"Tax Tips: Additional surtax to increase burden," by Carl Grassi published in Crain's Cleveland Business

By CARL GRASSI

Published in Crain's Cleveland Business

June 11, 2012

Amid all the focus on rising income tax rates beginning Jan. 1, 2013, a new tax is set to go into effect at the same time for many taxpayers.

Like the expiration of the current lower tax rates on most types of income, this tax will become law on Jan. 1 of next year unless there is specific legislative or judicial action.

This new tax — the surtax — is essentially an additional Medicare tax and was part of the 2010 health care act. The surtax is a 3.8% tax on the investment income of people whose income exceeds certain thresholds described below.

While a 3.8% additional tax may not seem like a particularly onerous amount, add this to the significant increases in ordinary income, dividends and capital gains tax rates, and the total tax burden quickly rises to more than 50% for many types of investment income.

The surtax is imposed on the investment income of a taxpayer, but only to the extent that the taxpayer’s adjusted gross income (with some modifications) exceeds $250,000 (for married couples filing jointly).

In addition to typical investment income such as interest, dividends and capital gains, the surtax also is imposed on many other types of income familiar to business owners.

The term “investment income” for purposes of the surtax includes almost any income derived from passive business activities. For instance, allocations of business income from an S corporation, LLC or partnership will be subject to the tax unless the taxpayer is active in the business. This determination must be made with reference to a complex set of rules.

Although active owners of partnerships and LLCs will not be subject to the surtax, they still will be subject to a higher Medicare tax under another provision of the health care act. In general, allocations of partnership and LLC income to those who are active in the business are subject to self-employment taxes.

Although the Medicare tax on wages and self-employment earnings is currently 2.9%, the health care act added a 0.9% increase for taxpayers with income above the thresholds noted above, bringing the rate in line with the surtax rate.

LLC and partnership owners, therefore, in most cases will pay the 3.8% surtax if they are inactive in the business or the 3.8% self-employment tax rate if they are active.

Although there are many considerations in making a choice of entity decision, one option for active business owners would be to convert their partnership or LLC to an S corporation. An LLC owner will in most cases be subject to the surtax whether they are active or inactive.

If the business is operated as an S corporation, salary payments to the owner still would be subject to the higher Medicare tax, but allocations of business income to an owner who is active in the business generally would not be subject to the surtax.

For active C corporation business owners, the surtax provides one more reason to consider making an S election if it is possible, since the gain from the sale of stock of a C corporation will be subject to the surtax; the sale of LLC, partnership or S corporation equity interests usually will not be subject to the tax if the owner is active in the business.

One important exception to the imposition of the surtax is that distributions from most pension and retirement plans, including IRAs, are not subject to this surtax. This should be another incentive to maximize contributions to these types of plans.

Roth IRAs would be especially useful, because distributions are free from the surtax and do not increase adjusted gross income. Since a Roth conversion is generally taxable and would increase adjusted gross income in the year of conversion, consideration should be given to making such conversion in 2012 to reduce the exposure to the surtax.

Decisions about choosing or changing the type of legal entity for a business or whether to convert a retirement benefit to a Roth account should not be made on the basis of minimizing exposure to the surtax without thorough consideration of other business and personal factors, but the surtax should factor into those decisions starting now.

Mr. Grassi is president of McDonald Hopkins LLC.