The Health Care and Education Reconciliation Act of 2010 1 added a new chapter 2A to subtitle A (Income Taxes) of the Internal Revenue Code effective for 2013. 2 Sec. 1411, the only provision in the chapter, imposes a 3.8% tax on the net investment income of an individual whose modified adjusted gross income (MAGI) exceeds a threshold that varies depending on the taxpayer’s filing status. The new surtax is also imposed on the undistributed net investment income of an estate or trust whose adjusted gross income (AGI) exceeds the dollar amount at which the highest tax bracket for an estate or trust begins.
This article examines how to determine the new surtax on net investment income that, like alternative minimum taxable income, effectively creates another tax base in addition to taxable income. After describing the calculation and reach of the surtax, this article suggests ways to lessen its impact or avoid altogether this “parallel universe” that mirrors the regular income tax and the alternative minimum tax (AMT).
Beginning in 2013, Sec. 1411 imposes a 3.8% tax on the net investment income of certain individuals, estates, and trusts. The tax does not apply to nonresident aliens 3 and any trust all of whose unexpired interests are devoted to a charitable purpose under Sec. 170(c)(2)(B). 4 The tax is not deductible for any income tax the Code imposes. 5
In the case of an individual, the surtax is (in addition to any other income tax) for each tax year 3.8% of the lesser of:
- The individual’s net investment income for the year, or
- The excess (if any) of the individual’s MAGI over a threshold amount. 6
The threshold amounts are (1) $250,000 for married individuals or a surviving spouse filing a joint return; (2) $125,000 for a married individual filing a separate return; and (3) $200,000 in all other cases. 7 MAGI for this purpose is AGI (increased by the foreign earned income exclusion 8) less properly allocated deductions. 9
Example 1: X and Y, married filing jointly, together have income of $500,000, all of which is salary. The surtax will not apply because they have no net investment income.
Example 2: X and Y, married filing jointly, have $500,000 of salary and $50,000 of net investment income. The surtax applies to the $50,000 of net investment income because it is less than the excess of MAGI over the threshold (i.e., $550,000 – $250,000 = $300,000).
Example 3: X, a single filer, has $275,000 of net investment income and no other income. The surtax applies only to the $75,000 that exceeds the $200,000 threshold for single filers.
Example 4: X and Y, married filing jointly, have $225,000 of salary income and $125,000 of net investment income. The surtax applies to $100,000, the difference between their threshold ($250,000) and MAGI ($350,000), which is less than their net investment income of $125,000.
Example 5: X, a single filer, has $500,000 of interest and a $500,000 net capital loss. The surtax applies to $297,000, $500,000 less $200,000 threshold and the $3,000 maximum capital loss that may offset ordinary income.
Estates and Trusts
An estate or trust is subject to the 3.8% tax to the extent of the lesser of:
- The estate’s or trust’s undistributed net investment income; or
- The excess (if any) of the estate’s or trust’s AGI 10 over the dollar amount at which the highest tax bracket begins for the year (i.e., $11,950 for 2013). 11
Example 6: The X Trust may pay income and principal as needed to its beneficiary, a single individual who has no other income. In 2013, the trust has dividend and interest income of $150,000, and net capital gain of $300,000. The trust makes no distributions and has AGI of $450,000. Because the highest tax bracket for a trust is $11,950 in 2013, the net investment income subject to the surtax is $438,050 ($450,000 – $11,950).
Example 7: If, in the preceding example, the $150,000 of dividend and interest income is distributed to the trust’s beneficiary, X Trust’s net investment income is $288,050 ($300,000 – $11,950). Because the surtax threshold for a single taxpayer is $200,000, the beneficiary is not subject to the surtax on the $150,000 of dividends and interest.
In all of the above examples, the surtax is subject to estimated tax requirements and penalties for underpaying estimated tax. 12
Net Investment Income
As the above discussion illustrates, the key concept of Sec. 1411 is the definition of the new tax base, “net investment income.” In enacting a new tax on net investment income, Congress has effectively created yet another separate tax base, the calculation of which parallels the calculation of taxable income, to which the regular tax rates apply, and AMT income to which rates of 26% or 28% apply. The tax on net investment income, however, is a surtax that is added to the taxpayer’s regular tax (and, if applicable, AMT) liability.
