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An In-Depth Look: 3.8% Net Investment Income Tax Regs Contain Substantial Changes.
(Parker Tax Publishing December 03, 2013)

The 3.8 percent net investment income tax rules of Code Sec. 1411 that became effective in 2013 have kept many practitioners guessing about whether certain items of income are subject to the tax, how the rules apply, and what planning opportunities might be available to navigate around the tax. Some of these questions were answered on November 26, when the IRS released 217 pages of final regulations (T.D. 9644 (12/2/13)) and 89 pages of proposed regulations (REG-130843-13 (12/2/13)) on the net investment income tax (NIIT).

There are several substantial changes in the final regulations of which practitioners should be aware:

1. The complex computations contained in the proposed regulations for computing gain and loss on dispositions of interests in partnerships and S corporations were replaced with new proposed regulations aimed at reducing the burden imposed by the 2012 proposed regulations.

2. While the final regulations retain the rule preventing allowable losses from reducing net gain on the sale of property below zero, they allow losses in excess of gains as properly allocable deductions. This means taxpayers are no longer prevented from deducting a capital loss of $3,000 from other investment income.

3. The final regulations provide a safe harbor for real estate professionals so that rental income will not be taxed under the NIIT rules.

4. While the IRS refused to expand the regrouping of passive activity rules to taxpayers other than those impacted by the NIIT, the regulations now allow for regrouping on certain amended returns The final regulations revised the method for computing properly allocable itemized deduction to a more simplified method.

5. Net operating losses, which were not allowed in the proposed regulations, are partially allowed in the final regulations.

The new proposed regulations also address for the first time the impact of the NIIT on various partnership items, such as guaranteed payments and Code Sec. 736 payments.

The IRS issued initial proposed NIIT regulations in December 2012. Those proposed regulations were reliance regulations, meaning taxpayers could rely on them for the 2013 tax year. The final regulations are effective for tax years beginning after December 31, 2013, except that the regulation provision that relates to charitable remainder trusts applies to tax years beginning after December 31, 2012. The preamble to the 2012 proposed regulations stated that taxpayers could rely on the proposed regulations for purposes of complying with Code Sec. 1411 until the effective date of the final regulations.

The final regulations are effective for tax years beginning after 2013. However, taxpayers may also apply the final regulations to tax years beginning before 2014. Thus, for tax years beginning before 2014, taxpayers may rely on either the 2012 proposed regulations or the final regulations. However, to the extent taxpayers take a position in a tax year beginning before 2014 that is inconsistent with the final regulations, and that position affects the treatment of one or more items in a tax year beginning after 2013, then the taxpayer must make reasonable adjustments to ensure that their Code Sec. 1411 tax liability in the tax years beginning after 2013 is not inappropriately distorted. For example, reasonable adjustments may be required to ensure that no item of income or deduction is taken into account in computing net investment income more than once, and that carryforwards, basis adjustments, and other similar items are adjusted appropriately.

Also, as noted above, the IRS issued additional proposed regulations under Code Sec. 1411. In addition to revising the rules on calculating net gain from the disposition of a partnership interest or S corporation stock, the 2013 proposed regulations provide new guidance on the NIIT treatment of partnership guaranteed payments and payments to retiring and deceased partners, as well as a new rules for the application of Code Sec. 664 system to charitable remainder trusts that derive income from controlled foreign corporations or passive foreign investment companies with respect to which a particular election is not in place. The 2013 proposed regulations also address the net investment income tax characterization of income and deductions attributable to common trust funds, residual interests in real estate mortgage investment conduits (REMICs), and certain notional principal contracts.

General Rules for the Net Investment Income Tax

The Health Care and Education Reconciliation Act of 2010 added Code Sec. 1411. In doing so, the law created Chapter 2A of Subtitle A (Income Taxes) under which this new provision falls. Effective for tax years beginning after 2012, Code Sec. 1411 imposes a 3.8 percent tax on certain individuals, estates, and trusts.

