Two New Taxes on High-Income Individuals

By Stanley Rose April 3, 2013

(3.8% tax on investment income and .9% tax on earned income)

A pair of new taxes sprung to life effective January 1, 2013 that will impact many high-income individuals.  One of them will first surface in pay stubs of effected individuals who cross certain thresholds, while the other will manifest itself first on 2013 Forms 1040.  The taxes consist of a 3.8% tax on investment income and a .9% tax on earned income.  Both taxes are rooted in the Patient Protection and Affordable Care Act and its subsequent amendment (the so-called “Obama-Care” provisions). The purpose of this article is to provide an overview of both.

3.8% Medicare tax

This tax was created with the addition of Section 1411 of the Internal Revenue Code (“IRC”).  The tax is equal to 3.8% of the lesser of two amounts: (1) net investment income or (2) the excess of modified AGI over a threshold amount.  The threshold amounts are:

1. For taxpayers filing joint returns or surviving spouses: $250,000;
2. For married taxpayers filing separate returns: $125,000;
3. For all other individual taxpayers: $200,000;
4. For estates and trusts: The dollar amount at which the highest tax bracket begins (currently $7,500).

“Modified AGI” refers to AGI increased by certain foreign income excluded from AGI.  This tax applies to “obvious” investment income like interest, dividends, annuities, royalties and rents, but it also applies to certain income that in other tax contexts historically has been viewed as trade or business income, as opposed to investment income.  It does so by treating an S Corporation shareholder’s share of ordinary income (allocated to the shareholder and reported on Schedule K-1) as investment income for all shareholders deemed to be “passive” owners.  The nauseatingly complex rules of IRC Section 469 define “passive,” but in general, an employee/owner will be treated as non-passive, but other owners may be deemed passive.  Passive income from LLCs and partnerships will be treated in the same manner.  Generally, LLC and partnership owners whose incomes are treated as self-employment income will avoid this tax, while others will incur it.  Also, generally any gain resulting from sale of S Corporation stock or LLC or partnership units will follow the same treatment as the ordinary income for purposes of this tax (passive and subject to the 3.8% tax for some, while non-passive and immune to the tax for others).

The 3.8% tax will be self-assessed and reported on Form 1040.  However, it is subject to estimated tax provisions, and should be considered on a quarterly basis throughout 2013.

.9% Employment tax

This tax is part of the “Hospital Insurance” tax imposed by Section 3101 of the IRC, described as “Additional Medicare Tax.”  It represents a .9% tax on wages and self-employment income exceeding certain levels (it shares the same individual levels as the 3.8% tax):

1. For taxpayers filing joint returns or surviving spouses: $250,000;
2. For married taxpayers filing separate returns: $125,000;
3. For all other individual taxpayers: $200,000.

For the self-employed, this tax will be self-assessed and reported on Form 1040, and is subject to estimated tax provisions.  However, some curious rules will impact employees.  Employers are required to begin withholding and submitting this additional tax to the IRS at the point in the year the employee’s wages exceed $200,000.  This applies regardless of filing status, and therefore withholding may occur toward a tax that will not apply (recall married taxpayers filing joint returns are not subject to the tax unless earned income exceeds $250,000).  Any excess withholding can be reclaimed upon the filing of the taxpayer’s 1040.  Form 941, Employer’s Quarterly Federal Tax Return, already has been altered to allow reporting of this tax.

Commentary/planning

In the past, Medicare taxes applied only to workers, and it now has expanded to impact those receiving investment income.  The rules are clear that it is possible for a taxpayer to incur both of these new taxes during the same year, but no single category of income will be subject to both taxes.  Instead, they will work together to put most high-income individuals in a similar position:

1. Wage earners: 1.45% Medicare Tax + 1.45% employer match + .9% new tax = 3.8%
2. Self-employed: 2.9% self-employment tax + .9% new tax = 3.8%
3. Investment income earners: 3.8%

Clearly, Congressional intent was to raise the Medicare Tax and ensure that nearly everyone (if their income is high enough) pays it.  There are some ways to avoid these taxes, but it involves a pretty narrow gauntlet.

Exception for muni income

First, it appears that tax-exempt interest income, such as interest from municipal bonds, will not be taxed as investment income, because it is not a component of “modified AGI.”

Qualified retirement plans

Also, contributions to qualified retirement plans, like Section 401(k) plans, are not part of the Medicare Tax base, and are not subject to the .9% tax.  Also, Section 1411 also makes it clear that distributions from qualified retirement plans are not subject to the 3.8% tax.  In other words, contributions to and distributions from qualified retirement plans can escape both of these taxes.

