|January 31, 2013|
Previously published on January 2013
The IRS has issued extensive proposed regulations on the 3.8 percent tax on net investment income that becomes applicable in 2013. The tax is imposed on the lesser of a taxpayer’s: i) net investment income; or ii) the excess of his adjusted gross income over $250,000 for taxpayers filing joint returns or $200,000 for single taxpayers.
In the case of an estate or trust, the tax applies to the lesser of: i) the undistributed net investment income of the trust or estate; or ii) the excess of the adjusted gross income of the trust or estate over the amount at which the maximum income tax rate first applies. For 2013, this amount is $11,950. The proposed regulations confirm that distributions from trusts and estates to their beneficiaries are considered to contain proportionate amounts of net investment income and other income. In the case of a grantor trust, the grantor simply reports the trust’s net investment income on his Form 1040 and pays any tax due.
It will often be advantageous for trusts and estates to distribute their net investment income to their beneficiaries. Each beneficiary will have his own threshold amount before the tax applies, and the threshold for individuals is also much higher than for trusts - $250,000 or $200,000 for individuals versus $11,950 for trusts and estates.
The net investment income tax applies in the tax years beginning after December 31, 2012. For any decedent who died during 2012, electing a fiscal year that ends on the last day of the month that is immediately prior to the month in which the decedent died will delay the application of this tax as long as possible. For example, for any decedent who died during December 2012, electing a fiscal year that ends November 30, 2013, will delay the application of the tax for 11 months until December 2013.
A taxpayer’s net investment income is his gross investment income reduced by deductions properly allocable to that income. Investment income includes interest, dividends, rents, royalties, gains from the sale of assets (other than assets used in the conduct of a business that is not a passive activity of the taxpayer) and income from non-qualified annuities, as well as income from a trade or business that is a passive activity of the taxpayer or from a business of trading commodities or financial instruments.
The tax does not apply to income from an active business that is not a passive activity of the taxpayer, except for the business of trading commodities or financial instruments, or gains from the disposition of assets used in such a business. It also does not apply to tax-exempt income, income treated as wages or subject to self-employment tax, or distributions from qualified retirement plans or accounts.
The tax was generally intended to apply to much or most of a taxpayer’s income that is not subject either to the Medicare taxes on wages or on self-employment income. Certain types of income are not subject to either tax; however, this includes income that flows through to a taxpayer from a business conducted by an S corporation that is not a passive activity of the taxpayer. The preamble to the proposed regulations also states that income from notional principal contracts (commonly referred to as “swaps”) is not treated as investment income unless it is derived from a trade or business of trading financial instruments. Tax-exempt income and distributions from qualified retirement plans and accounts are also not subject to either tax.
The proposed regulations provide some guidance on which deductions are considered allocable to gross investment income. If allocable deductions exceed the amount of the gross investment income in a tax year, the excess does not carry over to be used in subsequent years. All deductions that can be claimed against rent or royalty income on Schedule E of Form 1040 can also be used for purposes of computing net investment income.
Itemized deductions that can be used are limited. Allowed investment interest expense may be deducted in arriving at net investment income. Excess investment interest expense carries over to subsequent tax years the same as it does for purposes of determining the regular income tax. State and local income taxes imposed on investment income may also be deducted in computing net investment income. The apportionment of state and local taxes between investment income and other income may be done using any reasonable method. One reasonable method specifically approved in the proposed regulations is allocating state and local income taxes based on the ratio of investment gross income to all gross income. The proposed regulations also allow investment expenses as defined in IRC Section 163(d)(4)(C) to be deducted, including all deductions allowed that are directly connected with the production of investment income, such as fees paid for investment advisory services.
Any deductions that are disallowed by the limitation on miscellaneous itemized deductions (2 percent of AGI) or the itemized deduction phase-out may not be used in computing net investment income for purposes of the net investment income tax.
The estimated tax payment rules of the Internal Revenue Code also apply to the tax on net investment income, so a taxpayer may be subject to penalties if he does not include the tax due on his net investment income in his quarterly estimated tax payments.