The New 3.8 Percent Tax on Net Investment Income of Individuals, Estates, and Trusts
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 §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 §1411 and providing a myriad of definitions and rules relating to this new tax.7 On November 26, treasury issued final regulations under §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 adjusted gross income of $190,000, which includes $50,000 of NII. Based upon these facts, Joe Investor is not liable for NIIT in 2013, since his $190,000 of adjusted gross income does not exceed the income threshold for a single individual of $200,000. If during the 2014 taxable year, Joe Investor, who remains a bachelor, has modified adjusted gross income of $220,000, which includes $50,000 of NII, he would then be subject to $760 in NIIT (or 3.8 percent multiplied by $20,000), which is the lesser of $50,000 NII and the $20,000 excess of modified adjusted gross income over the income threshold amount ($220,000 – $200,000).15
NIIT for Estates and Trusts
Section 1411 also imposes a 3.8 percent NIIT on estates and trusts on the lesser of their undistributed NII or the excess of their adjusted gross income over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins, which is $12,150 for 2014 (and $11,950 for 2013).16 The NIIT is not applicable, however, to trusts that are exempt from income taxes (e.g., charitable trusts, qualified retirement plan trusts, and charitable remainder trusts (CRTs)), grantor trusts, and foreign trusts and foreign estates.17 While exempt estates and trusts will not themselves be subject to NIIT, distributions to individual, noncharitable beneficiaries may constitute taxable NII in the hands of the recipient.
An estate or trust’s undistributed NII is calculated in the same manner as that of an individual, with several adjustments that take into account certain distributions made to beneficiaries and charities during the year. Generally, undistributed NII is the estate or trust’s NII reduced by 1) distributions of investment income to beneficiaries to the extent of distributable net income (DNI) deductible under §651 or §661,18 and 2) amounts paid or permanently set aside for charitable purposes (and deductible under §642(c)).19 Importantly, the adjusted gross income of an estate or trust is similarly reduced by distributions to beneficiaries to the extent of deductible DNI so that such amounts do not inadvertently create NIIT for the estate or trust by eating up any available NIIT income threshold amount.
To illustrate, assume that in 2013 the Joe Investor Irrevocable Trust has $50,000 in NII, all of which is DNI, and distributes $20,000 to Joe’s nephew, Aaron, the trust beneficiary. Since the distribution to Aaron is deductible under §651 or §661, Joe’s trust will have undistributed NII of $30,000 and adjusted gross income of the same amount. As a result, Joe’s trust is subject to $685.90 in NIIT (3.8 percent multiplied by $18,050, which is the lesser of $30,000 undistributed NII and the $18,050 excess of adjusted gross income ($30,000) over the threshold amount ($11,950)). Furthermore, as the amount of DNI deducted by an estate or trust in calculating undistributed NII is NII in the hands of the beneficiary, Aaron may also be subject to NIIT on the distribution depending upon whether he has income in excess of the applicable threshold amount.
Consequently, there may be a tax incentive to distributing out as much of the trust or estate’s NII, which would be included in determining the trust’s or estate’s “distributable net income,” as permissible to beneficiaries with income below the applicable income threshold. Such an arrangement may reduce or potentially eliminate NIIT liability for the estate or trust. Assuming in the previous example that Aaron’s annual adjusted gross income does not meet the applicable NIIT income threshold for individuals, the trustee of Joe’s trust may consider providing greater distributions of net income to the beneficiary or beneficiaries. For instance, if Joe’s trust had instead distributed $50,000 to Aaron in 2013, its undistributed NII would be reduced to zero, and Joe’s trust would completely avoid paying NIIT. Of course, grantors and trustees will need to balance other tax and nontax factors (e.g., benefits of keeping and preserving assets in trust, and estate and gift tax implications) with the potential NIIT savings associated with increased trust distributions.
Passive Activity Business Income
As previously mentioned, NII includes income generated from and net gains attributable to a taxpayer’s passive activity business. In order to avoid this characterization, and, thus, avoid NIIT with respect to a business interest, a taxpayer must generally be considered “active” with respect to a “trade or business”20 n ot involving a trading business.21 A determination of whether a business activity is “passive” with respect to a taxpayer is determined under existing rules applying to so-called “passive activity losses” under §469. In the income tax context, these rules generally are intended to prevent taxpayers from sheltering active business income with nonactive business investment losses by deferring deductions for losses generated from a deemed “passive” trade or business activities to the extent that they exceed a taxpayer’s passive income in any given year.
