Startup Investors and the New Medicare Surtax

By Dan Wright (Principal at Clark Nuber), and Karlyn Kurokawa (Associate at Clark Nuber)

Currently, all U.S. individual wage earners are subject to a 1.45% Medicare tax on all of their wages and self-employed individual taxpayers are subject to 2.9% tax on their “self-employment taxable income”.

Beginning in 2013, new tax rules are scheduled to apply to high-income wage earners and high-income investors. These new provisions could substantially increase the amount of Medicare tax owed by some individual taxpayers.

First, individuals who earn over $200,000 ($250,000 if married filing jointly “MFJ”) are subject to an additional 0.9% hospital insurance tax on their wages and self-employment income over $200,000/$250,000.  .

Second, individuals who earn investment income may be subject to a 3.8% Medicare surtax (the “surtax”) on at a portion or all of their investment income. The reminder of this article discusses the basic provisions of the 3.8% surtax.

How the amount of income subject to the 3.8% surtax is computed

Individual investors who earn net investment income and who’s modified adjusted gross income “MAGI” exceeds $200,000 (or $250,000 for individuals who file under MFJ status) are subject to the surtax. (Note that “net investment income” and “modified adjusted gross income” or MAGI are defined below).

Here is how the formula works. The surtax tax rate of 3.8% applies to the lesser of:

  1. The individual’s net investment income, or
  2. The individual’s “excess” MAGI. Excess MAGI is computed by subtracting the applicable threshold amount of $200,000 (or $250,000 for couples filing MFJ) from the individual investor’s MAGI.

Clear as mud? Let’s look at some numerical examples:

Example 1:  Bill is a single taxpayer that has net investment income of $150,000 and $175,000 of salary income.  Here is how the surtax formula applies to Bill’s situation:

  1. Bill’s net investment income is $150,000 (as stated above)
  2. Bill’s excess MAGI is determined as the excess of–Bill’s MAGI of $325,000 ($150,000 of investment income plus $175,00 of salary) over the single taxpayer threshold amount of $200,000. Bill’s excess MAGI is $125,000.

Summary:  Since Bill’s excess MAGI ($125,000) is less than his net investment income ($150,000), only $125,000 of Bill’s net investment income is subject to the 3.8% surtax.   Bill’s surtax is $4,750 ($125,000 times .038).

Example 2:  Mary is a single taxpayer that has net investment income of $75,000 and salary of $275,000.  Mary’s MAGI is $350,000 ($75,000 plus $275,000), and therefore her excess MAGI is $150,000 ($350,000 less the $200,000 threshold amount). Since Mary’s net investment income ($75,000) is less than her excess MAGI ($150,000), $75,000 is subject to the Medicare surtax.  Mary’s Medicare surtax is $2,850.

Example 3: Frank is a single taxpayer that has reportable net income of $25,000 and a salary of $175,000.  Frank’s MAGI is $200,000.  His excess MAGI is $0.00 (MAGI of $200,000 less the threshold amount of $200,000).  Since Frank’s has no excess MAGI, none of his income is subject to the Medicare surcharge.

Net Investment Income defined

For this purpose, investment income includes the sum of an investor’s earnings from:

  1. Interest, dividends, annuities, royalties and rents (unless derived in the ordinary course of a non‑passive trade or business)
  2. Gross income derived from a passive trade or business, and
  3. Net gain attributable to the disposition of property held in a passive trade or business.

The new rules refer to “net” investment income because certain investment expenses (i.e., investment interest and management fees) are allowed as a reduction of investment income before the tax rate is applied.

Note that investment income that is normally tax exempt, like interest from state and municipal bonds, veteran’s benefits, and excluded gain on the sale of a residence, are also excluded from this definition of investment income.

Further, investment income does not include salaries, wages or bonuses, distributions from IRAs or qualified plans, any income taken into account for self-employment tax purposes, or gain on the sale of an active interest in a partnership or an S corporation.

Modified Adjusted Gross Income (MAGI) defined

MAGI is computed by starting with adjusted gross income (taxable income before reductions for exemptions, standard or itemized deductions).  Adjusted gross income is then “modified” by adding in certain foreign earned income.  (Note that the purpose of this modification is to insure that foreign income that may be excludable from the general computation of adjusted gross income is subject to the surtax.  Please note that the foreign earned income rules are complex and beyond the scope of this article.  If you are earning income from investments outside of the U.S., you should consult with your tax advisor as to how that income will be treated for purposes of computing the surtax.)

Planning to Avoid the Surtax

Since the surtax rate is substantial, many investors will be looking for opportunities to reduce either their net investment income or their MAGI.  Investors who own interests in profitable pass-through entities (limited liability companies, partnerships and S corporations) should carefully evaluate their level of personal involvement in business activities of the pass-through entity.  Passive investors may want to consider increasing their involvement in the management of the business activity if it would allow them to treat the investment as a “non-passive” activity.   Please note that this must be done with caution if the investor holds other passive activities that are generating losses.   Passive losses can only be offset against passive income activities (as opposed to active income like wages, and income from non-passive activities).  Changing the activity’s status to non-passive may prevent the opportunity to match otherwise deductible passive losses against passive income. The cost of losing the benefit of the passive activity loss in the current year could far outweigh the tax cost of the Medicare surtax.

For investors who are not concerned with passive losses, and who can practically increase their involvement in a profitable business investment, the following is a high level summary of the rules for determining when an investor is considered passive or non-passive.  A taxpayer is considered to be non‑passive if he or she materially participates in a trade or business, meaning that she or he meets one of the following:

  1. Taxpayer participates more than 500 hours,
  2. Taxpayer’s participation is substantially all of the participation in the activity,
  3. Taxpayer’s participation is more than 100 hours and participation isn’t less than any other individual’s participation in the activity,
  4. Activity is a significant participation activity and the individual’s aggregate participation in all significant activities is greater than 500 hours.

Please note that a full discussion of the passive activity rules is beyond the scope of this article. You should consult your tax advisor if you wish to consider other options for planning around these rules.

Other planning steps include considering the acceleration of income into 2012.  Since the surtax doesn’t apply until 2013, investors still have time to evaluate their investments.  If you are considering a large transaction closing the transaction before year-end may save you tax.

Investors who may otherwise be subject to the surtax may find tax-exempt interest bonds as attractive investment in 2013.  In addition to saving federal income tax by investing in tax-exempt bonds, investors will also avoid the 3.8% surtax on the interest earned on the bonds.

Tax reduction planning is rarely simple, and should never be done in isolation.  Any planning should be done in the context of all the applicable tax laws and in consideration of the investor’s overall investment goals.

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  • Catherine Smith

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