Business owners pay Medicare taxes on their salaries while those who are self-employed pay Medicare tax on their net earnings from self-employment. Whether salaried or self-employed, owners may also pay additional Medicare taxes. These additional taxes are handled as if they were income taxes. Understand what these taxes are, how to deal them, and proposals that would increase the tax burden on successful small business owners.
Additional tax on earnings from personal services
There is a 0.9% tax on salaries and net earnings from self-employment above a threshold amount that’s based on modified adjusted gross income (MAGI), which is dependent on tax filing status: $250,000 for joint filers, $125,000 for married persons filing separately, and $200,000 for all other filers. These dollar amounts were first effective in 2013 and are NOT adjusted annually for inflation. This means that as earnings grow—especially in light of inflation—more and more owners may become subject to this tax. If that $250,000 threshold that began in 2013 were reflected in 2023 dollars, it would be over $325,000. Find more details about the 0.9% additional Medicare tax in the instructions to Form 8959.
For employers, you must withhold this tax from employees’ paychecks once their taxable compensation exceeds $200,000, regardless of their filing status. However, there is no employer matching of the additional Medicare tax as there is with the Medicare tax that’s part of FICA.
Net investment income tax
There is also a net investment income (NII) tax when unearned income exceeds a set amount. The NII tax is yet another Medicare tax, which is 3.8% on the lesser of net investment income or MAGI over the threshold amounts listed above. For business owners, investment income includes income from a business in which the owner is a passive investor (i.e., does not materially participate in day-to-day activities), as well as net gains from the sale of a passive partnership or S corporation ownership interest.
Proposals to broaden these extra Medicare taxes
The Administration’s budget proposals released last March include applying the NII tax to active business income. More specifically, NII tax income would include:
- Ordinary income from S corporations in which owners materially participate
- Ordinary business income from limited partnerships or limited liability companies to the extent limited partners or LLC members materially participate
- Other business income not currently subject to the NII tax or self-employment tax
As part of the proposal, the amount of business income subject to the NII tax would be a percentage—from zero to 100—depending on the owner’s adjusted gross income as it increased from $400,000 to $500,000 for joint filers and singles (half that for married persons filing separately). Material participation would mean working for a business at least 500 hours a year. This works out to a modest 10 hours a week for 50 weeks.
If enacted, owners of pass-through entities would pay either self-employment tax or the NII tax on their share of business income. What’s more, the additional Medicare tax rate would be increased from 0.9% to 1.2% for taxpayers with more than $400,000 of income (half that for separate filers). Bottom line…those with income over $400,000 would pay an additional 5% to Medicare.
This isn’t the first time such an expansion of the NII tax has been proposed. We’ll have to wait until a budget for fiscal year 2024 is finalized to know if there are any changes in the additional Medicare tax and the NII tax. The deadline for the federal government’s budget is set for April 15, but, as usual, Congress missed the deadline and the budget isn’t expected until the last minute (the 2024 fiscal year begins October 1, 2023).
Both Medicare-related additional taxes must be factored into estimated taxes for the year. The failure to do so can result in underpaying estimated taxes and having penalties result. Keep an eye on your income throughout the year, your estimated tax payments and/or withholding on wages if you have them, and the legislative proposals—all of which may impact your tax bill for the year and for years to come.