Chapter 3. NIIT Impact on Trusts, Estates and Dispositions of Phps. and S Corps. New 3.8% Tax Applies to Trusts & Estates

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1 Chapter 3 NIIT Impact on Trusts, Estates and Dispositions of Phps. and S Corps. 1 New 3.8% Tax Applies to Trusts & Estates 2

2 Not: Charitable Trusts Retirement Plans 3 Trust or Estate NIIT is imposed on the lesser of: a) The undistributed net investment income of the estate or trust, or 3-5 b) The excess (if any) of the fiduciary AGI over the dollar amount at which the highest tax bracket begins. 4

3 Tax Calculation: 3.8% of lesser of: UNII FAGI > top bracket $11,950 5 Fiduciary AGI = Total income reduced by the personal exemption the distribution deduction and the deductions for costs incurred only because the property is held in an estate or trust (IRC sec. 67(e)). 6

4 Trusts and Estates 2013 Income Tax Rates If Taxable Income is: Tax Rate Not over $2,450 15% $2,451 to $5,700 25% $5,701 to $8,750 28% $8,751 to $11,950 33% Over $11, % 7 Relevance of Trust and Estate Top Bracket: (1) 3.8% NIIT (2) Capital Gains at 20% (3) Ordinary income at 39.6% 8

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6 Example (1). Calculation of undistributed net investment income In Year 1, Trust has: dividend income of $15,000, interest income of $10,000, capital gain of $5,000, and IRA distribution $25,000 (IRD). 11 Trust has no expenses. Trust distributes $10,000 of its current year trust accounting income to A, a beneficiary of Trust. 12

7 Trust allocates $5,000 of capital gain to principal for trust accounting purposes 13 DNI $15,000 (30%) Div. Int. Cap. Gains $10,000 (20%) Taxable IRA Distrib. $25,000 (50%) Total $50,000 (100%) Distrib. Ded. $3,000 $2,000 $5,000 $10,000 14

8 Trust Net Investment Income Dividend $15,000 Interest $10,000 Capital Gain $ 5,000 Trust NII $30,000 IRA income is excluded from NII $10,000 $15,000 $5,000 $5,000 $30,000 16

9 Trust Undistributed Net Investment Income Trust NII $30,000 Dividend Distrib. - $3,000 Interest Distrib. - $2,000 Trust UNII $25,000 $5,000 NIIT: $25,000 x 3.8% = $ DNI $15,000 (30%) Div. Int. Cap. Gains $10,000 (20%) Taxable IRA Distrib. $25,000 (50%) Total $50,000 (100%) Distrib. Ded. $3,000 $2,000 $5,000 $10,000 The distributed investment income is taxed to the beneficiary 18

10 Trust AGI Total Income $55,000 Distribution Ded. -$10,000 Exemption - $100 Trust AGI $44, $30,000 - $5,000 $25,000 $44,900 $11,950 $32,950 $25,000 $25,000 x 3.8% = $950 20

11 Section 1.643(a)-3(b)(1) provides that a fiduciary may allocate capital gains between corpus and DNI as long as such decision is a reasonable and impartial exercise of discretion and part of a consistent practice over time. Per preamble to final section 1411 regulations 21 Example (2) Calculation of undistributed net investment income -- with an amount paid for charitable purposes. 22

12 Final Reg. Example Estate with Fiscal Year Ending 10/31/2013 All estate income is $20,000 interest and $20,000 dividends distributed quarterly with the last quarter s payment on December 5, Estate is not subject to NII because it began 11/1/2012. Because the estate has no NII, the distributions to the beneficiaries are not NII. What about the Dec. 5, 2013 distribution? Make the IRC sec. 663(b) election to treat it as distributed Oct. 31,

13 A number of commentators requested that Treasury provide guidance on material participation of estates and trusts. Clearly, such guidance would apply primarily to IRC sec. 469 and secondarily to Treasury has agreed to open a reg. project on this issue. 25 TAM (April 26, 2013) 15-1 Only Trustee's Fiduciary-Capacity Activities Count For Material Participation Purposes 26

