It is safe to say that most Americans are aware of the recently enacted Health Care and Education Reconciliation Act of 2010. Because of the speed in which the Act was passed, and because of the wide-ranging scope of the Act (which spanned approximately 2400 pages), the full effects of the Act are still being discovered. A full summary of the Act is well beyond the scope of this article (and this newsletter), but one often overlooked tax provision is worth highlighting for passive owners of S corporations, LLCs and partnerships.
For the years beginning after 2012, the Act imposes a new 3.8% Medicare Tax on the unearned “net investment income” of individuals having an adjusted gross income of over $250,000 for joint filers and over $200,000 for all other taxpayers. The term “net investment income” includes gross income from dividends, interest, annuities, rents, and royalties other than income that is derived in the ordinary course of a trade or business. Therefore, items of dividends, interest, annuities, rents, and royalties that pass through an LLC, partnership, or S corporation to its members, partners, or shareholders, will retain their character as “net investment income” and will now be subject to the new 3.8% Medicare tax.
In addition, the definition of “net investment income” also includes the following:
a) Income from a trade or business if that trade or business constitutes a passive activity (under the IRS’ normal rules) with respect to the individual.
b) Any taxable gain (considered in computing taxable income) from the disposition of property other than property held in a trade or business which does not constitute a passive activity under the IRS’ normal rules with respect to the taxpayer.
As a result, the Act extends the Medicare tax, for the first time, to both investment income and the distributive share of the operating income of an LLC, partnership, or S corporation if the activity which creates that distributive share is a passive activity for that LLC, partnership, or S corporation.