3.8% Net Income Tax Question

[RWG1950]

I'm a little confused on how to apply certain deductions against NIT income. The IRS instructions are clear as mud to me.
Customers (MFJ) have about $ 282K of MAGI. Mainly pension & IRA but enough interest, dividends & cap gains to create about $ 126K of invest income.
Their form 8960 (without any subtractions) shows about $ 1,200 in NIT.
TTB P.P. 6-8 (and other sources) seem to say state & local income taxes (line 9-b of form 8960) & tax prep fees (line 9-c) reduce the taxable amount of NIT.
Does this mean such taxes & expenses paid in 2021 can be entered directly on these lines of form 8960 and be used to reduce the amount subject
to the 3.8% or is some sort of pro-ration involved ? Thanks for comments

[Lion]

Does your software generate a worksheet for Lines 9 & 10? Pro-ration sounds like a good description.

[Rapid Robert]

"The IRS instructions are clear as mud to me."

Form instructions:

Reasonable method allocations. To the extent that you have a properly allocable deduction that’s allocable to both net investment income and excluded income, you may use any reasonable method to determine that portion of the deduction that’s properly allocable to net investment income. The three items that may be allocated between net investment income and excluded income are the following.
• State, local, and foreign income taxes if properly deducted on your return when calculating your U.S. regular income tax.
• All ordinary and necessary expenses paid or incurred during the tax year to determine, collect, or obtain a refund of any tax owed if properly deducted on your return when calculating your U.S. regular income tax.
• [fiduciary stuff]

Note that the IRS says to be allocable in the first place, the expense must have been "properly deducted on your return when calculating your U.S. regular income tax". I don't agree with the IRS position, and wish I had a chance to take it to tax court.

True story: in 2018, first year of TCJA, my software (UltraTax) originally allowed an allocation for the full amount of state income tax, as had been the case in previous years. However, in mid-season, an update was issued with the following statement:

"Form 8960, Net Investment Income Tax – Individuals, Estates, and Trusts, line 9b will now calculate the State and local income taxes allocable to net investment income based on the limited State and local amount from Schedule A, if applicable. Returns completed prior to this update containing Form 8960 and state and local income taxes should be reviewed."

I had filed a return prior to this update, allocating the full amount of SALT, and it was not amended and the IRS never contacted the taxpayer about it, and I don't feel the least bit bad about it.

My position is that the SALT limitation only applied to regular tax. The NII tax, along with (for example) AMT and SE tax, is actually a parallel tax system to the regular tax, in fact NII tax is in a separate chapter or sub-section or whatever you call it of the tax code. So I do not agree that the SALT limitation applies to the allocable amount of state income tax allowed as a deduction against net investment income, because the law does not explicitly say so, at least not that I could find anywhere.

[RWG1950]

Thanks Robert. So are you saying that their State & Local tax paid can be prorated between investment income and regular income and used
as an 8960 subtraction, even though my customers had used the standard deduction ? What about the fees they paid to their financial advisor
and my tax prep fee ?

[Rapid Robert]

No, I'm saying the IRS position is that you can only allocate expenses that were "properly deducted on your return when calculating your U.S. regular income tax". With a standard deduction, no such expenses were "properly deducted", so no allocation for NII tax. And even with an itemized deduction, you would first have to apply the SALT deduction limitation and the elimination of misc-2%-AGI deductions before allocation.

[Rapid Robert]

"in fact NII tax is in a separate chapter or sub-section or whatever you call it of the tax code."

OK, maybe I finally found it (although I did not when I searched back in 2018).

?1411(c)(1)(B).

I still say, bah humbug.

EDIT: maybe here is the real question, that I have since recalled.

Why is the $10K SALT limit applied before allocating to NII expense? Why don't we allocate the full amount of SALT to NII, and then take the $10K SALT limit into account for the deductible amount?

[Rapid Robert]

Or how about this:

The form instructions state, "State, local, and foreign income taxes if properly deducted on your return when calculating your U.S. regular income tax.". Well, the full amount of state tax was properly deducted (and officially disclosed per regulation) on Schedule A, but because of TCJA it was simply not "taken into account" for purposes of Sec 164. "Not taken into account" is not the same thing as "disallowed".

[rbynaker]

Why is the $10K SALT limit applied before allocating to NII expense? Why don't we allocate the full amount of SALT to NII, and then take the $10K SALT limit into account for the deductible amount?

This is a programming choice. Drake and ProSeries take different approaches to this calculation. IMO, applying the SALT cap AFTER the allocation still constitutes a reasonable method. TCJA did not provide any sort of ordering rules as to which taxes are deducted once the $10K limit is reached. As long as your NIIT state tax expense allocation does not exceed $10K, I think you can be aggressive about this.

Rick

[RWG1950]

After studying this a little further, it appears to me that the subtractions asked about in my post (almost no matter what amount I'd be using) would
have no effect on the NII tax because the tax is applied to the lesser of net investment income or the excess of MAGI over the threshold amount.
The latter amount apparently will apply in this case because of the large amount of int, div & cap gain distributions involved, relative to the
amount of MAGI that would be in excess of the $ 250K threshold.