Time to Face Up to the New Investment Income Tax

In passing the Affordable Care Act in 2010, Congress enacted a new 3.8% surtax on investment income which kicks in January 1, 2013.  Now that the Supreme Court has upheld the Affordable Care Act, those of us who were hoping that this tax somehow might go away know one thing:  It won't (absent, that is, an overwhelming Republican victory this November).  So, with about 6 months still left in 2012, it's time to face up to this new tax and start planning.

Even if Congress extends the so-called "Bush tax cuts" on long-term capital gains and dividends (due to expire at the end of 2012), the new investment income tax still represents a big jump – from the current 15% rate to 18.8%.  If Congress doesn't extend the cuts, the combined increase in rates gets truly scary – from 15% to 23.8% for long-term capital gains, and from 15% to up to 43.4% for dividends (that is, the 3.8% investment income tax plus the top 39.6% federal individual rate which will apply to dividends and other "ordinary" income). And that's not even counting California taxes (which, depending on what ballot initiatives are passed in November, could jump another 3 percentage points for high-income filers, from 9.3% to 12.3%).  In a worst-case scenario, taxpayers could end up paying more than 55 cents of every dollar of rents, interest, dividends and other investment income over to the federal and state governments as taxes (adding together the top 39.6% federal rate on ordinary income, plus the top 12.3% California rate, plus the 3.8% federal investment income tax).

How the New Investment Income Tax Works

The 3.8% tax will apply to "net investment income" of individuals and trusts that earn income above certain thresholds during the year.

Definition of "Net investment income"

"Net investment income" includes items that you would expect (dividends, interest, rents, gains from sales of stock and other securities) and some items that you would not expect to be included, such as gain from sales of artwork and other collectibles; gain from the sale of your personal residence (to the extent you can't claim the exclusion for a personal residence sale which is $500,000 for married taxpayers filing jointly and $250,000 for others); and gain from the sale of your vacation home (no $500,000/$250,000 exclusion there at all).

"Net investment income" can also include an individual's or trust's share of income from a pass-through entity like a partnership, limited liability company ("LLC"), or "S" corporation.  An owner of such an entity must pay tax on that owner's share of income from the business (as reported on an annual K-1 schedule) regardless of the amount of cash the entity pays to cover the taxes, if at all.  Therefore, the new 3.8% surtax – combined with the income taxes that the owner must already pay – can present quite a cash flow problem to an owner who is not assured (through an agreement between the owners or otherwise) of getting sufficient cash each year from the entity to at least cover the taxes.

There is an important exception to imposition of the 3.8% surtax on pass-through income from a partnership, LLC or "S" corporation:  The tax does not apply if the owner "materially participates" in the entity's business.  Congress borrowed the "material participation" concept from anti-tax shelter measures (known as the "passive activity loss" rules) enacted back in 1986 which were designed to limit an investor's use of losses from a rental or business activity unless he or she "materially participated" in that activity.  The rules are complex and look at how many hours are spent per year in the activity and what the nature and extent of that activity is.  The bottom line is that if an individual keeps good records of his or her time and spends more than 500 hours a year in the activity (and this means "on the factory floor" or "in the manager's office" hours, not just looking at financial statements), then he or she "materially participates" and the 3.8% surtax will not apply.

One might ask how a trust (as opposed to an individual) "materially participates" – through its creators, beneficiaries, trustees, or anyone performing services on the trust's behalf?  This is a very good question and there is no official guidance from the IRS.  However, the IRS will almost certainly look at the activities of the trustees and no one else, and for now it is best for clients to proceed as if the IRS position were the law.

Application to individuals

For an individual, the 3.8% tax applies to the amount of his or her net investment income, but only to the extent that his or her "adjusted gross income" ("AGI") exceeds a "threshold amount" which is $250,000 for married filing jointly or surviving spouse; $125,000 for married filing separately; and $200,000 for all others.  "AGI" is, basically, the amount you put down at the bottom of the first page of your Form 1040 and includes all your wages, business and investment income minus your contributions to 401Ks and other retirement plans, but before you claim itemized deductions on Schedule "A" of your return for household mortgage interest, medical expenses, charitable contributions, state taxes and the like.

Example # 1:  Rhett and Scarlett, a married couple filing jointly, have $300,000 of AGI, $100,000 of which is net investment income.  They will pay $1,900 of new investment income tax – i.e., 3.8% of $50,000 of their net investment income because their $300,000 AGI exceeds their $250,000 threshold amount for married taxpayers filing jointly by only $50,000.

