Summary of the American Taxpayer Relief Act of 2012 – H.R. 8: Individual Income Tax, Estate and Trust Provisions

A. Introduction  

By a Senate vote of 89 to 8 and a House vote of 257 to 167, effective January 1, 2013 the American Taxpayer Relief Act of 2012 (the “Act”) permanently extends provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003, while extending and reinstating many previously expired provisions. The Act also permanently takes care of “patching” the alternative minimum tax (AMT). The Act temporarily extends many other tax provisions that had lapsed at midnight on December 31, 2012 and other provisions that had expired a year earlier. The Act’s nontax features include one-year extensions of emergency unemployment insurance and agricultural programs and postponement of automatic cuts in Medicare payments to physicians. In addition, it delays until March 2013 a broad range of automatic federal spending cuts known as sequestration that otherwise would have begun in January 2013.

Observation #1: According to the Congressional Budget Office (CBO), the previously enacted laws leading to the fiscal cliff had been projected to result in a 19.63% increase in revenue and 0.25% reduction in spending from fiscal years 2012 to 2013. However, the CBO projects that the Act eliminated much of the tax side of the fiscal cliff, citing an 8.13% increase in revenue and 1.15% increase in spending for fiscal year 2013. Adjustments to spending are expected to be reconciled in early 2013. The Act resulted in a projected $157 billion decline in the 2013 deficit relative to 2012, rather than the sharp $487 billion decrease projected under the fiscal cliff. The CBO estimated the above revenue forecasts before considering the effect of last minute sales of appreciated real estate and stocks and bonds by persons wanting to take advantage of the expiring 15% long-term capital gain tax rate; the actual revenue effect then may be higher than forecasted due to the effect of the acceleration into 2012 of significant taxable transactions. 

As cited in this Outline, the increase in revenue came from increased marginal income and capital gains tax rates relative to their 2012 levels for annual income over $400,000 ($450,000 for couples); a phase-out of certain tax deductions and credits for those with incomes over $250,000 ($300,000 for couples); an increase in estate taxes relative to 2012 levels on estates over $5 million; and expiration of payroll tax cuts (a 2% increase for most taxpayers earning under approximately $110,000). These changes would all be made permanent. A reduction in spending due to budget sequestration was delayed for two months under the Act and the debt ceiling was not changed, leading to further debate during early 2013.

Following are the more significant provisions of the Act and our Observations, pertaining to individuals and estates and trusts.

B. Ordinary Tax Rates for Individuals and Trusts

All the individual marginal tax rates in effect in 2012 are retained (10%, 15%, 25%, 28%, 33%, and 35%). A new top rate of 39.6% is imposed on taxable income over $400,000 for single filers, $425,000 for head-of-household filers and $450,000 for married taxpayers filing jointly ($225,000 for each married spouse filing separately). Taxable trusts will also be subject to a top tax rate of 39.6%.

The tax bracket increase for the highest income taxpayers is accompanied by the onset of an additional Medicare tax on earned income and net investment income, further increasing the effective tax rates for those making more than the above income thresholds, with these amounts not indexed for inflation.  The earned income portion of the additional Medicare tax is a 0.9% surtax on wages and self-employment income in excess of those levels.  Additional withholding will be required.  The net investment income portion of the additional Medicare tax is a 3.8% surtax on interest, dividends (qualified and non-qualified), rents, royalties, capital gains and income from passive activities. 

Observation #2: As depicted below, with the advent of the Medicare tax, there will be several different marginal tax rates on the type of income earned by those taxpayers whose taxable income exceeds the threshold amounts.


Type of Income    Marginal Income Tax Rate  3% Disallowance  Additional Medicare Tax Rate % Combined Marginal Tax Rate %
Wages   39.6   1.188   .9   41.69
Self-Employment Income over the FICA Threshold   41.76   1.188  .9   43.85
Interest, Royalties, Passive Income, Short-Term Capital Gains   39.6  1.188   3.8   44.59
Qualified Dividend and Long-Term Capital Gains  20  .6  3.8   24.4
Active Income, Pension Distributions, and Social Security Distributions  39.6   1.188   0 40.79
Capital Gains Related to Non-Passive Activities 20  1.188  0  21.188


The above assumes you are not subject to the Alternative Minimum Tax (AMT).

