Marks Paneth Tax Alert: IRS Provides Guidance for New 3.8% Tax on Net Investment Income

January 23, 2013 | Download PDF

Recently, the IRS issued proposed regulations regarding the new 3.8% net investment income tax (NIIT, also known as the Medicare contribution tax) that was created by the Health Care and Education Reconciliation Act of 2010 and takes effect Jan. 1, 2013. This Alert details what investment income is subject to the tax and how to calculate it. Please click here to learn more.

Introduction

Background

Income Subject to the NIIT

Income Exclusions

Calculating the Tax

Act Now and Plan Ahead

Marks Paneth Tax Planning Guide

For More Information

IRS Circular 230 Disclosure

Introduction

Recently, the IRS issued proposed regulations regarding the new 3.8% net investment income tax (NIIT, also known as the Medicare contribution tax) that was created by the Health Care and Education Reconciliation Act of 2010 and takes effect Jan. 1, 2013. This Alert details what investment income is subject to the tax and how to calculate it. Please click here to learn more.

On November 30, 2012, the IRS issued proposed regulations regarding the new 3.8% surtax on net investment income (also known as the Medicare contribution tax and called “NIIT” in this Alert) that was created by the Health Care and Education Reconciliation Act of 2010 and takes effect Jan. 1, 2013. The IRS also released answers to frequently asked questions (FAQs) concerning the new tax. Taxpayers may rely on the proposed regulations until final regulations are published. (At the same time, the IRS also issued proposed reliance regulations and FAQs on the 0.9% Additional Medicare Tax that individuals may also be subject to under the new health care law, which was the subject of a prior Marks Paneth Tax Alert published in December 2012. If you would like to see that Alert, it can be found in the Library on the Marks Paneth website or you can contact a Marks Paneth tax advisor.

Background

Beginning in 2013, higher-income taxpayers generally will be subject to the 3.8% NIIT on some or all of their net investment income. This is in addition to — and calculated separately from — the taxpayers’ regular income tax or alternative minimum tax liability.

NIIT applies to the lesser of net investment income or the amount of modified adjusted gross income (MAGI) over a threshold amount. For individuals, these thresholds (which are not indexed for inflation) are as follows: $250,000 for joint filers; $125,000 for married taxpayers filing separately; and $200,000 for single individuals, heads of household and other filers. Individuals who are exempt from Medicare taxes may nonetheless be subject to the NIIT if they have net investment income and they have MAGI above the applicable thresholds.

The new tax also applies to estates and trusts that have undistributed net investment income and adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for the taxable year. (Thus, the threshold amount for estates and trusts is very low – the amount is $11,650 for 2012; as of this writing, the 2013 amount has not yet been released.) Grantor trusts, exempt trusts (for example, charitable trusts) and trusts that aren’t classified as trusts for tax purposes (for example, real estate investment trusts) are not subject to the NIIT.

As mentioned above, individuals may also be subject to a new 0.9% Additional Medicare Tax on FICA wages and self-employment income over certain thresholds. (Please contact us to request another copy of our prior Alert on the new 0.9% Additional Medicare Tax”, if needed). Please note, however, that the 0.9% tax does not apply to income items included in net investment income.

Income Subject to the NIIT

According to the proposed regulations, investment income includes, but is not limited to:

  • Interest,
  • Dividends,
  • Capital gains,
  • Rental and royalty income,
  • Nonqualified annuities (including payments under life insurance contracts),
  • Income from businesses involved in the trading of financial instruments or commodities, and
  • Income from businesses that are passive activities to the taxpayer (meaning the taxpayer doesn't "materially participate" in the business).

Common examples of investment income include gains from the sale of stocks, bonds and mutual funds; capital gain distributions from mutual funds; gains from the sale of a second home; and, generally, gains from the sale of partnership or S corporation interests.

Net investment income is calculated by deducting from investment income certain expenses that can be allocated to that income. Expenses that can be deducted include interest expense, advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes. Deductions are not allowed for net operating losses.

