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The NEW Medicare Tax on Net Investment Income

August 20, 2012

The New 3.8% Medicare Tax on Net Investment Income for Tax Years Beginning After December 31, 2012

For tax years beginning after December 31, 2012, there is to be imposed an additional 3.8% Medicare tax on some or all of the net investment income ("NII") of individuals, estates, and trusts whose adjusted gross income surpasses certain thresholds. The new tax is imposed both on NII earned by these taxpayers from their direct holdings and on NII which passes through to these taxpayers from entities in which they own an interest and which are partnerships or S corporations. NII encompasses income from a broad array of activities that, for the most part, have never previously been subject to the Medicare tax. NII includes, with certain exceptions, such items as interest, dividends, annuities, royalties, rents, capital gains, income from trading in financial instruments or commodities, and income from a trade or business which is passive to the taxpayer.

There are some potential tax planning opportunities that can be used to avoid or minimize the applicability of this tax in certain cases of which you should be aware, some of which would need to be implemented by the end of 2012 in order to be effective.

The Old and New Laws

Currently, a 1.45% Medicare Tax (“MT”) is imposed on both employees and employers for wages paid, for a combined total MT rate of 2.9%. Sole proprietors and partners of partnerships, involved in a trade or business, are generally required to pay a 2.9% MT on their net earnings from self-employment (“SE Income”), on proprietor or partnership trade or business income. There is no MT currently imposed on investment income.

Effective for tax years beginning on or after January 1, 2013, there is imposed an additional .9% MT on employees on their wages in excess of $200,000 ($250,000 if married filing jointly and $125,000 if married filing separately) (the “Threshold”). This creates an effective overall MT rate of 3.8% on wages in excess of the Threshold. There is a similar increase in the MT on SE Income causing a 3.8% MT on SE Income over the Threshold.

Most significantly, under the new law, not only is there a 3.8% MT imposed on earnings over the Threshold, there is also a 3.8% MT imposed on NII over the Threshold. In the case of individuals, the new 3.8% tax is imposed on the lesser of (a) NII or (b) adjusted gross income with certain modifications, referred to as “modified adjusted gross income” (“MAGI”), in excess of the Threshold. A different formula applies to trust and estate NII. The following example demonstrates application of the formula for individuals:

H and W, a married couple who file a joint return, earn $370,000 in the aggregate in wages and have NII of $80,000. Their MAGI is therefore $450,000. Accordingly, H and W will incur an MT (in addition to the MT on their wages) of 3.8% times the lesser of (i) $80,000, their NII, or (ii) $200,000, the excess of $450,000, their MAGI, over $250,000, the Threshold. Accordingly, H and W's MT will be $3,040 (3.8% of $80,000).

Source of Income Included in NII

The definition of NII generally includes gross income (minus deductions) from the following sources:

A. Interest;
B. Dividends;
C. Annuities;
D. Royalties;
E. Rents;
F. Passive activity trades or businesses (within the meaning of Internal Revenue Code ("Code") Section 469 relating to passive losses);
G. Trading in financial instruments or commodities; and
H. Net gain from disposition of property.

There is an exception for this type of income earned in a trade or business, other than trading in financial instruments or commodities, in which the taxpayer is active under Code Section 469. The exception also extends essentially to gain from dispositions of interests in an S corporation or partnership to the extent gain from sale of the underlying assets would be gain from the sale of assets in a trade or business, active as to the taxpayer, which is not trading in financial instruments or commodities.

Added Impact of Possible Expiration of Bush Tax Cuts

The new MT coupled with the possible expiration of the so-called Bush tax cuts in January, 2013 has been referred to as the "Fiscal Cliff". The expiration of the Bush tax cuts include:

A. Maximum individual tax rate on ordinary income, including dividends, would increase to 39.6% from 35%.
B. Maximum individual general capital gains rates would increase to 20% from 15%, increasing the overall rate to 23.8%.
C. Maximum individual rates on certain dividends would increase from 15% to 43.4% (39.6% plus 3.8%).

Planning Concepts

Below are some general planning ideas for your consideration, which should not, however, be effectuated without an analysis of your specific situation conducted by your tax professional:

A. Accelerate sale of your business, securities, or other assets, with gains, into 2012 since the maximum effective capital gains rate could go from 15% in 2012 to 23.8% in 2013.
B. Accelerate dividends into 2012. C corporations, or even S corporations with accumulated C earnings and profits, can purge themselves of these earnings and profits in 2012 at a 15% overall federal tax rate vs. a 43.4% overall federal tax rate in 2013. This may be helpful in avoiding future tax on unreasonable accumulation of earnings under Code Section 531, tax on excess net passive income under Code Section 1375, loss of S status, or future capital gains tax on sale of stock at 23.8% (by decreasing value of stock at a 15% tax rate).
C. Tax-exempt municipal bond interest is not subject to the MT.
D. Engage in activities which do not produce, or which minimize, gross income, such as Code Section 1031 exchanges and buying a home.
E. Maximize holdings in individual retirement accounts and qualified retirement accounts since distributions from those accounts will not generally be subject to the MT on NII even if the assets in those accounts produce NII.
F. The new MT on NII creates additional incentives to be an S corporation. In some cases, S status will enable a taxpayer to: (i) avoid the MT on gain from sale of stock; (ii) avoid a double income tax, loss of favorable capital gains rates, and the MT, on certain asset sales and subsequent distributions; and (iii) avoid the MT on both earnings and on NII on distributive shares of S income where the shareholder is active in a trade or business of the S corporation and compensation is not unreasonably low.
G. Passive income has previously been favored over active income because passive income can absorb passive losses under Code Section 469. Because passive income is subject to the MT and active income is generally not, planning may change for certain taxpayers, i.e., particularly those with significant NII but insignificant passive losses.

This is not intended to be an exhaustive discussion of this important new tax, but only a summary to assist you to determine if you are in a situation where further consideration is advisable. If you feel you may be impacted by these changes and wish to discuss this and obtain a detailed analysis of your own situation, please feel free to contact your legal advisor at Greensfelder, Hemker & Gale, and P.C.

This communication (including any attachments) (a) was not intended or written to be used, and it cannot be used, by the recipient or any other taxpayer, for the purpose of avoiding penalties that may be imposed, under the Internal Revenue Code of 1986, as amended, on the taxpayer, and (b) cannot be used or referred to by anyone in promoting, marketing, or recommending a partnership or any other entity, investment plan or arrangement, to one or more taxpayers.