New Tax on Investment Income Scheduled for 2013

June 27, 2012

In 2010, Congress enacted a new tax on investment income of individuals, estates and trusts that applies beginning in 2013.  For individuals, the tax is 3.8% of the lesser of  (1) net investment income or (2) the excess of modified adjusted gross income over the “threshold amount”.

Applies Only to Taxpayers with AGI above $200,000/$250,000.
Modified adjusted gross income under this statute is adjusted gross income ( “AGI”–the amount reported on page 1 of the Form 1040) increased by the amount excluded from income for certain individuals working abroad.  The “threshold amount” is $250,000 for married taxpayers filing jointly and $200,000 for single taxpayers.  This means that the tax generally only applies to married taxpayers with AGIs above $250,000 and to single taxpayers with AGIs above $200,000.

Tax Base is Limited.
For taxpayers with AGIs above the $200,000/$250,000 threshold, the tax base to which the 3.8% tax applies is limited to the lesser of

  • net investment income, or
  • the excess of AGI over the $200,000 or $250,000 threshold.

For example, if married taxpayers filing jointly have net investment income of $30,000 and AGI of $270,000, the tax base to which the 3.8% tax applies is $20,000.

Net Investment Income is Broadly Defined.
Net investment income generally includes all passive income and gain and also income and gain from trading in financial instruments or commodities even if the taxpayer materially participates. Specifically, the statute defines net investment income as the excess of the sum of  the following reduced by permitted deductions:

  • gross income from interest, dividends, annuities, royalties, and rents (other than derived in a trade or business),
  • gross income derived from a trade or business which is either a passive activity (because the taxpayer does not meet the material participation standard) or a trade or business of trading in financial instruments or commodities, and
  • net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business income from which is not subject to the 3.8% tax.

The statute provides that where the taxpayer sells an interest in a partnership or S corporation, net gain is subject to the tax as it would have been had the partnership or S corporation sold its property. Under these provisions, if a taxpayer sells a partnership interest in a partnership that conducts two activities, and  the taxpayer materially participates in one activity but not the other, the gain attributable to partnership property used in the activity in which the taxpayer does not materially participate is subject to the tax.

Exclusions.  The tax does not apply to

  • trade or business income from an activity in which the taxpayer materially participates (other than financial trading)
  • income or gain excluded from taxable income under other provisions of the Internal Revenue Code (for example, gain on the sale of a personal residence up to the $250,000/$500,000 limit)
  • distributions from a qualified retirement plan
  • amounts subject to the FICA tax on self-employment income

Example.  If married taxpayers filing jointly have $400,000 of  salary income and $75,000 of net investment income, the excess of their modified AGI over the threshold amount is $225,000 ($475,000 – $250,000).  The 3.8% tax is applied to the lesser of such $225, 000 excess or the net investment income of $75,000.  Thus, the tax is applied to the $75,000 and the taxpayers pay tax of $2,850 ($75,000 x 3.8%).


Taxpayers anticipating large capital gains should consider accelerating sales transactions to occur in 2012.

Beginning in 2013, taxpayers should consider using installment sales to spread gain over a number of years.

Reminder:  2013 is also scheduled to bring a new tax on earned income-an additional .09 will be added to the Medicare surtax on the wages and self-employment income over $250,000 of married taxpayers filing jointly or over $200,000 of a single taxpayer.  This will bring the total social security and Medicare taxes on income over the wage base ($110,100 in 2012) to 3.8%.  Prior to these two new taxes (3.8% on investment income and additional .09 Medicare), S corporation shareholders who receive both a salary and distributions have considered whether they are better off with an increase in salary or higher distributions.  The new 3.8% investment tax should not apply to distributions of active trade or business income from an S corporation.  Therefore, it should not encourage increases in salaries and corresponding decreases in distributions for S corporation shareholders.