Good News on the 3.8% Net Investment Income Tax

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1 December 24, 2013 Good News on the 3.8% Net Investment Income Tax The IRS recently released its final regulations under Section 1411 on the new 3.8% net investment income tax (TD 9644, 11/26/2013). These regulations are officially not applicable until the 2014 tax year, but have importance and can be followed for the 2013 tax year when this tax initially applies to individuals, estates and trusts. Background Section 1411 was enacted by the Affordable Care Act in It imposes a new 3.8% tax on net investment income of individuals, trusts and estates, effective for tax years beginning in The tax is 3.8% of the lesser of: 1. Net investment income; or 2. The excess of the taxpayer s modified AGI (MAGI) over a threshold of $200,000 ($250,000 if married filing jointly) [Sec. 1411(a)(1)]. Modified AGI is defined as AGI increased by any foreign earned income exclusion, net of deductions and exclusions disallowed with respect to the foreign earned income. As a result, in nearly all tax returns, we will be using AGI as the measure of the $200,000 or $250,000 threshold for this net investment income tax (NIIT). Example 1: Computation of 3.8% NIIT Ted and Beth, joint filers, report $220,000 of salaries and $80,000 of rental income, for a total of $300,000 of MAGI in The 3.8% NIIT applies to the lesser of the $80,000 of net investment income (rental income) or the $50,000 excess of their $300,000 AGI over the $250,000 joint threshold. Because the $50,000 excess AGI is the lesser amount, Ted and Beth will incur $1,900 of net investment income tax in 2013 ($50,000 excess AGI x 3.8%). Definition of Net Investment Income (NII) NII is calculated as the sum of three categories of income: 1. Gross income from interest, dividends, annuities, royalties, and rents, unless derived in the

2 ordinary course of a business; 2. Income from a business in which the taxpayer does not personally materially participate within the meaning of Section 469, and business income from trading in financial instruments and commodities; and 3. Capital gains and other net gains from the disposition of property, except to the extent attributable to an active interest in a business [Sec. 1411(c)(1)(A)]. The sum of these three categories of income is reduced by allowable deductions properly allocable to the gross income or net gain. Examples of allocable expenses include investment advisory fees exceeding the 2%-of-AGI floor, investment interest expense, and state income tax that is allocable to net investment income. Exceptions to Definition of NII The statute identifies several items that are specifically excluded from the definition of NII: 1. Active business income is excluded, as well as gains from the disposition of an interest in a partnership or S corporation in which the taxpayer materially participates. 2. Qualified retirement plan and IRA distributions. 3. Any item taken into account in computing self-employment income. 4. Tax-exempt interest, excluded gain from the sale of a principal residence, and other items that are excluded for regular income tax purposes [Sec. 1411(c)(4)-(6)]. The Final Regulations: Self-Rentals and Business-Rental Groupings In a major concession of benefit to small business owners, the final regulations reverse a position in the proposed regulations and now allow rental income from self-rental arrangements to be excluded from NII. Specifically, Reg (g)(6) excludes gross rental income from the definition of NII under two situations: 1. To the extent of the net rental income from property rented for use in a trade or business in which the taxpayer materially participates within the meaning of Reg T for the taxable year [i.e., a self-rental per Reg (f)(6)]); or 2. The taxpayer has grouped a rental activity with a trade or business activity under Reg (d)(1), so that the rental activity is deemed to be a material participation trade or business. The self-rental exclusion extends to real estate leased to a closely-held C corporation activity in which the taxpayer materially participates. For those whose self-rental income remains consistently positive, this self-rental exclusion from NII eliminates any need to group a rental property/activity and its related business activity, if that grouping has not previously occurred. The advantage to grouping a rental and its related business under Reg (d)(1) is to eliminate the risk of a suspended passive loss under Section 469 if the rental activity becomes negative (this alternative is not available for rental property leased to a C corporation). To the extent gain or loss results from the disposition of property that is excepted from NII under either of the above two rules, the gain or loss is also considered as derived from an active business and is not subject to the NIIT [Reg (g)(6)(ii)]. Example 2: Exclusion of self-rental income from NII Art owns farmland which he leases to his active farming business, a C corporation, in which he materially participates. Art has not grouped his land and the farming business because the business is conducted in a C corporation, and grouping under Reg (d) is not permitted. However, because