S corporation income for active participants

A very interesting disparity has emerged from these rules in their collective treatment of employee/owners of flow-through entities.  It will allow non-passive S corporation owners who are drawing reasonable wages to sidestep both of these taxes on their share of the company’s income.  (Meanwhile, their counterparts owning an LLC or partnership will not escape it.)  This can best be explained by example.

Example – Showing attractiveness of S corporations

Assume Larry is an employee/owner of an LLC or partnership who earns $100,000 in “guaranteed payments,” which are similar to wages.  Also assume his share of ordinary entity earnings equals another $200,000, for total income of $300,000 from the LLC/partnership.  Curly owns LLC or partnership units (perhaps in the same entity as Larry), but is a passive owner who is allocated ordinary income of $300,000.  Moe owns a Subchapter S corporation who draws wages of $100,000 and is allocated another $200,000 of ordinary income from the corporation for a total of $300,000.  Each of the three stooges, therefore, receives a Schedule K-1 and/or W-2 for 2013 that report collective income of $300,000.

Assuming the other criteria are met, Larry would incur tax of $11,400 on his K-1 income, consisting of 2.9% self-employment tax and .9% additional tax applicable to both the guaranteed payments and the ordinary income.

Curly also would incur tax of $11,400 on his K-1 income, but consisting of the 3.8% tax applicable to the $300,000 “passive” investment income.

Moe, though, would incur tax of only $3,800.  It consist of wages of $100,000 subject to the old familiar Medicare Tax of 1.45%, matched by another 1.45% paid by his employer (his own S corporation), and another .9% additional tax on the same $100,000.  The $200,000 ordinary income, however, escapes both the 3.8% tax and the .9% tax, because it is neither fish nor fowl.  For active participants, S corporation earnings are not subject to the 2.9% self-employment tax or the new .9% tax (unlike active LLC or partnership owners), and Moe’s active participation prevents applicability of the 3.8% tax on investment income.  (Note that if Moe were a passive investor, he would incur tax of $11,400 – just like the other stooges.)

S corporation owners who are actively involved are required to take “reasonable wages” from the company (this has always been the case).  This means that the long-standing Medicare taxes of 1.45% (plus the employer match) cannot be completely escaped.  But once that requirement is met (a reasonable wage is paid), additional, unlimited S corporation earnings sail unscathed between the 3.8% and .9% taxes.  By contrast, LLC and partnership owners in otherwise identical positions who try to escape both of these taxes will find themselves instead between a rock and a much harder rock, as one of these taxes will apply.  I suspect S corporations may become more attractive relative to partnerships and LLCs as a result of these taxes – especially for those that are quite profitable.

Property rented to related party

Another curious result appears to impact property owners who rent facilities to entities also owned by them.  A classic estate planning and legal liability protection move involves use of two entities: one entity operating a trade or business, and another entity holding real estate used in that business.  One party may own both entities, and cause rent to be properly paid from the business entity to the real estate entity.  Recall that net rental income is subject to the 3.8% tax.  However, considering that the owner could have merely held the real estate in one entity (the operating entity), the two-entity structure essentially is creating “passive” income out of nothing beginning in 2013.  Without going into a hideous level of detail, there are some rules in place that, when it works in favor of the IRS, historically have caused “self-rental” income (as this arrangement is described in the rules), to be treated quite differently from rental income generated from unrelated parties.  There are plenty of rumblings (or perhaps merely wishful thinking) that self-rental income will be allowed to sidestep the 3.8% tax, because it seems inequitable and the IRS has demonstrated a willingness to view self-rental differently.  However, as the rules are written now, this appears to remain squarely in the IRS’ “heads I win, tails you lose” realm, and the 3.8% tax will apply regardless of who is paying the rent.

Conclusion

The 3.8% tax and .9% tax were set in motion some time ago, but are effective for income earned beginning in 2013.  For many taxpayers, there may be very little that can (or should) be done to avoid one of these assessments, as the tax tail cannot always wag the dog.  For those taxpayers, we hope you will be aware that for a number of reasons, all else being equal, April 2014 may be much more painful than April 2013 and you should plan accordingly.  However, for some taxpayers who own real estate, interests in LLCs, partnerships or S corporations, or investments, some planning opportunities may be available that deserve some attention.  There are many variables, some of which depend on 2013 AGI, but legitimate changes can be considered now that potentially can save a lot of money a year from now.

If you have any questions, please contact Stan Rose or your BNN tax advisor at 1.800.244.7444.