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New Medicare taxes deliver a blow to private equity funds; new economic substance laws also of concern
April 6, 2010
Private Equity Alert

This Private Equity Alert summarizes three tax provisions that were included in the recent health care reconciliation bill passed by Congress and signed by President Obama—the 0.9% increase in the Medicare tax, the new 3.8% Medicare tax on certain investment income, and the economic substance penalty regime—and how they will impact private equity deals.

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The Health Care and Education Affordability Reconciliation Act of 2010 (the “Act”), signed by President Obama on March 30, 2010, includes a number of revenue-raising provisions that will adversely affect private equity investors and fund managers. These tax increases are on top of the expected expiration of the “Bush tax cuts.”  After the end of this year, absent action by Congress, this expiration would automatically result in the increase of (i) the current maximum rate of 15% on capital gains and dividends to 20%, and (ii) the current maximum rate of 35% on regular ordinary income to 39.6%. In addition, while “carried interest” legislation was ultimately not included in the Act, it is still possible that Congress could enact it in the near term and thereby convert the treatment of capital gain allocable to fund managers to ordinary compensation income.

0.9% Medicare tax increase on wages and self-employment income

Starting with income received after December 31, 2012, the Act increases by 0.9% the Medicare tax from its current rate of 2.9% to 3.8% on an individual’s wages as an employee and self-employment income in excess of $250,000 (married filing jointly) or $200,000 (individual). Unlike current FICA and Medicare taxes, this additional tax is imposed solely on the employee and self-employed worker, and is not deductible. Employers will have, however, certain withholding obligations with respect to the Medicare tax increase.

3.8% Medicare tax imposed on individual net investment income

The Act modifies the Medicare tax to include a tax on individual’s, trust’s, and estate’s net investment income. Currently, Medicare is not subsidized by a levy against net investment income and is financed primarily by payroll taxes.

Implementation of the Medicare tax.  Beginning in 2013, the Act imposes a tax of 3.8% on the lesser of (i) annual net investment income or (ii) the excess of modified adjusted gross income (AGI) over the threshold amount ($250,000 in the case of a joint return, or $200,000 in the case of a single return). Net investment income is defined as:

  • gross income from interest, dividends, royalties, and rents;
  • net gains from the disposition of property, such as the sale of stocks, bonds, and real estate;
  • gross income derived from a business constituting a passive activity to the taxpayer (including operating income and gain on sale from an operating business that flows up to the taxpayer-investor in a fund that is taxed as a partnership for income tax purposes); and
  • gross income derived from a trade or business comprised of trading in financial instruments or commodities (whether or not the taxpayer is active in the business).

Gain from the sale of a partnership interest or stock in an S corporation is taken into account as if the entity had sold all of its properties at fair market value immediately before the disposition. Net investment income is reduced by properly allocable deductions to such income, including passive losses that offset passive gain. 

The tax does not apply to income from, or gain on the sale of, a business, where the taxpayer is an active participant. The Medicare tax also does not apply to nonresident aliens, trusts that are exempt under Code section 501, and certain other charitable trusts. Moreover, the Medicare tax does not apply to distributions from qualified retirement plans, tax-exempt bonds, and gain on the sale of a residence to the extent excluded from income.


Example 1: For tax year 2013, Investor X (married filing jointly) has $275,000 of net unearned income (interest and dividends less any allowable deductions). Investor X also has $500,000 of W-2 income. The Medicare tax is calculated as follows: 3.8% times the lesser of (a) $275,000 (net investment income) and (b) $775,000 (modified AGI) minus $250,000 (threshold amount). This results in a tax of $10,450 (3.8% of Investor X’s net investment income).

Example 2: For tax year 2013, Investor Y (married filing jointly) has $255,000 of net investment income and $125,000 of W-2 income. The Medicare tax is calculated as follows: 3.8% times the lesser of (a) $255,000 (net investment income) and (b) $380,000 (modified AGI) minus $250,000 (threshold amount). This results in a tax of $4,940 (3.8% of the excess of Investor Y’s modified AGI less the threshold amount).