Example # 2:  Same as Example # 1 above, except only $25,000 of the AGI is net investment income.  Rhett and Scarlett will pay $950 in the new tax – i.e., 3.8% of the amount of their net investment income ($25,000) because their $300,000 AGI exceeds the $250,000 threshold amount by more than their $25,000 net investment income.

Note that the new investment income tax kicks in depending on the individual's AGI, before the individual gets to reduce his or her AGI with itemized deductions and personal exemptions to arrive at his or her taxable income.  Therefore, a taxpayer with little or no taxable income could still owe net investment income tax (because the thresholds are pegged to AGI, not taxable income).

Wages and distributions from a "traditional' (as opposed to Roth) IRA, 401K or other retirement plan are not themselves subject to the 3.8% surtax, but they do increase AGI – and, to the extent that AGI is increased beyond the "magic" threshold amount, the 3.8% tax starts being imposed on whatever net investment income the taxpayer does have.

The threshold amounts for individuals are not indexed for inflation, meaning that as time goes on and people's earnings rise to keep pace with inflation, more and more people will end up paying the 3.8% tax on their net investment income.  This situation is similar to that of the alternative minimum tax, which was passed in the 1970s to clamp down on 30 mega-rich non-payers profiled in Forbes magazine, but now reaches more and more middle-class taxpayers who can hardly be called "rich."

Interaction with Medicare tax

If an individual's income is subject to the current Medicare trust fund tax, then it is not subject to the new investment income tax.  The Medicare tax is currently imposed at a 2.9% rate on all of an individual's earnings from performing services.  If an individual is an employee, then under the Federal Insurance Contributions Act ("FICA") the employer pays half the tax (1.45% rate) and withholds the remaining half from the employee; if an individual is a partner, sole proprietor or otherwise "self-employed," then under the Self-Employment Contributions Act ("SECA") he or she reports and pays the full 2.9% Medicare tax on the Form 1040 return.

Incidentally, the Medicare tax also goes up effective January 1, 2013. The revenue legislation accompanying the Affordable Care Act also imposes an additional 0.9% Medicare tax on the employee's portion (not the employer's portion) of payroll taxes under FICA for individuals with wages above the applicable threshold amounts, and a parallel increase applies to the Medicare portion of the SECA tax.

Example # 3:  Rhett, recently divorced, has wages of $190,000, net investment income of $30,000, and AGI of $210,000.  Rhett would not pay the enhanced 0.9% Medicare tax on his wages (because they are below the $200,000 threshold amount) but would pay net investment income tax of $380 (i.e., 3.8% of his net investment income the extent his $210,000 AGI exceeds his $200,000 threshold amount, or $10,000).

Example # 4: Alternatively, if Rhett had wages of $300,000, net investment income of $60,000, and AGI of $350,000, then he would pay the enhanced 0.9% Medicare tax on $100,000 of his wages (i.e., total wages of $300,000 minus the $200,000 threshold amount) and the 3.8% net investment income tax on all his $60,000 of net investment income (because the amount by which his $350,000 AGI exceeds his $200,000 threshold amount is greater than his $60,000 net investment income.).

Application to trusts

Basically, the new 3.8% investment income tax applies to all net investment income of a trust above a certain floor (which is so small as to be basically meaningless) except to the extent that the trust "distributes" such net investment income to its beneficiaries (who then must take such distributions into account in figuring out their own AGI and net investment income subject to the 3.8% tax at their levels).  Unfortunately, Congress in the 2010 legislation did not explain exactly how a trust distributes out its net investment income to its beneficiaries (even for regular income tax purposes, the rules are very complex), leaving to the IRS the unhappy task of figuring this out in regulations (which have yet to be issued).

What To Do?

What can we do to plan for the new 3.8% investment income tax (and even higher rates if the Bush tax cuts expire) during the six months still left in 2012?

