Taxpayers Beware: The New 3.8% Medicare Tax on Net Investment Income

In addition to higher federal income tax rates on dividend income, capital gains, and ordinary income, currently scheduled to take effect on January 1, 2013, the Obama Administration’s healthcare reform legislation will impose a new 3.8% “Medicare tax” on “net investment income” of taxpayers whose incomes exceed certain thresholds depending on filing status. Taxpayers and their tax advisors may now need to rethink how to structure business and investment activities to most efficiently minimize the combined federal income tax burden on these activities.

Overview

The new 3.8% tax on net investment income is being imposed in a complementary manner to increases in the Medicare portion of FICA and self-employment taxes. The new tax is imposed on net investment income to the extent that the taxpayer’s modified adjusted gross income exceeds $250,000 for married taxpayers filing a joint return.

Although the definition of net investment income is convoluted due to the statute’s use of double negatives, the term is defined so as to tax:

• • Gross income from passive activities under Section 469 of the Internal Revenue Code (the “Code”);

• • Portfolio income, but not if derived from an active trade or business;

• • Gross income from a trade or business of trading in financial instruments or commodities;

• • Net taxable gains from the disposition of property held in Code Section 469 passive activities;

• • Net taxable gains from the disposition of portfolio assets and personal assets; and

• Net taxable gains from the disposition of assets held in a trade or business of trading in financial instruments or commodities.

A “passive activity” is defined in the Code as a trade or business in which a taxpayer does not materially participate. Although passive activity income has been favorably perceived for the past twenty-five years because it can be offset by otherwise nondeductible passive activity losses, the imposition of the new tax on passive income changes this analysis. The new tax places even more importance in evaluating whether an activity is a passive activity, and in applying currently changing law as to whether a limited partner of a limited partnership or a member of a limited liability company is treated as materially participating.

Taxpayers should work with their tax advisors to plan for this new 3.8% tax on net investment income and reduce their exposure, including accelerating tax deductions into 2012, maximizing deductible contributions to qualified retirement plans, and evaluating the structures through which they hold their investments and business activities.

Background to the New Tax – Employment and Self-Employment Tax Increases

The new 3.8% tax on net investment income is being imposed parallel to increases in the Medicare insurance portion of both: (1) the Federal Insurance Contributions Act (“FICA”); and (2) the Self-Employment Contributions Act (“SECA”). Taxpayers who are familiar with the structure of these increases will better understand how the new 3.8% tax applies.

But for the Health Care and Education Reconciliation Act of 2010 (P.L. 111-152) (the “2010 Health Care Tax Act”), in 2013 both employers and employees would have been subject to: (1) an old age, survivors, and disability insurance (“OASDI”) tax of 6.2% of covered wages up to the taxable wage base ($110,100 in 2012); and (2) the hospital insurance or Medicare tax of 1.45% of all covered wages, for a total employment tax rate of 7.65%.

Pursuant to the 2010 Health Care Tax Act, the employee portion of the Medicare tax increases by 0.9% from 1.45% to 2.35% on wages in excess of the “threshold amount.” This additional tax is imposed on the combined wages of the employee and the employee’s spouse in the case of a joint return.¹ The “threshold amount” is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case. Therefore, under the 2010 Health Care Tax Act, the total Medicare taxes paid by both the employee and the employer will rise to 3.8% (employee at 2.35%, and employer at 1.45%).

Consistent with this, the 2010 Health Care Tax Act increases the Medicare tax portion of the self-employment tax by 0.9% – from 2.9% to 3.8% – on earnings in excess of $250,000 in the case of married taxpayers filing a joint return, $125,000 if married and filing separately, and $200,000 for all other taxpayers. Again, the increase is effective for tax years beginning after December 31, 2012. The OASDI component of the self-employment tax of 12.4% (6.2% + 6.2%) of the taxable wage base ($110,100 in 2012) remains the same.

The New 3.8% Medicare Tax on Net Investment Income

In addition to these changes to the Medicare tax portion of the FICA and SECA taxes, the 2010 Health Care Tax Act will subject certain investment income to a new 3.8 percent Medicare tax.

Effective January 1, 2013, Code Section 1411(a)(1) imposes this 3.8% tax on the lesser of: (1) “net investment income;” and (2) the excess of modified adjusted gross income over $250,000 in the case of married taxpayers filing a joint return, $125,000 for married taxpayers filing a separate return, and $200,000 for all other taxpayers.

Definition of Taxable “Net Investment Income”

For purposes of applying the 3.8% tax, “net investment income” is defined in Code Section 1411(c) to be the excess (if any) of —

(A) the sum of:

(i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2);
(ii) other gross income derived from a trade or business described in paragraph (2); and
(iii) 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 not described in paragraph (2),

over —

(B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.

Under Paragraph (2) of Code Section 1411(c), the 3.8% tax applies to a trade or business if the trade or business is:

(A) a passive activity (within the meaning of Code Section 469) with respect to the taxpayer; or
(B) a trade or business of trading in financial instruments or commodities.