Observation #3:  Trustees should consider making distributions where permitted under a trust instrument to beneficiaries who are in a lower tax bracket and not subject to the so-called “kiddie tax regime.” For newly formed trusts, consider drafting the distribution provisions broadly, so to provide the trustee flexibility in making distributions.

C. Rescission of the Temporary Lower 4.2% Rate for Employees’ Portion of the Social Security Payroll Tax 

The 4.2% employee tax rate (in effect in 2011 and 2012) for the Social Security payroll tax was not extended by the Act and has reverted to 6.2% on the first $113,700 in wages. Payroll taxes have been the key funding component for Social Security, and the 4.2% lower rate of the past two years had forced the government to replenish Social Security with borrowed money. However, the 4.2% rate was always meant to be temporary. Employees will now pay 6.2% of their wage earnings, up to the maximum wage base, and employers also will pay 6.2% of their employees’ wage earnings (for a combined total tax rate of 12.4%), up to the maximum wage base.

Observation #4: Workers earning the national average salary of $41,000 will receive $32 less on every biweekly paycheck. The higher the salary (up to $113,700), the bigger the tax increase, and lower-wage employees will feel it most.  Self-employed persons will pay the combined rate of 12.4% (the 6.2% employee portion and the 6.2% employer portion) on their net earnings from self-employment, up to the maximum wage base; however, self-employed persons are generally allowed broader deductions against their self-employment income compared to employees, which could reduce the amount of self-employment income subject to the tax. Further, a self-employed person is able to deduct one-half of his/her self-employment tax for federal income tax purposes. Retirement plan contributions by employees and self-employed individuals are not deductible against the Social Security tax wage base. 
D. Capital Gains and Dividends

A new 20% rate applies to capital gains and dividends for individuals above the top income tax bracket threshold ($400,000 for single filers, $425,000 for head-of-household filers, and $450,000 for married taxpayers filing jointly ($225,000 for each married spouse filing separately)). The 15% rate is retained for taxpayers in the middle brackets. The zero rate is retained for taxpayers in the 10% and 15% brackets.

E. Phase-out of Itemized Deductions and Personal Exemptions

The Act brings back the personal exemption phase-out rules and the limitation on itemized deductions, but at income thresholds slightly higher than in prior years.  The personal exemption phase-out rules and itemized deduction limits will affect taxpayers with adjusted gross income above the following income thresholds:

  • $300,000 for married couples and surviving spouses
  • $275,000 for heads of households
  • $250,000 for single taxpayers, and 
  • $150,000 for married filing separately.

In 2013, the total amount of personal exemptions is reduced by 2% for every $2,500 (or $1,250 for MFS) by which the taxpayer’s adjusted gross income exceeds the applicable thresholds.

Taxpayers with adjusted gross income higher than the above-listed thresholds must reduce certain itemized deductions by 3% of the amount that AGI exceeds these thresholds.  However, itemized deductions cannot be reduced by more than 80% in total.  The itemized deductions limitation excludes medical expenses, investment interest expense, casualty and theft and gambling losses. The personal exemptions and itemized deductions phase-out is reinstated at a higher threshold of $250,000 for single taxpayers, $275,000 for heads of household, and $300,000 for married taxpayers filing jointly.

As an example of the above thresholds, a taxpayer filing a joint return with AGI of $500,000 and itemized deductions of $80,000, including $10,000 of allowed investment interest would calculate the limitation as follows:

 Adjusted Gross Income  $500,000
 Threshold Amount  (300,000)
 Excess  200,000
 Reduction at 3%  6,000
 Itemized deductions  80,000
Less-excluded amounts – Investment Interest  (10,000)
80% of itemized deductions less exclusions 56,000
Itemized deductions less reduction amount
Allowable deductions, greater of 80% of deductions or deductions less limitation amount $74,000

Observation #5: A taxpayer who has AGI close to the threshold limitations may want to try to remain just under these income amounts.  A taxpayer could consider a slightly lower IRA distribution (required minimum distributions must be distributed but any excess can be reconsidered), monitor capital gains (if self-employed), defer revenue collections or pre-pay expenses to reduce income.

