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NEW MEDICARE TAX IMPACT ON BUSINESS PLANNING FOR CLOSELY HELD
COMPANIES
First Run Broadcast: January 3, 2013
Live Replay: April 26, 2013 1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes)
The new health care law imposes a new 3.8% Medicare tax on certain business and investment
income. The tax will apply to distributions from pass-through entities – LLCs, S Corps,
partnerships –and have a direct and substantial impact on all closely-held companies. Certain
planning techniques to avoid application of the new tax can have the effect of triggering the self-
employment tax. The tax will also change the economics of buying, selling and exchanging
interests in closely held companies. In short, the new tax fosters many new planning traps. This
program will provide you with a practical framework for understanding the new tax, how it
impacts closely-held business planning, distributions and sales, and cover strategies for
minimizing the tax.
Framework for understanding how the new Medicare tax works impacts closely held
businesses
Application of new tax to salaries and distributions from partnerships, LLCs, S Corps and
C Corps
Complex interrelationship of self-employment tax and the new Medicare tax – how
avoiding one, triggers the other
Effect of new Medicare tax on real estate and other passive investments and businesses
Planning for the sale of interests in LLCs, S Corps and partnerships
Sophisticated strategies for avoiding impact of tax
Speakers:
Alson R. Martin is a partner in the Overland Park, Kansas office of Lathrop and Gage, LLP,
where he has a national practice focusing on business law, taxation, health care, and retirement
plans. He is a Fellow of the American College of Tax Counsel and the American College of
Employee Benefits Counsel. Mr. Martin is the author of "Limited Liability Companies and
Partnerships" and the co-author of "Kansas Corporation Law & Practice (Including Tax
Aspects)." He is the president and a director of the Small Business Council of America. Mr.
Martin received his B.A., with highest distinction, from the University of Kansas, and his J.D.
and LL.M. from New York University School of Law.
Thomas J. Nichols is a partner in the Milwaukee, Wisconsin office of Meissner Tierney Fisher
& Nichols S.C, where he has more than 30 years’ experience in business and federal and state
tax planning for companies of every size. He has extensive experience in income, self-
employment and estate and gift tax planning for business clients. He formerly served as chair of
the S Corporation Committee of the ABA Tax Section and as chair of the Partnership Committee
of the State Bar of Wisconsin’s Business Law Section. Mr. Nichols received his B.A. from
Marquette University and his J.D. from Marquette University Law School.
PROFESSIONAL EDUCATION BROADCAST NETWORK
Speaker Contact Information
New Medicare Tax Impact on Business Planning forClosely Held Companies
Thomas J. NicholsMeissner Tierney Fisher & Nichols S.C. – Milwaukee, Wisconsin(o) (414) [email protected]
Alson R. MartinLathrop & Gage, LLP - Overland Park, Kansas(o) (913) [email protected]
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New Medicare Tax Impact on Business Planning
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2013 Medicare Taxes For Investors, Business Entities & Their Owners,Trusts & Estates
Alson R. MartinLathrop & Gage LLP
10851 Mastin BoulevardSuite 1000
Overland Park, KS [email protected]
TABLE OF CONTENTS
Page
© Alson R. Martin 201319715466v1
I. 2012 FICA, SECA & MEDICARE TAXES .......................................................... 1
A. Wages.......................................................................................................... 1
B. Self-Employment Income ........................................................................... 1
II. Overview - 2013 FICA, SECA, and Medicare Taxes Enacted By HealthCare Reform Act; New 3.8 % “Medicare” Taxes Effective in 2013 ...................... 1
A. Wages & Self-Employment Income ........................................................... 2
B. New 3.8% ‘Medicare” Tax On Net Investment Income (“NII”) ForIndividuals, Trusts & Estates With Income Over Threshold...................... 3
C. Three Kinds Of Income In 2013 ................................................................. 4
D. Organization Of Proposed Reliance Regulations ....................................... 6
III. Definition Of Net Investment Income (“NII”)........................................................ 6
A. Proposed Reliance Regulations................................................................... 6
B. Chapter 1 Definitions.................................................................................. 6
C. Net Investment Income.............................................................................. 6
D. Other Code Provisions Apply ................................................................... 13
E. Income That Is Not NII............................................................................. 16
F. Net Earnings From Self-Employment Not Subject To NII Tax. .............. 17
TABLE OF CONTENTS(continued)
Page
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IV. SE & NII TAX CONSIDERATIONS FOR S CORPORATIONSHAREHOLDERS; NO NII OR SOCIAL SECURITY & MEDICARETAX FOR DISTRIBUTIONS TO TAXPAYER MATERIALLYPARTICIPATING IN S CORPORATION BUSINESS ...................................... 19
A. General ...................................................................................................... 19
B. Use of S Corporation to Operate Closely Held Business ........................ 20
C. S Corporation Dividend Distribution Example........................................ 20
D. Section 338(H)(10) Election By Selling S CorporationShareholders; Net Gain From Disposition Of Property – Onus OnBuyer & Seller To Allocate As Deemed Asset Sale................................. 20
V. GAIN FROM THE DISPOSITION OF INTERESTS IN PARTNERSHIPSAND S CORPORATIONS; SALE OF OWNERSHIP SAME AS IFBUSINESS SOLD ALL ITS ASSETS................................................................. 20
A. General ...................................................................................................... 20
B. Deemed Asset Sale Method...................................................................... 21
C. Multiple Trades Or Businesses In One Entity Where OwnerParticipates In One But Not Other ............................................................ 23
VI. ESTATES & TRUSTS ......................................................................................... 24
A. Overview................................................................................................... 24
B. Net Investment Income ............................................................................. 25
C. Charitable Remainder Trusts .................................................................... 27
D. Grantor Trust; Grantor Taxed On NII Unless Not NII BecauseOwner Materially Participating................................................................. 28
E. Electing Small Business Trusts (ESBTs).................................................. 28
F. Real Estate Investment Trusts................................................................... 28
G. Bankruptcy Estates.................................................................................... 29
H. Foreign Estates and Trusts ........................................................................ 29
VII. CONTROLLED FOREIGN CORPORATIONS (CFCS) ANDPERSONAL FOREIGN INVESTMENT COMPANIES (PFICS) ...................... 29
VIII. DOCTRINES THAT MAY CAUSE TAX TROUBLE FORRESTRUCTURING TO AVOID NII TAX ......................................................... 30
A. Business Purpose ...................................................................................... 30
B. Economic Substance Doctrine (“ESD”) IRC 7701(o) .............................. 31
TABLE OF CONTENTS(continued)
Page
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C. Section 269- Acquiring Control Of A Corporation With ThePrincipal Purpose Of Evasion Or Avoidance Of Federal IncomeTax ............................................................................................................ 33
D. 269A; PSC, The Principal Purpose Of Which Is To Avoid/EvadeTax ............................................................................................................ 33
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2013 Medicare Taxes For Investors, Business Entities & Their Owners,Trusts & Estates
Alson R. MartinLathrop & Gage LLP
10851 Mastin BoulevardSuite 1000
Overland Park, KS [email protected]
I. 2012 FICA, SECA & MEDICARE TAXES.
A. Wages.
1. Wages are subject to social security (“FICA”) tax at the rate of6.2% imposed on both the employee and the employer on the first $110,100 of wages($113,700 for 2013), and 1.45% (the Medicare tax) on both the employer and theemployee on wages, a total of 7.65% by each for a total of 15.3%.. Temporary payroll taxcut legislation extended a two-percentage point payroll tax cut for employees, continuingthe reduction of their Social Security tax withholding rate from 6.2 percent to 4.2 percentof wages paid through December 31, 2012.
The Revenue Reconciliation Act of 1993 repealed the dollar limit on wages and self-employment income subject to the Medicare tax. Thus, employers and employees wereeach subject to the 1.45% Medicare tax on all wages, and self-employed individuals aresubject to the 2.9% Medicare tax on all self-employment income.
B. Self-Employment Income. This tax is the counterpart for employees’Social Security and Medicare taxes for the self-employed. The self-employment tax (“SETax”) was in 2012 imposed on net earnings from self-employment (“NESE”) at the rate of10.4% on the first $110,100 of such net earnings in 2012 ($113,700 for 2013), and 2.9%(the Medicare tax) on total net earnings from self-employment. Like the FICA tax, the10.4% rate reflects the 2% reduction of the temporary payroll tax cut legislation,continuing the reduction of the total rate from 12.4% to 10.4% on NESE throughDecember 31, 2012. Excluded from the definition of NESE are certain capital gains,rental income, interest, and dividends. Self-employed individuals are entitled to an abovethe line deduction equal to one-half of the SE Tax paid under § 164(f).
II. Overview - 2013 FICA, SECA, and Medicare Taxes Enacted By Health CareReform Act; New 3.8 % “Medicare” Taxes Effective in 2013.
The 2010 healthcare reform law enacted chapter 2A of the Internal Revenue Code entitled“Unearned Income Medicare Contribution” and contains § 1411, effective for tax yearsbeginning on an after Jan. 1, 2013. This is the tax on investment income and impactsindividuals, trusts and estates. In December, 2012, the IRS and Treasury issued a series of
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proposed regulations1 and questions and answers2 for the two new Medicare taxesscheduled to begin for tax years beginning on and after January 1, 2013: (1) the 3.8%Medicare tax on unearned income (generally, a 3.8% surtax on net investment income)above a modified adjusted gross income (“MAGI”) threshold, and (2) the 0.9% Medicaretax on earned income (i.e., wages and self-employment income) for employees and self-employed individuals above MAGI thresholds. The proposed regulations are available athttp://www.gpo.gov/fdsys/pkg/FR-2012-12-05/pdf/2012-29238.pdf.
A. Wages & Self-Employment Income.
1. General. The 2010 Healthcare Reform Act increased the Medicareportion of the Medicare tax on wages and self-employment tax by .9% (to 3.8%) (the“Additional Medicare Tax”) on modified adjusted gross income in excess of a thresholdbeginning in 2013. The thresholds are the same as for the new 3.8% tax on investmentincome (see chart below) - $250,000 in the case of married taxpayers filing a joint return(or a widow(er) whose spouse died within two prior tax years with a dependent child),$125,000 for married taxpayers filing a separate return, and more than $200,000 for allother taxpayers, effective for tax years beginning after December 31, 2012. Note that theIRS FAQs incorrectly state that the income threshold for a qualifying widow(er) is$200,000, rather than $250,000. See Q&A 3, http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Tax.
2. SECA - self- employment tax on net earnings from self-employment (NESE) includes partnership distributive share unless the partner is a“limited partner” under § 1402(a)(13).
3. FICA - payroll tax on wages (1/2 employer, ½ employee). Newextra .9% is not deductible and is part of employee’s share of Medicare taxes; comparabletreatment for the self-employed. Prop. Reg. §31.3101-2(b)(2)(ii); Prop. Reg. §1.1401-1(d).
4. RRTA - Railroad Retirement Tax Act (RRTA) compensation that issubject to Medicare Tax is subject to additional Medicare Tax if it is paid in excess of theapplicable threshold for an individual’s filing status. All FAQs that discuss the applicationof the Additional Medicare Tax to wages also apply to RRTA compensation, unlessotherwise indicated.3
5. Nonresident Aliens And U.S. Citizens Living Abroad. Nonresidentaliens are not subject to the NII tax. However, nonresident aliens will be subject to the taxif they elect to file a joint return with a resident or citizen spouse under § 6013(g). Prop.
