Implications of the New Medicare Surcharge Tax and Net Investment Income Tax

Transcription

1 I. Medicare Surcharge Tax Implications of the New Medicare Surcharge Tax and Net Investment Income Tax 61 st Annual University of Montana Tax Institute October 18-19, 2013 Professor Kristen G. Juras A. Medicare Taxes. The Federal Insurance Contribution Act (FICA) imposes a tax on salaries paid to employees. FICA has two components: Old-Age, Survivors, and Disability Insurance (OASDI, also commonly referred to as the social security tax ) and Medicare. The Self-Employment Contribution Act (SECA) is the FICA counterpart for self-employed individuals. Like the FICA tax, the SECA tax has two components: OASDI and Medicare. 1. For taxpayers who are self-employed, the Medicare tax is assessed at the rate of 2.9% of the taxpayer s self-employment income. IRC For wage-earners, the Medicare portion of FICA tax is imposed on the employer in an amount equal to 1.45% of wages, and on the employee in an amount equal to 1.45% of wages. IRC 3111(b), 3101(b). The employer is required to collect the employee portion of FICA tax by deducting the amount of the tax from wages, as and when paid. IRC Whereas earnings on which the OASDI tax is assessed is capped ($113,700 in 2013), there is no cap on the earnings on which the Medicare tax is imposed. 4. Under the Railroad Retirement Tax Act (RRTA), railroad employment is subject to a separate and distinct system of taxes from those imposed under the FICA. The RRTA serves as the functional equivalent of FICA for railroad employers, employees, and employee representatives (a group unique to the railroad industry). IRC 3201 et seq. B. Affordable Care Act. The 2010 Patient Protection and Affordable Care Act increases the Medicare tax for employees, self-employed persons, and railroad employees for wages or self-employment income received in any taxable year beginning after December 31, 2012, by an additional 0.9 percent on earned Medicare and NII Tax Page 1

2 income which exceeds certain threshold amounts. IRC 3101(b)(2), 1401(b)(2). In proposed regulations issued by the Internal Revenue Service (77 Fed. Reg (Dec. 5, 2012)), this tax is referred to as the Additional Medicare Tax. See, for example, Prop. Treas. Reg (g). 1. As noted in the IRS s Questions and Answers for the Additional Medicare Tax (IRS FAQs Medicare), (available at taxpayers may rely on the proposed regulations for tax periods beginning before the date that the final regulations are published in the Federal Register. If any requirements change in the final regulations, taxpayers will only be responsible for complying with the new requirements from the effective date of the final regulations. 2. The calculation of wages and self-employment income for purposes of the Additional Medicare Tax is no different than the calculation of earned income for FICA generally. For a discussion of what constitutes selfemployment income and wages, and exclusions therefrom, see Kristen G. Juras, Overview Federal Employment Tax Liability, 56 th Annual University of Montana Tax Institute (2008). See also Special Rules for Various Types of Services and Payments, in section 15 of IRS Publication 15, (Circular E), Employer s Tax Guide. 3. The Additional Medicare Tax differs from the standard medicare tax in that the Additional Medicare Tax is not imposed until wages exceed the following threshold amounts, based on the filing status of the individual. These threshold amounts are not indexed for inflation. Joint Return $250,000 Married Filing Separate $125,000 All Others (including Single, Head of Household, Qualifying Widow(er)) $200,000 Example: A, a single filer, has $130,000 in wages and no self-employment income. CA s wages are not in excess of the $200,000 threshold for single filers, so A is not liable for Additional Medicare Tax on these wages. Example: B, a single filer, has $220,000 in self-employment income and $0 in wages. B is liable to pay Additional Medicare Tax on $20,000 Medicare and NII Tax Page 2

3 ($220,000 in self-employment income minus the threshold of $200,000). Her tax liability is $180 ($20,000 x.009). C. Rules Applicable to Employees/Employers. The Additional Medicare Tax differs from the standard medicare tax in that there is no employer portion that corresponds to the amount owed by the employee. 1. An employer is required to withhold the Additional Medicare Tax to the extent that the wages paid by the employer to the employee exceed $200,000. IRC 3102(f)(1). The employer does not take into account the employee s filing status or other wages or compensation which may impact the employee s liability for the tax, Prop. Treas. Reg (a), (g), nor is the employer required to take into account any wages paid to the employee s spouse. Id.; IRC 3102(f)(1). a. Practice Tip: An employer is required to begin withholding Additional Medicare Tax in the pay period in which it pays wages in excess of $200,000 in any given year to an employee. IRS FAQ # The employee is liable for any Additional Medicare Tax that is not collected by the employer. IRC 3102(f)(2). The following example is provided at Prop. Treas. Reg (b): Example. J, who is married and files a joint return, receives $190,000 in wages from his employer for the calendar year. K, J s spouse, receives $150,000 in wages from her employer for the same calendar year. Neither J s nor K s wages are in excess of $200,000, so neither J s nor K s employers are required to withhold Additional Medicare Tax. J and K are liable to pay Additional Medicare Tax on $90,000 ($340,000 minus the $250,000 threshold for a joint return). 3. An employee may not request that the employer deduct and withhold Additional Medicare Tax on wages of $200,000 or less. However, an employee who anticipates liability for Additional Medicare Tax may request that the employer deduct and withhold an additional amount of federal income tax withholding on Form W-4, which can be applied against all taxes shown on Form 1040, including any Additional Medicare Tax liability. 77 Fed. Reg , (Dec. 5, 2012); Treas. Reg (i) 2. An employee who anticipates being liable for the Additional Medicare and NII Tax Page 3