A passive activity is one involving the conduct of a trade or business in which the taxpayer does not “materially participate.”22 In order to materially participate in an activity, the taxpayer’s involvement in the operations of the activity must be regular, continuous, and substantial. The regulations provide seven quantitative and qualitative tests for determining whether a taxpayer materially participates in an activity in a given year.23 For instance, a taxpayer may be considered to materially participate under the regulations if he or she spends more than 500 hours during the year participating in the activity. Provided the taxpayer satisfies one of the seven tests, the activity will be considered nonpassive or “active.” For purposes of the material participation tests, any work performed in a taxpayer’s capacity as an investor will not count as “active” participation unless the taxpayer is directly involved in the day-to-day management or operations of the activity.
In the simple case with a business operated by a taxpayer as a sole proprietor or through a state law entity not treated as a separate entity for tax purposes, such as a single-member limited liability company (LLC) classified as a tax disregarded entity or a grantor trust, the owner’s participation in the business determines whether the activity is passive or active. For a business conducted by an entity taxed on a passthrough basis (passthrough entity), such as a tax partnership (for example, a multiple-member LLC not taxed as a corporation) and an S corporation, the passive activity loss rules standards test the participation level of the individual owners of the entities, with a separate determination being made for each separate owner. In contrast, dividend income (including excessive, nondeductible compensation) received by a shareholder of a C or regular corporation is includible in NII, regardless of the degree of participation of the individual shareholder in the corporation’s business.
In the past, some taxpayers sought to characterize their activities as passive in order to generate passive gain and income to be sheltered by passive losses. In light of the NIIT, however, there may be considerable incentive for taxpayers to avoid passive status with respect to their activities and interests in passthrough entities. Accordingly, a taxpayer otherwise subject to the NIIT should assess whether passive income may be transformed into active income by increasing participation to qualify for nonpassive status under the material participation standards. As the passive activity loss rules generally apply on a year-by-year basis, taxpayers seeking to avoid NIIT by virtue of increased participation must materially participate in each taxable year to avoid future passive classification. Finally, a taxpayer intending on materially participating in an activity would be well advised to keep contemporaneous documentation, such as a personal activities log, substantiating the time spent with respect to the activity.24
Material Participation of Estates and Trusts
Historically, there has been considerable uncertainty as to how to apply the material participation standard to a trust or estate, as neither the Code nor the regulations provide guidance.25 Unfortunately, the government did not take the opportunity to address this long-standing issue in the final §1411 regulations or other NIIT related guidance. Until such definitive guidance is issued,26 estates and trusts will have to rely on the scant passive activity loss authorities currently available, which include the Senate report corresponding to the enactment of §469 and a Texas federal district court case.27 Based upon these limited authorities, an estate or trust may potentially be treated as materially participating in an activity if the personal representative or trustee, in his or her capacity as a fiduciary, actually materially participates in the activity. At this time, the taxpayer should assume that the participation has to be done by one or more of the fiduciaries in light of the IRS’ interpretation of the material participation test for estates and trusts.
One-time Regrouping of Activities
The passive activity loss rules permit taxpayers to make a one-time election to group one or more business or rental activities so that the material participation tests apply with respect to the taxpayers’ aggregate participation in the combined activity. Thus, for example, an otherwise passive 20-hour activity could potentially be considered active to the extent it can be grouped with a separate active 500-hour activity. Grouping of activities is allowed when the activities constitute an “appropriate economic unit” for measuring gain or loss, and activities conducted by different entities, such as a partnership or LLC, may be combined if the taxpayer has an ownership interest in both entities.28
Once a grouping election has been made, a taxpayer is generally not permitted to regroup the activities. With the imposition of the NIIT, however, and the renewed importance of the passive activity loss rules, Treasury granted taxpayers a one-time opportunity to regroup activities during the first taxable year in which the taxpayer meets the applicable NIIT income threshold and has NII.29 The election is to be made at the shareholder or partner level rather than at the entity level.
Thus, taxpayers meeting the applicable income threshold should consider whether to make use of the one-time regrouping election. This provision is likely to be of particular concern to those taxpayers involved in the rental of real property and interested in avoiding the passive activity taint generally applicable to rental activities. As this one-time regrouping of activities is allowed only in the first year the taxpayer meets the income threshold, tax advisors and their clients will need to carefully assess both the client’s current and anticipated future level of participation in the activities in deciding whether to make a regrouping election.
