Beginning with tax year 2013, certain individuals, trusts, and estates may be subject to a 3.8% surtax under Section 1411 of the Internal Revenue Code. Known as the Medicare surtax, this new investment income tax is earmarked to fund the health coverage program for older Americans [Medicare] and it could prove to be a headache for higher income earners.
Congress added the surtax as a part of the American Taxpayer Relief Act of 2012, which was the product of last-minute tax reform efforts that spilled over into the 2013 calendar year. As a result, the United States tax laws have ballooned to over 73,954 pages, most of which contain complex provisions in-and-of-themselves. Complicated as these provisions may be, the new surtax, which ABC News referred to as the “most dreaded” provision of ATRA, is of particular import.
Understanding the not-so-simple 3.8% surtax can be challenging. However, knowing these six simple rules should assist individual taxpayers as they determine their total tax liability for 2013 (and beyond):
1. Think of the tax as what it actually is: a surtax, not a traditional income tax.
Although technically oversimplified, federal income tax liability has historically been determined by applying pre-determined tax rates to different categories of income (e.g., ordinary income and capital gains). A taxpayer would aggregate sources of income, utilize applicable credits, deductions, and exemptions, and ultimately calculate the tax due based on the remaining amount of income and corresponding rates. The 3.8% Medicare surtax, however, applies a 3.8% tax rate to income that has already been taxed under the traditional income tax rules. In other words, when the surtax applies, it imposes an additional tax on certain amounts of income already subjected to the taxpayer’s applicable federal income tax rates.
2. Several popular names for the surtax are not exactly descriptive.
In this case, rhetoric is important. The terms “net investment income tax,” which is used by the IRS, and “unearned 3.8% Medicare surtax” are commonly used to describe the new surtax. However, both of these names could cause some confusion for many taxpayers around tax time. Contrary to these popular names, the 3.8% Medicare surtax is not necessarily imposed on a taxpayer’s “net investment income.” Furthermore, a taxpayer’s earned income plays a vital role in calculating the amount of the surtax.
The surtax is a “lesser of” tax—the 3.8% rate is applied against the lesser of (1) the taxpayer’s net investment income, or (2) the amount by which the taxpayer’s modified adjusted gross income exceeds a threshold amount (more on this later). Thus, although it is relevant to understand the definition of “net investment income” for purposes of determining the amount of income to which the 3.8% rate applies, the surtax is not necessarily imposed on a taxpayer’s net investment income. For example, assume a single filer has $180,000 of wages and $90,000 of net investment income, bringing the taxpayer’s modified adjusted gross income to $270,000. The threshold for the single filer, $200,000, is exceeded by $70,000. Since $70,000 is less than the taxpayer’s net investment income ($90,000), the 3.8% rate is applied against $70,000, bringing the surtax to $2,660. Thus, it would be inappropriate for taxpayers to conceptualize the surtax as applying exclusively to their “net investment income.”
The names “net investment income tax” and “unearned 3.8% Medicare surtax” are, however, somewhat descriptive, because the surtax does depend on the existence of net investment income (i.e., unearned income). Again, because it is a “lesser of” tax, if a taxpayer has no (or very little) “net investment income,” then the surtax will equal $0 (or a nominal amount).
Although passive income is an important determinant in the calculation of any surtax due, taxpayers should view the calculation of their net investment income as a necessary, but not sufficient, part of determining their overall tax liability.
3. The surtax requires both passive income and sufficiently high levels of income.
As indicated above, taxpayers without “net investment income” do not need to fear the 3.8% surtax. The “lesser of” nature of the surtax also means that taxpayers below certain income levels — referred to as “thresholds” — similarly do not need to worry about the surtax. For individuals, filing status determines the applicable threshold. If your filing status is married filing jointly, the threshold is $250,000. If your filing status is married filing separately, the threshold is $125,000. If your filing status is single, the threshold is $200,000. Accordingly, even if a taxpayer has “net investment income,” if the taxpayer’s modified adjusted gross income is below the applicable threshold, the taxpayer will not owe any additional amount for the surtax (another reason why the names “net investment income tax” and “unearned 3.8% Medicare surtax” are not entirely precise). If we reduce the taxpayer’s wage income to $109,999 in the example above, the taxpayer will not owe any surtax because her modified adjusted gross income ($199,999) is less than the applicable threshold. This is true even though the taxpayer has $90,000 of net investment income. Individuals should note that the thresholds do not correspond with the highest marginal ordinary income rates.
4. “Net investment income” is passive income less expenses associated with passive income.
“Net investment income” is investment income less certain expenses properly allocable to the investment income. If you think of investment income as generally passive income, then you are on the right path. For the most part, investment income includes interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities to the taxpayer. Thus, among other things, taxpayers will have investment income from (1) gains from the sale of stocks, bonds, and mutual funds; (2) capital gain distributions from mutual funds; (3) gain from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence); and (4) gains from the sale of interests in partnerships and S corporations (to the extent the partner or shareholder was a passive owner). On the other hand, investment income will not arise from wages, unemployment compensation, operating income from a non-passive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, and distributions from certain Qualified Plans. Then, to calculate net investment income, taxpayers would reduce investment income by expenses that are properly allocable to items of investment income, including investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees, fiduciary expenses (in the case of an estate or trust), and state and local income taxes.
5. For many individuals, “modified adjusted gross income” will be close in amount to their adjusted gross income.
Congress elected to define “modified adjusted gross income” by making reference to certain exclusions and inclusions of income that apply to citizens or residents of the United States who live abroad. As a result, “modified adjusted gross income” is generally adjusted gross income increased by the net amount of foreign source income that was exempt for regular tax purposes. Under the final regulations, taxpayers with income from controlled foreign corporations and passive foreign investment companies may have additional adjustments. For many individuals, this figure will be identical to (or only nominally different than) their adjusted gross income.
6. The IRS treats the surtax as if it were a traditional income tax.
Taxpayers will notice the addition of the reference to Form 8960 on Line 60(b) of their federal Forms 1040 for 2013. Form 8690 will be used to calculate the amount of the surtax to be included in determining a taxpayer’s total tax (Line 61). Applicable tax credits aside, total tax less the sum of withholding and estimated payments will determine whether a taxpayer owes additional tax (and, potentially, penalties) or is due a refund. Accordingly, taxpayers should generally consider the surtax as being subject to the estimated tax provisions. If you anticipate being subject to the surtax, you should either adjust your withholding or make estimated payments to account for the tax increase in order to avoid underpayment penalties.
The new 3.8% Medicare surtax for 2013 is, as its name suggests, an additional tax on income that has already been taxed under the traditional income tax rules at a taxpayer’s applicable federal income tax rates. Although the surtax is not a traditional income tax, taxpayers must recognize that the IRS seemingly treats it as such by including the surtax in the taxpayer’s finally-calculated total income tax and subjecting it to the estimated payment rules.