Net Investment Income Tax Update

Transcription

1 Net Investment Income Tax Update Jim Browne Crawford Moorefield Background Supplemental taxes (beginning 2013) Taxes on wages ( FICA ) 15.3% on base amount*; 2.9% on excess Paid ½ by employer and ½ by employee Additional 0.9% employee tax on excess wages of high-income individuals Self-employment tax ( SET ) 15.3% on base amount* adjusted for wages; 2.9% on excess Additional 0.9% tax on excess self-employment earnings of high-income individuals Net investment income tax ( NIIT ) New 3.8% tax on net investment income of certain high-income taxpayers *$118,500 for 2015 (indexed) Tax Symposium 1

2 Background Individuals 3.8% of the lesser of: net investment income ( NII ), or excess of modified adjusted gross income ( MAGI ) over the applicable threshold amount Threshold amounts (not indexed): $250,000 joint; $125,000 separate; $200,000 individual and other Trusts and estates 3.8% of the lesser of: undistributed net investment income, or excess of modified AGI over the highest income tax bracket threshold ($12,300 for 2015) 3 Additional information Background SET-and-NIIT-on-LLCs-Psps-and-S-Corps pdf Tax Symposium 2

3 Update / Deep Dive Can business income earned through a flowthrough entity (S Corp, LP, or LLC) escape both NIIT and SET? 5 SET/NIIT on S Corp Income Tax Symposium 3

4 S Corp Planning Trap #1 Using an S corporation to avoid SET/NIIT The distributive share income of an S corporation engaged in a non-trading business* is exempt from both SET and NIIT as to a shareholder who materially participates in the business BUT S corporations have significant disadvantages as compared to tax partnerships (e.g., one class of stock, no entity or foreign shareholders, no 754 election, no 721/731 exclusion for gain on property contributions and distributions, no inside basis step-up at death, etc.) The perceived SET/NIIT benefits are often overestimated A properly structured LLC or LP should provide similar SET/NIIT benefits without the disadvantages of S corporation status * a business that does not involve the trading of financial instruments or commodities 7 S Corp Planning Trap #2 S corporation election for an LLC or LP Tax preparers or other tax advisors often elect S corporation status for an LP or LLC solely to obtain SET and NIIT advantages. This can be a disaster! Same disadvantages as any S corporation (see prior slide) Plus additional potential problems: If the operating agreement provides for special allocations (which is common), the entity might not comply with the one class of stock requirement, and the entity might be classified as a C corporation! Other protective provisions commonly found in the governing documents for an S corporation (e.g., restrictions on transfers of stock to ineligible shareholders) may also be absent from the LP/LLC operating agreement Tax Symposium 4

5 S Corp Planning Trap #3 S corporation blocker What if the LP/LLC interests are owned by single member S corps? Individuals are employees of LLC or S Corps and are paid wages Distributive share income flows through S Corps Cumbersome and does not eliminate all disadvantages of S corporation ownership (e.g., no step up in asset basis at death) 9 SET/NIIT on LP/LLC Income Tax Symposium 5

6 LP/LLC Planning Challenge Can an LP/LLC member be sufficiently passive to avoid SET, but sufficiently active to avoid NIIT? For SET purposes, the LP/LLC member wants to be a passive limited partner to qualify for SET exclusion under Section 1402(a)(13) (the limited partner rule ) For NIIT purposes, the LP/LLC member generally wants to materially participate in the LLC business (to avoid passive activity status and have income from an active non-trading business) 11 LP/LLC Planning Challenge SET Precedents Section 1402(a)(13) income of a limited partner as such is exempt from SET even if the individual performs services to or on behalf of the partnership Renkemeyer, Campbell & Weaver, LLP v. Comm r, 136 T.C. 137 (2011) Riether v. United States, 919 F. Supp. 2d 1140 (D. NM 2012) Howell v. Comm r, T.C. Memo CCA Reporting Position Distributive share income of a member of a manager-managed LLC is exempt from SET if the member is paid reasonable compensation for services as a manager Tax Symposium 6

7 LP/LLC Structure Individuals perform material participation services for LLC as employees of an S corporation (or LLC) manager entity and receive wages or guaranteed payments for those services Individuals have no management rights as members of the LLC Same structure can be used for a limited partnership (manager entity is the general partner) 13 Significant Participation Sweet Spot What if the member does not meet the 500 hour test (or other tests) for material participation? If participation exceeds 100 hours but is less than 500 hours (i.e., is significant but not material), and if all significant participation activities have an overall net profit, the income from the LP/LLC is generally treated as not from a passive activity The individual s distributive share income is exempt from SET under the IRS safe harbor (proposed regulations) if limited liability, no management authority, and no service partnership [Prop. Reg (a)-2] The individual s distributive share income is exempt from NIIT (because the income is classified as active income) [Reg (b)(2)(i)] Tax Symposium 7

8 Self-Charged Rent If A and B materially participate in the professional practice, rent paid is deductible by the practice, and rent received through the real property holding company is generally subject to neither SET nor NIIT 15 Trusts Can a trust materially participate? Legislative history: trust material participation is tested by asking whether the fiduciary, in his capacity as such, is so participating IRS takes a restrictive view PLR (activities of non-fiduciary special trustee do not count) PLR (activities of special trustee in capacity as an employee of an S corporation owned by the trust do not count) Case law is more favorable Mattie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. TX 2003) (activities of trust employees and agents also count) Frank Aragona Trust v. Comm'r, 142 TC No. 9 (2014) (same; activities of trustees who are also employees of the business also count) Planning: document trustee role and relationships to support material participation Tax Symposium 8

9 Summary 17 Summary Avoid S corporations A properly structured LP/LLC can be used to conduct an active non-trading business and generate distributive share income free from SET and NIIT Must pay reasonable compensation for services provided Must not have management authority as a limited partner / LLC member Service partnerships are more problematic Monitor legislative, administrative, and judicial developments Tax Symposium 9

10 Disclaimer This document is not intended to provide advice on any specific legal matter or factual situation, and should not be relied upon without consultation with qualified professional advisors. Any tax advice contained in this document and any attachments was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter Tax Symposium 10