Application of NIIT Interests in Passthrough Entities
Individuals, estates, and trusts owning interests in passthrough entities may be subject to NIIT on the net income earned by the entity that flows through to them as Schedule K-1 income, as well as gain from the sale of passthrough entity equity (as further discussed below). Initially, to the extent the passthrough entity is not considered to be engaged in a “trade or business” for tax purposes (or is considered to be engaged in a trading business), all income and gain attributable to the passthrough entity is subject to NIIT. For passthrough entities conducting a nontrading business trade or business, income and gain from the passthrough entity that is attributable to a passive activity with respect to the partner, member, or shareholder is included in the taxpayer’s NII. In the alternative, if a taxpayer materially participates in the passthrough entity’s trade or business, the income and gain attributable to the entity during the taxable year will not be subject to NIIT.
As mentioned above, a determination is made on an owner-by-owner basis as to whether the taxpayer materially participates in the passthrough entity’s trade or business activity. As a result, certain owners of a passthrough entity may be considered “active” with respect to the entity’s business, while others may be considered “passive.” When the passthrough entity owns an interest in another passthrough entity ( i.e., a tiered-ownership structure), the owner’s actual participation in the relevant lower-tier entity’s business activity determines whether such activity is “active” or “passive” with respect to the owner; while a determination of the existence of the required nontrading business “trade or business” is made at each passthrough entity level with no activity attribution.
For sales of passthrough entity equity, NII includes net gains on the disposition of an interest in a passthrough entity with respect to a taxpayer that does not materially participate in the entity’s trade or business activities, but excludes gains from the disposition of active interests.30 Because owners are not considered to be in the business of selling the equity of their passthrough entity, the Code reaches the above result by determining NIIT based on a theoretical pre-equity sale of all of the passthrough entity’s assets at their fair market value. Though at first blush this appears to be a relatively straightforward provision, the applicable rules quickly become highly technical, as evidenced by Treasury revising applicable rules in the newly issued proposed regulations instead of finalizing the prior proposed rules. These proposed regulations implement the deemed asset sale rule by limiting the amount of NII on the disposition of an interest in a passthrough entity to the lesser of the amount of gain on the sale of the interest or the gain that would be recognized on the sale of the entity’s passive assets at fair market value.31 T he proposed regulations also provide rules to determine the amount of NIIT when the owner of the sold passthrough entity equity materially participates in some, but not all of the entity’s trade or business activities. As a result, taxpayers disposing of equity in passthrough entities conducting multiple activities, not all of which the taxpayer actively participates in, as well as those holding passive investment assets, may be required to come up with a valuation of the entity’s assets to determine the gain allocated to its NII generating assets. Furthermore, partners entitled to guaranteed payments or retiring partners receiving liquidated payments may also realize NII upon the receipt of these payments under special rules provided in the 2013 proposed regulations.32
With the implementation of the NIIT, individuals, estates, and trusts will need to review their portfolio of investments and business interests to determine whether and to what extent they will be subject to this new 3.8 percent tax. Advisors may consult with these taxpayers to assess potential planning opportunities to lessen the burden of the NIIT, including increasing participation in a profitable passive activity, or implementing certain safeguards to mitigate exposure to the tax. Finally, as additional guidance and further IRS interpretation of the NIIT is issued, taxpayers subject to the NIIT and their advisors will be wise to keep apprised of any significant developments in this area.
1 As the rules pertaining to the NIIT are particularly vast and complex (for instance, the preamble to the final NIIT Treasury regulations is itself 112 pages), a comprehensive review of this new tax is well beyond the scope of this article.
2 The NIIT should not be confused with the additional 0.9 percent Medicare tax that applies to individuals’ wages, compensation, and self-employment income over certain thresholds (but not items included in net investment income).
3 All statutory references are to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.
4 Individuals, trusts, and estates compute NIIT using the newly introduced Form 8960 (Net Investment Income Tax — Individuals, Estates, and Trusts).
5 Pub. L. No. 111-152 (2010) added §1411 to a new chapter 2A subtitle A (Income Taxes) of the Code.
6 It is uncertain whether Congress has actually achieved this goal. For a discussion of the issue in the context of fund managers, s ee Sheppard, News Analysis: Can Fund Managers Escape the New Medicare Tax?, 2013 TNT 37-1 (Feb. 20, 2013).
8 T.D. 9644.
10 IRS, Questions and Answers on the NIIT, http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs.
11 Charitable contributions are considered below-the-line deductions and have no effect on an individual’s adjusted gross income. See §§62 and 170.
