Starting in 2013, there are two additional Medicare taxes that can impact your business and you. What are they and what can you do about them?
The two additional Medicare taxes are:
- 0.9% on earnings (taxable compensation and net earnings from self-employment)
- 3.8% on the lesser of net investment income (NII) or modified adjusted gross income over a threshold amount ($200,000 for singles; $250,000 for joint filers; $125,000 for married persons filing separately).
The basic Medicare tax of 1.45% on the employee and the employer (2.9% on self-employed individuals) on all earnings continues to apply. The surtaxes apply only to workers; there is no employer matching (or "employer share" for self-employment tax purposes).
Additional Medicare tax on earnings
There are two considerations here: What you must do as an employer with respect to withholding for the additional Medicare tax on employees' wages and other taxable compensation (e.g., bonuses, tips, and taxable fringe benefits), and what you'll owe personally on your earnings.
Employer responsibility. You are required to withhold the additional Medicare tax when payments to an employee exceed $200,000 in a calendar year. This obligation is without regard to the employee's filing status or wages that may be paid by another employer. Withholding begins with the first paycheck that exceeds this threshold. For example, in November, a top salesperson's commissions put her at $210,000 for the year. You must start to withhold on the $10,000 (the amount over $200,000) and continue to withhold for additional payments through the end of the year. You are not required to give the employee any notification about the start of withholding for the additional Medicare tax, although it may be a good idea to do so.
An employer that fails to withhold the tax can be liable for it. What's more, even if not liable for the tax, the employer may be subject to penalties for failing to meet withholding, deposit, reporting, and payment responsibilities.
An employee cannot ask that you withhold more or less of this tax from his or her pay. However, if an employee expects to owe more than you are withholding, he or she can file a Form W-4 to request additional income tax withholding. This additional withholding can then be applied toward the Medicare tax obligation when the employee files his or her individual income tax return for the year.
Form 941 has been changed to add a new line (5d) for reporting the additional Medicare tax. However, on employees' W-2 forms, the regular and additional Medicare taxes are combined and reported on a single line.
Workers' obligation. Employees do not have to do anything; the onus is on the employer to withhold the tax.
Owner-employees in S corporations usually limit compensation to the Social Security wage base ($113,700 in 2013) in order to minimize payroll taxes, as long as such compensation is "reasonable." For them, the additional Medicare tax may not be an issue personally.
Self-employed individuals are subject to the additional Medicare tax on all of their net earnings from self-employment. They should include the amount of this additional Medicare tax in their estimated tax payments. There is no need to designate any portion of estimated tax payments that will be applied to the additional Medicare tax.
Learn more from the IRS landing page about this tax.
This tax impacts individuals with net investment income (investment income minus allocable investment expenses) who have sufficient modified adjusted gross income (MAGI). The same MAGI threshold for the additional Medicare tax on earnings applies for the NII tax.
Is business income considered investment income for the purposes of the NII tax? It depends.
Self-employment income is not treated as investment income. Income from an S corporation that is passed through to the owner is also exempt from investment income if the owner materially participates (i.e., is active in the business). However, if the owner is merely a passive investor, then income passed through is investment income. Passive income is determined using the rules for the passive activity loss limitations. Usually, this means you must work at the business for at least 750 hours during the year to be treated as materially participating. (There are also six other tests that can be used to determine material participation.) Find more information about the tests for material participation in IRS Publication 925, Passive Activity and At-Risk Rules.
Gains from the sale of interests in partnerships and S corporations are treated as investment income to the extent you were a passive owner. Thus, if you are active in the business and sell it, your gain is not viewed as investment income.
Caution: Even if business-related income is not treated as investment income, it is part of your MAGI. Thus, it can raise your MAGI above the threshold and trigger the NII tax on your investment income (e.g., from interest, dividends, royalties, capital gains, etc.).
Learn more from the IRS landing page on this tax.
Work with your tax advisor to ensure you are meeting your employer responsibilities for the additional Medicare tax on earnings. Also, determine what you can do to minimize or avoid the NII tax, such as increasing your participation in the business so your share of profits from the business is not treated as investment income.