NEW MEDICARE TAX IMPACT ON BUSINESS PLANNING FOR CLOSELY HELD COMPANIES

Transcription

1 NEW MEDICARE TAX IMPACT ON BUSINESS PLANNING FOR CLOSELY HELD COMPANIES First Run Broadcast: January 3, :00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) The new health care law imposes a new 3.8% Medicare tax on certain business and investment income. The tax will apply to distributions from pass-through entities LLCs, S Corps, partnerships and have a direct and substantial impact on all closely-held companies. Certain planning techniques to avoid application of the new tax can have the effect of triggering the selfemployment tax. The tax will also change the economics of buying, selling and exchanging interests in closely held companies. In short, the new tax fosters many new planning traps. This program will provide you with a practical framework for understanding the new tax, how it impacts closely-held business planning, distributions and sales, and cover strategies for minimizing the tax. Framework for understanding how the new Medicare tax works impacts closely held businesses Application of new tax to salaries and distributions from partnerships, LLCs, S Corps and C Corps Complex interrelationship of self-employment tax and the new Medicare tax how avoiding one, triggers the other Effect of new Medicare tax on real estate and other passive investments and businesses Planning for the sale of interests in LLCs, S Corps and partnerships Sophisticated strategies for avoiding impact of tax Speakers: Alson R. Martin is a partner in the Overland Park, Kansas office of Lathrop and Gage, LLP, where he has a national practice focusing on business law, taxation, health care, and retirement plans. He is a Fellow of the American College of Tax Counsel and the American College of Employee Benefits Counsel. Mr. Martin is the author of "Limited Liability Companies and Partnerships" and the co-author of "Kansas Corporation Law & Practice (Including Tax Aspects)." He is the president and a director of the Small Business Council of America. Mr. Martin received his B.A., with highest distinction, from the University of Kansas, and his J.D. and LL.M. from New York University School of Law. Thomas J. Nichols is a partner in the Milwaukee, Wisconsin office of Meissner Tierney Fisher & Nichols S.C, where he has more than 30 years experience in business and federal and state tax planning for companies of every size. He has extensive experience in income, selfemployment and estate and gift tax planning for business clients. He formerly served as chair of the S Corporation Committee of the ABA Tax Section and as chair of the Partnership Committee of the State Bar of Wisconsin s Business Law Section. Mr. Nichols received his B.A. from Marquette University and his J.D. from Marquette University Law School.

2 PROFESSIONAL EDUCATION BROADCAST NETWORK Speaker Contact Information New Medicare Tax Impact on Business Planning for Closely Held Companies Thomas J. Nichols Meissner Tierney Fisher & Nichols S.C. Milwaukee, Wisconsin (o) (414) Alson R. Martin Lathrop & Gage, LLP - Overland Park, Kansas (o) (913) amartin@lathropgage.com

3 VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT Fax: (802) PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name: Middle Initial: Last Name: Firm/Organization: Address: City: State: ZIP Code: Phone #: Fax #: Address: I will be attending: New Medicare Tax Impact on Business Planning Teleseminar January 3, 2013 Early Registration Discount By 12/27/2012 Registrations Received After 12/27/2012 VBA Members: $70.00 Non VBA Members/Atty: $80.00 VBA Members: $80.00 Non-VBA Members/Atty: $90.00 NO REFUNDS AFTER DECEMBER 27, 2012 PLEASE NOTE: Due to New Hampshire Bar regulations, teleseminars cannot be used for New Hampshire CLE credit PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association): $ Credit Card (American Express, Discover, MasterCard or VISA) Credit Card # Exp. Date Cardholder:

4 Vermont Bar Association ATTORNEY CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: January 3, 2013 Seminar Title: Location: Credits: New Medicare Tax Impact on Business Planning Teleseminar 1.0 General MCLE Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

5 2013 Medicare Taxes For Investors, Business Entities & Their Owners, Trusts & Estates Alson R. Martin Lathrop & Gage LLP Mastin Boulevard Suite 1000 Overland Park, KS TABLE OF CONTENTS Page I FICA, SECA & MEDICARE TAXES... 1 II. A. Wages... 1 B. Self-Employment Income... 1 Overview FICA, SECA, and Medicare Taxes Enacted By Health Care Reform Act; New 3.8 % Medicare Taxes Effective in A. Wages & Self-Employment Income... 2 B. New 3.8% Medicare Tax On Net Investment Income ( NII ) For Individuals, Trusts & Estates With Income Over Threshold... 3 C. Three Kinds Of Income In D. Organization Of Proposed Reliance Regulations... 6 III. Definition Of Net Investment Income ( NII )... 6 A. Proposed Reliance Regulations... 6 B. Chapter 1 Definitions... 6 C. Net Investment Income... 6 D. Other Code Provisions Apply E. Income That Is Not NII F. Net Earnings From Self-Employment Not Subject To NII Tax Alson R. Martin v1

