Although high-income taxpayers entered 2013 with a cloud of uncertainty hanging over their heads, this much was clear: You’ll have to contend with a new 3.8% Medicare surtax on investment earnings. The new surtax was included in the 2010 health care legislation upheld by the U.S. Supreme Court last year.
Alert: Now the IRS has issued new proposed regulations on the 3.8% surtax. (Proposed Reg-130507-11) The much-anticipated regs clarify and explain some of the key rules.
In addition, the IRS has posted the answers to frequently asked questions (FAQs) on its website.
Here’s the whole story: Effective Jan. 1, 2013, the 3.8% Medicare surtax applies to the lesser of “net investment income” (NII) or the amount by which modified adjusted gross income (MAGI) exceeds a threshold of $200,000 for single filers and $250,000 for joint filers. For example, if you’re a joint filer and have annual NII of $100,000 and a MAGI of $300,000 in 2013, you must pay a surtax of $1,900 (3.8% of the $50,000 above the MAGI threshold of $250,000). For estates and trusts, the surtax applies to the lesser of undistributed NII or adjusted gross income (AGI) above the taxable income threshold for the highest tax bracket.
For this purpose, NII includes interest, dividends, capital gains, rents, royalties, nonqualified annuities, income from passive activities, and income from the trading of financial instruments or commodities. But certain other items are excluded from the definition of NII, including wages, self-employment income, Social Security benefits, tax-exempt interest, operating income from a nonpassive business and distributions from IRAs and qualified retirement plans.
The new regulations also clarify the following points.
Gains: Unless otherwise provided, a gain that is not recognized under other tax code sections doesn’t count toward the 3.8% Medicare surtax. This includes gains deferred through installment sales, like-kind exchanges, involuntary conversions, and gains from selling a principal residence, up to the allowable exclusion of $250,000 for single filers and $500,000 for joint filers.
NII definitions: Items normally considered NII, such as dividends or interest, are not treated as NII if derived in the ordinary course of a trade or business. But this exception requires that the business not be a passive activity or trade in financial instruments or commodities. For a sole proprietor, this test applies at the individual taxpayer level. For a taxpayer owning an interest in a pass-through entity, such as an S corporation or partnership, the passive activity test is still applied at the taxpayer level, but the financial trading test is applied at the entity level.
Estates and trusts: The surtax applies to ordinary trusts, but not foreign estates and trusts and grantor trusts (although the income is treated as being received directly by the grantor and thus may be subject to the surtax at the grantor level). Tax-exempt trusts are exempt even if the trust is taxed on unrelated business income. A charitable remainder trust (CRT) isn’t subject to the surtax, but distributions may be treated as NII to the income beneficiary.
There are still a few holes in the guidance provided by the new regs. Significantly, income that isn’t included under the definition of NII under a particular provision may be “swept in” under other provisions. For instance, rental income qualifying under the exception to the passive activity rules could be treated as NII if it isn’t derived in the ordinary course of a trade or business.
Tip: The IRS also issued guidance on the new 0.9% Medicare tax that now applies to wages and self-employment income collected by higher-income individuals.
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