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Guest Article

The So-Called 3.8% Medicare Surtax: Unfit for Survival

By Alvin D. Lurie
January 21, 2014

A Tax Not Fit for Survival (In a Nutshell)

Section 1411 of the IRC, often erroneously called a Medicare surtax, is in actuality not that at all, and is rather in every respect a completely separate, full-blown, second income tax imposed on individual taxpayers, on trusts and estates, and indirectly on passive owners of interests in S corporations, LLCs and partnerships, on recipients of interests in qualified pension and other qualified plans and charitable remainder trusts inter alia -- an extraordinarily wide swath of taxpayers. This is no ordinary piece of income tax legislation, it is rather an extraordinarily complex tax that will prove very difficult and costly for taxpayers to comply with and for their professional advisers to provide the requisite guidance. It is remarkable that in so many venues, whether in the broad press for the general readership or in technical journals for the professional practitioner, the Medicare label is so glibly applied, as if no one sees the statute for what it actually is, namely not a payroll Medicare tax, rather an actual income tax. The source of this mislabeling is the statute itself, where it is titled "Unearned Income Medicare Contribution." Its revenues in fact are not dedicated to the Medicare Trust Fund, and go into the General Fund of the U.S. Treasury, like collections under the Internal Revenue Code generally, as the formal "Explanation" of section 1411 by the authoritative Joint Committee on Taxation explicitly acknowledges. See JCT Explanation, at p. 363.

This misrepresentation has doubtless been the principal reason why the tax has so far escaped public scrutiny and avoided any repeal attempts. It has been in force for the entire 2013 year and thereafter, imposing tax obligations in years beginning after 12/31/12 on the high-bracket taxpayers to whom it is addressed, notably the required inclusion of this new tax in and since the quarterly estimated 2013 income tax reports of taxpayers and, subsequently, in the filing of Form 1040 and other returns due in April 2014 and later. Most taxpayers potentially liable under section 1411 will be taken by complete surprise when and if they become aware of this new and costly tax levy. The time to spread the bad news to one's clientele is long past.

Even more problematic than the misleadingly false labeling of the tax is the establishment, as part of the Affordable Care Act, of a complicated, unbelievably difficult second income tax for the sole purpose of providing the government funds required to administer the health reform law, as long into the future as that legislation remains on the books. The federal government has almost endless ways to extract revenues from the public that would not have imposed on taxpayers generally the burdens and the costs (other than the tax dollars themselves) -- and on the government itself the huge compliance expenses -- that are entailed in this incredibly complex tax. It will spawn an entirely new and endlessly evolving body of law that has no other relation to health reform than to pay the government's bills for administering the Affordable Care Act. That in itself is a powerful reason to strike this tax from the law even if not a jot or tittle of the rest of the ACA were to be changed, except for substituting a different, self-enforcing revenue raising levy from among the array of excise taxes and fees that, with rate and other adjustments, could perform that function. Failure to go one such alternative route to the 3.8% tax can be said to have been a monumental miscalculation by the proponents of the ACA from the Oval Office to the leadership offices on Capitol Hill.

False Naming of Section 1411 as Medicare Tax: An Unlikely Survivor

Several months ago the Country was absorbed in the then-latest of many donnybrooks between the White House and the Republicans in Congress over endless aspects of the ACA, that latest one over the disastrous workings (or non-working) of the federal insurance exchanges. At that time almost everyone in America was unaware that a new killer income tax had come into effect. Very many still are: you could ask most anyone, even some tax cognoscenties, "What's section 1411?", and responses were likely to range from "section of what?" to a blank stare, almost no matter how high the responder is placed on a tax expertise scale.

That notwithstanding, Section 1411 is very much with us and an outsized presence on the national scene, imposing a 3.8% tax on the investment income of U.S. citizens and residents, which has been in effect since January 1 of 2013 for tax years beginning after 12/31/12. Because of the enormous complexity of determining that tax under the many fact patterns to which it applies, it could be among the most troublesome ever to be enacted in this country, as some surely have already discovered. Were it not for its occupying a niche below the radar screen of most Americans, principally due to its application only to relatively high-bracket taxpayers meeting income levels established in the statute, it is very possible (I might even say likely) that section 1411 would have drawn heavy fire from exposed taxpayers and their representatives in Congress, and that reaction could have led to its repeal, if not repeal of the entire ACA statute as a part of which section 1411 was enacted.

Survival of an Unfit Statute, and Four Improbable Factors Therefor

Regardless of one's views on the ACA as a whole, it is hard to justify inclusion within it of the so-called, falsely named 3.8% Medicare surtax, whose monumental complexity is grossly disproportionate, and thus unfit, to its very limited task of providing revenues to fund the government's costs of administering the health reform law. It is in fact a second income tax, as observed above, and imports into the ACA many of the difficult issues that are inherent in the present income tax, but adding its own complexities unique to the new tax, that are required to satisfy its special wrinkles.