1 Preamble to Prop Reg11/30/2012; Prop Reg § 1.1411-1, Prop Reg § 1.1411-2, Prop Reg § 1.1411-3, PropReg § 1.1411-4, Prop Reg § 1.1411-5 , Prop Reg § 1.1411-6 , Prop Reg § 1.1411-7, Prop Reg § 1.1411-8,Prop Reg § 1.1411-9, Prop Reg § 1.1411-10, and Prop Reg § 1.469-11.2 http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs;http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Tax.3Q&A 5, http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Tax.
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Reg. § 1.1411-2(a)(2). There are no special rules for U.S. citizens living abroad forpurposes of this provision. Wages, other compensation, and self-employment income thatare subject to Medicare tax will also be subject to Additional Medicare Tax if in excess ofthe applicable threshold.4
6. Withholding. Employers must withhold additional Medicare taxfrom wages paid to an individual in excess of $200,000 in a calendar year, without regardto the individual employee’s filing status or other wages/compensation. Prop. Reg.§31.3102-4(a). Withholding for the new 0.9% tax is based on an individual's own actual(not projected) income, and not a couple's income, as employers do not have the right torequest income about a current spouse's year-to-date earnings. Employees who anticipatethe Medicare tax as a married couple may request additional withholding to prepare forthe tax, but may not request additional FICA/Medicare tax withholding. Instead,employees can merely ask for an increase in overall withholding that can apply for bothincome and employment tax purposes. Taxpayers who anticipate they will owe AdditionalMedicare Tax, and who did not request additional income tax withholding, may need tomake estimated tax payments; however, taxpayers cannot designate any estimated taxpayments specifically for Additional Medicare Tax.5
B. New 3.8% ‘Medicare” Tax On Net Investment Income (“NII”) ForIndividuals, Trusts & Estates With Income Over Threshold.
1. General. The 2010 Healthcare Reform Act added § 1411 to a newchapter 2A of subtitle A (Income Taxes) of the Code effective for taxable years beginningafter December 31, 2012. Section 1411 subjects net investment income (“NII”) (ratherthan income derived from labor) for the first time in the history to the Medicare tax forthose with income over a threshold amount. However, this revenue does not go to theMedicare Trust Fund. The tax on net investment income is not deductible whencomputing any tax imposed by subtitle A of the Code (i.e., income taxes).6
2. Computation & Thresholds. Section 1411(a)(1) imposes a separate3.8% tax on the lesser of (a) “net investment income” or (b) the excess of modifiedadjusted gross income (“MAGI”) over the threshold amount. For most individuals, MAGIis their adjusted gross income unless they are U.S. citizens or residents living abroad andhave foreign earned income. Individuals will owe the tax and report in on Form 1040 ifthey have Net Investment Income and have modified adjusted gross income over thefollowing thresholds:
Filing Status Threshold AmountMarried filing jointly $250,000Married filing separately $125,000Single $200,000Head of household (with qualifying person) $200,000Widow(er) whose spouse died w/I 2 preceding tax years with dependentchild
$250,000
4 Id. At Q&A 6.5 Q&A 11 and 12 at http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Tax.6
Joint Committee on Taxation, Technical Explanation (JCX-18-10), at 135.
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3. Kiddie tax investment income that is taxed on a parent’s returnfrom Form 8814 is subject to this tax.7 However, the IRS says that the calculation of theparent’s net investment income doesn’t include: (a) amounts excluded from the parent’sForm 1040 due to the threshold amounts on Form 8814; and (b) amounts attributable toAlaska Permanent Fund Dividends.8
4. The tax on NII is subject to the estimated tax provisions per theproposed regulations and Code § 1411(e)(2).9 Individuals, estates, and trusts that expectto be subject to the tax in 2013 or thereafter should adjust their income tax withholding orestimated payments to account for the tax increase in order to avoid underpaymentpenalties.10
5. Unlike the employer’s 1.45% share of the Medicare tax and thecomparable portion of the tax on NESE, no part of the tax on NII is deductible. See JCT2011 Explanation, JCS-2-11, March 24, 2011, at 364.
6. AGI &MAGI. Prop. Reg. §1.1411-1(b) provides that all referencesto an individual's adjusted gross income shall be treated as references to adjusted grossincome (as defined in § 62) under chapter 1. Modified Adjusted Gross Income ("MAGI")is AGI increased by the excess of : (1) the amount excluded from gross income under §911(a)(1) (foreign source income of the taxpayer), over (2) the amount of any deductionsfor foreign source income (taken into account in computing adjusted gross income) orexclusions disallowed under § 911(d)(6) (denial of double benefits) with respect to theamounts excluded from gross income under § 911(a)(1). Prop. Reg. §1.1411-10
7. U.S. Residency. The term “individual” for purposes of § 1411means any natural person, except for natural persons who are nonresident aliens.Nonresident aliens will be subject to the tax if they elect to file a joint return with aresident or citizen spouse under § 6013(g). Prop. Reg. § 1.1411-2(a)(2)). The treatment ofbona fide residents of U.S. territories is different depending on whether the individuals areresidents of Guam, the Northern Mariana Islands, or the U.S. Virgin Islands, who are notsubject to the tax, or Puerto Rico or American Samoa, who may be subject to the tax.Prop. Reg. § 1.1411-2(a)(2)(iv)).
C. Three Kinds Of Income In 2013.
1. Earned Income. Wages and self-employment income.
2. Net Investment Income (NII) Taxed At 3.8% Where MAGI AboveThreshold. These items of income are not subject to the additional 0.9% Medicare taxon earned income. Instead, they are subject to the 3.8% tax for those with MAGI over therelevant threshold. Code § 1411(c) defines net investment income as:
7 IRS Q&A # 11 at http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs.8 IRS Q&A # 8 at http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs.9
Joint Committee on Taxation, Technical Explanation (JCX-18-10), at 135.10 IRS Q&A # 15 at http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs.
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a. Category (i) Income. Net interest, dividends, capital gains,rents (except rental activities that are a trade or business), royalties, and nonqualifiedannuities unless derived in the ordinary course of a trade or business to which the 3.8%surtax doesn’t apply. Code § 1411(c)(1)(A)(i). Code § 162 applies to determine whetheran activity is a trade or business for Code § 1411. This is “portfolio income” under the469 rules.
b. Category (ii) Income; Reg. §1.1411-5 Activities.
(i) Net income from business constituting a passiveactivity as to the taxpayer under § 469.
(ii) Net income from “trading in financial instruments orcommodities.” This would seem to include a hedge fund manager’s income.11 Code §1411(c)(1)(A)(ii).
c. Category (iii) Income. Net gains from a disposition ofproperty other than property held in a trade or business as well as a trade or business thatis a passive activity or trading in financial instruments or commodities. Code §1411(c)(1)(A)(iii).
Example. Taxpayer, a single filer, has $180,000 of wages. Taxpayer also received$90,000 from a passive partnership interest, which is Net Investment Income. Taxpayer’smodified adjusted gross income is $270,000. Taxpayer’s modified adjusted gross incomeexceeds the threshold of $200,000 for single taxpayers by $70,000. Taxpayer’s NetInvestment Income is $90,000. The Net Investment Income Tax is based on the lesser of$70,000 (the amount that Taxpayer’s modified adjusted gross income exceeds the$200,000 threshold) or $90,000 (Taxpayer’s Net Investment Income). Taxpayer owesNIIT of $2,660 ($70,000 x 3.8%).12 If the taxpayer’s sages were higher, the wages overthe threshold could be subject to the 3.8% Medicare tax on earned income as well.
3. Income Not Subject To Earned Income Or NII Medicare Taxes. Asdiscussed hereafter, certain types of income are not subject to either of the Medicare taxeson earned income of net investment income. Additionally, the proposed regulations statethat the regular income tax provisions that apply to limit income and deductions in otherparts of the tax code will apply for the purposes of the new Chapter 2A, the IRC § 1411Medicare tax.
4. Trusts & Estates.
Certain estates and complex (as opposed to simple) trusts are subject to the NII tax andreport it on Form 1041 if they have undistributed net investment income and also haveadjusted gross income over the dollar amount at which the highest tax bracket for anestate or trust begins for the tax year. For 2012, this amount was $11,650 and is $11,950
11Most hedge funds are considered to be active trades or businesses and not passive. Specifically, Temp.Reg. § 1.469-1T(e)(6) states that “[a]n activity of trading personal property for the account of owners ofinterests in the activity is not a passive activity.”12 IRS Q&A # 18 at http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs.
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in 2013. The proposed regulations provide that only income in the trust that was createdin 2013 or later will be treated as net investment income. The rules for estate and trustsare discussed in more detail hereafter.
D. Organization Of Proposed Reliance Regulations.
§1.469-11. Effective date and transition rules ((iv) Regrouping for taxpayerssubject to section 1411)
§1.1411-1 General rules. §1.1411-2 Application to individuals. §1.1411-3 Application to estates and trusts. §1.1411-4 Definition of net investment income. §1.1411-5 Trades and businesses to which tax applies. §1.1411-6 Income on investment of working capital subject to tax. §1.1411-7 Exception for dispositions of interests in partnerships and S
corporations. §1.1411-8 Exception for distributions from qualified plans. §1.1411-9 Exception for self-employment income. §1.1411-10 Controlled foreign corporations and passive foreign investment
companies.
III. Definition Of Net Investment Income (“NII”).
A. Proposed Reliance Regulations. Taxpayers may rely on the proposed 1411regulations to comply with the new tax, which applies for tax years beginning in and after2013, including making any election (such as the grouping of passive activities) availableunder the regulations that is binding on the taxpayer. Taxpayers who do not makeelections under the proposed regulations will be able to make these elections pursuant tothe final regulations if the final regulations contain the same or a similar election.
B. Chapter 1 Definitions. The proposed regulations state that income taxdefinitions from Chapter 1 of the Code apply to 1411 unless the regulations provideotherwise. Thus, as discussed more below, items not taxed under regular income tax rulesare not taxed by 1411.
“To prevent circumvention of the purposes of the statute,” the proposed regulationsmodify the Chapter 1 rules in certain cases. Examples include treating substitute interestand dividends as investment income even though not technically considered dividends orinterest under Chapter 1; and treating under Code Sections 959(d), 1293(c), or 1291 as netinvestment income. Additionally, the definition of adjusted gross income as it relates toinvestments in controlled foreign corporations and passive foreign investment companiesis different for 1411.
Thus, constructive dividends (payment of a personal expense with corporate funds) wouldbe NII.
C. Net Investment Income. NII includes (1) income from interest, dividends,annuities, royalties payments for use of patents, copyrights, goodwill, trademarks,
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franchises, etc.), and rents (payments for the right to use tangible property except thosefrom a rental trade or business) other than such income derived in the ordinary course of atrade or business, (2) a trade or business income that is a passive activity in which thetaxpayer does not materially participate under § 469, and a trade or business income from“trading in financial instruments or commodities.”13 (3) It also includes taxable net gainattributable to the disposition of property other than property held in an active trade orbusiness. See IRC § 1411(c)(1)(iii). Prop. Reg. § 1.1411-4 defines net investment incomeand its components.
Capital gain dividends from regulated investment companies and real estate investmenttrusts described in §§ 852(b)(3)(C) and 857(b)(3)(C), respectively, and undistributedcapital gains described in REIT rules in §s 852(b)(3)(D) and 857(b)(3)(D), are included inNII as net gain under § 1411(c)(1)(A)(iii) and not as dividend income under §1411(c)(1)(A)(i).
Corporate dividends paid in 2013 out of 2012 earnings and profits are NII subject to NIItax in 2013.
