Tax Legislation

“Lame Duck” is often used to refer to a politician who is known to be in his or her final term of office, when constituents and colleagues look toward a successor. The historical origin of the term is attributed to eighteenth-century England where the term was used to refer to an investor who could not pay his or her debts. Both usages are apropos when referring to the current dilemma facing Congress with the extension of the “Bush Tax Cuts,” also know as Economic Growth and Tax Relief Reconciliation Act of 2001 (often informally referred to as “EGTRRA”).

In my article in this blog last May, I posed the question “What if Congress Does Nothing.” It’s almost seven months later and Congress has, in fact, done nothing with regard to the many provisions of EGTRRA that will expire on midnight on December 31, 2010.

Congress returned from the holiday break this week and congressional leaders met with President Obama yesterday to discuss the tax expiration dilemma. Each side has appointed several negotiators to try to find a compromise. Those negotiations are taking place against the backdrop of a still-divisive post-election climate with and federal deficits continuing at an unprecedented level.

What will happen now? While my guess here is akin to a blind bet at a Vegas gaming table, I believe that Congress may agree on a compromise proposal to extend all of the EGTRRA tax cuts for another two years. As to the estate tax, a similar compromise could be made to reinstate the estate tax exemptions and rates at 2009 levels (i.e. with a $3.5 million exemption and a 45% top rate). However, a slightly less likely possibility is that Congress will simply do nothing and pass the “tax baton” to the next Congress to deal with in early 2011.

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.