14 Example (3) Calculation of an ESBT's NIIT 27 Final Regs. Detail Treatment of Charitable Remainder Trusts (CRTs) 28

15 Several commentators requested that the final regulations explicitly provide that section 1411(c)(1)(B) properly allocable deductions include fiduciary commissions, legal and accounting fees, and other estate and trust administration expenses. The final regs. do so % NIIT On Sales of S Corporation Stock And Partnership Interests 30

16 Category One Category Two Category Three Investment Income (before deductions) Gross Income Interest, Dividends, Annuities, Royalties, and Rents that is: Nonbusiness (investment) Passive business income Trading business income Other Gross Income that is: Passive business income or Trading business income Net Gain from the disposition of property that is: Nonbusiness (invest. or personal) Passive business Trading business 31 Category Three Net Gain from the disposition of property that is: Nonbusiness (invest. or personal) Passive business Trading business What escapes category three? Nonpassive business gain except for trading assets. 32

17 IRC Sec. 1411(c)(4): (4) Exception for certain active interests in partnerships and S corporations. In the case of a disposition of an 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 all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest, and (B) a rule similar to the rule of subparagraph (A) shall apply to a loss from such disposition. 33 Gain on sale of passthrough entity is NII only to the extent of the inside gain on Section 1411 Property. 34

18 Section 1411 Property is: Passive Business Property Investment Property Trading Property Personal Use Property 35 Example (1): Alice materially participates in her 100% owned C corporation s business. All assets are business property except marketable securities with $20,000 built-in gain. 36

19 In 2013, she sells her stock and recognizes a gain of $900,000. The entire $900,000 is category three NII. 37 Example (2): Same facts as Example (1) except the entity is an S corporation. The only Section 1411 Property of the S corporation is the marketable securities. 38

20 $20,000 of gain is NII The lesser of: $900, Chapter 1 gain or $20, Alice s share of inside gain on the Section 1411 Property 39 Example (3): Alice is a nonpassive partner in a business partnership and she recognizes a gain of $900,000 on the sale of her partnership interest. Assume $20,000 of built-in gain (Alice s share) on marketable securities ( Section 1411 Property ) 40

21 $20,000 of gain is NII The lesser of: $900, Chapter 1 gain or $20, Alice s share of inside gain on the Section 1411 Property 41 Example (4): Bill is the passive partner in a business partnership and he recognizes a gain of $900,000 on the sale of his partnership interest. Assume $20,000 of built-in gain on marketable securities ( Section 1411 Property ) 42

22 The entire $900,000 is category three NII If possible, use grouping rules to make Bill nonpassive 43 ABCD Balance Sheet Assets Tax Basis FMV Cash $100,000 $100,000 Inventory $20,000 $100,000 Investment asset $80,000 $100,000 Goodwill $100,000 $100,000 Total Assets $300,000 $400,000 Partner s Outside Basis Capital Alice $75,000 $100,000 $75,000 Bob $75,000 $100,000 $75,000 Carol $75,000 $100,000 $75,000 Don $75,000 $100,000 $75,000 Total Capital $300,000 $400,000 Alice sells to Debra for $100,000 44

23 Alice Materially Participates in the Partnership 45 Chapter 1 Income IRC sec. 751(a) If S stock, then $25,000 of capital gain 46

24 Draft 2013 Form 1040 $5,000 $20, $5,000 of gain is NII The lesser of: $25, Chapter 1 gain or $5, Alice s share of inside gain on the investment asset Section 1411 Property 48

25 Draft 49 Draft Form 8960 $25,000 Adjustment -$20,000 $5,000 50

26 If Alice does not materially participate, then her entire gain is NII under IRC sec Draft Form 8960 $25,000 Adjustment 0 $25,000 52

