General Overview of the Code Provision
I.R.C. 1411 imposes a new tax (in addition to other taxes imposed under subtitle A [Income Taxes]) on individuals for each taxable year equal to 3.8 percent of the lesser of (A) net investment income (NII) for the taxable year, or (B) the difference between MAGI for the taxable year and the “threshold amount” (generally, $250,000 for taxpayers making a joint return, $200,000 for others). A similar 3.8 percent tax also applies to estates and trusts. The tax is based on a slightly different base, as described in I.R.C. 1411(a)(2). The tax went into effect for the tax year beginning January 1, 2013.
The tax under I.R.C. 1411 was left undisturbed by the passage of the Tax Cuts and Jobs Act of 2017.
The tax does not apply to nonresident aliens. See I.R.C. 1411(e)(1).
Net investment income (NII) is the difference between (A) “Investment Income” and (B) deductions allowed under subtitle A which are properly allocable to the Investment Income.
I’ve used the term “Investment Income” as a placeholder to describe the gross income or net gain items listed below. The Code, however, does not use this term.
- Gross income from interest, dividends, annuities, royalties and rents (but not such income that is derived in the ordinary course of a trade or business that is not and Applicable Trade or Business – another placeholder that is defined below);
- Other gross income derived from an Applicable Trade or Business; and
- Net gain attributable to the disposition of property other than property held in the trade or business that is not an Applicable Trade or Business (and only to the extent the net gain was taken into account in computing taxable income).
Therefore, with respect to bonds, it should be noted that NII from interest on taxable bonds is included and is subject to the tax.
An “Applicable Trade or Business” is the “suspect” activity giving rise to NII tax. An Applicable Trade or Business is a trade or business that (a) is a passive activity (within the meaning of I.R.C. 469) with respect to the taxpayer, or (b) is a trade or business of trading in financial instruments or commodities.
There is a special rule for determining whether income on investment of working capital is NII. See I.R.C. 1411(c)(3) and I.R.C. 469(e)(1)(B).
There is a special rule and exception for determining whether active interests in partnerships and S corporations are NII. See I.R.C. 1411(c)(4).
There is a special rule and exception that excludes certain distributions from qualified plans from the definition of NII. See I.R.C. 1411(c)(5).
There is a special rule for items taken into account in determining self-employment income on which a tax is imposed by I.R.C. 1401(b) (tax on self-employment income – hospital insurance). See I.R.C. 1411(c)(6).
General Overview of the Proposed Regulations
The IRS issued proposed regulations under I.R.C. 1411 in December 2012 (REG-130507-11 and REG-130074-11). The proposed regulations and the preamble address the matters described below.
The tax cannot be deducted in computing any other taxes imposed by subtitle A.
NII does not include:
- Operating income from nonpassive business;
- Social Security benefits;
- Tax-exempt interest (mentioned in the preamble);
- Self-employment income;
- Alaska Permanent Fund Dividends; and
- Distributions from most qualified retirement plans.