Apart from its limited reach to just the top brackets and so of no direct concern to the overwhelming majority of taxpayers, I believe that four improbable and therefor unpredictable factors -- unrelated to the merits of the statute and to each other -- explain why their collective effect has been to enable section 1411 to remain on the statute books, free of any attack to this date: (1) a bizarre Supreme Court opinion by one man, Chief Justice Roberts, upholding the constitutionality of the ACA on a tortuous analysis that none of his colleagues agreed with; (2) the brouhaha that accompanied the calamitous opening of the federal insurance exchanges in October 2013; (3) the startlingly deceptive mislabeling of section 1411, (4) fear by the Republican leadership that, by appearing to support repeal of a tax that only hits high-bracket taxpayers, they will be vulnerable to Democratic charges of repeating the fatal Romney 47% gaffe during his successful run to win the Republican primary, when he was quoted as saying "We don't care about the poor" who pay no taxes.

My reasons for pointing to these four factors as the unwitting saviors of section 1411 are the following:

  1. Roberts' opinion as to the constitutionality of the ACA rested shakily on the "taxing" power of Congress, based on his ruling that, though the "penalty" for failing to observe the insurance mandate was deliberately so labelled by Congress, it was nevertheless a "tax" for constitutional purposes, notwithstanding that, in that same opinion -- in order to avoid the undesirable consequence of dismissing the case as premature for adjudication in the courts before the "tax" had actually become due from taxpayers (as specified in the federal Anti-Injunction Act) -- Roberts held, in complete contradiction to the first part of his opinion, that the "penalty" characteristics of the levy, as deliberately so named by Congress in the ACA, prevailed and must be respected in accordance with Congress's having explicitly used the "penalty" designation. See National Federation of Independent Business et al. v. Sebelius et al., 567 U.S. ___, 132 S. Ct. 2566 (2012).

    Roberts' opinion and the decision that rested upon it were completely unexpected by all the pundits. (Was it a legitimate application of King Solomon's biblical precedent of decreeing the splitting of the baby in half, or just devious pettifogging to keep this very high-profile and leading case on his Court's calendar? You be the judge.)

    If ACA's insurance mandate had led to unconstitutionality of that provision of the statute -- and it was one judge shy of the Court's so holding -- it is almost certain that section 1411 also would have fallen with that ruling, since the key severability principle would not have supported retention of a tax whose sole purpose was, without question, to contribute to the very considerable revenues needed to cover the enormous costs to the federal government of administering the ACA.

    To carry out its manifold responsibilities under the statute -- principally on the shoulders of three separate, giant administrative agencies (IRS, DOL and HHS), each with its own huge budget -- the section 1411 tax, and another lesser one that was indeed a payroll tax and boosted employees' and self-employed persons' shares of the health insurance payroll tax by 0.9%, were estimated by the Congressional Budget Office to deliver 20 percent of the required federal government costs to run the ACA, which the CBO projected to generate over $300 billion of additional tax revenues in the next 10 years. So that funding source was very instrumental to keeping Obamacare viable.

  2. The uproar over the monumental technical collapse of the initial rollout of the federal insurance exchanges, coupled with the early failure to sign up health insurance applicants in numbers anywhere close to the White House's glowing projections -- all the while that the chief occupant of the White House strove mightily to avoid having to admit blame for his misleading remarks as to the ability of health care policyholders to retain both their more favorable pre-ACA policies and their doctors, further compounded by his minimizing the disastrous functioning of the federal exchanges as merely some very short-lived software "glitches" -- drew not just the public's anger but even that of many of his staunchest fellow-Democratic supporters in Congress. That caused a swift and sharp drop in the public's view of the President's credibility generally and that of his Health and Human Services Secretary, Madame Sebelius. He was forced -- painfully, one can be sure -- to acknowledge fault and to reluctantly grant administratively what Republicans had been sharply calling for and what he had just as sharply refused, namely, a one year postponement of the effective date of the penalty for noncompliance with the individual health insurance mandate.

    All this to-do about the faulty performance of the exchanges obscured the real long-term problems with the Health Care legislation, high among which, I submit, is the unbelievably complex and costly means required to determine one's tax liability under section 1411. The totally unexpected insurance exchanges scandal produced such a preoccupation of the public with that aspect of the problems with the ACA as to distract attention from more seriously flawed elements of the law. The resulting failure of the media to throw light on section 1411 led directly to large-scale public ignorance of the law (and, may I add, with no slight intended to professionals in ACA-related fields, even to many of them), and, more surprisingly, even to Republicans bent on overturning the ACA, who appear to have said nothing about it in their many verbal assaults against the law. That very ignorance saved 1411 from public scrutiny and rage, and, at least for the present, even from remedial measures, let alone wholesale scrapping.

