One of the byproducts of the Affordable Care Act is a new tax called the Net Investment Income Tax (NIIT). This is an additional 3.8% tax on income for certain high income taxpayers who have investment income.
The calculation is somewhat complex, but generally, if you have a Modified Adjusted Gross Income (MAGI) above the below thresholds and you have investment income, you will likely owe this additional tax in April:
Married Filing Jointly or Qualifying Widow(er) $250,000 Married Filing Separately $125,000 Single or Head of Household $200,000 Undistributed Trust or Estate Income $12,500
When planning for this tax there are two factors to consider. First, the items of income will push you over the above thresholds. Second, the items of income will be specifically treated as Net Investment Income and therefore subject to the additional tax.
Avoiding Going over the MAGI
General tax deferral and avoidance strategies also work in deferring or avoiding the MAGI limit for purposes of this NIIT. For example, Installment Sale Reporting or Like Kind Exchange Treatment on the sale of an asset can defer the recognition of income that could otherwise trigger NIIT liability. Similarly, taking retirement payments over time rather than in a lump sum, or investing in Tax Exempt investments in the first place, can defer or delay triggering NIIT liability.
Gifts of appreciated property to charity or family can also avoid spikes in MAGI when those items are sold, and thus the application of the NIIT. You could also reduce your MAGI with contributions to retirement accounts to reduce reportable income. If cash resources are needed in a year where MAGI is a concern, consider borrowing money rather than taking taxable distributions from retirement accounts. Borrowing sources could include S Corp distributions to the extent of basis, Roth IRAs, and Life Insurance Cash Surrender Values.
Business owners can also utilize other traditional tax deferral methods such as accelerated deprecation, paying employee bonuses or accelerating other discretionary expenses in high income years, or selling assets that will generate losses to offset income. Keep in mind that net capital losses are still carried over to the next year for this purpose, you can only offset $3,000 against your ordinary income sources.
Avoiding the Net Investment Income
This income includes interest, dividends, net capital gains, rental and royalty income, non-qualified annuities, business income from trading financial instruments and commodities, and business income from passive activities. Items that are NOT included in this tax base are wages, unemployment compensation, operating income from a non-passive business, social security benefits, alimony, tax-exempt interest, self-employment income, and distributions from qualified retirement plans.
The largest unexpected taxed income appear to be passive rental income. However, the IRS does not include rental income as passive where the owner of a business rents real estate to a business he actively participates in operating. Special care should be taken at the time of liquidation of a Partnership or S Corporation interest as certain pass- through items could result in the recognition of Net Investment Income.
In sum, a 3.8% tax is not catastrophic, but it may serve to increase awareness of yearend tax planning strategies when timing can make a difference.
If you have questions regarding the Net Investment Income Tax, or other similar issues, please contact your HWE relationship attorney or visit us at http://www.hwelaw.com.