New section 1411 regulations answer a number of questions

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1 New section 1411 regulations answer a number of questions Taxpayers receive some favorable guidance in the final regulations interpreting the 3.8 percent net investment income tax Prepared by: Ed Decker, Director, Washington National Tax Don Susswein, Principal, Washington National Tax James Sansone, Director, Schaumburg, Ill December 2013 Executive summary The IRS on Nov. 26 released much-anticipated guidance regarding the 3.8 percent net investment income tax. Highlights in the final regulations include the following: y Taxpayer-friendly guidance excluding from net investment income certain self-rentals and other rental income that is properly grouped with a non-passive trade or business activity y A useful safe-harbor provision for qualified real estate professionals who participate in rental real estate activities for more than 500 hours per year y Taxpayer-friendly revisions that will, in some cases, allow taxpayers with losses in excess of gains from property dispositions to offset other investment or business income with the excess losses y Favorable changes with respect to calculating allowable deductions for items such as investment expenses The guidance also includes new proposed regulations dealing with issues that were either not previously addressed by the IRS or that involved significant modifications from the previously proposed regulations. This guidance includes rules governing guaranteed payments to partners and rules governing the disposition of an ownership interest in a non-passive S corporation or partnership. Taxpayers and their advisors should review these new rules carefully, as there may be opportunities to mitigate the impact of the 3.8 percent tax. Analysis Beginning in 2013, certain taxpayers are subject to a new 3.8 percent tax on various categories of unearned income. That tax, often referred to as the net investment income tax, was enacted via the addition of section 1411 to the Internal Revenue Code as part of the Health Care and Education Reconciliation Act of This new tax regime applies to individuals, estates and trusts. In general terms, for individuals, the net investment income tax is imposed on the lesser of 1) the taxpayer s net investment income, or 2) the taxpayer s modified

2 adjustment gross income in excess of a specified threshold. Similar rules apply to estates and trusts. By statute, net investment income comprises three categories of income: y Gross income from interest, dividends, annuities, royalties and rents, other than such income that is derived in the ordinary course of a trade or business, y Trade or business income from a passive activity with respect to the taxpayer or related to trading in financial instruments, and y Net gains attributable to the disposition of property (other than property utilized in a non-trading trade or business that is non-passive to the taxpayer) The sum of these three categories is reduced by properly allocable deductions to arrive at net investment income. To provide taxpayers with guidance on the application of this tax, the IRS on Nov. 30, 2012, released proposed regulations outlining rules in a number of areas. Following a review of public comments, the IRS released final regulations (T.D. 9644) on Nov. 26, These final regulations retained many of the provisions from the proposed regulations but also modified certain aspects of the proposed regulations and clarified the application of other rules. The final regulations continue to apply many passive activity rules to the net investment income tax. The IRS also released new proposed regulations (REG ) addressing certain issues that either were not previously discussed in the 2012 proposed regulations, or that were modified so significantly that the IRS wanted to provide taxpayers with an opportunity to comment prior to issuing the rules in final form. Most provisions of the final regulations are effective for taxable years beginning after Dec. 31, For 2013, taxpayers may rely on either the final regulations or the proposed regulations released in November The discussion that follows starts by highlighting the major changes and clarifications in the final regulations. It then outlines the major provisions of the new proposed regulations. Final regulations major provisions Trade or business definition The major category of investment income exempt from the tax is income from a trade or business in which the taxpayer materially participates under the passive activity rules of section 469 (excluding the business of trading certain financial instruments). Accordingly, a major interpretive question relates to the definition of a trade or business for these purposes. The IRS declined to provide any guidance on this question, pointing out that the same issue arises in many other areas of the tax law and suggesting that existing guidance in those areas should be sufficient. Self-rentals Despite the absence of a general definition of trade or business, the final regulations provide a very useful rule for so-called self-rental income, which typically arises when a business segregates its real estate in a separate legal entity for asset protection purposes and pays rent to the separate entity. In a typical situation, the real estate is held in a partnership or limited liability company (LLC), and the operating business is conducted in an S corporation, with the S corporation paying rent to the partnership or LLC. Although taxpayers typically employ this structure for non-tax reasons, the IRS historically has been concerned that this structure can be used as a mechanism to generate passive partnership income that could be used to absorb passive losses from other unrelated sources, which would not otherwise be allowed. As a consequence, the passive activity regulations recharacterize such income (i.e., self-rental income) as non-passive in certain circumstances. When 2

