On November 30, 2012, the Treasury Department and Internal Revenue Service released proposed regulations and a supporting FAQ elaborating the additional 3.8% tax on net investment income of higher income taxpayers, e.g., married filing jointly taxpayers with modified adjustable gross income (AGI) in excess of $250,000.

  • This additional tax (section 1411 of the Internal Revenue Code), which was a “pay for” in the Patient Protection and Affordable Care Act, is effective for taxable years beginning after December 31, 2012. The regulations would be effective for tax years beginning in 2014, but taxpayers may rely on the proposed regulations for the 2013 tax year.
  • In general, individuals, estates and trusts, but not corporations, are potentially liable for this tax.
  • For this purpose, “investment income” generally includes, but is not limited to, interest, dividends, capital gains, rental and royalty income, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities to the taxpayer (within the meaning of Code section 469), less certain expenses.
  • Income items that are not “investment income” include wages, unemployment compensation, operating income from a nonpassive business, Social Security benefits, alimony, tax-exempt interest and self-employment income.  

Under the proposed regulations, the section 1411 tax would apparently have only a limited effect on retirement savings and other employee benefit arrangements.

  • Trusts exempt from tax under Subtitle A of the Code – which would include trusts for qualified retirement plans, IRAs and governmental 457(b) plans treated as exempt from tax under section 501(a), Rev. Rul. 81-100/2011-1 collective trust funds, and voluntary employee beneficiary associations (VEBAs) exempt under section 501(c)(9) – are not subject to the tax.
  • Similarly, grantor trusts – which would include the rabbi trusts commonly used with nonqualified deferred compensation programs – are not liable for this tax.
  • The proposed regulation provides that “Investment income” does not include any distribution from a plan or arrangement described in sections 401(a), 403(a), 403(b), 408, 408A or 457(b). The proposed regulation specifically states that this exclusion encompasses rollovers, conversions to a Roth IRA, plan loan offset amounts or deemed distributions attributable to plan loans, corrective distributions, and imputed income for the cost of life insurance protection. This exclusion is apparently intended to be comprehensive.
    • Nothing is explicitly said about the treatment of income received from terminal funding or other annuity contracts distributed from qualified plans. (See the annuity discussion below.)
    • Taxable plan distributions would be taken into account in determining whether the AGI threshold is met, however. As a result, if a taxpayer otherwise below the AGI threshold becomes exposed to the section1411 tax by reason of, e.g., a taxable lump sum distribution from a qualified plan, that distribution is indirectly subject to the additional tax.  
  • The preamble briefly discusses nonqualified plans, including section 409A, 457(f) and 457A plans. Taxable income received in respect of those arrangements that is subject to wage withholding is income from employment, and therefore is excluded from section 1411, even if calculated by reference to items that otherwise are “investment income.”
  • Logically, the same result should obtain for most but not all equity-based compensation arrangements. For example, dividends received after a section 83(b) election is made with respect to a restricted stock award may be subject to section 1411.
  • In contrast, the taxable portion of annuity payments or withdrawals from and surrenders of nonqualified annuity contracts – i.e., annuity contracts purchased outside of qualified retirement plans, commonly to accumulate retirement savings – would be “investment income” for this purpose, as would gain from the sale of a nonqualified annuity to a third party. Similarly, taxable amounts received as an annuity from life insurance or endowment contracts would be treated as “investment income.”
  • The FAQ clarifies that mandatory wage withholding is not required with respect to the additional 3.8% tax where applicable.  

Comments on the proposed regulations are due 90 days after publication in the Federal Register (scheduled for December 5, 2012), and a hearing is scheduled for April 2, 2013.