Update on Net Investment Income and Medicare Taxes

Posted on 06.25.13

By Scott Zickefoose, CPA

The Treasury Department and the Internal Revenue Service have released proposed regulations surrounding Internal Revenue Code Section 1411.  This new Section provides for an additional 3.8 percent tax on net investment income (NII) and a 0.9 percent increase in the §3101 hospital insurance tax (Medicare tax).    This expansive tax change is in effect for tax years beginning after December 31, 2012.   With the impending change in the taxation landscape, it becomes imperative that taxpayers and their advisors evaluate all aspects of their personal and business tax situation.

While there are many ways to plan to minimize the effects of the new legislation on you and your business, this article focuses on those who have real estate or other passive activities as defined by IRC §469. Under the proposed regulations, income derived from passive activities will be subject to the additional 3.8% tax provided that the taxpayer exceeds certain income thresholds.

Under IRC Section 469 and Temporary Regulation Section 1.469-ST, a taxpayer can be deemed to "materially participate" in a rental activity. "Materially participating" in a rental activity allows the income to be classified as nonpassive, thus avoiding the additional 3.8 percent tax.   The criteria to determine material participation can be found here: https://keitercpa.com/client-alerts/a-quick-snapshot-of-the-rental-real-estate-rules/

By definition in the Internal Revenue Code, rents and royalties received by a taxpayer are passive to the taxpayer.   This classification as passive income would require the additional 3.8 percent tax be imposed, provided the other income thresholds were met. One tax planning opportunity is for the taxpayer to evaluate grouping activities that would otherwise be characterized as passive.

It is often difficult for a taxpayer to receive relief from passive activity and IRC §1411 rules by simply applying Temporary Regulation §1.469-5T. If the taxpayer is unable to get relief under these sections, they should evaluate grouping various activities that constitute an "appropriate economic unit". The details of this grouping can be found in Treasury Regulation §1.469-4. If a taxpayer is able to group activities, it allows them to view the various activities as one when evaluating material participation under Temporary Regulation §1.469-ST.   The one caveat worth mentioning is that in order to avoid the §1411 tax on passive income completely, the grouped activities will need to meet the definition of a trade or business under IRC §162. The gross income from rents derived from the grouped activities will not be excluded from the §1411 tax unless this stricter definition of a trade or business is met.

If you have not previously made a grouping election, this tax year you may find it beneficial to do so. If you have previously made a grouping election, you will want to take time with your advisor to evaluate if your previous grouping decision still provides optimal tax treatment. If you find that a previous grouping is outdated and that there is a more optimal grouping, the Internal Revenue Service is allowing taxpayers a one time opportunity to regroup activities. The taxpayer may regroup their activities the first year that the IRC §1411 applies to them.

As with most elections, there are potential consequences of making a grouping election. Keiter recommends that you contact your tax advisor to evaluate the benefit and consequences of grouping or regrouping your activities.