Were you one of the millions of Americans who paid the new 3.8% Medicare Tax in 2013?
If you are a single filer with adjusted gross income in excess of $200,000 or a couple with adjusted gross income over $250,000 and you had dividend, interest, rents, capital gains, passive activities or annuity income it’s likely that you did. While this new tax is affecting higher income individual taxpayers it doesn’t take nearly as much income to subject a trust or estate to the same Medicare Tax. In fact, if a trust or estate’s 2013 adjusted gross income was over $11,950 and has what’s defined as “net investment income” it probably paid Medicare Tax.
Defining “net investment income” can be tricky.
Net investment income includes the basics such as interest, dividends, net rental income, capital gains and annuity income but as in most cases with tax law, there are exceptions. Some of the exceptions that apply to an individual are not going to apply to an estate or trust. For example, if an individual has capital gains on the sale of a partnership interest and that individual was actively involved in running the partnership the 3.8% tax will not apply. The same holds true for the sale of S corporation stock if the shareholder was an active owner in the S corporation. In the case of a trust or estate, rarely will the entity be treated as materially participating in a business. Unless this is the case the capital gains exclusion afforded to individuals is not going to apply. Most of the time the income of a trust or estate is going to be net investment income and will be subject to the additional 3.8% Medicare Tax.
How does a trust or estate differ from an individual?
Net investment income is computed for a trust or estate the same way as for an individual but there are a few deductions that a trust or estate receives that an individual does not. Charitable contributions, distributions to beneficiaries and costs for administration of the estate or trust that would not have been incurred if the property was not held in a trust or estate are deductible. These costs include trustee, executor, attorney and accountant fees. Costs that are subject to a 2% floor, i.e., costs that are not specifically incurred because the property is held in a trust or estate are also deductible to the extent they exceed 2% of the adjusted gross income of the trust. Investment advisory fees are one example of this type of expense.
Minimizing the new Medicare Tax
So there are definitely ways to lower adjusted gross income and eliminate or at least minimize the 3.8% Medicare Tax. A philanthropic individual may give the trustee or executor of their trust/estate the power to make unlimited charitable donations to specific charities. With proper planning the trustee or executor can make the donation prior to year end so not only fulfill the philanthropic goal of the trust/estate but also reduce adjusted gross income.
A planning method frequently used by individuals can be used for the costs required for the administration of the trust or estate. “Bunching” deductions by paying legal fees, trustee fees, etc. prior to year end may increase that deduction enough to make a real difference in adjusted gross income. Approaching it from the income side, instead of taxable interest income should the investment plan include tax free municipal bonds? Do stock investments result in significant dividends? Should the investments be reallocated so that appreciation is the goal rather than income. This can be a sensitive issue, especially if the income beneficiaries are different than the remainder beneficiaries, but should be considered.
Can the new Medicare Tax be eliminated?
While capital gains are typically retained and taxable to the trust/estate, the trustee or executor is normally able to distribute non-capital gain income to the beneficiaries. Distributions of income reduce both trust/estate adjusted gross income and net investment income. Keep in mind, distributions transfer net investment income to the beneficiaries and if taxable, the beneficiary will pay the tax. In that case it’s the beneficiary that may be subject to the 3.8% Medicare Tax. But if the beneficiary is in a lower tax bracket than the trust/estate this is the simplest way to reduce the combined tax of the trust and beneficiary and get the best result.
If you have an trust and estate tax planning needs or with net investment income issues please contact Sherry Radmore at 714.569.1000..
