The Affordable Care Act introduced two major taxes on high income taxpayers in 2013. The first, which is the subject of this blog post, is a new tax on investment income. The other tax is a 0.9% surtax on wages and compensation over threshold amounts, and will be discussed in the companion blog post to this one. The net investment income tax of I.R.C. § 1411, designed to generate additional revenue for Medicare, is a 3.8% tax on “Net Investment Income.” The tax will only apply to taxpayers whose “modified adjusted gross income” exceeds a threshold amount based on the taxpayers’ filing status. Modified adjusted gross income is the same as adjusted gross income except for some minor adjustments for foreign earned income. The modified adjusted gross income thresholds are:
– $200,000 for single taxpayers
– $250,000 for married taxpayers filing jointly, and
– $125,000 for married taxpayers filing separately.
The 3.8% tax is imposed on the lesser of the net investment income or the amount by
which the taxpayer’s adjusted gross income exceeds the threshold amount. To illustrate how the tax works, let’s take a hypothetical married couple named Fred and Marcy. Fred earns $95,000 in wages, and Marcy earns $100,000 in wages in 2013. They also own a substantial amount of stock in MegaCorp. which pays them a dividend of $30,000 in 2013. Although the $30,000 dividend is net investment income, Fred and Marcy will not be subject to the tax because their total adjusted gross income ($225,000 = $95,000 + $100,000 + $30,000), does not exceed the $250,000 threshold for married filing jointly taxpayers.
If, for example, Marcy actually earned $150,000 per year, then the couple’s adjusted gross income would be $275,000, of which $30,000 is net investment income. In this situation, Fred and Marcy will be subject to an additional net investment income tax of $950. Their modified adjusted gross income exceeds the threshold amount by $25,000, which is less than the $30,000 of net investment income, and therefore the 3.8% is applied to this $25,000.
Net Investment Income is broken down into three categories. First, there is gross income from interest, dividends, and rents. It is important to note that rental income is only for net rental income, and deductions for rental activity are allowable in calculated net rental income for net investment income tax purposes. The next category is net gain attributable to the disposition of property that is not “trade or business property.” Therefore, stocks sold at a gain will increase net investment income, but gain on the sale of equipment used in a business will not be added to the net investment income calculation. The final category of income is “other income” derived from passive activity trade or business, which includes partnership or S Corporation income allocated to a limited partner or S corporation shareholder who is not involved in the day to day operation of the company. It is also important to note that net investment income does not include any distributions from retirement plans.
The following is a slightly more complicated example which details some of the principles of net investment income detailed above. Fred is a self-employed contractor and earns $100,000 per year. In his business as a contractor, he owns a particular tool that has appreciated substantially in value because the manufacturer has ceased making that particular model. He sells that tool for a gain of $10,000. He is also a limited partner in his son’s ice cream business, and $50,000 is allocated to him as net income for the year. Marcy earns $100,000 per year in wages, and the couple earns the same $30,000 dividend from MegaCorp. The couple’s adjusted gross income is $290,000. Their net investment income is $80,000. The $10,000 gain on the sale of the tool is not included in net investment income because it is trade or business property. The $50,000 of income from the ice cream partnership is net investment income because Fred is a passive investor in that company. As mentioned before, the dividend of $30,000 is also net investment income. Fred and Marcy exceed the $250,000 threshold by $40,000. Since the amount by which they exceed the threshold is less than the amount of net investment income ($80,000), the 3.8% tax is applied to $40,000. Therefore, they will owe an additional tax of $1,520.
The tax on net investment income is just an additional piece of the puzzle to consider when addressing your own personal tax circumstances. There are a number of techniques available that can help to alleviate the impact of the new net investment income tax. Please contact us to schedule a consultation to determine the most beneficial strategy for doing so.