Year-end planning: reducing exposure to the new 3.8% surtax on unearned income – Part I

Year-end tax planning for 2013 includes a new and unwelcome complication: the 3.8% surtax on unearned income. This two-part Practice Alert takes a look at year-end moves that can be used to reduce or eliminate the impact of this surtax. Part I, in this article, highlights the new Code Sec. 1411 surtax and overall year-end strategies for coping with it, and includes specific strategies for taxpayers with interests in passive activities.

Overview. For tax years beginning after Dec. 31, 2012, certain unearned income of individuals, trusts, and estates is subject to a surtax on “unearned income” (i.e., it’s payable on top of any other tax payable on that income). The surtax, also called the “unearned income Medicare contribution tax” or the “net investment income tax” (NIIT), for individuals is 3.8% of the lesser of:

(1) net investment income (NII), or
(2) the excess of modified adjusted gross income (MAGI) over an unindexed threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). (Code Sec. 1411(a)(1), Code Sec. 1411(b) )
MAGI is adjusted gross income (AGI) plus any amount excluded as foreign earned income under Code Sec. 911(a)(1) (net of the deductions and exclusions disallowed with respect to the foreign earned income). (Code Sec. 1411(d))

For an estate or trust, the surtax is 3.8% of the lesser of (1) undistributed NII or (2) the excess of adjusted gross income (AGI, as defined in Code Sec. 67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins. (Code Sec. 1411(a)(2))

For 3.8% surtax purposes, NII is investment income less deductions properly allocable to such income. Examples of properly allocable deductions include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes properly allocable to items included in NII.

Investment income is:

… gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the 3.8% surtax doesn’t apply,
… other gross income derived from a trade or business to which the 3.8% surtax contribution tax does apply, and
… 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 Medicare contribution tax doesn’t apply. (Code Sec. 1411(c))
The 3.8% surtax applies to a trade or business only if it is a Code Sec. 469 passive activity of the taxpayer or a trade or business of trading in Code Sec. 475(e)(2) financial instruments or commodities. (Code Sec. 1411(c)(2)) Investment income doesn’t include amounts subject to self-employment tax (Code Sec. 1411(c)(6)), distributions from tax-favored retirement plans (e.g., qualified employer plans and IRAs) (Code Sec. 1411(c)(5)), or tax-exempt income (e.g. earned on state or local obligations).

The surtax doesn’t apply to trades or businesses conducted by a sole proprietor, partnership, or S corporation (but income, gain, or loss on working capital isn’t treated as derived from a trade or business and thus is subject to the tax). (Code Sec. 1411(c)(3))

Gain or loss from a disposition of an interest in a partnership or S corporation is taken into account by the partner or shareholder as NII only to the extent of the net gain or loss that the transferor would take into account if the entity had sold all its property for fair market value immediately before the disposition. (Code Sec. 1411(c)(4))

The tax does not apply to: nonresident aliens (special rules apply to nonresident aliens married to U.S. citizens or residents); trusts all the unexpired interests in which are devoted to charitable purposes; trusts exempt from tax under Code Sec. 501; or charitable remainder trusts exempt from tax under Code Sec. 664. (Code Sec. 1411(e)) Also exempt are trusts treated as “grantor trusts” under Code Sec. 671 through Code Sec. 679 ; and trusts that are not classified as “trusts” for federal income tax purposes (e.g., Real Estate Investment Trusts and Common Trust Funds). (IRS’s “Questions and Answers on the Net Investment Income Tax,” Aug. 8, 2013)

For more details on the complex Code Sec. 1411 surtax, see the six-part series of articles covering proposing reliance regs on Code Sec. 1411, commencing with Weekly Alert ¶ 32 12/06/2012 .

Overview of Year-End Strategies to Cope With the 3.8% Surtax

As year-end nears, a taxpayer’s approach to minimizing or eliminating the 3.8% surtax will depend on his estimated MAGI and NII for the year. Some taxpayers should consider ways to minimize (e.g., through deferral) additional NII for the balance of the year, others should try to see if they can reduce MAGI other than unearned income, and others will need to consider ways to minimize both NII and other types of MAGI.

