Are You Subject to Net Investment Income Tax? Are You Sure?

If you are a hedge fund or individual who owns or has an interest in an offshore corporation, you might be subject to the new net investment income tax.

The net investment income (NII) tax was enacted as part of the 2010 healthcare reform legislation, and it went into effect on January 1, 2013. U.S. persons (as defined by the Internal Revenue Code) with adjusted gross income exceeding $200,000 (or $250,000 for taxpayers filing jointly) are subject to the additional 3.8% surtax on net investment income. NII includes interest, dividends, annuities, rents, royalties and gains from the sale of property, but many taxpayers don’t realize it also includes income resulting from a direct or indirect investment in a controlled foreign corporation (CFC) or passive foreign investment company (PFIC).

How is net investment income tax calculated?

The 3.8% NII tax is calculated on the lesser of 1) the amount that the taxpayer’s modified adjusted gross income exceeds the threshold (see above) or 2) the amount of the taxpayer’s net investment income.

NII consists of three categories of income:

1. Gross income from interest, dividends, annuities, royalties and rents;
2. Gross income derived from a trade or business that is either a passive activity or a trading business;
3. Net gain attributable to the disposition of property.

U.S. persons who are subject to the net investment income tax are required to file Form 8960 with their federal income tax return.

What is a controlled foreign corporation?

A CFC is any foreign corporation in which:

1. U.S. shareholders own more than 50% of the total combined voting power of all classes of stock entitled to vote on any day during the taxable year of such foreign corporation; or
2. U.S. shareholders own more than 50% of the total value of the stock on any day during the taxable year of the corporation.

Income that is subject to tax from a CFC is referred to as Subpart F income.

What is a passive foreign investment company?

A foreign corporation is a PFIC if it meets either the income test or asset test.

The income test requires that 75% or more of the corporation’s gross income for its taxable year is passive income. The asset test looks to see if at least 50% of the average percentage of assets held by the foreign corporation produce passive income or are held for the production of passive income. Passive income for PFIC purposes is generally defined as gross income from dividends, interest, royalties, rents, and annuities and the net gain from the sale or exchange of property.

PFIC income is reported on an individual’s tax return in, generally, one of three ways:

1. As current income under a qualified electing fund (QEF) election;
2. As current income under a mark-to-market election; or
3. When distributions are received.

The rules can be complex and create an administrative burden when investing in a controlled foreign corporation or a passive foreign investment company with a qualified electing fund election. A tax professional can help guide you through these complexities.

How does the NII tax affect investors and traders?

The net investment income tax will have a significant effect on investors, hedge funds and fund managers. The surtax applies to investment income, which typically represents most of a hedge fund’s income.

It’s important to determine whether the individual or entity making the investment is considered to be a “trader” or an “investor” for tax purposes. A trader receiving current QEF and/or Subpart F income is subject to the net investment income tax during the current year. However, an investor’s income would get hit with the NII tax at the time cash is actually received. The latter situation may create a timing difference between the regular individual income tax and the NII tax. Taxpayers could be required to keep separate sets of records to track the basis and income inclusion for both regular and net investment income tax purposes. Tiered partnership structures could make the reporting more arduous.

The “G election” eliminates the timing differences by allowing the taxpayer to include the net investment income simultaneously with the regular income tax inclusions. Although this alleviates the burden of having to keep separate sets of records to track the basis and income, it accelerates the income subject to the NII tax.

Taxpayers can make the election on a per-entity basis. With a partnership, for the 2013 tax year, all partners must consent to the G election. The tiered partnership structure also requires consent from the indirect partners. The G election is irrevocable, applying in the current year and all subsequent years.

To learn more about the net investment income tax and investments in foreign corporations, contact us.