Starting January 1, 2013, a new 3.8% Medicare tax will apply to the investment and “unearned income” of individuals, trusts and estates. The tax is intended to apply to income exempt from the regular FICA or self-employment taxes. Avoiding or reducing the impact of this new 3.8% tax will require sophisticated tax planning both pre- and post-January 1, 2013. However, it may be difficult to reduce the impact of this new tax, especially for taxpayers with significant amounts of investment and unearned income. The last part of this memorandum describes certain tax planning ideas that may be suitable for taxpayers depending on their particular tax and economic status.

Specifically, beginning January 1, 2013, a new 3.8% Medicare tax will apply to the lesser of a taxpayer’s (i) net investment income or (ii) the excess of the taxpayer’s modified adjusted gross income (MAGI) over a threshold amount. MAGI in the case of an individual generally equals an individual’s adjusted gross income with certain technical adjustments. For married individuals filing joint returns, the threshold amount is $250,000 and for single individuals the threshold amount is $200,000. In the case of a trust or an estate, the tax is imposed on the lesser of (i) “undistributed” net investment income or (ii) the excess of adjusted gross income over the dollar amount at which the highest income tax bracket applicable to a trust or estate begins (currently $11,650). Therefore, the low limits at which the tax can apply will force trusts and estates to pay particular attention to the tax. However, simple trusts that provide only for distributions of current income, and whose terms require all current income to be distributed, will avoid the new tax (although the trust beneficiaries may not). Also, the new tax does not apply to trusts where all unexpired interests are devoted to charitable purposes. For all taxpayers, the most important part of the new tax is the definition of “net investment income.” Net investment income is generally defined as investment income reduced by properly allocable deductions. Investment income generally will include all of the following...