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The Medicare surtax: Is it avoidable?

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One of the most annoying parts of the latest round of estate tax changes is the 3.8 percent Medicare surtax, enacted as part of the Affordable are Act (or ObamaCare) and taking effect last year. For trusts and estates, the 3.8 percent surtax is imposed on the excess of adjusted gross income over the dollar amount at which the highest trust/estate income tax bracket begins, or undistributed net investment income (NII), whichever is less.

So it’s really hard to avoid paying the tax one way or another. Who might bump up against the Medicare surtax? For 2014, the highest tax bracket is reached when a trust or estate reaches $12,150. Obviously, that’s not a very high number, so the surtax applies to an awful lot of trusts and estates.

The NII limit applies to any married couple with marginal adjusted gross income over $250,000. NII is defined as anything from three categories of gross income, each allowed to be reduced by deductions:

  • Gross income from interest, dividends, annuities, royalties and rents.
  • Gross income from trading in financial instruments or commodities, or a trade or business in which the client does not materially participate.
  • Capital gains.

The NII limit does not include tax-exempt bond interest, distributions from IRAs or qualified retirement plans, and business income.

Those easily reached limits made it very desirable for people to avoid the Medicare Surtax by distributing income to their children subject to the kiddie tax. Many clients have had the bright idea of avoiding this Medicare tax by transferring assets to their children, but the government is fully aware of that dodge.

The so-called “kiddie tax” was enacted by Congress to prevent parents from transferring income-producing assets to their children, thus shifting income from the parents’ higher tax bracket to the children’s lower tax bracket. It ensures that at least a part of the child’s unearned income can be taxed at the client’s highest marginal tax rate, obviating the reason for the transfer in the first place.

The kiddie tax was created in 1986 to keep parents from sheltering income by putting accounts in the names of their lower-taxed kids and has been updated over the years. At the moment, a child doesn’t have to pay taxes on any interest, dividends or capital gains up to $1,000. The child does have to pay taxes on the next $1,000, but usually at a much lower tax rate than their parents. The kiddie tax kicks in at $2,000: The earnings on anything above that are taxed at the parent’s top marginal tax rate, rather than at the capital gains rate.

As a way of avoiding the Kiddie Tax, the client can elect to include the child’s net unearned income on their income tax return as their own income. The Medicare surtax is one good reason not to do this, but there are other, pre-existing reasons against it as well.

If the client includes a child’s net unearned income as part of their own income, it will be surtaxed as part of NII. Unearned income of any person subject to the kiddie tax —anyone 19 or younger — will be taxed at the parent’s tax rate.

So it’s virtually impossible to avoid the Medicare Surtax by transferring pieces of a trust to the next generation. Is there another solution?

Marty Shenkman, in his “Nuggets” report to the Heckerling Estate Planning Conference, suggests complex trusts should consider the Medicare surtax issue as an opportunity to extend a bypass trust to all descendants, not just the surviving spouse. This would require that a separate income tax return be filed for the child, so that the child’s unearned income is not reported on the parent’s income tax return. If the child’s unearned income is reported on the parent’s return, the Surtax may still apply.

So that might help, but the Medicare surtax is not really an avoidable tax. It’s important for clients to understand that the best option is usually just to mitigate its effects; no one can make it completely go away.