Planning for the 3.8 Percent Medicare Tax on Investment Income

The health care reform package (the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010) imposes a new 3.8 percent Medicare contribution tax on the investment income of higher-income individuals beginning in 2013. Although this tax has a wide reach, certain steps may be taken to lessen its impact.

Net investment income. Net investment income, for purposes of the new 3.8 percent Medicare tax, includes interest, dividends, annuities, royalties and rents and other gross income attributable to a passive activity. Gains from the sale of property that is not used in an active business and income from the investment of working capital are treated as investment income as well. However, the tax does not apply to nontaxable income, such as tax-exempt interest or veterans’ benefits. Further, an individual’s capital gains income –both long-term and short-term– will be subject to the tax. This includes gain from the sale of a principal residence, unless the gain is excluded from income under Code Sec. 121, and gains from the sale of a vacation home. Planning the sale of “big ticket items,” therefore, now often requires attention to the new 3.8 percent surtax.

The tax also applies to estates and trusts, on the lesser of undistributed net income or the excess of the trust/estate adjusted gross income (AGI) over the threshold amount ($11,200) for the highest tax bracket for trusts and estates, and to investment income they distribute. Use of family trusts and other trust-based strategies now must factor in the 3.8 percent surtax in the construction and operation of the trust. Executors must also be aware of how the 3.8 percent surtax is applied against income on assets held by the estate rather than immediately distributed.

Deductions. Net investment income for purposes of the new 3.8 percent tax is gross income or net gain, reduced by deductions that are “properly allocable” to the income or gain. This is a key term that the Treasury Department expects to address in guidance, and which we will update you on developments. For passively-managed real property, allocable expenses will still include depreciation and operating expenses. Indirect expenses such as tax preparation fees may also qualify.

For capital gain property, this formula puts a premium on keeping tabs on amounts that increase your property’s basis. It also puts the focus on investment expenses that may reduce net gains: interest on loans to purchase investments, investment counsel and advice, and fees to collect income. Other costs, such as brokers’ fees, may increase basis or reduce the amount realized from an investment.

Thresholds and impact. The tax applies to the lesser of net investment income or modified AGI above $200,000 for individuals and heads of household, $250,000 for joint filers and surviving spouses, and $125,000 for married filing separately. MAGI is AGI increased by foreign earned income otherwise excluded under Code Sec. 911; MAGI is the same as AGI for someone who does not work overseas.

Example. Jim, a single individual, has 2013 modified AGI of $220,000 and net investment income of $40,000. The tax applies to the lesser of (i) net investment income ($40,000) or (ii) modified AGI ($220,000) over the threshold amount for an individual ($200,000), or $20,000. The tax is 3.8 percent of $20,000, or $760. In this case, the tax is not applied to the entire $40,000 of investment income.

The tax can have a substantial impact if you have income above the specified thresholds. Also, remember that, in addition to the tax on investment income, you may also face other tax increases that have taken effect in 2013. The top marginal income tax rate is now 39.6 percent and the top tax rate on long-term capital gains has increased from 15 percent to 20 percent. Thus, the cumulative rate on capital gains for someone in the highest rate bracket has increased to 23.8 percent in 2013. Moreover, the 3.8 percent surtax’s thresholds are not indexed for inflation, so a greater number of taxpayers may be affected as time elapses.

Exceptions. Certain items and taxpayers are not subject to the 3.8 percent tax. A significant exception applies to distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans. At the present time, however, there is no exception for distributions from nonqualified deferred compensation plans subject to Code Sec. 409A, although some experts claim that not carving out such an exception was a Congressional oversight that should be rectified by an amendment to the law.

The exception for distributions from retirement plans suggests that potentially taxed investors may want to shift wages and investments to retirement plans such as 401(k) plans, 403(b) annuities, and IRAs. Increasing contributions will reduce income and may help you stay below the applicable thresholds. Small business owners may want to set up retirement plans, especially 401(k) plans, if they have not yet established a plan, and should consider increasing their contributions to existing plans.

Another exception covers income ordinarily derived from a trade or business that is not a passive activity under Code Sec. 469, such as a sole proprietorship. Investment income from an active trade or business is also excluded. However, SECA (Self-Employment Contributions Act) tax will still apply to proprietors and partners. Income from trading in financial instruments and commodities is also subject to the tax. The tax does not apply to income from the sale of an interest in a partnership or S corporation, to the extent that gain of the entity’s property would be from an active trade or business.

The tax also does not apply to business entities (such as corporations and limited liability companies), nonresident aliens (NRAs), charitable trusts that are tax-exempt, and charitable remainder trusts that are nontaxable under Code Sec. 664.