1. Trade Or Business Of Entity Determined At Entity Level. Theindividual’s status under Code § 469 (active or passive participant) is irrelevant if thepass-through entity is not engaged in a trade or business. For the NII, whether somethingis a trade or business is determined as it is under Code § 162. Items of interest, dividends,annuities, royalties, and rents that pass through a partnership, LLC or S corporation to itspartners, members or shareholders, will retain their character as NII.
Non-passive activity income with respect to the taxpayer from a trade or business is
13 IRC § 1411(c) provides that NII means the excess (if any) of(A) the sum of— (i) gross income from interest, dividends, annuities, royalties, and rents, other than suchincome which is derived in the ordinary course of a trade or business not described in paragraph (2), (ii)other gross income derived from a trade or business described in paragraph (2), and (iii) net gain (to theextent taken into account in computing taxable income) attributable to the disposition of property other thanproperty held in a trade or business not described in paragraph (2), over
(B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.
(2) Trades and businesses to which tax applies. A trade or business is described in this paragraph if suchtrade or business is
(A) a passive activity (within the meaning of section 469) with respect to the taxpayer, or(B) a trade or business of trading in financial instruments or commodities (as defined in
section 475(e)(2)).
(3) Income on investment of working capital subject to tax. A rule similar to the rule of section469(e)(1)(B) shall apply for purposes of this subsection.
(4) Exception for certain active interests in partnerships and S corporations. In the case of a disposition ofan interest in a partnership or S corporation—
(A) gain from such disposition shall be taken into account under clause (iii) of paragraph(1)(A) only to the extent of the net gain which would be so taken into account by the transferor if allproperty of the partnership or S corporation were sold for fair market value immediately before thedisposition of such interest, and
(B) a rule similar to the rule of subparagraph (A) shall apply to a loss from suchdisposition.
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excluded from the definition of NII unless from trading in financial instruments orcommodities. Section 1411's statutory language and legislative history do not provide adefinition of trade or business. The proposed regulations incorporate the rules under § 162for determining whether an activity is a trade or business for purposes of § 1411. Prop.Reg. § 1.1411-5(a).
Gain from “property held in a trade or business” is excluded from NII, as long as suchtrade or business does not fall within the (1) passive activity OR (2) trading in financialinstruments and commodities categories.
Gross income from activities that are passive activities under § 469 will not be consideredas derived from a trade or business because the activity does not rise to the level of a tradeor business under § 162.
Example 1 of proposed Reg. §1.1411-5(b)(2) -Rents.
A, an unmarried individual, rents a commercial building to B for $50,000 in Year 1. A'srental activity does not involve the conduct of a § 162 trade or business, and under §469(c)(2), A's rental activity is a passive activity. Because paragraph §1.1411-5 (b)(1)(i),there is no “trade or business.” A's rental income of $50,000 is not derived from a tradeor business. However, A's rental income of $50,000 will still constitute gross income fromrents within the meaning of § 1.1411-4(a)(1)(i) because Reg. §1.1411- 4(a)(1)(i) does notrequire a trade or business.
2. Category (ii) Income; Regulation §1.1411-5 Trades or Businesses.The proposed regulations refer to the trades or businesses that are a passive activity ortrading in financial instruments or commodities as “Regulation §1.1411-5 Trades orBusinesses.” Net income from each of these activities is NII. Example –Substituteinterest or substitute dividends on securities lending is NII under the regulations.
a. Passive Activities. The new law considers “passiveactivity” trade or business income from K-1 businesses to be “investment” income. Thepassive loss rules were not designed to punish people with passive income until now, andthe way taxpayers “grouped” their income activities often never mattered. Now it does.Activity “groupings” matter because if you can group different operations into one“activity,” you can combine your participation in determining whether you “materiallyparticipate” in the activity (e.g., 500 hours). Normally one cannot change activity“grouping,” but the proposed regulations give everybody a free one-time opportunity tochange their groupings. Interest, dividends, etc. that are not derived in the ordinary courseof a trade or business are treated as portfolio income under Code § 469 and are not used todetermine whether there is income or loss from an activity. Thus, they are NII.
(i) The Material Participation Standard; Same As 469Regulations.
Under the § 469 regulations, a taxpayer “materially participates” in an activity if he or shemeets one of seven tests during the taxable year:
More than 500 hours of participation;
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Substantially all participation in the activity is by the taxpayer:
Participation for more than 100 hours, if no other individual participates more;
Significant participation activities (“SPAs”), where the taxpayer participates formore than 100 hours (“significant participation"), and the taxpayer’s aggregateparticipation in multiple SPAs exceeds 500 hours.
Material participation in an activity in 5 of the last 10 taxable years (covers retiredowner) as to year of sale);
Material participation in a personal service activity is always material participation(the fields of health, law, engineering, architecture, accounting, actuarial science,performing arts or consulting, and any other trade or business in which capital isnot a material income producing factor); and
Regular, continuous, and substantial involvement under the facts andcircumstances.
(ii) Material Participation by a Partner or S CorporationShareholder (Determined At Owner Level).
An individual partner or S corporation shareholder participates in an entity level activityonly if he or she is involved in the operations of the activity on a “regular, continuous, andsubstantial basis.”
(iii) Material Participation By Limited Partner.
Individuals can generally use one of the seven tests provided in the section 469regulations to establish that they materially participate and that the trade or business is notsubject to the passive loss limitations of section 469. If the individual holds an “interest ina limited partnership as a limited partner,” however, the individual is limited to one ofthree tests to establish material participation. Thus, it is significantly more difficult forlimited partners to avoid the passive loss limitations.
Several cases have determined that an LLC member is not a “limited partner” forpurposes of section 469 even though the member has limited liability. See e.g. Gregg v.U.S., 186 F.Supp.2d 1123 (D. Or. 2000), Garnett v. Commissioner, 132 T.C. 368 (2009),and Thompson v. U.S., 87 Fed. Cl. 728 (2009), acq’d result only AOD 2010-02. Accedingto the trend in the courts, these 2011 proposed regulations eliminate the current section469 regulations’ reliance on limited liability for purposes of defining a “limited partner.”
The 2011 section 469 proposed regulations define an “interest in a limited partnership asa limited partner” as (1) an interest in an entity treated as a partnership for federal incometax purposes where (2) “the holder of such interest does not have rights to manage theentity at all times during the entity’s tax year under the law of the jurisdiction in which theentity is organized and under the governing agreement.” Prop. Treas. Reg. section 1.469-5(e)(3)(i). If the individual holds an interest in a limited partnership as a limited partner,the general rule under Prop. Treas. Reg. section 1.469-5(e)(1) (“General Rule”) is that theindividual’s share of any income, gain, loss, deduction, or credit from the interest istreated as passive.
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Two exceptions to this General Rule are provided. First, if the individual satisfies one ofthree requirements for material participation in an activity during the tax year under Treas.Reg. section 1.469-5T(a)(1)1, (a)(5)2, or (a)(6)3, the General Rule does not apply. SeeProp. Treas. Reg. section 1.469-5(e)(2). Under this first exception, even if the partner hasno power to manage the partnership, the partner can avoid the characterization of theactivity as passive if the partner satisfies one of the three listed material participation tests.A limited partner is treated as materially participating if any one of the following tests issatisfied:
• The limited partner participates in the activity for more than 500 hours during theyear.• The limited partner materially participated in the activity for any five of the 10immediately preceding tax years.• The limited partner materially participated in a personal service activity for anythree prior years
The second exception is that, if the partner holds both a limited and non-limitedpartnership interest (such as a general partnership interest), the holder is not treated as alimited partner. See Prop. Treas. Reg. section 1.469-5(e)(3)(ii)..
(iv) Self-Rental Income Is Passive For NII. The passiveloss rules say that net income from “self-rental” to active businesses that they own is non-passive. This is to prevent taxpayers from artificially generating “passive” income to use“passive” losses. The proposed 1411 regulations make such rental income a form ofinvestment income. The proposed regulations say that such “self-rental” income must betreated as rental income, rather than as part of the non-passive activity that is paying therent.
(v) Material Participation Rental Income; Real EstatePros. Normally, real estate rentals are inherently passive regardless of the taxpayer’sparticipation. However, taxpayers who meet a 750-hour and more-time-than-anything-elsestandard in real estate operations under Code § 469(c)(7) and Reg. § 1.469-9 can test forwhether their real estate rental is “passive” using the same “material participation”standards that apply to other activities.
The proposed 1411 regulations say that such income must be “trade or business” incometo avoid the 3.8% tax and that a real estate professional meeting the 469 tests is notnecessarily engaged in a trade or business. If the trade or business test is met, the incomefrom rental real estate (including from its sale) would not be treated as net investmentincome for purposes of the tax under Code § 1411. Additionally, rental income and gainfrom the sale of property used in a trade or business is not treated as earnings from self-employment. Thus, it would also not be subject to self-employment taxes.
(vi) Working Interests In Oil & Gas. All the regulationssay about this is: “For rules regarding the treatment of working interests in oil or gasproperty, see § 469(c)(3).” A working interest in an oil and gas property that a taxpayerholds through an entity that does not limit the taxpayer’s liability, or one held directly, is
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not considered a passive activity.14 Therefore, royalties from this type of investment arenot subject to the 1411 tax. Oil and gas production payments, royalties, or other incomearrangements are subject to the NII tax if the investment is not a working interest.
(vii) Fresh Start Election to Redetermine Passive ActivityGroupings (Can Start Over In 2013 (And Again When Regulations Finalized If SoAllowed) Even If Did Something Different For 469 In Prior Years).
Proposed Reg. §1.1411-4 provides rules for defining an activity for purposes of applyingthe passive activity loss rule of § 469 (the “grouping rules”). The grouping rules willapplying in determining the scope of a taxpayer’s trade or business in order to determinewhether the trade or business is a passive activity.
Grouping generally helps a taxpayer aggregate gain and loss activities to satisfy theobjective material participation tests. Therefore, grouping may enable a taxpayer to avoidtreating business income as NII.
The proposed regulations confirm that a proper grouping of activities under § 469 will notconvert gross income from rents into other gross income derived from a trade or businessas described in Reg. §1.1411-5(a)(1).
The proposed regulations provide that taxpayers may regroup their activities in the firsttaxable year beginning after December 31, 2013, in which the taxpayer meets theapplicable MAGI threshold (i.e., $150,000, $200,000, or $250,000) and has NII. See Rev.Proc. 2010-13 for the requirements for reporting groupings and redetermining groupings.
b. Financial Instruments. Section 1411 does not define theterm “financial instrument.” Section 731(c)(2)(C) provides a definition of financialinstrument for purposes of § 731, and this existing statutory definition is used as aguideline for the § 1411 definition. Financial instruments include stocks and other equityinterests, evidences of indebtedness, options, forwards or futures contracts, notionalprincipal contracts, any other derivatives, and any evidence of an interest in such itemsincluding short positions and partial interests. Treas. Reg. §1.1275-6(b)(3). Treas. Reg. §1.988-1(a)(2)(iii) describes financial instruments to include financial derivatives.
c. Commodities. Commodities are defined by Section 1411with reference to Section 475(e)(2) and include any commodity that is actively traded,notional principal contracts with respect to such commodity interests, certain derivatives,options, futures, forwards or similar instruments.
d. Dealers, Traders & Investors. The proposed 1411regulations do not change the law regarding the classification of dealers, traders orinvestors and whether they have a trade or business under Code § 162. A dealer insecurities purchases from customers or sells to customers, or regularly offers to enter intopositions with customers, and is involved in a trade or business. A trader seeks profit from
14 IRC § 469(c)(3)(A) and Temp. Reg. § 1.469-1T(e)(4)(i).
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market swings and will be engaged in a trade or business if the trading is frequent andsubstantial. An investor seeks income from interest, dividends, and long-termappreciation. The proposed regulations provide that gross income from a trade or businessconstituting NII may be reduced by deductions described in § 62(a)(1) that are allocableto that income. This rule would permit a trader to deduct ordinary and necessary expensesof the trading business in calculating NII.
