How the Medicare Surtax Affects Planned Gifts

For upper-income taxpayers, income from planned gifts is subject to the new 3.8% Medicare surtax which takes effect January 1, 2013. The IRS has just issued interim guidance on the new tax. Here are some details on how the surtax will apply to planned giving.

Donors below the MAGI thresholds are exempt. The surtax kicks in when MAGI (modified adjusted gross income) is above $250,000 for joint returns and surviving spouses, $125,000 for married filing separately, and $200,000 for unmarried heads of households with qualifying dependent(s) and single taxpayers. The good news for taxpayers below the MAGI thresholds is that the Medicare surtax does not apply. When we speak below of various types of income from planned gifts being surtaxed, that only applies to taxpayers above the thresholds.

The Medicare surtax has two parts. The first part is an extra .9% tax on wages and self-employment income above the thresholds, which raises the Medicare tax on earned income for high earners from 2.9% to 3.8%. Just as there is no charitable planning against the current Medicare payroll tax,  this extra .9% will have little effect on gift planning. The second part is a 3.8% surtax called the Net Investment Income Tax or NIIT, which will be the focus of this article. This surtax is imposed on the lesser of (1) net investment income or (2) the amount by which MAGI exceeds the threshold.

Net investment income picks up planned gifts. There are three categories of net investment income subject to the surtax. Category 1 includes gross income from interest, dividends, annuities, royalties, and rents not earned in a qualifying trade or business. Category 3 includes capital gains (short-term or long-term) on the sale or other disposition of assets not held in a qualifying trade or business. The type of income planned gifts ordinarily produce will fall into Category 1 or 3. Note: Category 2 covers income from a trade or business involving a passive activity and trading in financial instruments or commodities, and will ordinarily not be applicable to planned gifts except for pass-through investments.

Surtax crosses regular tax brackets. For example, a couple who are married filing jointly with $100,000 in wage income and $200,000 of long-term gain on the sale of appreciated stock will be in the 25% tax bracket, with capital gains taxed at a lower rate of 15% (possibly rising to 20% in 2013). However, since their MAGI is $300,000, they are subject to NIIT on $50,000, which is the lesser of $200,000 in net investment income and $50,000 excess MAGI over the threshold ($300,000 - $250,000). This effectively raises their marginal capital gains tax rate from 15% to 18.8% (possibly 23.8% if the 15% rate rises back up to 20% in 2013). That makes giving appreciated property to charity more attractive.

Surtax may affect choice of gift assets. While other types of investments such as stocks, bonds, mutual funds, and certificates of deposit are subject to the surtax, qualified retirement plan distributions are exempt from the surtax. This will affect considerations regarding whether it is advisable to take a voluntary distribution from a qualified plan, which is exempt from the surtax, for purposes of putting it into a planned gift vehicle, which is not exempt from the surtax. Gains from sales of active business, S corporation, or partnership interests are also not subject to the surtax, but remain subject to regular capital gains taxes.

No charitable deduction for the surtax. Only properly allocable deductions paid or incurred to produce the income can be deducted for purposes of the surtax. That does not include the charitable deduction. However, subject to possible limitation in the ongoing fiscal cliff negotiations, the charitable deduction remains available for the regular income tax.

Gift Annuities are surtaxed on taxable portion. The ordinary income portion of the annuity will be surtaxed as Category 1. The capital gain portion is subject to surtax as Category 3 but can be spread over life expectancy under the same rules as for the regular income tax. This is the treatment afforded installment sales, and unfortunately the IRS guidance does not directly address gift annuities funded with appreciated property, but it seems to us the same principle applies. The tax-free portion is not subject to surtax.

CRTs are exempt but the CRT beneficiary is surtaxed. The charitable remainder trust itself is exempt from the surtax. However, the beneficiary is surtaxed taxed on the lesser of (1) the total amount of distributions for the year or (2) the current and accumulated net investment income for the CRT, with the accumulation starting after December 31, 2012. This means that the amount subject to surtax is not necessarily the same as the amount subject to the regular income tax. That’s because the CRT tiers of income approach takes into account income for all years of the trust, not just years after December 31, 2012. The good news is that the beneficiary is never surtaxed on more than their total distribution for the year, even if the CRT earns more than was distributed that year, such as a big capital gain on the sale of the donated property.

December 2012 offers a one-time planning opportunity for CRTs. It may make sense for CRTs to take gains in 2012 and delay taking losses from 2012 until 2013. That way capital gains taken in 2012 won’t be subject to surtax if distributed in later years, as they won’t be part of the accumulation base. That could be done as part of a portfolio rebalance. Likewise, efforts could be made to accelerate income from 2013 into 2012 and defer expenses from 2012 into 2013. However, with no control over the timing of dividend and interest income, and with investment fees needing to be paid when due, the window opportunity to shift income and expenses is more limited than shifting gains and losses.

PIF income is surtaxed. The beneficiary will be surtaxed on taxable distributions from a pooled income fund. The PIF itself is not exempt, and as a trust it may be surtaxed on short-term gains not distributed by the trust, if the trust’s undistributed net investment income exceeds $11,950 for 2013. Long-term gains retained by the pooled income fund and set aside for charity are excludable, as they are for the regular income tax. The IRS did invite further comments by March 5, 2013 on whether pooled income funds should be granted an exemption for administrative reasons, which would be very sensible, as under most PIF trust agreements both short-term and long-term gains are typically set aside for ultimate distribution to charity and any short-term gains are typically small amounts.

Nongrantor and testamentary CLTs are surtaxed on undistributed net investment income. Amounts distributed by a charitable lead trust to meet the charitable payout would escape the surtax. However, any excess would be subject to surtax at the trust level. The surtax threshold for trusts is the amount of income where the highest income tax bracket begins, only $11,950 for 2013. That could hit capital gains realized from portfolio rebalancing, as the capital gains tax does already, if those gains plus other income exceed what was distributed to charity.

Grantor CLTs are surtaxed on the donor. Grantor charitable lead trusts are exempt at the trust level but any net investment income passes through to the donor’s tax return, with no deduction for the charitable payout, in the same way as there is already no charitable deduction for the regular income tax imposed on the donor for grantor CLT income and capital gains.

RLEs are surtaxed on rental income. Typically, a retained life estate is for a home in which the donor continues to live and for which the donor receives no income, so there would be no surtax. But, in the rare case the home or farm is rented, that rent would be subject to surtax, unless the income comes from an active trade or business such as farming.

In summary, the Medicare surtax introduces additional complexity that gift planners will have to learn and adapt to in working with donors who may be subject to it. However, it strengthens incentives for charitable giving, particularly of appreciated property.

Additional reading:

IRS Proposed Regulations on the Net Investment Income Tax 

IRS Net Investment Income Tax FAQs (includes tax calculation examples) 

Gift Planning and the Medicare Surtax (with table of top tax rates)