Net Investment Income Tax

May 31, 2013 | Tax

The “Obamacare” tax on net investment income came into effect on January 1, 2013 although the guidance on the regulations under Section 1411 is not effective until after December 31, 2013.

First and foremost – what is this new tax? Basically, taxpayers must add an additional 3.8% tax on the lesser of their net investment income or their modified adjusted gross income less the applicable threshold.  HUH? Exactly. Lets get some definitions under our belt.

Net Investment Income is (1) interest, dividends, capital gains, rent and royalty income and non-qualified annuities; (2) income and gains from passive activities; (3) income and gains from businesses involved in the trading of financial instruments and commodities; and (4) gains from the sale of interests in partnerships and S-corporations to the extent the taxpayer is a passive owner. Of course, if any of the income set forth in items (1) – (4) are derived in an active trade or business (see below), then it is not Net Investment Income.

Net Investment Income also DOES NOT include (1) active trade or business income; (2) distributions from IRAs or other qualified retirement plans; and (3) income taken into account for self-employment tax purposes.

Modified Adjusted Gross Income is your adjusted gross income plus any net foreign earned income.

The Applicable Threshold is $250,000 for married taxpayers filing jointly; $125,000 for married taxpayers filing separately; $200,000 for all other taxpayers and $11,950 for trusts and estates.

Example: Joe and Jane Smith earned $350,000 in compensation and $40,000 from interest and dividend income.  They are subject to net investment income tax on the lesser of their net investment income ($40,000) or their MAGI ($350,000) less the applicable threshold ($250,000).  They owe an additional 3.8% tax on $40,000 or $1,520.

Estates and certain trusts* are not immune to this new tax and the applicable threshold is low.  In order to reduce the 3.8% tax, estates and electing trusts must select the proper year.  Example: Mary Smith dies January 2013 and the estate elects a November 30, 2013 year end, the surtax will not apply until the year beginning December 1, 2013.  And while this tax does not apply to charitable remainder trusts it does apply to net investment income paid to the non-charitable beneficiary.

Another twist in this new tax occurs for the taxpayer who owns a sole proprietorship, a single member LLC disregarded as separate from the owner or an interest in a partnership or S corporation, as the income or gain generated will be net investment income UNLESS:

  • The activity generating the income or gain is from an active trade or business; and
  • The income generated is derived from the ordinary course of that trade or business; and
  • The activity is not passive activity to the taxpayer per Section 469; and
  • The activity is not trading in financial commodities or instruments.

Keep in mind that all four exceptions must be met in order for the income or gain to avoid being treated as net investment income.  And under Section 469, rental activities are always treated as passive income, so unless the taxpayer meets the definition of “real estate professional,” (think material participation and 750 hours in the taxable year), the surtax will apply.  The IRS, feeling generous, is giving taxpayers a one-time opportunity in the first year beginning after 12/31/13 in which the taxpayer meets the applicable threshold and has net investment income, to change their activity groupings,** making it easier to achieve or avoid material participation and thus treat income and losses as passive or non-passive income.

This is a very simple summary of a new and complex tax.  We always recommend you reach out to your estate planning attorney to obtain a more in depth understanding of the tax and its impact.

* Non grantor trusts, electing small business trusts, pooled income trust, cemetery perpetual care funds, qualified funeral trusts, Alaska Native Settlement Trusts and foreign trusts with U.S. beneficiaries.

** Consistency rule for activity grouping under regulation Section 1-469-4(e) generally prohibits regrouping of activity unless original grouping was clearly inappropriate or there was a change in facts and circumstances rendering original grouping clearly inappropriate.

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