Income, gain, or loss that is attributable to the investment of working capital is treated as not derived in the ordinary course of a trade or business, and therefore is subject to the new 3.8% tax.

Importance of Passive Activity Loss Rules – Material Participation Generally

A trade or business activity is a passive activity – subject to the new 3.8% tax – if the taxpayer is not a material participant in the activity. Subject to a limited election for real estate professionals, rental real estate operations are treated as passive activities regardless of the level of participation. Under Treasury Regulation Section 1.469-5T, a taxpayer “materially participates” in a business activity if he or she meets one of the following seven tests during the taxable year:

1. 1. The taxpayer works 500 hours or more during the year in the activity;
   2. The taxpayer does substantially all the work in the activity;
   3. The taxpayer works more than 100 hours during the year in the activity and no one else works more than the taxpayer;
   4. The activity is a significant participation activity (a “Significant Participation Activity”) because the taxpayer works more than 100 hours in the activity, and the sum of the taxpayer’s time spent on Significant Participation Activities exceeds 500 hours that year;
   5. The taxpayer materially participated in the activity in any 5 of the prior 10 years;
   6. The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years; or
   7. Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year. However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.

Material Participation for Owners of Pass-Through Entities

Income generated in an active business operated by a partnership or S corporation will generally avoid application of the 3.8% tax on net investment income. The Code Section 469 regulations make clear that material participation in an activity conducted through a pass-through entity, such as a partnership or S corporation, is determined at the individual partner or shareholder level rather than the entity level. Therefore, tax items that pass through to the owners of a pass-through entity can be passive for certain owners, and active for others.

An individual partner or S corporation shareholder is deemed to participate in an activity only if he or she is involved in the operations of the activity on a regular, continuous, and substantial basis. There are two caveats. First, work done in connection with an activity is not treated as participation if the work is not of a type that is customarily done by an owner of such an activity and one of the principal purposes for performing the work is to avoid the disallowance of any loss or credit under Code Section 469.

Second, work done by an individual in the capacity of an investor, e.g., reviewing financial statements, compiling financial and operational summaries for personal use, and monitoring the activity in a non-managerial capacity, in an activity is not treated as participation unless the individual is directly involved in the day-to-day management or operations of the activity.

Therefore, the pass-through income earned by S corporation shareholders who materially participate in the business should be excluded from the definition of net investment income under Code Section 1411(c)(2)(A). Distributions to the S corporation shareholders should also be excluded under that section.

Shareholders who do not materially participate in the S corporation’s business activities will be subject to the 3.8% tax on net investment income. Similarly, gain on the sale or redemption of the stock of a passive S corporation shareholder should be subject to the 3.8% tax as well.

Limited partners are generally not treated as materially participating in partnership activities unless one of the following tests is satisfied:

1. 1. The limited partner participates in the activity for more than 500 hours during the year;
   2. The limited partner materially participated in the activity for any 5 of the 10 immediately preceding taxable years; or
   3. The limited partner materially participated in a personal service activity for any 3 prior years.

The Significant Participation Activity rules do not apply to limited partners. Therefore, the income from a limited partnership activity will automatically be passive unless the limited partner satisfies one of the foregoing three exceptions.

Importantly, under proposed regulations issued on November 25, 2011, an interest in an entity, such as a limited liability company, would be treated as a limited partnership interest if:

1. 1. The entity is classified as a partnership for federal income tax purposes; and
   2. The holder of the interest does not have rights “to manage the entity at all times during the entity’s taxable year under the law of the jurisdiction in which the entity was organized and under the governing agreement.²

The IRS had lost several court cases in attempting to classify limited liability company members as the equivalent of limited partners which would have led those members to fail the material participation test by focusing on the limited partners’ limited liability. The proposed regulations shift the focus to management participation.

Imposition of 3.8% Tax on Gains from Dispositions of Property

Net gain attributable to the disposition of property (other than property held in an active trade or business) is subject to the 3.8% tax on net investment income. A taxpayer’s gain from the sale of a passive trade or business, or a business of trading in financial instruments or commodities, is subject to the new tax. The tax will also apply to the gain from the disposition of nonbusiness assets, such as vacation homes, boats, and personal vehicles. Gain from the disposition of stock in a C corporation will generally be subject to the 3.8% tax on net investment income. Gain on the sale of a personal residence can also be subject to the new tax if the taxable gain on that sale is in excess of the Code Section 121 exclusion amounts (normally $500,000 for a joint return).³

In the case of the disposition of a partnership interest or stock in an S corporation, gain or loss is taken into account only to the extent gain or loss would be taken into account by the partner or shareholder if the entity had sold all of its properties for fair market value immediately before the disposition. Therefore, only net gain or loss attributable to property held by the entity that is not property attributable to an active trade or business is taken into account.

