Until recently maximum individual income tax rates remained below 40%.   But, the Health Care and Education Reconciliation Act of 2010 (“HCERA”) raised the highest marginal rate to 39.6%.

IRC § 1411 was the result, euphemistically referred to as the “super Medicare tax.”  This tax exposes the net investment income (“NII”) of individuals, estates and trusts to a 3.8% tax when their modified adjusted gross income (“MAGI”) exceeds certain threshold levels.   This also exposes individuals to a top marginal rate of 43.4 %. The Super Medicare tax is applied to the lesser of (a) the taxpayer’s MAGI in excess of the applicable threshold level or (b) their NII.  The current “threshold levels” are:

• Married individuals filing a joint return:                                              $ 250,000
• Married individuals filing separate returns:                              $ 125,000/each
• Unmarried individuals and other cases:                                               $ 200,000

What is Net Investment Income?

 The complexity of this tax gathers speed when identifying what constitutes NII.  Keep in mind:

• NII begins with obvious components such as interest, dividends, annuities, royalties and rents.  Annuities receive a slightly favorable treatment (only the income component of the annuity distribution is NII).

• NII includes income from “passive activities” as well as any trade or business engaged in trading in financial instruments or commodities.

• NII includes the net gain attributable to the disposition of property other than property held in a trade or business which is neither a “passive activity” nor a trade or business of trading in financial instruments or commodities.

Operating Rules:

Remember that interest, dividends, etc. allocated to a taxpayer by a pass-through entity (i.e. a partnership, an S corporation, or a disregarded entity) retain their NII character in the owner’s hands.   This is equally true with trusts and estates.  Trusts and estates pay super Medicare tax on their undistributed NII, so opportunities exist where income distributions are discretionary and certain NII allocations can favorably impact the super Medicare tax on the entities and their beneficiaries.

 If you report this type of income from pass-through entities you should consult with your H&M consultant to assure that your overall super Medicare tax exposure is minimized and the “passive activity” rules do not unfavorably impact you.

 The second grouping of NII components will be concerning to many.  If a taxpayer actively participates in a trade or business (i.e. not a passive activity) then the income is not NII.  This requires taxpayers’ to review of business activities to assure that they aren’t “passive”. 

 A complete exposition of the criteria for determining whether an activity is “active” or “passive” is well beyond the scope of this piece.  However, certain issues are worthy of exposition here.

• Income from self-rental arrangements is treated as “non-passive” income.  Hence, it’s not NII.

• Determining whether or not a taxpayer’s real property activities fall within the real property professional exception.

• The general standard for determining whether an activity is active or passive hinges on the taxpayer’s 500 hour participation in it.  However, there are activities grouping elections which may turn several under 500 hour activities into a single “active” trade or business.

These grouping rules and other strategies require a careful analysis which your H&M advisor can perform for you.

 The take-away:

The super Medicare tax could have very unpleasant consequences for those that don’t comply.   If your adjusted gross income is at or near the threshold levels, if you are a trustee or executor of an estate or trust, or hold passive activities, speaking to your H&M advisor is a prudent means of limiting your exposure to the super Medicare tax.