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Understanding the Net Investment Income Tax [CPA Journal, The]
[November 01, 2014]

Understanding the Net Investment Income Tax [CPA Journal, The]


(CPA Journal, The Via Acquire Media NewsEdge) Minimization Strategies for High-Income Individuals (ProQuest: ... denotes formulae omitted.) Beginning in 2013, noncorporate taxpayers-that is, individuals, trusts, and estates-are subject to a net investment income tax (NUT). Specifically, such individuals are subject to a 3.8% tax on income and gain from investments, provided they have net investment income (Nil) and modified adjusted gross income (MAGI) in excess of certain thresholds. It is estimated that only 2%-3% of all taxpayers will be subject to the NET. Under Internal Revenue Code (IRC) sections 1411(a)(1) and (b), the NET for individuals is equal to 3.8% times the lesser of NE or MAGI in excess of the following thresholds: $200,000 for single individuals and heads of households and $250,000 for joint filers and surviving spouses.



Most high-income individuals have NE (e.g., dividends, interest, capital gains); however, if they do not have excess MAGI, they are not subject to the NET. MAGI is AGI plus foreign earned income, net of associated expenses, that is otherwise excluded under IRC section 911. In other words, MAGI is AGI plus tax-free, foreign-source income [IRC section 1411(d)]. Most individuals do not have this tax-free income; thus, in most cases, and in the examples below, MAGI would be equal to AGI.

Background In these examples, unless otherwise indicated, the individual is single and thus has a NET threshold of $200,000.


Example 1. Exhibit 1 illustrates the calculation of an individual's NET. NE is constant, excess MAGI fluctuates, and the NET is 3.8% times the lesser of the two. In row 3, the individual has MAGI of $180,000 and there is no excess MAGI; thus, the individual has no NET. In this case, no matter how much income or gain the individual has from investments, the NET does not apply.

Dual-Base Tax System, Parallel Tax System Under the dual-base tax system, the first base is NE and the second base is excess MAGI. Taxpayers need to understand the interaction between the two bases.

Example 2. Refer to row 3 of Exhibit 1, where the individual has an NE of $25,000 and MAGI of $180,000. Assume that this individual gets a year-end bonus of $40,000, resulting in a MAGI of $220,000 ($180,000 + $40,000); thus, the individual moves from row 3 to row 2. As row 2 indicates, the first base (NE) remains the same ($25,000), but the second base (excess MAGI) increases by $20,000 (from $0 to $20,000); thus the NIIT ($760) is triggered.

Next consider the parallel tax system. Most tax preparers are familiar with chapter 1 of the IRC, including subchapters B (computation of taxable income), C (regular corporations), D (deferred compensation), E (accounting periods and accounting methods), F (exempt organizations), J (estates, trusts, beneficiaries, decedents), K (partnerships), L (insurance companies), and S (S corporations), among others.

The NIIT, imposed by IRC section 1411, does not fall under chapter 1; rather, it is in chapter 2A. (Indeed, section 1411 is the only IRC section in chapter 2A.) Consequently, when tax preparers face questions about income and gain from investments, they need to consider the following: * What is the tax consequence for income tax purposes under chapter 1? * What is the tax consequence for NIIT purposes under chapter 2A? Terminology and Concepts To grasp the ideas discussed below, it helps to understand the following terms and concepts: * "High-income individual" refers to an individual who has excess MAGI/AGI. This suggests the individual is in the 33%, 35%, or 39.6% tax brackets.

* "Individual is active" means that the individual materially participates in an activity; thus, the individual is engaged in an active activity. "Individual is passive" means that the individual does not materially participate in an activity; thus, the individual is engaged in a passive activity. For simplicity, "material participation" is determined by the 500-hour rule. If an individual participates for less than 500 hours, he does not materially participate and is considered passive. If the individual participates for more than 500 hours, he does materially participate and is considered active. (A detailed discussion of IRC section 469, dealing with passive activities, is beyond the scope of this article.) * A "flow-through entity" is a partnership, limited liability company, or S corporation. Members of such organizations report their distributive share of entity income, gain, loss, deduction, and credit on their own tax returns.