4 Medicare Tax also has the option of paying estimated taxes. 77 Fed. Reg , (Dec. 5, 2012). 4. Employers are liable for failure to properly deduct and withhold the correct amount of Additional Medicare Tax. If an employee subsequently pays the tax that the employer failed to deduct, the tax will not be collected from the employer, but the employer may be liable for penalties or other additions to tax for failure to properly withhold. IRC 3102(f)(3); Prop. Treas. Reg (c), (g)(3). 5. If an employer withholds Additional Medicare Tax, and it turns out that the employee is not liable for the tax, the employee may claim a credit for any withheld Additional Medicare Tax against the total tax liability shown on his individual income tax return (or, for a taxable year for which a tax return has been filed without claiming such credit, the taxpayer may file an amended return on Form 1040X). This process is in lieu of filing a claim for refund on Form Fed. Reg , (Dec. 5, 2012). Example: An employee earns $230,000 in His employer withholds $270 of Additional Medicare Tax on the portion of his wages ($30,000) that exceeds $200,000, as required under IRC 3102(f)(1). The employee s spouse has $10,000 in self-employment income; they file a joint income tax return. The threshold amount for the Additional Medicare Tax for married couples filing jointly is $250,000, and thus no Additional Medicare Tax is owed. The taxpayer may claim a credit for the $270 in Additional Medicare Tax withheld by his employer against the total tax liability shown on the 2013 joint return. Prop. Treas. Reg (a)-2(b)(3). 6. The IRS has prepared Draft Form 8959 on which to report and calculate Additional Medicare Taxes, a copy of which is attached to this outline. An employee who is liable for any Additional Medicare Taxes (above and beyond what an employer has withheld) must also file a Form 1040-SS. Prop. Treas. Reg (a)-1(h). 7. There will be no change to Form W-2. Additional Medicare Tax withholding will be reported in combination with withholding of regular Medicare tax in box 6 ( Medicare tax withheld ). IRS FAQ #42. Medicare and NII Tax Page 4

5 D. Rules Applicable to Self-Employment Income. The threshold amounts in determining whether a self-employed individual is subject to the Additional Medicare Tax under the Self-Employment Contributions Act (SECA) are the same thresholds that apply to employees. IRC 1401(b)(2)(A). If a taxpayer has both wages and self-employment income in a single year, the threshold of selfemployment income subject to the Additional Medicare Tax is reduced (but not below zero) by the amount of wages taken into account in determining Additional Medicare Tax under FICA. IRC 1401(b)(2)(B). 1. Prop. Treas. Reg (d)(2) provides the following examples of the coordination between self-employment income and wages in determining the applicable Additional Medicare Tax: Example 3. C, a single filer [$200,000 threshold], has $145,000 in self-employment income and $130,000 in wages [$275,000 total]. C s wages are not in excess of $200,000 so C s employer did not withhold Additional Medicare Tax. However, the $130,000 of wages reduces the self-employment income threshold to $70,000 ($200,000 threshold minus the $130,000 of wages). C is liable to pay Additional Medicare Tax on $75,000 of self-employment income ($145,000 in self-employment income minus the reduced threshold of $70,000). (Emphasis supplied.) Example 5. D, who is married and files married filing separately [$125,000 threshold], has $150,000 in self-employment income and $200,000 in wages [$350,000 total]. D s wages are not in excess of $200,000 so D s employer did not withhold Additional Medicare Tax. However, the $200,000 of wages reduces the self-employment income threshold to $0 ($125,000 threshold minus the $200,000 of wages). D is liable to pay Additional Medicare Tax on $75,000 of wages ($200,000 in wages minus the $125,000 threshold for a married filing separately return) and on $150,000 of self-employment income ($150,000 in self-employment income minus the reduced threshold of $0). 2. The Additional Medicare Tax is treated as a tax subject to estimated tax payment requirements. IRC 6654(m). Underpayment of the Additional Medicare Tax may result in an addition to tax under IRC Self-employed persons should calculate and include the Additional Medicare Tax when making estimated tax payments. An individual cannot Medicare and NII Tax Page 5