Observation #6: Regarding additional tax provisions to be aware of in 2013, the Hurricane Sandy and National Disaster Tax Relief Act of 2012, as still being debated in Congress, is expected to provide tax deductions for disaster cleanup expenses which could provide meaningful benefits for affected taxpayers.  Hurricane Sandy legislative proposals in their current form would allow for a full deduction for expenses paid or incurred as a result of disaster cleanup, and increase the 50% limitation for charitable contributions to qualified disaster relief initiatives. The current legislation would relax retirement plan distribution rules by waiving the 10% penalty tax that would otherwise apply on an early withdrawal from a retirement plan by victims of Hurricane Sandy; the current maximum amount that can be withdrawn without penalty is $100,000 and the legislation would increase the amount that Hurricane Sandy victims may borrow from their retirement plans without immediate tax consequences. A worker retention credit provision would provide a credit for disaster-damaged businesses that continued to pay their employees' wages regardless of whether they performed services (i.e., the business was not operating, but kept paying employees). Eligible employers would be those who (1) had active businesses in the disaster area that were rendered inoperable due to damage caused by the severe weather and (2) employed no more than 200 employees per day during the year before the disaster. The credit would equal 40% of the employee's first $6,000 in wages paid between the date the business became inoperable and the date it resumed significant operations, but before March 1, 2013. Mitigation and preparedness tax credits are also included in the legislation which repurposes unused New York Liberty Zone tax credits (valued at approximately $2 billion) into a new tax credit available for expenditures related to mitigation and preparedness for individuals and businesses. Generally, the legislation’s provisions are applicable for all 2012 FEMA Major Disaster Declarations.

F. Alternative Minimum Tax 

Annually taxpayers have patiently awaited Congress’ approval of the Alternative Minimum Tax (AMT, a 28% tax rate) patch, hoping to avoid being among an estimated 60 million taxpayers subject to AMT. 
The exemption amount for the AMT on individuals is permanently indexed for inflation. Under the Act, for 2012 the AMT exemption amounts are $78,750 for married taxpayers filing jointly, $39,375 for married filing separately, and $50,600 for single filers. Relief from AMT for nonrefundable credits is retained to the full extent of the taxpayer’s regular tax and AMT liability.

Observation #7: Planning for AMT is a multi-tax year computation along with the consideration of facts and assumptions: the prior year (for current year estimated tax purposes), the current year, and the following year.  For example:

  1. You are subject to the AMT (at 28%) in the current year, but don’t expect to be next year; therefore, general considerations include: 
    • Deferring until next year any deductions that are not deductible for AMT purposes, 
    • Accelerating ordinary income into the current year to benefit from the lower 28% AMT rate, and
    • Delaying the exercise of any incentive stock options (“ISOs” or other current year AMT income adjustments or preference items), since you will be assessed AMT on the spread between the fair market value and the exercise price. If you already exercised the options, consider a disqualifying disposition.
  2. You are not in the AMT in the current year and will be taxed at the regular tax rate (above 28%), but expect to be in the AMT next year; therefore general considerations include:
    • Prepaying deductions that are not deductible for AMT purposes to obtain the full tax deduction benefit this year rather than lose the tax deduction benefit next year,
    • Prepaying your current-year fourth-quarter state and local income tax estimate by December 31 of the current year,
    • Prepaying deductions this year (that are deductible against the AMT), such as charitable contributions, to gain the benefit of the higher ordinary tax rate this year,
    • Deferring ordinary income, such as bonuses if possible, to next year to take advantage of the lower AMT rate, and
    • Reviewing your ISO plans to determine if you can exercise any shares before the end of the year (and other current year AMT income adjustments or preference items). The exercise will be tax-free this year up to the extent of the break-even point between your regular tax and the AMT.

G. The Act Resurrects the IRA Charitable Rollover for 2012 and 2013

Under the Act, only through February 1, 2013, taxpayers can still take advantage of the rollover provision, with also a retroactive effect for the 2012 tax year.   Provided that you and/or your spouse are over age 70 1/2, you can exclude from income up to $100,000 annually of an otherwise taxable IRA distribution that is transferred directly from your IRA (including an inherited or Roth IRA) to a qualified charity. The IRA charitable rollover can be used to satisfy your required minimum distribution.

