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Planning for the Unearned Income Medicare Contribution Tax

The unearned income Medicare contribution tax is scheduled to come to life at the end of next year, and it may have a significant impact on some taxpayers.

August 2011
by Stanley Rose/The Tax Adviser

A stealthy tax originating in the Health Care and Education Reconciliation Act of 2010,
P.L. 111–152 (Reconciliation Act), is scheduled to come to life at the end of next year, and it may have a significant impact on some taxpayers. Although the unearned income Medicare contribution tax (UIMCT) first applies more than a year from now, some advance planning and communication by practitioners is in order to help clients minimize its sting and avoid unwelcome surprises.

Background

The 2010 Reconciliation Act was enacted in part to make several changes to health care rules, most of which were created by the Patient Protection and Affordable Care Act, P.L. 111–148, which had just been passed. Included with the many modifications, however, was an entirely new tax created by the addition of Sec. 1411: the unearned income Medicare contribution tax.

The new tax applies to individuals, estates, and trusts and is equal to 3.8 percent of the lesser of two amounts: net investment income or the excess of modified adjusted gross income (AGI) over a threshold amount. The threshold amounts are:

  • For taxpayers filing joint returns or surviving spouses: $250,000;
  • For married taxpayers filing separate returns: $125,000;
  • For all other individual taxpayers: $200,000; and
  • For estates and trusts: The dollar amount at which the highest tax bracket begins (currently $11,350).

“Modified AGI” refers to AGI increased by net foreign income excluded by Sec. 911. “Net investment income” includes such normal suspects as interest, dividends, annuities, royalties, and rents, but it also includes, depending on the circumstances, two additional and potentially far-reaching categories of income: trade or business income and gains.

In general, trade or business income is subject to the UIMCT if it represents a passive activity. For this purpose, the familiar Sec. 469 rules apply. (The UIMCT also applies to businesses trading in financial instruments under Sec. 475(e)(2).) Gains generally are taxable, but exceptions exist that are dependent on whether the activity producing the gain is passive. Gains attributable to the sale of property held by nonpassive activities are not subject to the tax, and gain generated by the sale of an interest in nonpassive activities also is not subject to the tax.

Analysis

For very high-income taxpayers with significant investment income, this tax may be unavoidable, and the adviser’s role may be limited to making clients aware of it. Several circumstances, though, present unique planning opportunities to help clients mitigate this tax.

Income management: Taxpayers whose income is close to the threshold amounts may avoid the UIMCT simply by keeping income below the applicable thresholds. Even if essentially all a taxpayer’s income is investment related, the tax will not apply until income exceeds those amounts. Special attention should be paid to long-term capital gains because depending on which side of the threshold they reside, the gains may now be taxed at two rates: 15 percent if the UIMCT does not apply and 18.8 percent if it does.

Classification of interest: Although Sec. 1411 is curiously silent on the matter, the committee report clearly notes that tax-exempt interest income is not included in net investment income for purposes of this tax (Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as Amended, in Combination with the “Patient Protection and Affordable Care Act”
(JCX–18–10), p. 135 (March 21, 2010)). Therefore, investments in state and municipal bonds may be more attractive than in the past, and although rates currently are quite low, the analysis of net-of-tax rate of return (when comparing exempt versus taxable investments) should include this new variable.

Passive vs. nonpassive: Sec. 1411(c)(2) notes that income from a trade or business is subject to the 3.8 percent tax if it is “a passive activity (within the meaning of section 469).” Although the analysis of whether investments are passive will have been performed for purposes of the more familiar passive loss restrictions, the addition of the UIMCT serves as an excellent reason to review the criteria for taxpayers who may be close to meeting some of the exceptions related to material participation. Also note that Sec. 1411(c)(3) invokes the Sec. 469(e)(1)(B) “working capital exception” to potentially increase the surcharge. In general, this rule isolates a portion of certain income from within the business activity and recharacterizes it as portfolio income. It applies to any income, gain, or loss that is attributable to an investment of working capital.

This article has been excerpted from The Tax Adviser. View the full article here.