Understanding the Net Investment Income Tax (NIIT): What Investors Need to Know

If your investments made money, you could face an additional tax on those earnings known as the Net Investment Income Tax (NIIT). Effective for the tax year 2013, the Internal Revenue Code (IRC) 1411 imposed NIIT on individuals and some estates and trusts with income exceeding certain thresholds. This additional tax is ultimately applicable to many high earning investment fund managers and investors, as investment funds typically generate some type of investment income.

NIIT Calculation and Eligibility

The tax is a 3.8% surtax on net investment income calculated using Form 8960. Individuals, estates and trusts with income exceeding certain thresholds are subject to paying NIIT. Individuals filing with married filing jointly status hit the threshold when modified adjusted gross income (MAGI) reaches $250,000 or $200,000 for single filing status. The thresholds for estates and trusts are significantly lower.

Domestic Investment Funds and Schedule K-1

Domestic investment funds are generally taxed as partnerships and issue a Schedule K-1 to their investors. Investors should pay particular attention to Box 20, Codes A and B. These boxes report investment income and expenses, respectively, as determined by the partnership. While these items assist in completing Form 4952, Investment Interest Expense Deduction, they can also be used to calculate NIIT. Nonetheless, the taxpaying individual or entity should complete this calculation, and you should not rely solely on the information reported in Box 20, Codes A and B for purposes of determining net investment income.

Income Subject to NIIT

Net investment income typically includes:

• Interest to the extent taxable
• Dividends
• Capital gains
• Rental income and royalties
• Distributions from non-qualified annuities
• Passive income from underlying investment activities

Material Participation and NIIT Exclusions

Keep in mind that if you materially participate in a partnership (i.e., general partner or manager), certain income may not be included for purposes of NIIT. For funds with “trader” status or with a Sec. 475(f) election in place, certain income may also be excludable. However, if you are receiving a carried interest or incentive allocation, the income allocated to you may still be subject to NIIT. As is the case with all partnership activities reported to an individual, it is important to understand the individual’s relationship with the underlying fund activities to determine if the NIIT is applicable.

In addition, formerly 2% miscellaneous itemized deductions, including management fees of investor funds, may be reported by the partnership. Consult with your tax advisor regarding proper treatment, as these expenses are generally not deductible at the individual taxpayer level under current tax law and thus should not be considered for NIIT purposes.

The rules surrounding NIIT are complex, but there are planning opportunities available to reduce the additional tax. Contact Weaver tax professionals today to explore how you can optimize your tax strategy and minimize your NIIT liability.

Authored by Meghan Matthews

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