Observation #8: If you made a direct contribution from your IRA to charity under this provision, you would not have any taxable income or deduction, which is effectively the same as withdrawing and including the distribution in income and receiving a full deduction for contributing the same amount to charity. 
You will benefit from the IRA Charitable Rollover strategy in the following situations; where you are:

  • Capped in making deducting charitable contributions due to AGI limitations,
  • Residing in a state that does not allow itemized deductions  such as New Jersey or Connecticut, or in  New York, where your itemized deductions may be severely limited,
  • Seeking ways in which to reduce your AGI to take advantage of other tax breaks or for other reasons you need to reduce your taxable income, or
  • Not itemizing deductions. With this strategy, a charitable deduction is not available.

H. The Act Expands In-Plan Roth Conversions

The Small Business Jobs Tax Relief Act of 2010 included a special Roth conversion opportunity that a plan sponsor may (but is not required to) offer to plan participants under its 401(k), 403(b), or 457(b) plan. Under this provision, an employee could elect to convert some or all of certain amounts that were contributed to a retirement plan on a pre-tax basis into a Roth after-tax account inside of the plan, which is known as an “in-plan” Roth conversion. However, the plan documents must specifically provide for Roth contributions and the in-plan conversion. Further, there is no re-characterization option for an in-plan Roth conversion, so once a conversion is made it is irrevocable.

Observation #9: Under the Act, any current or former plan participant who has an account balance in the plan and who is eligible to receive an eligible rollover distribution (“ERD”) could make the Roth in-plan conversion election. An ERD is triggered by a plan participant’s termination of employment, retirement, death, or permissible in-service distributions (as provided by the plan’s document).  The election is available to surviving spouses, but not non-spouse beneficiaries. There is no income limit or filing status restriction for this election. The conversion could be applied to any type of vested contributions (and earnings thereon) that were currently distributable and would be treated as an ERD. Contribution types that are eligible for conversion are: pre-tax 401(k), 403(b), and 457(b) deferrals; matching contributions; and profit sharing contributions.

This is a permanent provision, effective for transfers after December 31, 2012.

Observation #10: The Act eliminates the requirement that a participant’s account balance may only be converted through an in-plan conversion to Roth if it would otherwise be an ERD.  A 401(k), 403(b), or 457(b) plan that permits Roth elective contributions can now allow any amount in a non-Roth account to be converted to a Roth account through an in-plan conversion.  The plan participant will be required to pay income taxes on the amount converted to Roth for the year of the conversion.

Observation #11: It is important to remember that the plan’s document must provide for in-plan Roth conversions.  Given that only 10 to 15% of retirement plans currently contain Roth provisions, many plan sponsors will need to amend their plan documents in order for plan participants to be able to take advantage of this provision.  Additionally, plan sponsors will need to wait for IRS guidance regarding the form and timing of amendments to plan documents, as well as tax reporting and withholding guidelines.

I. Estate, Gift, and Generation-Skipping Transfer Tax Provisions

The unified estate, gift, and generation-skipping transfer tax regime in place since 2011 was made permanent, with the exception of a tax rate increase.  To summarize, the estate, gift, and generation-skipping transfer tax exemptions will remain at $5 million as indexed for inflation (i.e., $5.12 million in 2012), while the top estate, gift and generation-skipping transfer tax rate will increase from 35% to 40%, effective January 1, 2013.   The estate tax rate will be even higher for taxpayers residing in states with their own estate tax; for example, in states such as New York, with a top estate tax rate of 16%, taxpayers face a combined top federal and state estate tax rate of 49.6%. Also extended by the Act is GST provisions, including the deemed allocation and retroactive allocation provisions; clarification of valuation rules with regard to GST inclusion ratios; allowances for qualified severance of a trust; and relief from late GST allocations and elections.

The estate tax “portability” election, permitting a surviving spouse to “inherit” her deceased spouse’s unused estate tax exemption, was made permanent by the Act.  Furthermore, the Act made it clear that if a widowed spouse who inherits her deceased spouse’s unused estate tax exemption remarries and then dies, her surviving spouse can inherit her unused estate tax exemption and also her first spouse’s unused estate tax exemption, as long as together these exemptions don’t exceed the estate tax exemption effective at her death.

