Many employers are aware of the increase to the Medicare tax on high-wage earnersrequired under PPACA, which goes into effect on January 1, 2013.  However, employers may be less familiar with the entirely new imposition of a 3.8% Medicare tax on net unearned income for high-wage earners (which uses the same income thresholds as the increase to the existing Medicare tax does: $200,000 for single filers, $250,000 for joint filers, and $125,000 for persons married filing separately), also effective for tax years beginning after December 31, 2012.  This new tax applies to “net investment income,” which is defined in a new Internal Revenue Code Section 1411(c) to be “gross income from interest, dividends, annuities, royalties, and rents,” but “shall not include any distribution from a plan or arrangement described in section 401(a), 403(a), 403(b), 408, 408A, or 457(b)” (i.e., most tax-favored retirement plans).

Generally speaking, employers will not need to concern themselves with this new Medicare tax since it will be each individual employee’s responsibility to pay this tax on any “net investment income” he/she receives.  As such, it appears unlikely that employers will need to change any of their systems to account for this new 3.8% Medicare tax.

However, one potential impact this new Medicare tax may have on the benefits an employer provides is if their ESOP plan (including a 401(k) plan with an ESOP component) has a “dividend pass-through” feature as permitted by Internal Revenue Code Section 404(k), through which plan participants can elect to either 1) have cash dividends on employer stock paid to them in cash, or 2) keep those dividends in the plan and have them reinvested in additional shares of employer stock. 

  • It appears that if those dividends are kept in the plan and reinvested in additional shares of employer stock, then they will not be considered “dividends” subject to the new 3.8% Medicare tax, since the participant will eventually receive the benefit via a distribution from a qualified plan.
  • In contrast, it appears that if the plan participant instead elects to take the dividends in cash, such “404(k) dividends” (so called because Internal Revenue Code Section 404(k) allows the employer-corporation to deduct the amount paid in cash for them) may be considered “dividends” subject to the new 3.8% Medicare tax.

Whether such 404(k) dividends are considered “net unearned income” may depend on how the cash dividends are paid.  This is because 404(k) dividends the employer-corporation directly pays to plan participants and beneficiaries are reported on a Form 1099-DIV, and, in accordance with the instructions to that form, are taxed as “ordinary dividends.”  By contrast, 404(k) dividends that are instead first paid by the employer-corporation to the ESOP Plan, and then paid by the ESOP plan to the Participant, are reported on a Form 1099-R, which, in accordance with the instructions to that form, does not report any other distributions; as a result, one might argue that those 404(k) dividends should not be considered “net unearned income” because they are treated as a plan distribution instead.

It is interesting to note that, regardless of whether 404(k) dividends are reported on a Form 1099-R or a Form 1099-DIV, “404(k) dividends” are not considered “qualified dividends” eligible for the lower 15% tax rate for capital gains.  Therefore, there might be an argument that such 404(k) dividends should not be considered dividends subject to the new 3.8% Medicare tax either. 

In recently issued proposed regulations on this new Medicare tax on unearned income, the IRS has provided some additional guidance on whether certain types of dividends are subject to the new tax. Although these regulations do not specifically discuss 404(k) dividends, they do clarify that “substitute dividends” paid in a securities lending transaction will be considered “net investment income” subject to the tax.  The IRS’s clarification on this point is potentially meaningful because 1) like 404(k) dividends, “substitute dividends” are another type of dividend that is not eligible for the lower capital gains tax rate for “qualified dividends,” and 2) “substitute dividends” are reported on a 1099-MISC, which shows that the IRS will consider certain dividends to be subject to the new tax even if they are not reported on a 1099-DIV.  These factors seem to suggest that 404(k) dividends would likewise be considered “net investment income” subject to the new tax, but IRS guidance directly addressing this subject would be welcome.