Income Exclusions

Income from interest, dividends, annuities, rents and royalties is excluded from investment income if the income is derived in the ordinary course of a trade or business that is not a passive activity with respect to the taxpayer or trading in financial instruments or commodities. (The IRS refers to this as the “ordinary course of a trade or business exception.”) Investment income also does not include wages, unemployment compensation, operating income from an active (or nonpassive) business, Social Security benefits, alimony, self-employment income, interest on tax-exempt bonds and Alaska Permanent Fund Dividends.

The proposed regulations also exclude from net investment income distributions from the following retirement or similar plans:

  • Qualified pension, stock bonus or profit-sharing plans,
  • Qualified annuity plans,
  • Tax-sheltered annuities,
  • Traditional IRAs,
  • Roth IRAs, and
  • Deferred compensation plans of a state and local government or a tax-exempt organization.

Distributions from these plans are, however, taken into account when determining a taxpayer’s MAGI — so they could trigger NIIT on net investment income.

Notably, the NIIT also does not apply to any amount of gain that is excluded from gross income for regular income tax purposes. This means the first $250,000 ($500,000 for a married couple filing jointly) of gain recognized on the sale of a principal residence is excluded from the NIIT, provided the taxpayer meets the requirements for the exclusion.

For example, a single taxpayer who earns $210,000 in wages, which exceeds the applicable MAGI threshold of $200,000, sells the house she’s owned and lived in for 10 years for $420,000. Her cost basis in the home is $200,000; thus, she realizes a gain of $220,000. In this situation, she may exclude the gain from the NIIT because it’s $30,000 under the principal residence gain exclusion limit for regular income tax purposes.

Calculating the Tax

Individuals are required to report and pay the NIIT on their income tax returns. If a taxpayer meets the applicable MAGI threshold and has net investment income, the NIIT equals 3.8% of the lesser of the amount by which the taxpayer’s MAGI exceeds the threshold or the taxpayer’s net investment income.

Consider, for example, a single taxpayer who earned $180,000 in wages, and who also received $90,000 from a passive partnership interest, making his MAGI $270,000. His net investment income is thus $90,000. His NIIT would be based on the lower of $70,000 ($270,000 less the $200,000 threshold) or $90,000 (the net investment income). The taxpayer would therefore owe NIIT of $2,660 ($70,000 × 3.8%).

In another example, involving the sale of a home: Husband and Wife are married and file jointly. They sell the home they’ve owned and lived in for 10 years for a gain of $600,000, which exceeds the $500,000 exclusion. The gain that is subject to regular income taxes, and therefore includible in net investment income, is $100,000. If they have other investment income of $125,000, their total investment income comes to $225,000. If their MAGI is $300,000 (which exceeds the applicable threshold by $50,000), the couple would owe NIIT of $1,900 ($50,000 × 3.8%).

Act Now and Plan Ahead

The NIIT will become effective imminently (i.e., January 1, 2013), and thus higher-income taxpayers need to plan accordingly. If you might be affected, you should evaluate your potential liability and, if you expect to be subject to the NIIT in 2013, adjust either your income tax withholding with your employer or your estimated payments to account for the tax increase and avoid underpayment penalties. You may also consider selling highly appreciated securities before 2012 ends. Our Marks Paneth tax advisors would be pleased to help you assess the potential impact of the NIIT on your particular situation and provide additional ideas and strategies on how you can minimize it.

Marks Paneth Tax Planning Guide

To facilitate ongoing access to the latest tax rules and regulations, Marks Paneth offers an online tax guide that is updated on an ongoing basis.

For More Information

If you have questions about anything you read in this Alert or in the Marks Paneth tax guide, please contact a Marks Paneth tax advisor or Steven Eliach, JD, LLM, the Principal-in-Charge of the Marks Paneth Tax Practice, by phone at 212.503.6388 or by email at seliach@markspaneth.com.

IRS Circular 230 Disclosure

Treasury Regulations require us to inform you that any Federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

© Marks Paneth LLP 2013 | www.markspaneth.com


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