Question:  As I derive a significant amount of my income from passive sources. I am concerned about the new investment income tax and the impact it may have on me.  Are there any actions I can take to avoid or minimize this tax obligation?

Answer:  Many taxpayers are aware of the increased tax rates that take effect in the calendar year 2013 pursuant to the American Taxpayer Relief Act of 2012.  Fewer taxpayers are aware of the net investment income tax which, while enacted as part of the 2010 Health Care Act, also takes effect in the calendar year 2013.  The net investment income tax will be an unpleasant surprise for many individuals when they file their 2013 income tax returns.

Effective for tax years beginning after December 31, 2012, individuals are subject to a tax of 3.8% on the lesser of their (a) net investment income and (b) adjusted gross income with some modifications (“AGI”) in excess of an applicable threshold.  Net investment income generally consists of interest, dividends, annuities, royalties, rents and income from business activities in which the individual is not a material participant, less certain deductions in connection with such income.  Net investment income also includes gains from the sale of capital assets such as stocks, bonds, mutual funds and certain other assets not held for sale in the ordinary course of business.  AGI  is the bottom line number on page 1 of an individual’s income tax return and reflects income before itemized deductions such as mortgage interest, state income taxes, real estate taxes, charitable contributions and similar expenses.  The applicable threshold for married taxpayers filing joint income tax returns is currently $250,000 and the applicable threshold for single individuals is currently $200,000. To the extent an individual has AGI in excess of the applicable threshold, the additional 3.8% tax may be imposed on some or all of the individual’s net investment income. The combination of increased tax rates for high-income individuals under the new tax law along with the net investment income tax may create meaningful increases in taxes for many such persons.

Some strategies for minimizing the net investment income tax are as follows:

1. Income Timing. Remember that the net investment income tax only applies if AGI exceeds the applicable threshold. One way to avoid the impact of the net investment income tax is to time income recognition so that the AGI threshold is not exceeded. If AGI is kept below the applicable threshold, then the net investment income tax will not be incurred regardless of the amount of the individual’s net investment income. How can income be timed? Retirement plan distributions, provided that the statutory minimum distribution rules are satisfied, can be minimized to the extent possible. Capital gains can be structured for advantageous income recognition as well. For example, a taxpayer wishing to sell a block of stock might be better served by selling half of the shares in the current year and the other half in a subsequent year so as to keep income within the applicable threshold. Installment sales of assets may be beneficial as well. An individual selling certain capital assets such as real estate where gain will be recognized can structure the sale so that payments to the selling individual are made over a period of years rather than only in the year of sale; gain can similarly be reported over the time period that payments are made so that the applicable threshold is not exceeded. Taxpayers selling real estate and other assets which are eligible for tax-deferred exchanges where gain would otherwise be recognized might also take advantage of these rules to defer income recognition on the sales of such assets.

2. Other AGI Reduction Techniques. To the extent eligible, taxpayers can maximize their contributions to retirement accounts such as 401(k) plans, pension and profit sharing plans and Individual Retirement Accounts (“IRAs”). Employees may also consider entering into deferred compensation agreements with their employers whereby some portion of their compensation is paid in future years rather than in the current year. Taxpayers who have attained age 70 ½ can make contributions of some portion of their IRA assets directly to charity. All of these techniques serve to reduce AGI and may reduce or even eliminate the net investment income tax.

3. Income Shifting. Another strategy to reduce the net investment income tax is to shift investments from assets which generate interest, dividends and other traditional passive sources to assets such as municipal bonds, the interest from which is not subject to regular income tax nor the net investment income tax. Taxpayers should be mindful, however, that when municipal bonds are sold, any capital gain recognizable upon such sale could be subject to the net investment income tax.

4. Roth IRA Conversions. The law allows taxpayers to convert conventional IRAs to so-called Roth IRAs. The income from an IRA conversion is subject to income tax in the year of the conversion but all subsequent distributions from the Roth IRA, including amounts earned subsequent to the conversion, are not subject to income tax. An individual can convert a conventional IRA to a Roth IRA at one time or over a period of years. Whenever distributions are made from Roth IRAs, they will not affect AGI.

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter, you may contact Bruce at (312) 648-2300 or send an e-mail to [email protected].

CIRCULAR 230 Notice:  In order to comply with requirements imposed by the Internal Revenue Service, we wish to advise you that (a) any U.S. federal tax advice contained in this communication is not intended and cannot be used for the purpose of avoiding tax-related penalties, and (b) no one, without prior written consent, may use any advice contained in this transmission in promoting, marketing, or recommending any entity, investment plan, or arrangement to another taxpayer.