The Health Care and Education Reconciliation Act of 2010 (1) added a new chapter 2A to subtitle A (Income Taxes) of the Internal Revenue Code effective for 2013. (2) Sec. 1411, the only provision in the chapter, imposes a 3.8% tax on the net investment income of an individual whose modified adjusted gross income (MAGI) exceeds a threshold that varies depending on the taxpayer's filing status. The new surtax is also imposed on the undistributed net investment income of an estate or trust whose adjusted gross income (AGI) exceeds the dollar amount at which the highest tax bracket for an estate or trust begins.
This article examines how to determine the new surtax on net investment income that, like alternative minimum taxable income, effectively creates another tax base in addition to taxable income. After describing the calculation and reach of the surtax, this article suggests ways to lessen its impact or avoid altogether this "parallel universe" that mirrors the regular income tax and the alternative minimum tax (AMT).
Beginning in 2013, Sec. 1411 imposes a 3.8% tax on the net investment income of certain individuals, estates, and trusts. The tax does not apply to nonresident aliens (3) and any trust all of whose unexpired interests are devoted to a charitable purpose under Sec. 170(c)(2)(B). (4) The tax is not deductible for any income tax the Code imposes. (5)
In the case of an individual, the surtax is (in addition to any other income tax) for each tax year 3.8% of the lesser of:
* The individual's net investment income for the year, or
* The excess (if any) of the individual's MAGI over a threshold amount. (6)
The threshold amounts are (1) $250,000 for married individuals or a surviving spouse filing a joint return; (2) $125,000 for a married individual filing a separate return; and (3) $200,000 in all other cases. (7) MAGI for this purpose is AGI (increased by the foreign earned income exclusion (8)) less properly allocated deductions. (9)
Example 1: X and Y, married filing jointly, together have income of $500,000, all of which is salary. The surtax will not apply because they have no net investment income. Example 2: X and Y, married filing jointly, have $500,000 of salary and $50,000 of net investment income. The surtax applies to the $50,000 of net investment income because it is less than the excess of MAGI over the threshold (ice., $550,000 - $250,000 = $300,000). Example 3: X, a single filer, has $275,000 of net investment income and no other income. The surtax applies only to the $75,000 that exceeds the $200,000 threshold for single filers. Example 4: X and Y, married filing jointly, have $225,000 of salary income and $125,000 of net investment income. The surtax applies to $100,000, the difference between their threshold ($250,000) and MAGI ($350,000), which is less than their net investment income of $125,000. Example 5: X, a single filer, has $500,000 of interest and a $500,000 net capital loss. The surtax applies to $297,000, $500,000 less $200,000 threshold and the $3,000 maximum capital loss that may offset ordinary income. Estates and Trusts
An estate or trust is subject to the 3.8% tax to the extent of the lesser of:
* The estate's or trusts undistributed net investment income; or
* The excess (if any) of the estate's or trust's AGI (10) over the dollar amount at which the highest tax bracket begins for the year (i.e., $ 11,950 for 2013). (11)
Example 6: The X Trust may pay income and principal as needed to its beneficiary, a single individual who has no other income. In 2013, the trust has dividend and interest income of $150,000, and net capital gain of $300,000. The trust makes no distributions and has AGI of $450,000. Because the highest tax bracket for a trust is $11,950 in 2013, the net investment income subject to the surtax is $438,050 ($450,000-$11,950). Example 7: If, in the preceding example, the $150,000 of dividend and interest income is distributed to the trust's beneficiary, X Trust's net investment income is $288,050 ($300,000-$11,950). Because the surtax threshold for a single taxpayer is $200,000, the beneficiary is not subject to the surtax on the $150,000 of dividends and interest. In all of the above examples, the surtax is subject to estimated tax requirements and penalties for underpaying estimated tax. (12)
Net Investment Income
As the above discussion illustrates, the key concept of Sec. 1411 is the definition of the new tax base, "net investment income." In enacting a new tax on net investment income, Congress has effectively created yet another separate tax base, the calculation of which parallels the calculation of taxable income, to which the regular tax rates apply, and AMT income to which rates of 26% or 28% apply. The tax on net investment income, however, is a surtax that is added to the taxpayer's regular tax (and, if applicable, AMT) liability.