In general, Sec. 1411(c) defines investment income to be the sum of three categories of income: (1) interest, dividends, annuities, royalties, and rents other than income derived in the ordinary course of a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities; 13 (2) income (other than the income included in the first and third categories) from a trade or business that is a passive activity to the taxpayer under Sec. 469 14 or a trade or business of trading in financial instruments and commodities; and (3) net gain from the disposition of property other than property held in a trade or business that is not a passive activity or a trade or business of trading in financial instruments or commodities. 15 Investment income also includes income attributable to an investment in working capital. 16 Investment income does not include any income subject to self-employment tax 17 nor does it include distributions from qualified plans under Secs. 401(a), 403(a), 403(b), 408, 408A, or 457(b). 18
Example 8: Individual X’s only income for 2013 is a pension of $550,000 and $35,000 of tax-exempt income. The surtax does not apply because X has no investment income. 19
These investment income amounts are reduced by any properly allocable deductions to arrive at net investment income upon which the 3.8% tax is imposed. However, a net operating loss (NOL) deduction allowed under Sec. 172 cannot be taken into account in determining net investment income for any tax year. 20
Example 9: 21 In year 1, X, an unmarried individual, has $60,000 of wages, $20,000 of investment income, a $70,000 loss from a sole proprietorship, and $30,000 of expenses allocable to investment income, so that there is no net investment income. X elects to carry over the $20,000 NOL to year 2. In year 2, X has $200,000 of wages, $100,000 of investment income, an $80,000 profit from the sole proprietorship, and $10,000 of investment expenses. The $20,000 NOL carryover is allowed in computing X’s year 2 MAGI but not in computing X’s net investment income.
In measuring the Sec. 1411 tax base, income (e.g., interest, dividends, rents, etc.) that might otherwise be treated as investment income is not taken into account if it is derived in the ordinary course of a trade or business that is not a passive activity for the taxpayer or that is not from the trading of financial instruments or commodities, 22 meaning income from active trades or businesses is not subject to the tax, but income from trading financial instruments or commodities is. For this purpose the Sec. 1411 proposed regulations look to the case law under Sec. 162 to determine what constitutes a trade or business, only specifically excluding from net investment income any amount subject to self-employment tax, which generally requires the taxpayer be engaged in a trade or business under Sec. 162. 23
Example 10: 24 X rents a building, but the rental activity does not constitute a trade or business. Because X’s rental of a building does not constitute a trade or business, it is not income from a trade or business that is a passive activity. However, it is net investment income because it is income from rents.
Example 11: 25 Y engages in an equipment leasing activity where the average period of customer use is seven days or less, which means that the rental activity is not automatically passive. 26 If Y materially participates in the activity and the activity otherwise constitutes a trade or business under Sec. 162, the rent is not net investment income. If Y does not materially participate, the rent will be net investment income.
Even where an individual qualifies as a real estate professional under Sec. 469(c)(7) so that his rental activities are not passive, the taxpayer must still be considered to be engaged in a trade or business within the meaning of Sec. 162 and Prop. Regs. Sec. 1.1411-4(b) to exclude any rental profits from the surtax. 27
Application of Chapter 1 to Chapter 2A
In determining what is investment income and what deductions offset it, Sec. 1411, which alone constitutes chapter 2A of the Code, uses numerous terms commonly used in chapter 1 of the Code. The Sec. 1411 proposed regulations make clear that the general rules of chapter 1 for determining income or loss, including timing rules, exclusions, and deferrals, apply for purposes of chapter 2A and Sec. 1411. 28 Thus, for example, capital gain not recognized for income tax purposes under the installment method, 29 the like-kind exchange 30 or involuntary conversion rules, 31 or the exclusion of gain from the sale of a principal residence 32 does not constitute investment income under Sec. 1411. Similarly, deferral or disallowance provisions under chapter 1 also apply to chapter 2A’s definition of net investment income, e.g., the limitation on investment interest, 33 expenses relating to tax-exempt income, 34 the at-risk limitations, 35 passive activity loss rules, 36 and partner and S corporation shareholder basis limitations. 37
Furthermore, any rules allowing for carryover of unused amounts for income tax purposes also apply for determining net investment income in subsequent years. 38 Thus, suspended passive activity losses, capital loss carryovers, and excess investment interest expense from pre-2013 years apply to determine a taxpayer’s MAGI and net investment income for post-2012 tax years. 39 However, NOLs under Sec. 172 can be taken into account only in determining MAGI. They cannot be taken into account in determining net investment income for any tax year.
Itemized Deduction Limits on Net Investment Income
In calculating net investment income, deductions subject to the 2% floor on miscellaneous itemized deductions 40 are determined before determining the overall limitation on itemized deductions when AGI exceeds certain amounts (i.e., the Pease limitation). 41 The interaction of these various limitations and thresholds on the calculation of net investment income is illustrated below:
Example 12: 42 X, an unmarried individual, has AGI in year 1 of $2 million, consisting of $1,600,000 of wages and $400,000 of interest. X has itemized deductions as shown in Exhibit 1. X’s 2% floor is $40,000 (2% of $2 million), and the overall phaseout of itemized deductions begins at AGI of $200,000, 43 resulting in a disallowance of $54,000 of X’s itemized deductions (3% of the excess of $2 million over the $200,000 threshold). Taking into account the 2% floor, X’s miscellaneous itemized deductions, i.e., investment expenses and job-related expenses, are limited to $60,000 ([$70,000 + $30,000 – $40,000]), which consists of $42,000 of investment expenses and $18,000 of job-related expenses as determined in Exhibit 2.
