A new unearned income Medicare contribution tax, with an effective date of Jan. 1, 2013, was enacted as part of the healthcare act. That date has come and gone, and the tax is now applicable.
The new Medicare tax applies to net investment income of individuals whose modified adjusted gross income exceeds certain threshold amounts. The threshold amounts are $250,000 for married filing jointly, $125,000 for married filing separately and $200,000 for single taxpayers.
The tax also applies to undistributed net investment income of estates and trusts when adjusted gross income exceeds the highest estate and trust tax bracket.
Trade or business income
In the case of a trade or business, the Joint Committee on Taxation’s Technical Explanation of the provision says that the tax applies to business income if the trade or business:
- Is a passive activity, with respect to the taxpayer, or
- Consists of trading financial instruments or commodities
But the tax does not apply to other trades or businesses conducted by a sole proprietor, partnership or S corporation.
(Refer to Joint Committee on Taxation’s Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as amended, in combination with the “Patient Protection and Affordable Care Act,” March 21, 2010.)
Sale of business assets
Upon disposition of a business, only net gain or loss attributable to property held by the entity that is not property attributable to an active trade or business is subject to the tax. However, income, gain or loss on working capital is not treated as derived from a trade or business, so it’s taxable.
The tax applies to net investment income, including net gain (to the extent taken into account in computing taxable income), from the disposition of property other than property held in a trade or business. When a disposition of an active equity interest in a partnership or S corporation is made, rather than a disposition of the underlying assets, an exception also applies.
Sale of equity interests
An interest in a partnership or S corporation in most cases is not property held in a trade or business, according to the preamble to proposed regulations issued in November 2012. Therefore, gain or loss from the sale of a partnership interest or S corporation stock will be subject to the tax.
This generally is not the case when partners or S corporation shareholders materially participate in the business. So, dispositions of those interests should be closely reviewed for exemption from the tax.
Sale of partnership or LLC equity interests
A sale of equity interests in a partnership or limited liability company (LLC) is treated as a direct sale of partnership or LLC assets. Therefore, a net gain on the sale of partnership interests or LLC member interests by a partner or member who materially participates in the business is exempt from the tax. This result differs from the sale of interests in an S corporation, in which there is a strong distinction between stock and asset transactions.
Sale of S corporation stock
Absent further guidance, the sale of S corporation stock, even by a shareholder who materially participates in the business, would appear to be subject to the tax. Fortunately, the law itself provides an exception.
The Internal Revenue Code addresses gain in the case of a disposition of an interest in a partnership or S corporation. For purposes of the tax, gain is considered only to the extent of the net gain the seller would take into account if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of the equity interest.
Deemed asset sale election
The exception for a disposition of an active equity interest in an S corporation is inapplicable to the deemed asset sale and liquidation transactions that result from an election. The exception is unnecessary, since the exception for the sale of active business assets would apply directly.
The IRS requires information to verify a taxpayer’s eligibility for the exception for certain active interests in partnerships and S corporations. This information will be used to determine whether the amount of tax has been reported and calculated correctly.
The IRS specifically requests comments concerning whether the proposed collection of information is necessary for the proper performance of the IRS’s functions, including whether the information will have practical utility.
Payments for services, noncompete covenants and personal goodwill
In the context of selling a business, Form 8594, Asset Acquisition Statement Under Section 1060, asks – even for a stock sale – whether ancillary agreements were negotiated with the sellers in addition to the related stock or asset sale agreement.
Employment or consulting agreements may attract the new 0.9 percent Medicare tax. But they should not be subject to the 3.8 percent unearned income Medicare contribution tax because payments would not constitute net investment income. Noncompete payments should not be subject to either of the new taxes since they are neither self-employment income nor net investment income.
The sale of personal goodwill creates a capital gain that may be subject to the active trade or business exceptions to the 3.8 percent tax.
If the sale of an S corporation would have avoided the tax under the active trade or business exception, a question comes to mind: Would that gain also be excluded from the new tax with a tax-free merger of the S corporation into a C corporation and reduce the ultimate net investment income on a taxable sale of the stock received in the merger? Nothing in the statute, Technical Explanation or proposed regulations addresses that issue.
An additional 3.8 percent tax on top of a 20 percent capital gains tax amounts to a 19 percent surtax.
While it is appropriate to minimize the tax when possible, the Joint Committee on Taxation warned in March 2010 that the IRS will closely review transactions that manipulate a taxpayer’s net investment income to reduce or eliminate the amount of tax imposed.
Professional tax advice is strongly advised in applying the provisions of the unearned income Medicare contribution tax.