Finally after years of rumors, and theories, the Internal Revenue Service has issued Final Regulations (Regs) on Net Investment Income Tax (NIIT). I informed my readers of this tax last year at this time, but people are finally beginning to sit up and take notice. So let’s do a refresher for you on what this tax is, and then we will get into the meat of this.
For tax years beginning after Dec. 31, 2012, certain unearned income of individuals, trusts, and estates is subject to a surtax. A surtax is a tax that is over and above your normal taxes. In this case 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 or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount. This amount is $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. The threshold amount is not indexed for inflation. MAGI is adjusted gross income (AGI) plus any amount excluded as foreign earned income under IRC §911(a)(1).
Estates and trusts don’t escape this tax. For an estate or trust, the surtax is 3.8% of the lesser of (1) undistributed NII or (2) the excess of AGI (as defined in IRC §67(e) ) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins. Under IRC §1411(e)(2) , a trust, all of the unexpired interests in which are devoted to charitable purposes under IRC §170(c)(2)(B) , is excluded from IRC §1411 .
For 3.8% surtax purposes, NII is investment income less deductions properly allocable to such income. Investment income is:
- • 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;
- • Other gross income derived from a trade or business to which the Medicare contribution tax does apply; and
- • 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.
Confused yet? As we discussed last year, and most tax professionals are struggling to comprehend (I was ahead of this) is what constitutes Net Investment Income, and what is subject to the tax and what is not. Individuals subject to IRC §1411. The final regs retain the 2012 Proposed Regs' definition of the term "individual" for IRC §1411 purposes as "any natural person, except for natural persons who are nonresident aliens." Yes you are reading that right. There is a definition of individual.
Certain trusts with "special computational rules." The preamble to the 2012 Proposed Regs states that IRC §1411 applies to "ordinary trusts described in Reg. § 301.7701-4(a) that are subject to the provisions of part 1 of subchapter J of chapter 1 of subtitle A of the Code. Yep, this is exactly how this Reg reads. Even if the trusts have special computational rules." The preamble then names four such trusts-pooled income funds (PIFs) under IRC §642(c)(5) , cemetery perpetual care funds under IRC §642(i) , qualified funeral trusts under IRC §685 , and Alaska Native settlement trusts (ANSTs) under IRC §646 -and requested comments on whether these or other types of trusts should be excluded from the scope of IRC §1411.
The point is this Net Investment Income Tax is very complicated. You need a professional like me to go over your tax situation with you in detail.