The deduction for state income taxes is not subject to the 2%-of-AGI floor limitation, 44 and the $80,000 of investment interest expense is not subject to the itemized deduction 45 phaseout, leaving the following subject to the overall phaseout, as shown in Exhibit 3. The amount of deductible investment expenses allocable to investment income is $29,400, as shown in Exhibit 4. The amount of deductible state income taxes directly allocable to investment income is $14,000, as shown in Exhibit 5. The amount of deductible state income taxes indirectly allocable to investment income is $70,000, as shown in Exhibit 6.
If there had been mortgage interest and/or charitable contributions, similar allocations of the $54,000 phaseout would have been made, but the job-related expenses and the $70,000 of state income taxes are not allocable to investment income. Therefore, the total allocable deductions offsetting investment income are as shown in Exhibit 7.
This example demonstrates that the calculation of net investment income involves subtle and sometimes challenging calculations regarding which itemized deductions may reduce investment income to arrive at the new tax base.
Treatment of Income From Passthrough Entities
Another challenge in determining net investment income is the treatment of income passed through from partnerships, S corporations, or limited liability companies that are not disregarded entities. (If the passthrough entity is a disregarded entity owned by an individual, the determination of whether an item of gross income is from a trade or business is determined at the individual level.)
If the passthrough entity is not engaged in a trade or business within the meaning of Sec. 162, then the owner’s distributive share of the entity’s items of income that qualify as net investment income under Sec. 1411(c)(1)(A)(i) (interest, dividends, etc.) will be net investment income for the owner. If the entity is engaged in a trade or business, an owner’s share of all the income from the trade or business is also investment income if the trade or business is a passive activity with respect to the owner, i.e., the owner is not a material participant in that trade or business. Specifically, Sec. 1411(c) adopts the passive activity rules of Sec. 469, including the rules regarding material participation, to determine if the trade or business is a passive activity for the owner.
The income from a passthrough entity is also investment income for an owner if it is income from a trade or business of trading in financial instruments or commodities. Whether a passthrough entity is engaged in such a trade or business is determined at the entity level. The income retains its character as it passes through to the owner from the entity.
Example 13: X, an unmarried individual, owns a 50% interest in a limited liability company that rents a commercial building to B for $50,000 per year. The rental activity does not constitute a trade or business and under Sec. 469(c)(2) is a passive activity to X. Because the activity is not a trade or business, X’s share of the rental income is investment income to X.
If, on the other hand, the entity is engaged in a trade or business, the entity’s income attributable to X would be investment income because the activity is passive to X under Sec. 469.
Example 14: 46 C, an individual, owns stock in an S corporation. The corporation is engaged in a trade or business, but that trade or business is a passive activity to C under Sec. 469. The corporation earns $100,000 of interest that is not derived in the ordinary course of its trade or business and $1 million of income in the ordinary course of its trade or business, of which C’s pro rata shares are $5,000 and $50,000, respectively.
Although the corporation is engaged in a trade or business, the activity is passive to C, and, therefore, C’s distributive shares of interest and other income are investment income. If C materially participated in the corporation’s trade or business, the other income would not be investment income. However, the interest would remain investment income, because it was not derived in the ordinary course of a trade or business
Aside from the obvious computational challenges, the above example demonstrates the difficulty in determining the entity’s investment income attributable to an owner when a partnership or S corporation is actively engaged in a trade or business, but the owner of the entity is not.
Disposition of Interests in a Passthrough Entity
In the case of a disposition of an interest in a partnership or S corporation, gain or loss from the disposition is treated as investment income or loss to the extent it is attributable to the transferor’s interest in each asset, the sale of which by the partnership or S corporation would give rise to investment income or loss. 47 The regulations set out a four-step procedure to allocate gain from the sale of the partnership interest or S corporation stock to investment income for purposes of Sec. 1411. The steps are: (1) assume the entity has a cash sale of all its properties; (2) determine the gain or loss for each property; (3) allocate the gain or loss to the selling partner or shareholder; and (4) measure how much of that allocated gain or loss is attributable to property held in an active trade or business. After performing these steps, any gain attributable to property held in an active trade or business is subtracted from the gain on the sale of the interest itself when calculating investment income. If there is a loss attributable to the trade or business property, the entire gain on the sale of the interest is treated as investment income. 48
Example 15: 49 Individuals X and Y own 75% and 25%, respectively, of an S corporation. X does not materially participate in the S corporation’s trade or business, but Y does materially participate. X and Y sell their stock for $90,000 and $30,000, respectively, recognizing gains of $15,000 and $5,000, respectively. At the time of the stock sales, the corporation’s assets were as shown in Exhibit 8.
X’s gain is entirely investment income, but none of Y’s gain is investment income because his share of the gain attributable to a deemed sale of the corporation’s trade or business assets (25% × $20,000) equals his overall gain on the sale.
Any adjustment of the gain or loss from the sale of a partnership interest or S corporation stock under the rules in Regs. Sec. 1.1411-7(c) must be reported and explained on a statement attached to the seller’s return for the year of the disposition. 50
Tiered Passthrough Interests
Finally, income from a lower-tier passthrough (LTP) entity owned in part by an upper-tier passthrough (UTP) entity creates tracing problems for identifying the upper-tier owner’s share of the lower-tier entity’s investment income.
