There’s been much discussion about “taxing the rich” and making them “pay their fair share.” What may get lost in the discussion are the special taxes already being levied on certain higher income taxpayers—which include many small business owners—in addition to regular federal income tax. One of these special taxes is on earned income and the other on investment income (with certain adjustments). Understanding them is important (1) to better project estimated taxes each year and (2) to have a realistic take on what is actually paid by affected taxpayers. This is especially important for small business owners, who may be hit with one or both taxes, although not on the same income.
Additional Medicare tax on earned income
There is a 0.9% tax on wages and net earnings from self-employment of “high-income taxpayers.” These are single filers with modified adjusted gross income (MAGI) over $250,000 for joint filers, $200,000 for singles, and $125,000 for married persons filing separately. These MAGI limits are not adjusted for inflation, which means as income swells due to rising earning levels (in part because of inflation), more and more taxpayers become subject to the tax. The additional Medicare tax on earned income went into effect in 2013. If the MAGI threshold had been adjusted for inflation, then in 2022 they would be $313,680 for married filing jointly, $250,944 for singles, and $156,840 for married filing separately.
This tax is in addition to the regular Medicare tax of 1.45% for employees and 2.9% for self-employed individuals. But there are differences between the basic Medicare and additional Medicare taxes:
- For self-employed individuals, there is no deduction for one-half of the additional Medicare tax as there is for one-half of the basic Medicare tax.
- For married couples, while the basic Medicare tax is levied on each spouse’s earnings, the additional Medicare tax is on their combined earnings.
- For employers, the obligation to withhold the additional Medicare tax applies when an employee’s wages from an employer exceed the limit for someone who is single, even if the employee is married.
- Employers do not pay the additional Medicare tax; it is paid solely by the person with the earned income.
Only earned income over these limits is subject to the additional tax. What does this mean for small business owners? C corporation shareholders only pay this tax on salaries and other taxable compensation they receive from their businesses. For owners of pass-through entities, earned income includes their share of profits if they materially participate in the businesses (i.e., they’re active and not mere investors). In contrast, the distributive share of profits for those who are “silent partners” or other investors is not earned income.
Additional Medicare tax on investment income
In addition to the extra Medicare tax on earnings, there is a 3.8% additional Medicare tax on certain unearned income. The additional tax is levied on the lesser of net investment income or MAGI over $200,000 for singles, $250,000 for joint filers, and $125,000 for married persons filing separately. These are the same MAGI threshold applicable to the additional Medicare tax on earned income; they are not indexed annually for inflation.
Net investment income is the difference between certain income—interest, dividends, annuities, royalties, rents (other than derived from a business), and other income from a passive activity, and deductions related to investment income. Gain on the sale of a principal residence that is excludable ($250,000 for singles and $500,000 for joint filers) is not treated as investment income for this purpose. According to the IRS, dividends paid to owner-employees of corporations are always investment income, regardless of whether the owner-employees are active or passive in the business.
The additional Medicare taxes on earned income and net investment income are on top of small business owners’ regular income tax. Total taxes mount up for successful small business owners. The IRS has FAQs on these taxes, which clarify a number of issues.