Political debate for the past two years has focused on the future of the Patient Protection and Affordable Care Act, more recently called “Obamacare,” and the taxes enacted by Congress to help pay for it. With the national elections last month, we achieved greater certainty surrounding the future of this legislation. We now know that President Obama will remain in office and we know the political composition of both houses of Congress. We also know that the Supreme Court has declared Obamacare the law of the land. On January 1, 2013, two new taxes will become effective which will help fund Obamacare.
Treasury and the IRS released proposed regulations on November 30, 2012, for the new IRC section 1411, which codifies a 3.8 percent tax on “net investment income” and the section 3101 hospital insurance tax, which codifies a 0.9 percent increase on existing hospital insurance tax rates. Both new taxes take effect above certain threshold income levels.
The proposed regulations for the 3.8 percent tax on net investment income (NII), totaling 159 pages, are far more comprehensive and nuanced than many tax practitioners expected. These proposed regulations become effective on January 1, 2014, but the IRS has advised taxpayers that they may rely on the proposed regulations for compliance purposes beginning on January 1, 2013, when the taxes take effect.
The tax on NII can be far-reaching. Section 1411 imposes a 3.8 percent tax on the lesser of NII or the amount by which an individual’s modified adjusted gross income exceeds $200,000 (or $250,000 for joint filers and surviving spouses). NII includes capital gains, dividends, interest, annuities, royalties, rents, and income from passive activities. The 3.8 percent tax can also apply to the sale of a principal residence, the sale of stock in a corporation, and the sale of interests in a partnership or LLC.
The calculation of the NII tax can be illustrated by two examples:
Example 1: Taxpayer, a single filer, has wages of $180,000 and $15,000 of dividends and capital gains. Taxpayer’s modified adjusted gross income is $195,000, which is less than the $200,000 statutory threshold for a single filer. Taxpayer is not subject to the NII tax.
Example 2: Taxpayer, a single filer, has $180,000 of wages. Taxpayer also received $90,000 from a passive partnership interest, which is considered NII. Taxpayer’s modified adjusted gross income is $270,000.
Taxpayer’s modified adjusted gross income exceeds the threshold of $200,000 for single taxpayers by $70,000. Taxpayer’s NII is $90,000.
The NII tax is based on the lesser of $70,000 (the amount that Taxpayer’s modified adjusted gross income exceeds the $200,000 threshold) or $90,000 (Taxpayer’s NII). Taxpayer owes NII tax of $2,660 ($70,000 x 3.8%).
In addition to individuals, estates and trusts will be subject to the tax on undistributed NII. Under the proposed regulations, the new tax does not apply to foreign trusts or estates, unless there is a U.S. income beneficiary or income from the foreign trust is sourced to the U.S. The new tax also does not apply to nonresident aliens, but can apply is the nonresident alien is married to a U.S. citizen. The proposed regulations require that dividends and gains derived from the stock of a “controlled foreign corporation” or a “passive foreign investment company” (PFIC) be taken into account in calculating NII.
The proposed regulations do give taxpayers a one-time opportunity to regroup activities under the passive activity grouping rules of regulation section 1-469.4. This opportunity will occur after December 31, 2013.
Look for more blogs in the coming weeks which analyze the nuances of these taxes and the applicability to specific taxpayers and transactions. If you have further questions you may contact Brendan Lund at Carr McClellan either by phone: (650) 342-9600 or e-mail: email@example.com.