3.8% Medicare Surtax on Individuals, Estates & Trusts

Beginning in 2013, the Affordable Care Act will impose a 3.8% surtax on some types of income, subject to certain thresholds. However, the applicable threshold and the manner in which the surtax is calculated varies depending upon whether the taxpayer is an individual or an estate or non-exempt trust.

The applicable text of the statute is as follows (emphasis added):

In the case of an individual, there is hereby imposed (in addition to any other tax imposed by this subtitle) for each taxable year a tax equal to 3.8 percent of the lesser of

(A) net investment income for such taxable year, or

(B) the excess (if any) of—

(i) the modified adjusted gross income for such taxable year, over

(ii) the threshold amount.

Net investment income is included in modified adjusted gross income ("MAGI"), so even if an individual taxpayer has net investment income, the surtax will not apply unless the net investment income is in excess of the threshold amount.

In the case of an estate or non-exempt trust, there is hereby imposed (in addition to any other tax imposed by this subtitle) for each taxable year a tax of 3.8 percent of the lesser of

(A) the undistributed net investment income for such taxable year, or

(B) the excess (if any) of—

(i) the adjusted gross income (as defined in section 67(e)) for such taxable year, over

(ii) the dollar amount at which the highest tax bracket in section 1(e) begins for such taxable year.

Net investment income is included in adjusted gross income, so even if an estate or non-exempt trust has net investment income, the surtax will not apply unless the net investment income is in excess of "the dollar amount at which the highest tax bracket in section 1(e) begins for such taxable year".

Net Investment Income

Net investment income is the sum of investment income in excess of allowable investment expenses. For estates and non-exempt trusts, the surtax is only applicable to net investment income received but not distributed in a tax year. For individuals, the surtax is applicable to net investment income received by the taxpayer in a tax year.

Investment income includes:

  • Interest income,
  • Dividends,
  • Annuity distributions,
  • Rents,
  • Royalties,
  • Income from passive activities, and
  • Capital gains

Investment income does not include:

  • Salaries,
  • Wages,
  • Accrued bonuses,
  • IRA distributions,
  • 401(k) distributions,
  • Pension income,
  • Social Security Income,
  • Active royalties, and
  • Exempt interest income (e.g. tax-exempt bonds)

Thresholds

For individuals, the income threshold amounts depend on the filing status of the taxpayer and are $250,000 for married couples filing jointly, $125,000 for married couples filing separately, and $200,000 for all other individuals. For estates and non-exempt trusts, however, the effective threshold will likely be about $12,000.

This disparity in thresholds creates substantial opportunity for tax arbitrage in timing distributions of non-exempt trusts & estates and/or selecting the types of assets owned by non-exempt trusts & estates.

Timing Distributions

Section 663(b) of the Internal Revenue Code permits the fiduciaries of some estates and non-exempt trusts to treat distributions made within 65 days of the beginning of the taxable year of those estates and non-exempt trusts as occurring on the last day of the preceding taxable year. This provision can allow fiduciaries to reduce the estate's undistributed net investment income and the surtax associated with such income.

For example, the fiduciary of an estate determines that the net investment income associated with the estate will exceed the applicable threshold for the current tax year, but the estate had net investment income below the applicable threshold in the previous tax year. That fiduciary can make a distribution within 65 days of the beginning of the estate's current tax year to so as to increase the estate's net investment income in the previous tax year up to the amount of the net investment income threshold for that year thereby reducing the estate's net investment income in the current year.

Because distributions of net investment income may be subject to the surtax in the hands of taxpayers upon receipt, the timing of distributions of net investment income should likely be determined with reference to the individual taxpayers who will receive the distributions as well as the estate or non-exempt trust.

Asset Composition

The assets of estates or non-exempt trusts can be structured so as to reduce the applicability of the surtax in some situations.

For example, if a non-exempt trust owns certain types of assets, e.g. tax-exempt bonds, the income from those assets is not subject to the 3.8% surtax.

As with the timing of distributions, the composition of the non-exempt trust assets should likely take into account the trust beneficiaries of the non-exempt trust because distributions of net investment income could be subject to the 3.8% surtax in the hands of the beneficiaries.

This brief overview of some important considerations associated with the Affordable Care Act, estates, and non-exempt trusts is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Contact Us

If you are a current client of this firm, please do not send confidential or otherwise sensitive information via this site. Further, if you are not an existing client of this firm, unsolicited emails containing confidential or sensitive information cannot be protected from disclosure as no attorney-client relationship exists.