Starting in 2013, the Health Care and Education Reconciliation Act of 2010 will subject some taxpayers to a 3.8% tax on unearned income. This new Medicare tax will apply to single taxpayers with modified adjusted gross income (MAGI) over $200,000 and married taxpayers who file jointly with a MAGI over $250,000. Married taxpayers who file separately will be subject to the tax if they have MAGI over $125,000. This new tax clearly targets wealthier taxpayers and was added by Congress as a way to raise revenue to pay for the health care reform package.
For most taxpayers, MAGI will be equal to their adjusted gross income. The new tax will be equal to 3.8% of the lesser of net investment income or the amount by which MAGI exceeds the threshold amount ($200,000 in the case of a single taxpayer).
Net investment income includes interest, dividends, annuities, royalties, rents, and income from other passive activities. Net investment income does not include distributions from qualified retirement plans or IRAs, or tax-exempt interest. But net gain attributable to the disposition of property, other than property held in an active trade or business, is subject to this tax. Gains from trading in financial instruments or commodities are included, as is the taxable gain on the sale of a personal residence in excess of the personal residence exclusion amount.
Estates and trusts can be subject to this tax. The tax will not apply to nonresident aliens or a trust in which all of the unexpired interests are devoted to charitable purposes. The tax also does not apply to a trust that is exempt from tax under section 501 or a charitable remainder trust.
This tax on net investment income is not deductible when computing other federal taxes. Taxpayers are required to make estimated tax payments with regard to this tax.
Now may be a good time for taxpayers to analyze their investment portfolios and start cashing in on any year-end gains, thereby limiting the amount of MAGI subject to the 3.8% tax in 2013. Since the “wash sale rules” do not apply to gains, selling an appreciated security at year-end and then repurchasing it after year-end may make sense.
Any mechanism that reduces MAGI in 2013 and after is worth looking at. Taxpayers may want to avoid buying securities that generate dividends, and instead consider investments that will create long term capital gain. Taxpayers may also want to consider investments in tax-exempt securities. Taxpayers should consider after-tax IRA investments versus annuities because income from an IRA is not subject to this tax. And maximizing the amount of investments in any qualified plan or IRA should be considered as an alternative to other investments, since distributions from a qualified plan or IRA will not be subject to the tax.
Taxpayers should also buying life insurance products. The cash surrender value which builds up inside a life insurance policy is not subject to the new tax, or are the proceeds payable on death.
In the case of a trade or business, the tax only applies if the trade or business is a passive activity. Under current regulations, investors in a trade or business can avoid the new Medicare tax on their pass-through income if they are active (not passive) investors. While the pass-through income of a sole proprietorship or partnership is always subject to self-employment tax, pass-through income of an S corporation is not. So taxpayers should consider operating their active businesses in the form of an S corporation. This way, the taxpayers avoid the new Medicare tax because they are operating an active business, yet they also avoid self-employment tax (that would apply if the business were taxed as a sole proprietorship or partnership).
If you have any questions concerning the new Medicare 3.8% tax, please give me a call. Jsenney@pselaw.com or 937-223-1130.
AND ONE MORE THING. Minority interests in a closely-held company are worth less that controlling interests in the same company because minority interests lack the ability to control company decisions. Interests in a closely-held company are also worth less than comparable interests in a publicly-traded company because there is no stock exchange or other ready market for sale of closely-held stock. It is important for the owners of a business to consider and agree on how interests in the company are to be valued now and in the future for estate planning, succession planning and other reasons. Call if you have any questions about how to value interests in your company. Jsenney@pselaw.com or 937-223-1130.