How the Medicare tax impacts private equity investors and fund managers. Investors in private equity funds will feel the impact of the additional 3.8% Medicare tax, including on disposition gains previously taxed at low capital gains rates. Carried interest from the sale of underlying portfolio companies allocated to fund managers, which is currently taxed at a favorable capital gains rate, will now also be subject to the 3.8% Medicare tax. U.S. investors in and managers of hedge funds where active trading of financial instruments or commodities is conducted will be subject to the 3.8% tax hike. While U.S. investors could shield this type of trade or business income from the Medicare tax by investing through a corporation, it would seem that the resulting double taxation would still make a corporation less tax-efficient than the typical pass-through structure (note that dividends from a corporation are also subject to the new Medicare tax to the extent the taxpayer’s AGI exceeds the threshold amount). Foreign investors who are nonresident aliens for U.S. federal income tax purposes will continue to be exempt from U.S. tax on their portfolio income if they invest through a blocker entity and will also be exempt from the Medicare tax even if they invest directly in a U.S. fund taxed as a partnership.

As the Medicare tax does not go into effect until 2013, there is time for some tax planning. Funds could consider selling “winners” in 2010 (while the low maximum 15% capital gains rate remains in effect and before the rate increases to 20%) or in 2011 or 2012 (before the new 3.8% Medicare tax takes effect, increasing the top capital gains rate to 23.8%). Additionally, investment income can be sheltered by any passive losses (computed in the same manner as net investment income). It appears that passive losses that are not used to offset investment income can be carried forward to offset investment income in a future year. How the carry-forward will work in all circumstances is unclear. For example, it is not certain whether passive losses that a taxpayer carries forward from years previous to 2013 may be carried forward.

Addition of economic substance legislation

The Act adds new Section 7701(o) to the Code, which could adversely affect how private equity funds dispose of their portfolio companies. In general, new section 7701(o) provides that a taxpayer whose facts otherwise satisfy the technical legal requirements for a tax benefit shall be denied that tax benefit if in the opinion of the IRS (a) the taxpayer was motivated to arrange the transaction for the purpose of obtaining that tax benefit, (b) the benefit was not among the purposes Congress had contemplated in enacting the pertinent statute, and (c) the taxpayer fails to prove satisfaction of the economic substance test once the IRS asserts its application. A transaction that is properly challenged by the IRS will be treated as having economic substance only if (1) the transaction changes in a meaningful way (apart from U.S. federal income tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose (apart from U.S. federal income tax effects) for entering into such transaction.

The judicial “economic substance” doctrine has existed for many years and new section 7701(o) is not intended to depart radically from that judicial doctrine. The most important feature of section 7701(o) is its penalty regime. In general, if a taxpayer is found to have violated section 7701(o), a 20% penalty is imposed on the amount of underpaid tax. The penalty is increased to 40% if the transaction is not adequately disclosed on the taxpayer’s timely-filed tax return. There is no exception for reasonable reliance on a tax opinion or other reasonable cause or good faith, as was the case under prior law.

In the past, the economic substance doctrine has been applied most frequently in perceived “tax shelter” cases. On occasion, in the late 1990s and early 2000s, a few private equity funds engaged in such transactions in disposing of portfolio companies or permitted portfolio companies to engage in such transactions. The IRS successfully challenged many of these “tax shelter” transactions. With the new penalty regime, the stakes are higher for taxpayers.

There has been concern expressed in a few quarters that a tax-exempt investor’s use of a “blocker” entity that is taxed as a C corporation could run afoul of new section 7701(o). The application of section 7701(o) to this common planning technique would certainly be a surprisingly result. Given the harsher penalty regime, this and other areas might be appropriate for the IRS to resolve by issuing express guidance. There is case law supporting a taxpayer’s ability to make a “check-the-box” election under the IRS’s own regulations, regardless of the taxpayer’s tax planning motives.

Clients are encouraged to consult their tax advisors if there is any doubt that a proposed transaction could violate the new economic substance law.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.