IRS Asked to Clarify Rules for New Medicare Surtax

By Ken Berry

Critics are calling for the IRS to clarify certain rules relating to the new 3.8 percent Medicare surtax on net investment income (NII) that kicks in this year. Proposed regulations on the surtax were issued in December, but advocates of business owners and estates – particularly businesses operating as pass-through entities – have asked the IRS to shed more light on several murky areas. The requests were made at a public hearing on the proposed regs on April 2. 
The new Medicare surtax is one of the key revenue-raising components of the controversial health care legislation (sometimes called "Obamacare") enacted in 2010 and upheld by the US Supreme Court in 2012. Under this provision, the 3.8 percent surtax applies to the lesser of NII or the amount by which a taxpayer's modified adjusted gross income (MAGI) exceeds $200,000 for single filers and $250,000 for joint filers. For example, a single filer with $150,000 in NII and a MAGI of $300,000 in 2013 must pay a surtax of $3,800 (3.8 percent of $100,000 exceeding the $200,000 MAGI level). 
This additional tax is piled on top of regular income tax liability for individuals. Beginning in 2013, the top rate for single filers with taxable income of more than $400,000 and joint filers with taxable of more than $450,000 increases from 35 percent to 39.6 percent, while the maximum tax rate on long-term capital gain jumps from 15 percent to 20 percent.
The 3.8 percent surtax may also increase the tax liability of trusts and estates. For these entities, the surtax applies the lesser of undistributed NII or adjusted gross income (AGI) above the dollar amount for the top income tax bracket for trusts and estates ($1,950 in 2013).
One of the most critical aspects of the new surtax is what constitutes, and what does not constitute, NII for the calculation. It includes the following items, reduced by any deductions allocable to such income:
  • Interest, dividends, rents, royalties, and annuities; 
  • Income derived from passive activities; 
  • Trading financial instruments and commodities; and
  • Net capital gains derived from the disposition of property (other than property held in an active trade or business).
Conversely, NII does not include the following items:
  • Active trade or business income;
  • Gain on sale of an active interest in a partnership or S corporation;
  • Distributions from qualified retirement plans or IRAs;
  • Income from tax-exempt municipal bonds;
  • Tax-deferred nonqualified annuities;
  • Income taken into account for self-employment tax purposes; and
  • Capital gain excluded under the statutory limit for the sale of a principal residence.
Note that items that are excluded from a taxpayer's NII, like distributions from a qualified retirement plan or IRA, nevertheless increase MAGI, which could still trigger or increase liability for the 3.8 percent surtax.
Some of the "gray areas" in the proposed regs involve rental income earned by individuals or businesses and income paid out by trusts. Attorneys representing pass-through entities at the public hearing claim that conflicting tax code definitions make it difficult to determine if they are subject to the tax. With pass-through entities like partnerships, S corporations, and limited liability companies (LLCs), profits are passed through to the partners, shareholders, or members, who are then taxed on the income. These entities could face liability for the new surtax.
Furthermore, certain types of income that are not treated as NII may be swept in under other rules. For instance, rental income that is exempt under the passive activity exception (see above) may be treated as NII if the rental income is not derived in the ordinary course of a trade or business. Other advocates representing companies that lease property to related entities proposed rule changes.
Undoubtedly, we have not heard the last word on this subject. It seems likely that the IRS will tinker with the rules before it issues final regulations.
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