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Proposed Regulations on Net Investment Income Tax and Additional Medicare Tax

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The IRS has issued long-awaited and much needed proposed reliance regulations on the operation of the two new surtaxes imposed under the 2010 healthcare legislation: the 3.8 percent Net Investment Income Tax (NIIT), and the 0.9 percent Additional Medicare Tax. Both surtaxes are scheduled to come into full effect on January 1, 2013. The proposed reliance regulations and the frequently asked questions on the IRS website attempt to address many of the gaps in the application of these surtaxes that have been questioned by tax professionals, employers, and taxpayers. The guidance on each of these surtaxes is extensive and is immediately critical for affected taxpayers.

The 3.8 Percent NII Surtax<

For tax years beginning after December 31, 2012, the NII< surtax on individuals equals 3.8 percent of the lesser of:

  • net investment income for the tax year, or
  • the excess, if any, of

i. the individual’s modified adjusted gross income (MAGI) for the tax year, over

ii. the threshold amount.

For purposes of the NII< surtax computation, MAGI is defined as adjusted gross income before the foreign earned income exclusion.

The threshold amount is equal to:

  • $250,000 in the case of a taxpayer filing a joint return or a surviving spouse;
  • $125,000 in the case of a married taxpayer filing a separate return; and
  • $200,000 in any other case.

These amounts are not indexed for inflation. Consequently, the number of affected taxpayers is expected to increase over time.  

Net Investment Income. At the heart of the NII< surtax proposed reliance regulations are efforts by the IRS to more precisely define “net investment income” subject to the 3.8 percent tax. In general, net investment income is the sum of:

  • gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business;
  • other gross income derived from any trade or business that is a passive activity with respect to the taxpayer, or the trade or business of trading in financial instruments or commodities; and
  •  net gain attributable to the disposition of property, other than property held in a trade or business.

Less

  • deductions properly allocable to such gross income or net gain.

The proposed reliance regulations provide additional detail on the application of this general rule, including the proper reporting of items from a pass-through entity, the treatment of annuities, the definition of “derived in” and “properly allocable” deductions, and some exceptions to net investment income.

For example, net investment income does not include any income or deductions allowed in determining net self-employment income. In addition, net investment income does not include any distribution from a qualified plan or arrangement. However, the IRS reminds taxpayers that distributions that may be excluded from net investment income may be included in gross income, and therefore would be taken into account in determining MAGI for purposes of calculating the amount of net investment income subject to the surtax.

Trusts and Estates. The 3.8 percent NII< surtax is not just imposed on individuals. Trusts and estates are subject to the NII< surtax on the lesser of:

  • undistributed net investment income, or
  • the excess of adjusted gross income over the dollar amount at which the highest tax bracket begins (which, for 2013, is projected to be $11,950).

The NII< surtax does not apply to certain tax-exempt trusts and grantor trusts. Special NII< computational rules apply for electing small business trusts and charitable remainder trusts.

Unlike the individual threshold amounts, the threshold amount used for estates and trusts is adjusted for inflation because the threshold is tied to the highest tax bracket. Nevertheless, the amount is far less than the lowest threshold amount for individuals ($125,000 for married filing separately). Therefore, trusts and estates should consider distributing investment income, especially if one or more beneficiaries would not otherwise be subject to NII< surtax because of their threshold amount.

Additional 0.9 Percent Medicare Tax<

Effective for tax years beginning after December 31, 2012, the Additional Medicare Tax increases the employee’s share of Medicare tax on wages and compensation, as well as self-employment income, in excess of certain “higher-income-level” threshold amounts. The threshold amounts are based on the taxpayer’s filing status as follows:

  • $250,000 in the case of a taxpayer filing a joint return;
  • $125,000 in the case of a married taxpayer filing a separate return; and
  • $200,000 in any other case.

The threshold amounts are similar to the dollar amounts used in computing the 3.8 percent NII< surtax. However, the Additional Medicare Tax thresholds only include wages, compensation, and self-employment income rather than all income used to compute adjusted gross income. Also, these threshold amounts are not indexed for inflation. As a result, the pool of individuals captured by the Additional Medicare tax will progressively increase over time unless Congress adjusts the amounts higher.

There is no “employer match” for the Additional Medicare Tax. The 1.45 percent rate paid by employees remains unchanged after 2012. However, an employer is required to collect Additional Medicare Tax with respect to wages earned for duties performed by the employee only to the extent the employer pays wages to the employee in excess of $200,000. This rule applies regardless of the employee’s filing status or other wages and compensation.

Employees may not request that the employer withhold Additional Medicare Tax on wages of $200,000 or less. However, employees who expect to pay Additional Medicare Tax may request that their employer withhold an additional amount of income tax, which can offset any combined income and payroll tax shortfall, including from the Additional Medicare Tax. Taxpayers who anticipate that they will owe Additional Medicare Tax and who did not request additional income tax withholding, and the self-employed, may need to make estimated tax payments. However, taxpayers cannot designate any estimated tax payment specifically for the Additional Medicare Tax.

Individuals must report Additional Medicare Tax and pay any tax due that was not paid through withholding or estimated taxes on their 1040.

In response to the IRS guidance on the NIIT and Additional Medicare Tax, immediate action is advisable on a number of fronts. Year-end tax planning may indicate the need to accelerate income otherwise subject to one or both of the surtaxes. Employers may need to adjust their payroll practices for certain employees on January 1, 2013. Investment strategies and asset allocations may need revisiting as may the use of deferred compensation plans. In addition, elections related to the proposed NIIT regulations should be considered.

We can assist you in evaluating the impact of these surtaxes on your tax liability and guide you in a developing a tax saving strategy. Please call our office for an appointment.