The Supreme Court's Landmark Decision on the Health Reform Legislation Left the New 3.8% Medicare Surtax on Unearned Income Intact; the Effective Date for this New Tax is January 1, 2013

Unless Congress takes action before the end of the year, the Internal Revenue Code will subject high income individuals to an annual 3.8% Medicare contribution tax on their "net investment income" (the "NII Tax") in 2013. As discussed below, investors in hedge funds and private equity funds are a target of the new NII Tax and fund managers should begin planning to minimize the impact of the new tax on their investors. Managers of funds that are organized as tax partnerships should be aware that investment expenses that pass through to individual limited partners as itemized deductions (Code section 212 expenses) rather than trade or business expenses will generally not be deductible in calculating net investment income for purposes of the NII Tax. Consequently, the eligibility of a fund to qualify for federal income tax purposes as a being engaged in business as a "trader" rather than being classified as an "investor" fund will become an even more important tax planning matter if the NII Tax goes into effect as scheduled.    

I. Overview of the NII Tax

Congress added the NII Tax (which is in Internal Revenue Code section 1411) in 2010 as a means to pay for health care reform, but the effective date was delayed until 2013. The NII Tax is an "add on" surtax which must be paid in addition to the regular federal income tax on investment income. It should be noted that net investment income is often referred to as net unearned income because the NII Tax generally applies to any income that is not otherwise paid by an employer and subject to withholding or treated as self-employment income (i.e., earned income). Although the NII Tax only applies to individuals with adjusted gross income above relatively high specified levels (described below), the tax also applies to U.S. trusts and U.S. estates that have undistributed net investment income for the taxable year and adjusted gross income in excess of a much lower exemption (initially $11,650 adjusted annually for inflation). Individuals that are neither citizens nor residents of the United States (nonresident aliens) are exempt from the NII Tax.

No Deductions for NII Tax. The taxpayer is not allowed to claim a deduction for the NII Tax when computing any tax imposed by subtitle A of the Code (i.e., income taxes, including the alternative minimum tax).

Estimated Payments Required. Taxpayers subject to the NII Tax will be required to make quarterly estimated tax payments with respect to the NII Tax in the same manner as regular income tax estimated payments. 

II. Applicable Dollar Thresholds

The NII Tax will apply to single individuals with a "modified adjusted gross income" (MAGI) in excess of $200,000 and married persons with a MAGI in excess of $250,000 if filing a joint return, or $125,000 if filing a separate return. For trusts and estates, the applicable AGI threshold is initially $11,650 adjusted annually for inflation.

Note that these dollar threshold amounts for individuals and joint return filers are not indexed for inflation. Thus, as time goes by, more individual taxpayers will become subject to this tax.  

MAGI. For most individuals, MAGI will be their adjusted gross income (AGI) unless they are U.S. citizens or residents living abroad and have foreign earned income.

Formula for the NII Tax. For individuals, the tax is equal to 3.8% of the lesser of (i) net investment income or (ii) the amount by which the taxpayer's MAGI exceeds the applicable dollar threshold.  

For trusts and estates, the tax is equal to 3.8% of the lesser of (i) undistributed net investment income for the taxable year or (ii) the amount by which the trust or estate's AGI exceeds the applicable dollar threshold.

Impact on Tax Planning. High income individuals (and their tax advisors) will be required to keep track of both the taxpayer's projected AGI and net investment income in order to effectively plan to minimize the taxpayer's exposure to the NII Tax. Some high income taxpayers may decide that they are better off accelerating investment income into 2012 in order to avoid the effective date of the NII Tax as well as other tax increases on long-term capital gains and dividend income that may also go into effect in 2013. 

III. Definition of "Investment Income"

For purposes of this tax, "investment income" is defined to include:

1. Gross income from interest, dividends, annuities, royalties and rents, other than such income that is derived in the ordinary course of a trade or business not described in 2 or 3 below;

2. Gross income from a trade or business that consists of trading financial instruments or commodities (i.e., income from trader funds);

3. Gross income from a trade or business that is a passive activity for the individual (that is, income generated from an interest in a tax partnership that is engaged in a trade or business in which the partner does not actively participate); and

4. Net gain attributable to the disposition of property, other than property held in a trade or business not described in 2 or 3 above.

It should be noted that with respect to item 4, since the definition includes net gain only, a taxpayer could theoretically be subject to the NII Tax even if he has an overall net investment loss (that is, the taxpayer could be subject to the tax on his interest and dividend income without being able to reduce NII by an overall capital loss described in 4 above.) 

