Beginning in 2013, a new tax of 3.8% is imposed on certain unearned net investment income of individuals, estates, and trusts whose income exceeds applicable threshold levels. The new tax, commonly referred to as the “Net Investment Income Tax,” or NIIT, is found in new Internal Revenue Code (IRC) § 1411, enacted by the Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, 124 Stat. 1029 (the “2010 Health Care Act”). The IRS has issued proposed regulations under IRC § 1411 that would generally apply to tax years beginning after December 31, 2013. REG-130507-11 (Dec. 5, 2012). Taxpayers can rely on the proposed regulations, however, for compliance purposes until final regulations are adopted.
0.9% Additional Medicare Tax on Wages and Net Earnings from Self-Employment
Social Security and Medicare benefits are financed by Federal Insurance Contributions Act (FICA) taxes on covered wages and self-employment (SE) taxes on self-employment income. In an effort to increase Medicare funding, the 2010 Health Care Act increased the Medicare contribution tax rate on wage and self-employment income of high earners, which complements the NIIT. The 0.9% excess Medicare contribution tax applies to wages and self-employment income over the applicable threshold amounts, which are $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately, and $200,000 for all other individuals.
FICA taxes on wages comprise two parts: (1) Old-Age Survivors and Disability Insurance (OASDI) tax (6.2% on each of the employer and employee up to the taxable wage base, $113,700 in 2013); and (2) Medicare hospital insurance tax (1.45% on each of the employer and employee on all wages). SE tax is 15.3% (comprising 12.4% OASDI and 2.9% Medicare tax) of self-employment income up to the taxable wage base ($113,700 in 2013) and 2.9% Medicare tax on all self-employment income above the taxable wage base.
Beginning in 2013, the 2010 Health Care Act increases the Medicare portion of FICA and SE taxes for earned income over certain thresholds by 0.9%, raising the total Medicare contribution tax rate to 3.8% on that income. Unlike regular FICA taxes, which are split between employer and employee, the entire 0.9% excess Medicare contribution tax is imposed on the employee. In 2013, for a single taxpayer with wage income, the employer pays 6.2% OASDI on wages up to $113,700 and Medicare tax of 1.45% on all the employee’s wages. The taxpayer pays OASDI on wages up to $113,700, Medicare tax of 1.45% on wages up to the $200,000 applicable threshold, and Medicare tax of 2.35% (1.45% + 0.9% excess Medicare contribution tax) on all wages thereafter. The aggregate of the employer and employee’s portion of the Medicare taxes paid on the employee’s wages in excess of the applicable threshold is 3.8% (1.45% employer portion and 2.35% employee portion).
Net Investment Income Tax (NIIT)
With the enactment of NIIT, high-income taxpayers with substantial income from investments rather than wages or self-employment will not necessarily avoid Medicare contribution taxes. For individual taxpayers, the 3.8% NIIT is imposed on the lesser of the individual’s (1) net investment income (NII) for the taxable year or (2) the amount by which the taxpayer’s modified adjusted gross income (MAGI) for the taxable year exceeds the applicable threshold amount. The MAGI applicable threshold amounts are $250,000 for a married couple filing a joint return (including a final joint return by a surviving spouse), $125,000 for a married individual filing a separate return, and $200,000 in all other cases. These amounts are not indexed for inflation. An individual’s MAGI for purposes of calculating the NIIT is the individual’s adjusted gross income (AGI), increased for foreign earned income (net of deductions and exclusions disallowed for the foreign earned income) excluded from the individual’s AGI. The NIIT applies to U.S. citizens and residents but does not apply to nonresident aliens. A U.S. citizen or resident who is married to a nonresident alien will be treated as married filing separately for application of the tax and will be subject to the $125,000 threshold amount. Prop. Treas. Reg. § 1.1411-2(a)(2)(i).
Net Investment Income Defined
The NIIT does not apply to an individual unless the individual’s MAGI exceeds the applicable threshold. Thus, if the individual’s MAGI does not exceed the applicable threshold, there is no need to calculate the taxpayer’s NII for the taxable year.
