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Net Investment Income Tax: 3.8% NIIT, Nit-Picky Nuances for Americans Overseas or With Offshore Investments

If you meet the requirements, your 2013 tax return will reflect the new 3.8% Medicare surcharge imposed on high wage earners. This tax is more commonly called the “Net Investment Income Tax” or (“NIIT”).  Many people are confused with the taxation of capital gains and the NIIT. There is even greater confusion because the rules governing application of the NIIT contain nuances with regard to Americans working overseas and with regard to so-called nonresident alien individuals (NRA).  

Let’s start with some basics:

What is the NIIT / 3.8% Medicare Surcharge?

The NIIT is, broadly speaking a 3.8% surtax on “net investment income”. It applies only to certain high-income individuals. We will discuss very soon, precisely to whom the NIIT applies. 

What is Net Investment Income?

Net investment income must be distinguished from “earned” income (earned income is earned through one’s labor or services or because one is actively involved in a partnership or business). Investment income includes interest, dividends, capital gains, annuities, royalties and passive rents as well as income from businesses, such as trading of financial instruments and commodities and businesses that are considered “passive” with respect to the taxpayer.

Net investment income does not include distributions from qualified retirement plans (e.g., an employer-sponsored defined benefit plan, profit sharing plan, money purchase plan, Employee Stock Ownership Plan, a so-called 401(k), 403(b) or 457(b) plan). The term does not include distributions from an IRA or tax-exempt municipal bond – so, distributions from one’s Roth or regular IRA, for example, will not be hit with the NIIT.

These exemptions from the surcharge make good economic sense. Congress does not want to discourage taxpayer’s from investing in their own retirement planning since the Social Security scheme is in obvious turmoil. It also does not want to discourage taxpayers from investing in municipal bonds, since these debt obligations which are issued by states, cities, counties and other governmental entities, use the money for projects such as building schools, roadways, and other projects for the public welfare. 

What if I am a Shareholder in a Controlled Foreign Corporation (CFC) or Passive Foreign Investment Company (PFIC)?

The calculation of net investment income for the NIIT takes into account income attributable to investments in foreign corporations that are CFCs or PFICs. Net investment income includes dividends and gains from dispositions of stock of a CFC or a PFIC.  This becomes quite complicated because shareholders of CFCs and PFICs are subject to special anti-deferral legislation. Very broadly, the anti-deferral rules generally require US investors in a CFC or PFIC to pay US income tax on certain undistributed income of the foreign corporation. When these earnings that were previously taxed are then later distributed to the shareholder, he is permitted to exclude the distribution from taxable income. This prevents double-taxation. In other words, the US shareholder is not required to pay income tax again when he receives the actual distribution of the earnings, since they were taxed previously to him as undistributed income under the anti-deferral CFC or PFIC legislation.

How does this work in the case of the NIIT?  How is the previously taxed CFC or PFIC income treated under the NIIT rules? Under the NIIT rules, the US shareholder is allowed to make an election to include the undistributed income from the CFC or PFIC in his net investment income for the 3.8% NIIT in the year in which the US shareholder pays US income tax on that CFC or PFIC undistributed income. This election enables the shareholder to treat the undistributed income from the CFC or PFIC consistently as taxable income for both regular US income tax purposes and for purposes of the NIIT. If the election is not made, there is inconsistency in the tax treatment for the different tax years involved – e.g., the shareholder is required to pay the 3.8% NIIT in the year he gets the actual distribution from the CFC or PFIC. This actual distribution, however, is excluded from regular federal taxable income on his tax return because it was previously-taxed as undistributed income in an earlier tax year under the PFIC or CFC regimes. Messy (and nit-picky)!

Who is Subject to the NIIT?

Not everyone will be subject to the NIIT. You must meet two basic requirements for the NIIT to apply. You must: 1)  have Net Investment Income and 2) have modified adjusted gross income (“MAGI”) over certain applicable thresholds.  The thresholds are set out in the chart.  Significantly, the thresholds are not indexed for inflation.  Even if you are exempt from Medicare taxes, you may still be subject to the NIIT. Very simply, NIIT applies if you meet 1 and 2, above.

 

Filing Status

Threshold Amount

Married filing jointly

$250,000

Married filing separately

$125,000

Single

$200,000

Head of household (with qualifying person)

$200,000

Qualifying widow(er) with dependent child

$250,000

 

No NIIT for NRAs

Nonresident alien individuals are specifically exempt from the 3.8% NIIT. This is important, for example, for the nonresident alien owning investments or properties in the US and earning passive rents, dividends or capital gains with respect to the properties. Specific rules apply for dual-status individuals and those making a special election to be treated as a US “resident” for tax filing purposes. The IRS FAQ at number 5 gives further information. It can be accessed here.

 What is MAGI for purposes of the NIIT? – Special Considerations for Overseas Americans or Those With Foreign Shareholdings

The 3.8% NIIT is imposed on the lower of the taxpayer’s net investment income or the excess of MAGI over the income thresholds. MAGI is adjusted gross income (see Form 1040, Line 37). For Americans overseas to determine MAGI, they must add back all foreign earned income / foreign housing amounts that were excluded under Section 911 of the US Internal Revenue Code.  In the case of taxpayers with income from controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs), they may have additional adjustments to their adjusted gross income.  This was discussed above. 

Do I Need to Worry About Estimated Taxes for NIIT?

In a word, YES!  (Really, is there anything you need NOT worry about when it comes to taxes?)  Taxpayers who expect to be subject to the NIIT should adjust their income tax withholding or estimated tax payments to cover themselves for the tax increase in order to avoid underpayment penalties.

Can I Use My Foreign Tax Credits to Offset NIIT?

Sadly, no, you may not. This is due to a very technical reason.  Due to the way the US Internal Revenue Code is structured, any federal income tax credit that may be used to offset a tax liability imposed by subtitle A of the Internal Revenue Code may be used to offset the NIIT. However, if the tax credit is allowed only against the tax imposed by chapter 1 of the Internal Revenue Code (which chapter involves the regular income tax), those credits may not reduce the NIIT.  Unfortunately, the foreign income tax credits (sections 27(a) and 901(a)) are allowed as credits only against the tax imposed by chapter 1 of the Internal Revenue Code. As such they may not be used to reduce a taxpayer’s NIIT liability. 

All is not lost, however. If you take foreign income taxes as an income tax deduction on your tax return, (as opposed to taking them as a tax credit), some (or all) of the deduction amount may be deducted against your net investment income. You should discuss this matter with your tax return preparer.   

Where Can I Find Additional Information About the NIIT?

The IRS has issued FAQs about the NIIT which can be accessed here. 

You can find additional information about the NIIT in the 2013 final regulations and in a new 2013 proposed regulation published on Dec. 2, 2013.

The AICPA has done an interview with the authors of the NIIT final Treasury Regulations. Access it here.  The interview will assist in understanding the new IRS Form 8960, Net Investment Income Tax for Individuals, Estates and Trusts and the draft instructions.  AICPA also lists  more resources to help navigate the NIIT maze.

 

 

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