RIA illustration 1: For 2013, Joan, a single taxpayer estimates she will have MAGI of $200,000, consisting of $180,000 of salary and non-investment earnings, and $20,000 of NII. Since Joan’s MAGI is not above the level that would subject her to the 3.8% surtax, her year-end strategy for the surtax will be to avoid-if feasible, from the investment and practical viewpoint-realizing any additional income before the end of the year that will cause her to be subject to the surtax.

RIA illustration 2: Assume the same facts as in the first illustration, except that Joan’s MAGI will include $200,000 of salary and non-investment earnings plus $20,000 of NII. Since all of her NII of $20,000 is now subject to the surtax, she should try to avoid, to the extent possible, having any additional NII for the balance of the year since any additional NII will also be subject to the surtax.

RIA observation: Since, in illustration (2), all of Joan’s NII of $20,000 will be subject to the surtax, an increase in income other than NII will have no effect on the amount of her NII that is subject to the surtax.

RIA illustration 3: In January of 2013, Jack, a single, self-employed taxpayer, sold investment land for a $100,000 gain and does not anticipate selling any other investments during the balance of this year. He won’t have other NII. He estimates that he will have $100,000 of self-employment earnings and other non-investment-income for the year. Thus, Jack will be exactly at the $200,000 threshold for single taxpayers. He should, to the extent feasible and practical, defer additional amounts of earned income over $100,000 to 2014, as every additional dollar of earnings over that sum will expose a dollar of his $100,000 NII to the 3.8% surtax. For example, if he gets extra business toward the end of the year, Jack should consider deferring some of his billings until after year-end.

Specific Year-End Moves to Reduce Exposure to Surtax

Reexamine passive investment holdings. The 3.8% surtax applies to income from a passive investment activity, but not from income generated by an activity in which the taxpayer is a material participant. One subject a “passive” investor should explore with a tax adviser knowledgeable in the passive activity loss (PAL) area is whether it would be possible (and worthwhile) to increase participation in the activity before year-end so as to qualify as a material participant in the activity.

In general, under Reg. § 1.469-5T(a), a taxpayer establishes material participation by satisfying any one of seven tests, including: participation in the activity for more than 500 hours during the tax year; and participation in the activity for more than 100 hours during the tax year, where the individual’s participation in the activity for the tax year isn’t less than the participation in the activity of any other individual (including individuals who aren’t owners of interests in the activity) for the year. Special rules apply to real estate professionals.

RIA caution: Becoming a material participant in an income-generating passive activity wouldn’t make sense if the taxpayer also owns another passive investment that generates losses that currently offset income from the profitable passive activity.

Taxpayers that own interests in a number of passive activities also should reexamine the way they group their activities. Under Reg. § 1.469-4(c)(1) and Reg. § 1.469-4(c)(2), a taxpayer may treat one or more trade or business activities or rental activities as a single activity (i.e., group them together) if based on all the relevant facts and circumstances the activities are an appropriate economic unit for measuring gain or loss for PAL purposes. A number of special “grouping” rules apply. For example, a rental activity can’t be grouped with a trade or business activity unless the activities being grouped together are an appropriate economic unit and a number of additional tests are met. And real property rentals and personal property rentals (other than personal property rentals provided in connection with the real property, or vice versa) can’t be grouped together.

Once the taxpayer has grouped activities, he can’t regroup them in later years, but if a material change occurs that makes the original grouping clearly inappropriate, he must regroup the activities. (Reg. § 1.469-4(e), Reg. § 1.469-4(f) )

Proposed reliance regs issued late last year provide a regrouping “fresh start” allowing qualifying taxpayers to regroup their activities for any tax year that begins during 2013 if Code Sec. 1411 would apply to the taxpayer without regard to the effect of regrouping (i.e., they have NII and the applicable income threshold is met). A taxpayer may only regroup activities once, and any regrouping will apply to the tax year for which the regrouping is done and all later years. (Prop Reg § 1.469-11(b)(3)(iv)) The regrouping must comply with the disclosure requirements under Rev Proc 2010-13, 2010-4 IRB 329 and Reg. § 1.469-4(e) . (Preamble to Prop Reg11/30/2012; see Weekly Alert ¶ 47 12/06/2012 for more details)

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