Example 16: 51 X, an individual, owns an interest in UTP, a partnership that is engaged in a trade or business in which X actively participates. UTP owns an interest in LTP, also a partnership, which is not engaged in a trade or business. LTP receives $10,000 in dividends, $5,000 of which is allocated to X through UTP. The $5,000 of dividends is not derived in a trade or business because LTP is not engaged in a trade or business, even though UTP is engaged in a trade or business and X actively participates in that business. Consequently, the $5,000 of dividends is investment income to X.
Given the prevalence of tiered ownership structures, a partner or S corporation shareholder often has net investment income from an entity in which he or she materially participates because of that entity’s ownership of other passthrough entities in which the partner or S corporation shareholder does not materially participate.
Subpart F and PFIC Inclusions
Generally, under subpart F of the Code, a U.S. shareholder (defined in Sec. 951(b)) of a controlled foreign corporation (CFC, defined in Sec. 957) is required to include in taxable income currently certain amounts the CFC earned, regardless of whether the income is distributed to the shareholder (a subpart F inclusion). 52 Subpart F inclusions generally do not constitute net investment income unless they are treated as dividends or are attributable to a trade or business of the CFC that is a passive activity to the U.S. shareholder or a trade or business of trading in financial instruments or commodities. 53 Similarly, a U.S. person owning shares of a passive foreign investment company (PFIC, defined in Sec. 1297) is also required to include in taxable income currently his or her share of the PFIC’s income if the shareholder makes a qualified electing fund (QEF) election (a QEF inclusion). 54 QEF inclusions also are generally not taken into account in determining net investment income unless they are treated as dividends or are attributable to a trade or business of the QEF that is a passive activity to the U.S. shareholder or a trade or business of trading in financial instruments or commodities. 55
The regulations further provide that distributions of earnings and profits previously taxed as subpart F or QEF inclusions that are not treated as dividends for income tax purposes are treated as dividends for purposes of the net investment income tax. Therefore, although an individual may have deemed inclusions of investment income from an ownership interest in a CFC or QEF, 56 the surtax on net investment income will only arise when that investment income is actually distributed to the shareholder. Accordingly, individual owners of CFCs and QEFs must maintain separate records accounting for the income earned and taxed under chapter 1 of the Code but not under chapter 2A.
Example 17: X is the sole owner of CFC, which in year 1 earns $10,000 of investment income that is included under subpart F in X’s taxable income for that year. This amount is neither net investment income nor is it included in MAGI for purposes of Sec. 1411. If the $10,000 is distributed to X in year 2, it will not be taxed again for income tax purposes, but will be treated as net investment income and increase MAGI for purposes of the surtax in year 2.
To account for this differing treatment, the Sec. 1411 proposed regulations adopt elaborate rules that track the investment income of CFCs and QEFs currently taxable to their shareholders for income tax purposes but not taxed under Sec. 1411 until distributed. 57 Because of the difficulty in reconstructing the basis for a shareholder of a CFC or QEF to account for amounts previously included in taxable income, but not distributed as a dividend for net investment income purposes, the proposed regulations only apply to distributions of earnings and profits that were previously taxed as subpart F or QEF inclusions in tax years beginning after 2012. 58 Thus, a taxpayer need only determine basis differences attributable to net investment income and subpart F or QEF inclusions recognized after 2012.
Recognizing the complexity of these rules and to avoid the additional administrative burden of accounting for income and distributions from foreign corporations, the proposed regulations offer an election whereby an individual may treat the deemed inclusion for income tax purposes under subpart F or the QEF rules as investment income subject to the surtax of Sec. 1411 in the same year the income tax is paid on the undistributed investment income. 59 This election is described in more detail below.
Secs. 991 through 997 provide a benefit to certain taxpayers exporting property made in the United States and sold abroad through the creation of an interest charge domestic international sales corporation (IC-DISC). If the requirements are met, the IC-DISC is not a taxable entity and its shareholders include as a deemed dividend a portion of its net profit under Sec. 995(b)(1).
Because the IC-DISC is not engaged in an active trade or business, the deemed distributions treated as dividends would appear to be subject to the surtax if paid to U.S. individual shareholders. Some other forms of domestic export corporations, often referred to as “buy-sell DISCs,” may have employees and actual business activities and therefore may be considered to be engaged in trades or businesses. Whether the distributions from a “buy-sell DISC” constitute net investment income under Secs. 1411(c)(1) and (2) is unknown.
Because Sec. 1411 creates an entirely new tax regime, the proposed regulations offer several opportunities for individuals to make certain elections or to reconsider elections made before the enactment of the new tax. Each election that may reduce or eliminate the surtax is described below.
