The IRS has issued final and proposed regulations that provide guidance on the general application of the net investment income tax (“NIIT”) and the computation of net investment income (“NII”). This tax, which became effective in 2013, generally affects individuals, estates and trusts with income above certain threshold amounts.
The most common application of this new tax is on net income from most real estate rental activities whether directly or through a Limited Liability Company or other type of pass-through entity (S Corporation, Partnership, Trust, etc.). NII also includes capital gains as well as interest and dividends.
This tax is subject to estimated tax rules and is reported on Form 1040 for individuals and Form 1041 for estates and trusts. It is not required to be withheld from wages.
The 3.8 Percent Net Investment Income Tax
Individuals. For tax years beginning after December 31, 2012, the NII tax on individuals equals 3.8 percent of the lesser of:
- net investment income for the tax year, or
- the excess, if any, of
- the individual’s modified adjusted gross income, exclusive of any adjustment for the foreign earned income exclusion, for the tax year, over
- the threshold amount.
The threshold amount is equal to:
- $250,000 in the case of a taxpayer filing a joint return or a surviving spouse;
- $125,000 in the case of a married taxpayer filing a separate return; and
- $200,000 in any other case.
These amounts are not indexed for inflation. Consequently, the number of affected taxpayers is expected to increase over time.
Net Investment Income defined. The final regulations provide guidance on the calculation of “net investment income” subject to the 3.8 percent tax. In general, net investment income is the sum of:
- gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business;
- other gross income derived from any trade or business that is a passive activity with respect to the taxpayer, or the trade or business of trading in financial instruments or commodities; and
- net gain attributable to the disposition of property, other than property held in a trade or business.
deductions properly allocable to such gross income or net gain.
Trusts and Estates. Trusts and estates are subject to the NII tax on the lesser of:
- undistributed net investment income, or
- the excess of adjusted gross income over the dollar amount at which the highest tax bracket begins ($11,950 for 2013).
The NII tax does not apply to certain tax-exempt trusts and grantor trusts. Special NII computational rules apply for electing small business trusts and charitable remainder trusts.
Unlike the individual threshold amounts, the threshold amount used for estates and trusts is adjusted for inflation because the threshold is tied to the highest tax bracket. Nevertheless, the amount is far less than the lowest threshold amount for individuals ($125,000 for married filing separately). Therefore, trusts and estates should consider distributing investment income, especially if one or more beneficiaries would not otherwise be subject to NII tax because of their threshold amount.
The guidance on the computation of net investment income subject to the net investment income tax is complex. However, we can assist you in evaluating the impact of this tax on your total tax liability and guide you in a developing a tax saving strategy. Please call our office 800.282.2440 or contact us for an appointment.