ELITE ADVISOR BEST PRACTICES
What Advisors Need to Know About the 3.8% Net Investment Tax - Part Two
Is your “bucket list” up to date?
By Janice Eiseman
- According to the tax code, three distinct buckets of income are included in a client’s investment income tax base.
- Interest, dividends, annuities, royalties, rents, income from passive activities or income from trading in financial instruments or commodities may all be subject to NII tax.
- Net gain from the disposition of an investment asset or an interest in a passive trade or business is also subject to the NII tax. Allowable losses cannot be used to reduce net gain below zero.
As we discussed in Part One, the Net Investment Income Tax is an “overlay” on the regular income tax. It is computed on Form 8960 and cannot be computed until Form 1040 (individual) or Form 1041 (trust or estate) is completed. To calculate the tax, we need to know which of your client’s income is considered “investment income.” Surprisingly, the provision governing the tax, set forth in Code Section 1411, is short. Section 1411(c)(1)(A) provides that three buckets of income are included in the investment income tax base. Let’s take a closer look at each of the three buckets:
The first bucket of income consists of the specifically enumerated items listed in Section 1411(c)(1)(A)(i), which items are: (i) interest, (ii) dividends, (iii) annuities, (iv) royalties, and (v) rents, except to the extent that these items are derived in the ordinary course of a trade or business, which trade or business is neither a passive activity with respect to the taxpayer nor the trade or business of a trader trading in financial instruments or commodities. These amounts are reported on Lines 1, 2, and 3 of Form 8960. These amounts are picked up from your client’s Form 1040 or Form 1041.
If a trade or business is not a passive activity with respect to the taxpayer, or if the trade or business is not trading in financial instruments or commodities, then income and gain from the trade or business is not subject to Section 1411, and such trade or business is referred to as a “non-section 1411 trade or business” on Form 8960, Line 4b. This amount is subtracted from the income reported your client reports from rental real estate, royalties, partnerships, S corporations, trusts etc. reported on Line 4a of Form 8960. Note that a trading business in financial instruments or commodities can never be a “non-section 1411 trade or business.” An example of a non-section 1411 trade or business is a trade or business owned by a limited liability company or an S corporation in which the member or shareholder “materially participates” in the business so that his or her income from the business is not passive; that is, he or she has “active income” from the business.
Income listed in Bucket 1 can be excluded. For example, consider an individual shareholder of an S corporation that’s involved in the trade or business of banking. The shareholder materially participates in the banking business; that is, the activity with respect to the shareholder is not passive. Interest allocated to this shareholder on his or her Form K-1 is “excluded income” because it is not derived from a passive activity. Thus, it comes under the “ordinary course of trade or business” exception for these specifically identified items of income.
Bucket 2 income consists of other gross income derived in a trade or business that is from a passive activity with respect to the taxpayer, or that’s derived from the trade or business of a trader trading in financial instruments or commodities, i.e., a “section 1411 trade or business.” This bucket includes all other gross income from a passive activity or from a trading activity that is neither gross income included in Bucket 1 nor net gain included in Bucket 3.
Bucket 3 income consists of net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property, except the gain or loss attributable to property held in a “non-section 1411 trade or business.” Net gain may not be less than zero. Capital losses allowed under Code Section 1211(b) may offset gain from the disposition of assets other than capital assets that are subject to Section 1411. Treas. Reg. § 1.1411-4(d)(2). For example, say a taxpayer subject to the NII has a capital loss from the sale of stock equal to $40,000 and a capital gain from the sale of stock equal to $30,000, resulting in a $10,000 capital loss. The taxpayer also has $5,000 of interest income. For the NII tax, the taxpayer may reduce the $5,000 of interest income by the $3,000 of capital loss allowed for income tax purposes. The remaining $27,000 of capital loss may be carried over to reduce any capital gain in the next tax year.
“Net gain from the disposition of property” is the gain described in Section 61(a)(3) recognized from the disposition of property reduced, but not below zero, by losses deductible under Code Section 165--including losses attributable to casualty, theft, and abandonment or other worthlessness. Treas. Reg. § 1.1411-4(d)(3). Gains and losses attributable to a “non-section 1411 trade or business” are excluded from Bucket 3. However, this exclusion does not generally cover the sale of a partnership interest or stock in an S corporation because they are not held in a trade or business. However, net gain does not include certain gain or loss attributable to the interest in a non-section 1411 trade or business. Treasury Regulations have been issued regarding how to determine the amount of gain and loss that may be excluded under this exception for the sale of a partnership interest or S corporation stock when the entity conducts a non-section 1411 trade or business. For example, if your client operates an active trade or business through an S corporation, which business is a non-section 1411 business, then the sale of S corporation stock by your client will not fall into Bucket 3.
Section 1411 is drafted such that income must fall within one of the three buckets to be considered “investment income.” Furthermore, it lists certain income as being “excluded.” Treasury Regulation § 1.1411-1(d)(4) further defines what income is excluded from investment income. Excluded income is:
- Items of income excluded from gross income under the regular income tax rules. For example, tax-exempt interest under Code Section 103, gain from the sale of a principal residence under Code Section 121, and gain under Code Section 1031, the like-kind exchange provision. Treas. Reg. § 1.1411--1(d)(4)(i).
- Items of income not included in any one of the three buckets. For example, income from a non-section 1411 trade or business, wages, unemployment compensation, alimony, and Social Security Benefits. Treas. Reg. § 1.1411-1(d)(4)(ii).
- Items of gross income and net gain specifically excluded under Section 1411. For example, gain from the disposition of an non-section 1411 trade or business (Section 1411(c)(4)), distributions from qualified plans (Section 1411(c)(5)), and income taken into account in determining self-employment income subject to tax under Section 1401(b). (Section 1411(c)(6)).
Note again how income from qualified retirement plans is favored. First, investment income from these accounts is not subject to the 3.8 percent tax and distributions from these plans are also not subject to the 3.8 percent tax.
We know that the tax is applied to an individual’s “net investment income” or to the undistributed net investment income of a trust or estate. We will explore how to determine “net investment income” in my next report on this subject.