Under Reg. §1.1411-9(b), if a trader has deductions that did not reduce the trader’s NESE(after aggregating NESE from other trades or businesses) such excess deductions areproperly allocable deductions under § 1411(c)(1)(B). A person who qualifies as a tradermay be engaged in a trade or business for Code § 1411(c)(2)(B).
However, as noted in the preamble of the 1411 regulations, management of one’s owninvestments is not a Code § 162 trade or business no matter how extensive or substantialthe investments might be. Thus, income from personal investments is typically category(i) income and subject as such to the NII tax.
e. Pass-Through Of Commodity/Financial Asset IncomeDetermined At Entity Level. Whether the trade or business involves trading in financialinstruments or commodities is determined at the pass-through entity level. If the entity isinvolved in this business, the income retains its character when passing through to thetaxpayer. Prop. Reg. §1.1411-4(b)(2).
3. Category (iii) Income; Dispositions. The term “net investmentincome” includes any net gain (to the extent taken into account in computing taxableincome) from a “disposition” attributable to (1) the disposition of property, other thanproperty held in a trade or business, and (2) gain from a Regulation §1.1411-5 Trade orBusiness (i.e., a passive interest in a trade or business (with respect to the taxpayer) or abusiness involved in trading financial instruments or commodities. Chapter 1 rules applyto determine if the disposition is taxable NII.
A disposition includes the sale, exchange, transfer, conversion, cash settlement,cancellation, termination, lapse, expiration, or other disposition of property as determinedunder chapter 1 of the Code. See Prop Reg § 1.1411-4(d).
Examples – Sale of (2) C corp stock (publicly traded or privately held), whether ownedby an investor or a material participant, or (2) a real estate investment (not a principalresidence) is NII. (3) A sale of a boat that is a passive activity as to an owner is NII.
The income tax rules in chapter 1 generally will determine whether there has been adisposition of property under § 1411. For example, if a partner receives a distribution ofmoney from a partnership in excess of the adjusted basis of the partner's interest in thepartnership and recognizes gain under § 731(a), or if an S corporation shareholderreceives a distribution of money from the S corporation in excess of the adjusted basis ofthe shareholder's stock in the corporation and recognizes gain under § 1368(b)(2), the gainis treated as gain from the sale or exchange of such partnership interest or S corporationstock for purposes of § 1411(c)(1)(A)(iii).
4. Working Capital Income. Income, gain, or loss from the investmentof working capital is treated as not derived in the ordinary course, even in a non-passive
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trade or business, and is therefore subject to the 3.8% NII tax. IRC § 1411(c)(3). Prop.Reg. §1.1411-6). Cash-intensive businesses using interest-bearing accounts, as well asbusinesses that accumulate funds until a project begins, should be alert to this NII income.On the other hand, interest, dividends, etc. are not net investment income if they arederived in the ordinary course of a trade or business that is not a passive activity withrespect to the taxpayer and that is not trading of financial instruments or commodities.This is the “ordinary course of trade or business” exception.
D. Other Code Provisions Apply.
1. Items Not Taxed. The proposed regulations state that chapter 1Code provisions apply for Chapter 2A NII tax. Thus, gain not taxed under Chapter 1 isnot taxed under Chapter 2A.
2. Deductions. Allowable (“properly allocable”) deductions tocompute NII include the following:
Rents and royalties – deductions described in Code § 62(a)(4), such as depletion.Prop. Reg. §1.1411-4(f )(2).
Interest income – penalties described in Code § 62(a)(9) for penalties upon earlywithdrawals of savings.
Trade or business deductions described in Code § 62(a)(1). Certain itemized deductions, such as investment interest, investment expenses, and
taxes. Prop. Reg. §1.1411-4(f)(3)(i). Miscellaneous itemized deductions, but only after application of the 2-percent
floor under Code § 67 and the overall deduction limit under Code § 68. Prop.Reg. §1.1411- 4(f)(3)(ii).
3. Losses. Certain losses may also be taken into account indetermining net gain. This would apply to losses deductible under Code § 165 if theproperty is not held in a trade or business, or if the property is held in a trade or businesscategory related to net investment income. Capital losses that exceed capital gains are notrecognized for Code § 1411, but the $3,000 of losses allowable to noncorporate taxpayersmay offset gains from the disposition of noncapital assets.
Under the proposed regulations, a net operating loss (NOL) deduction reduces MAGI butcannot reduce net investment income because the items comprising the NOL are nottracked, once included in the NOL, and the overall NOL itself is not “properly allocable”to any specific item of income Prop. Reg. §1.1411-4(f)(1)(ii). Losses under Code § 165are deductible only in computing net gain from a disposition (Category (iii) income fromthe disposition of property), and only to the extent of gains, so they are not properlyallocable deductions. Prop. Reg. §1.1411-4(f )(4). The “net gain” from a dispositioncannot be less than zero and that any excess losses are not allowed in computing netinvestment income.
4. Deferral, Disallowance & Carryover Provisions. These apply aswell.
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Limitation on investment interest under Code § 163(d); Limitation of expense and interest relating to tax-exempt income under Code §
265; At risk limitations under Code § 465(a)(2); Passive activity loss limitations under Code § 469(b); Partner loss limitations under Code § 704(d); Capital loss carryover limitations under Code § 1212(b); and S corp shareholder loss limitations under Code § 1366(d)(2).
Further, carryover deductions in connection with these deferral or disallowance provisionsotherwise allowed in determining adjusted gross income (AGI) are also allowed indetermining NII.
5. Short Tax Years. The proposed reliance regulations explain that athreshold amount is generally not prorated in the case of a short tax year because of deathor other reasons. Prop. Reg.§1.1411-2(d)(2). However, if the short year is the result of achange of annual accounting period, the applicable threshold is reduced to an amount toan amount that bears the same ratio to the full threshold amount as the number of monthsin the short period bears to twelve. Prop. Reg. §1.1411-2(d)(2)(ii).
6. Capital Gains. Capital gains are generally included in netinvestment income subject to the 3.8% surtax. To the extent that gains aren’t otherwiseoffset by capital losses, the IRS notes that the following gains are common examples ofitems taken into account in computing net investment income:
Gains from the sale of stocks, bonds, and mutual funds; Capital gain distributions from mutual funds (i.e., regulated investment companies
(RICs)); Gain from the sale of investment real estate (including gain from the sale of a
second home that isn’t a primary residence); Gains from the sale of interests in partnerships and S corporations (to the extent
the taxpayer was a passive owner).15
In addition, capital gain dividends from real estate investment trusts (REITs) andundistributed capital gains from RICs and REITs are included in net investmentincome as net gain under Code § 1411(c)(1)(A)(iii), and not as dividend incomeunder Code § 1411(c)(1)(A)(i).
7. Capital Losses. Under the 1411 proposed regulations, net gain can’tbe less than zero. Losses allowable under Code § 1211(b) are allowed to offset gain fromthe disposition of assets other than capital assets that are subject to Code § 1411. Prop Reg§ 1.1411-4(d)(2). Net gain attributable to the disposition of property is the gain underCode § 61(a)(3) (i.e., dealings in property) recognized from the disposition of propertyreduced, but not below zero, by losses deductible under Code § 165, including losses fromcasualty, theft, and abandonment or other worthlessness. Net gain doesn’t include gain or
15 Id. Q&A #9.
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loss attributable to the disposition of property from the investment of working capital.Prop Reg § 1.1411-4(d)(3)(i).
The proposed regulations provide that additional $3,000 ordinary loss permitted forcapital losses ordinary income tax purposes is not allowed for the Medicare tax unlessthere are other noncapital gains (e.g., related to the disposition of a business or businessassets) against which they can be applied.
To the extent that disallowed losses are carried forward under the regular tax code, theycan be carried forward for the Medicare tax (with the notable exception of business netoperating loss carryforwards, which do not apply unless the underlying income/losscategory can be determined and applied separately). Capital loss carryforwards arepermitted as well. In addition, existing capital or other loss carryforwards (e.g., from 2012or prior) can be applied against 2013 gains (and reduce 2013 net investment income andpotential taxes due).
Example 1: In Year 1, Jane realizes a $40,000 capital loss on the sale of “C” corporationA stock and a $10,000 capital gain of on the sale of “C” corporation B stock, resulting in anet capital loss of $30,000. Jane has $300,000 of wages and earns $5,000 in interest.Under Code § 1211(b), Jane can use $3,000 of the net capital loss against other income,with the remaining $27,000 being a capital loss carryover. For Code § 1411 purposes,Jane’s $10,000 gain on the B stock sale is reduced by the $40,000 loss on the corporationA stock sale. However, because net gain can’t be less than zero, she can’t reduce the netinvestment income by the $3,000 of the excess of capital losses over capital gains allowedfor income tax purposes under Code § 1211(b).
In Year 2, Jane has a $30,000 capital gain on the sale of “C” corporation C stock. Forincome tax purposes, Jane can reduce the $30,000 gain by the Year 1 Code § 1212(b)$27,000 capital loss carryover. For Code § 1411 purposes, Jane’s $30,000 gain may alsobe reduced by the $27,000 capital loss carryover from Year 1. Therefore, in Year 2, Janehas $3,000 of net gain under Prop Reg § 1.1411-4(a)(1)(iii).
Example 2: Assume the same facts as in #1 above for Year 1, but Jane also realizes$20,000 of gain on the sale of rental property D (all of which is treated as ordinary incomeunder Code § 1250). Jane could use $3,000 of the net capital loss against other income forincome tax purposes, with the remaining $27,000 being a capital loss carryover. For Code§ 1411 purposes, Jane’s $10,000 gain on the B stock sale is reduced by the $40,000 losson the sale of the corporation A stock. The $20,000 gain on the sale of rental property D isreduced to the extent of the $3,000 loss allowed under Code § 1211(b). Accordingly,Jane’s net gain for Year 1 is $17,000, i.e., the $20,000 gain treated as ordinary income onthe sale of rental property D reduced by $3,000 loss allowed under Code § 1211.
8. CFCs & PFICs (Controlled Foreign Corporations And PassiveForeign Investment Companies); Funds that are Traders in Financial Instruments orCommodities.
Inclusions to a U.S. shareholder under the CFC rules are not dividends unless expresslyprovided in the Code. Similarly, inclusions to a U.S. person owning shares in a PFIC arenot dividends. As a result, these amounts are not net investment income unless the
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amounts are derived from a trade or business to which the tax applies (Category (ii)income) Prop. Reg. §1.1411-10(b). For investment funds treated as partnerships for taxpurposes, the determination of whether the fund will be considered a trader or an investoris made at the partnership level.
a. Traders. The proposed regulations do not alter current lawregarding when the trading activities of a fund are sufficient for the fund to be considereda trader. Gross income from partnerships engaged in trading financial instruments orcommodities is included in net investment income. For funds that are considered traders,net investment income will include (i) gross income as well as gains from disposition ofnotional principal contracts; (ii) gains from marking to market under Sections 475(f) and1256; and (iii) income deemed received from interests in controlled foreign corporations(CFCs) or passive foreign investment companies (PFICs). Gross investment income willbe reduced by all management fees, performance fees and other ordinary expenses of theinvestment fund. While the proposed regulations state that gross gains being included innet investment income, the final regulations likely will make clear that trading losses fromfinancial instruments and commodities are taken into account in computing net investmentincome. Individual investors who are allocated a net loss from a fund that makes a Section475(f) election may consider the net loss to determine net investment income in thecurrent taxable year. To the extent such ordinary loss exceeds other net investmentincome, it will not carry forward to reduce net investment income in a subsequent year.
b. Investors. For funds that are investors rather than traders,(i) the limitations on miscellaneous itemized deductions including investment advisoryexpenses under Section 67 and the overall limitation on itemized deductions underSection 68 will be taken into account to determine the properly allocable deductions andwill need to be apportioned between income that is and is not net investment income; (ii)gross income from notional principal contracts is not included; and (iii) special rules applyto deemed income inclusions attributable to interests in CFCs and PFICs. Absent anelection by an individual to include such deemed income in net investment income underthe timing rules applicable to the determination of gross income, individuals would notinclude such amounts for net investment income purposes until distributions are made bythe CFC or PFIC.
