The New Medicare Surtax: Will You or Your Special Needs Trust Be Affected in 2013?

by: Begley Admin

The Voice is the email newsletter of The Special Needs Alliance. This installment was written by Special Needs Alliance member James M. McCarten, at the Nashville, Tennessee law firm of White & Reasor, PLC, where he focuses on estate planning, general tax matters and counseling families on special needs planning. Mr. McCarten has been listed in The Best Lawyers in America since 2003 in several categories, is a Fellow in the American College of Trust and Estate Counsel, has served as the Chair of the Tennessee Bar Association’s Tax Section, and serves on the Boards of The ARC of Davidson County, Tennessee and the Autism Society of Middle Tennessee. You can learn more about Jim, his firm and his practice at www.whitereasor.com.


The New Medicare Surtax:  Will You or Your Special Needs Trust Be Affected in 2013?

When Congress passed the President’s health care reform initiative in March of 2010, the legislation came in two separate bills. First came the Patient Protection and Affordable Care Act (PPACA), followed by the Health Care and Education Reconciliation Act (HCERA) several days later. One focus of the HCERA was to implement the tax provisions designed to pay for healthcare reform. Several cases are pending in various federal courts challenging the constitutionality of the PPACA, but even if the courts eventually were to declare the PPACA to be unconstitutional, the non-insurance tax provisions in the HCERA will apply to taxpayers, including the disabled beneficiaries of special needs trusts (SNTs) and/or SNTs themselves. Like most taxes, the financial impact of the new tax in the HCERA can be minimized with proper planning. What follows is a very brief overview of the new tax, some general planning opportunities, and a brief discussion on how the tax will apply to SNTs.

Who Will Be Subject to the New Surtax?

One of the largest tax increases arising out of the President’s health care reform initiatives is a new tax on the qualified unearned or passive income of individuals, trusts and estates. That tax begins January 1, 2013, will be imposed at a 3.8% rate and is designated as a Medicare contribution tax (the Medicare surtax). Initially advertised as applying only to high income individuals, the Medicare surtax also applies to estates and trusts once the taxable income reaches the top marginal tax rate. Estates and trusts reach the threshold for taxation at the top marginal rate with far less income than individual taxpayers. In 2011, a trust hits the top marginal income tax rate as soon as its taxable income exceeds $11,350. While this threshold is indexed for inflation, that amount is not likely to change significantly by 2013. As a result, even though no one would describe most SNT beneficiaries as wealthy, some SNTs will end up with income subject to this new tax.

In contrast, individuals will be subject to the new tax only if they receive passive income during a year in which their modified adjusted gross income (MAGI) exceeds a certain threshold. For single individuals, the MAGI threshold is $200,000. For married individuals, the MAGI threshold is $250,000. ($125,000 for married individuals filing separately). When an individual’s MAGI exceeds the applicable threshold, and he/she received passive income during the year, the Medicare surtax will be assessed against the lesser of the taxpayer’s net investment income or the amount by which the taxpayer’s MAGI exceeds the applicable threshold above.

Scheduled Tax Rate Changes in 2013

So what do all these new rules, terms and alphabet soup actually mean for taxpayers? The so-called Bush era income (and estate) tax cuts are scheduled to expire after December 31, 2012, reverting to the rates that existed prior to 2001. If the income tax cuts do expire, the top marginal tax rates will affect relatively few individuals but many irrevocable trusts. At the end of this article is a chart showing the top 2012 and 2013 tax rates, with and without surtax, on various types of income: earned, taxable interest, dividends and capital gains. Investment income is precisely the type of income traditionally earned by a trust, and as the chart demonstrates, the tax rates applicable to most types of investment income will increase to nearly 40%. Add in the new 3.8% Medicare surtax, and the top marginal rates applicable to most forms of passive types of income jump to nearly 45%.

Passive Income Subject to or Exempt from the Surtax

What types of income are unearned or passive income for this new Medicare surtax? Generally, these are what one normally would consider investment income. The definition specifically includes interest, dividends, royalties, annuities, rents and capital gains. It also includes gross income from businesses in which the taxpayer is not actively involved. A good rule of thumb is that if the income is subject to self-employment tax or FICA tax, it is not passive income. Almost everything else is treated as passive income. For planning purposes, distributions from regular IRAs or qualified plans as well as distributions from Roth IRAs will not, themselves, be subject to the tax. However, taxpayers must recognize that distributions from regular IRAs and qualified plans will increase the taxpayer’s MAGI, so such distributions must be reviewed when planning to avoid this new tax.

