Proposed Regs Clarify New 3.8% Investment Income Tax

The IRS has issued proposed regulations that provide guidance on the new 3.8% healthcare surtax on investment income and gains (IRC Sec. 1411). This article explains the general operating rules of the tax, and specific rules applicable to estates and trusts.  

The proposed regulations can be found at this link:  Proposed Net Investment Income Tax Rules.  This article does not contain a complete analysis of the regulations.  Please review the regulations before applying them to your own situation.

Although there are still many unresolved issues surrounding 2013's tax rates and the so-called “fiscal cliff,” with this surtax, higher taxes on investment-type income and gains are a relative certainty for higher-income taxpayers who meet the thresholds explained below.

Background. Beginning in 2013, certain “unearned income” of individuals, trusts, and estates is subject to a surtax (i.e., it's payable on top of any other tax payable on that income). The surtax, also called the “unearned income Medicare contribution tax” or the “net investment income tax” (NIIT), is 3.8% of the lesser of:

(1) net investment income (NII); or

(2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). MAGI is adjusted gross income (AGI) plus any amount excluded as foreign earned income under Code Sec. 911(a)(1).

Example:  In 2013, a single taxpayer has net investment income of $100,000 and MAGI of $220,000. He pays the surtax only on $20,000, which is the amount by which his MAGI exceeds the threshold amount of $200,000, and because that is less than his NII of $100,000. Therefore, the surtax is $760 ($20,000 × 3.8%).

For an estate or trust, the surtax is 3.8% of the lesser of undistributed NII, or the excess of AGI (as defined in Code Sec. 67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.

Net Investment Income (NII) is defined as investment income less deductions properly allocable to such income.  Investment income is (a) gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the 3.8% surtax doesn't apply; and (b) other gross income derived from a trade or business to which the Medicare contribution tax does apply; and (c) 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 to which the Medicare contribution tax doesn't apply.

The 3.8% surtax applies to a trade or business only if it is a passive activity of the taxpayer or a trade or business of trading in financial instruments or commodities.

Investment income does not include amounts subject to self-employment tax, distributions from tax-favored retirement plans (e.g., qualified employer plans and IRAs), or tax-exempt income (e.g. earned on state or local obligations).

The surtax doesn't apply to trades or businesses conducted by a sole proprietor, partnership, or S corporation (but income, gain, or loss on working capital isn't treated as derived from a trade or business and thus is subject to the tax).

Gain or loss from a disposition of an interest in a partnership or S corporation is taken into account by the partner or shareholder as net investment income only to the extent of the net gain or loss that the transferor would take into account if the entity had sold all its property for fair market value immediately before the disposition.

The tax does not apply to: nonresident aliens; trusts all the unexpired interests in which are devoted to charitable purposes; trusts exempt from tax under Code Sec. 501; or charitable remainder trusts exempt from tax under Code Sec. 664.

General operating rules. The IRS has provided definitional rules in the proposed regs designed to both promote the fair administration of Code Sec. 1411 and prevent taxpayers from circumventing its purposes (significantly, to impose a tax on the unearned income or investments of certain individuals, estates, and trusts).  The IRS will closely review transactions that manipulate a taxpayer's NII to reduce or eliminate the amount of the surtax and, when appropriate, challenge such transactions based on applicable statutes and judicial doctrines (e.g., substance over form).

Application to Estates and Trusts. The proposed regs provide rules with regard to these specific trust types:

(a)   Grantor trusts. The income of a grantor trust (i.e., a trust any portion of which is treated as owned by the grantor, with items of income, deduction, and credit attributed accordingly) is taxed to the owner. So, these amounts are taken into account in calculating the owner's NII.

(b)   Electing Small Business Trusts (ESBTs). ESBTs, which are treated as two separate trusts when a portion of the ESBT's holdings is S corporation stock, are subject to special computational rules. The proposed regs treat the ESBT as two separate trusts for computational purposes, but consolidate the ESBT into a single trust for determining the AGI threshold.

(c)   Charitable remainder trusts (CRTs). CRTs are also subject to special computational rules. The trust itself isn't subject to Code Sec. 1411, but the annuity and unitrust distributions may constitute NII to the noncharitable recipient.

(d)   Foreign estates and foreign nongrantor trusts. In general, foreign estates and foreign trusts aren't subject to Code Sec. 1411.  However, IRS and Treasury believe that the NII of a foreign trust or estate should be subject to Code Sec. 1411 to the extent that such income is earned or accumulated for the benefit of, or distributed to, U.S. persons.

(e)   Bankruptcy estates. A bankruptcy estate of a debtor who is an individual is treated as an individual for Code Sec. 1411 purposes.  Therefore, the bankruptcy estate computes its tax in the same manner as an individual, and the rate is the same as that imposed on a married taxpayer filing separately.  

Effective date. The proposed regs are to be effective for tax years beginning after December 31, 2013.  However, taxpayers may rely on the proposed regs for purposes of compliance with Code Sec. 1411 until the effective date of the final regs.