“Net Investment Income Tax” is Hitting More Taxpayers … Americans Abroad Really Feeling the Pinch

The 3.8% Medicare surcharge, more commonly called the “Net Investment Income Tax” or (“NIIT”), was enacted to help fund “Obamacare” health coverage. It is imposed on “high wage earners” but because the NIIT thresholds are not subject to inflation, the rules are now grabbing more and more taxpayers. President Biden’s Green Book proposals if enacted into law would mean an even greater expansion of the NIIT’s reach since the proposals drag certain active business income into the net.  Many people are confused about the NIIT and there is even greater confusion because the NIIT rules contain nuances with regard to Americans working overseas, those owning certain foreign corporations and so-called nonresident alien individuals (NRA).

Let’s start with some basics:

What is the NIIT / 3.8% Medicare Surcharge?

The NIIT is, broadly speaking a 3.8% surtax on “net investment income” which applies only to certain high-income individuals. We will discuss very soon, precisely to whom the NIIT applies.

What is “Net Investment Income”?

Net investment income must be distinguished from “earned” income (earned income is earned through one’s labor or services or because one is actively involved in a partnership or business). Investment income includes interest, dividends, capital gains (this includes net capital gain from the sale of a residence that exceeds the exemption of $250,000 for single filers and $500,000 for joint filers), annuities, royalties and passive rents as well as income from businesses, such as trading of financial instruments and commodities and businesses that are considered “passive” with respect to the taxpayer.

Certain income is exempt from the NIIT: distributions from qualified retirement plans (e.g., an employer-sponsored defined benefit plan, profit sharing plan, money purchase plan, Employee Stock Ownership Plan, a so-called 401(k), 403(b) or 457(b) plan). Also exempt are distributions from an IRA or tax-exempt municipal bond – so, distributions from one’s Roth or regular IRA, for example, will not be hit with the NIIT.

These exemptions from the surcharge make good economic sense. Congress does not want to discourage taxpayer’s from investing in their own retirement planning since the Social Security scheme is in obvious turmoil. It also does not want to discourage taxpayers from investing in municipal bonds, since these debt obligations which are issued by states, cities, counties and other governmental entities, use the money for projects such as building schools, roadways, and other projects for the public welfare.  As such, these items are not subject to the NIIT.

What is Net Investment Income for Shareholders in a Controlled Foreign Corporation (CFC) or Passive Foreign Investment Company (PFIC)?

The calculation of net investment income for the NIIT takes into account income attributable to investments in foreign corporations that are CFCs or PFICs. Net investment income includes dividends and gains from dispositions of stock of a CFC or a PFIC.  This becomes quite complicated because shareholders of CFCs and PFICs are subject to special anti-deferral legislation. Very broadly, the anti-deferral rules generally require US investors in a CFC or PFIC to pay US income tax on certain undistributed income of the foreign corporation. When these earnings that were previously taxed are then later distributed to the shareholder, he is permitted to exclude the distribution from taxable income. This prevents double-taxation. In other words, the US shareholder is not required to pay income tax again when he receives the actual distribution of the earnings, since they were taxed previously to him as undistributed income under the anti-deferral CFC or PFIC legislation.

How does this work in the case of the NIIT?  How is the previously taxed CFC or PFIC income treated under the NIIT rules? Under the NIIT rules, the US shareholder is allowed to make an election to include the undistributed income from the CFC or PFIC in his net investment income for the 3.8% NIIT in the year in which the US shareholder pays US income tax on that CFC or PFIC undistributed income. This election enables the shareholder to treat the undistributed income from the CFC or PFIC consistently as taxable income for both regular US income tax purposes and for purposes of the NIIT. If the election is not made, there is inconsistency in the tax treatment for the different tax years involved – e.g., the shareholder is required to pay the 3.8% NIIT in the year he gets the actual distribution from the CFC or PFIC. This actual distribution, however, is excluded from regular federal taxable income on his tax return because it was previously-taxed as undistributed income in an earlier tax year under the PFIC or CFC regimes. Messy (and nit-picky)!

Who is Subject to the NIIT?

