Planning for the upcoming Medicare surtax on investment income

Now that the election is over, taxpayers can finally start implementing tax planning strategies for the current and upcoming year. Though much is yet to be decided between Congress and the President, a major surtax is scheduled to take effect on January 1, 2013. This surtax was part of the "Patient Protection and Affordable Care Act" (PPACA) and requires a 3.8 percent tax on net investment income for certain "high-income" taxpayers. This article is intended to inform you of what items are subject to this surtax and to provide tax planning suggestions on how to minimize your tax liability.

How it works

This surtax applies to individuals, trusts, and estates that have income exceeding specific thresholds. However, it is important to note this surtax is assessed differently for trusts and estates than it is for individuals. The income threshold amounts depend on the filing status of the taxpayer - $250,000 for married joint files, $125,000 for married separate files, and $200,000 for all other filers.

The surtax is calculated by multiplying 3.8 percent by the lesser of net investment income, or by the amount the Modified Adjusted Gross Income (MAGI) exceeds the threshold amount noted above. For example, if you are a joint filer, the threshold is $250,000. Let's say you have $50,000 of net investment income and $275,000 of MAGI. The amount by which MAGI exceeds the threshold is $25,000 ($275,000 - $250,000). Therefore, the tax is imposed on $25,000, since this amount is smaller than the $50,000 of net investment income. Note that for most taxpayers, those without significant foreign income, MAGI is the same as Adjusted Gross Income.

What is net investment income?

Net investment income has a broad definition. It includes common investment income such as interest, dividends, annuities, and royalties. Additionally, it includes non-intuitive items such as net income from passive activities, rents; less properly allocable deductions, and net gain from the disposition of non-business property (e.g. capital gains from selling stock), or the disposition of property held in a passive activity.

  • Net investment income does not include:
  • tax-exempt bond interest,
  • distributions from IRAs or qualified retirement plans,
  • active trade or business income,
  • ordinary and capital gain on the sale of an active interest in a partnership or S corporation,
  • or excludable gain from the sale of a principal residence.

The item that has the potential to catch taxpayers by surprise is the inclusion of passive activities in net investment income. For most people, rental activities are considered passive activities. In addition, any partnership or S Corporation in which the taxpayer is a partner or shareholder, but does not materially participate (e.g., sole owner, more than 500 hours, etc.), would be classified as passive, and any income from the activity would be subject to the additional tax.

Planning for the surtax

Though it is likely that many dental offices will be subject to the surtax, there are strategies that can be implemented to reduce the impact. Keep in mind that your overall objective should be wealth creation and preservation, not avoidance of income tax. Though these strategies will work for some individuals, they may not work for everyone. Two ways to avoid the additional surtax include reducing MAGI or reducing net investment income. Following are some strategies to accomplish these objectives:

Potential strategies

  1. Increase contributions to qualified retirement plans. Investments held outside of qualified retirement plans generate investment income included in MAGI. By holding these investments in a qualified retirement plan, you lower MAGI and Net Investment Income.
  2. Although IRA distributions are not investment income for purposes of the surtax, they will be included in MAGI. Additionally, Roth conversions will increase MAGI. Therefore, if you are required to take required minimum distributions from your IRA, you may benefit by converting your IRA to a Roth before January 1, 2013 (when the surtax takes effect).
  3. Re-balance portfolios to include tax exempt bonds (municipal bonds). An analysis of the trade-off in investment returns to tax savings will need to be completed.
  4. Examine your portfolio now to determine if capital gains, expected in 2013, can be advanced into 2012. This strategy would also help you avoid the expected increase in capital gains rates.
  5. If you are selling a vacation property or second home, the gain from such a sale will be subject to the surtax, and potential higher capital gains rates, if you delay the sale until 2013. Try and close the sale before the end of the year, if possible.
  6. Review your passive activity investments and re-examine your level of activity and involvement to determine if reclassification into non-passive status is appropriate. Also, consider grouping activities that constitute an appropriate economic unit for the determination of your participation in the group as a whole versus a single activity.
  7. Consider installment sales to spread the impact of gain recognition and subsequent increases to MAGI over a period of years to lessen the impact and utilize the full threshold in each year under the installment sale. On the other hand, if you are in the process of selling a passive business venture, you may benefit from selling in 2012 when capital gains rates are lower and you can avoid the additional 3.8percent tax.
  8. While the gift and estate tax environment is still desirable, consider gifting some appreciated stock to your kids or grandkids. They can sell the stock at the currently low capital gains rates (zero rate if they are at or below the 15 percent bracket), and, if it was a good investment, repurchase it after the required waiting period. Consider it a down payment on the estate. Note that if the recipient is either (a) under age 18 or (b) age 18 (or age 19-23 and a full-time student during the year), and their earned income is not at least half of their support, the "kiddie tax" rules may apply, which would dampen the effectiveness of this strategy.
  9. If you haven’t already, consider including your kids in your business and in the payroll. By doing this, you are transferring income to your kids (that you will probably transfer to them anyways for college, living expenses, etc.) They will pay taxes, but at their lower rate on earned income. Note that the amount paid needs to be reasonable for the work performed.
  10. Consider converting your C corporation into an S corporation. Along with some other benefits, this structure allows you to make an election to group your practice rental with the corporation to treat it as non-passive, and not subject to the surtax.

*Note for transitioning practices: though the gain from the sale of your practice (in which you actively participate) is not subject to the surtax, it will be subject to capital gains taxes. The common thought in the industry is that capital gains rates will go up for "high-income" taxpayers by as much as 5 percent. If you are in the process of selling your practice, this provides an incentive to try and close before year end. If you are buying a practice, keep this in mind when negotiating, as the seller has an incentive to sell quickly!

With the era of uncertainty hopefully coming to a close, there are still opportunities available for many taxpayers. In the coming weeks and months, we will hopefully have a clearer picture of the tax landscape that is in store for our country.