In the case of an individual, the tax is equal to 3.8 percent of the lesser of: (1) the individual's net investment income for the tax year, or (2) the excess (if any) of the individual's modified adjusted gross income for the tax year, over the applicable threshold amount. The threshold amount is: (1) in the case of a taxpayer filing a joint return or a surviving spouse, $250,000; (2) in the case of a married taxpayer filing a separate return, $125,000; and (3) in the case of any other individual, $200,000.

For purposes of calculating this additional tax, Code Sec. 1411(d) defines modified adjusted gross income as adjusted gross income increased by the excess of: (1) the amount excluded from gross income under the foreign earned income exclusion, over (2) the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed with respect to the amount excluded from gross income under the foreign earned income exclusion.

Net investment income is defined in Code Sec. 1411(c)(1) as the excess (if any) of: (1) the sum of (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which the tax does not apply (referred to as "one little i income"), (ii) other gross income derived from a trade or business to which the tax applies (referred to as "two little i income"), and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply (referred to as "three little i income"); over (2) the deductions properly allocable to such gross income or net gain.

As noted above "two little i income" is determined, in part, by reference to trades or businesses. Under Code Sec. 1411(c)(2), such income is subject to NIIT if the trade or business is:

1. a passive activity with respect to the taxpayer, or

2. a trade or business of trading in financial instruments or commodities.

In the case of an estate or trust, Code Sec. 1411(a)(2) imposes a tax (in addition to any other income tax imposed) for each tax year equal to 3.8 percent of the lesser of: (1) the estate's or trust's undistributed net investment income, or (2) the excess (if any) of the estate's or trust's adjusted gross income for the tax year, over the dollar amount at which the highest tax bracket in Code Sec. 1(e) begins for such tax year.

Clarification of the Term "Trade or Business"

The final regulations clarify that the term "trade or business," when used in Code Sec. 1411 and the final regulations, describes a trade or business within the meaning of Code Sec. 162 and the Code Sec. 162 reference incorporates case law and administrative guidance applicable to Code Sec. 162.

New Rules for Calculating Net Gain on Dispositions of Partnership & S Corporation Interests

One of the more welcome changes in the final regulations was the rejection of the proposed regulations' calculation of gain or loss on the disposition of interests in partnerships and S corporations. The IRS agreed with practitioners that the proposed regulations were complex and imposed a high compliance burden on taxpayers, including requiring a transferor of a partnership or S corporation interest to obtain information from the entity regarding the valuation and tax basis of all the entity's assets. Under the new proposed regulations, the IRS provides two methods for calculating net gain on the disposition of interests in partnerships and S corporations the primary method and the optional simplified reporting method.

Under the primary method, for dispositions resulting in gain, the transferor's gain equals the lesser of: (1) the amount of gain the transferor recognizes for income tax purposes, or (2) the transferor's allocable share of net gain from a deemed sale of the passthrough entity's Section 1411 property (i.e., property that, if sold, would give rise to gain or loss that is includible in determining the transferor's net investment income). The proposed regulations contain a similar rule when a transferor recognizes a loss for income tax purposes.

The proposed regulations direct the transferor to rely on the valuation requirements under Reg. Sec. 1.469-2T(e)(3), which a materially participating transferor should already be applying for income tax purposes. These valuation requirements allow the transferor to compute gain or loss activity by activity. Under Reg. Sec. 1.469-2T(e)(3), a taxpayer is required to determine the overall gain or loss from each activity and each taxpayer is required to compute for each activity the amount of net gain that would have been allocated to the holder of such interest with respect thereto if the passthrough entity had sold its entire interest in such activity for its fair market value on the applicable valuation date. The regulation also includes a corollary rule for dispositions at a loss. Thus, the proposed regulations require a materially participating transferor to calculate its gain or loss by reference to the activity gain and loss amounts calculated for income tax purposes. Specifically for purposes of Code Sec. 1411, the transferor's allocable share of gain or loss from a deemed sale of the passthrough entity's Section 1411 property equals the sum of the transferor's allocable shares of net gains and net losses (as determined under the Code Sec. 469 principles) from a hypothetical deemed sale of the activities in which the transferor does not materially participate.

