What s News in Tax Analysis That Matters from Washington National Tax An Income Tax by Any Other Name... Is an Income Tax The Unearned Income Medicare Contribution Tax, imposed by section 1411, is neither simple nor straightforward. The new 3.8 percent tax on net investment income affects tax returns filed for 2013. This article explores the types of income and gain that are included in and excluded from the tax base, as well as the deductions and losses that are allowed to reduce the tax base and special rules that apply to the calculation of net investment income. Monday, February 3, 2014 by Jeanne Sullivan, Paul Kugler, and Sarah Staudenraus, Washington National Tax Jeanne Sullivan is a director in the WNT Passthroughs group, a former IRS senior technical reviewer (Passthroughs and Special Industries), and a former U.S. Tax Court clerk. Paul Kugler is a director in the WNT Passthroughs group and a former IRS Associate Chief Counsel (Passthroughs and Special Industries). Sarah Staudenraus is a partner in the WNT Passthroughs group. The Unearned Income Medicare Contribution Tax, enacted as part of the Health Care and Education Reconciliation Act of 2010, is included in new chapter 2A to subtitle (A) (Income Taxes) of the Internal Revenue Code (the Code ). Section 1411 is the only provision included in chapter 2A and imposes a 3.8 percent tax on the lesser of an individual s net investment income ( NII ) or the excess (if any) of the individual s modified adjusted gross income over a threshold amount. Proceeds of the tax imposed by section 1411 are not designated for the Medicare Trust Fund and proceeds go into the General Fund of the United States Treasury. 1 For individuals filing a joint return, or for a surviving spouse, the threshold amount is $250,000; for married individuals filing separately, the threshold amount is $125,000. For all other individuals, the threshold amount is $200,000. Section 1411 also imposes a 3.8 percent tax on the lesser of an estate s or trust s undistributed net investment income and the excess (if any) of (1) the estate s or trust s adjusted gross income over (2) the dollar amount at which the highest tax bracket in section 1(e) begins for such tax year. Section 1411 does not apply to impose the 3.8 percent tax on nonresident alien individuals or a trust when all the unexpired interests are devoted to charitable purposes. 2 Moreover, there is an exception in the 1 2 Preamble, proposed section 1411 regulations issued in 2012, 77 FR 72612, citing JCT 2011 Explanation at 363; see also Joint Committee on Taxation, Description of the Social Security Tax Base (JCX-36-11)(June 21, 2011), at 24. Section 1411(e). entity. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.
An Income Tax by Any Other Name... Is an Income Tax page 2 statute for active interests in partnerships and S corporations, to be discussed later. 3 The tax on net investment income (the NII Tax ) is thus an additional income tax a flat 3.8 percent tax on specified income and gain of high income individuals, estates, and trusts. The 3.8 percent rate is the same as the rate under the hospital insurance portion of the Self Employment Contributions Act ( SECA ) and the Federal Insurance Contributions Act ( FICA ). Aside from the rate, however, there are significant differences among the taxes. SECA and FICA impose tax on income from selfemployment activities (the SECA Tax ) and wages (the FICA Tax ), respectively, while the NII Tax is a tax on certain income and gain from investment activities. In addition, while almost one-half of the SECA Tax is deductible, and the employee pays only one-half of the FICA Tax, the taxpayer is responsible for all NII Tax, with no deduction for any portion. The SECA, FICA, and NII Taxes have entirely different tax bases: Income from services is subject to the SECA Tax or FICA Tax, while the NII Tax is imposed on investment income, a category that explicitly excludes wages (subject to FICA) and income subject to SECA. In this connection, however, income and gain that are excluded from SECA or FICA are not automatically subject to the NII Tax. Rather, there are gaps where the FICA, SECA, and NII taxes do not apply. This article will explore the boundaries of the NII Tax, examining the types of income and gain that are subject to and the types of income and gain that are outside the reach of all three of these taxes in light of recently finalized and new proposed regulations under section 1411. Background Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended (the Code ) or the applicable regulations promulgated pursuant to the Code (the regulations ). Regulations recently published under chapter 2A have added almost 100 pages to the compilation of regulations in the Federal Register, and it is difficult to identify any portion of this guidance that is unnecessary. 4 Section 1411 appears to be a simple provision but there is considerable embedded complexity. The NII Tax is effective for an individual s, estate s and trust s tax years beginning after December 31, 2012. Thus, the 3.8 percent NII Tax affects tax returns filed in 2013. It is also important to note 3 Section 1411(c)(4). 4 This inescapably brings to mind a well-known quote from Will Rogers: The difference between death and taxes is that death doesn t get worse every time Congress meets.
