WEALTH STRATEGY REPORT
The 3.8% Surtax on Investment Income Individuals
OVERVIEW
Beginning in 2013, certain investment income will be subject to an additional 3.8% surtax (the surtax). This
surtax is in addition to the regular income tax, and it is in addition to the alternative minimum tax. It will also
have to be taken into account for estimated tax purposes. This is sometimes referred to as the “Medicare”
surtax because the legislation enacting this tax created a new chapter of the tax code entitled: “Chapter 2A –
Unearned Income Medicare Contribution.” However, this was simply a revenue-raiser enacted to offset the cost
of health care legislation; there is no requirement that this surtax be used for Medicare.
This surtax was enacted as part of the Health Care and Education Reconciliation Act of 2010, but its effective
date was delayed until 2013. So, the statute has been around for almost three years, allowing for much analysis
even before it becomes effective. Furthermore, on November 30, 2012 the IRS issued proposed regulations (the
“Regulations”) that offer additional guidance. (We have a separate Tax Alert 2012-07: New Regulations for
3.8% Medicare Surtax Answer Several Questions, Leave Others Unanswered.) Although the regulations are
proposed and final regulations are planned to be issued later in 2013, the IRS has made it clear that taxpayers
can rely on the proposed regulations in the meantime.
This summary describes this 3.8% surtax, how it is calculated, and some planning issues and opportunities for
individuals. We have a separate Wealth Strategy Report addressing how the surtax applies to trusts.
INTRODUCTION
The surtax applies to individuals, trusts and estates. For an individual 1, the surtax is imposed on the lesser of:
(i) “net investment income” (NII), or
(ii) the excess of “modified adjusted gross income” 2 (MAGI) over a certain threshold amount.
WHAT IS “NET INVESTMENT INCOME”?
NII is defined to consist of three categories of income. These are then reduced by “the deductions . . . properly
allocable to such gross income or net gain,” which are discussed below.
Category #1: Gross income from interest, dividends, annuities, royalties and rents (other than such income
which is derived in the ordinary course of an active trade or business). This would not include tax-exempt
municipal bond interest.
1
2
This tax does not apply to nonresident aliens.
“Modified adjusted gross income” is adjusted gross income increased by the net amount of foreign-sourced income that
was exempt for regular tax purposes under Section 911(a)(1).
WEALTH STRATEGY REPORT: THE 3.8% SURTAX ON INVESTMENT INCOME - INDIVIDUALS
It would not matter that these types of income are from your investment in a partnership or S corporation. For
purposes of this surtax, interest, dividends, etc., of a partnership or S corporation “flow through” and constitute
NII to the partner/shareholder. If these types of income are generated in the ordinary course of an active trade
or business, then that would not constitute NII. However, if these types of income are generated by an active
business’s investment of working capital, that would be NII.
Rental income. Although rent is generally considered passive income, which is Category #2 income discussed
below, the surtax statute includes in Category #1 rents other than rents derived in the ordinary course of an
active trade or business. As a result, rental income from a passive activity would be included in your NII under
Category #1.
Distributions From Trusts. Distributions from a trust can also result in the beneficiary/recipient receiving NII.
One example would be a distribution from a charitable remainder trust. Another example would be a
distribution from one of the many kinds of irrevocable trusts commonly used as part of estate planning. The
treatment of trusts is discussed in a separate Wealth Strategy Report: The 3.8% Medicare Surtax on Investment
Income -- Trusts.
Additional items of Category #1 Income. There are several types of investment income that are not clearly
included in the terms “interest, dividends, annuities, royalties and rents.“ The Regulations add the following to
Category #1 income.
• Investment income earned through foreign corporations. In the case of an investment in a
“controlled foreign corporation” (CFC) or a “passive foreign investment company” (PFIC),
investment income that is deemed income for regular tax purposes is not considered NII at that
time 3. Rather, when those amounts are later distributed, they will (i) not be subject to regular
income tax (having already been taxed), but (ii) will constitute NII to the extent such amounts are
distributions of earnings and profits that were previously subject to regular income tax after 2012.
This means the income from a CFC or PFIC might be taxed in one year for regular income tax
purposes but in a later year (when distributed) for purposes of the 3.8% surtax. This will generate
complicated accounting. To ease this, an election is allowed to treat this income as NII in the same
year it is reported as income for regular income tax purposes.