6 designate any estimated payments specifically for Additional Medicare Tax. IRS FAQ #12. E. Special RRTA Rules. Although the Additional Medicare Tax applies to RRTA compensation, some special rules apply. 1. Compensation subject to RRTA taxes and wages subject to FICA tax are not combined to determine Additional Medicare Tax liability. The threshold applicable to an individual s filing status is applied separately to each of these categories of income. The IRS FAQs-Medicare provide the following example: Example: J and K, are married and file jointly. J has $190,000 in wages subject to Medicare tax and K has $150,000 in compensation subject to RRTA taxes. J and K do not combine their wages and RRTA compensation to determine whether they are in excess of the $250,000 threshold for a joint return. J and K are not liable to pay Additional Medicare Tax because J s wages are not in excess of the $250,000 threshold and K s RRTA compensation is not in excess of the $250,000 threshold. 2. Although Section 1401(b)(2)(B) specifically provides for coordination of self-employment income subject to the Additional Medicare Tax with wages under the FICA, it does not provide for similar coordination with Additional Medicare Tax under the RRTA. Therefore, the amount of RRTA compensation taken into account in determining Additional Medicare Tax under the RRTA will not reduce the threshold amounts under section 1401(b)(2)(A) for determining Additional Medicare Tax under the SECA. 77 Fed. Reg , (Dec. 5, 2012). F. Interest-Free Adjustments of Employment Taxes. The Proposed Regulations provide rules under IRC 6205 and 6413 allowing employers to make interestfree adjustments of employment taxes. See Prop. Treas. Reg (4); (a)-1(2). 1. If the employer underwithholds the correct amount of Additional Medicare Tax from wages it pays to an employee and discovers the error in the same year it pays the wages, the employer may correct the error by making an interest-free adjustment on the appropriate corrected return (for example, Form 941-X). Once the employer has discovered the error, the Medicare and NII Tax Page 6

7 employer may deduct the correct amount of Additional Medicare Tax from other wages or other remuneration it pays to the employee on or before the last day of the calendar year. IRS FAQ #44. a. If an employer underwithholds Additional Medicare Tax and does not discover the error in the same year wages were paid, the employer should not correct the error by making an interest-free adjustment. However, to the extent the employer can show that the employee paid the Additional Medicare Tax, the underwithheld amount will not be collected from the employer. The employer will remain subject to any applicable penalties. IRS FAQ # If the employer overwithholds the correct amount of Additional Medicare Tax, and repays the overwithheld amount to the employee before the end of the calendar year, it may correct the error by making an interestfree adjustment on the appropriate corrected return (for example, Form 941- X). If the employer does not repay or reimburse the employee the amount of overcollected tax before the end of the year in which the wages were paid, the employer should not correct the error via an interest-free adjustment. Instead, the employer should report the amount of withheld Additional Medicare Tax on the employee s Form W-2 for that year so that the employee may obtain credit for Additional Medicare Tax withheld on the employee s individual income tax return. IRS FAQ #45. a. If the employer overwithholds and does not discover the mistake before the end of the calendar year, the employer should not correct the error by making an interest-free adjustment. Instead, the employer should report the amount of withheld Additional Medicare Tax on the employee s Form W-2 in the year that the mistake is discovered; that amount will be available as a credit against the employee s overall tax liability for the year in which the overwithholding is reported. IRS FAQ # For more information on rules and procedures applicable to employers and payroll service providers, see IRS FAQs-Medicare ## II. Net Investment Income Tax A. Introduction. The Health Care and Education Reconciliation Act of 2010 added a new chapter 2A to subtitle A (Income Taxes) of the Internal Revenue Medicare and NII Tax Page 7

8 Code, effective for taxable years beginning after December 31, IRC 1411, the only provision in the chapter, imposes a 3.8% tax (in addition to any other tax payable under subtitle A) on certain types of income in excess of certain thresholds. The 3.8% surtax is intended to replicate on unearned income a tax similar to the 3.8% medicare tax (2.9% +.09% additional medicare tax) imposed on earned income. However, the revenue generated by the 3.8% tax is not designated for the Medicare Trust Fund. 1. Observation: An individual taxpayer may be subject to both the Additional Medicare Tax and the 3.8% net investment income surtax, but not on the same type of income. 2. For individuals, the 3.8% tax is imposed on the net investment income of those taxpayers whose modified adjusted gross income (MAGI) exceeds the following threshold amounts, which vary depending on the taxpayer s filing status. The threshold amounts are not indexed for inflation. Filing Status MAGI Threshold Joint Return $250,000 Married Filing Separate $125,000 Single, Head of Household $200,000 Qualifying Widow(er) with Dependent Child (see IRC 2(a)) $250, The new 3.8% surtax is also imposed on the undistributed net investment income of an estate or trust whose adjusted gross income (AGI) exceeds the dollar amount at which the highest tax bracket for an estate or trust begins $11,950 in The tax does not apply to nonresident aliens. IRC 1141(e). As discussed in Section III below, there are also exemptions for certain trusts. 5. The IRS has issued proposed regulations consisting of 159 pages that contain detailed rules regarding the definition of net investment income and the application of the 3.8% surtax. 77 Fed. Reg (Dec. 5, 2012). The regulations are proposed to be effective for tax years beginning after Medicare and NII Tax Page 8

