March 4, 2013

Early planning may lessen or eliminate the effects of the new surtax that went into effect on Jan. 1, 2013, to help pay the costs of the healthcare act, popularly known as Obamacare.

The Health Care and Education Reconciliation Act imposes a 3.8 percent surtax on net investment income above certain statutory amounts. This surtax applies to individuals as well as estates and trusts.

dollar sign made of stethoscope

The higher tax rate applies to the lesser of net investment income or modified adjusted gross income (MAGI), to the extent either exceeds a threshold amount.

For individuals, the thresholds are $250,000 for married taxpayers filing jointly; $200,000 for single taxpayers; and $125,000 for married taxpayers filing separately. The thresholds for individuals are not adjusted for inflation.

For estates and trusts, the threshold is the dollar amount for the highest tax bracket for an estate or trust – estimated at $11,950 for 2013.

Importantly, taxpayers can avoid the surtax if they keep either their MAGI or their net investment income below the threshold amount.

Net investment income includes, but is not limited to:

  • Interest
  • Dividends
  • Capital gains
  • Rents and royalties
  • Nonqualified annuities
  • Income from businesses that are passive activities
  • Income from the trading of financial instruments or commodities

Other items, such as the following, are not included in net investment income:

  • Wages
  • Self-employment income
  • Social Security benefits
  • Tax-exempt interest
  • Operating income from a nonpassive business
  • Certain retirement distributions

To arrive at net investment income, gross investment income is reduced by properly allocable deductions. Examples include investment income expenses, advisory and brokerage fees, expenses related to rental and royalty income, and taxes allocable to items included in net investment income.

The tax on net investment income is reported on, and paid with, the taxpayer’s income tax return. If taxpayers expect to be subject to the surtax, they should consider whether they need to adjust their withholding or quarterly estimated payments to avoid underpayment penalties.

Gain from the sale of an asset that is not recognized for regular income tax purposes is not considered as part of net investment income. Examples include gain under the installment method, from like-kind exchanges or involuntary conversions, and from the sale of a principal residence, up to the statutory exclusion.

The surtax applies to most trusts but not to grantor trusts. However, if a taxpayer has a grantor trust, the trust income that is treated as received by the taxpayer can cause the taxpayer to be subject to the surtax.

While a charitable remainder trust is not subject to the surtax, distributions to the noncharitable beneficiary may include income that is considered net investment income.

Items normally considered net investment income, such as dividends or interest, are not if they are derived in the ordinary course of a trade or business. This exception requires that the business not be a passive activity and not be trading in financial instruments or commodities.

For a sole proprietor or disregarded entity, this test applies at the individual level. For a taxpayer owning an interest in a pass-through entity, the passive activity test is applied at the taxpayer level, but the financial trading test is applied at the entity level.

Employee income treated as wages is not net investment income. Thus, amounts paid to an employee under a nonqualified deferred compensation plan are not net investment income.

For taxpayers looking for loopholes, the IRS advises that it will closely review transactions that inappropriately manipulate net investment income to avoid the new surtax.

If you expect your income to exceed the threshold amount for 2013, it is a good idea to meet with your tax advisor early in the year to plan ways to mitigate or eliminate the effects of the new tax.

This article was originally posted on March 4, 2013 and the information may no longer be current. For questions, please contact GRF CPAs & Advisors at