* The two concepts embedded in the expression "the ordinary course of a trade or business" may be defined as follows: 1) Income and expenses are derived from the ordinary course of a trade or business when the income and expenses occur regularly and arise from transactions that commonly or frequently occur in the type of trade or business involved. [This expands upon Lilly v. Comm 'r, 343 US 90, 93 (1953).] 2) A trade or business involves participants in an enterprise who render personal services, themselves or through agents and employees, that are "considerable, regular, and continuous" [e.g., DeAmodito v. Comm >, 34 TC 894 (1960), afFd, 299 F2d 623 (CA-3, 1962)].

Calculating Nil Nil is calculated in two steps [see IRC section 1411(c)(1)]. In Step 1, an individual adds together three categories of income and gain. In Step 2, the individual subtracts deductions allocable to income and gain included in Step 1. Nil may not be less than zero [Treasury Regulations section 1.411-4(f)(l)(ii)]. ' Step 1. An individual adds together the following three categories of income and g3in [IRC section 1411(c)(1)(A)]. The first two categories are gross amounts and the third category is a net amount.

Category 1. Gross income from interest, dividends, annuities, royalties, and rents. (Exclude any such income that is derived from the ordinary course of a trade or business in which the individual is active. This exception is commonly called "the trade or business exception.") Category 2. Gross income derived from a trade or business in which the individual is passive. [Category 2 also includes the gross income of a trader in financial instruments and commodities under IRC section 1411(c)(2)(B); this topic is beyond the scope of this article.] Category 3. Net gain from disposing of property. (Exclude any such gain if the property is held in a trade or business in which the individual is active.) Category 3 may not be less than zero [Treasury Regulations section 14114(d)(2)].

Step 2. An individual subtracts deductions allocable to the types of gross income and net gain included in Step 1 [IRC section 1411(c)(1)(B)]. For example, the individual subtracts deductions related to rents and royalties described in category 1. Likewise, the individual subtracts deductions related to a trade or business described in category 2 [Treasury Regulations section 1.141 l-4(f)(2)(i),(ii)]. In addition, the individual subtracts investment interest expense, other investment expenses (e.g., advisory fees), and state and local income taxes allocable to items included in Step 1 [Treasury Regulations section 1.1411-4(f)(3)].

2014 Income Tax Rates The examples in this article have fact patterns that take place in 2014. Individuals with taxable income over $406,750 (singles) and over $457,600 (joint filers) face tax rates of- * 39.6% on ordinary income and shortterm capital gain (STCG), * 20% (generally) on long-term capital gain (LTCG), and * 20% on qualified dividend income (QDI).

Example 3. An individual in the 39.6% tax bracket has taxable interest of $10,000, QDI of $8,000, and investment advisory fees (allocable deductions) of $1,000. For income tax purposes, interest of $10,000 is taxed at 39.6%, and QDI of $8,000 is taxed at 20%. For NIIT purposes, $17,000 [($10,000 + $8,000) {Step 1} - $1,000 {Step 2}] is taxed at 3.8%, assuming there is no limitation related to excess MAGI.

Items Not Subject to the NIIT The following items are not subject to the NIIT: * Tax-exempt income (e.g., municipal bond interest) * Wages, unemployment compensation, alimony, Social Security benefits, and income subject to self-employment tax * Gain excluded from sale of a principal residence * Distributions from tax-favored retirement plans [e.g., IRAs, 403(b) plans, 401(k) plans, 457 plans, profit-sharing plans, stock bonus plans, qualified annuity plans].

If income or gain is not subject to income tax, it is not subject to the NIIT. For example, because life insurance proceeds are not subject to income tax, life insurance proceeds are not subject to the NET. If a gain is deferred or excluded under IRC sections 453 (installment sale), 1031 (like-kind exchange), 1033 (involuntary conversions), or 121 (sale of principal residence), it is deferred or excluded under the NET.

Category 1 Gross Income Example 4. In the following four scenarios, Individual receives interest income of $1,000 in 2014.

Scenario 1. Individual has a savings account, from which interest income of $1,000 is received; this is category 1 gross income.

Scenario 2. Individual operates a pizza parlor as a sole proprietor. The business generates extra cash that Individual puts in a savings account. From this account, interest income of $1,000 is received; this is category 1 gross income.

This interest does not satisfy the trade or business exception in category 1 because it was not derived in "the ordinary course of a trade or business." First, this interest income does not arise from transactions that commonly or frequently occur in the operation of a pizza parlor. Second, Individual is in the business of making pizzas, not generating interest income.

