3.8% of what? An overview of the net investment income tax.

• Author: Chambers, Valrie

In December 2012, the IRS issued proposed regulations (REG-130507-11) for the net investment income tax under Sec. 1411 that went into effect on Jan. 1, 2013. At the same time, the IRS released a list of frequently asked questions concerning the net investment income tax.

The new levy was created to help pay for health care reforms that were enacted in 2010. The rate is 3.8% of the lower of net investment income or the amount of modified adjusted gross income (MAGI) over specific thresholds. The key consideration, however, is what constitutes net investment income and which taxpayers are affected. Moreover, practitioners need to know what information they must obtain from clients to correctly compute the additional tax, and they need to be aware of common issues that may arise in computing the net investment income tax.

Only individuals with MAGI above the thresholds and certain estates and trusts are subject to the net investment income tax. Nonresident aliens and entities other than natural persons are not subject to the tax. The thresholds for individuals are: married filing jointly and qualifying surviving spouse, $250,000; married filing separately, $125,000; single and head of household, $200,000. The thresholds are not indexed for inflation. For most taxpayers, MAGI is the same as adjusted gross income (AGI). Excluded income and certain deductions under Sec. 911 of citizens or U.S. residents residing abroad are the only modifications to AG1 for the net investment income tax calculation.

Estates and trusts with undistributed net investment income and AG1 above the dollar amount at which the highest tax bracket for an estate or trust begins *for that tax year are also subject to the net investment income tax. (For 2013, $11,950.) Exempt trusts include grantor trusts under Secs. 671-679, REITs and common trust funds, tax-exempt trusts under Secs. 501 and 664, and charitable trusts under Sec. 170(c)(2)(B).

Three defined categories of income are subject to the net investment income tax (Sec. 1411(c)):

* Category I: Gross income from interest, dividends, rents, royalties, and nonqualified annuities, other than such income derived in the ordinary course of a trade or business not described in Category 11.

* Category II: Other gross income from businesses that trade financial instruments or commodities, and businesses that are passive activities within the meaning of Sec. 469.

* Category III: Net gain (to the extent taken into account in...