Avoiding the new 3.8% Medicare surtax

Feb. 1, 2013
Whatever rough riding may be ahead for the 2013 "tax rodeo," one mean bull has some sharp horns -- the 2013 Medicare surtax.

by Brian Hufford, CPA, CFP®

Whatever rough riding may be ahead for the 2013 "tax rodeo," one mean bull has some sharp horns -- the 2013 Medicare surtax.

Imagine selling your practice in 2013, only to discover that in addition to a large income tax bill, you owe an additional $20,000 for the 3.8% Medicare surtax on the gain. This is quite possible under the new law. In this column, we will analyze this new tax and provide an overview of strategies to minimize the impact.

The Affordable Care Act (ObamaCare) added a new 3.8% Medicare surtax on investment income for married couples who earn more than $250,000 (Modified AGI). This is in addition to any income taxes paid.

Investment income is defined as interest, dividends, annuities, rents, capital gains, passive income, and more. The definition of investment income seems as though it should be relatively straightforward, but like most tax law, the implementation can be quite complex.

For instance, under the law, income from an annuity is investment income, while income from an IRA is not. Municipal bond interest is exempt from the surtax, while taxable bond interest is not. With these two simple examples, one can quickly realize the need for extensive additional planning to minimize this new tax.

Contending with the Medicare surtax involves planning for two areas -- minimizing investment income, and lowering Modified AGI below the $250,000 married threshold. Neither of these strategies may be possible in many cases, but there is significant planning that can help most dentists.

The first wall of defense is a traditional deductible retirement plan such as a 401(k) or a cash balance plan. Under this new surtax, retirement plans are a double win. Distributions in retirement are not treated as investment income, unlike ordinary annuities or income from personal savings. Likewise, retirement plan deductions lower Modified AGI, possibly below the $250,000 limit.

At least for the time being, retirement plans such as 401(k) plans and cash balance plans are an effective tool to avoid the surtax. The new tax also makes saving outside the retirement plan arena, in either ordinary annuities or personal accounts, much less attractive because of the additional tax on investment income.

Since interest, rents, and passive income are defined as investment income subject to the surtax, there is some obvious planning potential that exists for many dentists. Rents for office buildings owned by the dentist and leased to the practice should be examined to minimize passive rental income. Large rents from the practice could convert business income to investment income, unnecessarily creating the surtax.

Increased depreciation deductions through cost segregation studies could limit passive income. Municipal bonds become much more attractive due to their exemption from the surtax. It is always important, though, to consider income and investment needs, as well as risks in addition to tax planning. Finally, all personal investing in stocks, bonds, and mutual funds should be put through a tax-efficient filter to minimize taxable dividends, interest, and capital gains.

The definition of investment income excludes certain types of income, in addition to tax-exempt interest, from the surtax. Income from the sale of a personal residence within the $250,000/$500,000 exclusion limit is exempt, as well as life insurance proceeds paid on account of death to a beneficiary, or additions to cash surrender value. Business income is also exempt (if not a passive activity). Proprietorship income from Schedule C for a dentist actively involved is exempt, as well as S Corporation income.

Under the new law, trade or business income -- which is exempt from the surtax -- includes proceeds from the sale of the dental practice under Sec. 1231 of the tax code. Certain Sec. 1231 gains receive capital gains treatment for income tax purposes, as well.

Some heavy factual issues create a need for expert tax advice related to the sale of a dental practice and the definition of investment income subject to the new surtax. Some of these thorny issues exist simply because of the choice of practice entity.

For instance, if a dentist practicing as a C Corporation sells the practice with a large component of "personal goodwill," is the personal goodwill investment income or business income? Personal goodwill likely is subject to the surtax as investment income.

Finally, this area of the tax law is highly complex, which creates the need for a thorough review by a capable tax advisor of your personal situation prior to implementing any strategies. New tax regulations and law changes may make some of the analysis and advice in this article moot or outdated due to the time between writing, publishing, and reading. These are the rules and risks of the rodeo. No clown provided.

IRS Circular 230 Notice: This communication and any federal tax advice contained herein is not intended to be used, and cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer or to promote, market or recommend to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.

Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064 or [email protected].

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