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Investment and Tax Planning in Light of the New Net Investment Income Rules

Ten strategies for reducing your clients’ exposure

By Blake Christian

Key Takeaways:

  • Single taxpayers making more than $200,000 in modified adjusted gross income (MAGI) or joint filers making more than $250,000 in MAGI will likely see their federal taxes increase and their after-tax return on investment (ROI) fall due to the new net investment income (NII) tax introduced in 2013 under the Affordable Care Act (ACA).

  • The 3.8 percent NII tax is applied against all or a portion of the taxpayer’s NII that exceeds the aforementioned thresholds. NII includes a broad assortment of unearned income such as dividends, interest, annuities, royalties, certain rents, capital gains, and passive activities from LLCs and Partnerships. Qualified Retirement Plan and IRA distributions are excluded from the new tax.

  • The net impact of this new tax is that high-income taxpayers now face marginal federal tax rates on the majority of their investment income as high as 43.4 percent (39.6% + 3.8%). That’s a 20.6 percent increase in the marginal rate on ordinary income above the calendar 2012 rate of 36 percent. Long-term capital gains are now subject to a potential 23.8 percent (20 percent capital gain plus 3.8 percent NII tax) federal tax rate — or a whopping 58.6 percent increase vs. the maximum 15 percent marginal federal rate on capital gains for calendar year 2012.

  • The erosion of ROI as a result of these new taxes can be disconcerting to both portfolio managers and their clients; however, there are a number of strategies to mitigate the NII tax impact.

As many high-income taxpayers and their investment advisors discovered when filing or extending their 2013 personal or trust/estate income tax returns this spring, a new unpleasant layer of tax appeared on their federal returns. This additional 3.8 percent excise, or surtax, is imposed on all or a portion of their net investment income (NII) in cases in which a taxpayer’s modified adjusted gross income (MAGI) exceeds statutory thresholds. Later we’ll explain strategies for reducing your clients’ taxable exposure, but first let’s look at the new tax landscape for the marginally affluent.

MAGI is essentially AGI from page 1 of a taxpayer’s Form 1040 adjusted for certain foreign investment income, certain passive income and losses, and certain deductions. This article provides an in-depth discussion of the required adjustments.

This new and troublesome tax was designed to help fund the Affordable Care Act (ACA) and adds complexity to both portfolio management and the tax planning process.

The tax became effective for individual and trust tax years beginning on or after January 1, 2013. Generally the NII tax is imposed on individual taxpayers with MAGI in excess of $200,000, joint taxpayers with MAGI in excess of $250,000, and trusts with AGI in excess of $11,950. Hitting these thresholds, the NII tax is imposed at the rate of 3.8 percent on the lesser of:

  1. the excess of the taxpayer’s MAGI over the threshold amounts above, or
  2. the taxpayer’s NII for the tax year.
Therefore, for a joint taxpayer with $275,000 of MAGI, but NII of $14,000, the NII tax will be $14,000 times 3.8 percent, or $532. However, as with the imposition of any new tax system, proper planning can mitigate, or eliminate, this additional tax burden. Following are ten planning suggestions to reduce exposure to the NII tax:
  1. Prior to year-end, attempt to offset any realized investment gains with investment losses sitting in your other investments. Caution: Make sure that you do not violate the “wash sale” rules contained in IRC Section 1091, which will temporarily disallow a tax loss on any stock or bond that is replaced with the identical investments within 30 days of the original sale. This is fairly easy to plan around. Reporting gains on assets other than publicly traded stocks or bonds under the installment sale rules may also provide opportunities for minimizing exposure to NII. Like-Kind Exchange structuring under IRC Section 1031 for certain appreciated assets also can minimize NII tax exposure.

  2. Invest in tax-exempt bonds and growth stocks to minimize NII and MAGI.

  3. To the extent consistent with your estate and gift tax planning strategies, shift income-generating assets to lower-income family members — including parents and children. Caution: The “Kiddie Tax” can still impose the parent’s tax rate on income earned by children under 19 (or under age 24 if the child is a full-time student).

