In 2010, the Health Care and Education Reconciliation Act
included a stealth tax increase that did not take effect until January 1st
of this year. Known as the 3.8% Medicare
surtax, the new tax applies to the lesser of “net investment income” (NII) or
the excess of “modified adjusted gross income” over certain thresholds
($200,000 of adjusted gross income for single taxpayers and $250,000 for
married taxpayers filing jointly). One
question I am receiving repeatedly from my clients and colleagues is: “How does
this new tax affect business owners?”
First, some basics. There
are three types of NII: (1) gross income from interest, dividends, rents and
royalties; (2) gross income from a passive activity or a trade or business of trading
in financial instruments or commodities; and (3) net gain to the extent taken
into account in computing taxable income.
Importantly, the first type excludes tax-exempt muni bond
interest. Also, it does not matter
whether the dividends, interest, rents or royalties are received individually
or as a result of your ownership of a partnership or S corporation. For income tax purposes, the income of these
entities flows through to the owners and retains its character. So, if you see dividends or interest on your
partnership or S corporation K-1 for 2013, you will need to include that income
in NII in determining whether are you subject to the 3.8% surtax.
if you have a business that is owned partially by you and partially by some of
your family members? Is the income from
that business subject to the 3.8% surtax?
The answer depends on whether you or the family members are actively
involved in the business. If you
materially participate in the business (applying the good ol’ passive loss
rules), then your share of the income escapes the surtax. However, if the family members do not
materially participate, the income will be treated as NII and potentially
subject to the surtax.
This rule applies whether the entity is structured as a
partnership, a limited liability company (LLC ) taxed as a partnership, or an S
corporation. By contrast, if you own
shares of a Master Limited Partnership (MLP) or an LLC that is treated as an
MLP for income tax purposes, your share of the net income generally will be passive
income and subject to the surtax.
As noted earlier, rental income generally is treated as NII,
unless it is derived in the ordinary course of an active trade or
business. While rental income from a
passive activity will be included in NII, rents from a trade or business that
is not passive will escape NII treatment.
The third type, net gain to the extent included in computing
taxable income, includes capital gains.
It is not clear yet whether you can use capital loss carryovers from
prior years to offset current capital gains in computing NII, although many
commentators believe this is possible.
The bigger question is what happens when you sell your
business? Is the entire capital gain
subject to the NII surtax?
There is a special rule that applies to sales of S
corporation stock and partnership interests (including LLC interests taxed as S
corporations or as partnerships). The
3.8% surtax is imposed only on the portion of that gain that would have been
subject to the tax if the entity had sold all of its property for fair market
value immediately before the sale of the partnership interest or stock. So, if you are actively involved in the
business prior to its sale, the capital gains income generated on the sale will
not be subject to the surtax!
I also was recently asked whether distributions from
retirement plans are subject to the 3.8% surtax. After all, in many cases, the retirement plan
assets may have grown substantially since the original contributions to the plan
were made. Fortunately, the statute expressly
states that distributions from qualified retirement plans, IRA’s, Roth IRA’s
and similar plans are not considered NII and therefore escape the surtax.
Note that the surtax is in addition to the alternative
minimum tax. Note also that, if you have
control over income that is not considered NII, then you may be able to
minimize exposure to the surtax in any given year. Making passive income into non-passive income
will help avoid the surtax.