9. Carried Interest Income Is Net Investment Income. Performanceallocations made by investment funds to managers would seem to be net investmentincome for the individual owners of the manager. Thus, a manager that currently receivesa performance allocation may wish to consider whether to switch to a performance fee tofall outside of net investment income. In connection with any such change, state taximplications (e.g., New York City unincorporated business tax), any deferral issues (e.g.,Section 457A taxes if the performance fee cannot be paid at least annually), the amount ofnet capital gains that the investment fund may realize and any self-employment taxconsiderations should also be taken into account. Fund documents would need to bereviewed to determine if such a change is permissible.
E. Income That Is Not NII.
The following items are not subject to the 1411 tax on NII:
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Wages and self-employment income. Municipal bond interest. Social security.16
Sale of principal residence gain exempt from tax ($250,000 for singles and $500,000for married filing jointly).17
Deferred gain on 1031` like-kind exchanges, involuntary conversion under 1033, andlife insurance conversions under 1035.
Alimony.18
Alaska Permanent Fund Dividends (see Rev. Rul. 90-56).19
Distributions from all types tax-qualified retirement accounts under §§ 401(a), 403(a),403(b), 408, 408A, or 457(b) are excluded, such as qualified retirement or annuityplans and all types of IRAs.
Deferred compensation plans of state and local governments and tax-exemptorganizations.
Tax-deferred annuity income. Life insurance inside build up. Income tax free life insurance death benefits. Active trade or business income passed through to “non-passive” S corporation
shareholders. For example, S corporation bank distributions in bank when shareholdermaterially participates in bank activities is not NII.
Limited partners and LLC members meeting the requirements for the limited partnerexception.
The tax on NII does not apply to a charitable trust (“a trust all of the unexpiredinterests in which are devoted to one or more of the purposes described in §170(c)(2)(B)”), including charitable remainder trusts. Split interest trust income istaxable to taxable beneficiaries.
Non-resident aliens are not subject to the tax on NII. Foreign estates and foreign trusts are not subject to § 1411. However, NII of a foreign
estate or foreign trust is subject to § 1411 to the extent such income is earned oraccumulated for the benefit of, or distributed to, US persons. US beneficiariesreceiving current distributions of NII from a foreign estate or foreign nongrantor trustis taxable under § 1411.
F. Net Earnings From Self-Employment Not Subject To NII Tax..
1. SE Tax Treatment of General and Limited Partners, LLC Members.
A general partner of a partnership must include as NESE his distributive share of ordinaryincome of the partnership (other than the excluded interest, rent and dividends). On theother hand, § 1402(a)(13) excludes from NESE a limited partner’s distributive share ofpartnership income (other than distributions that are guaranteed payments orcompensation for services to the extent that those payments are established to be in the
16 IRS Q&A #8 at http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs.17 Id #10; Prop Reg § 1.1411-4(a)(1)(ii).18 Id. #8.19 Id.
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nature of remuneration for those services to the partnership). Accordingly, a generalpartner’s distributive share of income from the partnership normally will be treated asNESE, while a limited partner’s distributive share of income from the partnershipnormally will not be treated as NESE.
The application of the SE tax with respect to a limited partner who also serves as a generalpartner in a partnership is less clear. Section 1402’s legislative history reflects an intent toapply these rules separately to limited partnership and general partnership interests, evenif held by the same partner.
2. LLCs & Limited Partner Exception To SE Tax.
The 1997 proposed regulations (never finalized) under Section 1402(a)(13) define thelimited partner exception for LLC members. Generally, an individual, such as an LLCmember, is treated as a limited partner (not subject to the SE tax) unless the individualmeets one of the following tests:
Liability test: personally liable for debts of or claims against the partnership bybeing a partner;
Authority test: has authority to contract on behalf of the partnership underapplicable state law; or
500 hour participation test: participates in the partnership’s trade or business formore than 500 hours during the taxable year.
3. Partners Holding Both General And Limited Partnership Interest(Bifurcation Allowed In Certain Circumstances).
The 1997 proposed regulations further provide that an individual holding more than oneclass of interest who does not qualify as a limited partner under the general rules canbifurcate his interest in the LLC and still be treated as a limited partner for specificinterests in certain situations. For bifurcation to be allowed, other partners who meet thelimited partner definition must hold a substantial interest in the partnership (20% in thesame class). Certain limited partners with more than 500 hours of participation may meetone of 3 LP tests and certain individuals holding only one class of interest who fail tosatisfy the general definition of limited partner solely because of the 500-hourparticipation limit may qualify as limited partners.
Other limited partners who satisfy the “liability” and “authority” tests must have asubstantial and continuing interest in the class of interest held by the participating partner.
An individual who is a service partner in a professional service partnership is never betreated as a limited partner under § 1402(a)(13) regardless of whether the rules above areotherwise satisfied. See also Renkemeyer v. Comm'r, 136 T.C. No. 7 (Law Firm LLPWith S Corp Owned 100% By ESOP As Partner In One Year), where a limited liabilitypartnership engaged in law practice had four partners: three attorneys (30% each)performing legal services, and S corporation (10%) 100% owned by ESOP. In 2004, theLLP’s net business income allocation was 87.5% to S corporation with the remainder tothe three service providing attorney partners (2-6% each). In 2005, the S corporation wasno longer a partner (due to enactment of § 409(p) and the net income allocations were 1/3equally to the three attorney partners. For both 2004 and 2005, attorney partners did not
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treat distributive shares as net earnings from self-employment. The Tax Court reallocated2004 net income based on partners' interests in profits and
IV. SE & NII TAX CONSIDERATIONS FOR S CORPORATIONSHAREHOLDERS; NO NII OR SOCIAL SECURITY & MEDICARE TAX FORDISTRIBUTIONS TO TAXPAYER MATERIALLY PARTICIPATING IN SCORPORATION BUSINESS.
A. General. Reasonable compensation should be paid for services renderedby S corporation shareholder-employees in order to avoid the recharacterization of Scorporation dividend distributions as wages. See Rev. Rul. 74-44, where twoshareholders of an S corporation drew no salary. The arrangement was for avoiding thepayment of federal employment taxes, and the IRS recharacterized the distributions aswages for FICA and FUTA purposes. See also Radtke v. United States (7th Cir. 1990),where the Court recharacterized distributions made to the sole shareholder-attorney of anS corporation law firm as wages subject to FICA and FUTA taxes where the shareholdermade all of his withdrawals from the S corporation in the form of distributions andreceived no salary from the S corporation during the taxable year.
Absent abusive facts, the IRS may have difficulty asserting that distributions made by anS corporation to shareholder-employees who are otherwise paid reasonable salaries shouldbe characterized as additional wages subject to Social Security taxes. However, when a Ccorporation converts to S status, prior C corporation compensation levels may be used asproof of reasonable compensation amounts by the Service.
Additionally, S corporation pass-through income (dividend distributions) does notconstitute net earnings from self-employment for purposes of the tax on self-employmentincome under § 1402(a)(2) (excluding dividends from self-employment income). Rev.Rul. 59-221.
Moreover, business income retained but passed-through for income tax purposes anddistributions to S corporation shareholders who materially participate in the business areexcluded from the definition of NII under § 1411(c)(2)(A).
Similarly, net gains on the sale or redemption of the shareholder’s interest in the Scorporation should be excluded from NII. As noted above, NII includes “net gain (to theextent taken into account in computing taxable income) attributable to the disposition ofproperty other than property held in a trade or business” unless the trade or business is apassive activity with respect to the taxpayer.
On the other hand, shareholders who do not materially participate in the businessactivities of the S corporation (that is, who are “passive”) should be subject to the 3.8%Medicare tax on pass-through income since it constitutes income from a passive activity.Similarly, net gains on the sale or redemption of the “passive” shareholder’s interest in theS corporation should be included in NII and subject to the 3.8% Medicare tax.
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B. Use of S Corporation to Operate Closely Held Business. The opportunityexists to avoid both the FICA/Medicare tax on earned income and (after 2012) the 3.8%tax on NII operating the business through an S corporation (or an LLC electing to betaxed as a corporation and electing S treatment), provided reasonable salaries are paid toshareholder-employees and they materially participate in the business.
C. S Corporation Dividend Distribution Example. If in 2013 your share of anS corporation's profit is $100,000 and $80,000 of this $100,000 represents profits from thebusiness operation, with $20,000 of profit coming from dividends, interest and capitalgains on investments held by the S corporation, no matter whether you are also anemployee of the S corp or a shareholder that is not an employee, you'll pay the Medicaretax on the $20,000 of investment income that flows through to you if your incomeexceeds the threshold amounts. The $80K is not subject to the NII tax unless from apassive activity with respect to the taxpayer or from trading financial instruments orcommodities.
D. Section 338(H)(10) Election By Selling S Corporation Shareholders; NetGain From Disposition Of Property – Onus On Buyer & Seller To Allocate As DeemedAsset Sale. If No Nonpassive Assets, No NII Unless Owner Not Materially Participating.
The proposed regulations provide that if stock of an S corporation is sold and a §338(h)(10) election is made, each shareholder's pro rata share of the deemed asset salegain or loss may be taken into account in determining NII under § 1411(c)(1)(A)(iii).
Furthermore, each shareholder may have additional gain or loss upon the deemedliquidation of the S corporation resulting from the § 338(h)(10) election, which gain orloss will also generally be taken into account under § 1411(c)(1)(A)(iii) in determiningNII.
The net loss resulting from the deemed liquidation often offsets the gain from the deemedsale.
V. GAIN FROM THE DISPOSITION OF INTERESTS IN PARTNERSHIPSAND S CORPORATIONS; SALE OF OWNERSHIP SAME AS IF BUSINESSSOLD ALL ITS ASSETS.
A. General. Gain from the disposition of interests in partnerships and Scorporations (i.e., pass-through entities) is excluded, but “only to the extent of the net gainwhich would be so taken into account by the transferor if all property of the partnership orS corporation were sold for fair market value immediately before the disposition of suchinterest. Generally, an interest in a partnership or S corp (a “pass-through” interest) is notconsidered property held in a trade or business although the underlying business itselfmay be. Therefore, gain or loss from the sale of a pass-through interest would be includedin NII under Category (iii) for dispositions. However, the amount of gain (or loss) on thedisposition of a pass-through interest that is included in NII under Category (iii) is limitedto the net gain (or loss) that would be taken into account if the partnership or S corp soldall of its assets at fair market value on a property by property basis immediately before thedisposition of the interest. Code § 1411(c)(4), Prop. Reg. § 1.1411-7(a). This rules doesnot apply if there is no trade or business, the activity is passive as to the seller, or the
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partnership or S corporation is in the trade or business of trading financial instruments orcommodities.