  3. The third of the specific reasons noted above that I contend are the main reasons for the section 1411 tax to have escaped repeal efforts so far -- and probably the most controlling one -- is its false labelling. It sailed into port flying false colors, titled a "Medicare contribution", which it very definitely is not; and there is little basis for doubting that was a conscious tactic by the draftsmen of the statute -- almost certainly on instructions from a "higher authority" -- with intention to slip it past "customs" (read "the public"). (Shades of the way drug smugglers move their illicit inventory across borders concealed in false carriers.) Section 1411 appears in the second of the two laws that together make up what has come to be called the Affordable Care Act, and was actually passed as part of that completely separate bill one week after the first bill. See the Health Care and Education Reconciliation Act of 2010, sec. 1422(a)(2). The first bill, the Patient Protection and Affordable Care Act, was 15 times longer than the second and included far and away the bulk of the health reform measures that were the principal claims of the supporters of the reform legislation, and, hence, its main objects of attention.

    The second act, which is largely a potpourri of lesser provisions, includes section 1411 under a title of that act named, inconspicuously, "Coverage, Medicare, Medicaid and Revenues," which is itself a catch-all grab bag of provisions. Its last subtitle is titled "Provisions Relating to Revenue"; and that, in turn, contains several miscellaneous sections unrelated to each other, imposing, among others, items styled "excise taxes and "fees." One section affects just the timing of a deduction for Medicare expenses. There are also several other assorted sections in that subtitle, one of which is titled "Unearned Income Medicare Contribution," that is the only section in the entire paired acts of the ACA that is relevant to this paper (as to which, more momentarily).

  4. The concerns of the Republican strategists now quite clearly appear to be to broaden their base so as not to continue to be seen as the party of the rich, whereby the GOP has continued to lose the hearts and minds -- and, hence, the votes -- of the majority of the electorate. In that way they hope to reverse the winning pattern by means of which the Democrats have corralled a majority of voters in the last two presidential elections. That could well be the principal reason the Republican leadership has so far refrained from employing, as ammunition for its continuing assault on the ACA, arguments underscoring the glaring vulnerability of section 1411, which impacts only high bracket taxpayers.

Stealth New Chapter of Internal Revenue Code

The ACA section titled Unearned Income Medicare Contribution (mentioned just above), buried deeply within the recesses of the ACA, is the section most directly related to the argument of this paper. It comprises an amendment of the Internal Revenue Code adding a new chapter 2A to the "Income Taxes" subtitle of the Code. It too is titled "Unearned Income Medicare Contribution". On close inspection one sees a section which, like many other income tax provisions of the IRC, "impose(s) (in addition to any other tax imposed by this subtitle) a tax equal to 3.8 percent" on a tax base explicitly defined in the statute.

Nowhere in the above-cited new Code chapter can one find anything to sustain a "Medicare" connection; but it was reassuring to this observer to read in the Proposed Regulations for ?1411 that "Amounts collected under section 1411 are not designated for the "Medicare Trust Fund," demonstrating to my satisfaction that I had read the statute correctly as purely an income tax. That gratuitous reference in the regulations to the Medicare Trust Fund also provides implicit recognition by Treasury and the IRS that the public will very likely be misled by the Medicare terminology in the title of the new chapter of the Code ( as, indeed, many already have been, even some experts).

To put a fine point on it, the proposed regulation adds that the 1411 tax "is subject to the estimated tax provisions," a sure indicia of its income tax properties as distinct from Medicare taxes. Ibid. (I must note that I am not gratified that it is an income tax rather than a Medicare tax, merely that, as a technician, one would be unable to deal with the tax satisfactorily if there were uncertainty or ambiguity as to which it was.)

There is a vast chasm between an income tax and a payroll tax, and even in the amount of tax each produces, despite the stated rate of tax -- 3.8% in this case -- being the same irrespective of which tax scheme is intended by the legislature. An obvious difference is in the income base to which the tax applies. A payroll tax is limited and easily ascertainable; the principle issue for highly compensated individuals is likely to be the year in which deferred compensation becomes taxable. But for that, a payroll tax is essentially self-enforcing. No difficult determinations of the underlying law or the calculations of tax are required. If the salary is $100,000 and the tax rate is 3.8%, the tax is $3,800. The taxpayer's only burden is to pay it.

