United States: Net Investment Income Tax
01 November 2013
Posted by: Author: Moira A. Jabir (Moritt, Hock & Hamroff)
Author: Moira A. Jabir (Moritt, Hock & Hamroff)
The "Obamacare" tax on net investment income came into effect on January 1, 2013. The net investment income tax affects income tax returns of individuals, estate and trusts filed in or after 2013. It does not impact returns filed in 2013 for tax years 2012 and earlier.
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. Let us 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 (MAGI) 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 1: Joe and Jane Smith earned $350,000 in compensation and $40,000 in net investment income. The "Obamacare" tax applies to the lesser of their net investment income ($40,000) or their MAGI ($390,000) less the applicable threshold ($250,000). The net investment income tax (NIIT) due is $1520 ($40,000 multiplied by 3.8%).
Example 2: The XYZ Trust may pay income and principal as needed to its beneficiary, a single individual who has additional income. In 2013, the trust has dividend and interest income of $100,000, and net capital gain of $200,000. The trust makes no distributions and has adjusted gross income of $300,000. Because the highest tax bracket for a trust is $11,950 in 2013, the net investment income subject to the "Obamacare" tax is $288,050 ($300,000 ‐ $11,950). The NIIT due is $10,945.90 ($288,050 multiplied by 3.8%).
As demonstrated in example 2 above, estates and certain trusts1 are not immune to this new tax and the applicable threshold is low. And while this tax does not apply to charitable remainder trusts it does apply to net investment income paid to a non‐charitable beneficiary. In order to reduce the 3.8% tax, estates and electing trusts must take care in selecting the proper year end for income tax purposes. For example, for any decedent who died in November 2012, by electing a year end of November 30, 2013, the application of the NIIT is delayed for eleven months.
Another interesting twist in this new tax occurs for the taxpayer who owns a sole proprietorship, a single member LLC that is taxed as a sole proprietorship 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 "Obamacare" tax 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 groupings2, making it easier to achieve or avoid material participation and thus treat income and losses as passive or non‐passive income.
This article first appeared in Mondaq.com