If there is a gain on the sale of the interest, and some of the underlying property is notdescribed in Code § 1411(c)(2) (passive activities or commodities or financial instrumenttrading,, a negative adjustment that reduces gain from the sale of the interest is required.In this case, the Code § 1411(c)(4) exception would apply, NII would be reduced, andthere would be less NII surtax due. The proposed regulations apply the partnership basisadjustment rules under Code § 743.
If a taxpayer purchased the stock of an S corporation for an amount less than the Scorporation’s net inside basis, and the deemed asset sale gives rise to a potential negativeadjustment that is greater than the gain the taxpayer recognized upon the sale of the pass-through interest, the negative adjustment is limited to the amount of the gain recognizedupon the sale of such interest. A taxpayer in such circumstances might want to consider asale of assets of the pass-through entity, which would give rise to gain that was not subjectto the tax under Section 1411, followed by a taxable liquidation of the pass-throughinterest, which would give rise to a capital loss that might offset other net investmentincome.
B. Deemed Asset Sale Method.
1. Four Steps.
a. The first step is a hypothetical disposition of all the entity’sproperties, including goodwill, for cash in a taxable transaction at fair market value(FMV) of the entity’s properties immediately before disposition of the interest.
b. The second step is a separate computation of gain or loss oneach of the entity’s properties (including goodwill), determined by comparing the FMV ofeach property with its adjusted basis.
c. The third step is the allocation of the gain or loss from eachproperty to the transferor, taking into account the partnership agreement or relevant S corpprovisions.
d. The fourth step is the determination of whether the gain orloss allocated to the transferor for each property would have been taken into account as acategory (iii) disposition.
2. Adjustment For Non-NII Assets.
Thus, if a property is either held in a trade or business described in section 1411(c)(2)(treated as NII) or is not held in a trade or business, there will be no adjustment of thetransferor’s gain (or loss) taken into account as NII. For properties that do not fall intothese categories, there is an adjustment under section 1411(c)(4) calculated in thefollowing manner.
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a. Aggregation. The gains and losses from the properties areaggregated, with a net gain creating a negative adjustment, and a net loss creating apositive adjustment Prop. Reg. §1.1411-7(c). The IRS in the preamble states that if, forexample, the transferor has a gain of $100,000 on the disposition of the interest, the Code§ 1411(c)(4) adjustment cannot be greater than $100,000, and cannot result in a loss.
b. Special Situations. The proposed regulations providespecial rules for various situations (Prop. Reg. §1.1411-7):
(i) If property was held in more than one trade orbusiness in the previous 12 months, the gain must be allocated among the trades orbusinesses on a basis that reasonably reflects the use of the property.
(ii) Special rules determine the gain or loss fromgoodwill for purposes of the Code § 1411(c)(4) exception.
(iii) If the taxpayer disposed of S corp stock and made aCode § 338(h)(10) election, the exception does not apply because the sale of stock istreated as an actual asset sale by the S corp.
(iv) If the taxpayer sells the pass-through interest in aninstallment sale, the adjustment to net gain is calculated in the year of the disposition, butthe gain and any adjustment are deferred. If an installment sale attributable to adisposition of an interest in a partnership or S corp occurred before the effective date ofCode § 1411, taxpayers may elect into the proposed reliance regulations.
(v) If a qualified subchapter S trust sells S corp stock,any gain or loss recognized on the sale will be that of the trust, not of the incomebeneficiary.
Any transferor making a Code § 1411(c)(4) adjustment must attach a statement to thetransferor’s return for the year of the disposition. The statement must include: (1) adescription of the disposed-of interest; (2) the name and taxpayer identification number(TIN) of the entity disposed of; (3) the fair market value of each property of the entity; (4)the entity’s adjusted basis in each property; (5) the transferor’s allocable share of gain orloss with respect to each property; (6) information regarding whether the property washeld in a trade or business not described in Code § 1411(c)(2); (7) the amount of theCode § 1411(c)(1)(A)(iii) gain on the disposition of the interest; and (8) the computationof the adjustment under Prop Reg §1.1411-7(c)(5). See Prop. Reg. §1.1411 7(d).
3. Differences In Deemed Asset Sale Method.
Prop. Reg.. § 1.1411-7 provides details on determining the gain or loss on the dispositionof interests in partnerships or S corporations. The proposed regulations provide that“Congress intended § 1411(c)(4) to put a transferor of an interest in a partnership or Scorporation in a similar position as if the partnership or S corporation had disposed of allof its properties and the accompanying gain or loss from the disposition of such propertiespassed through to its owners (including the transferor). However, the gain or loss upon thesale of an interest in the entity and a sale of the entity's underlying properties will not
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always match.”
First, there may be disparities between the transferor's adjusted basis in the partnershipinterest or S corporation stock and the transferor's share of the entity's adjusted basis inthe underlying properties.Second, the sales price of the interest may not reflect the proportionate share of theunderlying properties' fair market value with respect to the interest sold.
Similarly, since only net gain or loss attributable to property held by the entity that is notattributable to an active trade or business is taken into account, gain must be isolated forpurposes of classification as NII or not NII.
In order to achieve parity between an interest sale and an asset sale, § 1411(c)(4) must beapplied on a property-by-property basis, which requires a determination of how theproperty was held in order to determine whether the gain or loss to the transferor from thehypothetical disposition of such property would have been gain or loss subject to §1411(c)(1)(A)(iii).
C. Multiple Trades Or Businesses In One Entity Where Owner Participates InOne But Not Other.
If a pass-through entity has multiple businesses, each of which has goodwill, the goodwillis apportioned among the businesses in proportion to the fair market values of the assetsused in such businesses. Prop Reg § 1.1411-7(c), Preamble to Prop Reg11/30/2012.The proposed regulations provide a special rule for property held in more than one tradeor business during the 12-month period ending on the date of the disposition. In such case,the fair market value and the adjusted basis of the property must be allocated among thetrades or businesses in a way that reasonably reflects the use of the property.
If the property is held in a trade or business not described in Code § 1411(c)(2) (passiveactivity or trading in financial instruments or commodities), an adjustment must be made.First, the transferor's gains or losses from such property (or properties) are aggregated tocreate a net gain (which is treated as a negative adjustment) or a net loss (which is treatedas a positive adjustment). Second, based on the adjustment calculated and subject tocertain limitations, the transferor then must adjust the gain or loss from the disposition ofthe partnership or S corporation interest by the positive or negative adjustment.
Example 7 of Reg. 1.1411-7(e).Facts. Individuals A and B are shareholders of an S corporation (S). A owns 50 percent ofthe stock in S. During Year 2, S is engaged in two trades or businesses, Business X andBusiness Y. As to Business X, A is a material participant and is not engaged in a trade orbusiness described in Reg. §1.1411- 5(a)(1) (commodities or financial instrument trading).As to Business Y, A is engaged in a trade or business a described in Reg. §1.1411-5(a)(1)(a passive activity or trading in financial instruments or commodities). Thus, A is amaterial participant in Business X, but not a material participant in Business Y.S has five properties. Property 1 and Property 2 are held exclusively in Business X, andProperty 3 and Property 4 are held exclusively in Business Y. Property 5 is used half ofthe time in Business X and half the time in Business Y. On December 1 of Year 2, A sells
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his S stock to C for A's proportionate share of the fair market value of S's properties. Atthe time of the disposition, A's adjusted basis in his S stock is $110,000.
Calculation of gain subject to tax on NII. On the stock sale to C, A recognizes a gain of$50,000 ($160,000 minus $110,000), which is subject to Reg. §1.1411- 4(a)(1)(iii).Section 1411(c)(4) is applicable to A. However, any adjustment will only relate toproperty held in Business X and not Business Y (because Business Y is a trade orbusiness in which A is not materially participating, or which is engaged in tradingfinancial instruments or commodities). Upon a hypothetical disposition of S's propertiesfor cash equal to fair market value, S would receive $30,000 for Property 1, $30,000 forProperty 2, $40,000 for Property 3, $100,000 for Property 4, and $120,000 for Property 5.
Under § 1366, A is allocated $10,000 gain from Property 1, $20,000 loss from Property 2,$10,000 gain from Property 3, $40,000 gain from Property 4, and $10,000 gain fromProperty 5.
A must make an adjustment under paragraph (c)(5) to the amount of net gain determinedunder Reg. §1.1411-4(a)(1)(iii) with respect to the gain or loss on the properties used inBusiness X in which A is materially participating ( Properties 1, 2, and 50% of Property5). Because Property 5 is used 50 percent of the time in Business X, under paragraph(c)(5)(ii)(A),, 50 percent of the gain would be attributable to Business X (and A's sharewould be $5,000).
The gain or loss on Property 1, Property 2, and Property 5 are added together ($10,000minus $20,000 plus $5,000), and results a negative $5,000. A does not need to take the$5,000 into account and A has a $50,000 gain for purposes of Reg. §1.1411-4(a)(1)(iii).
VI. ESTATES & TRUSTS.
A. Overview. Prop. Reg. § 1.1411-3 contains the rules for trusts and estates,including the types of trusts to which the tax applies, i.e., ordinary trusts, as described inReg. § 301.7701-4(a). Prop. Reg. § 1.1411-3(a)(1)(i). The NII tax does not apply tobusiness trusts under Reg. § 301.770-14(b), certain state law trusts, pooled income funds,cemetery perpetual care funds, qualified funeral trusts, etc., as well as tax-exempt trusts,excluding even unrelated business taxable income of those trusts. Prop. Reg. § 1.1411-3(b)(1).
1. Trusts Subject To Tax. For Subchapter J U.S. domestic estates andnongrantor “ordinary” trusts, in order to appropriately allocate the incidence of income taxbetween an estate or trust and its beneficiaries, the Code provides for a deduction ofdistributions to beneficiaries in computing taxable income at the estate or trust level. Theamount deducted in computing the taxable income of the estate or trust is included in thecomputation of the taxable income of the beneficiaries. The character of the incomeearned at the estate or trust level is preserved at the beneficiary level for U.S. beneficiariesof domestic trusts. Similarly, in the case of the § 1411 tax, “undistributed net investmentincome” taxed to the trust is defined as net investment income reduced by (i) the share ofnet investment income included in the beneficiary distribution deduction of the estate or
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trust, and (ii) the charitable deduction for amounts paid or permanently set aside forcharitable purposes. Thus, an estate or trust is treated as a conduit of net investmentincome to the beneficiary and it is only that portion of net investment income that istrapped at the estate or trust level that is treated as undistributed net investment incomeand taxed to the estate or trust. Items of income characterized as NII and currentlydistributed to beneficiaries as DNI would retain the character of NII for purposes ofdetermining the NII tax liability of the beneficiaries.
In the case of a grantor trust treated as owned by the grantor or another person under Code§s 671 through 679 (a “grantor trust”), the § 1411 tax will not apply to the trust itself.Rather, the income of the trust will be treated as being the income of the grantor or otherowner for purposes of the § 1411 tax.
Thus, in addition to keeping record of trust accounting income and distributable netincome, beginning in 2013 trustees will be required to keep record of net investmentincome accumulated by a trust and net investment income distributed to a beneficiary,taking the character of the income into account.
B. Net Investment Income.
1. Calculation. The starting point is the computation of netinvestment income is the same for individuals, estates, and trusts. Prop. Reg. §1.1411-4.NII is the excess (if any) of the sum of:
gross income from interest, dividends, annuities, royalties, and rents, other thansuch income derived in the ordinary course of a trade or business,
other gross income from trades or businesses to which the tax applies (passiveincome or securities/commodities trading income), and
net gain (to the extent taken into account in computing taxable income) from thedisposition of property other than property held in a trade or business to which thetax does not apply,
less allowable deductions properly allocable to such gross income or net gain under § 651or § 661, and the share of NII allocated to the § 642(c) deduction of the estate or trust inaccordance with § 1.642(c)-2(b) and the allocation and ordering rules under § 1.662(b)-2.
