Reading the law about the tax on investment income I'm thoroughly confused.
??(c) NET INVESTMENT INCOME.?For purposes of this chapter? ??(1) IN GENERAL.?The term ?net investment income? means the excess (if any) of? ??(A) the sum of? ??(i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2), ??(ii) other gross income derived from a trade or business described in paragraph (2), and ??(iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2), over
??(B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.
What confuses me in (i) is the "other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2)".
Paragraph 2 describes passive and trading activities -- so for example UNG is considered to be an active activity according to regulation
1.469-1T(e)(6), but it will still be considered passive for this medicare tax and thus subject to the medicare tax. And I'd venture that investment clubs are trading activities too. So a business not derived from paragraph 2 is an active activity, like an S corporation that you own. So if the investment income is derived from an active activity, then it is not subject to the tax?In (ii) they say "other gross income". What exactly is that? Is it line 1 of schedule K-1 (ordinary business income) or line 11 (other income)? Basically (ii) says that other income from passive and trading activities is considered investment income.
Then (iii). Like (i) it mentions not described in paragraph (2). Capital gain from a business described in (2) -- ie. capital gain when you sell your K-1 -- will not be subject to the tax if the K-1 is from a passive or trading activity. But why? And will a loss from selling this passive K-1 be able to cancel out a gain from stock that you just hold in your individual account? If yes, that will reduce your medicare tax.
??(2) TRADES AND BUSINESSES TO WHICH TAX APPLIES.?A trade or business is described in this paragraph if such trade or business is? ??(A) a passive activity (within the meaning of section
469) with respect to the taxpayer, or ??(B) a trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2)).??(3) INCOME ON INVESTMENT OF WORKING CAPITAL SUBJECT TO TAX.?A rule similar to the rule of section 469(e)(1)(B) shall apply for purposes of this subsection. ??(4) EXCEPTION FOR CERTAIN ACTIVE INTERESTS IN PARTNERSHIPS AND S CORPORATIONS.?In the case of a disposition of an interest in a partnership or S corporation? ??(A) gain from such disposition shall be taken into account under clause (iii) of paragraph (1)(A) only to the extent of the net gain which would be so taken into account by the transferor if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest, and ??(B) a rule similar to the rule of subparagraph (A) shall apply to a loss from such disposition.
What on earth does (4) above mean? Maybe I just have a problem with the long winding sentence. Just can't parse it. In an earlier post I thought that the above means that when the S corp is liquidated then there is no medicare tax. But now it looks like the opposite. It seems if the S corp is liquidated then only the medicare tax applies, otherwise it does not.
??(5) EXCEPTION FOR DISTRIBUTIONS FROM QUALIFIED PLANS.?The term ?net investment income? shall not include any distribution from a plan or arrangement described in section
401(a), 403(a), 403(b), 408, 408A, or 457(b). ??(6) SPECIAL RULE.?Net investment income shall not include any item taken into account in determining self-employment income for such taxable year on which a tax is imposed by section 1401(b).Section 1401(b) describes the medicare tax on Schedule SE. So it looks like if you included interest income in determining your Schedule SE tax (for example if your Schedule C business earned interest in the bank), then that interest is not subject to the 3.8% medicare tax, although it will be subject to the 0.9% tax on earnings above 200k/250k.