Sec. 469 Groupings
Generally, the Sec. 469 regulations permit a taxpayer to group trades or businesses or rental activities together to satisfy the material participation standards and avoid characterization as a passive activity. 60 All relevant facts and circumstances are considered in determining an “appropriate economic unit” for this purpose, and any reasonable method may be used with the following factors given the greatest weight: (1) similarities and differences in types of trades or businesses, (2) the extent of common control, (3) the extent of common ownership, (4) geographic location, and (5) interdependencies among activities. 61
A taxpayer’s initial grouping is binding and generally cannot be changed unless the prior grouping was clearly inappropriate or there is a material change in facts and circumstances. 62 The IRS may regroup a taxpayer’s activities if the grouping is not an appropriate economic unit or was made with the principal purpose of circumventing Sec. 469. 63
Recognizing that Sec. 1411(c)(2)(A) relies entirely on Sec. 469 to determine if the income from an activity is included in net investment income, the Sec. 469 regulations are being revised to permit a one-time regrouping of activities, even if the present groupings are appropriate and there has been no change in facts that might otherwise permit a regrouping. 64 The regrouping may be made for the first tax year beginning after 2013 that the taxpayer is potentially subject to the surtax. It can also be made in 2013 in reliance on the proposed regulations if the taxpayer is subject to the surtax in 2013. 65 However, if the taxpayer does not rely on the proposed regulations to make the election for 2013, and the final regulations contain the same or a similar election, the taxpayer may make the election for 2014 under the final regulations. 66 Taxpayers must disclose details about the regrouping in a written statement attached to the original return in the year of the regrouping. 67 For this purpose, only one regrouping is permitted and is effective for all subsequent years. 68
Pre-Sec. 1411 Installment Sale
Generally, an individual’s sale of an interest in a partnership or S corporation is not considered to be a sale of property held in a trade or business so that gains and losses from the disposition constitute net investment income. However, as discussed above, the seller may adjust the gain or loss from the sale of a partnership interest or S corporation stock to put the seller in a similar position as if the partnership or S corporation had sold its underlying assets at fair market value immediately prior to the sale of the interest. 69 But, because the adjustment to net investment income is made in the year of the sale, 70 any installments received after 2012 attributable to a sale before enactment of Sec. 1411 cannot be recast so that the entire gain would be net investment income.
To change this result, the proposed regulations permit a taxpayer to make an irrevocable election to adjust gain on a pre-Sec. 1411 installment sale so that some or all of the installment payments received after 2012 can be excluded from net investment income. 71 Although there may be considerable difficulty and complexity in determining the fair market value and adjusted basis of the assets in the partnership or S corporation at the time the taxpayer sold the interest, the election will be advantageous if, in fact, the partnership or S corporation was engaged in a trade or business at the time of the sale.
The election to adjust net investment income for installment payments attributable to pre-Sec. 1411 dispositions must be made on the taxpayer’s original or amended return for the first tax year after 2013 in which the taxpayer is subject to Sec. 1411. The taxpayer may rely on the proposed regulations to make the election for 2013 before the Sec. 1411 regulations become final. However, if the taxpayer does not rely on the proposed regulations to make the election for 2013, and the final regulations contain the same or a similar election, the taxpayer may make the election for 2014 under the final regulations. 72
Election for CFC and QEF Stock
As discussed above, subpart F requires a U.S. shareholder of a CFC to include in income currently the shareholder’s pro rata share of certain types of CFC income. These amounts are not treated as dividends for income tax purposes and therefore do not constitute net investment income. Similarly, if a U.S. shareholder of a PFIC makes a QEF election, the shareholder currently includes in income his or her pro rata share of the PFIC’s earnings. Both subpart F income and QEF inclusions increase the shareholder’s basis in the CFC or QEF stock but are not net investment income until those amounts are distributed. As a result, there will be a mismatch on the timing of income recognition for income tax and Sec. 1411 purposes.
To alleviate this mismatch, the proposed regulations provide an election to include the subpart F and QEF inclusions as net investment income in the same year those amounts constitute taxable income regardless of whether the inclusions are distributed. Thus, beginning in the year in which an election is made, subpart F and QEF inclusions for income tax purposes may also be treated as dividends for purposes of Sec. 1411. 73
The election is made on a timely filed (including extensions) return for the first tax year beginning after 2013 in which the taxpayer holds an interest in a CFC or QEF and is subject to the surtax. 74
Nonresident Alien Election
Married taxpayers may not file a joint return if either spouse is a nonresident alien at any time during the year. 75 However, a nonresident alien spouse married to a citizen or resident of the United States may make an affirmative election to file a joint return for purposes of the income tax under chapter 1 of the Code. 76 Because Sec. 1411 is in chapter 2A of the Code, the election does not apply for purposes of the surtax on net investment income. Generally, a nonresident alien is exempt from the surtax. 77 A citizen or resident married to a nonresident is required to file a separate return to calculate his or her surtax based exclusively on the individual’s net investment income, with a $125,000 MAGI threshold for a married individual filing a separate return rather than the $250,000 for married taxpayers filing jointly. 78
The proposed regulations permit married taxpayers, one of whom is a nonresident alien, who have elected to file a joint return for income tax purposes to also elect to be treated as filing jointly for purposes of Sec. 1411. 79 Although the election potentially subjects the nonresident alien’s net investment income to the surtax, the AGI threshold on the joint return will be $250,000, rather than $125,000 for the citizen or resident spouse filing separately.