9 December 31, As noted in the IRS Questions and Answers on the Net Investment Income Tax (IRS FAQs-NIIT) Taxpayers may rely on the proposed regulations for purposes of compliance with section 1411 until the effective date of the final regulations. B. Application to Individuals. For individuals, the amount of the tax is 3.8% of the lesser of: 1. an individual s net investment income for such taxable year, or 2. the excess (if any) of (a) the individual s modified adjusted gross income for such taxable year, over (b) the threshold amount. IRC 1411(a)(1). Example 1: 1 X and Y, married filing jointly, together have income of $500,000, all of which is salary. The surtax will not apply because they have no net investment income. Note, however, that they will pay $2,250 of Additional Medicare Taxes discussed in Section I (.09% x $250,000, which is the amount by which their wages exceed the $250,000 threshold for taxpayers who are married and filing a joint return). Example 2: X and Y, married filing jointly, have $500,000 of salary and $50,000 of net investment income. The surtax applies to the $50,000 of net investment income because it is less than the excess of MAGI over the threshold (i.e., $550,000 $250,000 = $300,000). The resulting tax is $1900 ($50,000 x.038). Example 3: X, a single filer, has $275,000 of net investment income and no other income. The surtax applies only to the $75,000 that exceeds the $200,000 threshold for single filers. The resulting tax is $2850 ($75,000 x.038). Example 4: X and Y, married filing jointly, have $225,000 of salary income and $125,000 of net investment income. The surtax applies to $100,000, the difference between their MAGI ($350,000) and their threshold ($250,000), which is less than their net investment income of $125,000. The resulting tax is $3800 ($100,000 x.038). 1 These examples are provided by Donald T. Williamson, Planning for the Parallel Universe of the Net Investment Tax, The Tax Adviser, Aug. 1, 2013, available at Medicare and NII Tax Page 9

10 C. Computation of MAGI for Individuals. For most taxpayers, modified adjusted gross income is the equivalent of adjusted gross income as defined by IRC 62. For taxpayers who have taken advantage of the exclusion for foreign earned income under IRC 911, additional adjustments must be made. IRC 1411(d); Prop. Treas. Reg (c)(1). 1. The Proposed Regulations caution that additional adjustments may be required because of ownership interests in controlled foreign corporations or passive foreign investment companies. Prop. Treas. Reg (b). D. Computation of Net Investment Income. Net investment income may appear, on its face, to be a relatively simple concept, but over 100 of the 159 pages of the preamble and proposed regulations are dedicated to explaining what constitutes net investment income. In general, net investment income is the sum of three different categories of income, less allowable deductions allocable to such income. The three categories (or buckets ) of income include: 1. Portfolio income: interest, dividends, annuities, royalties, and rents other than income derived in the ordinary course of a trade or business that is neither (a) a passive activity nor (b) a trade or business of trading in financial instruments or commodities (IRC 1411( c)(1)(a)(i). Practice Tip: Start with the presumption that interest, dividends, annuities, royalties, and rents constitute net investment income. Then analyze whether such item can be excluded from portfolio income because: (1) the item is derived from a trade or business that is neither a passive activity nor trading in financial instruments and commodities; and (2) the item is be derived in the ordinary course of the trade or business. The Proposed Regulations do not provide guidance on ordinary course, but refer to case law and other applicable regulations. 2. Passive Activity Income: income (other than the portfolio income and net gains included in the first and third categories) from a trade or business that is either (a) a passive activity to the taxpayer under IRC Sec. 469 or (b) a trade or business of trading in financial instruments and Medicare and NII Tax Page 10

11 commodities (IRC 1411( c)(1)(a)(ii). Practice Tip: This category will consist of income (other than portfolio income and net gains) derived from an active trade or business in which the taxpayer does not materially participate, such as one of three siblings who owns a non-managing interest as a member of a limited liability company that owns and operates a ranch, and who does not meet the material participation requirements of IRC Net Gain: net gain (to the extent taken into account in computing taxable income) from the disposition of property other than property held in a trade or business that is neither (a) a passive activity nor (b) a trade or business of trading in financial instruments or commodities (IRC 1411( c)(1)(a)(iii). Practice Tip: This category will not apply if the property disposed of is held in an active trade or business other than a business trading in financial instruments or commodities. For example, the gain recognized on a sale by a farmer of a tractor used on the farm is not included in net gains property. On the other hand, the sale by a farmer of AT&T stock in which she has invested is net gains income. E. Some Special Rules. Although a detailed explanation of the proposed regulations rules regarding the three categories of net investment income and allowable deductions is beyond the scope of this outline, following is a brief highlight of some of the applicable rules. For an in-depth discussion of the various categories of income and allowable deductions, see Jeanne Sullivan and Stephanie Robinson, A Parallel Tax Universe: The Net Investment Income Tax, available at 1. Net investment income does not include any income subject to selfemployment tax. IRC 1411( c)(6). 2. Distributions from qualified plans described in IRC sections 401(a), 403(a), 403(b), 408, 408A, or 457(b)) are not included in net investment income. IRC 1411( c)(5). Practice Tip: While distributions from qualified plans are not Medicare and NII Tax Page 11

