Blake Christian
Blake E. Christian

Planning for the new 3.8% Medicare tax on unearned income

The new tax on net investment income takes effect Jan. 1.

December 13, 2012
by Blake E. Christian, CPA

With the recent reelection of President Barack Obama, the Patient Protection and Affordable Care Act, P.L. 111-148, the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, and the related new tax provisions will very likely be with American taxpayers for the long run.

Taxpayers and CPAs must fully understand some of the nuances and tax planning opportunities associated with these new rules.

The combination of the implementation of the health care reform legislation and the potential expiration of the Bush-era tax rates (and/or the cap on itemized deductions) beginning in 2013 can cause high-income taxpayers to experience tax rate increases ranging from 24% to 189%—depending on the type of income they receive:

% Rate Increase   2012 Rate  2013 Rate
189%   for qualified dividends: 15% 43.4% (39.6% + 3.8%)
24%  for passive income: 35%   43.4% (39.6% + 3.8%)
59%  for long-term capital gains: 15%    23.8% (20% + 3.8%)

Even without the expiration of the Bush-era tax rates, the new health care reform tax on unearned income will increase the maximum rate of tax for certain taxpayers by up to 10.86% (3.8% ÷ 35%).

Forewarned is forearmed! With 2013 just around the corner, there are a multitude of tax planning strategies to consider as 2012 comes to a close and planning for next year begins. The new Medicare contribution tax, for example, raises many important issues, some of which may require action before the end of 2012.


One of the funding provisions in the health care legislation imposes a Medicare contribution tax (Medicare tax) of 3.8% on certain “unearned income” for tax years beginning in 2013. This new surtax will apply to individuals, estates, and trusts. C corporations dodge this tax bullet.

For individuals, the unearned income Medicare tax is imposed on the lesser of (1) an individual’s net investment income for the tax year, or (2) any excess of modified adjusted gross income (MAGI) for the tax year over a “threshold amount”—defined below (Sec. 1411(a)(1)).

For estates and trusts, the new Medicare tax kicks in very quickly. The tax is imposed on the lesser of (1) undistributed net investment income for the tax year or (2) any excess of adjusted gross income over the dollar amount at which the highest tax bracket for estates and trusts begins for the tax year (Sec. 1411(a)(2)). Note that in 2012, the highest tax bracket for estates and trusts begins at $11,650.

Threshold amount for individuals

The threshold amount where the new Medicare tax begins to apply is $250,000 of MAGI for joint return filers and surviving spouses, $125,000 of MAGI for married taxpayers filing separately, and $200,000 of MAGI for all other taxpayers.

Net Investment Income

Net investment income is the excess of gross investment income over investment deductions (Sec. 1411(c)(1)). Gross investment income includes:

  • Gross income from a trade or business that is a “passive activity” with respect to the taxpayer under Sec. 469 or a business that trades in financial instruments or commodities;
  • Gross income from interest, dividends, annuities, royalties, and rents, other than these types of income derived in the ordinary course of a “nonpassive” trade or business; and
  • Net gains on the disposition of property, other than property held in a “nonpassive” trade or business.

Net investment income does not include Social Security income, tax-exempt interest, retirement income, alimony, or any item taken into account in determining self-employment income for the tax year; however, a portion of these items may increase MAGI and cause more net investment income to be subject to the surtax.

Additionally, investment deductions are those properly allocable to gross investment income (Sec. 1411(c)(1)(B)).

Note that a new, incremental 0.9% federal payroll tax applies to earned income beginning in 2013, but the 0.9% tax and the 3.8% Medicare tax can never be imposed on the same income item. The 0.9% tax has no corresponding employer portion, such as applies for other payroll tax purposes, but the employee portion is otherwise required to be withheld from wages and similar payments. For more on recent IRS guidance on the 0.9% tax, see “Guidance Issued on Additional Medicare Tax.”

Possible exceptions to the 3.8% Medicare tax

Summarized below are some possible exceptions where certain income may be excluded from the new Medicare tax:

Nonpassive owners of S corporations

Day-to-day material participation (often referred to as “active participation”) is necessary under Sec. 469 to avoid the “passive activity” characterization. For a nonpassive owner or shareholder of an S corporation, the taxpayer’s distributive share of income does not currently appear to be subject to the new 3.8% Medicare tax. This applies to the taxable income reported in Box 1 of the shareholder’s Schedule K-1, including any subsequent distributions of that income. For further detail on the new Medicare tax with respect to S corporations, see Wechter, “Using S Corporations to Avoid the Medicare Tax,” Tax Insider (June 14, 2012).