To make the election, the taxpayers must also elect to file jointly for income tax purposes under Sec. 6013(g), and the election must be made on a timely filed (including extensions) original or amended return. 80 The election must be made for the first tax year after 2013 in which the taxpayer is subject to the surtax and is effective for all subsequent years. 81
The issues described above regarding the determination of the net investment income surtax illustrate the problems even moderately high-income taxpayers will encounter in complying with the new rules. Clearly, individuals, trusts, and estates need to begin planning for the new tax by reducing their net investment income and/or MAGI.
Tax-exempt interest on municipal bonds can reduce both net investment income and MAGI. Consequently, investors should immediately consider rebalancing their portfolios for 2013.
Until they are sold for a gain, non-dividend paying growth stocks increase neither net investment income nor MAGI. Investors seeking to lessen exposure to the surtax should consider investing in stocks with little or no dividends to reduce taxable income and defer capital gains.
Because income from a trade or business that is a passive activity will likely be subject to the surtax, it may be wise to have some of that income paid as compensation if possible, thereby avoiding the surtax. However, beginning in 2013, the employee’s portion of the payroll tax for Medicare hospital insurance increases from 1.45% to 2.35% for wages in excess of $250,000 (married filing jointly); $125,000 (married filing separately); and $200,000 (all others). Thus, the total combined Medicare hospital insurance tax on an employer and employee could reach 3.8% of compensation, resulting in no benefit from this strategy.
Annuities allow for tax-deferred accumulation of income while providing the annuity holder flexibility to receive income in a lump sum or periodic payments, at a time of the annuitant’s choosing. The annuity’s earnings grow free of federal, state, and local income taxes until payments are received. 82 Therefore, annuities allow an investor to time the recognition of net investment income and MAGI so as to minimize or eliminate the surtax in any year.
Finally, cash buildup within a whole life insurance policy offers tax-deferred growth, free from current income tax and the investment surtax. 83 Taxpayers subject to the surtax can reallocate investment dollars from assets that produce net investment income and MAGI into a whole life insurance policy.
While distributions from qualified retirement accounts, such as IRAs or 401(k)s, are not included in net investment income, 84 those distributions will increase MAGI so that it may exceed the applicable threshold. That, in turn, can trigger the surtax. Distributions from Roth IRAs and Roth 401(k)s, on the other hand, are not included in net investment income or MAGI. 85 In addition, Roth IRAs do not require minimum distributions; they offer tax-free growth, and distributions from them are generally free from income tax. 86 Therefore, individuals should consider contributing to Roth plans, rather than traditional retirement plans, and consider converting their traditional IRAs into Roth IRAs with the caveat that for the tax year of conversion the income from converting the traditional IRA will increase MAGI.
Alternatively, however, individuals may prefer to contribute to a traditional plan because, unlike Roth IRAs, these contributions reduce MAGI. 87 Thus, individuals approaching the MAGI thresholds may escape the surtax by making contributions to traditional plans that keep MAGI below the surtax threshold.
Using the installment method of Sec. 453 to spread the gain on the sale of property over several years may minimize MAGI and net investment income to avoid the surtax. Because any gain under the installment method is recognized proportionate to the payments received each year, extending the term of the installment note may avoid the surtax on the gain altogether.
Similarly, a like-kind exchange avoids recognition of gain by exchanging business or investment property for property of the same nature or character, regardless of its grade or quality. 88 By deferring the gain upon the ultimate disposition of the replacement property to a year when MAGI is below the threshold, the surtax can be avoided. However, like-kind exchange treatment is inapplicable to most financial assets, including stocks, bonds, and other securities. 89
Finally, incentive stock options (ISOs) offer deferral opportunities in that the exercise of an ISO is not subject to regular income tax, although it is an AMT adjustment item. 90 Because this income is not subject to regular income tax, it is not net investment income. If the stock is later sold, it would generate capital gain, which is net investment income.
Estate Planning Options
Probably the simplest way to avoid the surtax on net investment income is to gift assets that pay investment income to a donee whose MAGI is below the threshold for the surtax. With the annual per donee gift tax exemption at $14,000 for 2013 91 and the lifetime gift tax exemption fixed at $5.25 million for 2013, indexed for inflation, 92 gifts of appreciated property not only avoid the surtax on investment income, but also wealth transfer taxes as a whole.
However, under the “kiddie” tax rules, unearned income from gifts of financial assets to children may subject the children to their parent’s tax rate, including the surtax. 93 Specifically, if a parent of a dependent child elects to report the child’s unearned income on the parent’s return, then the MAGI threshold of the parent is used to determine if the surtax applies to the child’s net investment income. 94 Presumably, if the child files his or her own return reporting the net investment income, the child will have his or her own $200,000 MAGI threshold.
