As part of the health care legislation that passed back in 2010, certain provisions were included which impose additional Medicare taxes on certain types of income. Beginning in 2013, salaries, wages and self-employment income above $200,000 will be subject to an additional .9% Medicare tax. In the case of married individuals filing jointly, the wage or self-employment income level is $250,000, and for married individuals filing separately, the wage or self-employment income level is $125,000. Also beginning in 2013, certain unearned income of individuals will be subject to a new 3.8% Medicare contribution tax when modified adjusted gross income (“MAGI”) exceeds $200,000. In the case of married individuals filing jointly, the MAGI level is $250,000, and for married individuals filing separately, the MAGI level is $125,000.
The new Medicare contribution tax on unearned income also applies to trusts and estates with adjusted gross income (“AGI”) above the dollar amount in which the highest tax bracket applies for that tax year. For 2013, the AGI threshold is $11,950 so income above this level could be subject to the Medicare contribution tax. Bear in mind that income distributed to beneficiaries is usually a deduction to the trust or estate for purposes of deriving AGI. However, capital gains are generally treated as part of principal rather than income depending on how it is defined in the trust instrument and applicable state law. In such a case, the capital gains could be subject to the Medicare contribution tax for a trust or an estate (unless it is the final return for an estate since gains are passed through to the beneficiaries on a final return).
What is included in unearned income? Unearned income includes investment related income such as interest, dividends, rents (from a non-active business), royalties, annuities, capital gains (that are not business related), and passive income. So what is excluded from unearned income? Excluded income includes distributions from qualified retirement plans, traditional and Roth IRA distributions, income from an active trade or business (e.g., income from an LLC, partnership or S corporation), active business rents, tax-exempt interest, and certain business related capital gains.
From a tax planning perspective, in structuring a business sale, consideration should be given to the Medicare contribution tax on the investment income, including the nature of the recognized gains associated with the sale. In general, if an actively involved stockholder of an S corporation sells stock, such gain on sale would not be subject to the Medicare contribution tax. Similarly, if the assets of the S corporation are sold, gains passed through to an actively involved stockholder would generally not give rise to the Medicare contribution tax. On the other hand, for the passive S corporation stockholder, the gains will be subject to the Medicare contribution tax in an asset or stock sale transaction assuming MAGI is high enough.
It will be interesting to see how management buyout transactions involving an ESOP will be affected by the new Medicare contribution tax. With respect to the beneficiaries of the ESOP, down the road as beneficiaries retire, income derived from the retirement plan will be exempt from the Medicare contribution tax. From the selling stockholder point of view, if the transaction involves a C corporation, and the stockholder is making the election to rollover all of the gain under IRC Section 1042, then the initial sale and entire rollover to qualifying replacement property will not give rise to the Medicare contribution tax. However, subsequent income derived from the qualifying replacement property (i.e., the qualifying replacement securities) could be subject to the Medicare contribution tax.
As with any significant transaction, it is important to seek competent tax counsel before entering into a transaction.
Posted by David DuWaldt.