- Imposing an additional Hospital Insurance (HI) tax rate of 0.9 percent on earned income in excess of $200,000 for individuals and $250,000 for married couples filing jointly;
- Imposing a 3.8 percent “unearned income Medicare contributions” (UIMC) tax on higher-income taxpayers.
The 3.8 percent UIMC tax is imposed on the lesser of:
(i) Net investment income; or
(ii) The excess of modified adjusted gross income (MAGI) over the threshold amount ($200,000 for single individuals or heads of households; $250,000 for married couples filing a joint return and surviving spouses; and $125,000 for married couples filing separate returns).
Net investment income includes interest, dividends, royalties, rents, gain from disposing of property from a passive activity, and income earned from a trade or business that is a passive activity. In determining net investment income, investment income is reduced by deductions properly allowable to that income.
Net investment income does not include distributions from qualified retirement plans, including pensions and certain retirement accounts. For example, income from individual retirement accounts (IRAs), 401(a) money purchase plans, 403(b) and 457(b) plans would be exempt.
Estates and trusts will also pay a 3.8 percent UIMC tax on the lesser of:
- Their undistributed net investment income for the tax year or
- Any excess of their adjusted gross income over the dollar amount at which the highest tax bracket for estates and trusts begins for the tax year.
*Charitable remainder and other tax-exempt trusts are excluded.
Non-passive owners of S corporations
The UIMC tax was designed to pick up everything that FICA and self-employment taxes do not. However, 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.
To go through the logic step-by-step, in the case of a trade or business, the UIMC tax applies to income from a trade or business if it is a passive activity as to the taxpayer. Conversely, active business ownership within a sole proprietorship, LLC, partnership, or S corporation is not subject to the UIMC tax. A passive investor in a trade or business housed within one of these pass-through entities is not subject to self-employment tax because the investor is not active in the business. Therefore, if a passive investor attempts to construct an argument that he or she is not passive to avoid the Medicare tax, they will end up being subject to self-employment tax, which is substantially higher.
However, in an S corporation, if a shareholder materially participates in the business, then their distributive share of income would not be subject to the UIMC tax because the income would not be considered investment income. This applies to the taxable income reported in Box 1 of the shareholder’s Schedule K-1, including any subsequent distributions of that income. Further, non-wage distributions are not subject to self-employment tax.
Taxpayers thinking of converting to such a structure should be mindful of the regulations regarding unreasonably low compensation for shareholder-employees of S corporations.
Rental real estate professionals
Generally, income derived from rental activities will be characterized as passive and subject to the UIMC tax. An exception to this rule relates to rental real estate professionals. A taxpayer qualifies as a real estate professional if:
- More than one-half of the personal services the taxpayer performs in trades or businesses during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and
- The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.
The key benefit for real estate professionals is that their income is considered non-passive by definition. For this reason, rental income received by rental real estate professionals should not be considered part of net investment income when calculating the 3.8% Medicare tax, as long as the rental real estate activities are conducted as part of a trade or business under Sec. 162.
Real estate professional taxpayers should consider making “grouping elections”, which combine all rental activities into a single rental real estate activity. This may help taxpayers meet the material participation requirement for all their rental properties.
Tax Planning Techniques
The UIMC tax applies only to taxpayers with both MAGI above the threshold amount and net investment income. As a result, taxpayers can minimize its impact by minimizing either MAGI or net investment income (or both). Tax planning strategies include:
- Income recognition and deferral planning. Items of income that are excluded from income reduce both MAGI and net investment income. This provides higher-income taxpayers potentially subject to the UIMC tax additional incentive to structure transactions that result in either tax-exempt or tax-deferred income, such as exempt state and local obligations, or tax-deferred annuities and related investments. Higher-income taxpayers can also minimize the UIMC tax by including non-dividend paying growth stocks, which do not increase MAGI or create investment income until sold, in their investment portfolio.
- Capital gain planning. Investment income includes net gain (to the extent taken into account in computing taxable income) from the disposition of property. Tax planning strategies that reduce or defer capital gain income will also reduce or defer net investment income for purposes of the UIMC tax.
Using the installment method of accounting to report gain on the sale of property sold on an installment basis, for example, will minimize the impact of the UIMC tax because it avoids a large increase in both MAGI and investment income in the year of sale. Taxpayers who sold property on an installment basis in 2012, however, should consider electing out of the installment method and recognizing the entire amount of the gain on their 2012 return.
- Retirement income planning. Because distributions from qualified retirement plans are not included in net investment income, the UIMC tax provides taxpayers with additional incentive to maximize retirement plan contributions. Although retirement plan distributions are not included in net investment income, distributions that are included in income (such as those from a traditional IRA or 401(k)) increase MAGI. This increase in MAGI may increase the amount of other investment income subject to the UIMC tax.
On the other hand, retirement plan distributions that are not included in income (such as those from a Roth IRA or Roth 401(k)) do not increase MAGI. This provides higher-income taxpayers with incentive to contribute to Roth-type retirement plans, rather than traditional plans. Contributions to traditional retirement plans reduce MAGI in the year of contribution, while contributions to Roth plans do not. Taxpayers with MAGI near the threshold level may be able to avoid or reduce current year’s UIMC tax by contributing to a traditional plan and reducing MAGI below the threshold.
Converting traditional IRAs into Roth IRAs in 2012, if this otherwise makes sense from a long-term planning perspective, will effectively reduce MAGI in future years when taxpayers take distributions from the accounts.
- Passive activity loss planning. Passive income is investment income for purposes of the UIMC tax. Classifying income as passive is generally advantageous for taxpayers with sufficient passive losses to offset the passive income. For taxpayers with net passive income; however, the UIMC tax increases the tax rate on passive income.
- Estates and trusts. Estates and trusts with undistributed net investment income will be subject to the UIMC tax whenever their adjusted gross income exceeds the dollar amount at which the top marginal tax rate begins. Estates and trusts can reduce undistributed net investment income and thereby minimize or eliminate the UIMC tax by distributing income to beneficiaries. Any distribution will increase the beneficiary’s net investment income and potential liability for the UIMC tax. However, the threshold amount for individuals is much higher than that for estates and trusts, and the UIMC tax can be eliminated if the beneficiary’s MAGI remains below the threshold amount.
Estates and trusts should also consider the UIMC tax in making investment decisions. The UIMC tax enhances the already existing incentives estates and trusts have to invest in tax-exempt and tax-deferred investments.
- Shareholder/partner loans to closely held business. Any interest income from shareholder loans (imputed or otherwise) will be subject to the UIMC tax, whether or not the taxpayer’s underlying trade or business is passive or non-passive. In the current low-interest-rate environment, taxpayers may be in a position to reduce interest rates on their related-party loans, potentially reducing the UIMC tax liability. Another strategy to avoid future interest income is converting the loan to a contribution to capital.