• Substitute payments. A substitute interest payment or a substitute dividend payment made to the
transferor of a security in a securities lending transaction or a sale-repurchase transaction is treated
as interest or dividends for purposes of the surtax.
• Notional principal contracts. Payments under notional principal contracts, such as interest rate
swaps and equity swaps, are deemed not to be NII (unless it is income from a passive activity). 4
Category #2: Gross income from (1) a passive activity, or (2) a trade or business of trading in financial
instruments or commodities. A “passive activity” is defined to be a trade or business in which you do not
“materially” participate.
3
Amounts that are included in income and that are derived from a trade or business of a CFC or PFIC would constitute
passive income and would be included in NII at the same time as for regular income tax purposes, as Category #2 income.
4
However, gain on the disposition of a notional principal contract is NII, being Category #3 gain.
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WEALTH STRATEGY REPORT: THE 3.8% SURTAX ON INVESTMENT INCOME - INDIVIDUALS
This category would include income from master limited partnerships (MLPs) that operate as limited liability
companies (LLCs) or partnerships and are taxed as partnerships. The income of such MLPs is business income,
and because of the LLC or partnership structure, that income flows through to passive investors as passive
income. Often, however, MLPs have deductions that offset much of the business income.
This category would also include business income from closely-held family businesses operating in LLC,
partnership or S corporation form, where some family members own units/shares but are not actively involved
in the business (i.e., they are “passive” under the tax rules). The business income that flows through to the noninvolved family members would be passive income and therefore would be NII.
Passive loss carryovers. To the extent you have a passive activity loss that cannot be used currently because of
the passive loss rules, that loss carries forward for regular income tax purposes and is considered a passive
activity loss in future years. The Regulations state that passive activity losses also carry forward for purposes of
calculating NII (including losses incurred prior to 2013).
One-time opportunity to re-group passive activities. When determining whether you are engaged in a “passive
activity” for regular income tax purposes, how you define “activity” is very important. For example, it is possible
that you participate in two separate businesses but in neither one does your participation rise to the level of
“material participation.” However, if you were to consider both businesses together to be one “activity,” then
your level of involvement might indeed be “material.” For regular tax purposes, there are regulations governing
the extent to which you can “group” activities. Generally, once you have grouped activities, you cannot change
those groupings.
The 3.8% surtax raises a new consequence for being engaged in a passive activity. Because of that, the
Regulations allow you to elect to re-group passive activities, once. Such a re-grouping would apply both for
regular tax purposes and surtax purposes. You would have to make this election to re-group on the tax return
for the first year you would be subject to the surtax.
The Regulations are proposed, and the goal is to have final regulations later in 2013. The election just described,
for re-grouping passive activities, is required to be made for the first year you are subject to the surtax, starting
in 2014. However, the Regulations also state that you can make such an election for 2013, if you want. It would
seem you could also (i) not make the election for 2013, even if you are subject to the surtax, but (ii) make the
election for 2014.
Category #3: Net gain “to the extent taken into account in computing taxable income.” This would include
capital gain. The Regulations state that capital losses can be carried forward for purposes of calculating NII
(including losses incurred prior to 2013).
Gain excluded from income for regular tax purposes is not subject to the 3.8% surtax. This would exclude gains
such as the following, all of which are excluded from taxable income for regular tax purposes:
• gain on the sale of a principal residence that is excluded from income under Section 121 (up to
$250,000; $500,000 for a married couple);
• gain on the sale of Qualified Small Business Stock that is excluded from income, either pursuant to
the exclusion rule or the rollover rule applicable to such stock;
• gain on tax-free like-kind exchanges;
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WEALTH STRATEGY REPORT: THE 3.8% SURTAX ON INVESTMENT INCOME - INDIVIDUALS
• gain on the sale of stock to an ESOP that is excluded from income due to the purchase of “qualified
replacement property”;
• gain on the tax-free exchange of insurance policies;
• the internal “build up” of value inside a life insurance policy.
Exception for business gain. “Net gain” is defined to be net gain “attributable to the disposition of property
other than property held in [an active] trade or business.” In other words, gain on the sale of business assets
used in an active business would not be subject to the surtax. The Regulations clarify that goodwill is indeed a
business asset. Therefore, if an active trade or business is sold and goodwill is included in the sales price, that
gain will not be NII.
The term “net gain” also includes “recapture” income that is often recognized on the sale of investment real
estate.
