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IRS Releases Final and Prop. Regs on 3.8% Net Investment Income Tax and Rethinks Rules for Dispositions (Parker Tax Publishing November 27, 2013)

Download REG-130843-13 PDF      Download T.D. 9644 PDF

The 3.8 percent net investment income tax rules of Code Sec. 1411 that became effective in 2013 have kept a lot of practitioners guessing on what 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 Tuesday, Nov. 26, when the IRS released 217 pages of final regulations (T.D. 9644) and 89 pages of proposed regulations on the net investment income tax (NIIT). The following is a summary of some of the more important provisions in the final and proposed regulations.

Final Rules Reject Prop. Regs Calculation of Gain on Dispositions of Partnership & S Corp 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 valuation and tax basis. As a result, the IRS withdrew the proposed regulations on this issue and issued new proposed regulations adopting practitioners’ suggestions. The proposed rules include two methods of calculating gain or loss includible in net investment income upon the disposition of a partnership or S corporation interest – a primary method and an optional simplified reporting method – as well as a list of exceptions as to who may use the optional simplified method.

IRS Declines to List Income and Deduction Items Excludible from NIIT

The IRS rejected practitioners’ attempts to have the regulations list income and deduction items that are excluded from the calculation of net investment income. The final regulations reconfirm the application of general income tax provisions in the absence of special rules for purposes of the net investment income tax. However, the final regulations provide, in certain instances, additional guidance on items of income that are or are not included in net investment income. The IRS said it may issue other guidance in the future, as necessary, to address the treatment of particular income items whose treatment is not apparent from the general rules of Code Sec. 1411 and the final regulations or from general income tax rules.

NIIT and Estimated Taxes

The final regulations address practitioners’ complaints that many investors do not know until the end of the year if a passthrough investment will generate net investment income for that year and, as a result, the IRS should not penalize taxpayers for failing to include net investment income in their calculation of estimated tax payments. Noting that a similar issue exists for general income tax purposes and special rules provide estimated tax penalty relief in certain situations, the IRS rejected calls for providing special relief for estimated taxes and the NIIT.

IRS Rejects Requests to Expand Regrouping Rule

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, the interaction between Code Sec. 1411 and Code Sec. 469 justifies the Code Sec. 1411 regrouping rule. The IRS said that, if a taxpayer does not have a Code Sec. 1411 tax liability, there is no reason to expand the regrouping rule to that taxpayer.


Practitioners had questioned the inability of an electing small business trust (ESBT) to offset net investment income losses (capital, ordinary, and/or passive) from one portion of the ESBT with net investment income from the other portion. The IRS noted that while the practitioners focused on the annual calculation of net investment income, neither addressed the potential problems from allowing income and losses to offset: (1) loss duplication in carryover years (because loss would offset gain across portions in Year 1 and also be a carryover to Year 2 within the originating portion), or (2) differences in loss carryforwards for general income tax purposes and for NIIT purposes. While the IRS agreed with the practitioners that that the method of consolidation may put ESBTs at a computational disadvantage, from a Code Sec. 1411 perspective, to similarly situated nongrantor trusts in the case of netting of income and losses, it noted that this computational disadvantage exists with regard to the tax imposed under general income tax provisions, and the rules regarding ESBTs (and the final regulations generally) adopt general income tax principles.

NIIT and Foreign Estates and Trusts

Code Sec. 1411 does not address specifically the treatment of foreign estates and foreign nongrantor trusts. The final regulations follow the proposed regulations and provide that foreign estates and foreign trusts are not subject to the NIIT. However, this rule does not exempt U.S. beneficiaries of foreign estates from the application of the NIIT to distributions from foreign estates.

Determining Material Participation of Estates and Trusts

A number of practitioners asked the IRS to provide guidance on determining the material participation of estates and trusts. They noted that the enactment of Code Sec. 1411 has created an additional and compelling reason for the need to determine how an estate or a trust materially participates in an activity. The IRS agreed that the practitioners had raised a valid concern but believes additional guidance in this area is more appropriately in Code Sec. 469 regulations.

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.

Partnership Guaranteed Payments and the NIIT

The proposed regulations address the treatment of Code Sec. 707(c) guaranteed payments under Code Sec. 1411. The treatment depends on whether the partner receives the payment for services or the use of capital. The proposed regulations exclude all Code Sec. 707(c) 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. The IRS believe that guaranteed payments for the use of capital share many of the characteristics of substitute interest, and therefore should be included as net investment income.

Partnership Section 736 Payments and the NIIT

The 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). (Parker Tax Publishing Staff Writers)

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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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