The New 3.8 Percent Tax on Net Investment Income of Individuals, Estates, and Trusts

During tax season, many tax preparers and their clients will be learning about the new 3.8 percent net investment income tax (NIIT), which affects certain passive investment income. This tax impacts many taxpayers, especially those with high earnings, and it’s important for taxpayers to understand how it works and how to minimize its impact. The tax applies to individuals, estates, and trusts with income above certain thresholds and is reported and paid with the annual income tax return. It’s important for taxpayers to anticipate and plan for this tax to avoid any surprises when the tax bill is due. There are also planning options available to structure transactions in a way that could avoid the NIIT. The NIIT is a new tax on investment income that was created to help fund the Affordable Care Act. It applies to all income at a rate of 3.8%, including wages, self-employment income, and now, unearned investment income. The Treasury has issued regulations to explain how the tax works, and taxpayers can rely on these regulations for guidance. If taxpayers don’t follow the regulations, they may have to adjust their taxes in the future. Net investment income (NII) is the money you make from investments like interest, dividends, and rent. If your NII is over a certain amount and your income is above a set threshold, you’ll have to pay a 3.8% tax on the extra income. But you can deduct certain expenses, like investment interest and brokerage fees, to lower the amount of NII you have to pay tax on. This tax applies to individuals, with different income thresholds depending on if you’re married or single. In 2013, Joe Investor made $190,000 and had $50,000 of investment income. He didn’t have to pay the Net Investment Income Tax (NIIT) because his income didn’t go over the limit. In 2014, he made $220,000 with $50,000 of investment income, so he had to pay $760 in NIIT. For estates and trusts, there’s also a 3.8% NIIT on investment income, but some types of trusts are exempt. If a trust doesn’t have to pay NIIT, the money it gives to beneficiaries might be taxed as investment income for the beneficiaries. In 2013, Joe’s trust had $50,000 in investment income. It gave $20,000 to Joe’s nephew, Aaron. Joe’s trust had $30,000 left over, and had to pay $685.90 in a special tax. If the trust had given Aaron more money, the trust might not have had to pay this tax. Passive Activity Business Income is income generated from a business in which the taxpayer is not actively involved. To avoid this classification and the associated taxes, the taxpayer must be considered “active” in the business. This means they must participate regularly and substantially in the business operations. There are specific tests to determine if the taxpayer is actively involved in the business, and if they meet these tests, the business will be considered “active” rather than passive. This means they won’t have to pay extra taxes on the income from the business. If you own a business by yourself or through a company that doesn’t have its own taxes, like a single-member LLC, your involvement in the business determines if it’s considered passive or active for tax purposes. If you have a business that passes its income to you, like a partnership or S corporation, the rules look at how much you’re involved in the business separately for each owner. But if you receive dividends from a regular corporation, that income is considered part of your net investment income, no matter how much you’re involved in the business. Some taxpayers used to try to make their activities seem passive to avoid paying certain taxes. But now, because of the NIIT, it may be better for taxpayers to be more active in their business activities. This means they may need to participate more in their businesses in order to be considered “nonpassive,” which can help them avoid certain taxes.

For trusts and estates, there’s still some uncertainty about how to apply the rules for being considered “active” in a business activity. Right now, it seems like the person in charge of the trust or estate would need to be the one participating in the business activity in order for it to count as “active.” Until there’s clearer guidance from the government, that’s what people should assume. The passive activity loss rules let taxpayers group their business or rental activities together for tax purposes. This can help them meet the “material participation” tests and potentially avoid passive activity rules. Normally, once activities are grouped, they can’t be changed. But because of a new tax, taxpayers have one chance to regroup their activities in the year they meet the income threshold for the new tax. This could be important for people who rent out real estate and want to avoid the passive activity rules. They should talk to a tax advisor to decide if they should use this one-time regrouping option. If you own a share of a business that passes its income through to you, you might have to pay a tax called the Net Investment Income Tax (NIIT) on that income. Whether or not you have to pay this tax depends on whether the business is considered a “trade or business” for tax purposes, and on your level of involvement in the business’s activities. If you’re actively involved in the business, you might not have to pay the tax, but if you’re not involved, you probably will. This determination is made on a person-by-person basis, so different owners of the same business might have different tax obligations. If the business you own a share of also owns a share of another business, your involvement in the second business also affects your tax obligation. The Net Investment Income Tax (NIIT) is a new 3.8 percent tax that applies to certain types of income, including gains from selling ownership in certain businesses. If you are not actively involved in the business, you may have to pay this tax on the profits from selling your ownership. It’s important to review your investments and business interests with a financial advisor to see if you will have to pay this tax, and to see if there are any ways to reduce the amount you owe. Keep an eye out for any updates or changes to the rules as the IRS provides more guidance on this tax. The NIIT is a new tax that applies to certain kinds of investment income for individuals, trusts, and estates. It is separate from the Medicare tax. The rules for the NIIT are very complicated and the tax forms are new. The income thresholds for the tax are not adjusted for inflation, and there are special rules for certain types of income and for nonresident aliens. The IRS sets the income threshold each year. The tax regulations for trusts and estates have specific rules for calculating the Net Investment Income Tax (NIIT). For trusts and estates, their taxable income, excluding certain types of income, is used to determine the NIIT. Charitable contributions can help reduce the NIIT for a trust. The definition of “trade or business” for NIIT purposes is the same as for regular income tax purposes. Income from a trade or business that the taxpayer is actively involved in is not considered Net Investment Income, but it can still affect the taxpayer’s overall income and potentially trigger the NIIT. The IRS is expected to issue guidance on how trusts and estates can meet the requirements for active participation in a trade or business. The article discusses the IRS rules for determining if a trust is actively involved in a business activity. It also mentions the tax consequences of receiving more money from a business than what you originally invested. The author of the article, Jordan August, is a tax attorney in Tampa. The article was submitted by the Tax Law Section of The Florida Bar.

Source: https://www.floridabar.org/the-florida-bar-journal/the-new-3-8-percent-tax-on-net-investment-income-of-individuals-estates-and-trusts/