NET INVESTMENT INCOME TAX AND PASS-THROUGH ENTITIES: NEW PROPOSED RULES. By Sam Starr Ryan Prillaman Bloomberg Tax Specialists

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1 /////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////////// Special Report Series on Section 1411 NET INVESTMENT INCOME TAX AND PASS-THROUGH ENTITIES: NEW PROPOSED RULES

2 NET INVESTMENT INCOME TAX AND PASS-THROUGH ENTITIES: NEW PROPOSED RULES By Sam Starr Ryan Prillaman Bloomberg Tax Specialists Beginning in 2013, taxpayers need to comply with the new net investment income (NII) tax enacted as part the Health Care and Education Reconciliation Act of Generally speaking, the new 3.8% tax applies to a taxpayer s net investment income, but the tax base is limited to the excess of the taxpayer s modified gross income over certain threshold amounts ($200,000 for single taxpayers and $250,000 for joint taxpayers). NII generally includes gross income from interest, and dividends, annuities, royalties and rents, other gross income from passive activities, and net gains from the disposition of passive activity property. Passive activities frequently come packaged in the form of ownership interests in partnerships and S corporations. Therefore a key exercise in computing NII is carving up net gains between passive and non-passive activities of passthrough entities. 2 The IRS has just released proposed regulations outlining the parameters for NII pass-through net gains. 3 Certain key issues raised by the proposed regulations are the focus of this insight. Grouping Activities A One Time Opportunity For purposes of the IRC 469 passive activity loss limitation rules, taxpayers are permitted to group certain trade or business activities as a single activity if the activities represent an appropriate economic unit for measuring gain or loss. 4 Grouping activities can have a favorable impact on a taxpayer s passive activity loss 1 P.L , 1402(a)(1), enacting IRC IRC 1411(c)(1)(A)(iii) makes clear that net gain is to include only passive net gains. Net gains from non-passive activities (except for a trade or business of trading in financial instruments or commodities) are excluded from the net gain calculation, and are not subject to the net investment income tax. 3 Prop. Regs , REG , 78 Fed. Reg (12/2/13). 4 Regs (c). 1

3 limitation; however, once a taxpayer has grouped its activities, the taxpayer is generally not permitted to regroup them from year to year. 5 Given the significant impact of the NII tax, the IRS acknowledges that taxpayers may want to regroup their trade or business activities made with respect to previously filed returns. In recently finalized regulations, the IRS permits taxpayers to regroup their activities one time for 2013 tax years and later, if and when they first become subject to the NII tax. 6 Taxpayers will need to meet the applicable income thresholds and have net investment income for the tax year in which they regroup activities. This regrouping will apply to the current tax year and all subsequent tax years. The regrouping would be made by individual investors in pass-through entities. Partnerships and S corporations cannot regroup their activities at the entity level under the new rule. 7 Observation: Regrouping trade or business activities, possibly as early as the 2013 tax year, is a significant tax planning opportunity, and will complicate the tax filing for many taxpayers in the upcoming tax season. These rules are effective for taxable years beginning after December 31, 2013, but taxpayers may apply this section of the regulations to tax years beginning after December 31, NII and Certain Partnership Payments Under IRC 1411(c)(A)(1)(iii), net gains from a trade or business that is a passive activity with respect to the taxpayer are included in the passive-taxpayer s NII for the taxable year. In general, IRC 731 distribution gains (actual and deemed distributions of money 9 or marketable securities in excess of partner outside basis) are treated as amounts received from a sale or exchange of a partnership interest. If a partnership s trade or 5 Regs (e)(2) permits limited regrouping of activities if the original grouping was clearly inappropriate or there has been a material change in a taxpayer s facts and circumstances. 6 T.D. 9644, 78 Fed. Reg (12/2/13), adopting Regs (b)(3)(iv). 7 Regs (b)(3)(iv)(A), T.D Regs (b)(3)(iv)(D). 9 Section 752(a) provides, in general, that any increase in a partner's share of partnership liabilities (or an increase in a partner's individual liabilities by reason of the assumption by the partner of partnership liabilities) will be considered a contribution of money by such partner to the partnership. Conversely, 752(b) provides that any decrease in a partner's share of partnership liabilities (or a decrease in a partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities) will be considered a distribution of money to the partner by the partnership. See Regs et seq. Proposed regulations would provide guidance as to when and to what extent a partner is treated as bearing the economic risk of loss for a partnership liability when multiple partners bear the economic risk of loss for the same partnership liability and, in addition, when a partner has a payment obligation with respect to a liability or makes a nonrecourse loan to the partnership (and no other partner bears the economic risk of loss for that liability) and such partner is related to another partner in the partnership. See REG , 78 Fed. Reg. (12/16/13). Entity-level debt does not similarly affect shareholders stock basis in S corporations. 2

