Internal Revenue Code Section 1411, which became effective for tax years beginning January 1, 2013, was added to tax law as part of the Health Care and Education Reconciliation Act of 2010, to increase revenue. Called the Net Investment Income Tax, it is imposed on individuals, trusts, and estates, levying a tax at the rate of 3.8 percent on investment income above specific threshold amounts.
The Net Investment Income Tax, or NIIT, includes income from capital gains, rentals, royalties, passive business operations, any business income (passive or active) from financial instruments or commodities trading, and nonqualified annuity payments. It does not include income from sources like salary, Social Security, unemployment, a payout from a life insurance policy, alimony payments, tax-exempt capital gains or tax-exempt interest, or qualified retirement plan income.
Not Everyone Must Pay
The NIIT applies to taxpayers with MAGI (modified adjusted gross income) higher than specified amounts, as follows:
Single or head of household above $200,000
Married filing jointly or qualifying widow(er) with a child over $250,000
While MAGI may be close to (or the same as) AGI (adjusted gross income) for some taxpayers, it can be different because some deductions are allowed to be taken against AGI but are added back to calculate MAGI. Examples that can be substantial are IRA contributions, student loan interest, half of the self-employment taxes, excluded foreign income, and in some cases, adoption expenses.
A Section 1411 Adjustment is the calculation made by adding investment income and subtracting costs that you incur in the process of earning the income. For example, buying stock may incur a commission, while buying and selling real estate typically has other costs associated with the transaction. The net amount (gain versus cost) is the investment income amount.
The Importance of Passive Versus Active Participation
For the purposes of determining which activities produce income that is subject to the NIIT, the IRS is reasonably specific in defining trade or business and in noting exclusions for both passive involvement and in leaving out businesses that trade in financial instruments or commodities. If the income is derived by active participation in a trade or business that is not excluded by that definition, it should not be subject to the imposition of NIIT. As always, we'd recommend consulting a qualified tax advisor in this regard.
The question of an active partnership comes up concerning potentially selling or disposing of the investor's interests in the business and how that act may or may not trigger a NIIT levy. A review of IRC 1411 (c)(4) indicates that any gain from such a disposition would only result in the imposition of NIIT to the same extent that it would if all property of the partnership or S corporation had been sold (for fair market value) immediately before the disposition or termination of the partnership.
Examination of IRS Revenue Ruling 99-6 indicates that a net capital gain from the sale of an active partnership interest in a business or trade that does not involve financial instruments or commodities may be exempt from the imposition of the NIIT, according to some tax experts.