Overall Effect of Imposition of New 3.8% Tax on Net Investment Income

The 2010 Health Care Tax Act’s new 3.8% tax on net investment income increases the top marginal tax rates in 2013 and future years on that income to levels that will surprise many taxpayers. Unless Congress and the President change this law this year or next, the highest marginal tax rates on common categories of income will be as follows, depending on whether the income is subject to the new 3.8% tax or not.

2013 Highest Marginal Federal Income Tax Rates

Interaction of New 3.8% Tax With Employment Taxes

The 3.8% tax on net investment income applies to trade or business income only if the underlying trade or business is a passive activity with respect to the taxpayer. At the same time, a passive investor in a pass-through entity is not subject to self-employment tax under SECA tax because the investor is not active in the business. In the case of an activity operated through a limited liability company or partnership, if an investor attempts to argue that the activity is active to avoid the new 3.8% tax on net investment income, then he will likely end up being subject to the higher self-employment tax rates with respect to that activity.

Code Section 1411(c)(6) states that net investment income does not include any item taken into account in determining self-employment income for such taxable year on which a tax is imposed by Code Section 1401(b). Thus, Section 1411(c)(6) effectively excludes from net investment income any items taken into account when calculating self-employment tax. A taxpayer should thus, at least, never have to pay both SECA tax and the 3.8% tax on the same stream of income. However, the question remains as to whether business income can be exempt from the 3.8% tax and SECA tax.

Planning Strategies for the New 3.8% Tax on Investment Income

There is still time to develop strategies for avoiding or minimizing the 3.8% tax on net investment income. Accelerating deductions during 2012 is one strategy, since itemized deductions will not be phased out for higher-income taxpayers. Methods to accelerate deductions include prepaying mortgage interest, making charitable contributions, and bundling together miscellaneous deductions, such as unreimbursed employee expenses and expenses related to job searches. In accelerating deductions, it is important to be aware of alternative minimum tax (“AMT”), as many common deductions are unavailable if a taxpayer is subject to AMT.

In addition, by maximizing deductible contributions to qualified retirement plans (e.g., traditional IRAs and 401(k)s), taxpayers can potentially receive a double tax benefit, in that contributions will reduce modified adjusted gross income and reduce the chances of exceeding the income thresholds that would expose any net investment income to the 3.8% tax, and the plan distributions received upon retirement will also be exempt from the 3.8% tax.

The Medicare tax on unearned income creates a new dynamic in tax planning for passive activities. Passive activity income has been favorably perceived for the past twenty-five years because it could be offset by otherwise nondeductible passive activity losses. This new tax may cause taxpayers and advisers to rethink this understanding, depending on a taxpayer’s circumstances.

For example, rents are subject to the 3.8% tax, unless derived in the ordinary course of a trade or business. Real estate investors must look to the active real estate investors rules to determine if they can avoid the tax by qualifying and electing under the “active” classification. Active real estate investors must spend more than one-half of their time in the real property trade or business out of their total trades or businesses. The materially participating taxpayer must perform more than 750 hours of services during the tax year in real property trades or businesses.⁴ Therefore, real estate investors should consider electing to treat all of their interests in real estate as one activity, which in turn aggregates all real property interests into one trade or business for Section 469 purposes.⁵

An opportunity exists to avoid both the Medicare tax on wages and the 3.8% tax on net investment income by operating an active business through an S corporation, provided that reasonable salaries are paid to shareholder employees. Only amounts paid as salary to shareholders who materially participate in the business should be subject to the Medicare tax on wages, whereas distributions to the shareholders should be exempt from the SECA tax⁶ and also from the 3.8% tax on net investment income under Code Section 1411(c)(2)(A). However, careful planning is required when using an S corporation in such a fashion – many tax advisors prefer the use of limited liability companies over S corporations, especially when holding appreciating property, or when dealing with more than a small number of investors.

The application of the new tax on net investment income is complex, and must be analyzed in conjunction with the other tax rate increases. Taxpayers should discuss with their tax advisors the possible implementation of strategies to minimize this tax, and carefully watch for changes to these laws over the next year.

Gibbons P.C:

This alert was written by Peter J. Ulrich, Director, and Leonard G. Sprishen, Associate, with the Gibbons Corporate Department in its Newark, New Jersey office.

IRS Circular 230 Disclaimer: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (1) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (2) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein. For more information on this disclaimer, please see the Gibbons website. htpp://files/Uploads/Documents/IRS.pdf

¹ In determining the employer’s requirement to withhold the additional 0.9% tax on the employee, only wages that the employee receives from that employer in excess of $200,000 a year are taken into account.
² Prop. Reg. Section 1.469-5(e)(3).
³ Joint Committee on Taxation, Technical Explanation (JCX-18-10), at 135.
⁴ Code Section 469(c)(7)(B)(i) and (ii).
⁵ Code Section 469(c)(7)(A).
⁶ See Revenue Ruling 59-221, 1959-1 C.B. 225.