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January 5, 2011

Medicare 3.8% Tax on Net Investment Income

January 5, 2011

For tax years starting on or after January 1, 2013, the 2010 Health Care Bills impose a new 3.8% "Medicare Tax" on "net investment income" in excess of specified amounts. The tax is generally levied on nonbusiness income from interest, dividends, annuities, royalties, rents, and capital gains. This memo will summarize the new tax (in highly simplified form) and offer some related observations which may illuminate how the tax works.

Note that for individual taxpayers engaged in passive activities, the post-2013 interplay of the income and Medicare Tax mean that current income tax reporting for aggregation of passive activities will likely have lasting (and possibly adverse) significance for the Medicare Tax in later years.

Simplified Summary – Tax on Individuals

An overly simplified summary of the tax as it applies to any individual might be as follows:

Each person will be taxed - in addition to his/her income tax - on 3.8% of the amount that the following income causes adjusted gross income to exceed $250,000 (for joint filers) or $200,000 (for non-married filers):

1. Nonbusiness interest, dividends, annuities, royalties, and rents;
2. Other gross income of a passive activity or a business trading financial instruments;
3. Net gain on the disposition of nonbusiness property (including net gain indirectly derived from disposition of a partnership interest or S corporation stock); and
4. Investment of any business's working capital.

Observation: The Medicare contribution tax is in addition to any other tax imposed by Subtitle A of the Code, relating to income taxes. The Medicare contribution tax is not deductible in computing the other subtitle A taxes.

Observation: The scope of net gain from the disposition of nonbusiness property is very broad. It will cover gain on the sale of stocks and securities, and gain on the sale of second homes and other personal use assets.

Observation: The business/nonbusiness distinction makes characterization of taxpayer activity extremely important. Activities entered into for profit are not necessarily business activities.

Observation: Although taxpayers may subtract allowable deductions allocable to Medicare taxed gross income, allocable investment expenses are allowed as deductions only to the extent they exceed 2% of adjusted gross income.

Observation: The Medicare tax creates an entirely new dynamic for tax planning for passive activities. Until now, passive activity income was generally perceived to be a favorable tax classification because it could be absorbed by passive activity losses. The Medicare tax will cause taxpayers to generally avoid this classification. This changed dynamic will put income and Medicare tax planning at odds in determining appropriate groupings of separate activities. Under Rev Proc 2010-13, the IRS requires tax return notice of activity grouping, with an explanation of changes from the prior year's grouping. This last observation suggests that current passive activity planning should take the Medicare Tax into account, despite its effectiveness only after 2013.

Observation: The term "financial instrument" will need to be defined by regulation. The term may not be as broad as "security." Hopefully the term will be limited consistently with Reg 1.1275-6(b)(3), defining financial instruments as "a spot, forward, or future contract, an option, a notional principal contract, a debt instrument, or a similar instrument, or combination or series of financial instruments." However, Code Section 731(c)(2)(C) defines the term more broadly as including stocks and other equity investments and evidences of indebtedness.

Observation: Gain from a disposition of an interest in a partnership or S corporation is taken into account as net investment income only to the extent of the net gain that the transferor would take into account if the partnership or S corporation had sold all its nonbusiness property for fair market value immediately before the disposition. Code Sec. 1411(c)(4)(A). A similar rule applies to a loss from a disposition of an interest in a partnership or S corporation. Code Sec. 1411(c)(4)(B). Accordingly, only net gain or loss attributable to property held by the entity that isn't property attributable to an active trade or business is taken into account.  For this purpose, a business trading financial instruments or commodities isn't treated as an active trade or business.

Observation: The statutory language and legislative history don't distinguish between "inside" and "outside" basis in specifying how entity-related nonbusiness gain is to be computed. Query: Will a low "outside" basis (as compared with the entity's "inside" basis) increase or create net gain that is taxable? Will a high "outside" basis reduce the taxable net gain?

Observation: Modified adjusted gross income is defined as adjusted gross income adjusted for excluded foreign earned income and related deductions. Code Sec. 1411(d)

Observation: The threshold amount for joint return filers and surviving spouses is $250,000. For married taxpayers filing separately the threshold amount is $125,000. For all other taxpayers, the threshold amount is $200,000. Code Sec. 1411(b).  These statutory threshold amounts are not inflation adjusted.

Tax of Estates and Trusts

Estates and trusts are subject to a Medicare contribution tax for each tax year equal to 3.8% of the lesser of:

1. the estate's or trust's undistributed net investment income for the tax year, or
2. the excess (if any) of:
... the estate's or trust's AGI (as defined in Code Sec. 67(e) for the tax year, over
... the dollar amount at which the highest tax bracket in Code Sec. 1(e) begins for the tax year. Code Sec. 1411(a)(2)

For 2010, the highest estate and trust income tax bracket begins at $11,200. These brackets are indexed for inflation.

The Medicare contribution tax for estates and trusts is in addition to any other tax imposed by Subtitle A of the Code, relating to income taxes. Code Sec. 1411(a)(2)

Estimated Tax

The Medicare contribution tax is subject to the individual estimated tax provisions. The Medicare contribution tax is treated as "tax" for purposes of computing the penalty for underpayment of estimated tax. Code Sec. 6654(f) as amended by 2010 Reconciliation Act §1402(a)(2)(B). Thus, taxpayers who expect to be subject to the Medicare contribution tax will have to take it into account when figuring their estimated tax payments.

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