Contained within the 2010 Health Care Act is a provision relating to what's often referred to as the "Medicare Surtax." Although final regulations have yet to be issued, it makes sense to start planning for the tax now. The 3.8 percent tax, which is scheduled to be effective starting January 1, 2013, will impact higher income earners, as well as the income generated by some trusts. It also may affect the structure that makes sense for a particular business.
The goal of this section of the legislation is to tax income that otherwise wouldn't be subject to the Medicare tax under FICA and SECA, the American Bar Association (ABA) reports. The revenues generated from the tax will be allocated to the Medicare Trust Fund.
As it stands now, the tax will be imposed on the lesser of a taxpayer's net investment income, or the amount by which the taxpayer's modified adjusted gross income exceeds the "threshold amount." For instance, for taxpayers that are married and file jointly, the threshold amount is $250,000. The threshold amounts are not indexed to inflation, so it's likely that they'll catch more taxpayers over time.
According to information from accounting firm Deloitte, net investment income for the purposes of this legislation includes gross income derived from a passive trade or business; other non-business passive income like interest, dividends, annuities, royalties and rents; and the net gain from the disposition of property, other than on property held in a trade or business that is not passive. Net investment income won't include tax-exempt interest, distributions from IRA and employer retirement plans, nor income from an active business, according to Wells Fargo.
The tax may prompt some taxpayers to consider forming an S corporation to limit the amount of taxes they owe, the accounting firm Gray Gray & Gray, LLP says. "The tax does not apply to business income earned by active S corporation shareholders, even if over the threshold amounts. The tax does apply to business income for passive shareholders in an S corporation."
On the other hand, a passive shareholder is able to offset income from the passive investment with losses from another passive activity, the ABA points out. That benefit isn't available to active shareholders.
And, it's possible that income from some S corporations eventually may be subject to the Medicare tax. Several pieces of legislation have been proposed to treat shareholders' distributions from professional services S corporations as subject to the Medicare tax, as Thomas Wechter, a partner with the law firm Duane Morris LLP, notes. So far, the bills have not passed.