An Income Tax by Any Other Name... Is an Income Tax page 3 that the NII Tax is not subject to withholding and must be taken into account in making estimated tax payments. On December 5, 2012, the Treasury Department and the IRS published proposed regulations under section 1411 (the 2012 Proposed Regulations ) and allowed reliance on the 2012 Proposed Regulations for the first tax year in which section 1411 applied. Toward the end of 2013, the Treasury Department and the IRS published final regulations under section 1411 (the Final Regulations ) 5 and a second set of proposed section 1411 regulations (the 2013 Proposed Regulations ). 6 The Final Regulations are effective for tax years beginning after December 31, 2013, with limited exceptions. In addition, taxpayers generally are permitted to rely on the 2013 Proposed Regulations. The 2013 Proposed Regulations are generally proposed to be effective for tax years beginning after December 31, 2013. This article explores the types of income and gain that are included in the NII Tax base as well as the exclusions from the NII Tax base, the deductions and losses that are allowed to reduce NII and special rules that apply to calculation of NII. Initially, however, it is important to understand certain fundamental principles that apply in determining the NII that may be subject to the NII Tax. The first of those principles is that the terms used in section 1411 do not always have the same meaning for purposes of chapter 2A and chapter 1. Thus, the Final Regulations provide definitions for many of the terms used in the statute and those definitions must be consulted before determining whether the NII Tax applies. Second, NII includes only income, gain, loss, or deduction that is recognized or allowed under chapter 1 of the Code. 7 For example, income that is not recognized because of section 1031 does not enter into the NII calculation and a loss that is suspended under section 469 is not allowed as a deduction from NII until the tax year when the loss is allowed under chapter 1. However, there are a number of corollaries to this rule. One is that gain recognized under chapter 1 during a tax year that begins after December 31, 2012, when section 1411 became effective, may be included in the NII calculation (unless it is excluded by a provision of 5 6 7 T.D. 9644. REG-130843-13, 78 Fed. Reg. 72451. Section 1.1411-1(a).
An Income Tax by Any Other Name... Is an Income Tax page 4 section 1411 or the regulations). Thus, gain on an installment sale may be included in NII even though the sale occurred prior to 2013, 8 unless the gain is attributable to gain on assets held in a trade or business that is excluded from section 1411. A second corollary is that the language of chapter 1 can affect how chapter 2A applies. For example, the Final Regulations provide that amounts that may be credited only against the tax imposed by chapter 1 (per the language of section 901, for example) are not creditable against the tax imposed by chapter 2A, the NII Tax. 9 Thus, foreign income, war profits, and excess profits taxes that are allowed as a foreign tax credit by section 27(a), section 642(a), and section 901, are not allowed as a credit against the tax imposed by section 1411, although, as we shall see, the taxes paid may be allowed as a deduction that reduces NII in certain circumstances. Finally, it is important to understand that section 1411 simply provides for a calculation of an aggregate amount of income and gain, as properly reduced by deductions and losses, that is subject to an additional 3.8 percent income tax; the character of the income, gain, loss or deduction is not relevant. Thus, NII can include capital gain, ordinary income, recapture income, section 1231 gain, and so on. Losses may be long-term or shortterm capital losses or ordinary losses. The key is whether the item is within the definition of NII. The Net Investment Income Tax 1. Inclusions in Net Investment Income The first step is understanding the inclusions (the additions) in the calculation of NII. Section 1411(c)(1) provides generally that NII is the excess (if any) of: (A) the sum of: (i) Gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which section 1411 does not apply (an Excluded Business ); 8 9 See section 1.1411-4(d)(4)(i)(C), Example 2. Section 1.1411-1(e).
An Income Tax by Any Other Name... Is an Income Tax page 5 (ii) (iii) Other gross income from a trade or business to which section 1411 applies (a Section 1411 Trade or Business ); and Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in an Excluded Business; over (B) the deductions allowed by subtitle A that are properly allocable to such gross income or net gain ( Properly Allocable Deductions ). In addition, income and gain attributable to the investment of working capital is included in NII. 10 A Section 1411 Trade or Business is a trade or business that is a passive activity within the meaning of section 469 with respect to the taxpayer (a Passive Business ) or a trade or business of trading in financial instruments or commodities as defined in section 475(e)(2) (a Trading Business ). 11 Broad categories of income are included in the NII calculation: interest, dividends, rents, royalties, and annuities ( Bucket 1 ); gross income from Passive Businesses and gross income from the Trading Business ( Bucket 2 ); and net gain from the disposition of property ( Bucket 3 ). The Final Regulations define the terms used in each of the three buckets of NII identified in the statute. a. Bucket 1: Listed Portfolio Income Items Gross income from interest includes any item treated as interest income for purposes of chapter 1 and also includes substitute interest, defined as payments made to the transferor of a security is a securities lending transaction or a sale-repurchase transaction. 12 In addition, the 2013 Proposed Regulations provide that guaranteed payments for the use of capital are treated as interest for purposes of NII 13 and that payments 10 11 12 13 Section 1411(c)(3). Section 1411(c)(2). Section 1.1411-1(d)(6). Prop. section 1.1411-4(g)(10).