Rental real estate professionals

Generally, income derived from rental activities will be characterized as passive and subject to the 3.8% Medicare tax. An exception to this rule relates to rental real estate professionals. A taxpayer qualifies as a real estate professional if:

  1. 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
  2. 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 nonpassive 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” (Regs. Sec. 1.469-9(g)), 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 considerations to mitigate the 3.8% Medicare tax in 2013

Summarized below are some additional actions that taxpayers should consider with respect to the 3.8% Medicare tax:

Shareholder/partner loans to closely held business

Any interest income from shareholder loans (imputed or otherwise) will be subject to the new surtax. This is the case whether or not the taxpayer’s underlying trade or business is passive or nonpassive. 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 tax liability resulting from the surtax. Another strategy to avoid future interest income is converting the loan to a contribution to capital.

Paying dividends from closely held corporations

To the extent shareholders and respective businesses have the means to pay a dividend, it may make sense to accelerate the payment into 2012. Public companies are taking this action in 2012. This is especially true if the company feels it has retained cash that the IRS may view as being subject to the accumulated earnings tax under Sec. 531.

Also, S corporations may have accumulated earnings and profits (E&P) from a prior C corporation tax year, which may be distributed before amounts from the accumulated adjustments account (AAA), provided certain elections are made. Additionally, tax-deferred income within an interest charge domestic international sales corporation (IC-DISC) may be available for distribution to the shareholder in the form of a dividend, which can escape the new tax by paying the dividend payment before the end of 2012. For further details on dividend distribution ordering, E&P, AAA, and related information, see Christian, “AAA, PTI and E&P,” Corporate Taxation Insider (Aug. 28, 2008).

Other considerations
  • Converting traditional IRAs into Roth IRAs in 2012, if this otherwise makes sense from a long-term planning perspective. This will effectively reduce MAGI in future years when taxpayers take distributions from the accounts.
  • Investing in tax-exempt bonds rather than taxable bonds since the interest is excludable.
  • Harvesting capital losses to offset capital gains to reduce net investment income.
  • Managing retirement plan distributions to maintain MAGI that does not exceed the “threshold amounts” of $200,000 and $250,000.
  • While care must be exercised to avoid other issues, evaluating whether investment income is held in a certain passthrough entity vs. a C corporation (currently or in the future) may yield benefits.

Proposed regulations

On Nov. 30, 2012, the IRS issued proposed regulations (REG-130507-11) on the new Medicare tax that provide additional guidance on what constitutes net investment income. It further defines “trade or business” income for purposes of the new surtax. Note that under the proposed regulations, Sec. 162 applies when defining a trade or business. Therefore, an activity may be a passive activity under Sec. 469, but if it constitutes a trade or business under Sec. 162, it may not be net investment income for this purpose.

The proposed regulations provide useful (albeit occasionally illogical) details regarding the suggested application of the new net investment income rules:

  1. Portfolio income earned on working capital of an active trade or business will always be viewed as net investment income, regardless of whether the business owner’s role is active or passive (Prop. Regs. Sec. 1.1411-6).
  2. For the sale of a partnership interest or the stock of an S corporation, the proposed regulations assume hypothetical gains and losses on a fair market value sale of the underlying assets held by the partnership or S corporation (similar to Sec. 338(h)(10) election). The gain or loss on the deemed sale of an asset will not be included in the calculation of net investment income if the asset is held in a trade or business (other than a trade or business of trading in financial instruments or commodities) of the S corporation and the owner was active with respect to that trade or business. The gain or loss on the deemed sale of property not held in a trade or business of the S corporation will be included in the calculation of net investment income (Prop. Regs. Sec. 1.1411-7).
  3. Net gains and losses associated with distributions or liquidation of a partnership/LLC or an S corporation will virtually always be treated as net investment income and will be subject to the new Medicare tax for both passive and active owners (Prop. Regs. Sec. 1.1411-4).
  4. Deferred or excluded income items, such as from Sec. 1031 or 1033 exchanges or sale of a personal residence, etc., are generally excludable from the tax (preamble to REG-130507-11).


Since the new Medicare tax will apply regardless of the “fiscal cliff” negotiations, all estates and trusts—with even low taxable income levels—and individual taxpayers with relatively high incomes and various passive investments, will experience increases in federal tax beginning in 2013. Changes in portfolio allocations, including moving to more tax-exempt bonds and/or non-dividend-paying stocks, may yield long-term tax savings. To the extent taxpayers can control their MAGI from year to year to stay under the applicable thresholds, the Medicare tax may be avoided altogether.

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Blake E. Christian, CPA, is a tax partner in the Long Beach, Calif., office of Holthouse, Carlin & Van Trigt LLP.