The 2013 Medicare Surtax: What You Need to Know

The American Taxpayer Relief Act of 2012 and the Patient Protection and Affordable Care Act of 2010 have ushered in new income tax provisions which become effective in 2013.  One of the new provisions is the 3.8% Medicare surtax on an individual’s Net Investment Income.  This tax is one of the funding provisions for the new health care legislation, known as Obamacare.  The surtax will impact high income taxpayers who have a modified adjusted gross income in excess of specific thresholds.

FIRST OF ALL, WHO IS A “HIGH INCOME” INDIVIDUAL?  WILL I BE SUBJECT TO THIS TAX?

Individuals will be subject to the tax if they have any amount of net investment income and their modified adjusted gross income (“MAGI”) for the year is greater than the following threshold amounts:

  •   Married filing jointly                                              $250,000
  •   Married filing separately                                        $125,000
  •   Single or head of household                                   $200,000

HOW IS THE TAX CALCULATED?

The 3.8% tax is calculated on the lesser of (1) your net investment income or (2) your MAGI in excess of the threshold amount.  Some common types of investment income are: interest (excluding tax exempt interest), dividends, capital gains, rental income (if you are not a real estate professional) and passive income from partnership activities.

DOES THE TAX APPLY TO THE GAIN ON THE SALE OF MY PERSONAL RESIDENCE?  WHAT ABOUT A VACATION HOME OR INVESTMENT REAL ESTATE?

Net investment income only includes the net taxable gain from the sale of a personal residence, which is the gain in excess of $500,000 for married individuals and $250,000 for single individuals.    The entire net capital gain from the sale of a vacation home, investment property or rental real estate is included in investment income.

DOES THIS TAX APPLY TO TRUSTS?

The tax will apply to estates and trusts with undistributed net investment income and an adjusted gross income in the amount of $11,650 for 2013.

WHAT CAN I DO TO MINIMIZE THE IMPACT OF THE SURTAX?

The timing of transactions becomes a very important tax planning tool in avoiding or minimizing the impact of the 3.8% surtax.  This is especially true for sales transactions of stock, real estate and other investments.  The current year tax impact of net investment income and other gains and losses should be reviewed in order to minimize the tax.

Other potential opportunities to minimize the surtax impact are:

  • Consider converting traditional IRAs to Roth IRAs.  This would reduce the MAGI in future years when distributions are taken from the accounts.
  • Investing in tax exempt bonds instead of taxable bonds.  The interest from the tax exempt bonds is excludable.
  • Harvesting capital losses to offset capital losses to reduce net investment income and MAGI.
  • Managing retirement plan distribution to maintain MAGI under the threshold amounts.

IS THE 3.8% SURTAX ON NET INVESTMENT INCOME THE ONLY MEDICARE SURTAX?  WHAT ABOUT EARNED INCOME?

No, there is also a .9% Medicare surtax on the wages and self-employment income of high income taxpayers.  This tax applies to earned income in excess of $200,000 for single filers, $250,000 for married taxpayers filing joint returns and $125,000 for married taxpayers filing separately.

For more information regarding tax planning, tax compliance and controversy, estate planning, or business law,  please visit the Hoffman & Associates website at www.hoffmanestatelaw.com or call us at 404-255-7400 or send us an email.

In accordance with IRS Circular 230, this article is not to be considered a “covered opinion” or other written tax advice and should not be relied upon for IRS audit, tax dispute, or any other purpose. The information contained herein is provided “as is” for general guidance on matters of interest only. Hoffman & Associates, Attorneys-at-Law, LLC is not herein engaged in rendering legal, accounting, tax, or other professional advice and services. Before making any decision or taking any action, you should consult a competent professional advisor.

GRAT Examples

Example of GRAT valuation:

$1,000,000 trust with grantor receiving a $50,000 annuity for 10 years. If the section 7520 rate is 3.2%, the value of the grantor’s retained interest is $396,260 and the remainder is valued at $609,740.

  •  So the right to receive the $50,000 annuity for 10 years is worth $396,260 and the right to receive the remainder at the end of the 10 years is worth $603,740.
  • The value of the remainder interest ($603,740) would be subject to gift tax upon creation of the GRAT.

Example of a qualified payment in a GRAT:

Grantor transfers 100 shares of X Company to a 3 year GRAT. The terms of the trust stipulate that the trustee must pay the grantor an annuity equal to 10% of the initial value of the trust in the first year with the annuity payment increasing 20% in the second year and 20% third year. After the third year the trustee is to distribute the remaining trust to the beneficiary.

Example of how a valuation formula will reduce the risk of unexpected gift tax consequences when dealing with hard to value assets:

Grantor transfers 100 shares of X Company to a GRAT, X Company has 200 shares outstanding and a company value of $1,000,000. Under terms of the GRAT, grantor retains an annuity of 15%, increasing by 20% annually, for 5 years, with the remainder interest going to his beneficiaries. Grantor files a gift tax return showing a transfer of $300,000 to the GRAT ($1,000,000 x 50% ownership minus 40% discount), with a gift of $44,872.50 to 3 beneficiaries. If on audit the IRS only allows a 20% discount, the taxable gift would be $59,830. Thus, an increase in the amount transferred by $100,000 increases the taxable gift by approx. $15,000.

 

H&A Successful in another Estate Tax Audit

H&A has again successfully settled an estate tax audit.   In this case, the IRS confronted the Estate with an additional assessment of nearly $2.4 million dollars in estate taxes.  The IRS assessment was based largely on three issues.  First, the IRS argued that an LLC created prior to death should be included in the estate under IRC Section 2036.  Second, the IRS argued that a vacation home  previously owned by a QPRT and rented back to the decedent should be included in the decedent’s taxable estate under IRC Section 2036.  Finally, the IRS disallowed an estate tax deduction for interest on a Graegin loan taken from the recently created LLC to pay estate taxes.

H&A was able to successfully defend the Estate on each and every issue on which the IRS based its assessment. Through proper planning, creative thinking, and hard work by H&A, the Estate recently received from the IRS a no-change closing letter.  This was a collaborative effort across all firm departments, and is a testament to the wide ranging skills and knowledge offered to our clients.   I’d like to thank everyone involved for their efforts in bringing this matter to a successful conclusion.

We cannot guaranty similar results, as success or failure of any audit defense depends on the facts and circumstances of the individual case.  If you need help dealing with the IRS, please do not hesitate to contact us at (404) 255-7400.