3 the farmland rental meets the self-rental definition of Reg (f)(6) as property leased to a business in which the taxpayer materially participates, Art is not subject to the 3.8% NIIT on his farmland rental income. While this provision regarding self-rentals in the final regulations will protect most active farmers from the NIIT, retired farmers who rent their land are exposed to this tax. Many will have modified AGI beneath the $200,000 single or $250,000 joint threshold at which this tax is imposed. However, when a sale of land occurs, a large capital gain from the sale of passive rental real estate would be subject to this tax. Retired farmers in this position will now have a greater incentive to consider an installment sale arrangement, if the result is to keep some or all of the gain beneath the threshold of this tax. Those who anticipate selling farmland in retirement years may also want to consider retaining an interest in the family farming business. To the extent the individual retains an interest in the active farming operation (e.g., a 5% ownership in the actively operated farming S corporation), they may continue to be eligible for the self-rental exception to the NIIT and also avoid the NIIT on a gain from the sale of the land. Many farm retirees will continue to participate to the extent of 500 hours per year during retirement years. But even if that participation declines below 500 hours, they may meet the test of having participated five out of the ten prior years and accordingly maintain the exemption from the NIIT on rental income and gain on the sale of land. Example 3: Exclusion of land gain by maintaining entity material participation Bill is retiring from full-time involvement in his farming corporation at age 68. Through a combination of gifts and stock sales, he has transitioned the ownership of 90% of the stock of this entity to his two sons, who have assumed the day-to-day management of the farming corporation. However, Bill continues to work long hours in the spring and fall busy seasons and assists with the grain marketing throughout the year, and achieves 500 hours of participation annually. As a result, Bill will continue to avoid the NIIT on the rental income he receives from the family farming corporation for the leasing of his farmland to the entity. Further, if Bill sells any land to his sons, the gain will be exempt from the NIIT, as it would represent a gain from property used in an active trade or business. Even if the sale occurs in a year when Bill is no longer materially participating by achieving 500 hours in the farming corporation but is still an owner, he may be materially participating under the five of ten year rule. Regrouping of Passive Activities The final regulations allow a one-time opportunity for an individual, estate or trust to regroup its potentially passive activities if the NIIT would otherwise apply. A taxpayer may regroup only in the first tax year after 2013 in which the taxpayer has NII and its income exceeds the threshold at which the tax would otherwise apply [Reg (b)(3)(iv)]. But the taxpayer may regroup for any taxable year that begins during 2013 if the eligibility criteria are met for that year. The following additional rules apply: 1. Regrouping must be made in the manner prescribed by other guidance and accomplished on an original return. Note that Rev. Proc requires grouping elections after 2010 to be in writing. 2. No regrouping is permitted by a partnership or S corporation. 3. Regrouping is only permitted on an amended return if the original return was not subject to the NIIT but the amended return (or IRS examination adjustment) causes NIIT, either because of an increase in AGI or an increase in NII. 4. If a taxpayer has regrouped but it is later determined that the taxpayer is not subject to the NIIT, the regrouping is voided. Commentary: This regrouping privilege is particularly important for taxpayers who have reported