The proposed regulations also allow certain transferors to apply an optional simplified method for calculating gain or loss. According to the IRS, a simplified method is warranted when the amount of gain associated with passive assets owned by the passthrough entity is likely to be relatively small. To use the optional simplified reporting method, the transferor must meet certain requirements. Use of this simplified method is not mandatory for qualifying transferors. However, the passthrough entity may not be required under the proposed information reporting rules to provide (but is not precluded from providing) a transferor who qualifies to use the simplified method with information that the transferor would need to report under the primary method. The following are excluded from the optional simplified method: (1) transferors that have held the interest for less than 12 months; (2) certain contributions and distributions during a defined holding period; (3) passthrough entities that have significantly modified the composition of their assets; (4) S corporations that have recently converted from C corporations; and (5) partial dispositions.

OBSERVATION: The simplified reporting method is intended to limit the information sharing burden on passthrough entities by allowing transferors to rely on readily available information to calculate the amount of gain or loss included in net investment income. For this purpose, the optional simplified method relies on historic distributive share amounts received by the transferor from the passthrough entity to extrapolate a percentage of the assets within the passthrough entity that are passive with respect to the transferor. For example, if 10 percent of the income reported on the applicable Schedules K1 is of a type that would be included in net investment income, then the simplified reporting method presumes that 10 percent of the gain on the disposition of the transferor's interest relates to Section 1411 property of the passthrough entity for purposes of calculating net investment income.

New Safe Harbor Rule Established for Real Estate Professionals

Once an individual establishes real estate professional status, that status only allows the taxpayer to treat rental real estate activities as nonpassive if the taxpayer satisfies at least one of the tests for material participation in Reg. Sec. 1.469-5T in the rental real estate activities. The status as a real estate professional alone does not establish that those rental real estate activities rise to the level of a trade or business within the meaning of Code 162. There are seven tests to establish material participation. However, not all of the material participation tests provide conclusive evidence that a taxpayer is regularly, continuously, and substantially involved in a rental trade or business within the meaning of Code Sec. 162. Thus, the IRS said that relying on the Reg. Sec. 1.469-5T material participation tests as a proxy to establish regular, continuous, and substantial activity within the meaning of Code Sec. 162 for NIIT purposes is not appropriate.

However, the final regulations do provide a safe-harbor test for certain real estate professionals. Under that safe harbor, if a real estate professional participates in rental real estate activities for more than 500 hours per year, the rental income associated with that activity is deemed to be derived in the ordinary course of a trade or business. Alternatively, if the taxpayer has participated in rental real estate activities for more than 500 hours per year in five of the last 10 tax years (one or more of which may be tax years prior to the effective date of Code Sec. 1411), then the rental income associated with that activity will be deemed to be derived in the ordinary course of a trade or business. The safe-harbor test also provides that if the hour requirements are met, the real property is considered as used in a trade or business for purposes of calculating net gain under "three little i". According to the IRS, it recognizes that some real estate professionals with substantial rental activities may derive such rental income in the ordinary course of a trade or business, even though they fail to satisfy the 500-hour requirement in the safe-harbor test. As a result, the final regulations specifically provide that such a failure will not preclude a taxpayer from establishing that such gross rental income and gain or loss from the disposition of real property, as applicable, is not included in net investment income.