The proposed regulations do not address the issue of whether the estate or trust is treatedas materially participating if the executor or trustee, in his capacity as such, is soparticipating. The longstanding IRS position has been that only the trustee of a trust cansatisfy the material participation test. That position was rejected by a federal court in2003. Mattie Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003), holding that the trust’semployees activity, if regular, continuous, and substantial, can satisfy the activeparticipation test and rejecting as irrelevant the legislative history cited by the Service.The IRS did not appeal because the trustee was also materially participating in theranching activities of the trust. The IRS has continued to maintain its position in TAM200733023 and PLR 201029014.
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2. U,S. Complex Trust Calculation Example. The complexity of the1411 tax to estates and trusts is demonstrated by the easiest example in the proposedregulations. In Year 1, Trust has dividend income of $15,000, interest income of $10,000,capital gain of $5,000 (NII of $30,000), and $60,000 of taxable income relating to adistribution from an IRA. Trust has no expenses. Trust distributes $10,000 of its currentyear trust accounting income to A, a beneficiary of Trust. For trust accounting purposes,$25,000 of the distribution from the individual retirement account is attributable toincome. Trust allocates the remaining $35,000 of taxable income from the individualretirement account and the $5,000 of capital gain to principal, and thus these amounts donot enter into the calculation of Trust’s distributable net income for Year 1.
Trust’s distributable net income is $50,000 ($15,000 in dividends plus $10,000 ininterest plus $25,000 of taxable income from an individual retirement account), fromwhich the $10,000 distribution to A is paid. The $10,000 distribution deduction reduceseach class of income comprising distributable net income on a proportional basis. The$10,000 is 20 percent of the $50,000 of distributable net income. Therefore, thedistribution consists of $3000 dividend, $2,000 interest income, and $5000 ordinaryincome attributable to the IRA. The $5,000 of capital gain allocated to principal for trustaccounting purposes does not enter into distributable net income, and no portion of thatamount is included in the $10,000 distribution, nor does it qualify for the DNI deduction.
Trust’s net investment income is $30,000 ($15,000 dividends, $10,000 interest, and$5,000 in capital gain). Trust’s $60,000 of taxable income attributable to the individualretirement account is not counted because it is excluded from net investment income.Trust’s undistributed net investment income is $25,000, which is Trust’s net investmentincome ($30,000) less the amount of dividend income ($3,000) and interest income($2,000) distributed to A. The $25,000 of undistributed net investment income iscomprised of the $5,000 capital gain allocated to principal, the remaining $12,000undistributed dividend income, and the remaining $8,000 undistributed interest income.A’s net investment income includes dividend income of $3,000 and interest income of$2,000, but does not include the $5,000 of ordinary income attributable to the IRA.
TrustReceipts
TrustAccountingIncome
Trust’s DNI A’sDistributionand Trust’sDistributionDeduction
Trust’sTotal
NII
A’s
ShareNII
TrustUNII
Dividends $15,000 $15,000 $15,000 $3,000 $15,000 $3,000 $12,000
TaxableInterest $10,000 $10,000 $10,000 $2,000 $10,000 $2,000 $8,000
CapitalGain $5,000 -- -- -- $5,000 -- $5,000
IRADistribution $60,000 $25,000 $25,000 $5,000 - - -- --
Total $90,000 $50,000 $50,000 $10,000 $30,000 $5,000 $25,000
Percentageof DNI 20%
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3. Chart Regarding Whether 1411 Applies.
Type of Trust 1411 TaxationBusiness trust treated as business entity Not applicableCommon trust funds taxed under § 584 Not applicableDesignated settlement funds taxed under§ 468B(b)(4) Not applicablePooled income funds described in Section642(c)(5) AppliesCemetery perpetual care funds described inSection 642(i) AppliesQualified funeral trust described in Section685 AppliesAlaska Native settlement trust described inSection 685 AppliesTax‐exempt fund or trust (e.g., charitableremainder trust, Archer MSA, health savingsaccount, 529 qualified tuition program,Cloverdale education savings account) Not applicable even if fund or trust subject
to § 511 tax on unrelated business taxableincome. Computation of NII part ofannuity or unitrust distribution fromcharitable remainder trust required
Trusts with unexpired interests for charitablepurposes (e.g., charitable lead trusts) Not applicableGrantor trusts under §s 671‐679 Not applicable to trust; NII of grantor or
other ownerElecting small business trust Applies; special rules to determine §
1411 tax baseForeign estate and foreign nongrantor trust Should not apply if little or no connection to
U.S.; potential application if U.S. beneficiaryBankruptcy estate of individual debtor Applies to debtor using deemed married
filing separately status for threshold amount
C. Charitable Remainder Trusts.
A charitable remainder trust is not subject to the § 1411 tax at the trust level. Theproposed regulations provide rules to track annuity and unitrust distributions thatconstitute net investment income to the non‐charitable beneficiary during the annuity orunitrust term.
Annuity and unitrust distributions from a charitable remainder trust to non‐charitablebeneficiaries are ordered for income tax purposes based on a four‐tier system (ordinaryincome, capital gains, tax‐exempt income, and principal). However, in the interest ofadministrative convenience, these ordering rules are not applied for the 1411 tax. Rather,the proposed regulations provide that annuity and unitrust distributions are treated asincluding net investment income in an amount equal to the lesser of (i) the total amount of
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the distributions for the year, or (ii) the current and accumulated net investment income ofthe charitable remainder trust. Accumulated net investment income is the total amount ofnet investment income received by a charitable remainder trust for all taxable years afterDecember 31, 2012 less the total amount of net investment income distributed for all priortaxable years that begin after December 31, 2012.
If a trust has multiple annuity or unitrust beneficiaries, the net investment income will beapportioned among the beneficiaries based on the respective shares of the total annuity orunitrust they are paid by the trust in a taxable year.
D. Grantor Trust; Grantor Taxed On NII Unless Not NII Because OwnerMaterially Participating.
Prop. Reg. §1.1411-3(b)(5) provides that the tax under § 1411 is not imposed on a grantortrust, but instead, where a grantor or other person treated as the owner of all or a portionof a trust under subpart E of part I of subchapter J of chapter 1, any items of income,deduction, or credit that are included in computing taxable income of such grantor orother person under § 671 are treated as if such items had been received or paid directly bythe grantor or other person for purposes of calculating such person's NII.
E. Electing Small Business Trusts (ESBTs).
The proposed regulations preserve the chapter 1 treatment of the ESBT as two separatetrusts for tax reporting but treat the ESBT as a single trust for determining the adjustedgross income threshold. Proposed §1.1411-3(c)(1)(ii) provides the method to determinethe ESBT's § 1411 tax base:
First, the ESBT will separately calculate the undistributed NII of the S portion and non-Sportion in accordance with the general rules for trusts under chapter 1, and combine theundistributed NII of the S portion and the non-S portion. If not distributed, it is taxed atthe trust level. If some retained and some distributed, aggregate income to determinewhether trust threshold amount is met.
Second, the ESBT determines its adjusted gross income, solely for purposes of § 1411, byadding the net income or net loss from the S portion to that of the non-S portion as asingle item of income or loss.
Third, to determine whether the ESBT is subject to § 1411, the ESBT will compare thecombined undistributed NII with the excess of its adjusted gross income over the § 1(e)threshold ($11,650 in 2012).
F. Real Estate Investment Trusts.
Capital gain dividends from real estate investment trusts described in § 857(b)(3)(C) andundistributed capital gains described in § 857(b)(3)(D) are included in NII for the REITinvestors as net gain under § 1411(c)(1)(A)(iii) and not as dividend income under §1411(c)(1)(A)(i).
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G. Bankruptcy Estates. A bankruptcy estate of a debtor who is an individualis treated as an individual for purposes of computing the tax under Code §. 1411. Code §1398 provides rules for the taxation of bankruptcy estates in chapter 7 and chapter 11cases under the Bankruptcy Code in which the debtor is an individual. In these cases, thebankruptcy estate computes its tax in the same manner as an individual. Code §1398(c)(2) provides that the income tax rate for the bankruptcy estate is the same as thatimposed on a married taxpayer filing separately, and Code § 1398(c)(3) provides that thebankruptcy estate is entitled to a standard deduction of a married taxpayer filingseparately. Therefore, regardless of the actual marital status of the debtor, a bankruptcyestate of a debtor who is an individual is treated as a married taxpayer filing separately forpurposes of the thresholds for calculating the tax, and therefore the threshold amountapplicable to such a bankruptcy estate is $125,000.
H. Foreign Estates and Trusts.
Foreign estates and foreign trusts with little or no connection to the United States are notsubject to the § 1411 tax. However, NII of a foreign estate or foreign trust is subject to §1411 to the extent such income is earned or accumulated for the benefit of, or distributedto, US persons. US beneficiaries receiving current distributions of NII from a foreignestate or foreign nongrantor trust is taxable under § 1411. The tax will apply to the extentthat income of a foreign nongrantor trust is earned or accumulated for the benefit of, ordistributed to, U.S. persons. For foreign grantor trusts, the § 1411 tax applies to the U.S.grantor or other U.S. owner.
VII. CONTROLLED FOREIGN CORPORATIONS (CFCS) AND PERSONALFOREIGN INVESTMENT COMPANIES (PFICS).
Undistributed taxable income is taxable for income tax purposes under 951 and 1251 butnot as dividends. Section 1411 allows election to include those inclusions as 1411income, which would accelerate tax, and subsequent inclusion would be treated as a returnof capital. Making election eliminates need to track basis.)
Income with respect to investments in foreign corporations is included in the calculationof NII for § 1411 purposes. Dividends and gains derived with respect to the stock of acontrolled foreign corporation (within the meaning of § 957(a)) (CFC) or a passiveforeign investment company (within the meaning of § 1297(a)) (PFIC) are taken intoaccount in computing NII.The proposed regulations provide that amounts included in income under § 951 and §1293 for chapter 1 purposes are not considered dividends that would be treated as NIIunder chapter 2A. However, when distributions are made from E&P attributable to yearsbeginning after January 1, 2012, such distributions will be taken into account indetermining NII.
Because of the different timing under chapter 1 and chapter 2A for including certainincome from investments in CFCs and PFICs, the proposed regulations contain rulescoordinating these provisions with the determination of the calculation of the § 1411 tax.
An individual may elect to treat § 951 and § 1293 inclusions as NII under Prop. Reg.
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§1.1411-10(g). Absent such an election, an individual who owns stock in a CFC or a QEFmust increase or decrease MAGI to reflect such inclusions in certain circumstances.
Proposed Reg. §1.1411-10(g) allows individuals, estates, and trusts to make an election toinclude inclusions under §s 951 and 1293 in NII in the same manner and in the sametaxable year as such amounts are included in income for chapter 1 purposes.
The proposed regulations provide rules that apply to an individual, estate, or trust thatowns stock of a CFC or QEF through a domestic partnership or S corporation. Because ofthe different timing rules under chapter 1 and chapter 2A, the proposed regulationsprovide rules on the determination for § 1411 purposes of (1) the partner's or shareholder'soutside basis in his interest, and (2) the partnership's or S corporation's adjusted basis inits CFC or QEF stock.