Finally, while estate plans frequently use trusts in deferring direct wealth transfers to children and grandchildren, any retention of net investment income by the trust in lieu of distributing it to beneficiaries will likely trigger the surtax. Because the MAGI thresholds for trusts and estates are significantly lower than for individuals and because trusts frequently hold assets that yield investment income, undistributed net investment income will more likely be subject to the surtax than if it is distributed to the beneficiaries. Therefore, the surtax’s impact must be taken into account whenever a trust is created to accumulate rather than distribute investment income to beneficiaries who the trust’s creator believes are not ready to receive such sums or otherwise need the financial advice of a trustee.
The new surtax on net investment income will come as a surprise to many individuals and will be a disincentive to conduct estate planning or asset protection planning through trusts. Even more surprising for individuals will be that most tax credits (e.g., the foreign tax credit and general business credit) available to offset the income tax of chapter 1 of the Code will be unavailable to offset the new surtax in chapter 2A.
Because the penalty for failure to pay sufficient estimated tax applies to underpayment of the surtax, individuals, estates, and trusts should begin to monitor their net investment income in the same manner as regular taxable income and alternative minimum taxable income. In short, beginning in 2013, the surtax on net investment income creates a new tax regime, or in fact, a new tax universe, that parallels the regular tax and the AMT. The explanations and strategies described in this article will mitigate the expected burden.
Author’s note: The author gratefully acknowledges the helpful suggestions of John Seibert, senior manager, Grant Thornton National Tax Office, in the preparation of this article.
Editor’s note: This article won The Tax Adviser 2013 Best Article Award.
1 Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
2 Although chapter 2A is titled “Unearned Income Medicare Contribution,” the amounts collected from this tax are not designated for the Medicare trust fund. See Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 111th Congress, at 363 (March 24, 2011).
3 Sec. 1411(e)(1). See Sec. 7701(b).
4 Sec. 1411(e)(2). Sec. 170(c)(2)(B) provides that a trust is “organized and operated exclusively for religious, charitable, scientific, literary or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals.”
5 See Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 111th Congress, at 364 (March 24, 2011).
6 Sec. 1411(a)(1).
7 Sec. 1411(b). These thresholds are not indexed for inflation.
8 For 2013, Sec. 911(a)(1) permits an exclusion of up to $97,600 of foreign earned income received by an individual who is a resident of or physically present in a foreign country or countries for an entire tax year or 330 days in any 365-day period.
9 Sec. 1411(d).
10 The AGI of an estate or trust is computed in the same manner as for an individual except deductions are permitted for (1) costs in connection with the administration of the estate or trust that would not have been incurred if the property were not held by an estate or trust; (2) the personal exemption under Sec. 642(b) of $600 for an estate, $300 for a simple trust, and $100 for a complex trust; and (3) distributions of income to beneficiaries not in excess of distributable net income (Sec. 67(e)).
11 Sec. 1411(a)(2).
12 Section 1402(a)(2) of the Health Care and Education Reconciliation Act of 2010 amended Sec. 6654(a) to include the chapter 2A tax, effective for 2013.
13 Prop. Regs. Secs. 1.1411-4(a)(1)(i) and 1.1411-4(b).
14 Prop. Regs. Secs. 1.1411-4(a)(1)(ii) and 1.1411-5.
15 Prop. Regs. Secs. 1.1411-4(a)(1)(iii) and 1.1411-5; Sec. 1411(c)(2)(B) cross-referencing Sec. 475(e)(2). See Sec. 731(c)(2)(C) defining financial instrument. This provision is aimed at hedge funds whose activity of “trading personal property for the account of owners of interests in the activity is not a passive activity” (Temp. Regs. Sec. 1.469-1T(e)(6)). Thus, interest, dividends, and capital gains derived from a partnership that regularly trades in securities will constitute investment income under Sec. 1411, even though the activity is not passive under Sec. 469.
16 Sec. 1411(c)(3) cross-referencing Sec. 469(e)(1)(B). Although undefined in either Sec. 1411 or Sec. 469, working capital generally refers to capital set aside for use in and future needs of a trade or business. See Prop. Regs. Sec. 1.1411-6.
17 Sec. 1411(c)(6).
18 Sec. 1411(c)(5).
19 See Prop. Regs. Sec. 1.1411-8.
20 Regs. Sec. 1.1411-4(f)(1)(ii).
21 See Prop. Regs. Sec. 1.1411-4(h), Example (3).
22 Prop. Regs. Sec. 1.1411-4(a)(1)(i) and -4(b).
23 See Secs. 1402(a) and (c); Prop. Regs. Secs. 1.1411-5 and -9.
24 Prop. Regs. Sec. 1.1411-5(b)(2), Example (1).
25 Prop. Regs. Sec. 1.1411-5(b)(2), Examples (3) and (4).
26 Sec. 469(1)(2) and Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(A).
27 See preamble to REG-130507-11, 77 Fed. Reg. 72611, at 72623 (Dec. 5, 2012).
28 Prop. Regs. Sec. 1.1411-1(a).
29 Sec. 453.
30 Sec. 1031.
31 Sec. 1033.
32 Sec. 121. See Prop. Regs. Sec. 1.1411-4(h), Example (4).
33 Sec. 163(d).
34 Sec. 265.
35 Sec. 465.
36 Sec. 469.
37 Secs. 704(d) and 1366(d).
38 See preamble to REG-130507-11, 77 Fed. Reg. at 72621.
39 See Prop. Regs. Sec. 1.1411-4(f).
40 Sec. 67.
41 Prop. Regs. Sec. 1.1411-4(f)(3)(ii). For 2013, the Sec. 68 AGI thresholds for reducing itemized deductions by 3% of AGI that exceeds the applicable threshold are: $300,000 for married individuals and surviving spouses; $275,000 for head of households; $250,000 for unmarried individuals; and $150,000 for married individuals filing separately.
