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Overview of the New Investment Tax

The enactment of the Health Care and Education Reconciliation Act of 2010 (the “Act”) has profound implications for U.S. investors. The Act imposes a new tax on investment income of certain individuals, estates and trusts. The focus of this article is on the new tax on individuals and how it operates.

IRC Section 1411: Imposition of 3.8% Tax

Section 1402(a) of the Act added section 1411 to a new chapter 2A of subtitle A (Income Taxes) of the Internal Revenue Code effective for taxable years beginning after December 31, 2012. IRC Section 1411 imposes a 3.8 percent tax on the investment income of certain individuals, estates, and to some trusts.

It is important to note that the new tax is not deductible against any other income taxes.

Who is Affected by the New 3.8% Tax?

As mentioned above, the tax applies to certain individuals, annuities, estates, and to some trusts. It is widely expected that the 3.8% tax applies only to those who are considered to be high-wage earners (at least, at the time the new tax was enacted, because the American Taxpayer Relief Act of 2012 seems to re-define who the high-wage earners are) who earn above certain thresholds and have investment income.

The tax does not apply to a nonresident alien and some other types of trusts (this is a complex subject that may be addressed in another article). If an nonresident alien is married to a U.S. citizen or resident and has made, or is planning to make, an election under IRC section 6013(g) to be treated as a resident alien for purposes of filing as Married Filing Jointly, the proposed regulations provide these couples with special rules and a corresponding IRC section 6013(g) election for the NIIT.

How Does the 3.8% Tax Work?

The application of the new tax can be quite complex, especially where the issues of subpart F and PFIC (Passive Foreign Investment Company) income are involved in the calculation of required thresholds. Generally, however, section 1411(a)(1) imposes a tax on the lesser of (A) the individual’s net investment income for such taxable year, or (B) the excess (if any) of (i) the individual’s modified adjusted gross income for such taxable year, over (ii) the threshold amount).

The threshold amounts are provided in Section 1411(b) and depend on the individual’s filing status (all amounts refer to modified adjusted gross income (“MAGI”)):

Single: $200,000
Married Filing Jointly: $250,000
Married Filing Separately: $125,00
Head of Household: $200,000
Qualifying Widow(er) with dependent child $250,000

Basically, this provision of Section 1411(a)(1) means that, in order for a taxpayer to be subject to the 3.8% tax, he has to have net investment income and MAGI above the thresholds listed above. The tax will be imposed either on the excess of income above MAGI or net investment income, whichever is less.

What Type of Income is Subject to the new 3.8% Tax?

Generally, any net investment income is potentially subject to the 3.8% tax. This includes net income from: interest, dividends, capital gains, rental and royalty income, non-qualified annuities and other income NOT derived in the ordinary course of trade or business (as specified in Section 1411(c)(2)). In order to arrive at the net income, the taxpayer may subtract from the gross investment income any allowable allocable deductions.

Also certain capital gains (that are not otherwise offset by capital losses),are taken into account in computing net investment income. Here is the list of common example: gains from the sale of stocks, bonds, mutual funds, capital gain distributions from mutual funds, gains from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence). Even gains from the sale of interests in partnerships and S corporations (to the extent that the taxpayer was a passive owner) are potentially included.

It is important to note that income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer are considered investment income.

On the other hand, certain income is excluded from the definition of investment income. Here is the list of most common exclusions: wages, unemployment compensation; operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends and distributions from certain Qualified Plans

The rules regarding determining whether your income is subject to the investment tax are complex, especially when it comes to businesses. You should contact a tax attorney to determine if your income should be subject to the 3.8% tax.

Where Should the 3.8% Be Reported by Individual Taxpayers?

The new tax should be reported on Form 1040 and paid with the rest of the tax when Form 1040 is filed.

It is also important to note that the new tax should be included in the estimated tax payments. Failure to do so may result in underpayment penalties.

Contact Sherayzen Law Office for Help with the New Investment Tax

If you are not sure whether you are facing the new investment tax or whether you wish to know if there is any tax planning available for dealing with the new investment tax in your particular situation, contact Sherayzen Law Office. Our experienced tax firm will thoroughly review your situation, determine whether the new investment tax applies to you and analyze alternative tax structures that would minimize the impact of the new tax in your particular situation.