The Medicare Tax and Active Traders

Article written by EricBank

Most folks have to pay Social Security and Medicare taxes on their income. A 3.8 percent Medicare tax is levied on taxpayers who reach certain thresholds for modified adjusted gross income (MAGI) or net investment income (NII). Self-employed individuals must pay self-employment tax to cover their Social Security and Medicare obligations. The good news is active traders, as defined by the IRS, do not pay self-employment tax on the income from their active trading business. The bad news is that you don't accumulate Social Security income when you avoid self-employment tax, meaning you might receive very meager Social Security checks when you retire.

How the Tax Works

The IRS levies a 3.8 percent Medicare surtax on the lesser of NII or the excess of MAGI above $200,000 for individuals, $250,000 for couples filing jointly, and $125,000 for spouses filing separately. NII applies to net rental income, dividends, taxable interest, net capital gains, royalties, passive income and the taxable portion of nonqualified annuity payments. NII does not include tax-exempt interest from municipal bonds and withdrawals from retirement plans/pensions. Social Security benefits, life-insurance proceeds, veterans' benefits, and income from businesses in which you actively participate, are also excluded from NII. MAGI includes NII, W-2 wages and income from retirement plans.

Active Traders

As we always like to point out, to be an active trader as defined by the IRS, you must clear three hurdles:

·       You seek profits from daily market movements in prices

·       You maintain substantial trading activity

·       You are continuously and regularly active as a trader

The IRS examines the facts and circumstances surrounding your trading activity to surmise whether or not you are an active trader. They look at trade frequency, trade size and the amount of time you devote to trading, among other things. Your security or commodity trading needs to be a means of livelihood, not an avocation.

Mark-to-Market and 1256 Trades

As an active trader, you can elect mark-to-market accounting rules, in which case your gains and losses are ordinary, not capital. As an active trader, you don't pay self-employment tax on your active-trading income, whether or not you elect MTM. However, if you engage in Section 1256 trades, the income from these trades is subject to self-employment tax. Section 1256 applies to certain commodity contracts such as futures, FOREX and non-equity options. If you are a commodity trader who (a) regularly trades 1256 contracts and (b) is registered with a domestic board of trade, this results in a self-employment tax obligation on any resulting income. [See http://www.taxresourcegroup.com/library/memo/1284.html

Other Factoids

If you run your trading business as a Subchapter S, the income eligible for payroll taxes is not subject to self-employment taxes, but certain profit distributions are. If you run your trading business as a C corporation, NIIT would only apply to corporate dividends, and the disposition of ownership stock. You face many considerations when deciding how to set up your active trading operation -- Traders Accounting can provide you valuable advice and services to set you up in the optimal trading vehicle