The Net Investment Income Tax

A new tax on investment income is in effect as of the start of the year. This "Net Investment Income Tax," or NIIT, is equal to 3.8% multiplied by the lesser of (1) the taxpayer's net investment income and (2) the amount that the taxpayer's modified adjusted gross income exceeds a certain threshold. The threshold amounts are $200,000 for single filers and heads of households, $250,000 for joint filers, and $125,000 for married individuals filing separate returns.

Investment income generally includes interest, dividends, capital gains, rental and royalty income, nonqualified annuities, and passive activity income. Expenses attributable to the investment income are subtracted to arrive at net investment income. The NIIT does not apply to wages, unemployment compensation, nonpassive business income, social security benefits, tax exempt interest, self-employment income, and distributions from qualified retirement plans. However, such amounts are included in the calculation of the modified AGI threshold amount.

For example, if a married taxpayer filing a joint return receives a $25,000 royalty with $5,000 worth of costs attributable to that royalty and has an AGI of $260,000, $10,000 will be subject to the NIIT. This is the lesser of the taxpayers net investment income and the amount the taxpayer's modified AGI of $260,000 exceeds the applicable threshold of $250,000. The taxpayer will owe a NIIT of $380.

One planning mechanism that can ameliorate the NIIT is for taxpayers to increase their participation in business activities that would otherwise be considered passive activities so that the income is not subject to the NIIT. Material participation generally means that the taxpayer be involved in the business operations on a regular, continuous, and substantial basis.

Another planning opportunity arises in the context of trusts for the benefit of a taxpayer's beneficiaries in lower income brackets. The NIIT applies to trusts at a much lower income threshold than it does for individuals. Accordingly, trusts that have the option of passing their income to the beneficiaries to be taxed on the individual level or retaining the income and paying any resulting tax at the trust level should opt for the former.

Other planning strategies focus not on reducing net investment income but on reducing adjusted gross income. For example, taxpayers should maximize contributions to retirement accounts such as 401(k)s, IRAs, and SEP accounts. As with any tax planning strategy, early implementation is key.

Posted in: Income Tax