New 3.8% Medicare Tax Impacts Pass-Through Entities

Hunter J. Brownlee of Fowler White Boggs P.A. recently wrote an article regarding the Medicare Tax Increase that was published in The National Law Review:

Effective for 2013, the Internal Revenue Code will impose a 3.8% tax on investment income and other unearned income. The purpose of the tax is to partially pay for the cost of health care reform.

This new 3.8% Medicare tax applies to individuals who have investment or unearned income and who have modified adjusted gross income above certain thresholds ($200,000 for single individuals or $250,000 for married individuals filing jointly).

Investment or unearned income includes:

  • Income from interest, dividends, annuities, royalties and rents, less allocable expenses, unless the income is earned in an active business.
  • Business income earned in a passive activity (for example, business income earned by a partnership or S corporation in which an individual invests, if the individual does not materially participate in the business activity).
  • Net taxable gains attributable to the sale of non-business property.

With respect to shareholders who are active in an S-corporation’s business, the 3.8% Medicare tax will have no effect because their share of the corporation’s active income will not be subject to the new tax. However, if a shareholder is not active in the business, the new tax will apply to pass-through income from the S-corporation.

The new 3.8% Medicare tax also affects limited liability companies (“LLC”) taxed as partnerships. Generally, if a member of an LLC takes the position that his distributive share of the LLC’s income is not subject to self-employment tax on the grounds that he is a limited partner and not active in the business, this income is likely subject to the 3.8% Medicare tax. However, if the member treats a portion of his distributive share of the LLC’s income as income from self-employment on the grounds that he is an active member, the 3.8% Medicare tax would not apply.

Gain from the sale of interests in pass-through entities, such as LLCs, partnerships and S-corporations, can be subject to the 3.8% Medicare tax, to the extent attributable to the entity’s non-business property. For example, if an individual owns an interest in a pass-through entity and sells that interest at a gain, the portion of the gain attributable to the entity’s passive portfolio investments and to business property used in the business in which the individual does not actively participate is subject to the 3.8% Medicare tax.

Finally, with respect to capital gains, the capital gains tax rate will be 20% in 2013 and the 3.8% Medicare tax may apply to certain high income individuals as discussed above.

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