An Income Tax by Any Other Name... Is an Income Tax page 6 made under section 736(a) may include a component treated as interest. 14 Thus, by definition, interest earned in any activity that is not a trade or business activity for purposes of section 1411 is generally included in NII. In this connection, the Final Regulations include a taxpayer-favorable rule that may avoid restructuring to avoid generating NII in the case of lending among commonly controlled groups of entities. Under the Final Regulations, self-charged interest from a loan to an entity that conducts a trade or business activity in which the taxpayer materially participates may be excluded from NII. That exclusion is discussed later in this article in some detail. For purposes of NII, gross income from dividends includes any item treated as a dividend for purposes of chapter 1, including substitute dividends, defined as payments made to a transferor of a security in a securities lending transaction or sale-repurchase transaction. 15 Items treated as dividends for purposes of chapter 1 include constructive dividends and amounts treated as dividends under section 1248(a) (except as provided in section 1.1411-10), section 1.367(b)-2(e)(2), and section 1368(c)(2). Despite the inclusive nature of dividends for NII purposes, the Final Regulations provide that inclusions from controlled foreign corporations ( CFCs ) and Qualified Electing Funds ( QEFs ) are generally not dividends for purposes of NII. The regulations further provide that when an actual payment is made from the CFC or QEF that is attributable to the previously taxed inclusion amount, that payment is included as a dividend for purposes of NII. The complexity associated with this discontinuity in tax treatment is discussed later in the article, as is an election that may be made to treat a CFC or QEF inclusion as a dividend for purposes of chapter 2A. Gross income from rents is defined for purposes of section 1411 as amounts paid or to be paid principally for the use of (or the right to use) tangible property. This definition is significantly broader than the definition of rent under section 469, as will be explained. As a result, the fact that a payment may not be treated as rent under section 469 does not mean 14 15 Prop. section 1.1411-4(g)(11). Section 1.1411-1(d)(3).
An Income Tax by Any Other Name... Is an Income Tax page 7 that it is automatically excluded from NII. The analysis required is more detailed and is discussed below. Royalties for purposes of NII include amounts received from mineral, oil, and gas royalties, and amounts received for the privilege of using patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other like property. As a result, royalty trusts that hold interests in oil and gas royalties as well as other entities formed to hold the licenses for the use of intangibles will generally produce NII. To be excluded from NII, the royalties must be generated by a non-passive trade or business of producing the royalty income, a category that is particularly limited with respect to mineral royalties, as discussed later. The Final Regulations also provide that gross income from annuities includes the amount received as an annuity under an annuity, endowment, or life insurance contract that is includible in gross income under section 72(a), (b) and (e), but does not include any amount received in consideration for services rendered. 16 This definition is consistent with the general principle of the Final Regulations: income from services is excluded from NII. The 2013 Proposed Regulations provide that NII also includes income from a residual interest in a REMIC, income and deductions from a common trust fund to the extent the amount would have been NII or deduction if the participant made the investments directly, and periodic and nonperiodic payments on any notional principal contracts to the extent that the referenced property would produce Bucket 1 income. 17 Finally, the Final Regulations provide that for purposes of section 1411, the definition of a trade or business means a trade or business within the meaning of section 162, and not as defined under section 469. The Final Regulations provide guidance on how to determine whether interest, dividends, rents, royalties or annuities are derived in the ordinary course of a trade or business of producing such income. If the activity is conducted directly by an individual (estate or trust) or through a disregarded entity owned by the taxpayer, the question of whether an activity is conducted with sufficient regularity and continuity to amount to a section 162 trade or business is determined at the owner level. In contrast, if the activity is 16 17 Section 1.1411-1(d)(1). Prop. section 1.1411-4(e)(3), (g)(12), and (13).
An Income Tax by Any Other Name... Is an Income Tax page 8 conducted through an entity such as a partnership or S corporation, the question of whether the activity is a section 162 trade or business (and whether the income is derived from that trade or business) is determined at the entity level. The nature of the income or gain does not change as it passes through upper-tier entities. To illustrate this rule, assume A, an individual, owns an interest in an upper-tier partnership (UTP) and UTP owns an interest in a lower-tier partnership (LTP). Assume LTP is engaged in the business of lending and UTP is an investment entity that is not engaged in a trade or business. If LTP produces interest income that it allocates to UTP and that UTP allocates to A, the interest is derived from the trade or business conducted by LTP for purposes of determining whether it is included in Bucket 1. The fact that it passes through UTP, an investment entity, and is reflected on the Schedule K-1 issued to A by an entity that does not conduct a trade or business activity does not change its character as interest derived in the ordinary course of a trade or business. Moreover, if UTP is in a trade or business and LTP is not, the interest derived from LTP is portfolio interest that is included in NII, despite the fact that it appears on the Schedule K-1 issued by an entity that is engaged in a trade or business activity. 18 In the case of a typical private equity structure, therefore, the fact that a fund is not engaged in a trade or business for purposes of section 162 does not affect the character of the income that passes through to the owners from trade or business activities held in lower-tier investments under the fund. In this connection, however, it is important to note that only items produced by passthrough entities retain their character. If a trade or business is held through a C corporation, dividends and capital gains generated by the C corporation are generally included in NII. As an illustration of this principle, consider the case of an individual, B, who owns a trade or business that is not a Trading Business (X) through a domestic corporation (X Corp). B is the CEO of X Corp and owns 100 percent of the X stock. If X Corp is a C corporation, the income earned in X is not subject to the NII Tax. Only when X Corp distributes dividends or when B sells the X stock will B potentially be subject to the NII Tax on the 18 This example is drawn from section 1.1411-4(b)(3), Examples 1 and 2. Clearly, partnerships and S corporations will be required to provide information to owners so that they can determine how to classify interest, dividends, rents, royalties and annuities for NII purposes.