Mark-to-market income and gains. For Category #1 income, there were certain types of investment income not
within the literal terms of the statute, and the Regulations addressed that by including several types of
investment income within Category #1. Similarly, the Regulations expand on what is included in Category #3
gain. Under certain statutory or regulatory provisions, a non-trader may be required to mark assets to market,
being taxed as if the assets had been sold. Such gains are deemed to be NII.
THE DEDUCTIONS PROPERLY ALLOCABLE TO SUCH GROSS INCOME OR NET GAIN
NII is defined to consist of the three categories of income described above, reduced by “the deductions . . .
properly allocable to such gross income or net gain.” The Regulations have clarified the deductions available
when calculating NII, following closely the rules governing deductions for regular income tax purposes.
For Category #1 income included in NII (gross income from interest, dividends, annuities, royalties and rents),
allowable deductions include (i) deductions allowed for regular income tax purposes for rent and royalty
income; (ii) investment expenses deductible for regular income tax purposes; and (iii) investment interest
deductible for regular income tax purposes. (Investment interest that is carried forward for regular income tax
purposes will also be carried forward for purposes of the surtax, even if incurred prior to 2013.) If any of these
expenses are limited for regular income tax purposes by (i) the 2% floor for “miscellaneous itemized
deductions”, or (ii) the so-called “Pease” limitations for certain itemized deductions, those same limitations will
apply for purposes of the 3.8% surtax. (If both limitations apply, the former is applied first, then the latter.)
For Category #2 income included in NII (gross income from a passive activity, which is a trade or business in
which you do not materially participate5), the business deductions allowed for regular income tax purposes are
also deductible for purposes of calculating the surtax (unless already deducted for self-employment tax).
For Category #3 income included in NII, net gain, capital losses can be carried forward for purposes of calculating
NII, including losses incurred prior to 2013.
In somewhat of a surprising result, state and local income taxes are also allowed as a deduction when calculating
NII, but only to the extent allocable to NII. For example, state and local income taxes allocable to salary would
5
Category #2 income also includes gross income from a trade or business of trading in financial instruments or
commodities.
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WEALTH STRATEGY REPORT: THE 3.8% SURTAX ON INVESTMENT INCOME - INDIVIDUALS
not be deductible when calculating the surtax because salary is not NII. The Regulations state that this
allocation of state and local income taxes between NII and non-NII can be “determined by taxpayers using any
reasonable method.” The Regulations provide an effective “safe harbor” by stating that allocating state and
local income tax based on the ratio of (NII)/(Gross Income) is an example of a reasonable method.
SPECIAL RULES FOR SALE OF S CORP STOCK OR PARTNERSHIP INTERESTS
In the case of gain on the sale of stock in an S corporation or an interest in a partnership (or an interest in an LLC
treated for tax purposes as a partnership), the seller can exclude from NII the amount of gain that would have
been excluded from NII if the entity (the S corporation or partnership/LLC) had sold all of its property for fair
market value “immediately before” the stock or interest was sold. This is intended to be a pro-taxpayer
provision, shielding from the 3.8% surtax net gain attributable to an active trade or business.
The Regulations set out a rather complicated 4-step process that one must go through in order to get the benefit
of this rule. These steps are: (1) pretend there is a cash sale by the entity of all properties; (2) determine the
pretend gain/loss for each property; (3) determine how much gain/loss would be allocated to the selling
partner/shareholder for regular income tax purposes; (4) determine how much of that gain/loss is attributable
to property held in an active trade or business.
After these 4 steps, if there is gain attributable to property held in an active trade or business, that amount of
gain is subtracted from that gain on the sale of the interest in the S corporation, partnership/LLC when
calculating NII. If there is loss attributable to property held in an active trade or business, that is ignored (i.e., all
the gain on the sale of the interest constitutes NII).
Note that this approach is not based on percentages. That is, if 40% of such a pretend asset sale would be
business gain, it is not necessarily the case that 40% of the gain from a stock sale (or partnership/LLC unit sale) is
also business gain. Rather, you start by assuming that all of the gain on a stock sale (or partnership/LLC unit
sale) is NII. Then you subtract, on a dollar-for-dollar basis, the amount that would have been business gain if
there had been an asset sale.
GAIN ON THE SALE OF A BUSINESS - SUMMARY CHART
Three rules have been discussed that apply to owners of S corporation stock or partnership/LLC units:
1. For purposes of the 3.8% surtax, as for regular tax purposes, the entity’s NII “flows through” to
the owners;
2. Gain from the sale of assets used in an active trade or business are not included in NII;
3. In the case of gain on the sale of stock in an S corporation or an interest in a partnership/LLC, the
seller can exclude from NII the amount of gain that would have been excluded from NII if the
entity had sold all of its property for fair market value immediately before the stock or
partnership/LLC interest was sold.