Observation #12:  Taxpayers who didn’t take advantage of the $5 million gift tax exemption in 2011 and 2012 didn’t lose out by not making large gifts in either of the past two years, as they can still do so in the future. Taxpayers who did make large gifts can still use any of their remaining gift tax exemption plus any future inflation-adjusted exemption increase to make additional tax-free gifts to their heirs.  Finally, taxpayers who wouldn’t otherwise be able to make annual exclusion gifts to generation-skipping trusts because they fully utilized their  generation-skipping transfer tax exemption with a $5.12 million gift last year, can still do so using the inflation-adjusted exemption increase.  These inflation-adjusted increases to the estate, gift, and generation-skipping transfer exemptions will become meaningful as they accumulate over a number of years.

Observation #13:  Some taxpayers who made large gifts using their gift tax exemptions in the past two years should keep in mind that they removed both the gifted asset, as well as its future appreciation, from their estate.  Furthermore, in certain cases, they may have leveraged the gift tax exemption through valuation discounts that would not otherwise be available at their death. 

Observation #14: The Act extends the deduction for state estate taxes; provisions affecting qualified conservation easements, qualified family-owned business interests, the installment payment of estate tax for closely-held businesses, and the repeal of the 5% surtax on estates over $10 million.  

J. Various Tax Provisions Scheduled to Sunset After 2012 Are Now Permanent

Marriage Penalty and Child and Dependent Care Credit Relief

The Act extended marriage penalty tax rate relief by increasing the 15% tax brackets for married couples to $72,500 from $60,550 (a tax savings of nearly $1,800).  The standard deduction for married couples was also increased to $12,200 resulting in an amount that is 200% more than that of a single filer.

The Act extends the child and dependent care credit. The current 35% credit rate is made permanent along with the $3,000 cap on expenses for one qualifying individual and the $6,000 cap on expenses for two or more qualifying individuals. The Act also extends permanently the Bush-era credit for employer-provided child care facilities and services. The Act extends permanently the adoption credit and income exclusion for employer-paid or reimbursed expenses up to $10,000 (adjusted for inflation) for non-special and special needs adoptions.   The adoption credit phases-out for taxpayers with a modified adjusted gross income that exceeds $189,710 in 2012.  In 2013, the phase-out is set to begin with modified adjusted gross income in excess of $191,530.  The 2013 limit on the credit is expected to be $12,770.  The Act extends the child tax credit of $1,000 permanently for each child under age 17.  This credit is not adjusted for inflation.

Observation #15: The amount of the child and dependent care credit under the Act will continue to be based on AGI, and is reduced by one percentage point for each $2,000 of AGI, or fraction thereof, above $15,000 through $43,000. Taxpayers with AGI over $43,000 are allowed a credit equal to 20% of employment-related expenses; without the Act provisions, the AGI range would have been reduced to $10,000 through $28,000.

Education Assistance Provisions

The Act extends permanently employer-provided educational assistance up to $5,250 annually.  This fringe benefit is excluded from an employee’s income and employment taxes; though the employer is allowed an annual tax deduction for qualified related expenses paid on behalf of an employee.

The Act made permanent the exclusion from income for the National Health Services Corps and Armed Forces Health Professions Scholarships.

The Act permanently suspended the 60-month limitation on the number of months during which interest paid on the student loan is deductible. The maximum allowable interest deduction is $2,500.  Further, the Act repeals the modified AGI phase-out range that would have limited the deduction, and allows voluntary interest payments to be deductible.

The Act extends the teacher’s classroom expense deduction allowing primary and secondary educators to deduct (above-the-line) qualified expenses up to $250 paid out-of-pocket and not reimbursed by the education institution, including books, certain supplies, equipment, and supplementary materials used in a classroom. This provision for relief is not permanent and is set to expire on December 31, 2013. 

Mortgage Debt Relief

Generally, cancellation of indebtedness income is taxable income unless otherwise excluded.  The Act extends through 2013 a provision excluding from income cancellation of mortgage debt on a principal residence of up to $2 million. This exclusion does not apply to vacation properties or rental properties.

Observation #16:  Homeowners who struggle to keep up with mortgage payments while their home has declined in value should consider restructuring their mortgages with their lender, keeping in mind long-term credit impairment.

Deductibility of Mortgage Insurance Premiums

Mortgage insurance premiums will be considered tax-deductible qualified residence interest through December 31, 2013 for those taxpayers with an AGI below $110,000.