4 business is a passive activity with respect to the distributee-partner, then IRC 1411(c)(A)(1)(iii) would treat 731 gains as NII subject to the additional 3.8% tax to the extent that the 731 gain on the distribution exceeds the applicable threshold amounts. In addition, two common partnership distributions (not considered IRC 731 distributions) are IRC 707(c) guaranteed payments and IRC 736 distributions to retiring or withdrawing partners in liquidation of their partner interests. The proposed rules provide guidance on which of these payments, and what type, should be included in included in the computation of net investment income, and possibly treated as net gains. Guaranteed Payments. IRC 707(c) guaranteed payments are payments made to partners not dependent on partnership profits, and can be payments made for services rendered by the partner to the partnership, or as a payment for the use of capital. Given that guaranteed payments are not treated as a IRC 704(b) distributive share of partnership income, 10 how should these payments be characterized for purposes of the NII calculation? For Services. Prop. Reg (g)(10) 11 provides that guaranteed payments to a partner for services are not considered net investment income under IRC 1411(c). The policy rationale is consistent with the NII tax it applies to investment income and not earned income. Earned income is already subject to 3.8% medical insurance premium tax. 12 Guaranteed payments for services in most situations would be subject to the medical insurance premium tax, as well as the self-employment tax. For Capital. On the other hand, guaranteed payments for capital are considered to be NII under Prop. Reg (g)(10), because such payments share many of the characteristics of interest, one of the taxable categories of NII under IRC 1411(c)(1)(A)(i). 13 Liquidating Payments to Retiring or Withdrawing Partners. IRC 736 applies to payments made to retiring or deceased partners to liquidate their partnership interests. 14 There are different types of payments that can be characterized as liquidating payments. Under IRC 736(a), payments could be made for a partner s past 10 Regs (b)(2)(iv)(o). 11 REG IRC 1401(b). 13 See REG Note, guaranteed payments for capital are included in NII, but are not net gains from dispositions of passthrough entities under IRC 1411(c)(1)(A)(iii). 14 The IRC 736 analysis summarized here would not apply to the liquidation of the entire partnership. Those payments would be characterized as sale or exchange and characterized as net gain under IRC 1411(c)(1)(A)(iii) if all the requirements are met. 3

5 services, use of capital, or for Section 736(a) property. 15 Under IRC 736(b), payments to retiring or deceased partners would generally be characterized as partnership distributions in exchange for partnership property. The characterization of these payments under IRC 736 determines their categorization for NII purposes under the proposed rules. The proposed rules generally divide their treatment of liquidating payments into three categories: (1) IRC 736(a)(1) payments; (2) IRC 736(a)(2) payments; and IRC 736(b) payments. Section 736(a)(1) Payments. Under IRC 736(a)(1), if a liquidating payment is made with regard to partnership profits, it is treated as distributive share of partnership income to the retiring or deceased partner. Under the proposed regulations, the items of income (e.g., interest, dividends, etc.) in that distributive share would be included in NII under IRC 1411(c), if the partnership investment is a passive activity for that partner. 16 Note, even if the partnership interest is active, interest income earned from working capital would be included in the NII calculation, e.g., if the partnership has an interest-bearing bank account. Section 736(a)(2) Payments. IRC 736(a)(2) payments are treated as guaranteed payments. If the payments are made to the retiring or deceased partner in return for services, then the payments would not be included in the partner s NII calculation under IRC 1411(c). This is similar to the proposed regulation s general treatment of IRC 707(c) service payments. If the IRC 736(a)(2) payment is made for capital, the payment shares characteristics of interest and would be included in NII. Finally, if the IRC 736(a)(2) payment is for so-called Section 736 property, then the proposed regulations would treat the payment as received in a disposition of a partnership interest under IRC 1411(c)(1)(A)(iii), and gains would be included in the net gains for purposes of the distributee-partner s NII tax liability where the partnership s trade or business is considered a passive activity with respect to the taxpayer. 17 Section 736(b) Payments. IRC 736(b) payments are made in liquidation of the retiring or deceased partner s partnership interest in partnership property. Therefore, under the proposed rules, IRC 736(b) payments for an 15 The term section 736(a) property, as used in REG , as payments to general retiring payments for unrealized receivables (but not IRC 751(c) receivables), and for goodwill. See Regs (b)(1), (2), and (3). 16 Prop. Reg (g)(11)(A). The proposed rules generally follow IRC 469 in determining whether a payment is passive or non-passive with respect to IRC 736(a)(1) payments. See, e.g., Prop. Regs (g)(11)(ii)(B) Ex. 1 (applying Regs (e)(2)(iii)), Ex. 2 (applying Regs (e)(2)(iii) except to extent of excess distributive share payment). 17 Prop. Reg (g)(11)(iii). 4