Scenario 3. Individual is a member of a flow-through entity that is in the business of microlending (i.e., making loans and receiving interest). Individual's distributive share of interest income is $1,000. Individual materially participates in the microlending business.

This situation satisfies the trade or business exception in category 1; that is, this interest is derived in "the ordinary course of a trade of business." First, this interest income arises from transactions that commonly or frequently occur in the operation of a lending business. Second, the entity is in the business of generating interest income. As a result, this is not category 1 gross income.

Scenario 4. Assume that Individual in Scenario 3 does not materially participate in the micro-lending business. Because Individual is passive, the trade or business exception in category 1 does not apply, thus this interest income is category 1 gross income.

Wbrking Capital Income from the investment of working capital is category 1 gross income, but gain from the investment of working capital is category 3 net gain [Treasury Regulations section 1.1411-6(a)].

Example 5. Individual operates a restaurant and pays all of the restaurant's obligations from cash flow [Modeled after Treasury Regulations Section 1.141 l-6(b)]. Individual has an interest-bearing checking account at a local bank, into which the restaurant's cash receipts are deposited and from which the restaurant's expenses are paid. The average daily balance in the checking account is $2,500. Individual has an interest-bearing savings account with a balance of $20,000. This account is a contingency fund that Individual will access if the funds in the checking account are not sufficient to pay the restaurant's expenses.

The amounts in the checking account ($2,500) and the savings account ($20,000) constitute working capital. The interest on this working capital is category 1 gross income.

Example 6. Assume that Individual in Example 5 invests the $20,000 contingency fund in the stock market rather than a savings account. In 2014, Individual receives dividends of $500 from the stock. In addition, Individual sells the stock for $21,000, realizing STCG of $1,000 ($21,000 - $20,000).

The dividends are categoiy 1 gross income. The STCG is category 3 net gain.

Categoiy 2 Gross Income Example 7. Individual bought a fourplex and rented it to tenants. In 2014, Individual collected rent of $72,000. According to IRC section 469(c)(2), rental endeavors are passive activities.

If Individual's landlord services are considerable, regular, and continuous, Individual is engaged in business. The $72,000 is category 2 gross income because it is from a trade or business in which Individual is passive. If Individual's landlord services are not considerable, regular, and continuous, Individual is engaged in a for-profit endeavor, not a business. Thus, the $72,000 is not category 2 gross income; rather, because it is rent, $72,000 is category 1 gross income.

Categoiy 3 Net Gain Category 3 includes net gain from the disposition of property. "Disposition" includes a sale, exchange, conversion, cancellation, termination, lapse, or expiration [Treasury Regulations section 1.14115(dXl)]. For income tax purposes, the character of gain is relevant, but for NET purposes it is not.

Example 8. Individual operates a forprofit venture. In 2014, Individual sells business equipment. For income tax purposes, and for NET purposes, Individual realizes and recognizes gain of $75,000, as calculated below.

...

Bie character of gain is determined as follows: ...

For income tax purposes, the relevant amounts are $50,000 of ordinary income and $25,000 of LTCG. For NET purposes, the relevant amount is $75,000 of category 3 net gain.

Types of Capital Gains For individual income tax purposes, friere are four types of capital gain: * STCG is taxed at no more than 39.6%.

* There are three varieties of LTCG- * collectibles gain (e.g., artwork, antiques, stamps, coins) is taxed at no more than 28%, * unrecaptured IRC section 1250 gain (relating to depreciable real property) is taxed at no more than 25%, and * all other LTCG is taxed at 0%, 15%, or 20%, depending upon an individual's tax bracket.

For NET purposes, there are two tax rates (0% and 3.8%). Because the character of the gain is not relevant, the NET applies to all four types.

In general, the following capital gains, after being offset by capital losses, are subject to the NET: * Gain from selling stock, bonds, mutual funds, and investment real property.

* Capital gain distributions from mutual funds.

* Taxable portion of gain from selling a principal residence.

* Gain from selling a second residence.

* Gain from selling personal-use assets (e.g., personal car).