Please contact our office if you would like to discuss the tax consequences to your investments of the new 3.8 percent Medicare tax on investment income.

Provisions of the Patient Protection and Affordable Care Act (PPACA) and its companion law, the Health Care and Education Reconciliation Act (HCERA)

On June 28, 2012, the United States Supreme Court issued its long-awaited decision on the constitutionality of the Patient Protection and Affordable Care Act (PPACA) and its companion law, the Health Care and Education Reconciliation Act (HCERA). In a nutshell, the nation’s highest court upheld the law – except for certain Medicaid provisions. The 5 to 4 decision preserves many far-reaching tax provisions and health insurance reforms. In coming months, lawmakers and legal scholars will examine all of the nuances of the Court’s highly complex decision.

Congress will, no doubt, make changes to these provisions in the weeks and months ahead. For the time being, individuals and businesses are concerned about what steps they need to take next.

Individual mandate

The PPACA includes a shared responsibility requirement for individuals. This has come to be known as the individual mandate. Broadly, this provision requires individuals to obtain minimum essential health coverage or pay a penalty starting in 2014. Many individuals, however, are exempt from the penalty. These include individuals covered by Medicare and Medicaid, individuals with coverage under military health plans, undocumented individuals, and others. The PPACA also imposes no penalty on individuals who could not afford coverage. Additionally, individuals with employer-provided coverage generally are treated as having minimum essential coverage and are exempt from the penalty unless the coverage is deemed unaffordable.

In National Federation of Independent Business et al. v. Sebelius, June 28, 2012, Chief Justice Roberts and Justices Ginsburg, Breyer, Sotomayor, and Kagan found that the individual mandate was a valid exercise of Congress’ taxing power under the Constitution. “Under the mandate, if an individual does not maintain health insurance, the only consequence is that he must make an additional payment to the IRS when he pays his taxes. That, according to the Government, means the mandate can be regarded as establishing a condition – not owning health insurance – that triggers a tax – the required payment to the IRS. Under that theory, the mandate is not a legal command to buy insurance. Rather, it makes going without insurance just another thing the Government taxes, like buying gasoline or earning income.”

The majority concluded: “Our precedent demonstrates that Congress had the power to impose the exaction in Section 5000A under the taxing power, and that Section 5000A need not be read to do more than impose a tax. That is sufficient to sustain it.”

Justices Scalia, Kennedy, Thomas, and Alito dissented. According to the dissenting justices, the majority?s decision that the individual mandate imposes a tax in essence was a rewrite of the PPACA and not an interpretation. The dissenting justices would have struck down the entire law.

Tax provisions

Along with the individual mandate, the PPACA includes many tax provisions, which remain law. It cannot be over-emphasized that the tax provisions impact nearly every individual and business.

The PPACA also imposes a penalty on applicable employers (generally employers with more than 50 full-time employees) that do not provide affordable health insurance coverage to their employees. The penalty is scheduled to take effect after 2013. Employers need to review their coverage to determine if it satisfies the minimum essential coverage and affordability requirements under the PPACA. Employers also should review their benefits packages for compliance with the PPACA.

Since passage of the PPACA/HCERA, the IRS and the U.S. Departments of Health and Human Services (HHS) and Labor (DOL) have issued extensive guidance on the new law. The pace of guidance is expected to accelerate now that the law has been upheld by the Supreme Court.

Insurance reforms

Along with the tax-related provisions we have discussed, the PPACA has set in motion many insurance reforms. They include:

  • Enhanced coverage for certain dependents
  • Summary of benefits coverage and uniform glossary
  • New rules for internal and external reviews of adverse decisions by health insurance carriers
  • Patient’s bill of rights
  • New rules for preventive services

Like the tax provisions, federal agencies have been busy issuing guidance on the insurance reforms. More guidance is expected in coming weeks and months.

Health insurance exchanges

The PPACA requires every state to establish an American Health Benefit Exchange and Small Business Health Options Program (SHOP Exchange) to provide qualified individuals and qualified small business employers access to qualified health plans. Some states have already begun the process of setting up exchanges. Other states waited to see the outcome of the Supreme Court case.


The PPACA also expanded Medicaid to cover more individuals with incomes below 133 percent of the federal poverty level. The federal government would cover 100 percent of the Medicaid costs of the newly eligible individuals, with the percentage dropping to 90 percent (with states covering the difference) by 2020. States would be required to make up the difference. The PPACA also set minimum essential levels of Medicaid coverage and made other changes. States that fail to comply with the PPACA risk termination of all Medicaid funding from the federal government.