3 the 2012 proposed section 1411 regulations were issued, commentators expressed concerns that it might be difficult to satisfy the IRS that the activities of the landlord entity were undertaken as part of a trade or business, even if the tenant entity were clearly so engaged. The juxtaposition of the passive regulations and the net investment tax regulations presents two questions. First, does the recharacterization of self-rental income to non-passive status apply for purposes of the net investment income tax? Second, if the recharacterization rule does apply, does the rental activity need to rise to trade or business status in order to avoid application of section 1411? Fortunately, the final regulations provide favorable guidance on both points. The regulations clearly state that self-rental income retains its non-passive status for purposes of the net investment income tax if the individual owner is materially participating in the business. The regulations also explicitly state that such income is deemed to be derived in the ordinary course of a trade or business. As a consequence, self-rental income is generally not subject to the net investment income tax for non-passive (i.e., active) owners. Real estate professionals The final regulations also provide favorable guidance for certain qualifying real estate professionals. If more than 50 percent of a taxpayer s personal service time in trades or businesses are performed in real property trades or businesses in which he or she materially participates, and more than 750 hours per year are spent by such taxpayer in real property trades or businesses in which he or she materially participates, the taxpayer can elect to treat all interests in rental real estate undertakings as a single activity. By making this rental real estate aggregation election, the taxpayer can ensure that the income or loss from the combined rental activities will avoid per se passive treatment. For purposes of this election, real property trades or businesses include any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Following the release of the 2012 proposed regulations, it remained unclear whether the real estate professional status protected the rental income component of the taxpayer s real estate activities from the net investment income tax. In particular, commentators questioned whether the election to treat the real estate activities as a single activity addressed the trade or business issue. That is, if the combined activities needed to qualify as a trade or business, or if each individual rental activity needed to separately satisfy the trade or business requirement in order to avoid application of section The final regulations clarify that not all real estate professionals are necessarily engaged in the trade or business of rental real estate. However, the regulations do provide a safe harbor. If a qualified real estate professional participates in rental real estate activities for more than 500 hours in a particular year, the rental income will be deemed to be derived in the ordinary course of a trade or business. Alternatively, if the taxpayer would have satisfied this rule in any five of the prior 10 years, the taxpayer will similarly satisfy the safe harbor. It should be noted that the 500-hour requirement applies exclusively to the rental component of the taxpayer s real estate activities. That safe harbor, coupled with the qualified real estate professional election, would generally protect the rental income and gains on sale from the net investment income tax. Self-charged interest Where a taxpayer has loaned money to a non-passive activity, his or her share of the interest income on the loan will be treated as derived in the ordinary course of a trade or business and will be excluded from net investment income to the extent of his or her share of deductions for interest expense incurred by the borrowing non-passive activity. 3