42 Prop. Regs. Sec. 1.1411-4(h), Example (6).
43 Sec. 68.
44 Sec. 67(b)(2).
45 Sec. 68(c)(2).
46 Prop. Regs. Sec. 1.1411-5(b)(2), Example (5).
47 Sec. 1411(c)(4).
48 Prop. Regs. Sec. 1.1411-7(c).
49 Prop. Regs. Sec. 1.1411-7(e), Example (1).
50 Prop. Regs. Sec. 1.1411-7(d).
51 Prop. Regs. Sec. 1.1411-4(b)(3), Example (1).
52 Sec. 951(a).
53 See preamble to REG-130507-11, 77 Fed. Reg. at 72629, citing Rodriguez, 137 T.C. 174 (2011).
54 Secs. 1293 and 1295.
55 See preamble to REG-130507-11, 77 Fed. Reg. 72629.
56 Sec. 1291.
57 See Prop. Regs. Sec. 1.1411-10.
58 Prop. Regs. Sec. 1.1411-10(c)(2)(i).
59 Prop. Regs. Sec. 1.1411-10(g).
60 Regs. Sec. 1.469-4(c).
61 Regs. Sec. 1.469-4(c)(2). Rev. Proc. 2010-13 requires individuals to report groupings on their returns.
62 Regs. Secs. 1.469-4(e)(1) and (2). Rev. Proc. 2010-13, 2010-4 I.R.B. 329, prescribes procedures for reporting groupings and regroupings.
63 Regs. Sec. 1.469-4(f)(1).
64 Prop. Regs. Sec. 1.469-11(b)(3)(iv).
65 Prop. Regs. Sec. 1.469-11(b)(3)(iv)(A).
66 Part 12 of the preamble to REG-130507-11, 77 Fed. Reg. at 72632.
67 Preamble to REG-130507-11, 77 Fed. Reg. at 72624.
68 Prop. Regs. Sec. 1.469-11(b)(3)(iv).
69 Prop. Regs. Sec. 1.1411-7(a)(1).
70 Prop. Regs. Sec. 1.1411-7(b)(1)(i).
71 Prop. Regs. Sec. 1.1411-7(b)(1)(ii).
72 Part 12 of the preamble to REG-130507-11, 77 Fed. Reg. at 72632.
73 Except with the IRS’s consent, the election is irrevocable. Prop. Regs. Sec. 1.1411-10(g)(2).
74 Prop. Regs. Sec. 1.1411-10(g)(3). While a taxpayer may also rely on the proposed regulations to make this election for 2013 before the effective date of the final regulations, not making the election in reliance on the proposed regulations will not preclude the taxpayer from making the election when the regulations become final.
75 Sec. 6013(a)(1). See Sec. 7701(b).
76 Sec. 6013(g).
77 Sec. 1411(e)(1); Prop. Regs. Sec. 1.1411-2(a)(1).
78 Sec. 1411(e)(1); Prop. Regs. Sec. 1.1411-2(a)(1).
79 Prop. Regs. Sec. 1.1411-2(a)(2)(i)(A).
80 Prop. Regs. Sec. 1.1411-2(a)(2)(i)(B)(2) and Regs. Sec. 1.6013-6(a)(4).
81 Id. The election can also be made for 2013 in reliance on the proposed regulations. A taxpayer not making the election for 2013 under the proposed regulations will not be prohibited from making the election when the regulations are made final. If the taxpayer terminates a Sec. 6013(g) election, it cannot be reinstated. Regs. Sec. 1.6013-6(a)(1)(flush language). Presumably this will also be the case for an election under Prop. Regs. Sec. 1.1411-2(a)(2).
82 Sec. 72(b)(1).
83 Sec. 72(e).
84 Sec. 1411(c)(5).
85 Sec. 1411(d).
86 Sec. 408A(d).
87 Secs. 219 and 408A(c)(1).
88 Sec. 1031.
89 Sec. 1031(a)(2).
90 Sec. 56(b)(3).
91 Sec. 2503(b); Rev. Proc. 2012-41, 2012-45 I.R.B. 539.
92 Sec. 2010(c); Rev. Proc. 2013-15, 2013-5 I.R.B. 444.
93 The kiddie tax rules are in Sec. 1(g).
Williamson is a professor of
taxation, the Howard S. Dvorkin
Faculty Fellow, and executive
director of the Kogod Tax Center
at the Kogod School of Business at
American University in Washington,
D.C. For more information about
this article, please contact Prof.