12 I.R.C. §1411(e)(1); see Treas. Reg. §1.1411-2(a)(2) for special rules applicable to nonresident aliens married to U.S. citizens or residents, dual resident individuals, and dual-status resident aliens.
13 I.R.C. §1411(b). Note that these statutory income thresholds are not indexed for inflation.
14 Individuals with income from controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs) may be required to make additional adjustments to calculate their modified adjusted gross income. See Treas. Reg. §1.1411-10(e). Additionally, taxpayers holding interests in CFCs and PFICs may receive amounts subject to NIIT attributable to those interests at different times and in different amounts as the income recognized in respect of the interests under the income tax. See Treas. Reg. §1.1411-10(c).
15 Treas. Reg. §1.1411-2(b)(2).
16 The income threshold is set forth annually by the IRS in a revenue procedure. See Rev. Proc. 2013-35.
17 Treas. Reg. §1.1411-3(b)(1). Additionally, the regulations provide a specific methodology for applying NIIT to electing small business trusts (ESBTs). See Treas. Reg. §1.1411-3(c).
18 Generally, DNI is the taxable income of an estate or trust without reduction for its personal exemptions, including tax-exempt income, and excluding capital gains allocated to corpus and not distributed to beneficiaries. I.R.C. §643.
19 Treas. Reg. §1.1411-3(e). Because a charitable contribution may reduce the NIIT for a trust, but not an individual, practitioners may consider recommending to their clients certain charitable planning techniques, such as a CRT, to potentially avoid the impact of the NIIT.
20 The term “trade or business” has the same meaning for §1411 purposes as it does for §162 purposes.
Treas. Reg. §1.1411-1(d). Though not cited in the final regulations, the Supreme Court held in Groetzinger v. Comm’r, 480 U.S. 23, 35 (1987), that for purposes of §162, in order for a taxpayer to “be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit.”
21 Although income and gain attributable to trade or business in which the taxpayer actively participates is not considered NII, such amount is still included in a taxpayer’s modified adjusted gross income and can thereby potentially inadvertently trigger NIIT by eating up available income threshold.
22 I.R.C. §469(c)(1).
23 See Treas. Reg. §1.469-5T(a)(1)-(7).
24 See, e.g., Bailey v. Comm’r, T.C. Memo. 2001-296 (unwilling to accept taxpayer’s “ballpark estimate” of time committed to the activity where there was no contemporaneous documentation).
25 See Dees, 20 Questions (and 20 Answers!) on the New 3.8 Percent Tax, Tax Notes (Aug. 12, 2013).
26 While the IRS has indicated that it expects to issue guidance on material participation for estates and trusts in 2014, as of the date this article was submitted to the editor, no such guidance had been issued. See Freda, IRS Expects to Issue Guidance on Material Participation for Estates, Trusts in 2014,
BNA Daily Tax Report No. 245 at 6-7 (Dec. 20, 2013).
27 See S. Rep. No. 99-313 (1986); Mattie K. Carter Trust v. U.S. , 256 F. Supp. 2d 536 (N.D. Tex. 2003) (holding that if the persons who conduct business on behalf of a trust, including its agents, employees, and trustees, are materially participating, a trust may be treated as materially participating in an activity). Note that the IRS has taken a more narrow approach to this matter by determining that only the activities of a fiduciary may be counted in determining whether a trust materially participates in an activity. See, e.g., TAM 201317010 (April 26, 2013).
28 See Treas. Reg. §1.469-4(c).
29 Treas. Reg. §1.469-11(b)(3)(iv).
30 It should be noted that a distribution by a passthrough entity in excess of an owner’s tax basis in its equity in the passthrough entity is generally treated by the owner as gain from the sale or exchange of the equity. I.R.C. §§731(a), 1368(b)(2).
31 See Prop. Treas. Reg. §1.1411-7. The regulations also provide an optional simplified approach for certain qualifying taxpayers.
32 See Prop. Treas. Reg. §1.1411-4(g)(10)-(11).
Jordan August is an associate at Barnett, Bolt, Kirkwood, Long & McBride, in Tampa, practicing in the areas of federal income, estate, and gift taxation. He holds a bachelor’s degree, J.D., and an LL.M. in taxation from the University of Florida.
This column is submitted on behalf of the Tax Law Section, Joel David Maser, chair, and Michael D. Miller and Benjamin Jablow, editors.