Medicare Surtax on Investment Income: Analysis and Planning

This article is not about Medicare. It’s about a new 3.8% income tax1 that you and your clients will pay beginning this year, 2013.

Welcome to the tax world of Alice in Wonderland – a place where we have never been and which is mysterious in so many ways. New Internal Revenue Code Section 1411 draws from many other areas of the IRC, but the IRS is reluctant to provide new definitions needed in order to apply the 3.8% surtax on net investment income. Come down the rabbit hole with me, and let’s see what we find.

This “new” tax is not so new. It was enacted in 20102 as part of the Affordable Care Act to be effective for the first time this year, 2013. The IRS issued proposed regulations3 on November 30, 2012 and we await final regulations which may have been issued by the time you read this article.

Let’s begin by describing who is subject to the Net Investment Income Tax (“NIIT”), also referred to as the Medicare surtax.4 An individual unmarried taxpayer is subject to the Medicare surtax when his/her Modified Adjusted Gross Income (“MAGI”)5 is greater than $200,000. A married couple is subject to the Medicare surtax when their MAGI is greater than $250,000. A same sex married couple whose marriage is recognized in the state in which they were married, and whose combined MAGI is greater than $250,000, will be subject to the Medicare surtax instead of being entitled to two-$200,000 thresholds. But as for estates and trusts, the threshold is significantly lower. For 2013, the threshold is $11,950 of taxable income and, because of the low threshold; estates and trusts easily will be subject to the 3.8% Medicare surtax.

If you expect to exceed the threshold applicable to you (or your client), keep reading.

What Is and Is Not “Net Investment Income”?

The tax is a tax on net investment income. We will get to deductions later. The following items have been described as “buckets” (of investment income) subject to the 3.8% tax.

Bucket 1: Interest, dividends, capital gains, annuities, rents, royalties, etc. The gain on the sale of a principal residence is subject to the Medicare surtax only to the extent that the gain exceeds the IRC Section 121 principal residence exclusion (generally $250,000 for an unmarried individual and $500,000 for a married couple).

Bucket 2: Passive activity income. That is a tax “term of art.” In its simplest form, it means income from an activity in which the taxpayer does not play an active role. For example, the taxpayer furnishes the money to a person (and becomes a partner or co-shareholder) in a business in which the money person is only an investor. Income generated by the taxpayer from this investment is ‘passive income’ and will be subject to the 3.8% tax. Also, in most cases, rental income is “passive income.” Bucket 3: Net gain that is attributable to the disposition of property (an interest in a limited liability company, a partnership, or an S corporation) unless the property is held in a non-passive activity trade or business. Without getting into the specifics, suffice it to say that a ‘non-passive activity trade or business’ is one that the taxpayer was operating.

The following types of income are not considered to be investment income and are not subject to the 3.8% tax:

1. Active trade and/or business income.

a. The income must be earned in the trade or business6 that the taxpayer is conducting.

b. The income must be earned in the ordinary course of the trade or business; therefore, investment income earned by the business would not be exempt from the Medicare surtax.

c. The trade or business cannot be passive to the taxpayer.

d. Income from the sale of an active business in which the owner is not passive.

2. Distributions from qualified retirement plans, including Individual Retirement Accounts.

3. Municipal bond income. When in­vestors consider the rate of return on municipal bond income, they calculate the interest rate that they would need to generate to net to the interest rate on the municipal obligation. Let’s say that a municipal obligation pays 3%. A taxpayer who is subject to the highest individual rate of 39.6% plus the new 3.8% NIIT, for a total of 43.4%, would need to purchase a taxable obligation paying 5.3% to net to 3% tax free. When you factor in the New York State income tax rate, the investor must earn more than 5.3% to net to the 3% tax free rate.

4. Social Security; life insurance; alimony; lottery and gambling winnings.

Deductions in Arriving at Net Investment Income

It makes sense that investment advisory and brokerage fees would constitute a valid deduction to reduce NII; however, it’s not that simple because the IRC requires that most miscellaneous itemized deductions be reduced by what is referred to as a 2% floor, i.e., reduced by 2% of AGI before allowing it as a miscellaneous itemized deduction.

Note that if the taxpayer is subject to the dreaded alternative minimum tax (“AMT”), which most New York State homeowners are, that negates a tax benefit for the deductible portion of the miscellaneous deductions; however, it still will be allowed as a deduction (to the extent that it exceeds 2% of AGI) in calculating the NIIT. Deductible investment interest ex­pense is a valid deduction for NIIT purposes. Here’s something new. State and local income taxes attributable to net investment income reduces the NIIT. Ah, but how is the allocated amount calculated? Per the proposed regulations, it’s calculated on a ‘reasonable’ basis but the starting point for determining what is ‘reasonable’ is, according to the proposed regulations, the deduction on the tax return being filed on the cash basis (i.e., the amount of state and local taxes paid in the calendar year).

Many commentators have opined that a more reasonable starting point should be the tax expense calculated on the taxpayer’s state and local tax returns being filed for the calendar year (similar to the calculation of the credit on the New York income tax return for taxes paid to another state).

