount for individuals is much higher than the threshold amount for estates and trusts, a distribution will in all likelihood reduce the overall amount of UIMCT paid.

The UIMCT should not apply to a simple trust, which is required to distribute all of its current income to beneficiaries and therefore does not have any undistributed net investment income.  In addition, the UIMCT should not apply to a trust treated as a grantor trust under Section 677.  The individual treated as the owner of the grantor trust would consider the trust’s income items in determining their potential liability for the UIMCT.

Tax Planning

Items of income that are excluded from income reduce both MAGI and net investment income.  This provides higher-income taxpayers potentially subject to the UIMCT additional incentive to structure transactions that result in either tax-exempt or tax-deferred income.  Higher-income taxpayers can minimize the UIMCT by including non-dividend paying growth stocks, which do not increase MAGI or create investment income until sold, in their investment portfolio.  Tax-deferred annuities and related investments will also minimize liability for the UIMCT, and may become more popular.

Because tax-exempt income is not included in either MAGI or investment income, higher-income taxpayers will have increased incentive to invest in state and local obligations exempt from tax.

Investment income includes net gain (to the extent taken into account in computing taxable income) from the disposition of property.  Tax planning strategies that reduce or defer capital gain income will also reduce or defer net investment income for purposes of the UIMCT.  Using the installment method of accounting to report gain on the sale of property sold on an installment basis, for example, will minimize the impact of the UIMCT because it avoids a large increase in both MAGI and investment income in the year of sale.  Taxpayers selling property on an installment basis in 2012, on the other hand, should consider electing out of the installment method and recognizing the entire amount of the gain before the 3.8% UIMCT goes into effect.

Because gain on the disposition of property is included in investment income only to the extent it is taken into account in computing taxable income, taxpayers should analyze their portfolios at the end of the year to determine whether they can reduce their MAGI and investment income.  For example, selling stock that has decreased in value and using the loss to offset capital gain that would otherwise be included in income will reduce both MAGI and investment income.

Because distributions from qualified retirement plans are not included in net investment income, the UIMCT provides taxpayers with additional incentive to maximize retirement plan contributions.

Taxpayers should consider the UIMCT in planning for passive activities.  Passive income is investment income for purposes of the UIMCT.  Classifying income as passive is generally advantageous for taxpayers with sufficient passive losses to offset the passive income.  For taxpayers with net passive income, however, the UIMCT increases the tax rate on passive income.  The UIMCT gives taxpayers with passive activities, including passive rental activities, and additional factor to consider in passive activity planning.

The UIMCT provides higher-income taxpayers with another incentive to consider the use of family limited partnerships and related estate planning techniques.  Investment income transferred from parents with significant MAGI and investment income to children with MAGI below the applicable threshold amount through the use of family limited partnerships will not be subject to the UIMCT on what otherwise would be the parent’s investment income.  Although investment income transferred to children through a family limited partnership may be taxed at their parent’s rate under the “kiddie tax” rules, the children will be subject to the UIMCT only if their income (including income from a family limited partnership) exceeds the applicable threshold.  Children subject to the kiddie tax are taxed at their parent’s rate for purposes of the regular tax.  Children will not be subject to the UIMCT merely because their parents are.

Estates and trusts with undistributed net investment income will be subject to the UIMCT whenever their adjusted gross income exceeds the dollar amount at which the top marginal tax rate begins.  Because the top marginal rate for estates and trusts begins at a relatively small amount of income ($11,650 in 2012), the UIMCT is of particular concern to estates and trusts and should be considered in both distribution and investment decisions.

Estates and trusts are subject to the UIMCT only if they have undistributed net investment income.  Estates and trusts can reduce undistributed net investment income and thereby minimize or eliminate the UIMCT by distributing income to beneficiaries.  Any distribution will increase the beneficiary’s net investment income and potential liability for the UIMCT.  However, the threshold amount for individuals is much higher than that for estates and trusts, and the UIMCT can be eliminated if the beneficiary’s MAGI remains below the threshold amount.

Estates and trusts should also consider the UIMCT in making investment decisions.  Because estates and trusts are subject to the UIMCT at a relatively low level of adjusted gross income, the previously discussed strategies for reducing adjusted gross income and net investment income are particularly important for estates and trusts.  The UIMCT increases the already existing incentives estates and trusts have to invest in tax-exempt and tax-deferred investments.

The new 0.9% tax on earned income and 3.8% tax on net investment income will increase the tax burden of higher-income taxpayers beginning in 2013.  Taxpayers should begin planning now in order to minimize the impact of these taxes in 2013 and beyond.