The Supreme Court held that Congress could expand Medicaid. However, Congress could not penalize states that choose not to participate in the expansion by taking away their Medicaid funding.

Looking ahead

Employers, taxpayers – indeed everyone – must prepare for sweeping changes in health care in coming years. Many of the provisions in the PPACA have already been implemented or are in the process of being implemented. Other provisions are scheduled to take effect after 2012. The Supreme Court’s upholding of the PPACA clears the way for implementation of the new law (unless a future Congress votes to repeal the law). Our office will keep you posted of developments and the steps you need to take in the coming months and years.

If you have any questions about the Supreme Court’s decision, please contact our office.

Substantiation Requirement for Charitable Contributions

The Tax Court has disallowed taxpayers’ charitable contribution deduction to their church because the donee organization failed to provide a properly completed contemporaneous written acknowledgment of the contribution. Although the donee twice attempted to provide letters adequately acknowledging the contribution, the letters failed to meet the substantiation requirements.

Durden, TC Memo 2012-140 illustrates the need for taxpayers to be vigilant about receiving proper and timely acknowledgment of $250 or more charitable contributions from donee organizations. A cancelled check and a simple written acknowledgment aren’t enough to substantiate a deduction. Further, a failure to receive the proper acknowledgment can only be remedied by the donee within a relatively short window of time.

Background. Under Code Sec. 170, a taxpayer is allowed a charitable contribution deduction for a contribution or gift to or for the use of an organization organized and operated exclusively for charitable or educational purposes. Under Code Sec. 170(f)(8)(A), no charitable contribution deduction for any contribution of $250 or more is allowed unless the taxpayer substantiates the contribution with a contemporaneous written acknowledgment of the contribution by the donee organization that meets certain specified requirements. Under Code Sec. 170(f)(8)(B), the donee organization must state in the acknowledgment whether the donee organization provided any goods or services in consideration, in whole or part, for the contributed property or cash. If so, the acknowledgment generally must include a description and good faith estimate of the value of any goods or services provided. (Reg. § 1.170A-13(f)(2)) Under Code Sec. 170(f)(8)(C), a written acknowledgment is contemporaneous if it’s obtained by the taxpayer on or before the earlier of: (1) the date the taxpayer files the original return for the tax year of the contribution; or (2) the due date (including extensions) for filing the original return for the year. (Reg. § 1.170A-13(f)(3))

The Durdens conceded that they had not strictly complied with Code Sec. 170(f)(8). However, they argued that they had substantially complied with the statute and were entitled to the claimed deductions. On the other hand, IRS contended that the first acknowledgment failed because it didn’t include a statement on whether any goods or services were provided to the Durdens in consideration for their contribution. IRS also argued that the second acknowledgment, which included the statement, failed because it wasn’t contemporaneous.

The Tax Court concluded that the Durdens failed, strictly or substantially, to comply with the clear substantiation requirements of Code Sec. 170(f)(8). Accordingly, their deduction for the charitable contributions at issue was disallowed.

President Obama’s Business Tax Reform Plan

In February 2012, the White House and Treasury Department released The President’s Framework for Business Tax Reform (the report), which presents five “elements” of business tax reform. For each element, the report provides background information to explain why reform is needed and describes the suggested reforms. Some of the reforms are specific, such as repealing LIFO, while others are more general, such as reducing “accounting gimmicks.”

A few of the specific proposals include:

  • Reduce the corporate tax rate to 28%.
  • Eliminate many tax expenditures and “loopholes,” including most of the ones for specific industries. Specifically mentioned are elimination of LIFO, oil and gas preferences, interest deductions related to life insurance, except for policies on employees who own at least 20% of the business, and special depreciation for corporate aircraft. Carried interests would be taxed as ordinary income.
  • Broaden the corporate tax base to allow for a lower rate and remove “harmful distortions.” Accelerated depreciation would be modified to better match economic depreciation. The current bias for debt over equity would be addressed by reducing interest deductions for corporations.
  • Improve parity among all large businesses regardless of organizational form without affecting small businesses. The framework suggests consideration of reforms suggested in the 2005 final report of President George W. Bush’s Advisory Panel on Federal Tax Reform and options analyzed by President Barack Obama’s Economic Recovery Advisory Board in 2010.
  • “Improve transparency and reduce accounting gimmicks.” The proposal suggests reducing the gap between book and taxable incomes and allowing for “greater disclosure of annual corporate income tax payments.”

In addition there are proposals to strengthen “manufacturing and innovation”, establish a minimum tax on foreign earnings (to encourage domestic investment), and “simplify and cut taxes for small businesses”.