Deductions, Keeping Schedules and Estimated Taxes

The deductions available for reducing the Medicare surtax base are not yet fully clear. Most advisors believe that a taxpayer’s gross passive income should be reduced by all deductions properly allocable to that income, including capital losses, passive losses and investment interest expenses, to name a few. The IRS will likely issue written guidance on these deductions as we get closer to 2013. Still, taxpayers should be aware that the preparation of tax returns is about to become even more complex. For example, passive losses may be limited or suspended for regular tax purposes but should be fully deductible for the Medicare surtax. Thus, taxpayers will need to keep schedules based upon the type of taxes to which the taxpayer is subject (regular income tax, Medicare surtax and the alternative minimum tax).

When planning for this new tax, advisors and trustees must understand that it applies to all passive income earned beginning as of January 1, 2013. Just like the regular income tax, the new Medicare surtax will be subject to the estimated tax requirements and its penalty provisions. Thus, if, when returns are filed on April 15, 2014, the tax ends up being due for the 2013 tax year and the taxpayer’s estimated tax payments did not anticipate that extra tax amount, penalties will be assessed.

Planning Ahead

Much like the regular income tax, certain types of investment income are tax-favored for purposes of the Medicare surtax. Specifically, municipal bond interest, tax-deferred growth in individual retirement accounts and other retirement plans, as well as cash value buildup in life insurance are exempt from this tax. Nevertheless, trustees should first consult with their certified financial planners, CPAs and/or other tax advisors before moving significant portions of an investment portfolio into such investments.

Tax planning with regard to the Medicare surtax will focus on two primary concepts: (1) managing the timing of income which increases the taxpayer’s MAGI, and (2) managing when the taxpayer recognizes passive income. In other words, how much income is recognized in any one year and thus might be subject to the tax. Trustees and financial planners must explore traditional tax planning strategies for the deferral of income, whether applied to the taxpayer’s passive income or other types of income, in order to reduce the taxpayer’s MAGI. Tax deferred annuities will likely help manage the amounts of taxpayer’s income, both regular income and passive income, recognized in any single year.

Special Needs Trust Tax Planning

For trustees of special needs trusts, the primary planning issue is who will report the income. If the trust is a first-party SNT (created to hold the beneficiary’s own funds, such as the proceeds from a lawsuit or an unrestricted gift or inheritance), the trust is taxable as a grantor trust. This means that the income is actually reported on the beneficiary’s tax return, at which point it is the beneficiary’s MAGI which serves as the threshold for application of the tax. If the trust is a third-party SNT (created as part of the parents’ or grandparents’ estate plan and funded with their assets), the trustee must determine whether the trust income is being accumulated or distributed.

If the income is being accumulated, it will be taxable to the trust at the higher marginal estate and trust tax rates. If some or all of the trust income is being used for the benefit of the special needs beneficiary, that income will be reported on the tax return of the beneficiary and the tax analysis will be similar to that of a first-party SNT. Planning opportunities are available in both circumstances, but the planning is so vastly different that trustees should consult and work closely with their tax advisors.

While the President and Congress meant this new tax to apply only to the wealthy, the Medicare surtax unfortunately may adversely impact the beneficiaries of third-party SNTs with accumulated passive income in excess of $11,350 annually. While most SNTs will not fall into this category, it is unfortunate that these beneficiaries with disabilities, who are among those meant to benefit from healthcare reform, will be among those who will bear the burden of paying for these much needed benefits.

How High Will Rates Go?

Type of Income 2012

(Pre-Expiration of the Bush-era tax cuts)


(Post-Expiration of the Bush-era tax cuts)


(Adding the new Medicare Surtax)

Earned Income 35% 39.6% 40.5%*
Taxable Interest 35% 39.6% 43.4%
Dividends 15% 39.6% 43.4%
Capital Gains 15% 20.0% 23.8%

* This figure does not include the already existing Medicare surtax on wages (1.45% paid by employee) or self-employment income (2.9%).

About this Newsletter: We hope you find this newsletter useful and informative, but it is not the same as legal counsel. A free newsletter is ultimately worth everything it costs you; you rely on it at your own risk. Good legal advice includes a review of all of the facts of your situation, including many that may at first blush seem to you not to matter. The plan it generates is sensitive to your goals and wishes while taking into account a whole panoply of laws, rules and practices, many not published. That is what The Special Needs Alliance is all about. Contact information for a member in your state may be obtained by calling toll-free (877) 572-8472, or by visiting the Special Needs Alliance online.

Reprinted with permission of the Special Needs Alliance –www.specialneedsalliance.org.