An Income Tax by Any Other Name... Is an Income Tax page 9 value in X. In contrast, if B makes a valid S election for X Corp, B may be able to avoid the NII Tax on both income from X and gains on sale associated with X and X Corp if B materially participates in X. However, the question of whether X is a Section 1411 Business or an Excluded Business takes us to Bucket 2. b. Bucket 2: Section 1411 Businesses The second category of NII includes gross income from a Passive Business (as defined in section 469) and from the Trading Business. A Passive Business is a trade or business activity in which the taxpayer does not materially participate and most rental activities. Section 469 provides detailed rules for determining whether there is a trade or business activity, how that activity may be grouped with other trade or business activities, and what it means to materially participate. It also provides detailed rules on the treatment of rental activities. In contrast, Trading Businesses are excluded from the purview of section 469 19 and the participation of the taxpayer in the Trading Business is irrelevant. Under section 1411, income and gain from a Trading Business is always NII. (i) Passive Businesses Section 469 provides generally that a taxpayer must aggregate all of the income, gain, loss and deduction from passive activities and, if the aggregate amount is a loss, the net loss from passive activities is suspended and may not be used during that tax year. The suspended loss is carried forward and treated as a loss from a passive activity that is incurred in the following year. If the aggregate amount is positive income or gain, section 469 allows the use of all losses from passive activities. In order to prevent taxpayers from generating passive income (that would allow use of more passive losses), the rules under section 469 include a number of recharacterization rules (discussed below) and exclude portfolio income from passive activity gross income. 20 Section 1.469-2T(c)(3) defines portfolio income for purposes of section 469 and includes the Bucket 1 items of NII (unless derived in the ordinary course of a trade or business as defined under section 469) as well as inclusions from CFCs and QEFs. In this connection, it is important to note 19 20 Section 1.469-1T(e)(6). Section 469 as it applies to closely held C corporation is beyond the scope of and is not discussed in this article.
An Income Tax by Any Other Name... Is an Income Tax page 10 that these CFC and QEF inclusions are not included in NII unless an election is made under section 1.1411-10(g), as discussed later. Thus, Bucket 2 of NII includes all income from trades or businesses that are passive activities and Bucket 1 of NII includes most (but not all) of the type of income generally classified as portfolio income under section 469 and most rental income. Income from a Trading Business is not subject to section 469 but is always included in NII. (ii) Trading Businesses Trading is never an Excluded Business and income and gain from a Trading Business is always included in NII. Section 1411(c)(2)(B) provides that the business of trading in financial instruments or commodities is a business to which section 1411 applies. The term financial instruments is defined broadly to include stocks and other equity interests, evidences of indebtedness, options, forward or futures contracts, notional principal contracts, any other derivatives, or any evidence of an interest in any of these items, such a short position or partial units. Commodities are defined in section 475(e)(2). Taxpayers who buy and sell financial instruments may be dealers, traders, or investors. Investors and traders generate income and gain that is generally included in NII regardless of their participation in the activity, either because the activity is not a trade or business (investor) or because the activity is the business of trading (trader). In contrast, income and gain from the trade or business of being a dealer is excluded from NII if the taxpayer materially participates in that trade or business. Thus, the distinction between dealers, traders and investors is now relevant to the determination of the NII Tax as well as to the treatment of expenses as section 162 or section 212 expenses or the opportunity to use mark-to-market accounting. Dealers maintain an inventory of stocks and securities and sell to customers. Traders and investors do not have customers but buy and sell on their own account. The distinction between a trader and an investor is determined under case law. Under Commissioner v. Groetzinger, 480 U.S. 23 (1987), activity constituting a trade or business must be regular and continuous. The trader/investor cases require more than simply frequent trading during
