Probate & Trust Law Section Conference Manual ... - Minnesota CLE

3. Planning for the Wannabes: Dealing with the Net Investment Income Tax
A principal concern for “wannabe” taxpayers starting in 2013 is the 3.8% tax on “net
investment income” under §1411. 5 The so‐called “Medicare tax” comes not from ATRA but
from the Patient Protection and Affordable Care Act of 2010 (popularly known as
“Obamacare”). The new surtax only applies to individual taxpayers with a “modified adjusted
gross income” (generally meaning the taxpayer‘s adjusted gross income plus any foreign earned
income excluded under §911) in excess of the “threshold amount.” The threshold amount for
married taxpayers filing jointly is $250,000 ($125,000 for married filing separately), and the
threshold amount for all other taxpayers is $200,000. For purposes of this surtax, a taxpayer‘s
net investment income includes interest, dividends, rents, royalties, capital gains, annuity
income, and passive activity income. The statute expressly provides that net investment income
does not include the income from an active trade or business, distributions from individual
retirement accounts, distributions from qualified plans, gain from the sale of an active interest
in a partnership or S corporation, and income taken into account in computing self‐employment
tax. To the extent the tax only applies to items of “income,” it does not apply to excluded forms
of income like municipal bond interest and, for instance, the gain from the sale of a principal
residence.
The 3.8% tax rate is applied against the taxpayer‘s net investment income or the
amount by which modified adjusted gross income exceeds the threshold amount, whichever is
less. Thus, individuals with either a small amount of net investment income or a modified
adjusted gross income barely above the threshold amount, the extra tax exposure probably
does not merit taking any special action. More affluent individuals with lots of net investment
income, however, may require special planning.
For instance, §1(g) (the so‐called “Kiddie Tax”) requires the unearned income of certain
children to be taxed at the marginal rate applicable to their parents. Some parents simply
include such unearned income on their own tax returns, but in light of the net investment
income tax, it now makes sense for the children to file their own returns even though the
Kiddie Tax will still apply. This is because the net investment income tax does not impute a
child’s net investment income to a parent even though the Kiddie Tax may apply. Few children
will have adjusted gross incomes high enough to trigger the net investment income tax, so the
family can avoid the 3.8% surcharge on a child’s unearned income by having that child file his or
her own return.
The net investment income tax may affect some traditional estate planning techniques.
Parents considering a leveraged gift of S corporation stock to children or other descendants, for
example, may now have more incentive to effect the wealth transfer through a grantor trust
instead of an outright gift. Where the transferor is a material participant in the S corporation’s
business but the intended transferee is not, the income from the S corporation would be net
5 Neither nonresident alien individuals nor charitable trusts are subject to the tax.
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