The result is yet another factor when considering the sale of a business, the consequences of which can depend
on (i) the form of the business (S corp., LLC, C corp., etc.) and (ii) whether it is an asset sale or a stock sale. The
following chart offers a summary of how the 3.8% surtax might now be a new consideration.
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WEALTH STRATEGY REPORT: THE 3.8% SURTAX ON INVESTMENT INCOME - INDIVIDUALS
Is gain on the sale of a business “Net Investment Income”?
(Assume this is an active business owner and all assets are used in the business)
Asset Sale
Sale of Stock/Units
No. The surtax N/A to gain
No. Special rules allows the business
from sale of an asset used
aspect to flow through, making it gain on
Business in S corp. form
in an active trade or
the sale of business assets
business
Business in Partnership
form or LLC taxed as a No. Same as above.
No. Same as above.
Partnership
Business in C corp. form
No. The surtax applies only
to individuals, trusts and
estates; it does not apply
to C corps.
Yes, this would be “net gain” includible in
NII, unless the gain is not recognized for
regular tax purposes (e.g., QSB stock
exclusion/rollover, ESOP rollover, etc.)
WHAT IS NOT INCLUDED IN NII
Exception for retirement plan distributions. The statute expressly states that distributions from the following
retirement plans are not NII:
•
qualified pension, profit-sharing, and stock bonus plans;
•
qualified annuity plans;
•
annuities for employees of tax-exempt organizations or public schools;
•
IRAs;
•
Roth IRAs;
•
deferred compensation plans of state and local governments and tax-exempt organizations.
The Regulations’ introductory text indicates that nonqualified deferred compensation is also not NII.
Incentive Stock Options (ISOs). Generally, the exercise of an ISO is not subject to regular income taxation,
though it is taxed as compensation for purposes of the alternative minimum tax. Because this income is not
subject to regular income tax, it is not NII. Note, however, that if the stock is later sold, it would generate capital
gain at that time, and that gain will be NII.
Other income. Any income not within the definition of NII would not be subject to this tax. This would include
the following:
• wages, salary and other compensation income;
• income on the exercise of compensatory options;
• income on the vesting of restricted stock;
All of these, however, would still be included in “modified adjusted gross income” (MAGI). That is also an
important element of the surtax and is discussed below.
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WEALTH STRATEGY REPORT: THE 3.8% SURTAX ON INVESTMENT INCOME - INDIVIDUALS
THE THRESHOLDS
The threshold amount (“Threshold”) for a tax year depends on your filing status, as set forth in the chart below.
Filing Status
Threshold
Married filing jointly, or
Qualifying Widow[er]
$250,000
Single, Head of Household
$200,000
Married filing separately
$125,000
These Thresholds are not indexed for inflation. As a result,
each year more taxpayers will become exposed to the surtax
because other items that enter into the calculation will
inflate, but these Thresholds will not.
UNDERSTANDING THE RELATIONSHIP BETWEEN NII, MAGI AND THE THRESHOLD
The surtax is imposed on the lesser of: (i) NII and (ii) the excess of MAGI over the Threshold. These three
numbers, NII, MAGI, and the Threshold, are inter-related, as illustrated in the chart below.
This chart contains eight examples/columns. In each case there is $100,000 of NII represented by the white
rectangle. All other income that is not NII but goes into MAGI (e.g., salary) is represented by the shaded
rectangle (“Other Income”), which increases from column 1 to column 8. The horizontal line at $250,000
represents the Threshold applicable to taxpayers filing jointly.
Columns 1 - 4: Even though NII is
$100,000, until the combined Other
Income and NII (which together are
MAGI) reaches the Threshold, the
surtax is not triggered.
Columns 5 - 7: Once you have
sufficient Other Income, you will
begin incurring the surtax because
the Other Income will “push” the NII
above the Threshold. When that
happens, only the NII over the
Threshold is subject to the surtax.
Columns 5 through 7 also illustrate a
useful warning, illustrated as follows.
Consider the following question: Is
my taxable Required Minimum Distribution (RMD) from a traditional IRA going to be subject to the 3.8% surtax?