A taxpayer’s NII comprises (1) gross income from interest, dividends, annuities, royalties, and rents, except those derived in the ordinary course of a trade or business that is neither a passive activity with respect to the individual, nor a trade or business of trading in financial instruments or commodities; (2) gross income from a trade or business that is a passive activity (as defined in IRC § 469) or a trade or business of trading in financial instruments or commodities; and (3) the net gain, to the extent taken into account in computing taxable income, that is attributable to the disposition of property held in a trade or business that constitutes a passive activity with respect to the taxpayer or is the trade or business of trading in financial instruments or commodities, less allowable deductions allocable to that gross investment income and net gain.
Passive Activity Rules Under IRC § 469
Passive losses are deductible against passive income, and excess passive losses are carried forward to be used to offset passive income in future years or when the passive activity is sold. Because generally passive activity losses may be used only to offset passive activity income, the characterization of income as passive has historically been seen as a favorable classification. For high-income taxpayers, the NIIT will require a shift in this thinking, because having passive activity income in excess of passive activity losses may subject the taxpayer to the tax. To avoid having excess passive activity income, high-income taxpayers may wish to convert passive activity income into nonpassive income to the extent such conversion does not suspend passive losses or trigger self-employment tax on the income.
The rules for determining whether an activity is active or passive with respect to a taxpayer are found in IRC § 469 and the corresponding Treasury Regulations. Under these rules, trade or business activities other than rental activities or working interests in oil and gas properties are considered passive activities unless the taxpayer materially participates in the activity. Material participation requires that the taxpayer’s involvement in the activity is regular, continuous, and substantial. A taxpayer is treated as materially participating in an activity if the taxpayer meets any one of seven tests during the taxable year:
- the individual participates in the activity for more than 500 hours during such year;
- the individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year, if the partner is not a limited partner;
- the individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year, if the partner is not a limited partner;
- the activity is a significant participation activity for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours, if the partner is not a limited partner;
- the individual materially participated in the activity (determined without regard to this bullet point) for any five taxable years (whether or not consecutive) during the 10 taxable years that immediately precede the taxable year;
- the activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
- based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year, if the partner is not a limited partner.
Two or more trade or business activities can be treated as a single activity for purposes of these material participation tests, but only if the activities constitute an appropriate economic unit for the purposes of measuring gain or loss for the passive loss rules. High-income taxpayers who would otherwise have excess passive activity income subject to the 3.8% NIIT may benefit from transforming passive income into nonpassive income by grouping activities together to satisfy the material participation tests, as long as this can be done without disallowing passive losses or subjecting the income to self-employment tax. Some of the factors used to determine whether activities may be grouped together to satisfy the material participation rules include similarities and differences in types of trades or businesses, the extent of common control or ownership, geographical location, and interdependence between activities.
Real estate rental activities are considered passive unless the taxpayer is a real estate professional. To be considered a real estate professional, more than one-half of the personal services performed by the taxpayer in trades or businesses during the taxable year must be performed in real property trades or businesses in which the taxpayer materially participates, and the taxpayer must perform more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. For gross income from rents to be excluded from net investment income, it must be derived in the ordinary course of a trade or business that is not a passive activity with respect to the taxpayer. Careful attention must be paid to the interaction of the passive loss rules and NIIT: gross income from rental activities that are classified as nonpassive with respect to the taxpayer are included in NII if the activity does not constitute a trade or business.
If an individual conducts a trade or business directly or through a disregarded entity, the determination of whether the trade or business activity is a passive activity with respect to the individual is made at the individual, rather than entity, level. On the other hand, if the individual owns an interest in a trade or business through one or more pass-through entities, such as a partnership or Subchapter S corporation, the determination of whether an item of gross income allocated to the individual is derived in a trade or business that is a passive activity with respect to the individual is made at the entity level. Thus, if a taxpayer owns an interest in ABC partnership, whether ABC’s trade or business is a passive activity with respect to the individual is made at the entity level, even if the individual is otherwise carrying on a trade or business.