  4. Maximize qualified retirement plan and Health Savings Account (HSA) contributions to minimize both NII and MAGI. In addition to current-year tax savings, future qualified plan distributions (both the original investment and the related appreciation) are not characterized as NII.

  5. Increase investments in insurance products such as whole life policies that allow tax-deferred cash surrender value buildup and/ or deferred annuities that will begin payouts when MAGI is lower than the thresholds above.

  6. Modify how you and/or your spouse are involved in certain businesses/investments in order to re-characterize K-1 income from “passive” (includable in NII) to “non-passive” (excludable from NII). This can provide a net advantage to the extent the K-1 income is from an S Corp, since the K-1 income is not subject to self-employment tax — which can be equal to or higher than the NII tax. K-1 income from partnerships and LLCs is generally subject to self-employment tax, so no net savings may be achieved. However, active/non-passive status may still be beneficial if the business generates losses, since the losses may be currently deductible rather than suspended when there are net passive losses (sum of passive income and passive losses) for the year. See IRC Section 469 and related regulations for guidance on documenting the required 500- or 750-hour active participation thresholds for general businesses or real estate professionals, respectively. Evaluation of how various K-1 and other activities are “grouped” is required, and potential new elections may be required prior to filing 2013 and future returns.

  7. Re-evaluate your compensation structure to the extent that you have control over the timing of bonus payments, options and other W-2 reportable incentives in order to minimize MAGI. Caution: This may offer only a short-term benefit and push you into a higher MAGI in subsequent years but provides you additional time to plan in minimizing NII. Also, the new ACA imposes an additional 0.9 percent payroll tax on W-2 and other “earned” income exceeding $200,000 for single taxpayers and joint taxpayers with W-2 or self-employment income above $250,000. This new 0.9 percent payroll rate combined with the 1.45 percent employer and employee (2.9 percent combined) Hospital Insurance (HI) portion of Social Security tax results in the same 3.8 percent rate for both the higher W-2 and NII. The rationale is to prevent attempts to game the system. However, S Corp status still allows gaming for “active” employees, since S Corp K-1 income for active owners is exempt from self-employment income and minimizing (within industry averages) W-2 payments to active shareholders will minimize overall income and payroll taxes.

  8. With respect to complex trusts and estates, consider electing to treat prior- year capital gains as “deemed” prior- year distributions to beneficiaries (who will not otherwise be subject to the NII tax), by making an election within 65 days of year-end under IRC Section 663(b).

  9. Dispose of passive activities with loss carryovers, or investments with deferred prior-year losses that were suspended due to insufficient tax basis. This can also generate current-year tax losses, which can lower MAGI as well as taxable income, thereby reducing overall federal taxable income and regular and NII tax.

  10. While reaching the $200,000 and $250,000 MAGI thresholds can trigger the NII tax, reducing overall taxable income via itemized deductions can also reduce overall federal taxes. In addition, many high-net-worth individuals fall into the lower 26 percent or 28 percent marginal tax rates due to the Alternative Minimum Tax (vs. the pre-NII tax 36 percent federal tax rate). Therefore, overall taxes can actually be lower in these AMT years, and consideration for accelerating income and deferring certain deductions may be a smart play.

While being subjected to the NII tax is not an optimal result for any taxpayer, there are a variety of ways to minimize the impact of the 3.8 percent additional federal tax rate and thereby increase the after-tax return on both passive and non-passive income.

Both the savvy investment advisor and the CPA can score points by getting ahead in the planning process as early in the year as possible.

About the Author

Blake Christian, CPA/ MBT is a Tax Partner in the Long Beach office of California-based Top 50 CPA firm HCVT LLP. Blake has over three decades of experience and specializes in corporate and high net-worth individual income, estate and gift tax planning. Blake is a frequent speaker and author and is a thought leader in best practices for professional service firms.