The Net Investment Income Tax, which was included as part of the Affordable Care Act, will be hitting taxpayers and practitioners alike this coming tax season.
One of those practitioners is David Kirk, executive director of personal tax services in the National Tax Department of Ernst & Young LLP in Washington, D.C. He brings a unique perspective, having worked at the Internal Revenue Service as an attorney in the Passthroughs and Special Industries division of the Office of Chief Counsel helping develop the forms and instructions to implement the tax before joining EY in March. The IRS recently finalized Form 8960 used for filing the NITT and the associated instructions.
The NIIT, which took effect Jan. 1, 2013, subjects taxpayers with incomes over $200,000 per year ($250,000 for married taxpayers filing jointly) to an extra 3.8 percent tax on the lesser of their net investment income, or the amount by which their modified adjusted gross income exceeds the applicable threshold.
“I was brought on to the NIIT project in November of 2010, so I’m looking at four years of my life that I’m not getting back,” Kirk joked in an interview last month with Accounting Today. “From the moment I started, it ended up taking two years, two weeks and two days for the proposed regs to come out. Those were 159 pages, and then 50 weeks later there’s the final regs, with the companion package that came out totaling 300 and some odd pages. What I could speak to is what we did up until February 28, which is when I left, so I’m not really privy to what they’re doing anymore. But I can tell you how it developed and give you a perspective on the form. We designed the form on an Excel spreadsheet. Then we sent it to Production to have them put it in form style, where it gets assigned an OMB [Office of Management and Budget] number, it gets assigned an order to put it in a tax return.”
The IRS Chief Counsel and Treasury help develop rules for the tax, while other parts of the IRS have the job of administering the NIIT, as well as developing the necessary forms, publications and instructions.
“Within a few months of getting the project, we started to assemble a team,” Kirk recalled. “Because everybody is so compartmentalized, we had to get the computer programming people for e-file and we had to get forms and instructions people, and we had to get the auditors and the examiners. Because it was health care related, the health care people had to be involved. So it was hub and spoke. Every little constituency had to be represented because the last time there was a brand new tax system that rolled out was in the late ’70s with the AMT [alternative minimum tax].”
He pointed out that even the generation-skipping transfer tax, or GST, layered on top of the existing estate and gift tax system. The NIIT represents a new tax system in the sense that it has own set of taxpayers, tax rate and tax base.
“The idea is we had a brand new system on our hands, and it was up to us as sort of the ivory tower to build out the infrastructure,” said Kirk. “If you think of a system as a building, you would have the architects come in and build and make sure that the structure itself is sound, and then you would have the interior designers come in, and make sure that the experience of the building, the usability of the building, makes sense and is functional, it flows, it works with the existing environment. You can see how on a major project that would work. We view Chief Counsel and Treasury as the architects of it, and at the same time Chief Counsel plus the IRS were the interior designers working with how the form works because that’s how people are going to interface with the system. They’re not going to interface with the studs in the walls or with the I-beams. They’re going to interface with how the system operates. I was kind of dead in the center of it all, because I ended up designing the forms, but it wasn’t just me. You can’t do anything with just one person. It requires an army. Writing the instructions, writing the forms, how do we bolt this on to an existing system without changing the existing system so much that it would cause disruption? We had gotten comments asking what is this going to look like for pass-throughs, partnerships and S corps? Are they going to have to issue a second Schedule K-1 to everybody because you have a different base on it? In other words, what is NII and what is not? Are you going to duplicate everything? That’s what AMT has done, intentionally or unintentionally. You can see the tax returns doubling in size. The IRS’s goal was to not do that.”
In a sense, the IRS wanted to do as little harm as possible to the existing tax system, but it still needed to be able to generate enough revenue to meet the projections from Congress’s Joint Committee on Taxation for funding the Affordable Care Act.
“It absolutely is do no harm,’” said Kirk. “If you look at who’s affected by this, you have maybe 3 million people with 1040’s. If you look at the revenue mark for this tax, it clocks in somewhere around $200 billion over six years [according to estimates from Congress’s Joint Committee on Taxation]. But it doubles between now and the end of the estimation period of, I think, 2019. There are a couple of reasons for that, I would suspect, though I was never part of the estimation. One, the brackets or the threshold amounts for individuals over $200,000 and married couples over $250,000 are not indexed for inflation the same way AMT wasn’t indexed for inflation, so you’re going to inflate your way into it. And the other piece is that as people start burning through their capital losses that they have from the Great Recession—and if you’re just the average two-earner couple with a stock brokerage account, you probably have some capital losses that are sitting on your Schedule D from bad years—well, if you’re just your average guy who holds mutual funds and gets capital gain distributions over a series of years, you’ll eventually whittle that away and then at that point your capital gains are going to start ticking up. And that’s one of the elements of the NII base. So when you add the inflating your way into it with that aspect burning out, you can kind of see, OK, maybe this is why they envisioned the revenue doubling because the tax rate is not going to double, so that means more people must be in it.”