IV.   Deductions Allowed in Calculating "Net Investment Income"

  • Net investment income is gross investment income reduced by any deductions properly allocable to such gross income or net gain that are allowed under the regular rules for federal income tax purposes.
  • Note that this rule essentially eliminates a high income individual's ability to reduce net investment income by any expenses that are otherwise limited as miscellaneous itemized deductions subject to the 2 percent floor (that is, below the line expenses).  
  • Similarly, the investment interest limitations, capital loss limitations and any other deduction limitations that apply for regular income tax purposes would also apply in calculating net investment income subject to the NII Tax. 

V. Certain Types of Income Excluded from Net Investment Income

The following income items are exempt from the NII Tax:

1. Active trade or business income

2. Any income that is subject to the self-employment tax

3. Tax-exempt bond interest

4. Excluded gain from sale of a principal residence ($500,000 for married filing jointly, $250,000 for others) that is excluded from gross income for federal income tax purposes

5. Distributions from qualified retirement plans and IRAs, etc. The exempt plans include qualified pension and profit-sharing plans, Keogh plans, qualified annuity plans, regular individual retirement accounts, Roth IRAs and section 457(b) deferred compensation plans of state and local governments and tax-exempt organizations

6. Veterans' benefits 

VI. Application of NII Tax to Income from Private Investment Funds

A. Funds Organized As Partnerships for U.S. Income Tax Purposes

Generally, most income allocated to U.S. investors from U.S. and foreign hedge funds and private equity funds that are classified as tax partnerships for U.S. tax purposes will be classified as investment income subject to the NII Tax. To the extent the fund generates income from activities that constitute a trade or business, for example purchasing life settlements or investing in operating partnerships, the income will likely still be classified as investment income for limited partners because it will generally be classified as income from a passive activity for such investors. (Application of the NII Tax to the general partner is discussed below.)

B. Funds Classified as Foreign Corporations for U. S. Tax Purposes

If a U.S. individual investor invests in an offshore fund that is a passive foreign investment company, such investor would typically make the election to treat such PFIC as a qualifying electing fund (QEF).  As a result of such election, the investor would report currently his share of the PFIC's undistributed income as "QEF income".   Similarly, if the offshore fund were classified as a  controlled foreign corporation (CFC), certain U.S. investors could be required to report their share of the Fund's undistributed Subpart F income as current income.

Somewhat surprisingly, it is at present somewhat unclear whether such types of imputed income inclusions are classified as "dividends" or other covered "investment income" for purposes of the NII Tax.

As a policy matter, this result does not seem to be consistent with Congress's intention to apply the NII Tax to passive investment income. Consequently, it should be expected that the Treasury or IRS will issue guidance to treat this income as net investment income for purposes of the NII Tax. It is also possible that Congress will adopt a technical amendment to specifically state that QEF inclusions and Subpart F income  are treated as dividend income for NII Tax purposes.

It should be noted, however, that income inclusions under both PFIC QEF rules and Subpart F  are limited to the foreign corporation's earnings and profits, which would be reduced by any allocable expenses. Code section 212 and the investment interest deduction limits do not apply to foreign corporations.  As a result, an individual investor would be able to reduce the income inclusions by investment-related expenses of the foreign corporation that would probably not be deductible if the fund were organized as a tax partnership.  

C. Application of NII Tax to Partners in Management Companies

The management company of a fund should be viewed as engaged in an active trade or business for federal income tax purposes. As a result, a partner's distributive share of ordinary fee income from a management company (excluding any interest, dividends, or other investment income the management company may receive) should be exempt from the NII Tax provided the partner is an active participant in the management company's business (e.g., by having more than 500 hours of service during the tax year) so that the partnership would not be considered a passive activity with respect to the partner.

D. Application of the NII Tax to General Partner Entities

The general partner of a fund typically receives the incentive allocations, known as carried interest, as an allocation of the fund's partnership income. Under current law, such incentive allocations are characterized for federal income tax purposes by reference to the character of the income realized by the partnership in the year such allocations are made. Thus, to the extent the carried interest produces interest income, dividends or capital gain for the general partner, it would appear that such income would be classified as investment income subject to the NII Tax when it passes through to individuals that are partners in the GP entity. 


U.S. Treasury Circular 230 Notice: Any U.S. federal tax advice included in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal tax penalties.


The information contained herein was prepared by Sadis & Goldberg LLP for general informational purposes for clients and friends of Sadis & Goldberg LLP. Its contents should not be construed as legal advice, and readers should not act upon the information in this Tax Alert without consulting counsel. This information is presented without any representation or warranty as to its accuracy, completeness or timeliness. Transmission or receipt of this information does not create an attorney-client relationship with Sadis & Goldberg LLP. Electronic mail or other communications with Sadis & Goldberg LLP cannot be guaranteed to be confidential and will not create an attorney-client relationship with Sadis & Goldberg LLP.

Cheryl Spratt