It was supposed to be simple. It ends up being extremely complicated.
The Healthcare and Education Reconciliation Act of 2010 (P. L. 111-152) added a new Code section (Section 1411) effective for taxable years beginning after December 31, 2012, creating a new net investment income tax (NII). In December 2012, the IRS issued proposed regulations (REG-130507-11) attempting to clarify the application of the law where needed. This article explains what this tax means to asset management and other financial services entities.
While the 3.8% Medicare surtax is generally deemed to be assessed on unearned or passive income, taxpayers in the trade or business of trading financial instruments or commodities will include related income as NII.
The NII tax applies to individuals (US citizens or residents), estates, and trusts; generally taxing unearned income. The NII tax on individuals is calculated using a 3.8% tax rate and is imposed on the lesser of "net investment income" for such taxable year, or
(i) the excess (if any) of the individual’s modified adjusted gross income for such taxable year, over
(ii) a threshold amount ($250,000 for a married taxpayer filing a joint return, $125,000 for a married taxpayer filing separately, and $200,000 in all other cases).
This tax is subject to the estimated tax requirements.
Net Investment Income is defined in Section 1411(c) (1) as:
A) The sum of the following three categories of income:
- Bucket 1: gross income from interest, dividends, annuities, royalties, and rents, unless those items are derived in the ordinary course of a trade or business that is not a passive activity or a business of trading in financial instruments or commodities (as defined in Section 475(e)) (trading business);
- Bucket 2: other gross income derived from a trade or business that is:
- a passive activity with respect to the taxpayer, or
- a trade or business in financial instruments or commodities (as defined in Section 475 (e)), and
- Bucket 3: net gain attributable to the disposition of property other than property held in a trade or business that is not a passive activity or trading business.
B) The deductions that are properly allocable to categories 1, 2, and 3 above. Any allowed or disallowed expenses, as well as any deferral, under the regular income tax rules will be similarly treated under the NII tax.
- The determination of whether a taxpayer is trading in "financial instruments" or "commodities" is made at the level of the entity that produced such income.
- The determination of whether a taxpayer is engaged in a passive activity is made at the individual taxpayer’s level.
- If a trader has deductions that did not reduce the trader’s self-employment income, such excess deductions are allowable for determining NII.
Observation: Income that is derived from the ordinary course of a trade or business (that is not a trading business and is not considered passive to the taxpayer) is not subject to the NII tax.
Trader funds and investor funds are treated differently
Similar streams of income are categorized differently for trader and investor funds. For trader funds, all gross income (including mark-to-market gain under Section 475(f)) that is not described in category 1 is included in category 2 (gross income); nothing is included in category 3 (net gains). Investor funds have the same category 1 income category, but will have no category 2 income. Only investor funds net capital gain will be included in category 3.
The proposed regulations do not treat losses from the sale or exchange of property as an allocable deduction; instead those losses should be taken into account only in determining net gain under category 3. Since category 3 does not apply to trader funds, gross gains, rather than net gains, are included as net investment income. However, if a fund is not engaged in a trader business (e.g., investor fund), then such funds generally will net gains from the disposition of stocks and securities (becoming category 3 NII). Thus, a literal application of the proposed regulations will allow the netting of gains and losses for investor funds but not for trader funds.
Since category 3 cannot be less than zero, investor funds with capital losses will not be able to use the losses to offset category 1 income. In addition, if an individual invests in both a trader and an investor fund, he will not be able to offset the capital gain generated by the trader fund with the losses generated by the investor fund and he will not be able to carryover the losses to the subsequent year because the losses were used for regular tax purposes. Hopefully this illogical result will be corrected in the final regulations.
Swap income is treated as income for trader funds but not for investor funds. It is pulled into category 2 as other income from trading. Category 1 and 3 do not have the concept of other income. However, if the sale of the swap produces a gain, that income will be included in either category 2 or 3 based on the type of fund (i.e., trader vs. non-trader) that produced such gain.
General Partner entities
When a (non-active) General Partner (GP) of a fund receives an incentive allocation or carried interest, the character of the income is the same as that of the fund. The NII tax applies to the GP similarly to the fund investors. GPs of investor or trader funds are treated in the same manner.
For this discussion, the management company and the GP are separate entities and the GP is not actively involved in the management of the fund. As such, the fund managers are deemed to actively participate in the trade or business of the management company, therefore not engaged in a passive activity. Consequently, the distributive share of ordinary income from a management company to a partner who materially participates in the partnership should not be subject to the NII tax. In addition, if the management company is a limited partnership with a 1% GP, as long as the fund managers (as limited partners) are receiving a reasonable guaranteed payment for their work, the remainder of their distributive share of ordinary income likely is not subject to self- employment tax either (regulatory exception).
Under the current rules, because there is an anomaly between a trader and an investor in how they are taxed under NII, there are a number of planning opportunities that need to be considered, from a federal, state, and local income and employment tax perspective. Your Baker Tilly tax advisor is ready to assist.
The proposed regulations are effective for tax years beginning after December 31, 2013. The IRS is expected to issue final regulations later in 2013 and has said taxpayers may rely on the proposed regulations for tax years beginning after December 31, 2012.