6 interest in a partnership are treated as net gains subject to the NII tax 18 to the extent the partnership s trade or business is treated as a passive activity with respect to the taxpayer. Multiple Payments. For IRC 736(a)(2) and IRC 736(b) type payments treated under IRC 1411(c)(4), if multiple payments are made over a period of years, i.e., an installment sale, then the determination of whether or not the distributive share is passive would be made at the time the liquidation of the partner s interest commenced. 19 If a portion of the multiple payment amounts are to be excluded from IRC 1411(c)(1) because they are non-passive, then these excluded amounts are to be treated as an addition to basis under IRC 453 in determining the amount of gain included in NII as the payments are received. 20 Observation: This is a complicated rule, and in practice, would require a separate calculation of IRC 1411 installment sale basis to reach an accurate calculation of NII for multiple year transactions involving pass-through entities. Disposition of Active Interests in Pass-through Entities Under the current passive activity loss rules, an owner of an investment in a pass-through entity 21 (partnership or S corporation) may be either passive or active with respect to the trade or business activities conducted by the pass-through entity. And the characterization of passive or non-passive for any particular activity will vary from one owner-investor to another. IRC 1411(c)(4) excludes net gains from dispositions of active interests in pass-through entities from NII. The newly released proposed rules provide detailed guidance on how to calculate the active-interest net gain exclusion amount. The 2012 proposed required owners of pass-through interests to first compute gain or loss on the disposition of their interest, and then reduce that gain or loss by any non-passive gain or loss that would have 18 Prop. Reg. S (g)(11)(iv) 19 Prop. Reg (g)(11)(v); Regs (e)(2)(iii). See, e.g., See Prop. Regs (g)(11)(ii)(B) Ex. 1(i), (ii) (status of partnership s trade or business as passive activity with respect to partner determined under Regs (e)(2)(iii) at time liquidation of partnership interest commences and remains fixed for duration of payments where partnership agreement provides for payment of partner s share of partnership s unrealized receivables over 60 months). Cf. Prop. Regs (g)(11)(ii)(B) Ex. 2 (status of partnership trade or business as passive activity with respect to partner determined at time each liquidation payment is made to extent of excess distributive share payment (i.e., payment in excess of fair market value of partner s share of partnership s unrealized receivables) pursuant to partnership agreement as incentive for early retirement of partner). See also Prop. Regs (g)(11)(ii)(B) Ex. 1 (iii) (entire payment attributable to partnership s trade or business of trading in financial instruments and commodities treated as NII of retiring-distributee-partner regardless of status of partnership activities as passive or nonpassive with respect to the taxpayer). 20 Prop. Regs (d). 21 Prop. Regs (a)(2)(i). 5

7 been allocated to owner upon a hypothetical sale of all the pass-through entity s assets for fair market value immediately before transfer. Some commentators took issue with this approach. 22 The new proposed rules take these comments into account, and only include the owner s share of gain or loss from pass-through entity passive assets. Thus, the newly proposed calculation would exclude gains or losses from non-passive activities which hones closer to the statutory rule in IRC 1411(c)(4). The proposed rules provide two approaches to calculating the net gains to exclude non-passive activities a primary approach and an optional simplified method. Primary Approach. Under the primary approach, an owner disposing of an interest in a pass-through entity at a gain would include as net gain under IRC 1411(c)(1)(A)(iii) the lesser of: (a) the amount of gain the transferor would otherwise recognize under Chapter 1 of the Internal Revenue Code; or (b) the transferor s allocable share of net gain from a deemed sale of the pass-through entity s section 1411 property. 23 A similar rule applies to losses. To determine the gain or loss on Section 1411 property, the IRC 469 valuation rules are used. So rather than valuing an interest in a pass-through entity property-by-property, the proposed regulations would measure gain or loss activity-by-activity. 24 To determine the transferor s allocable share of net gain from section 1411 property, a deemed gain or loss calculation needs to be done based on a hypothetical sale of the entity s property activity-by-activity at fair market value (whether or not the transferor is passive or active with respect to the activities). 25 However, the transferor s allocable share of gain or loss from a deemed sale of a pass-through entity s section 1411 property only equals the sum of the transferor s allocable net gains or losses from the deemed sale of the transferor s passive activities (i.e., the activities in which the transferor does not materially participate). To perform this calculation, the pass-through entity would need to come up with a valuation of all its activities at the time of a disposition of interests by one of its owners. A net gain or loss calculation would need to be done for all activities taking into account the aggregate bases of all assets in each activity. These net gains 22 See REG See Prop. Regs (b)(2) Exs. 1, 2. Prop. Regs (a)(2)(iv) defines Section 1411 Property as owned by a passthrough entity, and if sold, would result in net gain or loss allocable to the transferor that would be characterized as NII (i.e., passive investment activity property with regards to that particular transferor). 24 Prop. Regs (b)(1)(i)(B), (ii)(b) (referencing Reg T(e)(3)). 25 See Regs T(e)(3)(ii)(B)(1)(i), (e)(3)(ii)(b)(2)(i). 6

