Navigating the murky Medicare tax waters for small business owners.

• Author: Gall, Michael K.

Leaving aside any political or policy aspect of the Patient Protection and Affordable Care Act, P.L. 111-148, it is undeniable that the legislation (and the related Health Care and Education Reconciliation Act, P.L. 111-152) added significantly to the complexity of small business owners' federal tax reporting. While they made significant changes to the income tax regime, their changes to taxes designated for Medicare have been nothing short of monumental. These Medicare tax changes affect high-income employees, self-employed persons, and, for the first time, investors, including investors in small businesses. (The net investment income tax applies to individuals, trusts, and estates, but this discussion is limited to its application to individuals.)

Additional Medicare tax on wage income: Sec. 3101(b)(2) added a 0.9% employee Medicare tax on wage income in tax years beginning after Dec. 31, 2012, over the relevant threshold (e.g., $250,000 in the case of joint taxpayers). This increases the rate on the employee's share of the Medicare tax to 2.35% on wages above the threshold amount. The 0.9% tax does not apply to the employer portion of the Medicare tax. Wages, of course, are also subject (up to $118,500 in 2015) to the combined 12.4% Social Security tax that is split evenly between the employer and employee.

Additional Medicare tax on self-employment income: Sec. 1401(b) (2) added a 0.9% Medicare tax on net self-employment income over the relevant threshold (the same as for the tax on wage income). This increases the Medicare tax rate on self-employment income above the threshold amount to 3.8%. The threshold amount for the self-employment tax is reduced to the extent the taxpayer has wage income above the Sec. 3101(b)(2) threshold amount. Self-employment income is also subject to the 12.4% Social Security tax, which falls on the self-employed person only

Medicare tax on net investment income: Sec. 1411 was added to the Internal Revenue Code and imposes a 3.8% Medicare tax on net investment income. Net investment income is income in the following three categories, less related deductions:

* Gross income from interest, dividends, annuities, royalties, and rents, other than those that are derived in the ordinary course of a trade or business that is not a passive activity under Sec. 469 with respect to the taxpayer or a trade or business of trading in financial instruments or commodities;

* Other gross income derived from a trade or business that constitutes a passive activity under Sec. 469 with respect to the taxpayer or a trade or business of trading in financial instruments or commodities; and

* Net gain attributable to the disposition of property other than property that is held in a trade or business that is not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities.

In determining whether an activity is a passive activity under Sec. 469 for these purposes, material participation is determined at the taxpayer level. Determination of whether there is a trade or business (and its nature) is made at the entity level where the income is generated inside a partnership or S corporation.

The tax base is the lesser of (1) net investment income or (2) modified adjusted gross income over the relevant threshold amount (e.g., $250,000 in the case of joint taxpayers). Modified adjusted gross income is adjusted gross income with certain adjustments with respect to foreign earned income.

Two key additional features of the net investment income tax are worth noting. First, any income that is considered self-employment income is not considered net investment income. Second, passive income (e.g., interest) is net investment income even if it results from an investment of working capital.

The relative newness of these taxes, combined with other recent activity in the self-employment tax world, leaves enough questions that a brief summary might be helpful for those who do not operate in this space every day. This item analyzes how these taxes may apply...