27 ABCD Balance Sheet Sale at a 5% Discount Assets Tax Basis FMV Cash $100,000 $100,000 Inventory $20,000 $100,000 Investment asset $80,000 $100,000 Goodwill $100,000 $100,000 Total Assets $300,000 $400,000 Partner s Outside Basis Capital Alice $75,000 $100,000 $75,000 Bob $75,000 $100,000 $75,000 Carol $75,000 $100,000 $75,000 Don $75,000 $100,000 $75,000 Total Capital $300,000 $400,000 Alice sells to Debra for $95, Alice Materially Participates in the Partnership 54

28 Chapter 1 Income Gain Realized without $20,000 ($95K - $75K) IRC sec. 751 Sec. 751 Ord. Inc. - $20,000 ($80,000 4) Capital Gain $ 0 If S stock, then $20,000 of capital gain 55 $5,000 of gain is NII The lesser of: $20, Chapter 1 gain or $5, Alice s share of inside gain on the investment asset Section 1411 Property 56

29 Draft 57 Draft Form 8960 $20,000 Adjustment -$15,000 $5,000 NII was $0 under the 2012 proposed regs. because the discount was all attributed to the 1411 Property 58

30 ABCD Balance Sheet Sale at a $30,000 Premium Assets Tax Basis FMV Cash $100,000 $100,000 Inventory $20,000 $100,000 Investment asset $80,000 $100,000 Goodwill $100,000 $100,000 Total Assets $300,000 $400,000 Partner s Outside Basis Capital Alice $75,000 $100,000 $75,000 Bob $75,000 $100,000 $75,000 Carol $75,000 $100,000 $75,000 Don $75,000 $100,000 $75,000 Total Capital $300,000 $400,000 Alice sells to Debra for $130, Alice Materially Participates in the Partnership 60

31 Chapter 1 Income Gain Realized W/0 751 $55,000 ($130,000 - $75,000) IRC sec. 751(a) Ordinary Income - $20,000 Capital Gain = 35,000 If S stock, then $55,000 of capital gain 61 $5,000 of gain is NII The lesser of: $55, Chapter 1 gain or $5, Alice s share of inside gain on the investment asset Section 1411 Property 62

32 63 Draft Form 8960 $55,000 Adjustment -$50,000 $5,000 $35,000 of NII under the 2012 Proposed Regs 64

33 Sale at a Loss 65 ABCD Balance Sheet Sale at a 20% Discount Assets Tax Basis FMV Cash $100,000 $100,000 Investment asset $100,000 $200, Asset $200,000 $100,000 Total Assets $400,000 $400,000 Partner s Outside Basis Capital Alice $100,000 $100,000 $100,000 Bob $100,000 $100,000 $100,000 Carol $100,000 $100,000 $100,000 Don $100,000 $100,000 $100,000 Total Capital $400,000 $400,000 Alice sells to Debra for $80,000 66

34 Alice Materially Participates in the Partnership 67 Chapter 1 Capital Loss of <$20,000> ($80, ,000) Same if S stock Assume that Alice also recognizes a capital gain of $20,000 from her sale of Apple Inc. stock in 2013; so her regular tax net capital gain is zero. 68

35 Form 1040 Schedule D: Apple Inc. Sale Gain $20,000 ABCD Php Sale Loss <$20,000> Draft 2013 Form 1040 $0 69 $0 of loss is in NII The lesser of: $20, Chapter 1 Loss or $0 - Alice s share of inside loss on Section 1411 Property 70

36 71 Draft Form 8960 $0 Adjustment +20,000 $20,000 Impact, the entire $20,000 capital gain from the sale of Apple Inc. is NIIT 72

