Planning for the 2013 Medicare Tax

By: Jeffrey J. Zellers & Tina L. Annis – as appeared in Bar News – April 13, 2012

Beginning in 2013, the Health Care Educational and Reconciliation Act of 2010 imposes a 3.8 percent tax on certain income of high-earning individuals. This year, 2012, presents an opportunity to assist clients with planning to minimize or possibly avoid the tax.

This so-called “Medicare Tax” will apply to single taxpayers with modified adjusted gross income (MAGI) in excess of $200,000 and to married taxpayers with MAGI in excess of $250,000, if filing a joint return, or $125,000 if filing separate returns.

In most cases, an individual’s MAGI is equal to adjusted gross income, unless the individual has foreign earned income. The tax is calculated by multiplying the 3.8 percent tax rate by the lesser of: (1) “net investment income” or (2) the amount by which MAGI exceeds the threshold amounts described above.

Trusts and estates will also be subject to this tax, on the lesser of (1) undistributed net investment income or (2) the excess (if any) of adjusted gross income over the dollar amount at which the highest tax bracket begins ($11,200 for 2013).

In general, for purposes of the Medicare tax, “net investment income” includes capital gains, dividends, interest, royalties, rents, and annuities, unless such income arises in the ordinary course of a trade or business. Deductions, exceeding 2 percent of MAGI and allocable to the investment income, are allowed in arriving at net investment income. Net investment income also includes income from a business that is considered a passive activity and income from a business that trades financial instruments or commodities. Gain on the disposition of property not held in an active trade or business is subject to the tax, as is the gain on the disposition of a passive interest in a partnership or S corporation.

Confusion exists concerning gain on the sale of a principal residence. That portion of the gain from the sale of a principal residence which is excluded from federal income tax under IRC section 121 is not subject to the tax. Any gain beyond the exclusion limit is subject to the tax. Note that a second home is not a “principal residence” and therefore the entire gain would be subject to the tax. Certain trusts which are exempt from tax, including charitable remainder trusts, are exempt from this new 3.8 percent Medicare tax.

Net investment income does not include distributions from qualified retirement plans, including those from tax-qualified pension, profit sharing, 401(k) and annuity plans, as well as traditional and Roth IRAs. Net investment income also does not include income from tax-exempt bonds.

Planning and Analysis

Attorneys and their affluent clients have a little less than one year to develop strategies to minimize the impact, or possibly avoid, the new tax. Although many tax advantageous transactions will take place in the last quarter of 2012, planning now for those transactions is well advised. In general, the best strategy is to work with your clients, their accountants and financial advisors to reduce the client’s modified adjusted gross income. Getting your client’s MAGI below the above noted thresholds can avoid the application of the Medicare tax altogether. Reducing net investment income is another appropriate strategy.

Attorneys and financial advisers should consider and discuss with their wealthier clients the following strategies:

1. Investors and financial planners may have favored dividend paying securities in the past (due to lower rates for qualified dividends). Clients should now consider investing in IRAs and 401Ks instead of taxable income producing investments, or invest in tax exempt bonds, which are excluded from the Medicare tax. Comparing tax-exempt bonds with other taxable investments has typically involved the application of the taxpayer’s marginal tax rate to determine whether or not the generally lower yielding taxexempt bond is worthwhile when compared against a taxable investment. The tax rate used in this analysis will now need to include the 3.8 percent Medicare tax. The incorporation of this additional 3.8 percent tax rate could make tax-exempt bonds more attractive than their taxable counterparts, all other things being equal.

2. As the capital gains tax rate is scheduled to increase in 2013, 2012 may be a good year to realize such gains (also subject to the Medicare tax) and invest in qualified plans or tax exempt bonds. Any change in investments may have unintended consequences, however, such as exposure to the Alternative Minimum Tax. Each client should review the total impact of any change in investment strategy with their advisors.

3. Clients may wish to consider insurance products to avoid the new tax, as the inside build-up of life insurance cash surrender value is not subject to the Medicare tax, nor are insurance proceeds that are otherwise excludable from income tax.

4. Unless derived in the ordinary course of an active trade or business, rents will be subject to the Medicare tax. Clients should review in greater depth whether or not their involvement with their real estate business constitutes “active” participation. A tension arises between the desirability of an active role in connection with a real estate business which may subject distributions from the business to the self-employment tax and the desire to avoid the Medicare tax on income from passive activities. Thus, a taxpayer who wishes to avoid the Medicare tax by arguing that his or her involvement with the real estate business is not “passive” but rather “active,” may avoid the Medicare tax but then subject him/herself to the self-employment tax.

5. Owners of “pass-through” active trades or businesses will need to pay attention to the nature of the assets inside the entity which give rise to the flow-through income in order to determine the impact of the Medicare tax. Interest, dividends and royalty income earned in the ordinary course of a trade or business are generally not subject to the new Medicare tax, but similar earned income on passive investments may be subject to the tax.

6. Clients should consider transferring income producing investments to children or other family members with a lower MAGI, which will reduce the transferor’s MAGI and investment income.

7. The Medicare tax is subject to federal estimated tax provisions. Taxpayers who expect to be subject to the new tax should increase payroll withholding or make estimated tax payments to cover the additional tax.

It remains to be seen whether the application of the Medicare tax under the Health Care and Education Reconciliation Act of 2010 will survive the elections of 2012. While Congress may take action to change the law once again, attorneys should advise their clients about this anticipated new tax. Many clients will wait until November or December of 2012 to call their advisors to discuss the impact of the Medicare tax. Attorneys should begin the effort of educating their clients now, to increase the options for taking appropriate steps to avoid, where possible, the application of the Medicare tax in 2013.

To ensure compliance with requirements imposed by the IRS, any US tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding US tax penalties.