4 Regroupings One of the major planning opportunities outlined in the proposed regulations was the provision that allowed certain taxpayers a one-time opportunity to regroup activities for purposes of the passive activity rules (section 469). Because the determination of whether an undertaking is passive (generally subject to the tax) or non-passive (generally not subject to the tax) is made based on the grouped activity, taxpayers who qualify to regroup their activities could potentially avoid application of the tax to the extent they materially participate in the grouped activity. Among the concerns raised by commentators were the following: y The opportunity to regroup was only available to taxpayers who were subject to the net investment income tax, not to all taxpayers y For certain groupings where rental activities were included in the grouping, it was uncertain whether each separate undertaking would need to be a trade or business, or whether the trade or business requirement could be met where only some, but not all, undertakings within the group were trades or businesses y S corporations and partnerships, which are also subject to the grouping rules, were not provided the opportunity to regroup activities at the entity level Although the IRS acknowledged commentators concerns, the final regulations do not extend the regrouping opportunity to S corporations or partnerships, or to taxpayers who are not subject to the tax. The final regulations do indicate that if gross rental income from a rental activity is properly grouped with a trade or business activity that is non-passive to the taxpayer, the rental income is deemed to be derived in the ordinary course of a trade or business. Trusts The net investment income tax applies to estates and trusts to the extent of the lesser of 1) the trust s undistributed net investment income, or 2) the excess of the trust s adjusted gross income over the dollar amount of the highest income tax threshold ($11,950 for 2013). Given the extremely low income threshold at which the tax applies, there were many trust-specific comments following the release of the proposed regulations. One comment related to electing small business trusts (ESBTs). Based on the proposed regulations, an ESBT would calculate its undistributed net investment income separately for the S corporation portion and for the non-s corporation portion of the trust, based on normal tax rules. As a consequence, losses in one portion would not be available to offset income in the other portion of the trust, thereby potentially subjecting the trust to tax despite the possibility of an overall loss. Although the IRS acknowledged that the ESBT may be at a computational disadvantage relative to other trusts in the case of netting income and loss items, it refused to modify the rule outlined in the proposed regulations. A more contentious issue relates to the material participation standard for trusts. A trust that can establish material participation in an activity will generally avoid the net investment income tax on that activity s undistributed income, similar to the treatment of an individual. There is significant uncertainty, however, when it comes to determining whether a trust is materially participating in an activity. Legislative history suggests that only the fiduciary s participation is relevant when making this determination. Judicial guidance has at times indicated that participation by the beneficiaries and employees of the trust in the activities may also be considered. 4

5 Again, the IRS acknowledged the issue. It refused, however, to provide additional guidance in the final regulations, noting that 1) such guidance would be addressed more appropriately in the section 469 (passive activity) regulations, and 2) the issue is currently under study and may be addressed in separate guidance at a later date. This means that a trust will continue to have relatively little certainty when making a determination as to whether it satisfies the material participation standard. Losses The final regulations acknowledge that the rules of the 2012 proposed regulations would have yielded situations where gross gains and gross losses flowing through from a trader hedge fund, for example, would not have been allowed to offset each other. To solve this inequity, the final regulations remove gross gains from the second category of gross investment income and place them into the third category, where gains and losses are netted to yield net gains. In addition, where there are losses in excess of gains in that category, the excess losses (allowable for regular income tax purposes and not previously used in determining net gain under section 1411) are usable for purposes of section 1411 against other categories of gross investment income as properly allocated deductions. This also applies to net losses arising under section 475 (for example, in the case of a trader fund that had elected to apply the mark-to-market rules of that provision). Section 1231 losses and the annually allowed $3,000 income tax deduction of capital losses against ordinary income would be permissible for section 1411 purposes as well, as long as there was ordinary gross investment income against which such losses could apply. New proposed regulations Sale of S corporation or partnership interest Although gains from the disposition of property are generally included in net investment income, there is an exception for gains related to a transferor s disposition of a non-passive interest in a partnership or an S corporation. Many believe the statute provides that the gain is generally excludable from net investment income. The 2012 proposed regulations described the method a taxpayer would use to exclude this gain on disposition of such interests. Those rules were not well-received for a number of reasons, including: y Commentators felt the proposed regulations were inconsistent with the statute, potentially subjecting embedded gain to the tax in situations where the activity was non-passive to the transferor. Embedded gain would exist to the extent a transferor s outside tax basis in the entity was less than the transferor s pro rata share of the inside basis of the entity s assets. y The proposed regulations outlined burdensome information reporting requirements, despite the fact that the transferor might have limited ability to access the information required to substantiate the adjustment. In response to these concerns, the IRS withdrew the 2012 proposed regulations and issued new proposed regulations in this area. The new proposed regulations modify significantly the calculation of gain includible in net investment income and make substantive changes to the information reporting requirements. Under the new primary method outlined in the proposed regulations, the transferor s includible gain is calculated as the lesser of 1) the amount of gain recognized, or 2) the transferor s allocable share of net gain from a deemed sale of the entity s section 1411 property (i.e., property that, if sold, would generate gain or loss that would be includible in net investment income). This change addresses the inconsistency between the 2012 proposed regulations and the statute. In addition, the transferor is no longer required to provide property-by-property information (as was outlined in the 2012 proposed regulations) to substantiate the exclusion of gain. Instead, taxpayers are allowed to compute the information on an activity-by-activity basis, thereby significantly reducing the compliance burden. 5