Observation #17: This additional itemized deduction is also allowed for AMT purposes.
Transit Benefits

Employer-provided mass transit and vanpool benefits remain in parity with parking benefits, which under the one-year extension would increase the monthly exclusion from $125 to $240. 

Observation #18: These benefits are tax-free fringe benefits not subject to tax withholding.

K. Extension of Individual Credits Scheduled to Expire at the End of 2012

The Act allows the American Opportunity tax credit for qualified tuition and other expenses of higher education to be extended through 2017. This temporary education credit allows taxpayers to claim a tax credit on 100% of their first $2,000 of qualified tuition and related expenses. A credit of 25% will be allowed on qualified expenses of $2,000 (capped at $4,000) for a maximum credit allowance of $2,500 for each eligible student for the first four years of post-secondary education.

The Act extends the above-the-line deduction for higher-education tuition and related expenses through December 31, 2013 and is retroactive for the 2012 tax year. A maximum deduction of $4,000 is allowed for taxpayers whose modified adjusted gross income does not exceed $65,000 ($130,000 joint filers). A $2,000 deduction is allowed for taxpayers whose adjusted gross income exceeded $65,000, but did not exceed $80,000 ($160,000 for first time filers).

Observation #19: Taxpayers cannot claim in the same year that they claim the American Opportunity Tax Credit or the Lifetime Learning Credit. This rule also applies in cases where another taxpayer claims the American Opportunity Tax Credit of the Lifetime Learning Credit on the same qualifying student.

The Act extends a number of energy tax incentives, primarily directed to promote growth in the business sector. Among the credit extenders was an extension of the non-business energy property credit. This credit affords taxpayers who have not previously made energy efficient improvements to their existing residences to claim a credit of up to $500 ($250 for windows and skylights.)

Observation #20: This credit is a lifetime credit, thus any taxpayers who have already made energy efficient improvements and claimed the $500 credit will not be entitled to an additional credit.

L. The Hospital Insurance Tax on High-Income Taxpayers

In addition to the various provisions discussed above, some new taxes also took effect January 1 as a result of 2010’s health care reform legislation.

The employee portion of the hospital insurance tax part of FICA, normally 1.45% of covered wages, is increased by 0.9% on wages that exceed a threshold amount. The additional tax is imposed on the combined wages of both the taxpayer and the taxpayer’s spouse, in the case of a joint return. The threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case.

Observation #21: For self-employed taxpayers, the same additional hospital insurance tax applies to the hospital insurance portion of Self-Employment Contribution Act (SECA) tax on self-employment income in excess of the threshold amount.

Observation #22: Under current law a self-employed person deducts one-half of his/her self-employment tax; the additional 0.9% tax is not deductible. Earned income is defined as income derived from an individual’s labor, including wages, salaries, commissions or similar compensation.

M. Medicare Tax on Investment Income

Starting January 1, 2013 a tax is imposed on individuals equal to 3.8% of the lesser of the individual’s (and a trust’s and estate’s) net investment income for the year or the amount the applicable taxpayer’s modified adjusted gross income (AGI) exceeds a threshold amount. For estates and trusts, the tax equals 3.8% of the lesser of undistributed net investment income or AGI over the dollar amount at which the highest trust and estate tax bracket begins. The Medicare Tax was included in the Patient Protection and Affordable Care Act as signed into law by President Obama on March 23, 2010. While certain elements of the legislation took effect prior to December 31, 2012, the federal unearned income surtax is effective January 1, 2013. The 3.8% surtax is in addition to taxes imposed in 2013 on individuals, trusts, and estates. For married individuals filing a joint return and surviving spouses, the Medicare tax threshold amount is $250,000; for married taxpayers filing separately, it is $125,000; and for other individuals it is $200,000.

Observation #23: Net investment income means gross investment income reduced by deductions properly allocable to that income. Investment income includes income from interest, dividends, annuities, royalties, and rents, and net gain from disposition of property, other than such income derived in the ordinary course of a trade or business. However, income from a trade or business that is a passive activity and from a trade or business of trading in financial instruments or commodities is included in investment income.                                                                                                                                    

For individuals the tax is 3.8% on the lesser of net investment income (NII), or the excess of modified AGI over $250,000 if married, $125,000 if married filing separately, or $200,000 for all others; these amounts are not indexed for inflation.  For trusts and estates, the 3.8% surtax is imposed on the lesser of (i) undistributed NII, or (ii) the excess of adjusted gross income over a threshold amount.