An Income Tax by Any Other Name... Is an Income Tax page 11 periods throughout the year. Higgins v. Commissioner, 312 U.S. 212 (1941) held that traders are in and out of the market and seek profit from short-term swings in price. In determining whether a taxpayer who manages his own investments is a trader, and thus engaged in a trade or business, relevant considerations are the taxpayer's investment intent, the nature of the income to be derived from the activity, and the frequency, extent, and regularity of the taxpayer's securities transactions. Moller v. United States, 721 F.2d 810, 813 (Fed. Cir. 1983). Generally, investors hold financial instruments for appreciation in value and income, while traders buy and sell with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a shortterm basis. Liang v. Commissioner, 23 T.C. 1040, 1043 (1955). 21 An issue that arose under the 2012 Proposed Regulations was an unintended mismatch between gains and losses for traders. The 2012 proposed regulations provided that gross income from trading gains was included in section 1411(c)(1)(A)(ii) (Bucket 2) and losses from trading was included in section 1411(c)(1)(A)(iii) (Bucket 3). Since, as discussed below, Bucket 3 cannot be negative, net losses from trading were potentially unavailable to offset gains from trading. The Final Regulations address this by moving all income and gains from trading (both mark-to-market and non-mark-to-market) to Bucket 3 and allowing any net loss in Bucket 3 (an Excess Loss ) to reduce gross income included in NII as a properly allocable deduction. In addition, to the extent a trader has expenses of conducting his trade or business or trading that are not used to offset income subject to self employment tax, those deductions are allowed as deductions in determine the trader s NII. 22 Bucket 3: Net Gain on Disposition of Property Section 1411 provides that NII also includes net gain from the disposition of property other than property held in a non-passive trade or business that is not the Trading Business. The Final Regulations define disposition broadly to include a sale, exchange, transfer, conversion, cash settlement, cancellation, termination, lapse, expiration, or other 21 22 See also Chen v. Commissioner, T.C. Memo. 2004-132; Vines v. Commissioner, 126 T.C. No. 15 (2006); T.A.M. 200423015; and T.A.M. 200429011. Section 1.1411-9(b) and (c), Examples 3 and 4.
An Income Tax by Any Other Name... Is an Income Tax page 12 disposition (including a deemed disposition, for example, under section 877A). 23 As noted immediately above, because the statute refers to net gain from dispositions, the Final Regulations provide that Bucket 3 cannot be negative and reflect a net loss from dispositions, but allow use of that net loss (the Excess Loss) elsewhere in the general calculation of NII. Bucket 3 includes gains and losses on dispositions of all property, whether or not it produces the items of income listed in Bucket 1 or the type of business described in Bucket 2. The only gains and losses excluded are those derived from an Excluded Business. 2. Exclusions from Net Investment Income a. Listed Exclusions Although it is quite expansive, NII does not include all income or all capital gains. In fact, the Final Regulations include a list of excluded income: 24 Amounts paid in consideration for services rendered, even if such amount are subject to the rules of section 72 25 Income that is subject to SECA Wages Distributions from certain qualified plans Unemployment compensation Alaska Permanent Fund Dividends Alimony Social Security Benefits Inclusions from a CFC for which a section 1.1411-10(g) election is not in effect 23 24 25 Section 1.1411-4(d)(1). See generally section 1.1411-1(d)(4) for excluded income. Section 1.1411-1(d)(1).
An Income Tax by Any Other Name... Is an Income Tax page 13 The Final Regulations provide that other possible excluded items may be identified in future guidance. 26 The most significant exclusion from NII, however, is the income and gain associated with an Excluded Business. b. Excluded Business To qualify as an Excluded Business, two conditions must be satisfied: The activity must amount to a trade or business activity under the principles of section 162 (other than a Trading Business) The trade or business must not be a Passive Business. If the activity does not satisfy both of these conditions, the income and gain associated with it is not from an Excluded Business and may be included in NII. We will address each of these requirements, beginning with the characterization of income and gain as non-passive under the rules of section 469. (i) Non-passive Income and Gain To be excluded from NII, income or gain from a trade or business activity must be non-passive under the rules of section 469. Section 469 does not apply at an entity level and does not necessarily apply to each trade or business undertaking conducted by a taxpayer. Rather, in order to determine if income or gain is passive or non-passive, the taxpayer must first group his or her trade or business activities conducted directly or through a passthrough entity in order to identify each of the taxpayer s section 469 activities. Under section 1.469-4, a taxpayer may group the taxpayer s trade or business activities together for purposes of section 469 if they form an appropriate economic unit or may treat each trade or business activity as separate. Each choice is treated as a grouping for purposes of section 469. The significance of groupings under section 469 is that the test for material participation is made at the section 469 activity level. In addition, suspended passive losses are released only when substantially all the section 469 activity is disposed of in a qualifying disposition. 27 Thus, there are competing interests at work in making grouping decisions: a larger 26 27 Section 1.1411-1(d)(4)(iii) and the preamble to the Final Regulations at 72395, Section 1, Comments of General Applicability. Section 469(g).
