In December 2012, the IRS issued proposed regulations (REG-130507-11) for the net investment income tax under Sec. 1411 that went into effect on Jan. 1, 2013. At the same time, the IRS released a list of frequently asked questions concerning the net investment income tax.
The new levy was created to help pay for health care reforms that were enacted in 2010. The rate is 3.8% of the lower of net investment income or the amount of modified adjusted gross income (MAGI) over specific thresholds. The key consideration, however, is what constitutes net investment income and which taxpayers are affected. Moreover, practitioners need to know what information they must obtain from clients to correctly compute the additional tax, and they need to be aware of common issues that may arise in computing the net investment income tax.
Only individuals with MAGI above the thresholds and certain estates and trusts are subject to the net investment income tax. Nonresident aliens and entities other than natural persons are not subject to the tax. The thresholds for individuals are: married filing jointly and qualifying surviving spouse, $250,000; married filing separately, $125,000; single and head of household, $200,000. The thresholds are not indexed for inflation. For most taxpayers, MAGI is the same as adjusted gross income (AGI). Excluded income and certain deductions under Sec. 911 of citizens or U.S. residents residing abroad are the only modifications to AGI for the net investment income tax calculation.
Estates and trusts with undistributed net investment income and AGI above the dollar amount at which the highest tax bracket for an estate or trust begins for that tax year are also subject to the net investment income tax. (For 2013, $11,950.) Exempt trusts include grantor trusts under Secs. 671–679, REITs and common trust funds, tax-exempt trusts under Secs. 501 and 664, and charitable trusts under Sec. 170(c)(2)(B).
Three defined categories of income are subject to the net investment income tax (Sec. 1411(c)):
Category I: Gross income from interest, dividends, rents, royalties, and nonqualified annuities, other than such income derived in the ordinary course of a trade or business not described in Category II.
Category II: Other gross income from businesses that trade financial instruments or commodities, and businesses that are passive activities within the meaning of Sec. 469.
Category III: Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property, other than property held in a trade or business that is not described in Category II. Gains and losses from dispositions of trade or business property used in passive activities are included in calculating the net investment income tax.
To arrive at net investment income, investment income from these categories is reduced by investment expenses such as early-withdrawal penalties, interest expense, adviser fees, directly related rental and royalty expenses, and state and local taxes allocable to items included in investment income. Wages, self-employment income, unemployment compensation, business income from nonpassive sources, Social Security benefits, tax-exempt interest, and qualified pension, annuity, and individual retirement account distributions are excluded when calculating the net investment income tax.
Some real estate industry representatives and others have spread alarm, incorrectly, that the net investment income tax applies to all proceeds from sales of personal residences. As described in Category III, only the taxable portion of any gain from the sale of property, including a primary personal residence, is potentially subject to net investment income tax. Any gain excluded under the principal residence provisions under Sec. 121 is not considered net investment income. Since up to $250,000 of gain for single individuals and $500,000 for taxpayers filing jointly generally is exempt (if the ownership, use, and other requirements are met), many or most taxpayers are unaffected by the net investment income tax on the sale of their principal residences. However, gain attributable to depreciation adjustments (which cannot be excluded from income under Sec. 121(d)(6)) is included in net investment income. Gains from sales of second homes are subject to the tax. And, of course, the taxpayer must have MAGI exceeding the applicable threshold for the net investment income tax to apply.
Passive activities: With the inclusion of passive activity income in net investment income, it is even more critical that taxpayers properly identify their activities as passive or nonpassive and group them appropriately. Since the enactment of the net investment income tax, the IRS recognizes that previous groupings may no longer be appropriate. Therefore, in the first tax year beginning after Dec. 31, 2013, individual, estate, or trust taxpayers subject to the net investment income tax will be allowed a one-time “fresh start” for regrouping (Prop. Regs. Sec. 1.469-11(b)(3)(iv)). An individual, estate, or trust to which Sec. 1411 applies in a tax year beginning in 2013 may regroup activities in that tax year. Regroupings must comply with the rules in Rev. Proc. 2010-13 and Regs. Sec. 1.469-4. Practitioners should take this valuable opportunity to review all activity groupings and revise them, as appropriate.
S corporations and partnerships: Gain from disposition of an interest in a passthrough entity (a partnership or S corporation) where the interest is not a passive activity with respect to the taxpayer would seem to be included in Category III as net investment income. However, Sec. 1411(c)(4) provides that the amount of gain or loss included in net investment income from the disposition of an interest in a nonpassive passthrough entity is limited to the amount of gain or loss that would result if the entity sold all of its assets at fair market value (FMV) for cash immediately before the disposition of the interest (deemed-sale method). Gains from the sale of assets used in a nonpassive qualified trade or business are not included in net investment income. Under the proposed regulations, each asset must be separately valued, including goodwill, and a determination must be made whether the asset is used in a qualified trade or business. The individual shareholder’s or partner’s basis in the interest may have been adjusted outside the entity. The proposed regulations provide instructions for allocating adjusted basis among the gains and losses for purposes of adjusting net investment income.
Fortunately, the proposed regulations do not specify that the reporting entity must provide FMV and detailed asset use information to former partners or S corporation shareholders with their Schedule K-1, Shareholder’s [or Partner’s] Share of Income, Deductions, Credits, etc. However, sellers must attach a statement to their tax return for the year of disposition that includes specific information and the calculation of the adjustments to net investment income computed under this exception.
As a practical matter, since FMV and asset details are not usually readily available to shareholders and partners, obtaining these values and making the calculation will require assistance from the entity’s accountants. This will require asking preparers of Forms 1065, U.S. Return of Partnership Income, and 1120S, U.S. Income Tax Return for an S Corporation, for information that will be time-consuming to provide and, in the worst case, could lead to litigation. Sellers should consider including the information required to compute adjustments to net investment income as part of the sale agreement to avoid any future conflict with the IRS and to expedite the calculation of net investment income. In another twist, the deemed-sale exception does not apply to dispositions of S corporation stock if Sec. 338(h)(10) is elected.
Foreign entities: Prop. Regs. Sec. 1.1411-4(g) provides special rules for the treatment of distributions from controlled foreign corporations and passive foreign investment companies.
Kiddie tax: If parents elect to include a child’s interest, dividends, and capital gains on the parents’ Form 1040, U.S. Individual Income Tax Return, the child’s income, less the excluded amount on Form 8814, Parents’ Election to Report Child’s Interest and Dividends, is included in the net investment income tax calculation. Alternatively, if the child files his or her own return and computes the tax based on the parents’ effective rate, it appears that the child’s MAGI determines whether the net investment income tax is owed; but no official guidance is available.
While the net investment income tax was effective Jan. 1, 2013, the effective date of the proposed regulations is generally Jan. 1, 2014; however, taxpayers may rely on the proposed regulations for compliance purposes until the effective date of the final regulations. The IRS announced it expects to finalize the regulations under Sec. 1411 in 2013. Many more issues will likely arise in accurately calculating the net investment income tax. Preparers should be alert to new regulations as they are proposed and finalized.