37 What if Alice Does Not Materially Participate in the Partnership Sale for $80, ABCD Balance Sheet Sale at a 20% Discount Assets Tax Basis FMV Cash $100,000 $100,000 Investment asset $100,000 $200, Asset $200,000 $100,000 Total Assets $400,000 $400,000 Partner s Outside Basis Capital Alice $100,000 $100,000 $100,000 Bob $100,000 $100,000 $100,000 Carol $100,000 $100,000 $100,000 Don $100,000 $100,000 $100,000 Total Capital $400,000 $400,000 Alice sells to Debra for $80,000 74

38 Form 1040 Schedule D: Apple Inc. Sale Gain $20,000 ABCD Php Sale Loss <$20,000> Draft 2013 Form 1040 $0 75 A <$20,000> passive capital loss all allowed for NII Purposes. 76

39 77 Draft Form 8960 $0 Adjustment Impact, the entire $20,000 capital gain from the sale of Apple Inc. is offset by the $20,000 passive capital loss on the sale of the ABCD partnership interest. +0 $0 78

40 Optional Simplified Method Use the K-1s to determine NII 79 Optional Simplified Reporting: Multiply Chapter 1 gain by the following fraction. Numerator: seller s share of net income, gain loss, and deductions on Section 1411 property in the year of disposition and two prior years (the Section 1411 Holding Period) 80

41 Denominator: seller s share of all items of net income, gain loss, and deductions in the Section 1411 Holding Period. 81 Conditions for Simplified Method 1) 5% or less of the sum of separately stated income, gain, loss and deduction items (with loss and deductions as positive numbers) is attributed to Section 1411 Property during the Section 1411 Holding Period And gain or loss is under $5 million. 82

42 Or 2) The gain or loss recognized does not exceed $250, Example (1): A owns a 50% interest in P a partnership. A sells the interest for $2,00,000. A s outside basis is $1,100,000 A s gain is $900,000 84

43 Aggregate Income/Loss in 1411 Holding Period X (Nonpassive to A) $1,800,000 Y (Passive to A) ($10,000) Marketable Securities $20,000 The 5% Test is Met: 30,000/1,830,000 is less than 5% And gain is under $5 million 85 Numerator: seller s share of net income, gain loss, and deductions on Section 1411 property in the year of disposition and two prior years (the Section 1411 Holding Period) $10,000 86

44 Denominator: seller s share of all items of net income, gain loss, and deductions in the Section 1411 Holding Period. $1,810, Gain in NII = $4, ($900,000 x 10,000/1,810,000) 88

45 Example (2): Same as Example (1) but A sells at a loss of <$200,000> Because the income or loss during the 1411 Holding Period is positive $10,000, and the sale was at a loss, the fraction is $0. None of the loss is in NII 89 Information Reporting Transferors who use the primary method must generally obtain from the Passthrough Entity the share of net gain or loss from the deemed sale of the Section 1411 Property. 90

46 However, the proposed regulations only require the Passthrough Entity to provide this information to transferors that are ineligible for the optional simplified reporting method in proposed (c). 91 If a transferor qualifies to use the optional simplified reporting method but prefers to use the primary method the transferor must negotiate with the Passthrough Entity the terms under which the information will be supplied. 92

47 Any transferor applying proposed reg , must attach a statement to the transferor's income tax return for the year of disposition. 93 That statement must include: (1)the taxpayer's name and taxpayer identification number; (2)the name and taxpayer identification number of the Passthrough Entity in which the interest was transferred; 94

48 3) the amount of the transferor's gain or loss on the disposition of the interest under chapter 1; and 4) the amount of adjustment to gain or loss by reason of basis differences for chapter 1 and section 1411 purposes if a CFC or PFIC. See (d). 95 The transferor must also attach a copy of any information provided by the Passthrough Entity to the transferor relating to the transferor's allocable share of gain or loss from the deemed sale of the Passthrough Entity's Section 1411 Property. 96

49 Partners IRC sec. 731 Gains are generally category three NII 97 IRC sec. 707(c) guaranteed payments for services are NOT NII (whether SE income or not) 98

50 Guaranteed payments for capital are like interest thus NII if not subject to SE tax 99