This assumes the exception relating to category 3 net gain does not apply. This exception provides that gain is excluded from category 3 net gain if it relates to property held in a trade or business in which the individual is active. (See "Questions and Answers for the Additional Medicare Tax," Q9 and 10, http://www .irs.gov/Businesses/Small-Businesses-&Self-Employed/Questions-and-Answersfor-the-Additional-Medicare-Tax.) Example 9. Individual is in the 39.6% tax bracket. In 2014, Individual moves to Ohio, and sells two residences in Maryland. Individual sells a principal residence for gain of $300,000 and a second home (weekend retreat) for gain of $75,000. Individual has total gain of $125,000, as calculated below.

...

For income tax purposes, $125,000 (LTCG) is taxed at 20%. For NET purposes, $125,000 is taxed at 3.8%, assuming there is no limitation related to excess MAGI/AGI.

To calculate category 3 net gain, from gross gain, a taxpayer subtracts losses deductible under IRC section 165. Such losses include capital losses, casualty and theft losses, and losses from abandonment or worthlessness (e.g., of securities) [Treasury Regulations section 1.1411smm Example 10. In 2014, Individual has category 3 net gain of $6,000, as calculated below: ...

Comprehensive Example Example 11. Individual is a cook who owns three restaurants (A, B, and C), each of which represents a separate activity. Individual cooks in restaurant A, so he materially participates in activity A; thus in activity A, Individual is engaged in a business in which he is active. Individual does not cook in restaurants B and C, so he does not materially participate in activities B and C. In activities B and C, then, Individual is engaged in businesses in which he is passive.

Aside from activities A, B, and C, Individual is a partner in LMN Partnership. Individual does not materially participate in LMN affairs. As a result, Individual's distributive share from LMN is passive.

Exhibit 2 lists items of income, gain, or loss that Individual sustains in 2014. Column 4 is used for a tax analysis. (Recall that calculating NE is a two-step process. Step 1 focuses on three categories of income and gain.) For NET purposes, the capital loss of $12,000 offsets the capital gain of $11,000, and a net loss of $ 1,000 can be used to offset amounts in categories 1 and 2.

Example 12. Calculate NET based on Example 11, assuming Individual is single. Individual's NET is zero: 3.8% x $0 (the lesser of $15,800 or $0).

NE = $17,800* (Step 1) - $2,000* (Step 2) = $15,800.

[dagger] $700 + $600 + $4,000 + $50,000 - $40,000 + ($5,000 + $6,000 - $11,000) + $900 + $1,500 + $100 (Relevant amounts from column 3 in Exhibit 2).

[double dagger] Assumed.

Excess MAGI = $107,800§ (MAGI) - $200,000 (threshold) = $0.

§ $700 + $600 + $4,000 + $90,000 + $50,000 - $40,000 + ($5,000 + $6,000 - $12,000) + $1,000 + $900 + $1,500 + $100 (Relevant amounts from column 2 in Exhibit 2).

Example 13. Refer to Example 11. Calculate Individual's NIIT based on Example 11, only now assuming a) Individual is married, b) Wife has a salary of $150,000, and c) on their joint return, their MAGI is $257,800 [$107,800 (Individual) + $150,000 (Wife)].

Their NET is $296: 3.8% x $7,800 (the lesser of $15,800 or $7,800).

NII = $15,800 (see Example 12).

Excess MAGI = $257,800 (MAGI/) - $250,000 (threshold) = $7,800.

Some Allocable Deductions Are Subject to Limitations As mentioned previously, calculating NE is a two-step process. In Step 2, a taxpayer subtracts those deductions that are allocable to income and gain included in Step 1. As Example 14 illustrates, some of the allocable deductions are subject to a 2% floor, and some are subject to a 3% phaseout.

Example 14. [Modeled after Treasury Regulations section 1.141 lA(f)(7)(iv).] On their 2014 joint return, Husband and Wife have MAGI of $600,000: salary of $500,000, STCG of $100,000. Nil is $93,831, as calculated below.

...

The Step 2 allocable deductions are illustrated in Exhibit 3. Column 1 lists their itemized deductions. Column 2 lists the relevant amounts after applying a 2% floor. Column 3 lists the relevant amounts after applying a 3% phaseout.

