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The New 3.8% Surtax on Investment Income

The Health Care and Education Reconciliation Act of 2010, signed into law by President Obama on March 30, 2010, created a 3.8 percent surtax on certain net investment income.  The application of the surtax began on January 1, 2013.

Net Investment Income (NII) is defined as:

(1)   gross income from interest, dividends, annuities, royalties, rents, substitute interest payments and substitute dividend payments unless such income is derived in the ordinary course of a trade or business that is neither a passive activity with regard to the taxpayer nor a financial instrument or commodities business;
(2)   other gross income derived from a trade or business that is either a passive activity with respect to the taxpayer or a financial instrument or commodities business; and
(3)   net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property except to the extent the gain is from the sale of property held in an active trade or business other than a financial instrument or commodities business.

Self-employment income, active trade or business income, gain on the sale of an active interest in a partnership or S-Corp, IRA or qualified plan distributions, trusts for charity (except CLTs) and non-resident alien’s income are all excluded from NII.

Application of the Tax on Individuals

The 3.8 percent tax applies to all individuals who have adjusted gross incomes over the threshold amounts and receive net investment income as defined in the Act (see above).  The amount subject to the surtax will be the lesser of (1) the net investment income; or (2) the amount of the taxpayer’s adjusted gross income that exceeds an applicable threshold amount.  The threshold amount for a single taxpayer is $200,000.  The threshold amount for a married taxpayer filing jointly is $250,000 ($125,000 if filing married separate).

By definition, your adjusted gross income includes wages from work, net investment income, qualified distributions from a retirement plan such as a traditional IRA, 401(k), or 403(b), and any foreign earned income exclusion you may have earned during the tax year.

How Does the Tax Affect Trusts & Estates?

The general rule is that the surtax applies to all trusts and estates described in Subtitle A, Chapter J, Part 1 (IRC §§ 641 – 685) that earn income over the threshold amount.  That amount is $11,950 for 2013.  There are however, the following exceptions:

1.     A trust under which all the unexpired interests are devoted to one or more of the charitable purposes described in IRC § 170(c)(2)(B);
2.     A grantor trust or § 678 trust;
a.     Since income in a grantor trust or a § 678 trust is reported on an individual’s income tax returns, the NII will be added to the individual’s 1040 and the surtax will be calculated according to the rules for individuals;
3.     A trust exempt from tax under IRC § 501(c);
4.     A charitable remainder trust;
5.     Most foreign trusts;
a.     The Treasury Department has indicated that they will take the position that NII accumulated in a foreign trust for the benefit of a domestic beneficiary should be subject to the surtax;
6.     Business trusts;
7.     Common trust funds; and
8.     Pooled income funds.

The 3.8 percent tax will be imposed on the lesser of: (1) the total undistributed net investment income for the taxable year; or (2) the excess of the entity’s AGI for the taxable year over the highest trust and estate tax bracket ($11,950 for 2013).

The surtax will not affect everyone but its effect could be steep. Taxpayers, including trusts and estates, in the highest marginal income tax rate, which is currently 39.6 percent, will pay 43.4 percent with the surtax in 2013.

To view the original post on the BBA Trusts & Estate Section's Blog, please click here

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