Limitation on Using Losses Against Other Investment Income Revised

The final regulations retain the overall limitation on allowable losses, which provides that the calculation of net gain under "three little i" cannot be less than zero. However, the final regulations provide that losses described in Code Sec. 165 are allowed as a properly allocable deduction to the extent such losses exceed the amount of gain and are not taken into account in computing net gain under "three little i" by reason of the overall limitation. Thus, the final regulations allow losses in excess of gains as a properly allocable deduction to the extent the losses would be allowable in computing taxable income. This means a loss under "three little i" can offset gains under "one little i" and "two little i" to the extent the taxpayer would otherwise be allowed to deduct such amounts for income tax purposes. Thus, a taxpayer, such as a Code Sec. 475 trader, that has ordinary losses in excess of ordinary gains and net capital gains, may claim those excess losses as a properly allocable deduction.

IRS Rejects Requests to Expand Regrouping Rule, but Allows Regrouping on Amended Returns

Although practitioners requested otherwise, the final regulations retain the requirement that regrouping under Reg. Sec. 1.469-11(b)(3)(iv) may occur only during the first tax year beginning after December 31, 2012, in which (1) the taxpayer meets the applicable income threshold under Code Sec. 1411, and (2) has net investment income. According to the IRS, if a taxpayer does not have a Code Sec. 1411 tax liability, there is no reason to expand the regrouping rule to that taxpayer. However, the IRS did agree with practitioners that taxpayers should be allowed to regroup on an amended return. Thus, regrouping is allowed on an amended return but only if the taxpayer was not subject to NIIT on his or her original return (or previously amended return), and if, because of a change to the original return, the taxpayer owed tax under NIIT for that tax year.

OBSERVATION: There are several reasons why a taxpayer may wish to regroup activities. First, if the taxpayer has multiple business entities and each business entity is a separate and distinct activity, the taxpayer might not meet any of the seven material participation tests contained in the regulations. On the other hand, if the taxpayer can group related entities into one single larger activity and the taxpayer works more than 500 hours in that larger activity, losses from all the entities are nonpassive, even if the taxpayer performs no work whatsoever in one or more of the entities. Second, a business activity and a rental generally cannot be grouped together. However, if the rental activity is "insubstantial" in relation to the business activity, the two activities may be grouped. Thus, the rental escapes the automatic passive taint. The group, including the rental, is completely excepted from the passive loss limitations, assuming the taxpayer materially participates in the business activity. Third, a business may be grouped with a rental activity if they are owned in identical percentages. If they form an appropriate economic unit and the taxpayer materially participates in the grouped activity, neither the business nor any rental losses are limited by the passive activity rules.

New Method of Computing Properly Allocable Itemized Deductions

Under the 2012 proposed regulations, properly allocable deductions that were itemized deductions subject to the 2-percent floor on miscellaneous itemized deductions under Code Sec. 67 or to the overall limitation on itemized deductions under Code Sec. 68 were deductible in determining net investment income only to the extent that they were deductible for income tax purposes after applying both limitations. The proposed regulations provided a method for apportioning these limitations to determine the amount of deductions allowed in computing net investment income after applying Code Sec. 67 and Code Sec. 68. This method first applied Code Sec. 67 to all deductions subject to the 2-percent floor. The disallowance was applied proportionately to each deduction subject to Code Sec. 67. The proposed regulations then applied a similar process to deductions subject to Code Sec. 68.

The final regulations do away with the pro rata method and instead provide an ordering approach to the Code Sec. 67 and Code Sec. 68 limitations. Under the final regulations, the amount of miscellaneous itemized deductions allowed under Code Sec. 67 in determining net investment income (but before the application of Code Sec. 68) is the lesser of: (1) the amount of miscellaneous itemized deductions before applying Code Sec. 67 that are properly allocable to net investment income, or (2) the amount of all miscellaneous itemized deductions allowed after applying Code Sec. 67. The amount of itemized deductions subject to limitation under Code Sec. 68 that are deducted in determining net investment income is the lesser of: (1) the amount of such deductions that are properly allocable to net investment income allowed after applying Code Sec. 67 but before applying Code Sec. 68, or (2) the amount of all deductions allowed after applying Code Sec. 68.

