Tax Law: Preparing for the New Tax on Investment Income

Tax Law: Preparing for the New Tax on Investment Income

May 1, 2012

As part of the 2010 Reconciliation Act, Congress enacted new Internal Revenue Code (“Code”) section 1411. The Code provision imposes on “unearned” income a new Medicare contribution tax on individuals (U.S. citizens and resident aliens), estates and trusts. This new tax comes into effect January 1, 2013 for taxable years beginning after December 31, 2012.

The new levy applies to income from interest, dividends, annuities, royalties, rents and capital gains. It is a new tax on investment income. Code section 1411 is not a tax on business income.

“Investment income” is the sum of (i) gross income from interest, dividends, annuities, royalties and rents (other than such income derived in the ordinary course of trade or business to which the Medicare contribution tax does not otherwise apply), (ii) other gross income derived from any business to which the tax applies, and (iii) 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 tax does not apply.

Code section 1411’s tax rate is 3.8 percent. As applied to individuals, the tax is levied on the lesser of “net investment income” or the excess of “modified adjusted gross income” over the “threshold amount.”

The term “net investment income” is investment income reduced by the deductions properly allocable to such income.

The term “modified adjusted gross income” is adjusted gross income increased by the amount excluded from income as foreign earned income under Code section 911(a)(1) (net of the deductions and exclusions disallowed with respect to the foreign earned income).

Under Code section 1411, the “threshold amount” is $250,000 for joint returns or surviving spouses. It is $125,000 in the case of a married individual filing separately and $200,000 for all other taxpayers. Note that the threshold amounts are not indexed for inflation. As a result, it is possible that the new tax will affect more taxpayers each year.

In the case of an estate or trust, the tax is 3.8 percent of the lesser of undistributed net investment income or the excess of adjusted gross income over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.

The new tax does not apply to a non-resident alien or to a trust in which all the unexpired interests are devoted to charitable purposes. This new tax will also not apply to a trust that is exempt from tax under Code section 501 or to a charitable remainder trust exempt from tax under Code section 664.

It is significant to note that the new tax is subject to the individual estimated tax provisions. The new tax is not deductible in computing any tax imposed by Subtitle A of the Code (relating to income taxes).

Since the new Code section 1411 will not tax what is presently excluded from the scope of gross income, it will not apply to items such as, by way of examples only, tax-exempt bond interest, Veteran’s benefits or capital gains from the sale of a principal residence to the extent excluded from gross income.

In the case of a trade or business, the new tax will apply if the trade or business is a passive activity with respect to the particular taxpayer or if the business consists of trading financial instruments or commodities as defined in Code section 475(e)(2). The tax does not apply to other trades or businesses conducted by a sole proprietor, partnership or S corporation.

The new levy will apply to dispositions of a partnership interest or stock in an S corporation, but only to the extent gain or loss would be taken into account by the partner or shareholder if the entity had sold all its properties for fair market value immediately before the disposition. Consequently, only net gain or loss attributable to property held by the entity which is not property attributed to an active trade or business is taken into account. Significantly, income, gain or loss on working capital is not treated as derived from a trade or business.

Investment income does not include amounts that are subject to self-employment tax or distributions from qualified retirement plans. “Net investment income” does not include any distributions from Code section 403(a) qualified annuity plans, Code section 403(b) annuities, Code section 408 individual retirement accounts (IRA’s), Code section 408A (Roth IRAs), or Code section 457(b) deferred compensation plans of tax-exempt organizations and state and local governments.

New Code section 1411 probably will not apply to either simple trusts or grantor trusts.

The new tax or investment income raises some planning opportunities for well-advised clients and will doubtlessly catch some taxpayers unaware of its enactment.

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