The new 3.8 percent tax on net investment income of individuals, estates, and trusts.

• Author: August, Jordan D.
• Position: Tax Law

During this federal income tax filing season, many return preparers and their clients will be familiarizing themselves with the new 3.8 percent net investment income tax (NIIT), applicable to certain passive investment income earned by individuals, trusts, and estates. This sweeping tax, which began in 2013, impacts numerous taxpayers, particularly investors with substantial earnings, and makes it critical for practitioners to understand the fundamental aspects of the tax as well as possible planning techniques available to taxpayers seeking to reduce its impact on their bottom line. As payment of the NIIT may be inevitable for many, practitioners will need to inform and advise their clients of its potential application so that their clients can avoid any "sticker shock" when the tax bill becomes due. Moreover, there may be planning alternatives available in structuring a transaction that could avoid the imposition of this 3.8 percent NIIT surtax. This article includes a general overview of the mechanics of the NIIT and highlights some of the more pressing issues relating to the tax. (1)

The NIIT Generally

Often referred to as the "Medicare tax" or "health care tax," (2) the NIIT is imposed under [section]1411 of the Internal Revenue Code (Code). (3) This new tax, which is effective for tax years beginning after December 31, 2012, applies at a rate of 3.8 percent on the "net investment income" of individuals, estates, and trusts with income above stated thresholds. NIIT is reported on, and paid in conjunction with, the taxpayer's annual income tax return (Form 1040 or 1041), filed with the Internal Revenue Service (IRS). (4) Since the NIIT is subject to the estimated tax provisions, individuals, estates, and trusts that expect to pay NIIT need to adjust their income tax withholding or estimated payments to account for the tax increase.

The NIIT, ostensibly intended as a revenue raiser to fund programs instituted under The Patient Protection and Affordable Care Act, (5) is in all respects a new tax on investment income, and is imposed in addition to all other taxes that are otherwise due for the taxable year. The NIIT also represents the first time the federal government has imposed employment-type taxes on "unearned" investment income. Therefore, the effect of the NIIT is to potentially subject all income to a 3.8 percent Medicare tax, whether as employment wages subject to Federal Insurance Contributions Act (FICA) tax, as other income subject to Self-employment Contributions Act (SECA) tax, or, now, as unearned income subject to NIIT. (6)

To assist taxpayers and their advisors with the complexities of the NIIT, treasury published proposed regulations on December 5, 2012, interpreting [section]1411 and providing a myriad of definitions and rules relating to this new tax. (7) On November 26, treasury issued final regulations under [section]1411 that generally follow the proposed regulations (with a few clarifications and modifications), (8) as well as a new set of proposed regulations offering further guidance on the computation of the NIIT. (9) For taxable years beginning before January 1, taxpayers may rely on the 2012 proposed regulations, the 2013 proposed regulations, or the 2013 final regulations. (10) However, taxpayers taking a position in the 2013 tax year that is inconsistent with the final regulations will be required to make reasonable adjustments to ensure that their NIIT liability in the taxable years following December 31 is not inappropriately distorted.

Net Investment Income

Net investment income (NII) is broadly defined to include the sum of 1) investment-related gross income, such as interest, dividends, rent, royalties, and annuities, other than such amounts derived in the ordinary course of a trade or business (but excluding amounts derived from a financial instruments or commodities trading business (trading business) or a business that is a "passive activity" with respect to the taxpayer (passive activity business)); 2) other gross income derived from a trading business or a passive activity business; and 3) net gain attributable to the disposition of property other than property held in a trade or business other than a trading business or passive activity business. As described in greater detail below, income from a passive activity business generally includes income derived from a trade or business in which the taxpayer does not "materially participate." Individuals may offset their gross investment income by deducting expenses that are allocable to items of investment income, such as investment interest expenses, advisory and brokerage fees, and tax preparation fees, to arrive at NII. However, unlike in the context of the regular income tax, charitable contributions cannot be used to reduce an individual's NIIT liability-a treatment likely to catch many tax-savvy individuals by surprise. (11)

NIIT for Individuals

For individuals, other than nonresident aliens, (12) the 3.8 percent NIIT applies to the lesser of 1) the individual's NII for the taxable year; or 2) the excess of modified adjusted gross income over a statutory income threshold amount dependent on the individual's filing status. The designated income threshold is $250,000 for married individuals filing jointly, $125,000 for married individuals filing separately, and $200,000 for all other individuals. (13) Modified adjusted gross income generally equals an individual's adjusted gross income. (14) Thus, in the event an individual's modified adjusted gross income exceeds the applicable income threshold amount, the individual will owe NIIT provided he or she has earned NII during the taxable year.

The following example illustrates the calculation of the NIIT with respect to an individual. Assume that during the 2013 taxable year an unmarried U.S. citizen, Joe Investor, modified...