October 21, 2013 at 8:23 am

The Additional Medicare Taxes Trap

by Jeff Jackson, CPA/PFS, CFP 

Beating the New Net Investment Income Tax and Additional Medicare Taxes

In our last overview of Net Investment Income Tax (NII), my associate Sue Miller, CPA, explained which types of income are subject to the tax. The companion Additional Medicare Tax on High Income Individuals is intended to capture most types of earned income that are excluded from the NII. My article will review the Additional Medicare Tax and point out opportunities for higher income individuals to avoid both taxes and thereby reduce their tax rate by 3.8%.

The Additional Medicare Tax on wages and other earned income adds an additional .9% tax on top of the regular 2.9% Medicare or Self Employment tax that applies to almost all earned income of individuals. Employees actually pay Medicare tax at the rate of 1.45% on all wages without any cap. Their employer matches the tax for a combined 2.9% rate. Self-employed individuals pay both employer and employee share for a combined rate of 2.9%. Now, for those with incomes above certain threshold amounts, an additional tax of .9% applies. The threshold amounts are $250,000 for married couples filing joint returns, $125,000 for married couples filing separately, and $200,000 for those filing as single or head of household.

What types of income are excluded?

There are limited types of income that are not subject to one or the other of these companion taxes. Exceptions include distributions from IRA’s and retirement plans, tax exempt income, social security benefits and S corporation profits where the owner is active in the business.

Planning opportunities do exist that might allow business owners to reduce their exposure to these taxes.

  • Reconsider the form of your business. The profits of LLC’s and partnerships are subject to SE tax if the owner is active in the business. They are subject to the NII if the owner is not active in the business. Highly profitable business owners may substantially reduce their exposure to these taxes by making an S election and then setting salaries at a low, but still reasonable, level. This strategy may produce savings since the profits of the S corporation which are distributed to shareholders are not subject to the tax so long as the shareholder is active in the business.
  • Where the business rents real estate from its owners, consider having rents set at a high, but reasonable, level. Rents from related companies where the real estate owner materially participates in the business are treated as non-passive where the rental activity reports a profit. Recall that rents are generally subject to the NII. But, where they are re-characterized under this rule, they will escape NII since they are not treated as passive.
  • Since tax rates are much higher this year for those with higher levels of income, tax saving opportunities that did not justify their cost in the past, may be more appealing now. For example, reconsider the type of retirement account you use in your business and the level of funding. Contributions to retirement plans reduce your income and may save the Additional Medicare Tax. But when you take distributions, the distributions are not subject to that tax, or the NII, so they may result in a permanent tax savings. Similarly, consider the bonus depreciation benefit of placing equipment in service this year. Higher income individuals may realize federal, state and local tax savings which approach or exceed 50%. We have advised some of our clients to delay cost segregation studies from 2012 to 2013 to take advantage of the more significant tax savings that will result by the one year delay. If you have business real estate which may produce additional depreciation deductions by use of a cost segregation study, talk to your tax advisor now.

Tax deductions and tax planning could be much more valuable now than at any time in the past decade.

Call your Brady Ware advisor now for a review to see what opportunities you might consider.

And if you do not have a Brady Ware advisor, call anyway. We’ll be happy to schedule a review of your business and personal tax situation and show you how we work to serve our clients.

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