We will keep you apprised of the legislative progress of this proposal.  Please contact our office if you have concerns or questions.


Zions Bank “Speaking in Business”

On Monday, February 27, Trader Roberts & Spangler will be featured on Zions Bank’s “Speaking on Business” broadcast on KSL Radio, 1160 AM. Along the Wasatch Front, it will air at 7:23 AM, 11:47 AM and 5:23 PM. If you miss the broadcast it will be available at some point during the week at

We appreciate the support of all of our clients, friends and family in contributing to the success of the firm. Additionally, we would like to acknowledge Zions Bank and Chris Redgrave for their support.


The House and Senate approved and President Obama is expected to sign legislation that extends through 2012 the current-law 2 percent payroll tax relief, emergency unemployment insurance benefits, and provisions to prevent a cut in payments to doctors who serve Medicare beneficiaries


We receive a number of calls regarding the standard mileage rates taxpayers can use. The IRS has released amounts for use in 2012 (Notice 2012-1).

For business use of an automobile remains at 55½ cents per mile. For medical or moving expenses, it is 23 cents per mile (a half-cent decrease from the second half of 2011). For services to charitable organizations, the rate (which is set by statute) is 14 cents per mile.
Rather than using the standard mileage rates, taxpayers may instead use their actual costs if they maintain adequate records and can substantiate their expenses. The rules for substantiating these amounts appear in Rev. Proc. 2010-51.

For automobiles a taxpayer uses for business purposes, the portion of the business standard mileage rate treated as depreciation is 23 cents per mile for 2012 (it was 22 cents per mile for 2011).

As always, if you have questions please feel free to call us.


Although most Americans will not have to worry about 2012 taxes until early 2013 when 2012 tax returns are due, self-employed individuals or anyone who must pay quarterly tax payments will want to plan ahead.

The IRS recently announced cost-of-living adjustments for the 2012 tax year that bump up brackets, deductions and other thresholds for inflation.

The following is a summary of the key changes for 2012:

  •  Exemptions are up: The personal and dependent exemption increases to $3,800, up $100 from 2011.
  • Standard deductions have increased: The 2012 standard deduction increases to $11,900 for married couples filing a joint return, $5,950 for singles and married individuals filing separately, and $8,700 for heads of household.
  •  Tax-bracket adjustments: Tax-bracket thresholds have increased for each filing status.
  •  Estate tax exclusion has increased: The estate tax exclusion increases to $5,120,000, up from $5,000,000 for 2011. The annual exclusion for gifts will remain at 13,000.
  • Earned income credit rise: The maximum earned income tax credit (EITC) rises to $5,891, up from $5,751 in 2011. The maximum income limit for the EITC increases to $50,720, up from $49,078 in 21011.

Several tax benefits are uncharged in 2012. For example, the additional standard deduction for blind people and senior citizens remains at $1,150 for married individuals and $1,450 for singles and heads of households.

The details on these and other inflation adjustments can be found in Revenue Procedure 2011-52. Please feel free to contact us to discuss your individual situation.

Reporting Capital Gains and Losses on Schedule D and Form 8949

The IRS has unveiled a new tax form for reporting capital gains and losses from stocks, bonds, mutual funds and similar investments. Starting with the 2011 tax year, investment transactions will be reported on the new Form 8949, Sales and Other Dispositions of Capital Assets.

Starting with 2011, Schedule D now functions as a summary of all capital gains transactions. Individual investment sales are to be detailed on the new Form 8949.

Any particular investment sales transaction will fall into one of three categories:

  • Sales of covered securities for which cost basis is provided;
  • Sales of non-covered securities for which no cost basis is provided on the 1099-B; or
  • Sales of investments assets for which no 1099-B is received.

The new Form 8949 reflects this categorization. A separate Form 8949 is required for each type of transaction, with the appropriate check box indicated at the top of the form. Form 8949 is further divided into two pages, with short-term transactions being listed on page 1 and long-term transaction listed on page 2.

Does Your Business Accept Bankcards?

If you have accepted merchant cards for payments, or received payments through a third party network that (1) exceeded $20,000 in gross total reportable payment transactions and (2) the total number of those transactions exceeded 200 for the calendar year, you will receive a form 1099K. Merchant card and third party network payers, as payment settlement entities (PSE), must report the proceeds of payment card and third party network transactions made to you on form 1099-K under Internal Revenue Code section 6050W beginning in 2011.

The information from this form 1099K is necessary to complete your business tax return (c-corporation, s-corporation, limited liability company, partnership, or proprietorship.