One answer would be that no, it is not included in NII, which is true. However, that overlooks the relationship
between NII and Other Income such as the RMD. If your surtax situation before the RMD is described by
Column 4 but after the RMD is described by Column 7, the RMD will cause more of your NII to be “pushed” over
the Threshold, triggering the surtax.
Column 8: After a certain amount of Other Income, your NII might be fully exposed to the surtax. For example,
assume a Husband and Wife have a fixed amount of NII, $100,000. Both work and their combined salaries are
$275,000, represented by the shaded rectangle in Column 8. That level of salary will push their NII fully above
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WEALTH STRATEGY REPORT: THE 3.8% SURTAX ON INVESTMENT INCOME - INDIVIDUALS
the Threshold, meaning they have exposed 100% of their NII to the surtax. In that case, it is useful to know that
exposure to the surtax has maxed out and additional Other Income will not generate additional exposure.
The chart above assumes that NII was fixed at $100,000 and Other Income varies. Now assume the reverse:
Other Income is fixed at $100,000 and NII varies.
Columns 1 - 4: Until the combined Other
Income and NII (which together are
MAGI) reach the Threshold, the surtax is
not triggered. This is the same dynamic
as in the previous chart.
Columns 5 - 11: Once the surtax applies
(when enough NII has been recognized to
cause MAGI to exceed the Threshold), the
dynamics here are very different than in
the prior example. Here, the amount of
NII exposed to the surtax does not hit a
maximum. Rather, as NII increases, the
amount of income exposed to the surtax
increases, without a limit. In this case, the
straightforward planning would be to
reduce your NII so that MAGI does not
exceed the Threshold.
PLANNING: OVERVIEW
The two preceding charts illustrate the important relationship between NII and Other Income (which together
comprise MAGI). These two categories also suggest how to approach planning: you can minimize NII and/or
you can minimize Other Income.
When planning to minimize the 3.8% surtax, it is important to keep in mind that there are two other similar
taxes. You don’t want to avoid this 3.8% surtax only to trigger a different 3.8% tax, for no net benefit.
3.8% tax on wages. Wages are subject to payroll taxes that consist of two parts: 6.2% for Old-Age, Survivors,
and Disability Insurance, and 1.45% for Hospital Insurance. The $113,700 wage base limit (for 2013) only
applies to the first component; there is no cap for the 1.45%. Employers also pay these taxes, so the Hospital
Insurance tax totals 2.9%. Beginning in 2013, the employee’s portion of the Hospital Insurance tax increases by
9/10ths of a percentage point to 2.35% for wages in excess of $250,000 (married filing jointly); $200,000 (single);
or $125,000 (married filing separate). Thus, the total combined Hospital Insurance tax imposed on wages is
1.45% + 1.45% + 0.9% = 3.8%.
3.8% tax on self-employment income. A self-employed individual pays both the employer and employee
components of these payroll taxes. As a result, beginning in 2013 self-employment income will also be subject
to a 3.8% Hospital Insurance tax.
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WEALTH STRATEGY REPORT: THE 3.8% SURTAX ON INVESTMENT INCOME - INDIVIDUALS
PLANNING: MINIMIZING NII
The first step should be to confirm whether there is any benefit to minimizing NII. As shown in the charts above,
it could be the case that recognizing additional NII would not expose you to the surtax; it might not be an issue.
If it is, here are some planning considerations.
Tax-exempt bonds. Investing in tax-exempt bonds might result is less exposure to the surtax than investing in
taxable bonds. That will depend on a comparison of the after-tax yields of both. The after-tax yields of taxable
bonds will now be affected by this surtax. If the after-tax yield of a tax-exempt municipal bond and the after-tax
yield of a taxable bond are the same after factoring in the 3.8% surtax, then you would be indifferent for tax
purposes as to which type of bond you owned (absent other differences).
Minimize dividends. Dividend-paying stocks may now be taxed more heavily. This could encourage a
preference for investments that pay little/no dividends and instead generate capital appreciation. This could
include non-dividend or low-dividend stocks and, in general, non-principal protected structured notes. While
the resulting capital gain from these investments would also be included in NII, there would be two differences:
(i) the capital gain would be exposed to the surtax only when the stock is sold; and (ii) capital gains can be offset
by capital losses whereas dividends cannot. 6
Increase participation to make passive income non-passive. Income from a passive activity may be subject to
the 3.8% surtax. If your level of activity could be increased so that the business income becomes non-passive,
that could avoid the surtax. However, keep in mind that depending on the form in which the business is
operated (i.e., S corp., LLC, etc.), you might be recharacterizing the income to be self-employment income,
which might simply be triggering a different 3.8% tax, discussed above.