12 included in net investment income, they will increase MAGI which can trigger the surtax. Distributions from Roth IRAs and Roth 401(k)s, on the other hand, are not included in net investment income or MAGI 3. Generally, income or gain that is excluded from income under Chapter 1 (such as tax-exempt interest under IRC 103, gain from the sale of a principal residence excluded under IRC 121, excludable portions of annuity payments under IRC 72, and any gain deferred under the installment sale provisions of IRC 453) is not included in net investment income. 77 Fed. Reg , (Dec. 5, 2012); IRS FAQs-NIIT, #10. Practice Tip: Taxpayers who face the surtax on net investment income may want to consider investing in tax-exempt bonds (the interest from which is excludable in computing both net investment income and MAGI) and deferring gain where possible under the installment sales deferral provisions to minimize MAGI and net investment income. 4. Income derived from the investment of working capital is not treated as derived from a trade or business for purposes of section 1411(c)(1) and is potentially subject to the 3.8% surtax. IRC 1411(c)(3). 5. In most cases, an interest in a partnership or S corporation is not property held in a trade or business, and thus any gain recognized by a taxpayer upon the sale of such an interest is included in the net gain bucket of income. However, IRC 1411(c)(4) provides an exception from the net gain bucket for gains recognized upon the disposition of certain active interests in partnerships and S corporations. 77 Fed. Reg , (Dec. 5, 2012). In the case of a of an interest in a partnership or S corporation, provides, gain is included in the third bucket only to the extent of the net gain which would be so taken into account by the transferor if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest, i.e., a deemed sale analysis. IRC 1411(c)(4). Under this analysis, the net gain included should be the lesser of (a) outside gain or (b) the taxpayer s attributable portion of inside gain that would be included in the taxpayer s net investment income, which, in turn, depends on whether the gain is attributable to an active business of the entity and whether the taxpayer materially participates in that business. Unfortunately, congress failed to Medicare and NII Tax Page 12

13 take into account that outside basis and inside basis often differ. As a result, when the inside gain is lower than the outside gain, a passive owner benefits from the statutory limit (which limits gain to the inside gain). The Proposed Regulations ignore the statutory language (Prop. Treas. Reg ), and apply rules that would not benefit a passive owner and which furthermore cause an active owner to be taxed if her outside gain exceeds her inside gain. For a discussion of these rules, see Carolyn Sprinchorn, Basis Disparities and Valuation Discrepancies under the NII Tax, 2013 Tax Notes Today For a critique of the regulations, see American Bar Association Section of Taxation, Comments Concerning Proposed Treasury Regulations Under Section 1411, at (Apr. 5, 2013) (Doc ). a. Practice Tip: Prop. Treas. Reg (d)(3) requires that a seller of a partnership interest or S corporation stock attach a statement to his return showing the fair market value of each and every asset of the entity, including goodwill, along with the partner's share of gain or loss on each such asset, referred to by one commentator as a compliance horror. Gary R. McBride, Godzilla Meets Frankenstein: Subchapter K and the NII Tax, 2013 Tax Notes Today IRC 469 is relied upon to determine whether a trade or business is passive and thus generates income or gain that can be classified in the second passive category of net investment income. Generally, a passive activity is one in which the taxpayer does not materially participate. IRC 469(h)(1) defines material participation as involvement in the operations of the activity on a regular, continuous, and substantial basis. Special rules apply to rental activities, real estate development, working interests in oil and gas, and limited partners. It is essential to brush up on your understanding of the 469 rules in analyzing the application of the net investment tax rules. Practice Tip: For taxpayers who own an interest in a pass-through entity, an analysis must be undertaken at both the entity level (is the entity engaged in a trade or business, and was the expense incurred in the course of that business?) and at the taxpayer level (does the taxpayer materially participate in the entity s activities?). The Preamble to the Proposed Regulations provide the following illustration: Medicare and NII Tax Page 13

