A significant change in tax law became effective on January 1, 2013 – the implementation of the 3.8% Medicare surtax on net investment income of individuals, estates and trusts.    This new tax came about as part of the funding provisions of the new healthcare legislation being phased in over the next few years.  The tax affects all estates and trusts with a low taxable income as well as individuals with incomes starting as low as $125,000 (married filing separately), $200,000 (single) and $250,000 (joint/surviving spouse).   With the imposition of this new tax, maximum federal tax rates for higher income individuals sky-rocket to as much as 43.4%!

For individuals, the tax applies to “net investment income” also called “unearned income” which is derived from deducting qualified investment expenses from gross investment income.  Taxpayers that meet the income thresholds and also have income from interest, dividends, annuities, royalties, rents, or capital gains will be subject to the tax.  Interesting planning opportunities are available for investors in pass-through entities, such as S-corporations, who might become subject to the tax due to the different types of income that generate from these entities and wind up on the shareholder’s individual income tax returns.

ImageSince the current provisions seem to exempt trade or business income from non-passive pass-through entities for exclusion from the tax, S-corporation shareholders in particular who are currently treated as “passive” will want to consider the possibility of changing the nature of their investment from passive to non-passive by increasing their material or “active” participation in the activity.   Taxpayers with more than one passive activity may be able to group similar passive activities, for which there is also common ownership and control or an inter-dependence between the activities, to meet the “active participation” requirements.  This grouping is done on the individual’s tax return itself and not at the entity level.  Investors who desire to take this route will want to ensure that they understand the time and managerial participation requirements put forth by the regulations.  Although the rules allow for a taxpayer to switch between passive and non-passive treatment from year to year, depending upon the individual circumstances applying to each tax year, careful structuring of the shareholder’s role in the pass-through entity is necessary to ensure that the taxpayer can defend the change in case of subsequent tax authority examination or audit of the taxpayer’s tax returns.   Taxpayers will want to discuss the passive activity and material participation rules with their CPA every year to ensure that the activities are treated correctly each year on the tax return.

Regardless of whether a shareholder is considered passive or non-passive, if they have outstanding loans to the corporation that are subject to either imputed or stated interest (typically a loan principal amount of $10,000 or more), the interest charged to the corporation and picked up by the shareholder will be considered subject to the new tax.  With this in mind, the corporation can review and revise the interest rate to current market rates, which are still at considerable record lows.  If possible, the company may want to refinance the shareholder’s loans through an unrelated funding source such as a bank, or possibly by factoring their receivables.  Otherwise, the shareholder can choose to convert all or a portion of the loan to additional paid in capital.  Many times capital contributions can be paid back as a tax-free return on investment once the company is in a position to do so.  As long as the principal loan amount is below $10,000, it typically is not subject to deemed interest.  Be warned however, that sometimes it is inadvisable to pay back shareholder loans, especially if the company has experienced net losses in prior years, as this may trigger other taxable income to the shareholder in turn negating the original purpose behind the effort of minimizing the 3.8% Medicare surtax in the first place.

Again, as with any tax planning strategy, these approaches should be carried out with care, in line with the bylaws of the corporation and properly documented.  Shareholders should not wait until year-end to discuss these issues with both their CPA and attorney to ensure that transactions are correctly structured as early as possible in the year.   Why not discuss these items with your tax preparer when you make your annual appointment this year?  You’ll be glad you did.

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