Not everyone will be subject to the NIIT, but more and more taxpayers are being hit with the NIIT due to inflation since the thresholds outlined below, are not indexed for inflation.  Two basic requirements must be met for the NIIT to apply.  A taxpayer must have: 1) Net Investment Income and 2) modified adjusted gross income (“MAGI”) over certain applicable thresholds.  MAGI is discussed later. The MAGI thresholds are set out in the chart.   Even if a taxpayer is exempt from Medicare taxes, he may still be subject to the NIIT. Very simply, NIIT applies if the taxpayer meets 1 and 2, above.

Filing Status	MAGI Threshold Amount
Married filing jointly	$250,000
Married filing separately	$125,000
Single	$200,000
Head of household (with qualifying person)	$200,000
Qualifying widow(er) with dependent child	$250,000

What is MAGI for purposes of the NIIT? – Special Considerations for Overseas Americans or Those With Foreign Shareholdings

The 3.8% NIIT is imposed on the lower of the taxpayer’s net investment income or the excess of MAGI over the income thresholds. MAGI is the taxpayer’s adjusted gross income (see Form 1040, Line 11). For Americans overseas to determine MAGI, they must add back all foreign earned income / foreign housing amounts that were excluded under Section 911 of the US Internal Revenue Code.  In the case of taxpayers with income from controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs), they may have additional adjustments to their adjusted gross income, as discussed above.

No NIIT for NRAs

Nonresident alien individuals are specifically exempt from the 3.8% NIIT. This is important, for example, for the nonresident alien owning investments or properties in the US and earning passive rents, dividends or capital gains with respect to the properties. Specific rules apply for dual-status individuals and those making a special election to be treated as a US “resident” for tax filing purposes. The IRS FAQ at number 5 gives further information. It can be accessed here.

“Covered Expatriates” and NIIT

Certain individuals (“covered expatriates”) who give up their US citizenship or their green cards are subject to the so-called “exit tax” imposed under Section 877A of the Internal Revenue Code (Code).  My blog post here provides all the details about expatriation, exit tax and other consequences that befall the individual who qualifies as a “covered expatriate”.  The exit tax is what is known as a “mark-to-market” rule.  Under this rule, the individual is subject to tax on the net unrealized gain on all of his worldwide assets as if such property were sold for its fair market value on the day before the expatriation date. Thus, the individual must pay US income tax on gain (typically, capital gain) that he is “deemed” to have earned by operation of the exit tax rules, when in fact, the individual has not sold anything and is without any cash in hand to pay the tax.  In other words, the law “pretends” the individual has sold all of his assets and tax will be owed on the “pretend” gain, if any.   The NIIT can also apply to this “pretend” gain.  Nowadays it has become much easier to be treated as a “covered expatriate” since one can be treated as “covered” if the individual has a net worth of USD2 million or more. This amount is not indexed for inflation and would impact the typical expatriate who owns a home with significant equity, and has savings and/or a pension.

Do I Need to Worry About Estimated Taxes for NIIT?

In a word, YES!  (Really, is there anything you need NOT worry about when it comes to taxes?)  Taxpayers who expect to be subject to the NIIT should adjust their income tax withholding or estimated tax payments to cover themselves for the tax increase to avoid underpayment penalties.

Can I Use My Foreign Tax Credits to Offset NIIT?

Sadly, no, you may not. This is because of a very technical reason due to the way the US Internal Revenue Code is structured.   However if  a taxpayer uses foreign income taxes as an income tax deduction on the tax return, (as opposed to taking them as a tax credit), some (or all) of the deduction amount may be deducted against one’s net investment income. This should be discussed with an experienced tax advisor.

Where Can I Find Additional Information About the NIIT?

The IRS has issued FAQs about the NIIT which can be accessed here.

Listen to the podcast with attorney John Richardson on the NIIT and its impact on the American abroad.  The podcast brings to the fore how the American overseas is treated so much worse than his or her US counterpart when it comes to the NIIT … in fact, the American citizen abroad is even treated worse than the foreigner when it comes to NIIT.  As mentioned above, Congress  permits foreign persons with US investment income to escape the NIIT regime entirely.

Posted July 27, 2023

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