An Income Tax by Any Other Name... Is an Income Tax page 14 grouping makes it easier to materially participate and a smaller grouping makes it more likely that suspended losses will be allowed more quickly. Once a taxpayer groups activities, there can be no change in the grouping unless there is a material change in facts and circumstances that makes the original grouping clearly inappropriate or the original grouping was clearly inappropriate (the consistency rule). 28 Material participation in a section 469 activity is an annual determination and depends upon relatively bright-line tests established by section 1.469-5T. An individual must satisfy only one of the following seven tests in order to materially participate in the section 469 activity: 29 1. The individual participates in the activity for more than 500 hours during the year; 2. The individual s participation in the activity for the year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for the year; 3. The individual participates in the activity for more than 100 hours during the tax year and such individual s participation in the activity for that year is not less than the participation in the activity of any other individual (including individuals who are not owners of interest in the activity) for the year; 4. The activity is a significant participation activity (within the meaning of paragraph (c) of section 1.469-5T) for the tax year, and the individual s aggregate participation in all significant participation activities during such year exceeds 500 hours; 5. The individual materially participated in the activity (determined without regard to this paragraph) for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year; 6. The activity is a personal service activity and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or 28 29 Section 1.469-4(e). Limited partners may satisfy only tests 1, 5, or 6. Section 1.469-5T(e)(2).
An Income Tax by Any Other Name... Is an Income Tax page 15 7. Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year. These tests apply only to individuals; there are no regulations relating to establishing material participation by estates and trusts. In addition, a limited partner may use only the tests in numbers 1, 5, and 6 above to establish material participation. The regulations make it clear that, if trades or businesses are appropriately grouped together into a single section 469 activity, the taxpayer will materially participate in the activity even if the individual works sufficient hours in only one of the trades or businesses. For example, assume a taxpayer owns a restaurant and a bakery and works full time in the bakery and not at all in the restaurant. If the taxpayer treats the restaurant and bakery as separate activities, the restaurant is a passive activity and the bakery is non-passive. In contrast, if the taxpayer groups the restaurant and bakery as a single activity, the grouped activity is non-passive. Clearly, the rules relating to grouping of section 469 activities is fundamental to the operation of both section 469 and section 1411. In an acknowledgement of this, the Final Regulations allow an exception to the consistency rule: In the first year that section 1411 would apply to a taxpayer in the absence of a regrouping, the taxpayer is permitted to regroup under the rules of section 469. 30 If the taxpayer makes a change to historical section 469 groupings, it is necessary to comply with the disclosure requirements of Revenue Procedure 2010-13, 2010-4 I.R.B. 329. Moreover, all grouping decisions apply for purposes of both section 469 and section 1411. (a) Grouping Section 469 includes very flexible rules on grouping of trade or business activities so long as the grouped activities form an appropriate economic unit and certain other rules are followed. In order to determine if activities form an appropriate economic unit, the regulations provide that all the facts and circumstances are taken into account, including (but not limited to) the following factors: common ownership, common control, geographical location, similarity or differences in business, and 30 Section 1.469-11(b)(3)(iv).
An Income Tax by Any Other Name... Is an Income Tax page 16 interdependence among activities. 31 If a trade or business activity is conducted through a partnership or an S corporation, the entity does the initial grouping and the partner or shareholder then can further group activities conducted directly and through other entities if they form an appropriate economic unit. Partners and shareholders cannot treat activities as separate activities once the partnership or S corporation has grouped them together, however. In addition, the Final Regulations do not provide partnerships or S corporations with the authority to regroup regardless of how their current groupings affect their owners liability under section 1411. Certain groupings are not permitted, however. Grouping rental activities with trade or business activities is not allowed unless the rental and the trade or business activity form an appropriate economic unit and either the trade or business is insubstantial in relation to the rental or the rental is insubstantial in relation to the trade or business, or each owner of the trade or business has the same proportionate ownership in the rental activity. In the latter case, the portion of the rental activity that involves the rental of items of property for use in the trade or business may be grouped with the trade or business activity. 32 Real property and personal property rentals may not be grouped together. 33 Finally, certain activities 34 of limited partners (or limited entrepreneurs) 35 may not be grouped with any other activity unless the activities are in the same type of business. 36 (b) Rental Activities Under section 469, rental activities are per se passive (unless one of the few exceptions under the section 469 regulations applies) and material participation is therefore irrelevant. As a result, most rental income will be passive income and will be included in NII. To understand these rules, however, it is necessary to define a rental activity for purposes of both sections 469 and 1411. 31 32 33 34 35 36 Section 1.469-4(c)(2). Section 1.469-4(d)(1). Section 1.469-4(d)(2). The activities referenced are the activities described in section 465(c)(2), which include a taxpayer s activity with respect to each: film or videotape; section 1245 property that is leased or held for leasing, farm, oil and gas property (as defined under section 614); or geothermal property (as defined under section 614). A limited entrepreneur is defined in 464(e)(2)) as a person who has an interest in an enterprise other than as a limited partner and does not actively participate in the management of such enterprise. Section 1.469-4(d)(3).
