Under Current Sections (of the Internal Revenue Code) 3101(b), 3111(b), and 1401(b), a 2.9% Medicare tax is imposed on all wages and self-employment income. Beginning in 2013, the Medicare tax on wages and self-employment income increases to 3.8% on wages in excess of $250,000 for a joint return, $125,000 for married taxpayers filing separately and $200,000 for single individuals.
In addition, Section 1411, enacted under the Patent Protection and Affordable Care Act, will impose a new Medicare tax of 3.8% on the lesser of net investment income or modified adjusted gross income exceeding $250,000 for married individuals filing joint returns, $125,000 for married taxpayers filing separately and $200,000 for single individuals.
Net Investment Income as described above, is investment income reduced by the deductions properly allocable to that income. Investment income includes gross income from interest, dividends, annuities, royalties and rents, but excludes those types of income if they are derived in the ordinary course of a trade or business that is not considered a passive activity for the income recipient and does not constitute trading in financial instruments or commodities.
With the application of the Medicare tax to net investment income to begin in 2013, there will be renewed interest in the use of an S-Corporation to avoid both the increased Medicare tax on wages and the new tax on investment income. Income from S-Corporations whose shareholders provide personal services would not be subject to the new Medicare tax because that income would not be considered investment income under Section 1411. A shareholder, who was active in the business, would probably be considered materially participating, and as a result, the shareholder’s distributive share would not be considered investment income. The use of an S-Corporation to avoid Medicare tax might become more of an everyday reality.
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