Estimated Tax The NET is subject to estimated tax (see "Questions and Answers for the Additional Medicare Tax," Q15, http://www.irs.gov/ Businesses/Small-Businesses-&-SelfEmployed/ Questions-and-Answers-for-theAdditional-Medicare-Tax). Individuals should adjust their withholding or estimated tax payments in order to avoid underpayment of interest and penalties.

Tax Planning Opportunities The NIIT thresholds ($200,000 and $250,000) are a focal point of tax planning for high-income individuals. If taxpayers can reduce MAGI below the NET thresholds, no matter how high NE is, there will be no NIIT owed. By the same token, if there is no NE, no matter how high MAGI is, there will be no NET owed. As long as one of the two bases (NE or excess MAGI) is zero, no NET will exist.

The formula for calculating an individual's taxable income (TI) is as follows: ...

If taxpayers are concerned with tax rates on ordinary income, dividends, and LTCG, they should focus on strategies related to 33. If taxpayers are more concerned with NET, they should focus on strategies relating to AGI (MAGI).

Shift Deductions "from" AGI to "for" AGI Example 15. Individual conducts business as a sole proprietor. Individual wants to make a charitable contribution of $1,000. Should Individual write a company check and deduct $1,000 on Schedule C as a business expense, or write a personal check and deduct $1,000 on Schedule A as an itemized deduction? If Individual writes a personal check, the charitable contribution is deductible "from" AGI. ff Individual writes a business check, the charitable contribution is deductible "for" AGI. If Individual is concerned about the NET, Individual should write a business check because this reduces AGI.

Example 16. Individual has education expenses. Some education expenses are deductible "for" AGI, some are deductible "from" AGI, and some are tax credits. If Individual is concerned about NET, education expenses should be deducted "for" AGI whenever possible, because this reduces AGI.

Control Timing of Gain/Loss from Investments Example 17. Before considering gain from investments, Individual is projected to have MAGI of $190,000 in 2014 and $150,000 in 2015. Assume Individual has the prospect of realizing capital gain of $20,000 (NE) and can control the timing of gain from investments.

If Individual realizes the $20,000 (NE) in 2014, Individual's MAGI will be $210,000 ($190,000 + $20,000) in 2014, over the NET threshold ($200,000). In this case, $10,000 [the lesser of $20,000 (NE) or $10,000 (excess MAGI/AGI)] is subject to NET in 2014. If Individual realizes the $20,000 (NE) in 2015, however, MAGI will be $190,000 in 2014 and $170,000 ($150,000 + $20,000) in 2015. By postponing the capital gain until 2015, Individual is not subject to the NIIT in either 2014 or 2015; by controlling the timing of gain from investments, Individual can reduce exposure to the NET.

Example 18. Assume Individual in Example 17 will have MAGI of $190,000 every year. If Individual is eligible for, and conducts, an installment sale in 2014, Individual can spread the gain over the collection period. If the installment sale covers two years (2014 and 2015), Individual will realize gain of $10,000 in 2014 and $10,000 in 2015; thus Individual will have MAGI of $200,000 ($190,000 + $10,000) in both years. Because Individual's excess MAGI is zero in both years, Individual is not subject to the NET. By using the installment method, Individual can control the timing of gain from investments, reducing exposure to the NET.

Example 19. In 2014, before considering gain from investments, Individual has MAGI of $200,000. Assume Individual will realize capital gain of $15,000 (Nil) in 2014. Also assume Individual has the prospect of realizing capital loss of $15,000 at some point and can control the timing. If the capital loss of $15,000 is realized in 2015, it is subject to the NET in 2014. If the capital loss of $15,000 is realized in 2014, the loss offsets the gain, so it is not subject to the NET in 2014. By controlling the timing of loss from investments, Individual can reduce exposure to the NIIT.

Convert Nonbusiness Income to Business Income According to the trade or business exception, category 1 gross income is not subject to the NET if the income is derived from the ordinary course of a trade or business in which the individual is active.

Example 20. Individual sells an invention and receives royalty income. If Individual is a part-time inventor, she is engaged in a for-profit activity, not a business. This follows because Individual's services are not considerable, regular, and continuous. In this case, royalty income is category 1 gross income. If Individual is concerned about the NET, Individual should become a more-than-part-time inventor, making services considerable, regular, and continuous. In the process, Individual will convert a nonbusiness to a business; in so doing, royalty income will be derived in the ordinary course of a trade or business in which Individual is active. Thus, the trade or business exception in category 1 applies, and royalty income will not be category 1 gross income.