In general, Sec. 1411(c) defines investment income to be the sum of three categories of income: (1) interest, dividends, annuities, royalties, and rents other than income derived in the ordinary course of a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities; (13) (2) income (other than the income included in the first and third categories) from a trade or business that is a passive activity to the taxpayer under Sec. 469 (14) or a trade or business of trading in financial instruments and commodities; and (3) net gain from the disposition of property other than property held in a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities. (15) Investment income also includes income attributable to an investment in working capital. (16) Investment income does not include any income subject to self-employment tax (17) nor does it include distributions from qualified plans under Secs. 401(a), 403(a), 403(b), 408,408A, or 457(b). (18)
Example 8: Individual X's only income for 2013 is a pension of $550,000 and $35,000 of tax-exempt income. The surtax does not apply because X has no investment income. (19) These investment income amounts are reduced by any properly allocable deductions to arrive at net investment income upon which the 3.8% tax is imposed. However, a net operating loss (NOL) deduction allowed under Sec. 172 cannot be taken into account in determining net investment income for any tax year. (20)
Example 9: (21) In year 1, X, an unmarried individual, has $60,000 of wages, $20,000 of investment income, a $70,000 loss from a sole proprietorship, and $30,000 of expenses allocable to investment income, so that there is no net investment income. X elects to carry over the $20,000 NOL to year 2. In year 2, X has $200,000 of wages, $100,000 of investment income, an $80,000 profit from the sole proprietorship, and $10,000 of investment expenses. The $20,000 NOL carryover is allowed in computing X's year 2 MAGI but not in computing X's net investment income. In measuring the Sec. 1411 tax base, income (e.g., interest, dividends, rents, etc.) that might otherwise be treated as investment income is not taken into account if it is derived in the ordinary course of a trade or business that is not a passive activity for the taxpayer or that is not from the trading of financial instruments or commodities, (22) meaning income from active trades or businesses is not subject to the tax, but income from trading financial instruments or commodities is. For this purpose the Sec. 1411 proposed regulations look to the case law under Sec. 162 to determine what constitutes a trade or business, only specifically excluding from net investment income any amount subject to self-employment tax, which generally requires the taxpayer be engaged in a trade or business under Sec. 162. (23)
Example 10: (24) X rents a building, but the rental activity does not constitute a trade or business. Because X's rental of a building does not constitute a trade or business, it is not income from a trade or business that is a passive activity. However, it is net investment income because it is income from rents. Example 11: (25) Y engages in an equipment leasing activity where the average period of customer use is seven days or less, which means that the rental activity is not automatically passive. (26) If Y materially participates in the activity and the activity otherwise constitutes a trade or business under Sec. 162, the rent is not net investment income. If Y does not materially participate, the rent will be net investment income. Even where an individual qualifies as a real estate professional under Sec. 469(c)(7) so that his rental activities are not passive, the taxpayer must still be considered to be engaged in a trade or business within the meaning of Sec. 162 and Prop. Regs. Sec. 1.1411-4(b) to exclude any rental profits from the surtax. (27)
Application of Chapter 1 to Chapter 2A
In determining what is investment income and what deductions offset it, Sec. 1411, which alone constitutes chapter 2A of the Code, uses numerous terms commonly used in chapter 1 of the Code. The Sec. 1411 proposed regulations make clear that the general rules of chapter 1 for determining income or loss, including timing rules, exclusions, and deferrals, apply for purposes of chapter 2A and Sec. 1411. (28) Thus, for example, capital gain not recognized for income tax purposes under the installment method, (29) the like-kind exchange (30) or involuntary conversion rules, (31) or the exclusion of gain from the sale of a principal residence (32) does not constitute investment income under Sec. 1411. Similarly, deferral or disallowance provisions under chapter 1 also apply to chapter 2A's definition of net investment income, e.g., the limitation on investment interest, (33) expenses relating to tax-exempt income, (34) the at-risk limitations, (35) passive...