14 B, an individual, owns an interest in S, an S corporation, which is a bank. S earns interest in the ordinary course of its trade or business (which is not trading in financial instruments or commodities). Accordingly, the interest B earns through S is not derived in a trade or business described in section 1411(c)(2)(B). B will then have to determine if S s trade or business is a passive activity with respect to B. If B is passive with respect to S s banking business, then even though the interest was not subject to section 1411(c)(1)(A)(i) because of section 1411(c)(2)(B), B s pro rata share of S s interest is net investment income under section 1411(c)(1)(A)(ii) because of section 1411(c)(2)(A). See Example 3 of proposed (b)(3). 77 Fed. Reg , (Dec. 5, 2012). 7. Generally, IRC 469 and related regulations permit a taxpayer to group trades or businesses or rental activities together to satisfy the material participation standards and avoid characterization as a passive activity. Treas. Reg ( c). A taxpayer s initial grouping generally cannot be changed unless the prior grouping was clearly inappropriate or there is a material change in facts and circumstances. Treas. Reg (e)(1)- (2); see also Rev. Proc , I.R.B The proposed regulations include a revision to the regulations under IRC 469 to permit a one-time regrouping of activities, even if the present groupings are appropriate and there has been no change in facts that might otherwise permit a regroup. Prop. Treas. Reg (b)(3)(iv). This is intended to provide taxpayers the opportunity to elect to regroup with the 3.8% tax in mind. 77 Fed. Reg , (Dec. 5, 2012). Taxpayers may make a one-time election to regroup their activities in 2013 or F. Allowable Deductions. In determining net investment income, deductions under Subtitle A that are properly allocable to such gross income or net gain are allowed. IRC 1411(c)(1)(B). The Proposed Regulations contain detailed rules regarding the types of deductions allowed against each bucket of income or gain comprising net investment income. 1. If a deduction is not entirely used in the current year, it can only be carried forward as allowed by the applicable Chapter 1 rules (such as the allowance of the carryforward of suspended passive activity losses under IRC 469(b)). Prop. Treas. Reg (f). Medicare and NII Tax Page 14

15 2. Net operating losses may not be carried forward in subsequent years to reduce net investment income. Prop. Treas. Reg (f)(1)(ii). 3. Under the proposed regulations, IRC 165 losses are only deductible in computing the third bucket of net gains. Prop. Treas. Reg (f)(4). Section 165 losses include not only losses, for example, on the sale of stock, but also include casualty losses, foreign currency losses, disaster losses, and others. Commentators have criticized this aspect of the proposed regulations, arguing that if 165 losses, for whatever reason, are not absorbed in computing net gains, they should be allowed, to the extent allowable under the tax code, in determining the other two buckets of net investment income. G. Estimated Taxes. The net investment income tax is subject to the estimated tax provisions. Individuals should adjust their income tax withholding or estimated payments to account for the tax increase in order to avoid underpayment penalties. A taxpayer may request that additional income tax be withheld from wages. IRS FAQs-NIIT # H. Form The IRS has prepared a Draft Form 8960 for purposes of reporting and calculating the net investment income tax, a copy of which is attached to this outline. III. Application of the Net Investment Tax to Trusts and Estates A. Summary. As noted above, estates and trusts will be subject to the net investment income tax on the lesser of (a) undistributed net investment income or (2) the excess of adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year (in other words, the excess of AGI over $11,950 for 2013). IRC 1411(a)(2). 1. The $11,950 is not reduced or prorated in the case of an estate or trust that has a short taxable year. Prop. Treas. Reg (a)(2). Example: Trust A has undistributed net investment income in 2013 of $50,000. Trust A has adjusted gross income of $41,950. The 3.8% tax will be assessed on $30,000, which is the excess of the trust s AGI ($41,950) over the $11,950 threshold for 2013, and is also less than the Trust s $50,000 of undistributed net investment income. The tax will be $1,140 ($30,000 x.038). Medicare and NII Tax Page 15

16 Practice Tip: Because the threshold amounts that trigger the imposition of the net investment tax are so much higher for individuals (i.e., $200,000 of MAGI for a single filer) than for trusts ($11,950 of AGI in 2013), fiduciaries of complex trusts should consider whether making discretionary distributions of net investment income to beneficiaries is appropriate, especially when those beneficiaries have MAGI below the individual thresholds. However, as discussed below, capital gains pose unique problems for trusts. Capital gains are included in a trust s net investment income, but they are typically allocated to trust principal and are not distributed. Furthermore, the DNI deduction rules may limit the ability of a trust to deduct any capital gains that are actually distributed to a beneficiary in an attempt to avoid the 3.8%. B. Adjusted Gross Income. Under IRC 67(e), the adjusted gross income for trusts and estates is the same as for an individual, except that three additional types of deductions are allowed, including (1) administration expenses that would not have been incurred but for the existence of the trust or estate (such as fiduciary fees); (2) deductible distributions to beneficiaries under IRC 651 and 661 (discussed below); and (3) the trust or estate's personal exemption. C. Exempt Trusts. The following trusts are not subject to the net investment income tax: 1. The net investment income tax does not apply to trusts that are exempt from income taxes imposed by Subtitle A of the Internal Revenue Code (including charitable remainder trusts exempt from tax under IRC 664 and qualified retirement plan trusts exempt from tax under IRC 501). Prop. Treas. Reg (b)(2)-(3). a. In the case of a charitable remainder trust, any net investment income distributed by the trust to individual beneficiaries is apportioned among the beneficiaries based on their respective shares of the total annuity or unitrust amount paid by the charitable remainder trust for that taxable year. Prop. Treas. Reg (c)(2). Any net investment income accumulated in a charitable remainder trust prior to 2013 is not subject to the tax if subsequently distributed. 2. The net investment income tax does not apply to a trust in which all of the unexpired interests are devoted to one or more of the purposes described in IRC 170(c)(2)(B). Prop. Treas. Reg (b)(1). Medicare and NII Tax Page 16