Accelerate income into 2012

Taxpayers sitting on substantial gains, or who own corporations with substantial retained earnings, may want to accelerate income into 2012 before rates go up.  For example, a taxpayer whose investment portfolio has grown with the off-and-on recovery in the equity markets might want to sell in 2012 and "harvest" the gains at lower rates than what will otherwise apply in 2013 and thereafter.  A taxpayer who is planning to sell his or her business anyway (and there are plenty of factors to be considered in addition to tax rates), that taxpayer might want to consider closing before the end of this year and also take all cash as opposed to an installment note (payments on an installment note after 2012 will be subject to the higher rates even if the sale closes in 2012).  Finally, a closely-held "C" corporation with substantial retained earnings might want distribute those earnings as a dividend in 2012 so that its shareholders can take advantage of the current 15% rate.  If the corporation cannot make a cash distribution (because, for example, its retained earnings are being used to expand its business or for some other capital transaction), then outside financing may be available to generate the necessary cash.

Plan for "material participation"

If you own a business through a partnership, LLC or "S" corporation, then rental or business income from that entity should not be subject to the new 3.8% levy if you "materially participate" in that business.  You should consult with your tax advisor about how to ensure that you meet this standard – you will need to keep careful records of the number and nature of the hours you spend, and also be sure to make special elections on your tax returns to achieve the desired tax treatment.  Also, the rules are different depending on whether you are engaged in rental real estate versus a non-real estate trade or business.

Individuals need to navigate carefully between freeing rental or business income from the new investment income tax on the one hand, and subjecting that income to FICA or SECA Medicare tax on the other.  This delicate balance can be achieved with proper planning, particularly if an "S" corporation is used.  If the taxpayer avoids the new investment income tax on rental or business income, but subjects that same income to FICA or SECA Medicare tax, then the taxpayer will not have achieved any tax savings.

If you're forming a trust and the trust is to own a business through a partnership, LLC or "S" corporation, then you should consider whether the trustee will be actively engaged in the underlying business (because, as we mentioned, the IRS takes the position that whether the trust "materially participates" is to be determined based on the trustees' involvement, and no one else's).  The consideration militates against using a bank or other "institutional" trustee for such a trust.  If the trust is to own exclusively stocks, bonds and other investment assets, then the trustee selection is less critical from this standpoint (because income and gains from the investment portfolio will be "net investment income" in any event).

Consider tax-advantaged vehicles

Taxpayers should consider traditional investment and other strategies that help to keep AGI below the applicable threshold amount; do not generate net investment income subject to the 3.8% tax; or both.

Maximizing contributions to traditional IRAs, 401Ks and other qualified retirement plans will help reduce an individual's AGI for purposes of the new tax, and distributions out of such plans will not be considered "net investment income."  Note, however, that such distributions will increase AGI and, therefore, potentially subject "net investment income" of the individual from other sources to the new 3.8% tax.

The true "sweet spot" is to find vehicles that do not generate "net investment income" and do not generate or increase AGI.  These include, for example, interest on municipal bonds; life insurance; and Roth (as opposed to traditional) IRAs.  A Roth IRA differs from a traditional IRA in that contributions to a Roth IRA cannot be deducted but distributions out of the Roth IRA are tax-free and do not increase AGI.  For this reason, we can anticipate a flurry of conversions before year-end from traditional to Roth IRAs.  Although converting a traditional IRA to a Roth IRA is a taxable event, Roth IRAs can offer more flexibility than traditional IRAs because their investment assets and future earnings are forever free of income tax and because there are no required minimum distributions. If an individual pays the conversion tax from a taxable portfolio that otherwise produces "net investment income," the taxpayer has effectively converted assets that would be taxable (after 2012) under the new 3.8% tax into non-taxable ones.

Consider family succession planning

Taxpayers have always had a variety of techniques at their disposal – creation of trusts, creation of intra-family investments partnerships or LLCs, and/or inter-generational sales of investment assets – to move assets out of their taxable estates (and thereby reduce estate taxes down the road) and also to move income to younger generations whose tax rates are usually lower. The new 3.8% tax makes these techniques even more appealing because younger generations will more typically have AGIs below the "magic" thresholds such that the 3.8% tax does not apply.  (Plus, the window for making up to $5 million of transfers to younger generations without paying transfer tax is also set to close after 2012, but that is a whole other story.)

How Nossaman Can Help

Attorneys in Nossaman's Corporate Practice Group can help you with any questions you may have about the new 3.8% tax and strategies for limiting your exposure (including a possible sale of your business or "bail-out" of retained earnings as a cash dividend before year-end to take advantage of the lower rates through the end of 2012).

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including attachments), unless expressly stated otherwise, is not intended or written to be used, and cannot be used, for the purpose of (I) avoiding tax-related penalties under the Internal Revenue Code or (II) promoting, marketing or recommending to another party any tax related matter(s) addressed herein.