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The 3.8% Net Investment Income Tax [PODCAST]

The 3.8% Net Investment Income Tax became effective Jan. 1, 2013, and applies to all taxpayers whose income exceeds a certain threshold amount, thereby raising the marginal income tax rate for affected taxpayers. NIIT includes interest, dividends, annuity distributions, rents, royalties, passive activity income and net capital gain from the disposition of property; it excludes salary, wages, IRA distribution from qualified plans, self-employment income, gain on sale of an active interest in a partnership or S corporation and items which are otherwise excluded or exempt from income under tax law. The threshold amount is the key factor in determining NIIT; thresholds are not inflation protected.

Strategies for reducing net investment income include municipal bonds, tax deferred annuities, life insurance, rental real estate, oil and gas investments, choice of accounting year for estate/trust and timing of estate/trust distributions. Strategies for reducing modified adjusted gross income include Roth IRA conversion, CRTs, non-grantor CLTs, and installment sales. Join Robert Keebler, CPA of Keebler & Associates LLP in this podcast as he walks you through year-end planning for the 3.8% NIIT. Visit the AICPA PFP Section’s Post American Taxpayer Relief Act and NIIT Toolkit for more in-depth resources on planning in preparation for year-end. (Email subscribers can listen to the podcast on our website.)


Year End Planning Net Investment Income Tax



This podcast was original recorded Oct. 3.


ROBERT S. KEEBLER, CPA:  On behalf of the Personal Financial Planning Division of the AICPA, welcome to Year-End Tax Planning: The 3.8% Net Investment Surtax. I'm Bob Keebler, and I'll be your host today.

What we're going to do today is talk about the new investment surtax. Effective January 1st, 2013, a new 3.8% Medicare surtax applies to all taxpayers whose income exceeds a threshold amount. This new surtax in essence raises the marginal income tax rate for many of your clients. So client in the 39.6% bracket is now going to be in the 43.4% bracket when you add in the surtax. Now, that is slightly understated, because some of the itemized deductions which apply for both regular tax and for the surtax are scaled back because of the PEP and Pease limitations.

Now, the net investment income tax mathematically is computed by taking into account -- okay, so what we need to do is take into account your net investment income, and then you need to compare that to your modified adjusted gross income minus a threshold amount. And the result of that, you actually multiply by 3.8%, okay? So that's going to be basically how we do this.

Now, for estates and trusts, it's more or less the same equation except the threshold for estates and trusts is much lower. For example, for a married couple, the threshold is $250,000. Single person, the threshold is $200,000. But for an estate or a trust, the threshold is a mere $11,950. So it's a very low threshold that you have to cover. So we're concerned about that, okay? And you -- When you're working with estates and trusts, you're going to do a lot of planning to get dollars out of an estate or trust in the form of DNI, so those dollars are reflected on the beneficiary's tax returns, not on the trust or the estate's return.

So what is included in gross investment income? Interest, dividends, taxable annuity distributions, royalties, rents, income derived from passive activities, even if they're business activities, and net capital gain derived from the disposition of property.

What's not included? The good news is, wages, salaries and bonuses are not included, distributions from IRAs and qualified plans, any income taken into account for self-employment purposes, the gain in the sale of an active interest in a partnership or S corporation, and items which are otherwise excluded from income, such as tax-exempt muni bond income, a capital gains excluded under the homeowner provisions when you sell your home, certain veterans' benefits are not going to be included.

Now, when you compute your 3.8% net investment income surtax, you're allowed some deductions. Interest in -- of operating losses, regardless of the genesis of those losses -- they could be from investments -- are not going to be taken into account for determining the net investment income for a particular year. Now, right now, the way the regs are structured, you would be able to reduce your income by passive loss carry-forwards that are freed up, and you would be able to reduce your income by capital loss carry-forwards.

Now, deductions described in Section 62(a)(4) allocable to rents and royalties are also taken into account. That's good. And deductions allocable to business expenses are likewise taken into account.

Now, let's say you have an investment portfolio managed by a trust company, and that trust company has a fee of 2%. Okay? What's going to happen is that 2% is deductible as an itemized deduction, but that's subject to a limitation, okay? So there's going to be a 2% miscellaneous itemized deduction rule plus 3% scale-back on your itemized deductions, commonly called the Pease limitation.

