Medicare 3.8% Surtax

As part of the Health Care and Education Reconciliation Act of 2010 (Obamacare) a 3.8% surtax on certain net investment income was instituted to support the cost of Medicare. The Net Investment Income Tax goes into effect on Jan. 1, 2013. The NIIT will affect income tax returns of individuals, estates and trusts for their first tax year beginning on (or after) Jan. 1, 2013. The new surtax is separate from, and in some cases in addition to, the traditional income tax, the AMT provisions, and the new 39.6% tax rate.

Income Subject to Tax

Individual taxpayers have a threshold of $200,000 for a single individual and $250,000 for a married couple. It is only amounts over these thresholds that are subjected to the 3.8% surtax. For Trusts and Estates the number is substantially lower: $11,950 in 2013, and indexed for inflation thereafter.

The 3.8% surtax is based, for trusts and estates, on the lesser of (1) the undistributed net investment income (NII) of a trust or estate, or (2) the excess of adjusted gross income over the top bracket for estate and trust income (the $11,950 threshold).

There are three categories of gross income included in NII. These categories can be reduced by deductions that are allocable to such income. The first category is gross income from interest, dividends, annuities, royalties, rents, substitute interest or dividends, unless the income is derived in the ordinary course of a trade or business (that is neither a passive activity for the taxpayer, or a financial instrument or commodities business). The second category is other gross income derived from a trade or business that is passive activity for the taxpayer, or a financial instruments or commodities business. The third category is net gain (to the extent taken into account in computing taxable income) that is attributable to the disposition of property except to the extent the gain is from the dale of the property held in an active trade or business (other than a financial instrument or commodities business).

Net investment income also includes the taxable portion of any annuity as well as gain or loss from the sale of the annuity that would be treated as net investment income. The regulations treat an estate or trust as a conduit by reducing the estate’s or trust’s taxable income to take into account distributions to beneficiaries and charities. Accordingly, undistributed net investment income of an estate or trust is reduced by the share of net investment income included in the deductions for the estate or trust.

Working Capital Exception

Generally, any income attributable to the investment of working capital is treated as not being derived in the ordinary course of a trade or business and is therefore subject to the NIIT. The proposed regulations generally define working capital as capital set aside for the use and the future needs of a trade or business. These amounts may be invested in savings accounts, certificates of deposits or similar investments.

Disposition of Interests in Partnerships and S Corporations

Generally, net gain on the sale of a partnership interest (including LLCs taxed as partnerships) or S Corporation stock will be subject to the NIIT. The regulations apply a hypothetical sale of assets on a property-by-property basis which requires the taxpayer to determine what would have been subject to gain or loss. Net gain will generally be subject to tax where (i) there is no trade or business, (ii) the trade or business is a passive activity with respect to the transfer, or (iii) where the partnership or S Corporation is in the trade or business of trading in financial instruments or commodities. The regulations include a deemed asset sale methodology to determine the amount that is subject to tax.

Passive Activity

The Medicare surtax applies to a trade or business only if it is a passive activity with respect to a taxpayer. A passive activity, under the IRC is defined as one in which the taxpayer does not materially participate. Individuals show material participation in a specific activity or business only by meeting one of the seven tests enumerated in Reg. § 1.469-5T(a). The testate are largely based on the number of hours that the taxpayer spends in the activity. The test for material participation is determined at the activity level, and allows taxpayers to group activities together as an economic unity under passive loss rules. Grouping allows the hours spend on the individual activities to be added together, increases the probability of satisfying the test. The income is then exempted from the surtax, as it no longer qualifies as a passive activity.

Regulations under Code Sec. 469 provide that once activities have been grouped, the taxpayer cannot regroup them at a later date. There is a special fresh start rule in the proposed regulations currently under consideration, but even if that passes, the regrouping will only be allowed once.

Income Not Subject to Surtax

Types of income that are not subject to the Medicare surtax include: wages, unemployment compensation, operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends and distributions from certain Qualified Plans (those described in sections 401(a), 403(a), 403(b), 408, 408A, or 457(b)). All of the above sources of income are exempted from the 3.8% surtax.

Managing Distributions

A possible method of avoiding the surtax is to distribute the income. If income will be accumulating for years (e.g. a trust for the benefit of a minor, with distributions to begin only when the child attains majority), it may be better to consider a grantor trust. This way the income is being reported on the grantor’s individual tax returns, which avoids the Trust surtax. For individual taxpayers (as opposed to estates and trusts), the surtax is based on the lesser of (1) net investment income, or (2) the amount by which modified adjusted gross income (MAGI) exceeds the threshold amount in that tax year. In this manner the grantor has a much higher threshold, up to $200,000 (or $250,000) before any surtax is charged.

Assume a trust has a single beneficiary who earns a salary of $110,000, where the trustee has discretion to distribute income and principal, and the trust earns $100,000 in income. If the trust does not distribute any of the income, there will a 3.8% on everything over $11,950 resulting in a $3,346 surtax. However if $88,050 is distributed to the beneficiary, then no surtax would be charged on the $11,950 undistributed net investment income. Additionally the $198,050 of the salary and the interest income would be below the $200,000 MAGI threshold for individuals, so the income would escape the surtax there as well.

Year – End Selection

The surtax only applies for tax years that begin on or after January 1, 2013. It is worth collaborating with a CPA to choose a proper yearend (fiscal or calendar) to allow for the greatest advantage. This method is only applicable to Estates, as trusts are required to use the calendar year. However under IRC 644, the estate’s first taxable year maybe any period of 12 months or less, that ends on the last day of a month. So an estate may be able to defer the application of the surtax. If a yearend of Nov. 2012 is chosen, then it is possible to avoid the 3.8% surtax until December 2013 (because if the tax year starts December 1st, 2012, the surtax is not applicable).

Exempt Trusts

Generally the tax applies to all estate and trusts. However a number of trusts have been specifically excluded:

  • A trust where all unexpired interests are devoted to charitable purposes (as described in IRC § 170(c)(2)(B))

  • A grantor Trust or a § 678 trust
  • A trust exempt from tax under IRC § 501(c)
  • A charitable remainder trust
  • Most foreign Trusts

  • Business Trusts
  • Common Trust funds, and
  • Pooled income Funds

It is important to note that while a trust may be exempt from the surtax, the exemption does not mean that the income entirely escapes the surtax. A grantor trust is specifically exempted, for example, but the trust’s income is reported on the owner’s Form 1040 and the surtax will apply to the individual’s net investment income. While a Charitable Remainder Trust is a deemed a charitable entity and is not subject to tax ordinarily, the distributions from a CRT are taxed to the non-charitable beneficiaries, as any other distribution from a trust.

Exempt Trusts

Sources used:
3) Understanding the Health Care Surtax: Robert S. Keebler, CPA, MST (2011).
4) WealthCounsel Webinar: The 3.8% Surtax’s Immediate Impact on Estates and Trusts (July 2012)
5) Family Tax Planning Forum: Observations on the 3.8-Percent Medicare Contribution Tax Proposed Regulations, Robert S. Keebler (February 2013).
6) Income Tax Planning Newsletter #40 (March 21, 2013) at Http://
Disclaimer: The information on this blog is provided for general informational purposes and is not legal advice. Information contained in this blog, the comments, or any correspondence with the author or others do not create an attorney-client relationship and are not a substitute for professional legal advice from a licensed attorney in your jurisdiction.

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