Modified Net Operating Losses Now Allowed

The 2012 proposed regulations provided that in no event would a net operating loss (NOL) deduction be taken into account in determining net investment income for any tax year. The final regulations provide that taxpayers may deduct a portion of an NOL deduction in determining their net investment income. The portion of an NOL deduction for a tax year that may be deducted for Code Sec. 1411 purposes is calculated by first determining the applicable portion of the NOL for each loss year. The applicable portion of the NOL is the lesser of: (1) the amount of the NOL for the loss year that the taxpayer would have incurred if only items of gross income that are used to determine net investment income and only properly allocable deductions were taken into account in determining the NOL, or (2) the amount of the taxpayer's NOL for the loss year. Next, the amount of the NOL carried from each loss year and deducted in the tax year is multiplied by a fraction. The numerator of this fraction is the applicable portion of the NOL for the loss year as determined above. The denominator of the fraction is the total NOL for the loss year.

A separate fraction is determined for each loss year. The result of this multiplication is the amount of the NOL deduction from the loss year that is allowed as a Code Sec. 1411(c)(1)(B) deduction in the tax year, referred to as the Section 1411 NOL amount. The sum of the Section 1411 NOL amounts for each NOL carried to and deducted in the tax year, referred to as the total Section 1411 NOL amount, is the amount of the NOL deduction for the tax year that is properly allocable to net investment income.

Partnership Guaranteed Payments and the NIIT

The 2013 proposed regulations address the treatment of partnership guaranteed payments under Code Sec. 1411. According to the IRS, the treatment depends on whether the partner receives the payment for services or the use of capital. The proposed regulations exclude all guaranteed payments received for services from net investment income, regardless of whether these payments are subject to self-employment tax, because payments for services are not included in net investment income. However, the proposed regulations provide that guaranteed payments for the use of capital share many of the characteristics of substitute interest, and therefore are included as net investment income.

Partnership Section 736 Payments and the NIIT

The 2013 proposed regulations address the treatment of partnership Code Sec. 736 payments under Code Sec. 1411. Because the application of the NIIT rules depends on the underlying nature of the payment received, the Code Sec. 736 categorization controls whether a liquidating distribution is treated as net investment income for purposes of Code Sec. 1411. Thus, the treatment of the payment for purposes of Code Sec. 1411 differs depending on whether the distribution is a Code Sec. 736(b) distribution in exchange for partnership property or a Code Sec. 736(a) distribution in exchange for past services, use of capital, or Code Sec. 736(a) property. Among Code Sec. 736(a) payments, the proposed regulations further differentiate the treatment of payments depending on: (1) whether or not the payment amounts are determined with regard to the income of the partnership and (2) whether the payment relates to Code Sec. 736(a) property or relates to services or use of capital. The proposed regulations generally align the Code Sec. 1411 characterization of Code Sec. 736 payments with the treatment of the payments as passive or nonpassive under Reg. Sec. 1.469-2(e)(2)(iii).

The proposed regulations provide that Code Sec. 736(b) payments to a retiring partner are taken into account as net investment income as net gain or loss from the disposition of property. If the retiring partner materially participates in a partnership trade or business, then the retiring partner must also apply Prop. Reg. Sec. 1.1411-7 (relating to gain on the disposition of interests in partnerships and S corporations) to reduce appropriately the net investment income. Gain or loss relating to Code Sec. 736(b) payments is included in net investment income regardless of whether the payments are classified as capital gain or ordinary income (for example, by reason of Code Sec. 751).

Payments received under Code Sec. 736(a) may be an amount determined with regard to the income of the partnership taxable as distributive share under Code Sec. 736(a)(1) or a fixed amount taxable as a guaranteed payment under Code Sec. 736(a)(2). The categorization of the payment as distributive share or guaranteed payment will govern the treatment of the payment for purposes of Code Sec. 1411. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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