Convert Passive Income to Active Income Example 21. Individual is a member of a pass-through entity. In 2014, Individual's distributive share consists of ordinary income of $5,000. If Individual participates in the entity's affairs for 400 hours, he does not materially participate and thus is passive. In this case, the distributive share ($5,000) would be category 2 gross income.

If Individual is concerned about the NET, he should increase his participation from 400 hours to at least 500 hours. In so doing, Individual's distributive share will go from passive to active. In this case, the distributive share ($5,000) would not be category 2 gross income.

Regroup Activities Pursuant to IRC section 469, individuals group their activities for the purpose of determining whether the activities are active or passive. Beginning in 2013, individuals have a "fresh start"-that is, individuals may regroup activities if IRC section 1411 applies to them [Treasury Regulations section 1.469-1 l(b)(3)(iv)]. Thus, these individuals have the opportunity to convert passive activities to active activities, reducing exposure to the NET. Individuals may regroup only once, and this regrouping will apply to all friture years.

Example 22. Individual conducts two activities (X and Y) that are not rental activities. In 2014, Individual participates for 600 hours in X and 100 hours in Y, making X active and Y passive. Individual's income from X will not be subject to the NUT, but Individual's income from Y will be. If Individual is subject to the NET in 2014, Individual can regroup activities in 2014. If X and Y are regrouped to be treated as one activity (Z), Individual would participate for 700 (600 + 100) hours in Z. Individual's income would derive from a business in which Individual is active. As a result, income from Y would not be subject to the NUT; by regrouping activities, Individual can reduce exposure to the NET.

Real Estate Professionals Real estate professionals, as defined in IRC section 469(c)(7)(B), are involved with, among other things, real property development, construction, operation, management, and rentals. While they escape the passive activity rules under this section, real estate professionals do not escape the NUT rules-with one exception. If taxpayers participate for more than 500 hours per year (or 500 hours per year in five of the last 10 years) in real property rentals, their rental income from rental property and their gain from selling rental property are not subject to the NIIT [Treasury Regulations section 1.141 l-4(g)(7)(i)]. To reduce exposure to the NIIT, real estate professionals should participate in real property rentals for more than 500 hours per year.

Other Tax Planning Opportunities For high-income individuals, the income tax system is now two-dimensional-that is, such taxpayers are subject to income tax and the NIIT. To manage their tax consequences, high-income individuals need to be aware of the NIIT. There are a number of ways tax advisors can help such taxpayers to minimize, or eliminate, exposure to NIIT. Besides the tax planning opportunities mentioned above, individuals should also consider the following: * Shift income-producing investments into tax-deferred plans, such as IRAs and 401(k) accounts.

* Consider tax-exempt bonds instead of taxable bonds.

* Give income-producing investments to children or other family members not subject to the NIIT.

* Consider holding mutual funds with a high turnover rate (e.g., 100%) in a taxdeferred (e.g., retirement) account. A high turnover rate implies frequent trading of stock and more frequent capital gain. A turnover rate of 100% implies that all stocks owned by a fund are sold, on average, in one year (i.e., the average holding period is one year). A turnover rate of 20% implies that 20% of funds holdings are sold, on average, each year (i.e., the average holding period is five years).

* Consider holding mutual funds with a low turnover rate (e.g., 15%) in a taxable account. A low turnover rate implies infrequent trading of stock and less STCG.

* Consider holding broad-based exchanged-traded funds, such as an S&P 500 index fund, in a taxable account. These funds trade stock infrequently, so distributions of capital gains are deferred.

* If an individual wants to dispose of business or income-producing property and acquire other business or income-producing property, the individual should consider making an IRC section 1031 like-kind exchange. In general, gain from such exchanges is not subject to income tax, so it is not subject to the NIIT.

If taxpayers can reduce MAGI below the NIIT thresholds, no matter how high Nil Is, there will be no NIIT owed.

For high-income individuals, the income tax system is now two-dimensional.

Larry Witner, LLM, CPA, is an associate professor, and Tim Krumwiede, PhD, is a professor, both at Bryant University, Smithfield, R.I.

(c) 2014 New York State Society of Certified Public Accountants

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