Health care legislation requires new planning strategies.

• Author: O'Connell, Frank J., Jr.

The Patient Protection and Affordable Care Act, P.L. 111-148, and the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, contain many new tax provisions. Two of the more significant are the increase in the employee portion of the hospital insurance tax (Medicare Part A, "Medicare") and the expansion of the Medicare tax to some forms of investment income (Sec. 1411). Because of these tax increases, tax practitioners will inevitably need to reevaluate some of the current strategies employed by their clients. Two areas that practitioners should examine for opportunities to reduce the impact of Medicare tax increases on their clients are the structure of privately owned businesses and holdings in passive investment activities.

Overview of the Revisions to the Medicare Tax

The changes to the Medicare tax are scheduled to begin in 2013. For single individuals earning more than $200,000, or $250,000 for married couples filing jointly, the tax rate will increase from 1.45% to 2.35%, a 0.9% increase. The Medicare tax rate for self-employed individuals will also increase from its current 2.9% rate to 3.8%. In addition to the tax increase on wages, net investment income will now be subject to the Medicare tax as well. Specifically, the tax is imposed on single individuals with modified adjusted gross income (AGI) in excess of $200,000 ($250,000 for married filing jointly; $125,000 per individual if married filing separately) (Sec. 1411(b)). Modified AGI for this purpose is AGI increased by any amount excluded from gross income under Sec. 911. This presents a potential material tax increase over the earnings threshold to taxpayers who have interest, dividends, annuities, royalties, rents, gross income from passive activities, or net capital gains. In addition, trusts and estates are subject to the 3.8% tax on the lesser of undistributed net income or the excess of AGI over the dollar amount at which the highest tax bracket begins for the tax year (Sec. 1411(a)(2)). Although the tax does not take effect until 2013, proper planning is vital to current high earners and those who may find themselves in the high earner category when the tax is imposed.

Structure of the Business

One of the more unusual provisions of the health care reform legislation is that any income from the active participation in an S corporation is not subject to the 3.8% Medicare tax. While self-employment income from a partnership will be subject to the 0.9% tax...