17 3. The tax-exempt trusts mentioned above are exempt from the net investment income tax, even if the tax-exempt trust may be subject to unrelated business taxable income and even if that income includes net investment income. 77 Fed. Reg , (Dec. 5, 2012). 4. Grantor trusts (IRC ) are not subject to the net investment incomce tax. Instead, any net investment income of a grantor trust is attributable to the grantor. Prop. Treas. Reg (b)(5). 5. Trusts that are not classified as trusts for federal income tax purposes (e.g., real estate investment trusts) are not subject to the net investment income tax. Prop. Treas. Reg (b)(4). 6. The bankruptcy estate of a debtor who is an individual is treated as a married taxpayer filing separately for purposes of the thresholds in section 1411(b), and therefore the threshold amount applicable to such a bankruptcy estate is $125,000. Prop. Treas. Reg (a)(2)(i), (ii). 7. The Preamble to the regulations request comments as to whether pooled income funds, cemetery perpetual care funds, and qualified funeral trusts should be exempt from the net investment income tax. 77 Fed. Reg , (Dec. 5, 2012). D. Net Investment Income. As with individuals, a trust or estate s net investment income is comprised of three categories of income (portfolio income, passive activity income, and net gains); the same methods apply to trusts and estates as apply to individuals in calculating net investment income. 77 Fed. Reg , (Dec. 5, 2012). To avoid double taxation in the hands of both a beneficiary and a trust, the 3.8% tax is only imposed upon a trust or estate s undistributed net investment income. Once distributed, whether or net investment income is subject to the 3.8% tax is determined at the beneficiary s level. Although undistributed net investment income is not defined in IRC 1411, the proposed regulations intend to conform its calculation for purposes of IRC 1411 to the rules governing taxable income and distributable net income of trusts and estates as set forth in Part I of subchapter J. 77 Fed. Reg , (Dec. 5, 2012). 1. A trust or estate s net investment income is determined in the same manner as for an individual. Prop. Treas. Reg (e)(1). In determining net investment income, deductions that are properly allocable to such gross income or net gain are allowed. IRC 1411(c)(1)(B). Medicare and NII Tax Page 17

18 Whereas a fiduciary must allocate direct expenses to the category of income related to the expense, a fiduciary has some discretion in allocating indirect expenses (such as administrative fees), although some portion has to be allocated to tax-exempt interest. Treas. Reg (b)-3(b). 2. Under the proposed regulations, an estate or trust s undistributed net investment income is the estate s or trust s net investment income determined under reduced by distributions of net investment income to beneficiaries, subject to the limitations of IRC 651 and 661 discussed below. Distributions to charitable organizations also reduce net investment income, to the extent allowed under IRC 642( c). Prop. Treas. Reg (e)(b). Practice Tip and Warning: Capital gains properly allocable to principal are generally not included in DNI under IRC 643(a)(3), and thus are excluded in determining the amount of deductible distributions under IRC 651 and 661. Furthermore, governing instruments often limit or restrict a fiduciary s ability to distribute capital gains that have been allocated to principal. As a result, capital gains will often be trapped in the trust s net undistributed net income. 3. IRC 651 (governing simple trusts that are required to distribute income annually) and 661 (governing complex trusts that allow discretionary distributions of income) impose important limitations on the ability of a trust or estate to deduct amounts distributed by it to beneficiaries. a. For simple trusts, the amount of the distribution deduction is limited to the lesser of trust income or distributable net income. IRC 651. b. For complex trusts, the amount of the distribution deduction is limited to the lesser of distributions actually made or distributable net income. IRC IRC 643(a) provides that distributable net income (DNI) is the Medicare and NII Tax Page 18

