Beginning in 2013, Section 1411 of the Internal Revenue Code imposes a 3.8% “net investment income tax” (“NIIT”) on the net investment income (a specifically defined term) of individuals, estate and trusts that have income above certain statutory threshold amounts. Many clients are concerned with whether or not they will be impacted by the new tax, and others are unsure of the application of the tax to income received from their businesses.
The NIIT is an entirely new tax system, which is imposed in addition, and generally without regard to, all other applicable income taxes. Similar to the alternative minimum tax, Section 1411 requires the computation of a dual tax base in order to determine its applicability. For individuals, the statute imposes a 3.8% tax on the lesser of (1) net investment income, or (2) modified adjusted gross income (“MAGI”) in excess of (a) $250,000 for Married, Filing Jointly and Surviving Spouses, (b) $125,000 for Married, Filing Separately, and (c) $200,000 for all others (Single, Head of Household, etc.) For estates and trusts, the statute imposes a 3.8% tax on the lesser of (1) undistributed net investment income, or (2) adjusted gross income in excess of the dollar amount at which the highest tax bracket applicable to trusts and estates begins (currently $11,950).
What is net investment income for purposes of Section 1411? The statute and the recently released Treasury Regulations relating to Section 1411 provide that net investment income is the sum of three “categories” or “buckets,” less properly allocable deductions. Included with the first category is gross income from interest, dividends, annuities, royalties and rents (unless earned in the course of an active trade or business); included within the second category is other gross income from passive activities and trading in financial instruments or commodities; and included within the third category is the net gain from the disposition of property, including property held for use in passive activities and trades or businesses of trading in financial instruments or commodities. Importantly, the statute does not include the following in the calculation of net investment income: wages, unemployment compensation, operating income from a non-passive business, social security benefits, tax-exempt interest, self-employment income and distributions from qualified retirement plans, such as 401(k)s and IRAs. However, because of the dual tax basis calculation required by the statute, the inclusion of these items in a taxpayer’s MAGI can result in the application of the 3.8% tax to other items of income that may have otherwise avoided the imposition of the new tax.
At this point, an example may be helpful. Assume that a taxpayer, a single filer, has wages of $180,000 and $15,000 of dividends and capital gains. The taxpayer’s modified adjusted gross income is $195,000, and his net investment income is $15,000. The 3.8% NIIT is applied to the lesser of (1) the taxpayer’s net investment income ($15,000), and (2) the taxpayer’s MAGI in excess of $200,000 ($0). This taxpayer will not currently be subject to the 3.8% tax.
Assume instead that the taxpayer still has $180,000 of wages, but also has $90,000 of rental income and $10,000 of dividends. The taxpayer’s modified adjusted gross income is $280,000, and his net investment income is $100,000. The taxpayer’s MAGI exceeds the threshold for single taxpayers by $80,000, and his net investment income is $100,000. The NIIT is applied to the lesser of $80,000 (the amount that the taxpayer’s MAGI exceeds the $200,000 threshold) or $100,000 (the taxpayer’s net investment income, assuming there are no exceptions to the passive activity rules). The taxpayer will owe net investment income tax of $3,040 ($80,000 x 3.8%) in addition to all other generally applicable taxes.
Although the statute specifically exempts distributions from retirement accounts from the NIIT calculation, the dual base approach to the application of the tax can have the effect of taxing such distributions. For example, if a single filer taxpayer has $10,000 of interest income and $190,000 of wages, his MAGI is $200,000. Thus, the taxpayer will pay no NIIT. However, if the taxpayer had received a $5,000 distribution from an IRA or rolled over a $5,000 IRA to a Roth IRA, that distribution will not be included in net investment income, but it would increase the taxpayer’s MAGI. Thus, the taxpayer’s MAGI is now $205,000 and his net investment income is still $10,000. The NIIT is applied to the lesser of net investment income ($10,000) and the excess over the $200,000 threshold ($5,000); as a result, the taxpayer will pay the 3.8% NIIT tax on $5,000, even though all that has changed was that the taxpayer received a distribution from an IRA. Thus, although the retirement account distribution was excluded from the net investment income calculation, the dual base application of the tax had the effect of taxing the distribution.
With regard to income received from the ownership of a business, the statute applies the 3.8% NIIT to income earned from passive activities (other than rental income, which will, absent limited exceptions, always be included in net investment income). In general, a passive activity is one in which the taxpayer does not materially participate. A taxpayer only materially participates in an activity if the taxpayer is involved in the operations of the business on a regular, continuous and substantial basis. There are a number of tests in the regulations to check for material participation, but, in general, a taxpayer materially participates in an activity if he participates for more than 500 hours during the taxable year. Thus, if a taxpayer works more than 500 hours per year (or an average of 10 hours per week) in a business, the income received from that business will be non-passive, and will not be included in his net investment income. However, it will continue to be included in the taxpayer’s MAGI, and because of the dual bases explained above, may result in the application of the NIIT to income that would not have otherwise been subject to the tax.
Although the application of the Section 1411 rules can be complex, certain planning opportunities do exist to work within the boundaries of the statute. For example, you may be able to manage your modified adjusted gross income through the use of like-kind exchanges, above-the-line deductions, tax-exempt bonds, and Roth IRAs. You may be able to avoid the imposition of the net investment income tax to income received from your business by “materially participating” in the activity. Because all of these changes may have an effect on other aspects of your financial, business and estate planning needs, it is important to consult with your advisors regarding the “big picture” prior to making any immediate changes. However, planning techniques do exist to lessen or eliminate exposure to the net investment income tax, and these techniques should be used in conjunction with your current investment, income and estate planning arrangements.