4 passive business income in pre-2013 tax years and would now face the NIIT on that passive business income beginning in If that passive business income activity can be grouped with other business activities so as to achieve material participation, the NIIT can be eliminated. This grouping is under the authority of Reg (c), and requires that the grouped businesses represent an appropriate economic unit as defined under those regulations [Reg (b)(3), Example 2]. Example 4: Grouping to convert passive business income to active Chuck is a 25% owner in two S corporations in which he materially participates, a grain farming operation and a livestock operation. He is also a 25% owner in a third S corporation, a seed processing business, in which he does not participate. All three S corporations are owned by Chuck and his brothers. Chuck has reported the seed processing business as passive income, because there has been no benefit in the past in grouping this activity with the other family farming business operations. However, beginning in 2013, Chuck should consider grouping under the appropriate economic unit test of Reg (c). By doing so, he converts the seed processing business income flowing through on the S corporation Schedule K-1 from passive to active, and avoids the 3.8% NIIT. Re-grouping is permitted in the first year after 2013 in which Chuck is subject to the NIIT and he may choose to regroup in 2013 if he is subject to the NIIT in Self-Charged Interest The final regulations add an exception from NII for self-charged interest income. To the extent the interest income is attributable to a deduction of the interest expense from a nonpassive entity, the interest income is recharacterized as not subject to NII. For example, if a taxpayer collects $1,000 of interest income from a loan that the taxpayer made to a material participation business, and if 50% of the interest expense from that material participation business is allocable to the taxpayer, 50% of the interest income is recharacterized as not subject to NII. However, this rule does not apply to the extent the interest deduction is taken into account in determining self-employment income [Reg (g)(5)]. Disposition of a Partnership or S Corporation Interest The earlier proposed regulations contained a complex methodology for computing the portion of the gain on disposition of a pass-through entity that was allocable to an active business interest versus the portion allocable to NII. There was a deemed asset sale approach of the entire business in those earlier regulations, and a complex adjustment required because of possible differences between inside and outside basis. The IRS has simplified that approach in new proposed regulations for dispositions of partnership or S corporation interests where the owner materially participates in at least one business activity within the entity. In that case, the gain reportable for NII purposes is the lesser of: 1) the total gain of the transferor; or 2) the transferor s allocable share of the gain from a deemed sale of only the Section 1411 property within the entity [Prop. Reg (b)]. Example 5: Identifying the gain subject to NIIT Dan, an individual who conducts his active farming business through an S corporation, is selling 20% of the S corporation stock to his son. Because Dan materially participates in the S corporation, the gain is generally exempt from the NIIT. However, the S corporation has invested in several publicly-traded stocks over the years, and holds a small portfolio of securities with $50,000 of appreciation. The share of Dan s gain attributable to the stock is $10,000 ($50,000 total stock gain x 20% stock ownership). Dan would be exposed to the NIIT on that $10,000 share of his gain. The new proposed regulations also contain an optional simplified reporting alternative. To be eligible for this simplified alternative, the transferor of the interest in the partnership or S corporation must meet one of two tests:

5 1. The total amount of gain or loss recognized by the transfer or does not exceed $250,000; or 2. Considering the current and prior two years, the sum of the allocable income, gain, loss and deduction items of the transferor from that activity that are allocated to NII items are 5% or less of all income, gain, loss or deduction items attributable to the transferred interest (treating all loss and deduction items as positive numbers in computing both the numerator and denominator), and the total amount of gain or loss recognized by the transferor from the disposition of the interest in the passive entity does not exceed $5 million. If the taxpayer is eligible, the simplified reporting calculation allocates the amount of total gain from the disposition of the activity to NII by applying the ratio of the NII income, gain, loss and deduction items during the current and prior two year periods to the total allocable gain or loss on disposition [Prop. Reg (c)]. Summary Active ag producers will generally find their rental income exempt from the NIIT because of the selfrental exemption in the final regulations. But in retirement years, those who are exclusively landlords will face NII status on both their rental net income and their gain from disposition of the land. Installment sales or Section 1031 trades will have increased importance; an installment sale may assist in keeping the taxpayer s modified AGI beneath the threshold of the NIIT. One possible solution for landlords, as noted in Example 3 above, is for a retiree to maintain a materially participating interest in the operating entity. These final regulations and the companion new proposed regulations represent a significant improvement over the earlier draft in The preceding summary only covers selected highlights of the regulations that we considered to be of greatest interest to ag clients. Please consult the full regulations for further questions. Andy Biebl and Chris Hesse This has been sent to clients and friends of CliftonLarsonAllen. The information contained in the does not constitute the rendering of legal, accounting, investment, tax, or other professional services, but rather is intended as a means to inform our clients and friends about current topics of interest. This is a paid service from which you can unsubscribe at any time. CliftonLarsonAllen respects your privacy and will not share your address information with any third party without your expressed consent. To ensure compliance imposed by IRS Circular 230, any U. S. federal tax advice contained in this communication (including attachments) is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The information (including any attachments) contained in this document is confidential and is for the use only of the intended recipient. If you are not the intended recipient, you should delete this message. Any distribution, disclosure, or copying of this message, or the taking of any action based on its contents is strictly prohibited. View disclaimers for CliftonLarsonAllen LLP and CliftonLarsonAllen Wealth Advisors, LLC.

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