An Income Tax by Any Other Name... Is an Income Tax page 17 Under section 1411, gross income from rents includes amounts paid or to be paid principally for the use of (or the right to use) tangible property. 37 The regulations under section 469 define an activity as a rental activity during the tax year if both: Tangible property held in connection with the activity is used by customers or held for use by customers, and The gross income attributable to the conduct of the activity during such tax year represents or, in the case of an activity in which property is held for use by customers, the expected gross income from the conduct of the activity will represent amounts paid or to be paid principally for the use of the tangible property (without regard to whether the use of the property by customers is pursuant to a lease, service contract, or other arrangement that is not denominated a lease). 38 The section 469 regulations provide that the following activities involving the use of tangible property are not rentals: 39 If the average period of customer use for such property is seven days or less If the average period of customer use for such property is 30 days or less and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers If extraordinary personal services are provided by or on behalf of the owner in connection with making the property available for use by customers (without regard to the average period of customer use) If the rental of such property is treated as incidental to a nonrental activity of the taxpayer If the taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers 37 38 39 Section 1.1411-1(d)(10). Section 1.469-1T(e)(3)(i). Section 1.469-1T(e)(3)(ii).
An Income Tax by Any Other Name... Is an Income Tax page 18 If the provision of the property is for use in a non-rental activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest If the activity is not a rental activity under section 469, it may still generate gross income from rents under section 1411. For example, if the average period of customer use of leased property is seven days or less, the lease payment may still be rent for purposes of section 1411 because it is payment for the use of property. The significance of the distinction is that, if the activity is not a rental activity under section 469, it is not per se passive. Therefore, if the activity is a trade or business activity and if the taxpayer materially participates in the leasing trade or business, the rents are not included in NII. In contrast, if the activity is a rental activity under section 469, the analysis is different: In that case, it is necessary to look to the exceptions to passive status for rentals under section 469 as the only avenue to avoid section 1411. There are a number of limited exceptions available and the Final Regulations provide certain assumptions to facilitate operation of section 1411. (i) Real Estate Professionals and the Safe Harbor If an individual qualifies as a real estate professional under section 469, the individual is permitted to establish material participation in each of his or her rental activities. In order to be a real estate professional, an individual must spend more than half of his personal service hours and more than 750 hours in real property trades or businesses in which the individual materially participates. 40 Real property trades or businesses include rental and leasing activities, as well as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, operation, management or brokerage trade or business. A real estate professional may make an election to treat all rental activities as a single activity; material participation may then be established in the single grouped rental activity generally, a much easier task. The 2012 Proposed Regulations took the position that simply materially participating in the real estate professional s rental activities was not sufficient to exclude the rental income from section 1411; rather, the 40 Section 469(c)(7).
An Income Tax by Any Other Name... Is an Income Tax page 19 taxpayer was also required to establish that the rental activity was also a section 162 trade or business. The Final Regulations do not change the basic principle that rent must be both nonpassive and derived in the ordinary course of a section 162 trade or business. However, in response to comments, the Final Regulations establish a safe harbor for real estate professionals. 41 Under the safe harbor, if the real estate professional participates for more than 500 hours in the rental activity in a tax year, the rent will be deemed to be derived in the ordinary course of a trade or business. Alternatively, if the taxpayer has participated in rental real estate activities for more than 500 hours per year in five of the last ten tax years (one or more of which may be years prior to the effective date of section 1411), then the rental income will be deemed to be derived in the ordinary course of a trade or business. In addition, if these requirements are met, the net gain on disposition of the rental property is treated as held in a trade or business. Finally, if the taxpayer cannot satisfy this safe harbor, the taxpayer is not precluded from establishing that gross rental income and gain or loss from disposition is not included in NII by establishing both material participation and section 162 trade or business status for the rental activity. 42 (ii) Certain Nonpassive Rents Excluded from NII Section 469 includes recharacterization rules and grouping rules that can operate to create nonpassive rental income. One of these is included in section 1.469-2(f)(6) and provides that, if a taxpayer rents property for use in a nonpassive trade or business activity of the taxpayer, the net rental income is recharacterized as nonpassive. In many cases where this rule applies, the leasing entity owns only one property and the lease may be a net lease that requires very little administration. For purposes of section 1411, the issue was whether the leasing activity is sufficient to constitute a section 162 trade or business or whether the nonpassive rental income would be included in NII. In addition, if a rental activity is properly grouped with a trade or business activity under section 1.469-4(d)(1) and the grouped activity is treated as a nonpassive activity, the gross rental income is treated as nonpassive 41 42 Section 1.1411-4(g)(7). Section 1.1411-4(g)(7)(iii).
