This article was posted on Saturday, Feb 02, 2013

The Internal Revenue Service has issued massive preliminary guidance after two years of no guidance whatsoever relating to the details of the new healthcare laws starting January 1, 2013.

The tax aspects of this law is expansive and so complex that this will be the first of a multi-part series as to the regulations that attempt to explain the general operating rules under the new law and specific rules applicable to individuals, estates and trusts.  

Although there continues to be many unresolved issues surrounding the rules that go into effect on January 1, 2013 relating to the tax rates and the so-called “fiscal cliff,” the 3.8% surtax and other higher taxes on investment-type income and gains are a certainty for higher-income taxpayers who meet the thresholds explained below.

For tax years beginning after December 31, 2012, unearned income of individuals, trusts, and estates is subject to surtax on unearned income above defined income levels.

The surtax, also called the “Unearned Income Medicare Contribution Tax,” is 3.8% of the lesser of: 

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  • Net investment income
  • OR the excess of modified adjusted gross income over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case).

 The threshold amount is not indexed for inflation.

For an estate or trust, the surtax is 3.8% of the lesser of: 

  • Undistributed net investment income
  • OR the excess of adjusted gross income – Adjusted Gross Income over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.

For 3.8% surtax purposes, Net Investment Income is investment income less deductions properly allocable to such income. Investment income for the purposes of Obamacare is defined as: 

  • Gross income from interest, dividends, annuities, royalties, and rents.
  • Other gross income derived from a trade or business to which the Medicare contribution tax does apply, and
  • Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the Medicare contribution tax does not apply.

The 3.8% surtax applies to a trade or business only if it is a passive activity of the taxpayer or a trade or business of trading financial instruments or commodities. Investment income does not include amounts subject to self-employment tax.

Distributions from tax-favored retirement plans (e.g., qualified employer plans and IRAs) (Code Sec. 1411(c)(5)), or tax-exempt income (e.g. earned on state or local obligations) are not subject to the surtax.

The surtax does not apply to trades or businesses conducted by a sole proprietor, partnership, or S corporation (but income, gain, or loss on working capital is not treated as derived from a trade or business and thus is subject to the tax).

Gain or loss from a disposition of an interest in a partnership or S corporation is taken into account by the partner or shareholder as net investment income only to the extent of the net gain or loss that the transferor would take into account if the entity had sold all its property for fair market value immediately before the disposition.

The tax does not apply to nonresident aliens, or trusts where all the unexpired interests in which are devoted to charitable purposes, and trusts exempt from tax under Code Sec. 501. Charitable remainder trusts exempt from tax under Code Sec. 664. are also excluded from the surtax.

Gains that are not recognized for a tax year such as installment sales are not recognized in the current tax year but will be recognized in the following years when installments are collected.

Deferral or disallowance provisions used in determining Adjusted Gross Income (AGI) apply to the determination of Net Investment Income (NII), and example of which is the limitation on investment interest, and passive activity loss limitations);

Importantly capital loss deductions applied to current year capital gains is applicable in lowering capital gains subject to the surtax. In other words, carryover losses from prior years, including those prior to the new law are allowable deductions as applied under normal circumstances.

Peter Muffoletto is with Peter Muffoletto & Company and may be reached at (818) 346-2160, or you can visit us on the web at


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