The new Medicare tax takes effect this year, and for top earners who are business owners that can mean a tax rate increase of up to 3.8%. While the increase can be significant, there are ways that the owners can limit their burden.
First and foremost, you may be asking yourself what exactly this change in tax law is and why it has come about. The new Medicare Tax was established out of the Health Care and Education Reconciliation Act, which passed in 2010 as a reaction to concerns about the lack of future funding available for Medicare. As mentioned above, the maximum threshold imposes a 3.8% tax on net investment income when that income surpasses a specific amount.
As tax matters go, this issue is considered more complicated than others. However, if you are invested in multiple interests as a business owner, these changes are crucial to note.
As part of this tax provision, investment income includes income from a trade or a business, typically operated under an S corporation, partnership or LLC structure, where an investor or a shareholder is not an active participant in the business. For example, cases where family members are shareholders in a business but not actively working in the business on a regular basis fall under this tax provision.
Usually investment income consists of interest, dividends, annuities, rents, royalties and portfolio gains. The above broader definition encompasses income arising from a trade or business, which is typically not considered to be investment income.
What does this wide definition of investment income for this tax provision tell us? It shows that Medicare tax could gouge a much larger swath of income than some business owners are envisioning. This holds especially true for passive investors in a number of different business entities.
By holding a passive interest in businesses, investors may be subject to a 3.8% tax on their earnings from 2013 and beyond. For an investor with passive income of $200,000 a year, this tax liability can amount to $7,600.
Before panicking or blowing your top, there is good news for taxpayers who find themselves in this situation. Under the Tax Reform Act of 1986, taxpayers are permitted to structure and conduct their business activities in a way that enables them to benefit from the passive activity loss rules. These rules were developed to decrease the use of abusive tax shelters that were meant to allow passive investors to generate losses, then allowing investors to offset other gains.
However, the rules have other consequences. For example, investors can group business activities so they can potentially be treated as a single activity for tax purposes; the effect can cause an investor to look more active than passive. If the grouped investments appear to be active instead of passive, the new 3.8% Medicare tax will not apply.
In order to be categorized as an active investor rather than a passive investor, a taxpayer needs to satisfy at least one of several tests. The IRS covers the question from various angles to determine whether a given taxpayer is a true active participant in the business based on several factors. The factors considered are the following: how many hours spent working in the business, how many hours others spent, and how active the taxpayer has been with the business in the past.
When a taxpayer groups their business interests together, the activity level can be looked at on an aggregated basis as well. This makes it easier for the taxpayer to meet the standard for being ”active.”
To add another layer to the testing, the IRS also provides some tests for determining what kinds of businesses may be grouped based on how similar or dissimilar the businesses are. They are also grouped by how they are controlled, how they are owned, where they are located and how independent they are.
While it can be a complex formula for determining where passive business investments can be eligible for grouping, the exercise is well worth the effort if it means avoiding the onerous new tax.