IRS Proposes Regulations Implementing the New 3.8% Tax on Investment Income: Proposed Regulations Implement the New 3.8% Tax on Net Investment Income of Individuals, Estates and Trusts with Income in Excess of Statutory Thresholds

Sullivan & Cromwell LLP - December 10, 2012

The IRS recently issued proposed regulations (the “Proposed Regulations”) that implement the new 3.8% tax on the “net investment income” of individuals, estates and trusts with “modified adjusted gross income” in excess of statutory thresholds (the “NIIT”). The Proposed Regulations provide that:

  • Income derived in the ordinary course of a trade or business generally is not subject to NIIT unless (i) the trade or business is a “passive activity” with respect to the taxpayer as defined in Section 469 of the Internal Revenue Code (the “Code”) (i.e., the passive loss rules) or (ii) the trade or business is trading in financial instruments and commodities (note, however, that income excluded from NIIT as trade or business income may, in many cases, be subject to the 3.8% tax on net earnings from self-employment);
  • Net investment income subject to NIIT is reduced by properly allocable suspended passive losses deductible against current year passive income, carried forward investment interest, capital loss carryforwards and certain applicable itemized deductions, but not by net operating losses (“NOLs”);
  • Net gain from the disposition of property is subject to NIIT, unless the property is held in an active trade or business (e.g., gain from the sale of primary residence in excess of statutory exclusions is subject to NIIT);
  • Net gain from the disposition of property is not subject to NIIT to the extent such gain is deferred under other provisions of the Code (such as those attributable to like-kind exchanges);
  • No portion of the tax on net investment income is deductible for income tax purposes (unlike the 3.8% tax on net earnings from self-employment for which a deduction of 1.45% is permitted);
  • U.S. shareholders of controlled foreign corporations (each a “CFC”) and shareholders of passive foreign investment companies (each a “PFIC”) with respect to which a so-called QEF election has been made generally recognize net investment income from such investments upon distributions of previously taxed income (and not when such income otherwise accrues for income tax purposes);
  • Taxable distributions from a charitable remainder trust can be subject to the tax; and
  • Distributions from most qualified retirement plans and non-qualified deferred compensation plans are not subject to NIIT.

Although NIIT will be imposed for taxable years beginning on or after January 1, 2013, the Proposed Regulations become effective January 1, 2014 (except for the rules applicable to charitable remainder trusts, which are effective January 1, 2013). In the interim, taxpayers may rely on the Proposed Regulations.

The Patient Protection and Affordable Care Act under which NIIT is imposed also increased the uncapped portion of FICA taxes imposed on wages and net earnings from self-employment by 0.9%.