8 or losses would then need to be allocated to the owner-transferor. Only those gains and losses from the ownertransferor s passive activities would be included in NII. Arguably, any pass-through entity that has passive investors is already performing these calculations for IRC 469 purposes, and there would not be that much additional administrative burden imposed on taxpayers. In addition, where a taxpayer is passive with regards to all activities of their pass-through investment, this should prove to be a more straightforward exercise; however, when an owner-transferor is passive and non-passive to activities in the same pass-through entity, the calculation of net gain on disposition of the pass-through interest becomes much more difficult. Optional Simplified Approach. Under the new optional simplified approach, the owner-transferor of a passthrough entity interest uses the relative percentage of their allocable NII-type items of income and loss, over their total allocation of income and deduction items, during the section 1411 holding period, as the percentage of passive net disposition gain. 26 The section 1411 holding period includes the current disposition tax year and the two prior tax years. 27 To qualify to use the optional simplified approach in calculating net gain on a disposition of a passthrough interest, the taxpayer must meet either, or both, of two tests. First, the taxpayer s allocable share of NII-type income from the pass-through entity must be only 5% or less of all separately stated items of income or loss allocated to the taxpayer during the section 1411 holding period. 28 To use the 5% test, the total amount of gain or loss recognized by the owner-transferor on the disposition of pass-through interests cannot exceed $5 million (including gains or losses from multiple dispositions as part of a plan). Observation: The 5% threshold seems very tight. It would never apply to owner-transferors who are passive as to all activities of their pass-through entity investment. It would appear to be most useful to those owners who are material participants with regards to most of their pass-through entity s activities. Second, if the gain or loss on the disposition of the pass-through entity interest does not exceed $250,000 (including gains or losses from multiple dispositions as part of a plan), the owner-transferor can use 26 Prop. Regs (c)(4). 27 Prop. Regs (a)(2)(iii). 28 Prop. Regs (c)(2)(i). 7

9 the optional simplified method without regard to the amount of any allocation of NII from the pass-through entity. This test would be useful to smaller, passive owner-transferors. The optional simplified method cannot be used by owner-transferors who have held their pass-through entity interest for less than 12 months. 29 The proposed rules also prohibit use of the optional simplified method to other taxpayers including: C corporations that have converted to S corporation status during the section 1411 holding period, and partnerships that transfer a partial interest, rather than a proportionate interest, in the economic rights in the partnership. Tiered Entities The proposed rules reserve on the issue of tiered pass-through entities. In the preamble to the proposed regulations, the Treasury highlights its concern that transactions that occur in lower-tier entities can have an impact on the owners of an upper-tier entity, but there is no current mechanism to provide information to upper tier owners of lower-tier transactions. The Treasury requests comments on these issues. Information Reporting By Pass-through Entity. Pass-through entities are required to provide to owner-transferors their allocable share of net gain or loss from the deemed sale of the entity s section 1411 property, but only if these owner-transferors cannot qualify to use the option simplified method. 30 If a taxpayer qualifies to use the optional simplified method, but instead wants to use the primary computation method, then the taxpayer will need to negotiate with the pass-through entity to obtain the necessary information to undertake the calculations. By Owner-Transferors Disposing their Interests. Any owner-transferor who intends to rely on Prop. Regs must attach a statement to their income tax return providing identifying information and the amount of gain or loss on their disposition of the pass-through interest. In addition, the owner-transferor must attach a copy of any information provided by the pass-through entity regarding the deemed sale of section 1411 property. 31 Conclusion 29 Prop. Regs (c)(3). 30 Prop. Regs (g)(1). 31 Prop. Regs (g)(2). 8

10 Passive activity income is subject to the NII tax. Thus, the proposed NII pass-through entity regulations certainly will have their greatest impact on passive activity investors. The proposed rules rely heavily on existing IRC 469 rules for detailed guidance and parallel treatment. With these rules, the IRS has attempted to minimize taxpayers administrative burden under the net investment income tax. Alas, as well intentioned as these efforts are, the net investment income tax will substantially increase pass-through entity owners taxes and their administrative burden. 9