Medicare Contribution Tax: An ObamaCare Increase For 2013

Changes are coming in 2013. I’ve tried to make that clear over the last couple of months. If the world doesn’t end on Friday, we might get to find out. I’ve discussed the possible changes in 2013 tax brackets, the possible Estate Tax changes in 2013, and I’ve told you my biggest fear regarding the uncertainty surrounding the fiscal cliff negotiations on tax rates.

Now, in my latest installment, I’ll talk about the new Medicare contribution tax on unearned income, and its implications for those who manage and benefit from trusts and estates.

Starting in 2013, certain trusts and estates will be exposed to the new 3.8% “Medicare Contribution Tax.” Several factors will determine the extent to which this tax is actually imposed on a particular trust or estate under section 1411.

Here’s how it works. For the sake of clarity, I will discuss the applicability of the tax in the context of a trust. keep in mind, however, that the same rules apply to estates.

Hmm…I think a screw would have been more appropriate

First, some background on trusts

In many situations, trusts are not taxed at the entity level. For example, if a trust is a “grantor trust” all income earned in the trust is taxed directly to the trustor/settlor/grantor/trustee. All Revocable Living Trusts are grantor trusts. So that makes the new 3.8% tax inapplicable at the entity level for any of these “will-substitute” types trusts.

Since the income from the trust is taxable directly to the grantor, he will be responsible for paying the 3.8% tax on the lesser of his net investment income or his adjusted gross income in excess of $200,000.

Even in the situation of a nongrantor trust, most income is taxable to the beneficiaries of the trust, not the trust itself

If a trust pays all of its income out to beneficiaries each year (as is commonly the case with most irrevocable trusts, and always the case in the context of a QTIP trust), there should not be any additional taxes imposed at the trust level.

So, when will trusts need to pay the new Obamacare tax?

Trusts will need to pay the new 3.8% tax directly whenever all of the income in thew trust is not paid out directly to beneficiaries. Trusts that retain income will need to pay 3.8% on
1) the lesser of the trust’s Adjusted Gross Income for the year
2) the trust’s “undistributed net investment income” for the year
$11,950 (the highest projected tax bracket for trusts in 2013).

Again, this is not likely to be an issue for most trusts – where income is not taxed at the entity level. A trust’s taxable income is computed in part by deducting distributions made to beneficiaries.

More work for estate planning attorneys

Even if few trusts will be exposed to this new tax, it is important to note that the work that goes into preparing returns for certain trusts could increase. Section 1411 specifically does not apply to charitable trusts (such as CRATs and CRUTs). According to regulations proposed by the IRS, however, those preparing returns for these types of trusts will now be required to apply arduous computational rules to track distributions to non-charitable beneficiaries.

The bottom line is this – things aren’t getting any easier out there for taxpayers with these kinds of tax issues. I always recommend that you seek the advice from a qualified tax professional.

For more information, see this informative piece from Suzanne Sheir over at Northern Trust. H/T to Kurt Koehler, Senoir VP at Northern Trust, for pointing us to Sheir’s terrific article.