November 26, 2013

Planning Ideas for Minimizing the 3.8% Medicare Tax on Net Investment Income (article)

In our previous edition of InTouch, we gave an overview of the new Medicare contribution tax on unearned income which is effective beginning in 2013. Combine this new 3.8% tax with the increase in the top rate on long-term capital gains and qualified dividends, and impacted taxpayers will see their Federal income taxes on these types of income increase by nearly 60%. With year-end rapidly approaching, taxpayers facing the 3.8% Medicare tax should consider a number of planning strategies to mitigate this new tax.


The unearned income Medicare contribution tax effective for tax years beginning in 2013 imposes a 3.8% tax on individuals, estates and trusts. For individuals, the tax base on which the tax is imposed is the lesser of net investment income (NII) or the excess of modified adjusted gross income (MAGI) over a threshold amount. For this purpose, MAGI is adjusted gross income increased by certain foreign income exclusions. The threshold amounts for individuals are $250,000 for surviving spouses and taxpayers filing a joint return, $125,000 for married taxpayers filing separate returns, and $200,000 for all other individual taxpayers. Estates and trusts are subject to tax on the lesser of undistributed NII or the excess of adjusted gross income over the dollar amount at which the highest income tax bracket begins ($11,950 for 2013).

NII includes:

  • Interest, dividends, annuities, royalties and rents (unless such income is derived in the ordinary course of a trade or business), less allocable deductions.
  • Income from a passive activity.
  • Income from a trade or business of trading in financial instruments or commodities.
  • Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in an active trade or business.
  • Income on investment of working capital.

Certain types of income are excluded from the 3.8% Medicare tax, including:

  • Qualified retirement plan distributions.
  • Active trade or business income.
  • Tax-exempt income.
  • Any item taken into account in determining self-employment income.
  • Gain on sale of principal residence to the extent the gain is excluded from gross income. 

In addition, gain from a disposition of an interest in a partnership or S corporation is NII only to the extent of the net gain which would be taken into account by the transferor if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest (same rule applies for losses).

Individual Planning Ideas

Below is a list of potential planning ideas and considerations for individuals subject to the 3.8% Medicare tax:

  • Manage overall MAGI to the extent possible by accelerating business deductions and deferring income using traditional tax planning strategies. If MAGI is less than the threshold amounts the tax will not apply.
  • Consider tax-exempt investments.
  • Consider investing in growth stocks that do not pay dividends.
  • Consider investing in whole life insurance policies.
  • Harvest capital losses to offset capital gains that are subject to the tax (but be careful of the wash sale rules).
  • Consider timing and amounts of distributions from retirement accounts. Although distributions from such accounts are not NII, the taxable portion of such distributions increases MAGI which may ultimately create a tax on NII. Note that since Roth IRA distributions are not taxable, they do not increase MAGI. Taxpayers with traditional IRAs may consider converting to a Roth in a year when NII is minimal.
  • Consider installment sales and the timing of principal collections to attempt to remain below threshold for taxability.
  • Consider using like kind exchanges under Section 1031 to defer the recognition of net gains.
  • Consider reinvesting involuntary conversion proceeds under Section 1033 to defer the recognition of net gains.
  • Examine all activities to determine how they are defined: passive or nonpassive. Consider grouping elections to achieve material participation (i.e., nonpassive). Weigh whether converting passive income to nonpassive will affect your ability to utilize passive losses.
  • Consider the election to group activities to become a "real estate professional."
  • Consider disposing of a passive activity to trigger suspended passive loss carryovers.
  • Watch the "kiddie" tax rule. If a parent of a dependent child elects to report the child's unearned income on the parent's return, then the MAGI threshold of the parent is used to determine if the tax applies to the child's net investment income. If the child files his or her own tax return reporting the net investment income, the child will have his or her own $200,000 MAGI threshold.
  • Reduce the amount of investments that generate NII by gifting such assets to certain donees. For 2013, the annual gift tax exclusion is $14,000 and the lifetime gift/estate tax exemption is $5.25 million. Remember that the kiddie tax rule discussed above may negate some of this benefit.
  • Consider funding a Charitable Remainder Trust (CRT) with long-term appreciated securities rather than selling the securities outright. Deferring the gain until the income is paid out of the trust allows one to: 1) spread the net gain recognized over a period of time that may keep the taxpayer below the annual threshold amounts; 2) if children are named as beneficiaries of the trust, the children may be in a lower MAGI than the parents and may not be subject to the tax; and 3) the CRT itself is not subject to the 3.8% tax.

Estate & Trust Planning Ideas

While individuals generally are not subject to the 3.8% Medicare tax unless they have MAGI in excess of $200,000 ($250,000 for married couples filing jointly), trusts and estates are subject to the tax at a much lower threshold ($11,950 in 2013). Here are some planning considerations for estates and trusts:

  • Manage overall adjusted gross income to the extent possible by accelerating deductions and deferring income using traditional tax planning strategies. Remember that if adjusted gross income is less than the threshold amount the tax will not apply.
  • Since the tax applies for tax years beginning in 2013, consider electing a fiscal year end for estates of individuals who died in 2012.
  • The investment ideas noted in the individual section above could also apply to investments of estates and trusts.
  • Harvest capital losses to offset capital gains that are subject to the tax (again, be mindful of the wash sale rules).
  • Consider making discretionary distributions to beneficiaries that will reduce the NII by the distributable net income deduction. The individual beneficiaries may be under the tax threshold at the individual level, and accordingly, the NII would essentially escape the 3.8% tax.
  • Generally, since only passive income (as opposed to nonpassive income) is subject to NII, examine trust activities for material participation purposes. Due to the limited authority and uncertainty surrounding the material participation standard for trusts, it may be appropriate to ensure that the trustee (or executor) materially participates in any trade or business in which the trust (or estate) owns an interest. Appointing a "special" trustee whose role would be limited to participating in the operations of the trade or business may make sense and possibly increase the chances of success of proving material participation.

While some of the strategies referenced above will be more beneficial in 2014 and beyond when they can be applied for an entire year, others can still benefit you in 2013. For more information on how to mitigate the 3.8% Medicare tax, consult your local CBIZ MHM tax advisor.

Copyright © 2013, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. To ensure compliance with requirements imposed by the IRS, we inform you that—unless specifically indicated otherwise—any tax advice in this communication is not written with the intent that it be used, and in fact it cannot be used, to avoid penalties under the Internal Revenue Code, or to promote, market, or recommend to another person any tax related matter. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC and other Financial Services subsidiaries of CBIZ, Inc. (NYSE: CBZ) that provide tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies.

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