Practice Areas

New Tax on Net Investment Income of Individuals, Trusts and Estates Goes Into Effect

January 23, 2013
Joshua L. Cannon

With the turning of the calendar to 2013, higher income individuals and certain trusts and estates must now contend with the new 3.8% tax on net investment income (“NII”) contained in Code section 1411, which was created as part of PPACA.  Along with the increase in the highest marginal tax bracket of 39.6%, which was reinstated as part of the year-end American Taxpayer Relief Act of 2012 for couples making over $450,000 ($400,000 for single filers), higher income individuals are potentially facing a substantial tax increase in 2013 and subsequent years.

The new NII tax affects only individuals filing a joint return with modified adjusted gross income of more than $250,000 ($200,000 for single filers) and trusts and estates with undistributed net investment income and adjusted gross income in an amount placing such trust or estate in the highest income tax bracket for trusts and estates ($11,950 for 2013).  Significantly, the threshold amounts for individuals are not indexed for inflation. 

NII includes many types of gross income commonly considered to be “investment” income, such as interest, dividends, and capital gains.  NII also includes income that may not be as obvious, such as rents and gross income generated from passive activities or from a trade or business of trading in financial instruments or commodities.  A special rule applies when calculating the amount of gain from the disposition of interests in partnerships and S corporations includable in NII.  Certain deductions may be taken against the sum of these various income categories to the extent such deductions are properly allocable to the income, such as brokerage fees and state income taxes applicable to the taxpayer’s NII.

Importantly, several types of investment income earned in the ordinary course of a trade or business are not includable in NII, although income earned on the investment of working capital counts as NII.  Distributions from qualified plans and IRAs are also not considered to be NII. 

The IRS recently proposed regulations addressing many of the issues raised by the statutory language.  These proposed regulations contain considerable detail on exactly which individuals, estates, and trusts are subject to the tax, what income is includable in NII, and what deductions may be taken against such income.  The IRS has indicated that taxpayers may rely on the proposed regulations for purposes of complying with the NII tax provisions until the effective date of final regulations.

TAX ADVICE LIMITATION:  To ensure compliance with the requirements of Circular 230, we inform you that any tax advice contained above is not intended or written to be used and cannot be used (i) by any taxpayer for the purpose of avoiding penalties that may otherwise be imposed under the Internal Revenue Code or (ii) by anyone for the purpose of promoting, marketing or recommending to another party any entity, investment plan or arrangement addressed herein.