The ACA investment tax: How will it affect you?

A new tax as a part of the Affordable Care Act may mean you will owe more in taxes, and with tax season in full swing, now is the time to figure out just how much more you could be made to pay.

The Health Care and Education Reconciliation Act has presented us the Net Investment Income Tax, referred to by many as NIIT or the super Medicare tax. This tax exposes the net investment income of individuals, estates and trusts to a 3.8% tax when their modified adjusted gross income exceeds certain threshold levels.

These levels are: $250,000 for married individuals filing a joint return, $125,000 per each for married individuals filing separate returns and $200,000 for unmarried individuals and other cases. Trusts and estates have a much lower threshold for when this tax applies. This new tax is creeping up on many and there could be unpleasant consequences for those that don’t comply.

This new tax calls for taxpayers to truly understand what constitutes net investment income. The obvious components are involved — interest, dividends, annuities, royalties and rents. These are just the tip of the iceberg and if you feel as though you could be affected by the tax, you should consult a CPA immediately to understand its complexity

Interest, dividends, trusts and estates can all make their way to a taxpayer through a pass through entity and then maintain their net investment character.  The concept of “passive activity” also comes into play here. As income from passive business activities, this includes any capital gain from the sale of those activities, is generally subject to the NIIT, whereas income from nonpassive business activities generally is not.

Bloomberg BNA summarizes this concept best, explaining that it stems from the IRS’s passive activity loss rules, which prohibit taxpayers from deducting losses from so-called passive activities, or activities in which the taxpayer does not materially participate. These guidelines usually apply to the actions of the owner of the business interest, not the business itself, although special rules apply to real estate activities. When is your interest in a business not to be a passive activity? Again, according to IRS rules and regulations, you must materially participate in the operations of the business. Meaning, your involvement in the business operations is regular, continuous and substantial. The IRS regulations provide both quantitative as well as qualitative tests for meeting this requirement. For example, you will be materially participating if you work more than 500 hours during the year in the business.

Because the IRS passive activity rules apply to restrictions on deducting losses, taxpayers with positive income from passive activities may have had little reason to differentiate those activities from nonpassive activities. However, the distinction might become significant. For example, the IRS has rules that have allowed taxpayers to “group” related activities in order to determine whether the overall group represents a passive or nonpassive activity. Taxpayers with multiple business or real estate investments might be able to eliminate or reduce their exposure to the NIIT with appropriate decisions in this area.

In regards to those who farm, there are important things to be aware of when it comes to this new tax. For instance, income from hedging activity or hedging income from a pass through entity may not be subject to the NIIT, in the event that they are engaged in the trade or business of farming and not the trade of business of trading in commodities. In order to not be subject to the NIIT, the commodity trading activity must be in line with the definition of hedging. This is just one example of how farmers will have to navigate the NIIT. What is and isn’t subject to the tax is something that should be determined by a trusted CPA, with experience in agribusiness.

Knowing the ins and outs of this new tax could result in a large savings for many taxpayers. Don’t wait until your return is prepared to learn how this new tax will affect you. Contact a tax professional today that is already well versed on NIIT.

Justin is a CPA and a Certified Financial Planner. Farming is in Justin’s blood, he grew up on a farm and has vast knowledge of everything from grain handling to farm ownership. A farm manager himself, Justin understands the needs of those who work in agribusiness. Justin is also well-versed in the areas of tax, manufacturing, professional services and family/closely held business. He can be contacted at 614-494-5300 or holbrookmanter.com. Holbrook & Manter is a professional services firm founded in 1919 in central Ohio.