The IRS wanted the system to be usable by taxpayers—along with tax professionals—and relatively easy to administer.
“Designing the system, the main goal of the Service—at least this was my goal, being in the center of this all—was to make it administrable and usable, for the two-earner couple that will do it on computer software at their kitchen table, and also the people with the $60 million AGIs that are the titans of their industry,” said Kirk. “That the average person that has this type of income, whether they’re two young professionals or whatever, can do it by themselves, and at the same time not be so easily manipulable by the higher echelons of the socioeconomic stratosphere, that it would cause the people in the rank and file to not believe that the system has any integrity. Generally that is the goal of tax administration generally, that it’s fair, it’s equitable, that no one can abuse the system too much. So that’s what we tried to do.”
Now that Kirk is on the other side of the fence, dealing with the NIIT at Ernst & Young, he is seeing that the tax is not so straightforward after all.
“I think that there are growing pains for the year,” he admitted. “I mean, this year was the first year that people are seeing this. Everybody involved is going to have some growing pains. Even us, dealing primarily with the higher end of the scope of people, are having to almost relearn tax, about how mechanically things work, because the rules for Net Investment Income are based off of what the mechanics are of the regular income tax system. We need to understand how those mechanics work. But at the same time, we have seen, and being part of the AICPA, we’re seeing it from other areas, that the software people are learning as well.”
Kirk pointed to the seeming simplicity of the form itself. “It was a one-page form, with 12 lines, to compute Net Investment Income, but it is a lot more difficult to compute than just 12 lines,” he said. “The idea was to make it only 12 lines so that it is not overly intimidating for the people doing it at their kitchen table. That was our [way of] trying to balance it. We could make it look like a six-page form, but that would be too daunting for the middle-class folk that tend to be coming up against the [$200,000 per year for individuals and $250,000 for married couples threshold].”
In contrast, the instructions are 20 pages long for Form 8960. “The instructions were actually very difficult to write because we have 300 pages of regulations that are hyper-technical,” said Kirk.
The instructions also had to be written to achieve a certain level of readability to make it understandable in plain English.
“It has to be consumable, it cannot be overly technical, it cannot be littered with citations,” said Kirk. “That was the hard part, translating this incredibly complicated system into 20 pages that are consumable by the masses. We got both compliments and criticisms about it. That’s what you expect. But at the same time, the compliments and criticisms were saying the same thing, that it’s 20 pages. Because in order to really do it and fully explain it, you’re probably at 50 pages, but then that’s not consumable. So that was a very tough thing that we struggled with.”
Now that he is at EY, he can see how taxpayers and practitioners are dealing with the brand new tax.
“It’s kind of like releasing your baby into the world, pushing it out and seeing how it goes. Hopefully it doesn’t fall off a cliff,” said Kirk. “That was sort of my time to come out and see how it’s being applied. Landing at EY was the place to see if it actually works. So it’s been really rewarding, being here, to see how it works.”
Working at EY, he sees a few adjustments that could have been made back at the IRS.
“I’d almost, if I could, want to go back into the Service for just a couple of months, just to fix some things that I’ve seen on the outside that could be better clarified and improved, areas that I’ve gotten too many questions on,” said Kirk. “I’m still in contact with the people I’ve worked with in the past on this project, and I’ve sent them suggestions, but now I’m just a regular CPA. I’m just like anybody else that calls in with an idea or a question or a suggestion.”
At EY, Kirk is more likely to deal with high-income taxpayers than the average Mom and Pop at the kitchen table, but he still feels a responsibility to make sure the tax works correctly.
“The problem for me is that I still have to sit at Thanksgiving dinner with my in-laws,” he joked. “So if I screw that up, then I’ve got bigger problems than the guy with the $60 million AGI. So I worried about making that work for them as much, because they know where I live. Just because you have a $60 million AGI does not mean automatically that you are more complicated. Your $60 million could be a W-2. Granted, that’s a very nice W-2. I would very much like to have such a thing. Or it could just be interest and dividends. You could be a massive shareholder in a single company that pays dividends and you could have that, or a giant bond portfolio. That does not make you complicated. But it’s some of the people that have all of these pass-through interests that when one partnership is good, four is better, or 16 is better. And that’s where it gets complicated.”
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