Tuesday, January 27, 2015

UNDERSTANDING THE ACA NET INVESTMENT INCOME TAX

If you make more than $125,000 a year, you will want to read on. A new tax as a part of the Affordable Care Act may mean you will owe more in taxes. The Health Care and Education Reconciliation Act has presented us the Net Investment Income Tax, referred to by many as NIIT or the super Medicare tax. This tax exposes the net investment income of individuals, estates and trusts to a 3.8% tax when their modified adjusted gross income exceeds certain threshold levels.

These levels are: $250,000 for married individuals filing a joint return, $125,000/each for married individuals filing separate returns and $200,000 for unmarried individuals and other cases. Trusts and estates have a much lower threshold for when this tax applies. This new tax is creeping up on many and there could be unpleasant consequences for those that don't comply.

This new tax calls for taxpayers to truly understand what constitutes net investment income. The obvious components are involved- interest, dividends, annuities, royalties and rents. These are just the tip of the iceberg and those that feel they could be affected by the tax should consult a CPA immediately to understand its complexity.

Interest, dividends, trusts and estates can all make their way to a taxpayer through a pass through entity and then maintain their net investment character.  The concept of “passive activity” also comes into play here. As income from passive business activities, this includes any capital gain from the sale of those activities, is generally subject to the NIIT, whereas income from nonpassive business activities generally is not. Bloomberg BNA summarizes this concept best, explaining that it stems from the IRS's passive activity loss rules, which prohibit taxpayers from deducting losses from so-called passive activities, or activities in which the taxpayer does not materially participate. These guidelines usually apply to the actions of the owner of the business interest, not the business itself, although special rules apply to real estate activities. When is your interest in a business not to be a passive activity? Again, according to IRS rules and regulations, you must materially participate in the operations of the business. Meaning, your involvement in the business operations is regular, continuous and substantial. The IRS regulations provide both quantitative as well as qualitative tests for meeting this requirement. For example, you will be materially participating if you work more than 500 hours during the year in the business.

Because the IRS passive activity rules apply to restrictions on deducting losses, taxpayers with positive income from passive activities may have had little reason to differentiate those activities from nonpassive activities. However, the distinction might become significant. For example, the IRS has rules that have allowed taxpayers to “group” related activities in order to determine whether the overall group represents a passive or nonpassive activity. Taxpayers with multiple business or real estate investments might be able to eliminate or reduce their exposure to the NIIT with appropriate decisions in this area.

The super Medicare tax will affect the tax returns of many people. Knowing the ins and outs of this new tax could save them thousands of dollars. Don't wait until your return is prepared to learn how this will affect you. Contact a tax professional today that is already well versed on 1411.