A partnership or S corporation separately state, in addition to a partner's distributive shareof the amounts included in the partnership's income under § 951(a) or § 1293(a), apartner's distributive share of any distributions of previously taxed earnings and profits ofa CFC or QEF received by the partnership or S corporation that are dividends for purposesof chapter 2A.
The Treasury Department and the IRS request comments on appropriate ways todetermine a partner's distributive share of a distribution of previously taxed earnings andprofits given the purpose of § 1411.
VIII. DOCTRINES THAT MAY CAUSE TAX TROUBLE FORRESTRUCTURING TO AVOID NII TAX.
A. Business Purpose. If the corporation or other business entity is formed witha business purpose, or it engages in business activity, it should be respected. If not, thestructure or transaction can be recharacterized by the Service.
1. Moline Properties v Commissioner, 319 U.S. 436 (1943).
A corporation will be recognized as a separate taxable entity if:(1) the purpose for its formation is the equivalent of business activity or(2) the incorporation is followed by the carrying on of a business by the corporation.
The courts are lenient about finding a business purpose for incorporation for general-purpose business corporations. For example, corporations formed to encourage thefounders' children to take an active interest in business, and to provide the children withadditional income and to facilitate estate planning were held viable enterprises becausethey engage in sufficient business activities. These activities consist of complying withoutside creditors' requests that the corporation sign promissory notes and mortgages thataffected business property, the receipt of dividends, and use of the corporate name inconnection with receipts and disbursements. Britt v US, 431 F2d 227 (5th Cir. 1970).Another case validated a corporation organized to hold title to real estate so as to avoidancillary administration of the taxpayer's estate. Est. of Whitfield v CIR, 192 F2d 494 (5th
Cir. 1951); Hagist Ranch, Inc. v CIR, 295 F2d 351 (7th Cir. 1961). However, if a
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corporation performs the necessary quantum of activity to be recognized as a corporation,it does not matter that a purpose for forming the corporation was avoidance or reductionof estate taxes. Sparks Farm, Inc. v. CIR, T.C. Memo. 1988-492.
2. Robucci v. Commissioner, T. C. Memo. 2011-19 (January 24,2011). Robucci transferred his sole proprietor medical practice to a limited liabilitycompany (“LLC”) owned 95% by him and 5% by a professional corporation (“PC”)wholly owned by him. A second corporation, Westsphere, was formed to employ staff andperform certain services associated with the practice. The 95% interest in the LLC heldby T was divided between a 10% general partner interest and a 85% limited partnerinterest. T paid self-employment tax on the distributions associated with the 10% generalpartner interest only.
The Tax Court determined that the taxpayer’s structure failed to satisfy either of theMoline Property tests. The Tax Court noted that the PC was appointed as a manager of theLLC, but there was no evidence that it performed any management, had any assets, hadany service contracts with LLC, or paid any salaries. The CPA advising the doctor hadwritten a message that the corporate entity did nothing. The court concluded that PC was amere corporate shell and had no tax significance. Taxpayer was ruled to be a soleproprietor for federal tax purposes, which was his status before the formation of the LLCand corporations. All of his income was self-employment income.
B. Economic Substance Doctrine (“ESD”) IRC 7701(o).
IRC § 7701(o), effective for transactions on and after March 31, 2010, is the codificationof the economic substance judicial doctrine and provides that a “transaction shall betreated as having economic substance only if -(A) the transaction changes in a meaningful way (apart from Federal income tax effects)the taxpayer’s economic position, and(B) the taxpayer has a substantial purpose (apart from Federal income tax effect) forentering into such transaction.”
The economic substance doctrine is a judicial doctrine commonly cited as originating inGregory v. Helvering, 293 U.S. 465 (1935), that has been used to disallow the tax benefitsgenerated by transactions satisfying the literal requirements of the Code but lacking anypractical economic significance apart from their tax consequences. Different circuitsinterpreted it differently but the doctrine in all circuits now has the conjunctive dual testquoted above.
1. Transaction Defined.
a. Includes a series of transactions.
b. Includes common variations of the step transaction doctrine.
c. JCX-18-10 suggests that ESD will apply to isolated step,and cites Coltec Indus. v. United States, 454 F.3d 1340 (Fed. Cir. 2006) for application tothe particular step that produced the tax benefit (high basis). This Joint Committee of
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Taxation explanation was revised as various bills were introduced, ultimately resulting inJCX-18-10 (March 21, 2010).
2. When Will the Economic Substance Doctrine Apply?
Examples in which the economic substance doctrine should not be considered relevant arefound in JCX-18-10 and JCS-3-09. Footnote 344 in JCX-18-10 states that “if therealization of the tax benefits of a transaction is consistent with the Congressional purposeor plan that the tax benefits were designated by Congress to effectuate, it is not intendedthat such tax benefits be disallowed.” The examples given to illustrate this concept are thevarious tax credit provisions enacted to encourage certain activities. In effect, thisstatement provides a “safe harbor” to the taxpayer in that it defines the economicsubstance doctrine as applying to tax benefits that the IRS perceives as not consistent withthe purposes of the particular Code provision that the taxpayer is relying upon for taxbenefits. In addition, JCX-18-10 and JCS-3-09, the Joint Committee Staff Description ofBusiness Tax Revenue Provisions in the President’s Fiscal Year 2010 Budget Proposal(September 2009), state that Section 7701(o) is not intended to alter the tax treatment ofcertain basic business transactions that, under longstanding judicial and administrativepractice are respected, merely because the choice between meaningful economicalternatives is largely or entirely based on comparative tax advantages. Both reports listthe following four transactions as examples where the ESD should not be applied:
Choice between capitalizing a business enterprise with debt or equity; U.S. person’s choice between utilizing foreign corporation or domestic corporation
to make a foreign investment; Choice to enter transaction or series of transactions that constitute corporate
organization or reorganization under subchapter C; and, Choice to utilize related-party entity in transaction provided that arm’s-length
standard of section 482 and other applicable concepts are satisfied.
IRS Large Business and International Division (LB&I) Directive LB&I 4-0711-015 (July15, 2011) provides guidance for IRS examiners and managers. The LB&I Directiveprovides examiners with a four-step framework for applying the doctrine and requiresthem to seek guidance from local managers and counsel and obtain approval from aDirector of Field Operations (DFO; a high-level IRS manager) in all cases before applyingthe doctrine.
Importantly, LB&I Directive for Industry Directors, LB&I Control No: LB&I-4-0711-015limits the strict liability penalties to cases in which other judicial doctrines or approaches,such as re-characterization (substance over form) or step-transaction, are more appropriatethan economic substance.
3. Penalties For Disallowance Of Claimed Tax Benefits.
Section 6662(b)(6) provides a separate category of accuracy related penalty for anydisallowance of claimed tax benefits by reason of a transaction lacking economicsubstance or failing to meet the requirements of any similar rule of law.
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a. The penalty is 20% of amount of disallowance.
b. If relevant facts affecting the tax treatment are notadequately disclosed on the return or a statement attached to the return, the penalty is 40%of the amount of the disallowance
c. Strict liability- no reasonable cause or good faith defense.
C. Section 269- Acquiring Control Of A Corporation With The PrincipalPurpose Of Evasion Or Avoidance Of Federal Income Tax.
Section 269(a)(1) provides that if any person or persons directly or indirectly forms acorporation, or acquires stock possessing at least 50% of the vote or value of acorporation, and the principal purpose for the acquisition is evasion or avoidance offederal income tax by securing the benefit of a deduction, credit, or other allowance whichsuch person would not otherwise enjoy, then the IRS may disallow the deduction, creditor other allowance.
Under this section, the IRS may attempt to deny many benefits that an individual,domestic corporation or tax-exempt may obtain by organizing a foreign corporation andinvesting in it. Section 269 applies to the formation of a new corporation. See JamesRealty Co. v. United States, 280 F.2d 394 (8th Cir. 1960) (incorporation of a real estateholding company constitutes an acquisition under § 269). FSA 200205003 opined that269 could be used to deny deductions to a consolidated group for costs associated withforming new subsidiaries with no business purpose but rather to take deductions onworthless properties..
The IRS has repeatedly ruled in private letter rulings that it would respect the use of awholly-owned foreign corporation by a tax-exempt organization to avoid UBTI where theforeign corporation provided an added layer of limited liability, provided greaterflexibility in disposing of the underlying investment, and permitted management of thetaxpayer’s investments.
D. 269A; PSC, The Principal Purpose Of Which Is To Avoid/Evade Tax.
In order to prevent the use of a personal services corporation ("PSC" or "PC") to avoid orevade federal income taxes, Congress enacted Code Section 269A, which permits the IRSto allocate the income and other items of a PSC to its owner if such allocation is necessaryto prevent avoidance or evasion of federal income tax or to clearly reflect the income ofthe PSC or its owner. The term "personal service corporation" is defined for purposes ofCode Section 269A as "a corporation the principal activity of which is the performance ofpersonal services and such services are substantially performed by employee-owners."Code Section 269A(b)(1). Section 269A has never been used successfully by the IRS inlitigation.
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The IRS may make a Code Section 269A allocation only if substantially all the services ofthe PSC are performed for one other entity and the principal purpose of using the PSC forthe performance of services is the avoidance or evasion of federal income taxes. CodeSection 269A(a). The provision is aimed at taxpayers who use a PSC as a vehicle toprovide services to the one employer that they would have provided services to directly inthe absence of a PSC. If a taxpayer forms a PSC that provides services for more than oneentity, Code Section 269A is not implicated.
When a corporation whose principal activity is the performance of personal services byowner-employees (personal service corporation) (1) performs substantially all its servicesfor one entity and (2) the principal purpose of forming the personal service corporation isto avoid tax, the IRS can allocate all income, deductions and credits between the personalservice corporation and its owner-employees. Code Sec. 269A. Even prior to enactmentof 269A, avoiding federal income taxes has not an acceptable business purpose. Theleading authority is a case in which a transitory corporation was formed in connectionwith a corporate reorganization solely to save its shareholder income taxes. Gregory v.Helvering, 293 US 465 (1935). Regulations under 269A were proposed in 1983, widelycriticized, and have never been finalized.
In determining whether a taxpayer's use of a PSC will be recognized as valid under theassignment of income doctrine, the courts look at (1) whether the PSC controls thetaxpayer's actions and income; and (2) whether the PSC's control is recognized by theentity paying the taxpayer's salary. Johnson v. United States, 698 F.2d 372 (9th Cir.1982). If the contract is with the taxpayer and a third party, an assignment to the PSC bythe taxpayer is invalid. All income attributable to the taxpayer's personal services remainstaxable to the taxpayer.
Generally, any business, including a personal service business composed of one person,may incorporate and divert that person's compensation income to the corporation. In onecase, the IRS sought to tax the individual directly on all of the income that theprofessional corporation received based upon Code Sec. 482, which grants the IRS theauthority to allocate gross income among or between controlled organizations, trades orbusinesses. However, the Tax Court found that, to the extent that the IRS attempted toshift all of the professional corporation's income to the individual, its determination wasarbitrary and capricious. Keller v CIR, 77 T.C. 1014, aff'd, 723 F2d 58 (10th Cir. 1983).The corporation must be the person actually performing the services for which thepayment is received. Code Sec. 269A(b)(1).
The IRS ruled that a medical corporation that employed its sole shareholder as the solepracticing physician was not formed or availed of for the principal purpose of avoiding orevading income tax. Although contributions made to the corporation's pension plan werein excess of the maximum allowed for a self-employed individual, such plans could not betaken into account in determining the purpose of the corporation. The relatively smallamount of taxable income retained by the corporation did not establish that its principalpurpose was tax avoidance. See PLR 8737001.
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