Review how your passive activities are grouped. In determining whether you are active or passive in an
“activity,” there are rules governing what constitutes an “activity” and how different activities might be grouped
and considered one single “activity.” The Regulations allow you a one-time opportunity to re-group your
activities. This was discussed above at page 3.
Convert passive income to salary. Income from a trade or business that is a passive activity will taxed as
ordinary income and may also be subject to the 3.8% surtax. If some of that income could instead be paid as
compensation, that would also be taxed as ordinary income but would avoid the 3.8% surtax. However, it would
also expose that income to payroll taxes discussed above, which could result in even heavier taxation.
Capital loss harvesting. Harvesting capital losses is a common tax planning idea that could now be even more
important. Similarly, certain investment programs that emphasize harvesting capital losses on a regular basis
throughout the year could now be more appealing. One example of such a program is U.S. Trust’s Tax Efficient
Structured Equity (TESE) Program.
Installment sales. An installment sale is a sale where some of the payments are to be received in a future year.
In that case, if certain conditions are met, you can report any resulting capital gain ratably as the payments are
received, rather than reporting all of the gain in the year of sale. If the capital gain involved is NII, then
6
After capital losses are used to offset capital gains, another $3,000 of capital losses can be used to offset other
income, for regular tax purposes. For purposes of the 3.8% surtax, however, this $3,000 “extra” does not
reduce NII.
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WEALTH STRATEGY REPORT: THE 3.8% SURTAX ON INVESTMENT INCOME - INDIVIDUALS
spreading it out over multiple years might cause the 3.8% surtax to be less than if all of the capital gain were
included in NII in the year of sale.
PLANNING: MINIMIZING OTHER INCOME
If you can minimize non-NII income, then that could minimize the excess of MAGI over Threshold, which could
minimize the surtax. Again, however, you should confirm whether there is any benefit to such planning. As
discussed above, it could be the case that recognizing additional income would not expose you to additional
surtax. If it would, here are some planning considerations.
Income in AGI. There are several opportunities to reduce AGI (and therefore MAGI), which can be seen by
looking at the front page of Form 1040. The planning here is not to reduce NII; the income described below is
not NII. Rather, it is the second part of the calculation – the excess of MAGI over the Threshold – that is being
planned for here. Also, none of these income-reducing ideas is new. For example, presumably you were
motivated to minimize Schedule C income even before enactment of the surtax.
• Schedule C income – sole proprietor. Any expenses that would reduce the net business income on Schedule
C will reduce AGI and possibly the amount of income exposed to the surtax.
• Schedule D - capital gains. Harvesting losses would now save 23.8% (assuming the rate applicable to longterm capital gain is 20% in 2013). Similarly, certain investment programs that emphasize harvesting capital
losses on a regular basis throughout the year (such as U.S. Trust’s TESE Program) could now be more
appealing.
• IRA distributions. Distributions from an IRA are not NII. However, if an IRA distribution is taxable, that will
increase MAGI, which could have the result of exposing NII to the surtax. Therefore, minimizing the income
from IRA distributions could minimize the surtax. That could include the following planning considerations:
o The charitable IRA rollover provision. This provision allows for distributions directly from your IRA to
certain charities. The American Taxpayer Relief Act of 2012 extended this provision for 2012 and 2013.
We have a separate Wealth Strategy Report: Lifetime Distributions from IRAs to Charities. Using this
provision would cause you to have less income in your MAGI, which could decrease your exposure to
the surtax.
o Roth conversion. 7 If your traditional IRA is converted to a Roth IRA, then future distributions that are
“qualified distributions” would be tax-free and therefore would not increase your MAGI or otherwise
affect your exposure to the surtax. This could be another factor in favor of a Roth conversion. Note,
however, that a Roth conversion itself would cause you to recognize income, which would increase your
AGI, which could affect your exposure to the surtax in the year of conversion.
• Schedule E – income from rental real estate, royalties, partnerships, S corporations, estates, trusts, REMICs,
etc. Any expenses that would reduce the net business income on Schedule E will reduce AGI and possibly
the amount of income exposed to the surtax.
• Schedule F – farming. Any expenses that would reduce the net business income on Schedule F will reduce
AGI and possibly the amount of income exposed to the surtax.
