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New Health Care Law Includes 3.8% Medicare Tax on Investment Income

President Obama Sign Health Care Legislation into Law

In the coming months (possibly years), tax lawyers and accountants will be analyzing the ramifications to business of the new health care legislation which was recently signed into law by President Obama. One of the new provisions of this law marks the first time in history that the federal Medicare tax will be extended beyond wages and self-employment income to interest, dividends, capital gains, annuities, royalties and rents. This new tax applies to individuals with adjusted gross income above $200,000 and joint filers over $250,000.

For individuals above the $200,000/$250,000 thresholds, the tax will apply to all “net investment income”. In addition to all applicable income taxes, the new Medicare tax will be 3.8%. For regular wages, the new law also adds an additional 0.9% tax on wages over the threshold amounts (thus increasing the current tax on such wages from 1.45% to 2.35%).

One noteworthy aspect of this provision is that several types of income are excluded from the definition of “net investment income” and hence are not subject to the new tax. First, the tax does not apply to income from the operation of a trade or business. Therefore, the law appears to retain the current law’s exemption whereby the Medicare tax does not apply to S corporation distributions. 

The Medicare tax applies to income that is derived from rental income only if the landlord is a passive investor under the Tax Code’s current “passive activity” rules. Hence, if the landlord is a sole proprietor or an active investor in a partnership, LLC, or S corporation, the Medicare tax does not apply. Note, however, that if the landlord is a sole proprietor or an active investor in a partnership or LLC (but not an S corporation), income from the activity may be considered trade or business income that may already be subject to the Medicare self-employment tax, which the new law separately increases from 2.9% to 3.8% for high earners.

Capital gains are generally included in the new Medicare tax. However, gain from the sale of an interest in a partnership (including an interest in an LLC that is taxed as a partnership) or S corporation is subject to the new tax only to the extent that the gain is attributable to passive investment assets and not property held by the entity which is attributable to an active trade or business.

Finally, the Medicare tax does not apply to distributions from qualified retirement plans. This exclusion extends to distributions from employee profit-sharing and 401(k) plans, IRAs, Roth IRAs, and 403(b) plans from tax-exempt organization.

The new Medicare tax will become effective on January 1, 2013.