Planning for the unearned income Medicare contribution tax.

• Author: Bakale, Anthony S.

A stealthy tax originating in the Health Care and Education Reconciliation Act of 2010, PJL 111-152 (Reconciliation Act), is scheduled to come to life at the end of next year, and it may have a significant impact on some taxpayers. Although the unearned income Medicare contribution tax (UIMCT) first applies more than a year from now, some advance planning and communication by practitioners is in order to help clients minimize its sting and avoid unwelcome surprises.

Background

The 2010 Reconciliation Act was enacted in part to make several changes to health care rules, most of which were created by the Patient Protection and Affordable Care Act, P.L. 111-148, which had just been passed. Included with the many modifications, however, was an entirely new tax created by the addition of Sec. 1411: the unearned income Medicare contribution tax.

The new tax applies to individuals, estates, and trusts and is equal to 3.8% of the lesser of two amounts: net investment income or the excess of modified adjusted gross income (AGI) over a threshold amount. The threshold amounts are:

* For taxpayers filing joint returns or surviving spouses: $250,000;

* For married taxpayers filing separate returns: $125,000;

* For all other individual taxpayers: $200,000; and

* For estates and trusts: The dollar amount at which the highest tax bracket begins (currently $11,350).

"Modified AGI" refers to AGI increased by net foreign income excluded by Sec. 911. "Net investment income" includes such normal suspects as interest, dividends, annuities, royalties, and rents, but it also includes, depending on the circumstances, two additional and potentially far-reaching categories of income: trade or business income and gains.

In general, trade or business income is subject to the UIMCT if it represents a passive activity. For this purpose, the familiar Sec. 469 rules apply. (The UIMCT also applies to businesses trading in financial instruments under Sec. 475 (e) (2).) Gains generally are taxable, but exceptions exist that are dependent on whether the activity producing the gain is passive. Gains attributable to the sale of property held by nonpassive activities are not subject to the tax, and gain generated by the sale of an interest in nonpassive activities also is not subject to the tax.

Analysis

For very high-income taxpayers with significant investment income, this tax may be unavoidable, and the adviser's role may be limited to making clients aware of it. Several...