Now, whatever number you compute, whatever number ends up as your deduction on your Form 1040, Schedule A is going to be your deduction when you compute your 3.8% net investment income tax. What does that mean to us? What that means, if I incurred on a million-dollar portfolio, if I incurred a $15,000 investment management fee -- make it 1.5%. But because of my 2% income limitation and because of the 3% scale-back on itemized deductions, I could only deduct 11,000 of that 15. What's going to happen is, I'm only going to deduct 11,000 of that 15 not only for regular tax, but also for the net investment income tax. So the rate, that 3.8% rate, is in essence going to be a little bit higher.

Now, net investment income, you are allowed to reduce it by penalties under early withdrawal of savings. You can take into account interest expense and other investment expenses. But you do have to work through the 2% floor on miscellaneous itemized deductions and the overall limitation on itemized deductions. So we don't want to lose track of that.

Non-deductible items, I have a list on page 10 of the non-deductible items, most importantly, like I mentioned before, deductions attributable to non-passive trade or businesses and net operating losses. Charitable deductions under 170, if you're deducting those as itemized deductions, those are a below-the-line deduction.

And then we get into all of the provisions of partnership rules, S corp rules, 465, the at-risk rules, and 469, the passive loss rules. Those all will come into play. And your personal exemptions also do not help you to reduce this tax.

Now, the threshold amounts. You'll have to eventually memorize these. Single taxpayers, 200,000. Married taxpayers, 250. Married filing separately, 125. But estates and trusts are limited to an exemption of $11,950. So a very light exemption.

One of the key concepts when we're working with the 3.8% net investment income tax is a concept called modified adjusted gross income, or MAGI. Now, MAGI for this purpose is specifically defined under Section 1411 of the Internal Revenue Code. Do not worry about definitions under other code sections. They are irrelevant, okay? Definitions under other code sections are irrelevant. MAGI in this case equals line 37 of the tax return plus your foreign earned income exclusion, and you're also going to adjust it for the income from controlled foreign corporations and QEFs, okay? So if you have that, you'll have to learn those rules.

Now, the form to do all this work is actually out. It's Form 8960. Unfortunately, the instructions are not out for the form, so -- But you can gather a little bit from the form on how they want you to do the computations.

Now, when we get into the heart of this, what we're really worried about, the heart of the issue is, how can we reduce your net investment income? Strategies like buying muni bonds, maybe tax-deferred annuities. Life insurance is going to be a leading strategy because of the tremendous tax shelter associated with whole life and universal life insurance. Rental real estate can work because of your depreciation. Oil and gas, likewise, in the right circumstance can also help you to reduce your net investment income. Obviously, in today's economy, oil investments seem to be working much better than natural gas investments.

The choice of an accounting year for estates or trusts becomes very important. To the extent that you had 2012 deaths, take a look at exactly how to structure those year-ends.

We also want to look at the timing of estate and trust distributions, because taking dollars, if we -- instead of trapping dollars in an estate or trust, you're much better to flow those out to the beneficiaries.

Now, some of the things we've been looking at, we believe there's a lot of efficacy to Roth conversions, because they will reduce your MAGI in the future. Charitable lead trusts can have -- be efficacious when you have someone who's making large charitable gifts but still paying a lot of net investment income tax. Installment sales, likewise, can help you to spread out income along -- charitable trusts can do the same thing, because they allow you to, if you will, fly below the radar screen.

And what we mean by that is they're going to allow you to keep your income below the $250,000 threshold, which is very important, because what you want to avoid with somebody engaging in a large sale is they sell a piece of property they bought for $100,000 for $3.1 million -- I've had this happen -- and all of a sudden their income goes up by 300 -- by $3 million just for one year.

Under the current law, they're going to get hit with an additional 5% capital gains tax, because it will jump up to 20, plus the 3.8% surtax, in essence, a combined rate of 23.8%, 8.8% above their normal rate. Maybe for part of that income, 23.8% above their normal rate if this is going to be most of their income going forward. So let's say you had a client who was going to sell land to a child. The child can borrow the money and pay them all at once, and they will have $3 million worth of income, and they'll lose -- on the last dollar of that, they'll lose 23.8% to tax.

On the flip side of that, what if the child could do things differently? What if the child could do that on an installment sale and pay their parents $250,000 a year for -- with inter -- with interest and principal over X number of years? They would fly below the threshold every year and potentially never pay a penny of surtax, and certainly never pay any of the extra 5% capital gain rate. 8.8% of a $3 million gain is $264,000 of taxes they did not have to pay because you structured the transaction correctly, because you helped them, if you will, fly below the radar screen. A charitable trust can basically do the same thing.

So we've covered a lot of ground today. These are all very powerful transactions. We'll talk about them more in some of the other podcasts. But on behalf of the Personal Financial Planning Division of the AICPA, this has been Bob Keebler, and thank you for joining us today.


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