7
We have a separate Wealth Strategy Report on Roth conversions.
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WEALTH STRATEGY REPORT: THE 3.8% SURTAX ON INVESTMENT INCOME - INDIVIDUALS
Above the line deductions. The following deductions are allowed before determining AGI and therefore could
reduce the income exposed to the surtax:
• deductible contributions to a Health Savings Account;
• deductible contributions to self-employed retirement accounts;
• deductible contributions to a traditional IRA.
MAXIMIZING THE THRESHOLD
Presumably there is limited opportunity here. Nevertheless there are situations when there is a choice of filing
status. In those cases, the filing status chosen would determine the Threshold, which could affect the impact of
the surtax. One example could be where a U.S. citizen/resident (subject to the surtax) is married to a
nonresident alien (not subject to the surtax). The question is how the various Thresholds would apply. The
Regulations provide the following.
Default Rule. In the case of a U.S. citizen or resident who is married to a nonresident alien, the spouses will be
treated as married filing separately for purposes of the surtax. As a result, the U.S. citizen or resident spouse
will be subject to the $125,000 Threshold and must determine his or her own NII and modified adjusted gross
income, and the nonresident alien spouse will not be subject to the surtax.
Election. Generally, a married couple cannot file a joint return for regular income tax purposes if one spouse is a
nonresident alien. However, under Section 6013(g) of the tax code, an election can be made to treat the
nonresident alien as a resident for income tax purposes, allowing a joint return to be filed. The Regulations
state that a nonresident alien spouse can also now elect to be treated as a resident for purposes of the surtax,
which would mean (i) the couple could file jointly and use the $250,000 Threshold, and (ii) the NII and modified
adjusted gross income of both spouses would be considered.
THE ROLE OF ITEMIZED DEDUCTIONS
Itemized deductions are taken into account after the calculation of AGI and so do not affect MAGI. As a result,
itemized deductions do not factor into planning for the surtax. For example, charitable contributions are
deductible as an itemized deduction for regular tax purposes but will have no effect on the amount of income
exposed to the surtax.
However, the statute allows for “the deductions allowed by this subtitle which are properly allocable to such”
investment income. Some of these deductions allowed for surtax purposes also happen to be itemized
deductions for regular tax purposes. These deductions are discussed at page 4 above.
PLANNING FOR THE “KIDDIE TAX”
The so-called “kiddie tax” was enacted by Congress to prevent parents from transferring income-producing
assets to their children in order to shift income from the parents’ higher tax bracket to the children’s lower tax
bracket. If certain conditions are met, a part of your child’s unearned income will be taxed at your highest
marginal tax rate. (We have a separate Wealth Strategy Report: The “kiddie tax.”)
As part of planning for the kiddie tax, you can elect to include your child’s net unearned income on your income
tax return as your own income. There are often reasons not to elect to do this; the 3.8% surtax is another
reason not to make this election. That is, if you include your child’s net unearned income on your income tax
return as your own income, it will be surtaxed as your NII.
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WEALTH STRATEGY REPORT: THE 3.8% SURTAX ON INVESTMENT INCOME - INDIVIDUALS
If you do not make this election but rather have your child prepare his/her own tax return and report his/her
own NII, then although that will not save any income tax (due to the “kiddie” tax), it will allow the child the
calculate his/her own surtax, using his/her own Threshold of $200,000 for a single taxpayer.
PLANNING FOR TRUSTS
We have a separate Wealth Strategy Report addressing how the 3.8% surtax applies to trusts.
CONCLUSION
If you have any questions, we invite you to contact your U.S. Trust advisor.
— National Wealth Planning Strategies Group
Any examples are hypothetical and are for illustrative purposes only.
Note: This is not a solicitation, or an offer to buy or sell any security or investment product, nor does it consider individual investment objectives or financial
situations.
Information in this material is not intended to constitute legal, tax or investment advice. You should consult your legal, tax and financial advisors before making any
financial decisions. If any information is deemed “written advice” within the meaning of IRS Regulations, please note the following:
IRS Circular 230 Disclosure: Pursuant to IRS Regulations, neither the information, nor any advice contained in this communication (including any attachments) is
intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties or (ii) promoting, marketing or recommending to another
party any transaction or matter addressed herein.
While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. U.S. Trust operates through Bank of America,
N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC.
© 2013 Bank of America Corporation. All rights reserved. | AR9F038C | 092013
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