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As tax laws change, it is important to look ahead and be ready for potential planning opportunities.
The Patient Protection and Affordable Care Act (HR 3590) extended the reach of taxation to fund Medicare. Currently, the Medicare tax is applicable only to wage income. The new act applies Medicare tax to investment income also. The new Medicare tax takes effect after 2012, so planning opportunities currently exist.
The tax is equal to 3.8 percent of the lesser of net investment income or the excess of modified adjusted gross income (MAGI) over $250,000 for joint filers and over $200,000 for singles. MAGI is adjusted gross income increased by the net amount of excluded foreign earned income. The thresholds are not indexed for inflation, so barring change, this tax will affect more taxpayers as years pass.
Some notable highlights of the new provision in its current form include:
* The thresholds effectively reinstitute the "marriage tax" due to the high degree of disparity between the single MAGI threshold of $200,000, which is not doubled for the joint threshold, which is only $250,000.
* Net investment income for purposes of the Medicare contribution tax include: interest, dividends, capital gains, annuities, royalties, rents, and some forms of pass-through income. Items excluded from the tax include tax exempt bond interest, qualified retirement plan distributions, some types of business income and gain from the sale of a personal residence (if less than the present Section 121 exclusion).
* The tax also affects income within a trust. The 3.8 percent Medicare tax on net investment income applies to trusts in addition to currently levied taxes. There is no threshold comparable to MAGI for individuals for trusts, meaning even those with modest earnings will be subject to the tax. For trusts, the tax is applied to the lesser of the trust's undistributed net investment income or the excess, if any, of the trust's AGI over the dollar amount at which the highest tax bracket begins ($11,200 for 2010 which is indexed for inflation).
* Qualified retirement plan distributions will not be included in net investment income, but depending on the type of retirement vehicle, they may be included in MAGI. This could cause other types of investment income to be subject to the Medicare tax.
* Roth IRAs increase their attractiveness because they are not subject to the Medicare tax, and Roth distributions are not included in MAGI calculations for the purposes of the Medicare tax. Regular IRA distributions (to the extent of pre-tax contributions) will be included in MAGI calculations.
* Perhaps the most important area for future consideration is the tax's impact on passive activity planning, particularly in terms of classification of activity and entity selection. The tax appears to be less onerous to active owners of S corporations. A sole proprietor or active member of a partnership currently pays Medicare taxes on 100 percent of their business profits and would see a .9 percent increase in Medicare tax, (the difference between the 2.9 percent they currently pay and the 3.8 percent they will have to pay after 2012). This increase would only be applicable to amounts over the MAGI thresholds. The tax does not apply to business income earned by active S corporation shareholders, even if over the threshold amounts. The tax does apply to business income for passive shareholders in an S corporation. It should be noted that income retains its character for purposes of this tax. For example, investment interest income earned within an S corporation is still treated as interest income when it is passed through to the shareholder.
To illustrate, consider each entity earning $600,000 of ordinary business income. For a sole proprietor or general partner, the tax increase would be equal to .9 percent on the amount over the threshold. For a passive S-corp shareholder, the full 3.8 percent increase in tax will apply to their passive investment income. The active S-corp shareholder fares better. Say income is split between $200,000 in salary (reasonable compensation), and the remainder of $400,000 is ordinary business income. The $400,000 would not be subject to the 3.8 percent Medicare tax, even if the taxpayer is over the threshold amounts.
This tax tip contributed by
David Dreidel, CPA
Testone, Marshall & Discenza, LLP
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