Is an anomaly in form 8960 resulting in an unintended tax on tax-exempt income?

• Author: Schlereth, Michele

EXECUTIVE SUMMARY

* The 3.8% net investment income tax applies to individual taxpayers whose net investment income exceeds certain amounts. The calculation of the tax for individuals differs from its calculation for trusts and estates.

* If a taxpayer has both income that is subject to the tax and exempt income, the taxpayer's expenses must be allocated between the two types of income in calculating the tax.

* Although the net investment income tax should not apply to tax-exempt income, the difference in the treatment of certain expenses on Form 8960 from their treatment on Form 1040 or 1041 may lead to the practical result that a taxpayer with both types of income will be subject to the net investment income tax on a portion of the tax-exempt income.

PREVIEW

* This article provides an overview of the net investment income tax calculations for individuals and trusts.

* Find out how the rules work regarding the allocation of expenses between taxable and tax-exempt income for net investment income tax purposes.

* See how the allocation rules can cause trusts with taxable and tax-exempt income to be liable for a higher net investment income tax than trusts with the same amount of taxable income but no tax-exempt income.

The Patient Protection and Affordable Care Act, (1) as amended by the Health Care and Education Reconciliation Act, (2) sought to ensure that all Americans have access to quality, affordable health care and was funded in part by a 3.8% tax on the net investment income of individuals, trusts, and estates. The tax went into effect Jan. 1, 2013.

To report the net investment income tax due, the taxpayer must file Form 8960, Net Investment Income Tax-- Individuals, Estates, and Trusts, beginning with the 2013 tax year. With implementation of the tax in its infancy, an unintended anomaly in the calculations on Form 8960 may have slipped through the cracks. A large number of computations in Form 8960, such as for modified adjusted gross income (MAGI), deductions properly allocable to individual taxpayers' income, undistributed net investment income, adjusted gross income (AGI), and deductions properly allocable to trust income contribute to this perhaps unintended result. The anomaly effectively penalizes the taxpayer for allocating part of its portfolio to tax-exempt income-generating assets, which is probably not what Congress intended when it enacted the net investment income tax.

This article first reviews the fundamentals of the net investment income tax and Form 8960. It then describes the anomaly in detail, examines whether Congress intended this result, and proposes solutions to eliminate the anomaly.

Basics of Net Investment income Taxation

The net investment income tax is imposed on unearned income of individuals, estates, and trusts, including (1) interest, (2) dividends, (3) capital gains, (4) annuities, (3) (5) rents, (6) royalties, (7) passive activity (4) income, (8) income from a trade or business of trading in financial instruments or commodities, and (9) net gain attributable to the disposition of property, unless the property was held as part of a nonpassive activity (i.e., an active trade or business) other than a trade or business of trading in financial instruments or commodities. (5) Income sources not subject to the tax include (1) active trade and/or business income (other than income from a trade or business of trading in financial instruments or commodities); (6) (2) distributions from qualified retirement plans, including IRAs; (7) (3) income subject to self-employment tax; (8) (4) municipal bond interest; (9) (5) Social Security benefits; (10) (6) life insurance death benefits; (11) (7) alimony; (12) (8) unemployment compensation; (13) and (9) wages. (14)

For an individual whose MAGI exceeds the threshold amount, net investment income tax is imposed for each tax year at a rate of 3.8% of the lesser of (1) net investment income for that tax year, or (2) the excess (if any) of the taxpayer's MAGI for that tax year over the threshold amount (15) ($250,000 for married taxpayers fifing jointly (or a surviving spouse), $125,000 for married taxpayers fifing separately, and $200,000 for all other individuals). (16)

For an estate or trust, net investment income tax is imposed for each tax year at a rate of 3.8% on the lesser of the (1) undistributed net investment income for that tax year, or (2) the excess (if any) of adjusted gross income (AGI) for that tax year over the dollar amount at which the highest tax bracket in Sec. 1(e) begins. (17) For 2014, the highest Sec. 1(e) tax bracket begins at taxable income of $12,150; for 2015, it is $12,300.

Allowable Deductions When Calculating Net Investment Income Tax

Regs. Sec. 1.1411-4(f) sets forth the deductions allowed against net investment income, which include (1) investment advisory and brokerage fees (subject to a 2% floor on miscellaneous itemized deductions); (18) (2) investment interest expense; (3) state, local, and foreign taxes that are allocable to net investment income under Regs. Sec. 1.1411-4(g)(l); (4) items described in Sec. 212(3), such as tax preparation fees and legal fees in connection with the determination, collection, or refund of any tax, to the extent allocable to net investment income under Regs. Sec. 1.1411-4(g)(l) (for individuals only, subject to the 2% floor on miscellaneous itemized deductions); and (5) fiduciary expenses, to the extent allocable to net investment income under Regs. Sec. 1.1411-4(g)(l).

Regs. Sec. 1.1411-4(g)(l) states that any reasonable method may be used in determining the amount of expenses allocable to net investment income. The final regulations do not provide examples of unreasonable methods, but they do provide one example of a reasonable method. "Examples of reasonable methods of allocation include, but are not limited to, an allocation of the deduction based on the ratio of the amount of a taxpayer's gross income (including net gain) described in [section]1.1411-4(a)(l) [i.e., gross income from interest, dividends, annuities, royalties, and rents] to the amount of the taxpayer's adjusted gross income (as defined under section 62 (or section 67(e) in the case of an estate or trust))." (19)

Although the regulations do not specifically state that deductions should be allocated to tax-exempt income, since properly allocable deductions must be allocated to excluded income, that appears to include tax-exempt income. (20) One reasonable method to allocate state, local, and foreign taxes, and legal, tax preparation, and...