Types of Unearned Income Subject to the Medicare Surtax



Capital Gains 




Income from a trade or business involving passive activities, and

Income from a trade or business involving trading in financial instruments and commodities.

Types of Income Exempt from the Surtax

Disposition of certain active partnerships and S corporations

Distributions from qualified plans

Tax exempt interest

The “non-taxable” portion of gains from sale of residences, but it does apply to the capital gains in excess of the tax exempted portion (i.e., over $500,000 of gain from sale of principal residence
for joint filing taxpayers), and

The disposition of property held in a trade or business.

Observation #24: The surtax applies to capital gains from sales that closed prior to 2013; therefore considerations should be given to electing out of installment sale treatment for pre-2013 sales.

Income Subject to the Surtax Is Called Net Investment Income

As stated above, a taxpayer is allowed to reduce the amount of gross investment income for expenses associated with earning that income. However losses in one category cannot offset income in another category (i.e., capital losses cannot offset interest income; those losses can only be used to offset capital gains).

The Surtax Applies to Income from LLCs and S Corporations

The surtax applies to income received by LLC members and S corporation shareholders only if the members and shareholders do not materially participate in the entities as defined in the Passive Activity Rules under IRC Sec. §469. Thus the distributive share of ordinary income from an S corporation to a shareholder who materially participates in the trade or business of the S corporation (including rental income for real estate professionals) will not be subject to the 3.8% Medicare tax. However, this income will be taken into account for determining the $200,000 and $250,000 income thresholds.
Other types of investment income flowing through the S corporation such as interest, dividends and rents will retain their character and will be subject to the tax regardless of active participation.

Observation #25: If AGI for a single individual is $275,000, then the excess over $200,000 would be $75,000 ($275,000 minus $200,000). Assume that this individual’s net investment income is $60,000. The new 3.8% tax applies to the smaller amount. In this example, $60,000 of net investment income is less than the $75,000 excess over the threshold. Thus, in this example, the 3.8% tax is applied to the $60,000. If this single individual had AGI of $275,000 and net investment income of $90,000, then the new tax would be imposed on the smaller amount: the $75,000 of excess over $200,000.
Real Estate Owners/Operators: Are Rents and Gains Subject to the Medicare Surtax?

No. If the ownership and operation of real estate you own is your sole occupation, then those activities are your “trade or business.” Income derived from a trade or business is not subject to the 3.8% tax. If the owner of rental properties has a “day job,” however, real estate investments are not considered as a trade or business, but are rather considered as investments, even if they are a major source of income.
Many realtors engage in business activities that are the “typical” selling, leasing and brokerage endeavors usually associated with the term “realtor.” If they also own rental real estate assets as part of their own personal investment portfolio, the net rents from that portfolio could become subject to the new 3.8% tax on net investment income, depending on AGI. (Per FAQ from National Association of Realtors)

N. The Medical Care Itemized Deduction Threshold

The threshold for the itemized deduction for unreimbursed medical expenses has increased from 7.5% of AGI to 10% of AGI for regular income tax purposes. This is effective for all individuals, except, in the years 2013-2016, if either the taxpayer or the taxpayer’s spouse has turned 65 before the end of the tax year, the increased threshold does not apply and the threshold remains at 7.5% of AGI.
O. Health Flexible Spending Arrangements

Effective for cafeteria plan years beginning after December 31, 2012, the maximum amount of salary reduction contributions that an employee may elect to have made to a flexible spending arrangement for any plan year is $2,500.

Observation #26: Additional medical expenses do not impact Health Savings Accounts.

This Outline was authored by EisnerAmper LLP’s Personal Wealth Advisors Practice and Employee Benefits Practice. The Outline is not intended to be a comprehensive analysis of the Act, but is a summary of the Act’s significant individual income tax and estate and trust provisions. We advise you to contact your tax and financial planning advisor to discuss how specific provisions of the Act will impact your tax, investment, business, and financial planning objectives and fact pattern. The information in this Outline should not be relied upon as, nor intended to provide, investment or tax or economic advice. This Outline also does not provide investment or tax or other advisory services. EisnerAmper LLP is a certified public accounting firm and is an independent member of Allinial Global


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