Trade or Business
To be excluded from the definition of NII, gross income from interest, dividends, annuities, royalties, and rents must be derived in the ordinary course of a trade or business. If the pass-through entity is not engaged in a trade or business, the gross income passed through to the taxpayer does not qualify for the ordinary course of business exception regardless of whether the taxpayer (or an intermediary pass-through entity) is engaged in a trade or business. Thus, if taxpayer D is a partner in DEF partnership and the partnership is not engaged in a trade or business, gross income passed through to the taxpayer from DEF cannot qualify for the ordinary course of business exception to NII even if taxpayer D is otherwise carrying on a trade or business.
Similarly, the determination of whether a trade or business carried on by a pass-through entity is a trade or business trading in financial instruments or commodities is made at the entity level and the income passed through from such trade or business retains its character as it passes through from the entity to the taxpayer. For this purpose, financial instruments include stocks and other equity interests, evidences of indebtedness, options, forward or futures contracts, notional principal contracts and any other derivatives, or any evidence of an interest in any of them. Evidence of an interest in a financial instrument includes short positions or partial units.
Other Income Excluded from NII
The third component of NII is net gain (to the extent it is taken into account in computing taxable income) attributable to the disposition of property but not if the property disposed of is held in a trade or business that is neither a passive activity with respect to the taxpayer nor a trade or business of trading in financial instruments. Net gain from the disposition of property held in a trade or business is excluded from net investment income unless the trade or business is a passive activity with respect to the taxpayer or is a trade or business of trading in financial instruments or commodities.
Only net gain that is taken into account in computing taxable income is included in NII. A common myth is that the NIIT will apply the 3.8% tax to home sales, but this is largely untrue. Gain that is not taken into account in computing taxable income is excluded from net investment income. Thus, to the extent the gain from the sale of a personal residence is excluded from taxable income (up to $250,000, and $500,000 for married taxpayers filing jointly), it is also excluded from NII. For example, suppose married taxpayers filing a joint return have MAGI of $400,000 and sell their personal residence, realizing a gain of $600,000. Under IRC § 121, $500,000 of the gain on the sale of their residence is excluded from their taxable income and is thus also excluded from NII. The couple is subject to 3.8% NIIT on $100,000, which is the lesser of (1) the amount by which their MAGI exceeds the applicable threshold $150,000 ($400,000 MAGI − $250,000 threshold) or (2) their NII, $100,000.
Certain other types of income are also specifically excluded from NII. These include any item taken into account to determine self-employment income and distributions from qualified retirement plans.
Trusts and Estates
In the case of a trust or estate, the 3.8% NIIT is imposed on the lesser of undistributed NII or the excess of AGI over the dollar amount at which the highest income tax rate applicable to an estate or trust applies ($11,950 in 2013). As with individuals, the NIIT is applicable to a trust or estate only if the entity’s adjusted gross income exceeds the threshold amount. The threshold amount that applies to trusts and estates, however, is low enough that the application of the NIIT to trusts and estates is a trap for the unwary.
Certain types of trusts are exempt from the NIIT. Under the statute, the NIIT does not apply to trusts in which all the unexpired interests in the trust are devoted to certain charitable purposes. The proposed regulations also provide that the NIIT does not apply to trusts exempt from tax under IRC § 501, charitable remainder trusts, any other trust, fund, or account that is exempt from taxes imposed in Subtitle A of the IRC, or foreign trusts (except certain foreign trusts with U.S. beneficiaries). An electing small business trust (ESBT) is taxed on its S corporation income at the highest income tax rate, including the NIIT.
A grantor trust is not subject to NIIT at the trust level, but each item of income or deduction that is included in calculating the grantor’s (or other person’s) taxable income under the grantor trust rules is treated as if it had been directly received by or paid to the person for purposes of calculating that person’s net investment income. The higher individual threshold amounts will apply to calculate the individual taxpayer’s NIIT.
Contrast an ESBT with a qualified Subchapter S trust (QSST), the beneficiary of which is treated as the deemed owner under the grantor trust rules. The QSST beneficiary’s income tax bracket might be low enough to avoid the NIIT. Furthermore, the QSST beneficiary’s participation would determine whether the income is active trade or business income excluded from NII, rather than looking to the trustee’s participation. A trust that qualifies for QSST treatment can switch between QSST and ESBT status every 36 months.
