On March 30, 2010, the President signed into law the Health Care and Education Reconciliation Act of 2010. This legislation imposes a new Medicare contribution tax on unearned income that will affect individual taxpayers, including holders of MLP units, beginning in 2013.

Under new section 1411 of the Internal Revenue Code, individuals will be subject to a 3.8 percent Medicare tax equal to the lesser of the individual’s “net investment income,” or modified adjusted gross income over a threshold amount ($250,000 for taxpayers filing joint returns, $125,000 for married taxpayers filing separately, and $200,000 for all others). Similar rules apply to income of estates and trusts.

The provision defines net investment income as investment income reduced by deductions properly allocable to that income. Investment income includes gross income from interest, dividends, annuities, royalties, and generally, rents.

Investment income also includes gross income derived from a trade or business, including a trade or business conducted by an MLP or other partnership, if the trade or business is a passive activity with respect to the taxpayer under the passive loss rules of section 469 (or the business consists of trading financial instruments or commodities). Under this rule, a public unitholder’s share of the MLP’s income generally will be treated as unearned income subject to the new tax.

Trade or business income of partners who materially participate in the MLP’s trade or business, however, will not be subject to the new tax. But, as under the passive loss rules, interest on working capital will not be treated as trade or business income to nonpassive partners, and therefore will be subject to the new tax.

A passive investor’s net gain attributable to the disposition of property, including MLP units, will be unearned income subject to the tax. Again, gain is not subject to the new tax if the property sold is held by a partner who materially participates in the trade or business activity.

In the case of a disposition of an MLP unit or other partnership interest, gain or loss is taken into account only to the extent gain or loss would be taken into account if the partnership had sold all its properties for fair market value immediately before the disposition. Under this rule, an individual that disposed of MLP units would need to obtain additional information — not required under current law — on the fair market value of the MLP’s assets on the date of sale in order to determine liability for the new Medicare tax. It is our understanding that this rule was designed for nonpassive partners and that a statutory clarification would be appropriate to address the difficulties the application of the provision would create for passive MLP unitholders.

For more information, please contact Vinson & Elkins lawyers Barry Miller, Christine Vaughn, Tim Devetski, or Debra Duncan. Visit our website to learn more about V&E's MLP practice, or e-mail one of the V&E MLP practice contacts.