2013 NET INVESTMENT INCOME TAX FOR INDIVIDUALS, TRUSTS AND ESTATES

Sean Urbany, CPA

In addition to the various tax increases enacted on January 1st of this year as part of the American Taxpayer Relief Act of 2012 (which averted the so-called fiscal cliff), taxpayers should note one other tax change for 2013: the 3.8% tax on net investment income. While it was actually put in place way back in 2010 as part of the health-care law, it went into effect for this year and will apply to individual returns due April 15, 2014.

Specifically, this is a 3.8% tax on the lesser of a taxpayer’s net investment income for the year or the excess of his/her modified adjusted gross income (AGI) at the following thresholds:

  • Over $250,000 for taxpayers filing a joint return;
  • $125,000 for married taxpayers filing separate returns;
  • $200,000 for all other taxpayers.

If your adjusted gross income does not exceed those limits, the net investment income tax will not apply to you.

What is Net Investment Income?
In general, net investment income is defined as the sum of interest income, dividends, certain annuities, royalties, rents, and income not derived from an active trade or business. It also includes net capital gains from the disposition of property.

Net investment income will not include any income or gains treated as self-employment income for the tax year. So if you conduct your trade or business through an LLC which you own, that income is not subject to the net investment income tax because it is considered active trade or business income.

Other Tax Increases for 2013
As part of the aforementioned fiscal cliff legislation, the tax rate for the highest income tax bracket has increased from 35% to 39.6% for single taxpayers with AGI over $400,000 ($450,000 for married taxpayers filing jointly). Those same taxpayers will also be subject to a 20% long-term capital gains rate (as opposed to 15% for those under the AGI limits). The 20% long-term capital gains rate effectively becomes 23.8% when you factor in the net investment income tax.

Effect on Taxpayers – 2012 vs. 2013
Both tax increases (the net investment income tax and the increased tax rates for those in the top tax bracket) take effect in the 2013 tax year. Here are some examples of how you could be affected in 2013 compared to 2012:

Example #1: 
John is a single taxpayer and has an AGI of $270,000, which includes $180,000 of wages, $40,000 of qualified dividends, and $50,000 of long-term capital gains. Assuming John claims the standard deduction, his total federal tax liability for 2012 would be approximately $57,000. Using the same assumptions for 2013, John will be subject to a total tax of approximately $60,000. For both years, John will be in the 33% tax bracket and, as such, his long-term capital gains and qualified dividends will be subject to a maximum tax rate of 15%. However, for 2013, he will also be subject to the additional net investment income tax on $70,000 (the lesser of [$270,000 – $200,000] or $90,000 net investment income), resulting in increased taxes.

Example #2:
Joe and Jane are married taxpayers that file jointly. Together they have an AGI of $700,000, which includes $100,000 of wages, $200,000 of qualified dividends, and $400,000 of long-term capital gains. Assuming that they will claim the standard deduction, their total federal tax liability for 2012 would be approximately $116,000. Using the same assumptions for 2013, their total federal tax would increase to approximately $145,000.

For 2012, Joe and Jane would have been in the highest tax bracket, with a 35% tax rate, and their long-term capital gains and qualified dividends would have been subject to a maximum rate of 15%. In contrast, for 2013, they will still be in the highest bracket, but the rate has now increased to 39.6%. Also, long-term capital gains and qualified dividends will now be subject to a maximum rate of 20%, as the couple’s AGI is greater than $450,000. Additionally, Joe and Jane will also be subject to the additional net investment income tax of 3.8% on $450,000 (the lesser of [$700,000 – $250,000] or $600,000 net investment income).

You can see from the two examples above how both tax increases can drastically impact a taxpayer’s final tax bill.

Net Investment Income Tax for Estates and Trusts
In the case of an estate or trust, the net investment income tax is 3.8% on the lesser of undistributed net investment income for the year, or the excess of AGI over $11,950. As you can see, the threshold for which an estate or trust will be subject to the net investment income tax is much lower than that of an individual taxpayer. Consideration should be given to distributing 100% of the income generated by the estate or trust in an effort to avoid having to pay net investment income tax on this income. The distributed income will then be taxable income to the beneficiaries; however, income that would have potentially been subject to the net investment income tax at the trust may not be subject to the tax on the individual taxpayer level because the threshold is much higher.

There are many intricacies with the net investment income tax, particularly as it applies to pass-through entities (what is passive versus what is trade or business income). The IRS has so far not finalized its regulations, so taxpayers are relying on proposed regulations. As always, it is best to consult your tax advisor to discuss your particular situation.

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