The Patient Protection and Affordable Care Act (PPACA) imposes an Additional 0.9 Percent Medicare Tax on earned income above specified dollar amounts. The 0.9 percent tax is imposed on individuals and does not apply to corporations, estates, or trusts. The tax on earned income is in addition to the existing 1.45 percent Hospital Insurance (HI) tax on earned income; thus a combined tax of 2.35 percent may apply to the employee’s earned income. Existing employer contributions of 1.45 percent also apply to earned income, for an overall combined rate of 3.8 percent.
The Additional Medicare Tax applies to an individual’s total wages, other compensation, and self-employment income for the tax year that exceeds specified thresholds, without limit. These thresholds are $200,000 for a single individual; $250,000 for married couples filing a joint return; and $125,000 for married filing separately. For married couples, the tax applies to the combined earned income of both the husband and wife, unlike the general 1.45 percent HI tax that applies to wages and other earned income of individuals. This apparently is taking many two-earner families by surprise.
For passthrough entities, the Additional Medicare Tax applies to earned income that is paid or that passes through the individuals holding an interest in the entity. As a practical matter, partnership income that flows through to a general partner is treated as self-employment income. If this income (or this income plus other earned income) exceeds the applicable thresholds, the 0.9 percent tax applies. However, partnership income allocated to a limited partner is not treated as self-employment and would not be subject to the 0.9 percent tax. Furthermore, income that flows through to S corporation shareholders is currently not treated as earned income and would not be subject to the tax, although there have been proposals to change this treatment of S corporation income.
Withholding of the Additional Medicare Tax is imposed on an employer only if an employee receives wages from the employer that exceed $200,000 for the year. Even if the employee is married, and the applicable threshold is $250,000, the employer must start withholding at the $200,000 threshold. The employer is not responsible for determining whether the employee is married. The employer can also disregard any wages received by the employee’s spouse.
The penalty for underpayment of estimated tax applies to the Additional Medicare Tax. Thus, even though an employer does not have to withhold on an employee whose income is $200,000 or less, the employee may be responsible for estimated tax if the employee’s income – whether wage income, self-employment income, or both -- combines with the spouse’s income to exceed the applicable $250,000 threshold on married couples.
In response to the Additional Medicare Tax, some business owners might consider setting up their business entity as an S corporation, rather than as a partnership, so that the entity’s income allocable to owners is not treated as earned income. If an entity is operating as a partnership, the owners could convert it to an S corp. Also to be considered is maximizing the amount of compensation that can be contributed pre-tax to a qualified retirement savings plan. Such amounts are not subject to employment taxes, including the Additional Medicare Tax, at the time of contribution or at the time funds are later distributed in retirement.
If you have any questions about the Additional Medicare Tax or would like to discuss planning techniques, please contact our office.
IRS Circular 230 Disclosure
Pursuant to U.S. Treasury Department Regulations, information contained in this article is not intended by TOPC Potentia P.C. to constitute a covered opinion pursuant to regulation section 10.35 or to be used for the purpose of (i) avoiding tax-related penalties under Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any tax-related matters addressed herein.