It’s no fun to be sick. Illness often requires spending time in a pharmacy, doctor’s office, or hospital, all of which can be very expensive. Congress intended the Patient Protection and Affordable Care Act to increase the rate of health insurance coverage and reduce health care costs, but it comes at a price.
One way the Act is designed to pay for itself is through a new 3.8 percent Medicare contribution tax (Health Care Tax), which is now effective for the 2013 tax year. This article will discuss who is subject to the tax, how it works, and planning concepts for minimizing its impact. Family business owners will want to consider the application of the tax to themselves and their families as individuals, as well as to trusts and estates that may, now or in the future, hold an interest in the family business.
The Health Care Tax, like the common cold, can apply to any individual. The tax is assessed, however, only when modified adjusted gross income, or MAGI, exceeds certain threshold amounts. For individuals these amounts vary as follows depending on filing status:
Married taxpayers filing jointly $250,000
Married taxpayers filing separately $125,000
All other individual taxpayers $200,000
If MAGI exceeds the threshold, the tax is calculated as 3.8 percent of the lesser of 1) net investment income, or 2) MAGI in excess of the applicable threshold.
To determine the amount of tax imposed, these income categories must be defined and then compared. Net investment income includes income considered to be unearned, such as interest, dividends, capital gains, rents and royalties, annuities and income from businesses that are passive activities in relation to the taxpayer. (Whether an activity is passive or nonpassive depends generally on an individual’s degree of participation or involvement in the activity.)
Generally excluded from net investment income are wages, unemployment compensation, nonpassive trade or business income, Social Security benefits, distributions from IRAs or other qualified retirement plans, tax-exempt interest and self-employment income. Also excluded is gain from the sale of a primary personal residence that would otherwise be excluded for income tax purposes: up to $250,000 for a single person or $500,000 for a couple filing a joint return, subject to restrictions and limitations.
MAGI is adjusted gross income, found on line 37 on page 1 of the 2012 Form 1040, with certain adjustments for foreign earned income. For most taxpayers MAGI is simply AGI, so we will refer to AGI for the remainder of the article.
The AGI thresholds, income definitions and “lesser of the excess…” comparisons involved in this tax calculation can be hard to swallow, but a few examples may help. If a married couple filing a joint tax return has AGI of $150,000, that couple is not subject to the 3.8 percent tax regardless of how much of the $150,000 is net investment income because AGI does not exceed the $250,000 threshold. If the same couple has AGI of $300,000, however, and net investment income of $100,000, they will owe $1,900 of additional tax (3.8 percent multiplied by $50,000). In this case the amount by which AGI exceeds the threshold is $50,000, which is less than the $100,000 of net investment income.
In addition to individuals, trusts and estates are also subject to the 3.8 percent Health Care Tax.
One of the significant differences in the application of the tax to these entities is the threshold at which the tax is triggered. For trusts and estates, the AGI threshold is $11,950 for tax year 2013, which is much lower than the AGI thresholds for individuals (see table). The lower threshold, along with the fact that trust income tends to be primarily investment or passive business income, will generally result in a greater portion of trust or estate income being subject to the Health Care Tax than individual income.
The passive versus nonpassive business income distinction for individuals also extends to trusts and estates: Passive business income is included in net investment income subject to the 3.8 percent tax, but nonpassive business income is not. For trusts and estates, it is the level of involvement of the trustee or other fiduciary that determines whether the business activity is passive or nonpassive. To be nonpassive, the trustee or fiduciary should generally be involved in the activity operations on a regular, continuous and substantial basis.
Determination of the fiduciary activity is an issue that recently has been addressed by the courts and the Internal Revenue Service. If a trust owns an interest in a family business, the business owner would be wise to have the activity of the trustee evaluated to determine if it satisfies the requirements for the business income to be treated as nonpassive, thereby avoiding the Health Care Tax.
Unlike individuals, some trusts are exempt from the tax, including charitable organizations formed as trusts (private foundations are an example) and charitable remainder trusts. A grantor trust also is not subject to the tax, but the deemed owner (the grantor) must include the trust’s income in his or her own AGI, which might then be subject to the 3.8 percent tax at the individual level.
The best treatment for the Health Care Tax is to manage its symptoms so it hurts as little as possible. Limiting AGI to the applicable income threshold is one clear way to avoid the additional tax. When AGI exceeds the threshold, minimizing either the excess AGI or net investment income reduces the additional liability. There is little reason to forgo a dollar of income to save 3.8 cents of tax. Instead, there are ways to use available deductions and manage the timing of income to trim the tax: It’s like eating what you want and still losing weight.
Individuals can reduce AGI through deductible contributions to 401(k) plans, IRAs and other qualified retirement investments. Trusts and estates can reduce net investment income by personal exemptions, the amount of any income distributed to beneficiaries and certain administrative costs. The income distributed to a beneficiary will reduce the trust or estate’s burden but the beneficiary will need to include the income in his or her calculation of the tax. Since higher AGI thresholds apply to individuals, trust or estate income distributed to an individual beneficiary might remain below the individual threshold and escape the tax completely. Tax-exempt investments, moreover, provide income that does not add to individual, trust, or estate AGI or net investment income.
In addition to deductions, trust distributions and tax-exempt income, AGI and net investment income can be managed from a timing perspective. If, for example, harvesting unrealized gains in a single year would push income over the threshold, spreading those gains over multiple years could produce similar income while keeping AGI beneath the threshold for each year.
With education, understanding and planning, you can minimize your Health Care Tax liability and keep your finances out of the emergency room.
Jeff Sayers is a senior associate and Bruce Vandermeulen is a senior director with the local office of BDO USA LLP.