An income tax, on the contrary, can range over a wide variety of kinds and sources of income, and rates of tax, and allowable deductions and credits. The calculations require extensive knowledge of the intent of the Congress in enacting the tax, judicial and administrative interpretations of its language and reach, ascertainment of the facts, marriage of the three, possibly an overlay of related law and facts (like carryovers, years of realization, etc.).

Application of an income tax to a given taxpayer often necessitates the services not just of a single-discipline tax specialist, but sometimes a combination of accountants, lawyers, CLUs, CFPs, actuaries and other experts in various configurations in order to enter the correct numbers on lines of the taxpayer's return. There is, of course, no shortage of competent practitioners in those professions willing and able to fill that need. But was it appropriate to erect such an elaborate structure for the sole purpose of funding the government's Obamacare responsbilities, and then to impose its ultimate costs on one segment of the private sector of the economy, irrespective of how un-rich its targets actually could be, considering the relatively low level of taxable "net investment income" which section 1411 establishes as the threshold figure at which a taxpayer can be caught in the 1411 tax net?

What Does One Even Call This Tax?

Section 1411 does not give a name to the tax it establishes. The only thing even approaching a name is the designation that the second act of the ACA applies to the title of its section 1402, i.e., "Unearned Income Medicare Contribution," that amends the Code to establish a new chapter also named "Unearned Income Medicare Contribution," which consists of just a single Code section, 1411, that is called unimaginatively "Imposition of Tax."

Commentators on the new section in print and on the lecture circuit have called it, literally and accurately, "Net Investment Income Tax" (or "NIIT"); and they seem to have gotten it just right, because the new tax form which the IRS designed for reporting this tax (Form 8960) also has named it "Net Investment Income Tax," together with a second line reading "Individuals, Estates, and Trusts"; so that's as official as one can make it. Alert readers of the 159 pages of the Proposed Regulatons would have caught at the top of the first page, in the title of the regulations, the words "Net Investment Income Tax." No shilly-shallying about "Medicare contributions" or other such dissimulations.

A full-fledged income tax it is, with its own special tax reporting form. At least it is such as long as Congress does not reconsider, repeal and replace the current NIIT, and, then, upon the President's anticipated veto, overcome it by the requisite majorities in both Houses. That iron-fisted Congressional response is not a far-fetched scenario, given how onerous the tax will prove to be generally for all parties concerned after experience with it, due to its enormous complexity, the tremendous compliance burdens and costs it will impose on taxpayers, and how difficult effective enforcement will be for the Service.

It is no exaggeration to say that IRC ?1411 has so far led a charmed life, like a slender raft maneuvering around Scylla and Charybdis that could easily have wrecked a sturdier craft. Of course, as it is regularly said in insurance and securities proposals, the past is no predictor of future performance. Taxpayers within the reach of 1411 will in time discover that beneath the "Medicare" mask hides a very over-the-top tax. We have seen above in this piece a possible explanation of why those who so oppose the overkill of the ACA and ardently wish its demise have so far refrained from using the enormous potential firepower that highlighting the hugely complex and costly 1411 tax could add to their futile efforts until now.

Remember Section 89

Seasoned practitioners will remember IRC section 89, a well-intentioned piece of benefits reform legislation enacted in 1986. Designed to eliminate discrimination in employee fringe benefits, it proved to be so onerous that it was amended two years later to simplify its operation. Within a year after that, when it still proved too difficult to administer and required tremendous compliance efforts by employers, it was repealed retroactively and never took effect.

If, as presently seems to be the case, early disappointments with the performance of the ACA, as compared with its promise, turn a roughly evenly split public into a decidedly anti-ACA majority, and that provides winning majorities for the Republicans in the next mid-term elections, the odds of repeal of the ACA -- and, of course, of the NIIT with it -- would increase significantly.

What is that axiom about unremembered history? Those opting for such an outcome could do worse than to bring to mind of the current generation of Congress the fate of Section 89.



Copyright 2014, A. D. Lurie
Alvin D. Lurie is a practicing pension attorney. He was appointed as the first person to administer the ERISA program in the IRS National Office in Washington. He is general editor of Bender's Federal Income Taxation of Retirement Plans (LexisNexis), a 2-volume treatise, and he is also editor of the annual compendium of articles published under the title New York University Review of Employee Benefits and Executive Compensation (LexisNexis). Mr. Lurie is the first recipient of the Lifetime Employee Benefits Achievement Award sponsored by the Employee Benefits Committee of the American Bar Association Tax Section. He can be contacted at Alvin D. Lurie, P.C. in Larchmont, New York, at (914) 834-6725 or via email: <allurie1@verizon.net>.
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