Medicare Surtaxes: Being Forewarned Is Forearmed

By Ken Berry

The new Medicare surtaxes are coming, the new Medicare surtaxes are coming . . .
Regardless of whether or not Congress resolves the looming "fiscal cliff" crisis or the nation is allowed to fall into the abyss, two new Medicare surtaxes will take effect on January 1, 2013. At long last, the IRS has issued comprehensive proposed regulations on the surtaxes – spanning 159 pages – clarifying some of the finer points. The regs also include a stern "warning" to tax evaders in the preamble (NPRM REG-130507-11). 
History lesson: Neither Medicare surtax is related to the expiring "Bush tax cuts" for capital gains and dividends and scheduled increases in individual income tax rates. The add-ons were included in the Affordable Care Act of 2010 (commonly referred to as "Obamacare"). Now that the president has been reelected and the US Supreme Court upheld the constitutionality of Obamacare, it's unlikely that the surtaxes will be part of any political horse-trading at year-end. It's been estimated by the Joint Committee on Taxation that the two surtaxes together will raise $317.7 billion over the next ten years.
You can expect some of your wealthier clients to be hit by one or both of the surtaxes in 2013. Here's how they work in brief:
1. The 3.8 percent Medicare surtax applies to the lesser of "net investment income" (NII) or the amount by which modified adjusted gross income (MAGI) exceeds $200,000 for single filers and $250,000 for joint filers. For estates and trusts, the surtax applies to the dollar amount at which the entity begins to pay the highest tax rate.
NII includes interest, dividends, capital gains, rents, royalties, nonqualified annuities, passive activity income from passive activities, and income from trading financial instruments or commodities. But certain items are specifically excluded from the definition of NII, such as wages or self-employment income, Social Security benefits, tax-exempt interest, operating income from a non-passive business, and distributions from most retirement plans. 
2. The 0.9 percent Medicare surtax applies to "earned income" exceeding $200,000 for single filers and $250,000 for joint filers. For this provision, "earned income" is defined the same way as it's defined for other federal income tax purposes. This includes wages or self-employment income, commissions, bonuses, and tips, but not investment income. 
The IRS provides the following example: Suppose a single filer earns $180,000 in wages and realizes another $90,000 from NII. The taxpayer's MAGI is $270,000. In this case, the taxpayer would have to pay a 3.8 percent surtax on the lesser figure of $70,000, or $2,660, but would not have to pay the 0.9 percent surtax on any wages.
Under the new proposed regulations, gain that isn't recognized under other tax code sections doesn't count toward the 3.8 percent Medicare surtax, including gain deferred under an installment sale, gain from like-kind exchanges or involuntary conversions, and gain from the sale of a principal residence up to the statutory exclusion amount. The 3.8 percent surtax applies to ordinary trusts, but not grantor trusts (although the grantor may be taxed on trust income). Similarly, charitable remainder trusts aren't subject to the tax, but income may be taxed as NII to the income beneficiary. 
Nevertheless, the new regulations don't explain several key issues that have been perplexing tax practitioners. For instance, it's not clear how rents will be treated for purposes of the 3.8 percent Medicare surtax. The rules for application of the 0.9 percent surtax are more straightforward.
Caution: If you're looking for loopholes within the new proposed regulations, the IRS might use some other authority to thwart your efforts. In the preamble to the proposed regs, it warns that it would closely review transactions attempting to manipulate NII in order to avoid the new 3.8 percent surtax. When it deems it to be warranted, the IRS will challenge such transactions based on the applicable statutes and judicial doctrines.
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