An Income Tax by Any Other Name... Is an Income Tax page 20 under section 469. This raised a similar issue as that created by the selfrental rules. The Final Regulations provide that, in both of these situations, the nonpassive rental income is deemed to be derived in the ordinary course of a trade or business and will be excluded from NII. Moreover, the net gain or loss from disposition of the property will also be excluded from NII. In other cases, however, it remains necessary to establish that income and gain is derived in the ordinary course of a trade or business as well as that the income and gain is nonpassive in order to exclude the income and gain from NII. (c) Self-Charged Interest The Final Regulations adopt a rule similar to the section 469 self-charged interest rule contained in section 1.469-7. Section 1.1411-4(g)(5) provides that a portion of the gross income from interest received by the taxpayer from a nonpassive activity of the taxpayer (that is not a Trading Business) is treated as derived in the ordinary course of an Excluded Business and not included in NII. However, this favourable rule does not apply to the extent the deduction is taken into account in determining income from self-employment that is subject to section 1401(b). The operation of this very favorable rule is important and requires an understanding of the selfcharged interest rules of section 469. In a lending transaction between a taxpayer and a passthrough entity in which the taxpayer owns an interest and a lending transaction between passthrough entities in which a taxpayer owns interests, the section 469 regulations recharacterize the applicable percentage of the interest income or the interest deduction as income or a deduction from a passive activity. 43 The section 469 rule also applies to guaranteed payments for capital in certain circumstances and applies only to interest income and interest expense that are recognized in the same tax year. Under section 1.469-7(c)(3), in the case of taxpayer loans to a passthrough entity, the applicable percentage is separately determined for each of the taxpayer s activities and is defined as the percentage obtained by dividing the taxpayer s share for the tax year of the borrowing entity s self- 43 Section 1.469-7.
An Income Tax by Any Other Name... Is an Income Tax page 21 charged interest deductions that are treated as passive activity deductions from the activity by the greater of: The taxpayer s share for the tax year of the borrowing entity s aggregate self-charged interest deductions for all activities (regardless of whether these deductions are treated as passive activity deductions) or The taxpayer s aggregate income for the tax year from interest charged to the borrowing entity for all activities of the borrowing entity. The section 469 regulations include similar rules for passthrough entity loans to the taxpayer and for loans between identically owned passthrough entities. In the case of identically owned passthrough entities, if the taxpayer has interest income from a loan between these entities, the taxpayer is treated as having made the loan to the borrowing entity. The section 1411 Final Regulations provide that the same percentage of interest income that would have been treated as passive activity gross income in the case of taxpayer loans to a passthrough entity is excluded from NII. However, the Final Regulations do not include a similar rule for loans to the taxpayer from a passthrough entity and neither the Final Regulations nor the section 469 regulations have a rule that recharacterizes interest income for non-identically owned passthrough entities. As an illustration, assume individual A owns a 50 percent interest in PRS, PRS borrows $20,000 from A and is required to pay interest income of $2,000 per year. The interest deduction is not taken into account in determining A s income from self-employment. Assume further that A materially participates in the PRS trade or business activity (that is not the Business of Trading). Under the Final Regulations, $1,000 of A s interest income is treated as derived in the ordinary course of an Excluded Business and is not NII and the other $1,000 is included in NII unless A is in the business of lending and materially participates in the lending business. In the alternative, assume A and Corp B each own 50 percent of PRS 1 and PRS 2 and that the same lending transaction is undertaken between
An Income Tax by Any Other Name... Is an Income Tax page 22 PRS 1 (lender) and PRS 2 (borrower), rather than between A and PRS. A materially participates in the trade or business of PRS 2. In this case, A is treated as making a loan to PRS 2 to the extent A shares in the interest income of PRS 1. A has a 50 percent share of the $2,000 income and a 50 percent share of the interest deduction of $2,000 (which is not taken into account in determining A s income from self-employment). If there is no other relevant activity, all of A s share of interest income ($1,000) is treated as derived in the ordinary course of an Excluded Business. 44 Finally, however, if PRS lends the money to A or if PRS 1 and PRS 2 are not identically owned, there does not appear to be a rule that recharacterizes the interest income allocated to A from the lender partnership. Therefore, unless the lending entity is in a nonpassive trade or business of lending, A s share of interest income is included in NII and A s interest deduction is characterized at A s level and may be a properly allocable deduction from NII if it is not a personal loan and if the interest expense is not limited by section 163(d). (d) Other Recharacterization Rules The regulations under section 469 recharacterize income from certain activities as not from a passive activity for purposes of section 469. These are generally activities that would be expected to produce income, rather than loss, and might otherwise be used to avoid suspension of passive activity losses from other activities if the income is characterized as passive. The following are subject to the recharacterization rules: 1. Income from significant participation passive activities. 45 These are activities in which the taxpayer participates for more than 100 hours but does not materially participate under the rules of section 1.469-5T. There is a special rule that may recharacterize a portion of the gross income from these activities as nonpassive. 2. Net rental income from rental of nondepreciable property. 46 If less than 30 percent of the unadjusted basis of property held for use or used by customers in a rental activity is subject to depreciation, the net rental income is recharacterized as not from a passive activity. 44 45 46 This alternative is based on the example in section 1.469-7(e)(3). Section 1.469-2T(f)(2). Section 1.469-2T(f)(3).