Paying for Health Care Reform: Tax on Investment Income

Paying for Health Care Reform: Tax on Investment Income

By: Martin M. Shenkman, CPA, MBA, JD

Expansion of Medicare Tax to Passive Income

By Martin M. Shenkman, Esq.




Paying for health care reform won’t be cheap, and the wealthy will bear a bigger burden. One of the dramatic changes is taxing investment income with the almost 4% Medicare tax. This change will affect how you invest, save and plan your estate. It may also be just the first sign of many more changes likely to come to extract tax dollars from those viewed as wealthy.


Rates and Income Levels


Under current law, only wages and earnings are subject to the Medicare tax above, but starting in 2013 the 3.8% Medicare tax will apply to net investment income if your adjusted gross income (AGI) is over $200,000 single ($250,000 joint) threshold amounts. IRC Sec. 1411. More specifically, the greater of net investment income or the excess of your modified adjusted gross income (MAGI) over the threshold, will be subject to this new tax.


The 3.8% is in addition to the Medicare rate of .9% above so the surcharge for higher earning taxpayers begins to near 5%. This increased marginal rate will have an impact on net of tax calculations for budgets, investments, etc.


No Inflation Indexing


These amounts are not supposed to be indexed so inflation will erode these overtime. Failure to inflation adjust these amounts is a significant departure from many prior tax law changes. Over time these caps and the tax raise will shift from applying to the wealthiest sliver of taxpayers to a broader range of taxpayers, just like the AMT expanded over time.


Net investment income includes interest, dividends, royalties, rents, gross income from a passive business, and net gain from property sales. Income from a trade or business will not be included in definition of net investment income. IRC Sec. 1411(c).


Planning Considerations for Medicare Tax on Investment Income


Planning will be more complex. Consider some of the following possibilities:


  • You can reduce net investment income by properly allocable deductions.  Existing rules that determine how you allocate deductions to municipal bonds and other tax exempt income could be used, or other regulatory guidance might be provided.
  • Your advisers may have to allocate their bills by category to help.
  • Investment income derived as part of a trade or business is not subject to the new Medicare tax on investment income. Does that mean that if you retain liquid assets and the income they generate inside your business that the tax will be avoided? Likely not unless the business can justify a business purpose for this. Although there are no rules or guidance yet, creating minutes documenting the business purpose of retaining investment assets in the business might be one of the steps to take to support this type of action. However, one downside for this type of planning will be exposing liquid assets to business creditors and claimants.
  • This extension of the Medicare tax won’t apply to retirement assets. IRC Sec. 1411(c)(5). Roth IRAs are perhaps even a better result that initially thought. Earnings on non-IRA investments could be subject to this higher tax, but if used to pay tax on a Roth conversion the earnings will all be inside the tax deferred Roth thereafter.
  • If you earn a salary from an active business the Medicare tax will apply without limit. If you receive a divided from a passive business the Medicare tax will apply without limit. But what if you shift income from salary or profits distributions to dividends from an active business. Will those payments escape the increased Medicare tax on all fronts?
  • Passive real estate, as defined under the existing passive loss rules of Code Section 469 could be adversely impacted. Great timing, just as commercial real estate is facing some of the most daunting economic challenges in recent memory. There might be some incentive for real estate owners to re-evaluate their status under the passive loss rules.
  • Hug your insurance agent. Yes, the cash free build up inside an insurance policy will remain protected. Coupled with the expectation of most tax advisers that income tax rates on the wealthy will continue to rise and the estate tax will return, permanent life insurance inside an irrevocable life insurance trust is looking quite handsome.
  • How will passive versus active distinctions for businesses be determined and what impact will this have on the structure of business and investments? The definitions under the passive loss rules of Code Section 469 will apply.  IRC Sec. 1411(c)(2)(A). Cool. That leaves us all with complete uncertainty as to how these rules will apply to trusts. There are two authorities on the issue, and well, they reached polar opposite answers. In Mattie K. Carter Trust v. US  the trust managed various assets, including the Carter Ranch which involved cattle, oil and gas. The trustee hired a ranch manager and other employees to carry out most ranching duties. The Service argued that only the trustee’s efforts should be considered in determining if the trust met the test of materially participating in the ranch. The trustee’s position was that the trust’s material participation in the ranching activity should be evaluated with consideration to the efforts of not only its fiduciaries, but also its employees and agents. The U.S. District Court for the Northern District of Texas determined that the law did not mandate that only the trustee’s activities could be considered. In the aggregate, the efforts of the trustee, ranch manager and others, showed regular, continuous and substantial involvement so that the trust was deemed to materially participate and could deduct the losses. 256 F. Supp. 2d 536 (Tex. 2003). In this recent ruling, dated August 17, 2007, the Service determined that a trust’s effort to characterize losses as not being passive (and hence not currently deductible). The Service maintained that the trustee’s activities alone should be considered in determining if the trust materially participated in the activity. It is the material participation of the trustee that is the litmus test. The Service expressly addressed the Carter court opinion above and stated that it disagreed. TAM 200733023.
  • How will investment location decisions be made? Will it become more advantageous for high income taxpayers to retain income assets inside the tax protective envelope of qualified plans? Will the calculus of investing in tax exempt versus taxable bonds change? For wealthy taxpayers with variable year to year income the determination may not be easy or consistent from year to year.
  • Using charitable remainder trusts (CRTs) and non-grantor charitable lead trusts (CLTs) will shift investment income to the trust formed and avoid the new Medicare investment income tax.
  • When planning to harvest gains and losses on security positions this new tax might enter into the analysis. Shifting deductions to the extent feasible to control investment income from year to year, using installment sales and tax deferred Code Section 1031 exchanges might keep you below the threshold.




The unfortunate bottom line with this type of micro tax change is that while it will be costly, the cost in terms of professional fees and effort of planning around it may be greater than the benefit to many taxpayers.



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