Pre-2013 (as well as current and future) net passive loss carryforwards reduce net passive net investment income in 2013 and thereafter but net operating losses, no matter when incurred, do not reduce net investment income on the theory that the NOL cannot be allocated to a specific type of income.

The IRS uses “difficulty” as a reason for not allowing the net operating loss carryforward to be factored into the calculation of net investment income. The New York State Society of Certified Public Accountants commented to the IRS state that “…it would be possible to track the portion of an NOL allocable to a net investment loss without creating rules that would be unduly complex and not administrable.” Other organizations have submitted similar comments.

Although the net operating loss carryforward, for the time being, cannot be used to reduce NII, an NOL carryforward can be used in calculating the current year’s AGI (perhaps to bring the taxpayer’s AGI below the applicable threshold and avoid having to pay the NIIT).

Estates and Trusts

Fiduciaries have the responsibility to consider the interests of both the income beneficiaries and the remaindermen when making discretionary decisions. Beginning in 2013, the ordinary and capital gains (and qualified dividends) income tax rates on estates and trusts have increased (to 39.6% and 20%, respectively) and, because of the low threshold, as noted earlier, estates and trusts easily will be subject to the 3.8% Medicare surtax.

The NIIT is an additional danger area for fiduciaries’ decision making. While the taxes on estates and trusts can be minimized by making distributions to beneficiaries who are eligible for a higher threshold before becoming subject to the Medicare surtax, the fiduciary needs to consider state law (e.g., as a general rule, capital gains do not flow through a beneficiary except in the year that the estate/trust is terminated); the governing document (which may contain prohibitions on specified distributions); and the grantor’s intent.

Also, state and local (e.g., New York City) income taxes imposed on the recipient beneficiaries may be a consideration when deciding whether to make distributions where the estate/trust is in a state without an income tax.

Additionally, beneficiaries who have capital loss carryforwards may want the capital gains to be distributed, if possible, since they will not incur the 20% capital gains tax and 3.8% NIIT (whereas gains trapped within the estate/trust will incur the 20% capital gains tax and 3.8% NIIT). Their share of the capital gains will be offset by their capital loss carryforwards.

Some disadvantages to beneficiaries receiving discretionary distributions, and the taxable income resulting therefrom, include a higher adjusted gross income which, inter alia, increases the 2%/3% floors on itemized deductions; has an effect on Roth and traditional IRA contribution limitations; has an effect on the amount of taxable Social Security; and has an effect on the oft-forgotten calculation of Medicare premiums of ‘high earners.’

On August 7, 2013, the IRS issued, in draft form, the one-page Form 8960,7 Net Investment Income Tax-Indivi­duals, Estates, and Trusts. The form makes numerous references to “see instructions.” The instructions are not expected out until after the regulations are finalized later in the year.

Further Guidance on the NIIT

The IRS has issued Q & A’s which are understandable.8 Also, many well-written articles have been published on the subject and many organizations (including the American Bar Association and the New York State Bar Association) have submitted comments to the IRS with suggestions as to how the proposed regulations should be changed.

The benefit to reading the comments is that they highlight the problems with interpreting the law and alert you as to matters that might be of interest to you. There also are sites, such as Google, to help you search for information of use to you.


Re-evaluate Federal tax estimates and alert the client if the 2013 Federal tax estimate should be increased or if a larger Federal tax balance will be due in April 2014.

… and finally, death cures the Medicare surtax (and capital gains tax) on gains unrecognized at the time of the death of the decedent (because the tax basis of most9 assets is re-valued at death).

Alan E. Weiner, CPA, JD, LL.M. is Partner Emeritus of Baker Tilly (formerly Holtz Rubenstein Reminick) and was its founding tax partner (1975). He served as the 1999-2000 President of the New York State Society of CPAs. He is the author of All About Limited Liability Companies and Partnerships and DFK International’s Worldwide Tax Overview.

1. The statute also imposes an additional tax of .009 on certain employees and self-employed individuals’ earned income. This article is limited to the surtax on net investment income.
2. See 26 U.S.C. § Subtitle A. IRC § 1411 provides that it shall apply to taxable years beginning after December 31, 2012.
3. 77 Fed. Reg. 234 (Dec. 5, 2012).
4. Although commonly referred to as the Medicare surtax, the 3.8% tax collected is not earmarked for the Medicare Trust fund. Also, none of the 3.8% tax is deductible either as a medical deduction or as part of the self-employment tax deduction.
5. MAGI is the taxpayer’s normal adjusted gross income on the Form 1040 plus income earned by the taxpayer while working outside of the country if the income is eligible to be excluded from taxable income under IRC section 911.
6. The proposed regulations do not define “trade or business,” something that the IRS is reluctant to do. The IRS has said to look at cases and other regulations and perform a ‘facts and circumstances’ test.
9. ‘Income in respect of a decedent’ (i.e., income earned before death but not yet collected, such as rental income) is not re-valued at death.