Money Matters: Tax planning for new 3.8 percent Medicare taxes

Barry Rosen, The Daily Record Newswire

Since the passage of federal health care reform in 2010, tax professionals have been focused on the number 3.8 and its potential effect on two Medicare-related taxes.

At first, professionals wondered whether the new taxes would ever go into effect because of constitutional challenges to health care reform and demands by Republicans to repeal Obamacare. The constitutional question was laid to rest in last summer’s Supreme Court decision in National Federation of Independent Business v. Sebelius, and President Obama’s re-election removed the likelihood of repeal.

As a result, it is now important for high-income taxpayers to start planning to mitigate the adverse tax consequences of two new 3.8 concepts that became effective on Jan. 1.

The first encounter with 3.8 comes with the current Medicare tax on earned income. Beginning in 2013, the Medicare payroll tax increased by 0.9 percent (from 2.9 percent) on wages and self-employment income above $250,000 for joint filers and $200,000 for singles.

This is not a new tax, but the addition of a progressive element to what had been a flat tax on such earned income. Unlike the Social Security payroll tax, which is capped at a certain amount of wages or self-employment income ($113,700 in 2013), the Medicare payroll tax is uncapped.

The second encounter with 3.8 is a new surtax (and not just an increase in rate) under IRC § 1411 on the “unearned income” of an individual, trust or estate. In the case of an individual, the surtax is equal to 3.8 percent of the lesser of a taxpayer’s net investment income or modified adjusted gross income (MAGI) exceeding $250,000 for married couples filing jointly or a surviving spouse, $125,000 for married couples filing separately and $200,000 for everyone else. In effect, the new surtax on unearned income is a flat tax on investment income above the $250,000/$125,000/$200,000 thresholds, and these thresholds are not adjusted for inflation.

For most taxpayers, investment income consists of three categories of gross income. Category 1 is gross income from interest, dividends, royalties, rents and annuities. This type of income can be earned directly by the taxpayer or earned by a pass-through entity, such as a partnership, limited liability company or S corporation, in which the taxpayer has an ownership interest.

Category 2 is gross income from a “passive activity” (or a trade or business of trading in financial instruments or commodities). A passive activity is a trade or business in which the taxpayer does not materially participate.

Category 3 is “net gain” to the extent taken into account in computing taxable income. This would include capital gain, including gains on the disposition of an investment asset, such as a personal residence or stock in a corporation.

The potential effect of the new surtax on investment income can be illustrated by the example of a husband and wife earning substantial income from their investment in securities. If their MAGI before considering those investments is $210,000 and they have $25,000 in interest income from CDs and bonds, $45,000 in dividend income and capital gains of $70,000 from the sale of stock, then their total investment income is $140,000, which raises their MAGI to $350,000.

Their excess MAGI over the $250,000 threshold is $100,000, and is less than their $140,000 of net investment income. That lower amount is, therefore, the base against which the new 3.8 percent surtax is applied. In this example, the new surtax results in additional taxes of $3,800.

Importantly, gain from the disposition of an investment asset is subject to the 3.8 percent tax only to the extent it is taken into account in computing taxable income. This would exclude, for example, (i) gain on the sale of a principal residence up to the exclusion amount of $250,000 for single taxpayers and $500,000 for joint filers; (ii) gain excluded under the like-kind exchange rules; and (iii) gain excluded on the sale of “qualified small business stock.” Gain on the sale of non-investment assets used in a non-passive trade or business are also not subject to the 3.8 percent surtax.

Of course, some last-minute developments in 2012 have added to the current tax bite and, therefore, underscore the importance of planning. First, starting in 2013, the general tax rate on capital gains increased from 15 percent to 20 percent for married taxpayers with income above $450,000 filing jointly and $400,000 for unmarried taxpayers. When this 5 percent increase in the capital gains rate is combined with the new 3.8 percent Medicare surtax, the result is an additional 8.3 percent in tax on the sale or exchange of a capital asset.

Also starting in 2013, the top tax rate on ordinary income increased from 35 percent to 39.6 percent for taxpayers exceeding those same income thresholds. This, combined with the new 3.8 percent Medicare surtax, increases the tax on ordinary income, including income from dividends, interest, rents, royalties and annuities, by 7.8 percent for those taxpayers.

There are, however, a number of effective strategies that can be used to reduce MAGI and/or net investment income, and thereby decrease the base on which the Medicare surtax is paid. In addition to the exclusions from gross income noted above (for example, the exclusion of income on the sale of a principal residence or the deferral of gain through the use of a § 1031 like-kind exchange), other opportunities to consider include investing in tax-exempt bonds and tax-deferred annuities; utilizing Roth IRA conversions and charitable remainder trusts; use of the installment sale rules to spread income over several years; holding assets until death; and maximizing above-the-line deductions (which reduces MAGI).

Physician groups should also explore alternatives, such as the use of S corporations. If effectively structured, an S corporation can both decrease payroll earnings subject to the 2.9/3.8 percent Medicare tax on earned income, and, if the physician materially participates in the corporation’s activities, also avoid the new 3.8 percent Medicare surtax on the doctor’s share of the corporation’s profits.

In all cases, taxpayers should take quick action to explore strategies that keep these adverse tax changes to a minimum.


Barry F. Rosen is the chairman and CEO of the law firm Gordon Feinblatt LLC, heads the firm’s Health Care Practice Group and can be reached at 410-576-4224 or Steven M. Gevarter is chairman of Gordon Feinblatt’s Tax Practice Group and can be reached at 410-576-4260 or