Effective for tax years beginning after December 31, 2012 a new 3.8% tax is imposed on unearned income of individuals, estates and trusts which meet certain income thresholds.

In the case of individuals, the 3.8% tax is imposed on the lesser of (i) “net investment income” for the taxable year, or (ii) the excess of adjusted gross income for the taxable year over $250,000 (for a joint return or surviving spouse), $125,000 (for married filing a separate return) or $200,000 (for any other filing status).

In the case of estates and trusts the 3.8% tax is imposed on the lesser of (i) undistributed “net investment income” for the taxable year; or (ii) the excess of the adjusted gross income (computed under Section 67(e) of the Code) for the taxable year over the dollar amount at which the highest tax bracket in Section 1(e) of the Code begins for such taxable year which for 2013 is $11,950.

For purposes of the 3.8% tax “net investment income” means the following items of income:

  1.  interest, dividends, annuities, royalties and rents other than such income derived in the ordinary course of a trade or business which is not a passive activity with respect to the taxpayer;
  2.  other income which is derived from a trade or business which is a passive activity with respect to the taxpayer; and
  3.  net gain from the disposition of property other than property held in a trade or business which is not a passive activity with respect to the taxpayer.

Deductions allowed for income tax purposes which are properly allocable to such items of income can be deducted in arriving at “net investment income”. The passive activity rules of Section 469 of the Code are applied to determine whether income is derived from a trade or business, which is a passive activity with respect to the taxpayer. Thus, the 3.8% tax will apply to a S corporation shareholder’s share of the S corporation’s income where the shareholder meets the income threshold, and the S corporation’s trade or business is a passive activity with respect to the shareholder. The 3.8% tax will not apply to such shareholder’s share of the S corporation’s income if such shareholder materially participates in the S corporation’s trade or business so that the S corporation’s trade or business will not be a passive activity with respect to the shareholder. Likewise the 3.8% tax will apply to a partner’s share of partnership income if the income threshold is met, and the partnership trade or business is a passive activity with respect to the partner, but will not apply if the partner materially participates in the partnership trade or business. Similar rules apply to an S corporation shareholder or partner who realizes a net gain on the sale of such shareholder’s S corporation stock or of such partner’s partnership interest.

Special rules treat income on investment of working capital and income from a trade or business of trading in financial instruments or commodities as net investment income.

Net investment income does not include any distribution from a qualified plan described in Sections 401(a), 403(a), 403(b), 408, 408A or 457(b) of the Code or any item taken into account in determining self-employment income on which the 3.8% medicare tax of Section 1401(b) of the Code is imposed.