Clients ask tax advisors to compare alternatives by illustrating the net tax effect of the choices available to the client. In order to compute the tax effect, one must assume a certain tax rate to use in the calculation. There are times, such as now, when the choice of a tax rate is not readily apparent.
§1411 imposes a new 3.8% tax on unearned income applicable to individuals, estates and trusts. This tax is not imposed on non-resident aliens and charitable trusts exempt from tax. A good deal of effort will be required to understand the definition of unearned income subject to this new tax and to calculate its impact.
The computation requires advisors to calculate Modified Adjusted Gross Income (MAGI) and Net Investment Income (NII). NII is comprised of (1) passive investment income (dividends, rents, interest, annuities, royalties), (2) income from passive activity or trading financial investments or commodities, and (3) gains from the disposition of property, including assets held by pass-through entities. The §1411 tax has even caught the sale of a personal residence in its trap.
Taxpayers and advisors will need to revisit the passive loss rules, tabulate hours to satisfy material participation and allocate expenses among activities in order to mitigate the impact of §1411. There is, however, one more indirect benefit worth your attention.
The United States Treasury has given taxpayers a one-time opportunity to revise its grouping of activities under the passive loss rules in response to the imposition of tax under §1411. Prior to this year, Rev. Proc 2010-13 required the taxpayer to explain to the IRS why the previous grouping was inappropriate, an explanation that taxpayers were hesitant to provide. Now, taxpayer’s have an opportunity to arrange their groupings in a manner that will minimize the impact of the 3.8% tax and correct any past mistakes.
The opportunity to revise groupings without seeking permission will permit some taxpayers to better utilize losses from active and passive sources.