6 In addition to the primary method outlined above, the proposed regulations allow certain transferors to apply an optional simplified reporting method in situations where the gain associated with passive assets is likely to be small. This method significantly reduces the information-sharing burden on the pass-through entity by allowing the transferor to use information from historical Schedules K-1 to determine the percentage of the overall gain that will be includible in net investment income. To qualify for this simplified method, the transferor must satisfy one of two requirements: y For the year of disposition and the prior two years, 1) the cumulative sum of the transferor s allocable share of separately stated items that ordinarily would be includible in net investment income (e.g., interest income, dividend income, etc.) must be 5 percent or less of the cumulative sum of all separately stated items, and 2) the total gain must be $5 million or less, or y The total gain must be $250,000 or less If either of those two conditions is met, the taxpayer has the option of using the simplified method, which essentially involves applying the historic percentage outlined above (includible net investment income and loss items for the current and prior two years as a percentage of total separately stated items for that period with loss and deduction items treated as positive amounts) to the total gain or loss recognized on the sale. The calculated amount would be included in net investment income. In addition to these changes, the new proposed regulations modify the information reporting that would be required by the transferor and the pass-through entity. In situations where the pass-through entity knows, or has reason to know, that the transferor does not qualify for use of the optional simplified reporting method, the proposed regulations require that the pass-through entity provide information to the transferor sufficient for the transferor to calculate the reportable gain under the primary method. If, however, the transferor qualifies to use the simplified method, the pass-through entity is not required to provide any additional information to the transferor. Treatment of certain payments by a partnership IFollowing the release of the 2012 proposed regulations, many commentators requested guidance on the treatment of a variety of items not explicitly addressed in the regulations. Among these items were guaranteed payments by a partnership (section 707(c) payments) and payments to a retiring or deceased partner (section 736 payments). The new proposed regulations provide guidance on these areas. The preamble to the new proposed regulations indicates that guaranteed payments for the use of capital share many of the characteristics of interest. As a consequence, the new proposed regulations indicate that such payments are includible in net investment income. However, guaranteed payments for services are not includible, regardless of whether the payments are subject to self-employment tax. Payments that are considered to be a distributive share of partnership income conform to the normal rules with respect to such payments. Payments treated as a distributive share of partnership income are either passive (subject to the tax) or non-passive (not subject to the tax) based on the normal section 469 rules. With respect to payments to a retiring or deceased partner, the proposed regulations provide that payments in exchange for partnership property (i.e., section 736(b) payments) are treated in a manner similar to partnership distributions. Therefore, gain on such distributions will normally be includible in net investment income, except in the case of dispositions where the partner materially participated in the activity. 6

7 Conclusion The preceding discussion addresses a number of the more significant changes and clarifications outlined in the final regulations and the new proposed regulations. However, this discussion is not all-inclusive, and many additional changes referenced in these regulations will impact many taxpayers. There are also additional details, including many examples, pertaining to the items summarized above. A thorough review of the complete guidance is critical to analyzing how these rules will ultimately impact specific taxpayers and identifying opportunities to mitigate the tax This publication represents the views of the author(s), and does not necessarily represent the views of McGladrey LLP. This publication does not constitute professional advice. This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services. This document does not constitute assurance, tax, consulting, business, financial, investment, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein. McGladrey LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person. McGladrey LLP is an Iowa limited liability partnership and the U.S. member firm of RSM International, a global network of independent accounting, tax and consulting firms. The member firms of RSM International collaborate to provide services to global clients, but are separate and distinct legal entities that cannot obligate each other. Each member firm is responsible only for its own acts and omissions, and not those of any other party. McGladrey, the McGladrey logo, the McGladrey Classic logo, The power of being understood, Power comes from being understood, and Experience the power of being understood are registered trademarks of McGladrey LLP McGladrey LLP. All Rights Reserved. 7

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