19 taxable income of the estate or trust, with certain adjustments. 2 For example, in computing DNI, certain items that may have been deducted in computing taxable income are added back in, including, for example, the personal exemption. Section 643(a) and the regulations promulgated thereunder will be very important in determining the amount of an estate or trust s undistributed net investment income. 5. As noted above, capital gains are generally allocated to principal and are not includable in DNI. Deductions for distributions to beneficiaries may not exceed DNI. Thus, as a general rule, capital gains will be trapped as undistributed net investment income of a trust or estate, subject to the 3.8% tax once the trust s AGI exceeds $11,950. a. Under Treas. Reg (a)-3(b), there are certain limited circumstances under which capital gains may be included in distributable net income. Capital gains may be included in DNI if, pursuant to the terms of the governing instrument and applicable local law or pursuant to a reasonable and impartial exercise of discretion by the fiduciary (in accordance with the power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law): 1. Capital gains are allocated to income (but if income consists of a unitrust amount, a discretionary power to allocate gains to income must be exercised consistently); 2. Capital gains are allocated to corpus but are treated 2 Many commentators have pointed out that Examples 1 and 2 of Prop. Treas. Reg (f), upon which this example is based, erroneously compute the trust s DNI as $50,000. The drafters correctly excluded the $5,000 in capital gains from DNI, but erroneously excluded the $35,000 of the IRA distribution allocated by the fiduciary to principal. An item of income (other than capital gain) that is allocated by a fiduciary to principal is irrelevant in determining the trust s DNI, and the correct amount of DNI is $85,000 ($90,000 in taxable income reduced by the capital gain), rather than the $50,000 calculation ($90,000 - $5,000 capital gain - $35,000 IRA allocated to principal) set forth in the regulations. Medicare and NII Tax Page 19

20 consistently 3 by the fiduciary on the trust s books, records, and tax returns as part of the distribution to a beneficiary; or 3. Capital gains are allocated to corpus but are actually distributed to the beneficiary or used by the fiduciary in determining the amount that is distributed or required to be distributed to a beneficiary. Practice Tip: Attorneys and accountants should coordinate with the fiduciary to determine options available with respect to allocating capital gains either to income or principal in such a way that they could be included in distributable net income, provided that such actions are appropriate in view of the fiduciary s obligations in administering the trust. The tax tail should not wag the dog; the needs and interests of the income beneficiaries and remaindermen must be considered, and a decision to allocate capital gains to income for purposes of avoiding the 3.8% tax should not be made if doing so would endanger the interests of the trust beneficiaries, including the remaindermen. E. Material Participation. Neither the proposed regulations under IRC 1411 nor the existing regulations under IRC 469 provide guidance on how to determine whether a trust materially participates in an activity, so as to avoid including the income from such activity in the trust s net investment income. The Senate report accompanying the enactment of IRC 469 states that a trust or estate materially participates when its fiduciary materially participates. Case law has expanded the Senate report test to allow the trust to include the actions of the trust's agents and employees in determining material participation. S. Rep. No (1986), at 735 and n. 287; Mattie K. Carter Trust v. United States, 256 F. Supp.2d 536 (N.D. Tex. 2003) (involving the operation of a ranch by a trust). In its comments on the proposed regulations under IRC 1411, Tax Section of the American Bar Association recommends that the proposed regulations allow a trust or estate to satisfy the material participation requirement if one of the following three tests is met: 3 When the consistency requirement became effective upon adoption of the 643 regulations in 2004, fiduciaries made decisions how to treat capital gains when there was no net investment income tax. Commentators have proposed modifications to the proposed regulations that allow a fiduciary to revisit its decision with regard to the treatment of capital gains without violating the consistency requirement under 643. Medicare and NII Tax Page 20

21 a. The fiduciary materially participates under the standards that apply to individuals under previously promulgated Regulations; b. The fiduciary, based on all facts and circumstances, participates in the activity on a regular, continuous and substantial basis during the year; c. The fiduciary participates in the activity on a regular, continuous and substantial basis, either directly or through employees or contractors whose services are directly related to the conduct of the activity. American Bar Association Section of Taxation, Comments Concerning Proposed Treasury Regulations Under Section 1411 (Apr. 5, 2013). F. Electing Small Business Trusts. The proposed regulations also contain special rules for an electing small business trust (ESBT) that holds S corporation stock. The unique aspect of an ESBT is that the portion of the trust that consists of S corporation stock is treated as a separate trust and is taxed at the highest rate on the taxable income determined for that portion. The non-s portion of the ESBT is likewise taxed as a separate trust consistent with the normal rules for part 1 of subchapter J of chapter 1 of subtitle A of the Code. The proposed regulations preserve the treatment of the ESBT as separate trusts for computational purposes but consolidate the ESBT into a single trust for determining the AGI threshold for the ESBT. Prop. Treas. Reg (c)(1). Thus, the unfairness of being able to use two thresholds for what is really one trust is avoided by consolidating the undistributed net investment income of the two portions to apply a single AGI threshold. Medicare and NII Tax Page 21