Strategies for Minimizing a Trust’s NIIT
Trusts and estates are subject to NIIT on the lesser of undistributed net investment income or the excess of adjusted gross income over the applicable threshold amount. A trust or estate with AGI over the applicable threshold amount can minimize NIIT by either reducing its net investment income or distributing it.
The same definition of net investment income that applies for individuals also applies to trusts and estates. Thus, a trust or estate can reduce its net investment income by minimizing its passive activity income. Just as with an individual, an activity is considered passive unless the trust materially participates in the activity.
How to determine whether an activity is passive or nonpassive with respect to a trust has been the subject of litigation. The IRS takes the position that only the trustee’s direct actions on behalf of the trust should be considered in determining whether the trust materially participates in an activity. If a beneficiary participates in an activity, consider giving the beneficiary a role as trustee whose authority is limited to acting on behalf of the trust for investments that need to be tested under the passive activity rules. To be considered a fiduciary under the passive loss rules under the IRS’s view, the special trustee must have some discretionary authority to act on behalf of the trust. See, e.g., PLR 200733023. Some state laws may allow for a nonjudicial settlement agreement to not only add a special trustee for this purpose but also protect the trustee from liability. Mattie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003), held that actions by the trustee’s agents were sufficient, presenting another option, but one that might not satisfy the IRS’s view of the tests.
Another way to minimize a trust’s or estate’s exposure to the NIIT is to restructure the trust’s or estate’s investments to avoid its receipt of net investment income. Consider, for example, using tax-exempt investments such as municipal bonds or tax-deferred investments or accounts such as life insurance or deferred annuity contracts.
Distributing Net Investment Income
NIIT is imposed on a trust or estate only if the trust or estate has undistributed net investment income. The trust or estate can avoid NIIT by distributing its net investment income to its beneficiaries.
Under the income tax rules applicable to trusts and estates, the beneficiaries are taxed on the portion of trust income that is distributed to the beneficiaries, and the trust is taxed on the portion of income it retains. To the extent a trust or estate distributes NII to its beneficiaries, that NII is passed through to the beneficiaries. If the beneficiary’s MAGI exceeds the beneficiary’s applicable threshold amount, those items of net investment income will be included in the beneficiary’s NIIT calculation. On the other hand, to the extent the trust or estate retains the net investment income items, that undistributed net investment income is included in the trust’s or estate’s NIIT calculation.
The differences in the tax brackets and the applicable thresholds for individuals, trusts, and estates present a potential opportunity for decreasing the aggregate tax liability. If the trust’s AGI would exceed the applicable threshold amount, the trustee can consider distributing NIIT, particularly to a lower-income beneficiary whose MAGI does not exceed the applicable threshold and is thus not subject to NIIT.
Beginning in 2013, high-income individuals, and many trusts and estates, may be subject to the 3.8% NIIT. Taxpayers should first determine whether they are potentially subject to the tax by comparing their MAGI (for individuals) or AGI (for trusts and estates) with the applicable threshold amounts. Only taxpayers whose MAGI or AGI exceeds the applicable threshold amount need to calculate their net investment income to determine their NIIT liability. Note that income that is excluded from NII might be includible in MAGI (for example, IRA distributions), making the taxpayer subject to NIIT. For those individual taxpayers whose MAGI exceeds the threshold, careful attention should be paid to whether particular items of income meet the exceptions to the net investment income definition. In particular, consider whether excess passive activity income may be transformed into nonpassive activity income, for example, by aggregating activities to satisfy the material participation tests. The proposed regulations allow taxpayers to change the grouping elections they previously made under the passive loss rules.
Trusts and estates with AGI in excess of the amount at which the highest income tax rate bracket applies ($11,950 for 2013) should also consider whether they would benefit from restructuring their investments to reduce NII. Trusts and estates with excess passive income may consider whether the passive income may be converted into nonpassive income by aggregating multiple activities or by appointing a beneficiary or agent who materially participates in the activity as a special trustee to meet the material participation tests. Finally, trusts and estates should consider whether distributing NII to lower-income beneficiaries may lessen the overall tax burden.