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New Regulations Fill In Gaps On 3.8% Surtax

The tax landscape is changing dramatically in 2013.  One potential pitfall is the advent of the new 3.8% Medicare surtax authorized by the 2010 Affordable Care Act.  The surtax is tacked on to any regular income tax you owe on investment transactions.

At the end of 2012, the IRS issued proposed regulations explaining the rules for the surtax.  The new regulations, plus answers to frequently asked questions (FAQs) posted on the IRS website, can help fill in the gaps left by the legal language of the legislation.

Basic rules:  Beginning in 2013, a 3.8% Medicare surtax applies to the lesser of “net investment income” (NII) or the amount by which your modified adjusted gross income (MAGI) exceeds a threshold amount.  The threshold is $200,000 for single filers and $250,000 for joint filers.  These figures aren’t adjusted for inflation.  For example, if you’re a joint filer and have annual NII of $100,000 and a MAGI of $225,000, you owe no surtax.  However, if your MAGI increases to $300,000 next year and your NII stays the same, you’ll owe a surtax of $1,900 (3.8% of the $50,000 above the MAGI threshold, which is less than 3.8% of your $100,000 NII). 

For an estate or trust, the surtax is levied on the lesser of undistributed NII or the adjusted gross income (AGI) above the beginning dollar amount of the highest tax bracket for trusts and estates.  Due to the relatively compressed tax brackets for trusts and estates, this could have an even greater impact than the surtax on individuals.

NII is defined to include interest, dividends, capital gains, rents, royalties, nonqualified annuities, income from passive activities, and income from the trading of financial instruments or commodities.  Conversely, the NII definition specifically excludes certain items, including wages, self-employment income, Social Security benefits, tax-exempt interest, operating income from a non-passive business, and distributions from qualified retirement plans. 

To arrive at NII, gross investment income is reduced by deductions that may apply.  According to the FAQs on the IRS website, a few examples are investment income expenses, advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes related to items included in NII.  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 towards the 3.8% Medicare surtax, either.  This includes gain deferred in an installment sale, gain from like-kind exchanges or involuntary conversions, and gain from the sale of a principal residence up to the exclusion amount ($250,000 for single filers and $500,000 for joint filers).

Estates and trusts:  The surtax applies to ordinary trusts. Although it does not apply to business trusts or common trust funds, it may apply to pooled income funds.  The tax doesn’t apply to tax-exempt trusts, even if the trust is taxed on unrelated business income.  Similarly, it doesn’t apply to grantor trusts, although grantor trust income is treated as received directly by the grantor and may be taxable.  While a charitable remainder trust isn’t subject to the surtax, distributions to an income beneficiary may be considered NII (equal to the lesser of trust distributions or the current and accumulated NII of the trust).  Generally, foreign estates and trusts aren’t subject to the surtax.

NII items:  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 consist of trading in financial instruments or commodities.  For a sole proprietor, this test applies at the individual level.  For a taxpayer owning an interest in a pass-through entity such as an S corporation or partnership, the passive activity test is applied at the taxpayer level, but the financial trading test is applied at the entity level.

Although the new regulations provide some clarity, proceed with caution.  Certain types of income that are not included in NII under a particular provision may still be swept in under other rules.  For example, rents escaping inclusion under the exception to the passive activity rules may be subject to NII if the rental income isn’t derived in the ordinary course of a trade or business. Moreover, this is doubtless not the final word on the subject, so be on the lookout for further updates.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.


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