How the Net Investment Income Tax Can Bite Your Clients, and How to Get Them Prepared

If there is one thing that all CPAs can agree upon, it is that the 2014 tax return filing season was one of the most strenuous that any practitioner has seen in their career. Between rate increases, the imposition of new taxes, and the reinstatement of the Pease limitation, it was interesting to say the least, especially with the included task of explaining the interrelation of these changes on each client’s tax position to them.

By now all practitioners have read volumes of articles and editorials related to IRC section 1411 or the net investment income tax (NIIT). However, now that the season is over it is important to take a look quick look back at one illustration and see what the implications of the tax law changes were and what we can do as practitioners in the future.

The following is an actual illustration. Mr. and Mrs. Smith, are a retired couple with significant investment assets. These assets are the only source of income that they use to support their lifestyle. They had similar sources and amounts of income and deductions in 2013 as in 2012, however, for ease of comparison, we are going to assume the same amounts for both years.

	2012	2013
Interest	7,187	7,187
Tax Exempt Interest	97,303	97,303
Dividends	44,703	44,703
Qualified Dividends	2,695,140	2,695,140
Net LT CG	4,560	4,560
Pass Through (passive)	(21)	(21)
Social Security	30,195	30,195
AGI	2,781,764	2,781,764

Gross Itemized Deducitons	(371,413)	(371,413)
Phase-Out	–	74,453
Exemptions	(7,600)	(7,800)
Phase-Out	–	7,800
Taxable Income	2,402,751	2,484,804

Qual Div/Net LTCG	349,808	463,586
AMT	56,542	58,979
Foreign Tax Credit	(10,338)	(10,338)
3.8% Sur Tax	–	96,207

Net Federal Tax	396,012	608,434

Effective Rate	16.48%	24.49%

As you can see from the table above, the only real changes before taxable income are the limitation of itemized deduction due in part to the reinstatement of IRC section 68 (Pease limitation) and the limitation of exemptions. The limitation for exemptions is calculated by reducing the total amount of exemptions by 2% for each $2,500 adjusted gross income that exceeds a specific threshold.

Due to the composition of the income, the majority of the income is being taxed at the long-term capital gain rate, which increased from 15% to 20%, mainly from qualified dividends. This source of income caused the increase of tax, whether it was from the 5% increase in the long-term capital gain rate or the 3.8% net investment income tax. Overall, with the same amount of income and deductions, the client saw a $212,422 increase in tax from the prior year – essentially an 8% increase in the overall effective tax rate. The problem here is not the math, but explaining the outcome to the client.

The goal of this article is not to provide a brief reexamination of the new tax laws during 2013; its real purposes is to provide insights on what tax practitioners should be doing. The job of the tax practitioner is not merely to put numbers on a form, it is to work with the client, throughout the year, to provide updates and insight related to their tax position for the current and future years.

Doing so can be accomplished with tax planning and communication. Being proactive can mean the difference. The first place to start this process is communication with the client regarding their expectations of income and deductions. Further communication may be needed with brokers, wealth advisors, and/or controllers of privately held businesses to provide a clearer picture as to the potential income or losses. Once the necessary information is obtained, it should be merged into a consolidated tax projection. This is where

the knowledge of the tax practitioner is used to develop strategies and work with the client’s other advisors. Looking at the projection, one should consider what the main sources of income are and the categories of those sources (passive, nonpassive, investment, capital gains, or ordinary income, etc.)

Using the example above of Mr. and Mrs. Smith, the vast majority of their income is from qualified dividends. Working with their wealth advisor, it would make sense to see if there was a different type of investment vehicle available that could produce the same return (whether realized or unrealized) and reduce their potential tax liability for future years. While talking with the investment advisor, it was discovered that in the next year there would be large capital gains from the liquidation of securities.

Like most high net worth individuals, this couple has multiple investment accounts with different brokers. By communication with the others wealth advisors, the client will be able to offset the capital gains with capital losses. Thinking about this technique, but in reverse, if the client is expecting large capital losses, harvesting gains and then repurchasing the same securities will provide the client with a “step-up” in basis but not change their position in the securities. This would be beneficial to offset capital gains in the future that would be subject to the NIIT.

Another potential planning opportunity is if the client is charitably inclined. The most tax efficient way to give to charity is through the contribution of appreciated securities. The client will get a deduction for the fair market value of the security on the date of transfer while not incurring the gain and thus paying tax.

Once the tax practitioner has adjusted the tax projection based upon input and collaboration from the client’s other advisors, the most important aspect is to communicate the results with the client. Remember that with tax planning and communication, the key is to be proactive with the client. While this all may seem simple, sometimes the simplest ideas can go a long way.

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Chris Budd is a Tax Supervisor with Keiter in Glen Allen, Virginia. He shares his tax consulting and compliance insights with clients in a variety of industries with a focus on the real estate industry. Chris also provides tax services to the Firm’s high wealth individuals.