Venable partners Brian O'Connor and Norman Lencz were quoted extensively in a BNA Daily Tax Report article on October 24, 2012, on the new 3.8 percent Medicare tax on investment income. The article derived most of its content from O'Connor and Lencz's recent webcast presentation on tax code Section 1411 for the American Law Institute CLE.
O'Connor said "The new 3.8 percent Medicare tax on investment income under the health care law is worse than the general self-employment or employment tax provisions already in place, in terms of the tax bite it will take on households over certain thresholds." The current Medicare tax allows employers and self-employed individuals to deduct the employer portion of the tax. O'Connor explained that "no such deductions will be available under the new Medicare tax on investments. The overall employment tax rate is less than the 3.8 percent Medicare tax, and that is even after a 0.9 percent increase in the employee portion of the tax."
O'Connor added that "The tax is historic, being the first time in history that employment type taxes have applied to investment income. Historically, they have only applied to wage-type income, so this truly is a revolutionary development in the tax law." He warned that the new tax will have "a pretty significant impact, particularly when you combine it with the expiration of the so-called Bush tax cuts. When combined with the Bush tax reductions disappearing, the tax rates on items such as interest, dividends, annuities, and royalties will rise to as high as 43.4 percent."
O'Connor further demonstrated that "Essentially, the new tax means that the 2.35 percent employee portion of the Medicare tax is not going to be deductible. The 1.45 percent attributable to the employer will remain deductible, while no portion of the 3.8 percent Medicare tax is deductible. Therefore the overall employment tax rate is less than the 3.8 percent, and that is even after the 0.9 percent increase in the employee portion." He concluded that "We're looking at pretty significant tax rates on typical ordinary investment type income."
Regarding passive activity loss principles of Section 469, Lencz suggested that "The passive rules are now very, very critical to this whole exercise. For instance, while a taxpayer can receive an income allocation from an S corporation in which he materially participates under Section 469 without being subject to the new 3.8 percent tax, IRS is not happy with situations where a taxpayer is not drawing a salary from an S corporation that would be subject to regular employment taxes."
Lencz proposed that "there are opportunities for a trust to distribute all its income to a beneficiary, so that the trust would receive a distribution deduction, and the $200,000 individual threshold would be at work rather than the trust's $11,600 threshold." He further illustrated that "The thresholds are not indexed for inflation, which is an easy way for Treasury to raise taxes annually, and which he said amounts to back door tax increases. While the tax is slated to hit the top 2 or 3 percent of income earners, over time it could pull in many more people, he said, just as the AMT has done."
Lencz concluded, saying "Spreading income over time could obviously help with the threshold amounts. Tax planners and taxpayers are saying that maybe they should be triggering capital gains now, or with family estate planning, move some income to children."