6 TABLE OF CONTENTS (continued) Page IV. SE & NII TAX CONSIDERATIONS FOR S CORPORATION SHAREHOLDERS; NO NII OR SOCIAL SECURITY & MEDICARE TAX FOR DISTRIBUTIONS TO TAXPAYER MATERIALLY PARTICIPATING IN S CORPORATION BUSINESS A. General B. Use of S Corporation to Operate Closely Held Business C. S Corporation Dividend Distribution Example D. Section 338(H)(10) Election By Selling S Corporation Shareholders; Net Gain From Disposition Of Property Onus On Buyer & Seller To Allocate As Deemed Asset Sale V. GAIN FROM THE DISPOSITION OF INTERESTS IN PARTNERSHIPS AND S CORPORATIONS; SALE OF OWNERSHIP SAME AS IF BUSINESS SOLD ALL ITS ASSETS A. General B. Deemed Asset Sale Method C. Multiple Trades Or Businesses In One Entity Where Owner Participates In One But Not Other VI. ESTATES & TRUSTS VII. VIII. A. Overview B. Net Investment Income C. Charitable Remainder Trusts D. Grantor Trust; Grantor Taxed On NII Unless Not NII Because Owner Materially Participating E. Electing Small Business Trusts (ESBTs) F. Real Estate Investment Trusts G. Bankruptcy Estates H. Foreign Estates and Trusts CONTROLLED FOREIGN CORPORATIONS (CFCS) AND PERSONAL FOREIGN INVESTMENT COMPANIES (PFICS) DOCTRINES THAT MAY CAUSE TAX TROUBLE FOR RESTRUCTURING TO AVOID NII TAX A. Business Purpose B. Economic Substance Doctrine ( ESD ) IRC 7701(o) v1 -ii-

7 TABLE OF CONTENTS (continued) Page C. Section 269- Acquiring Control Of A Corporation With The Principal Purpose Of Evasion Or Avoidance Of Federal Income Tax D. 269A; PSC, The Principal Purpose Of Which Is To Avoid/Evade Tax v1 -iii-

8 2013 Medicare Taxes For Investors, Business Entities & Their Owners, Trusts & Estates Alson R. Martin Lathrop & Gage LLP Mastin Boulevard Suite 1000 Overland Park, KS I FICA, SECA & MEDICARE TAXES. A. Wages. 1. Wages are subject to social security ( FICA ) tax at the rate of 6.2% imposed on both the employee and the employer on the first $110,100 of wages ($113,700 for 2013), and 1.45% (the Medicare tax) on both the employer and the employee on wages, a total of 7.65% by each for a total of 15.3%.. Temporary payroll tax cut legislation extended a two-percentage point payroll tax cut for employees, continuing the reduction of their Social Security tax withholding rate from 6.2 percent to 4.2 percent of wages paid through December 31, The Revenue Reconciliation Act of 1993 repealed the dollar limit on wages and selfemployment income subject to the Medicare tax. Thus, employers and employees were each subject to the 1.45% Medicare tax on all wages, and self-employed individuals are subject to the 2.9% Medicare tax on all self-employment income. B. Self-Employment Income. This tax is the counterpart for employees Social Security and Medicare taxes for the self-employed. The self-employment tax ( SE Tax ) was in 2012 imposed on net earnings from self-employment ( NESE ) at the rate of 10.4% on the first $110,100 of such net earnings in 2012 ($113,700 for 2013), and 2.9% (the Medicare tax) on total net earnings from self-employment. Like the FICA tax, the 10.4% rate reflects the 2% reduction of the temporary payroll tax cut legislation, continuing the reduction of the total rate from 12.4% to 10.4% on NESE through December 31, Excluded from the definition of NESE are certain capital gains, rental income, interest, and dividends. Self-employed individuals are entitled to an above the line deduction equal to one-half of the SE Tax paid under 164(f). II. Overview FICA, SECA, and Medicare Taxes Enacted By Health Care Reform Act; New 3.8 % Medicare Taxes Effective in The 2010 healthcare reform law enacted chapter 2A of the Internal Revenue Code entitled Unearned Income Medicare Contribution and contains 1411, effective for tax years beginning on an after Jan. 1, This is the tax on investment income and impacts individuals, trusts and estates. In December, 2012, the IRS and Treasury issued a series of v1 1

9 proposed regulations 1 and questions and answers 2 for the two new Medicare taxes scheduled to begin for tax years beginning on and after January 1, 2013: (1) the 3.8% Medicare tax on unearned income (generally, a 3.8% surtax on net investment income) above a modified adjusted gross income ( MAGI ) threshold, and (2) the 0.9% Medicare tax on earned income (i.e., wages and self-employment income) for employees and selfemployed individuals above MAGI thresholds. The proposed regulations are available at A. Wages & Self-Employment Income. 1. General. The 2010 Healthcare Reform Act increased the Medicare portion of the Medicare tax on wages and self-employment tax by.9% (to 3.8%) (the Additional Medicare Tax ) on modified adjusted gross income in excess of a threshold beginning in The thresholds are the same as for the new 3.8% tax on investment income (see chart below) - $250,000 in the case of married taxpayers filing a joint return (or a widow(er) whose spouse died within two prior tax years with a dependent child), $125,000 for married taxpayers filing a separate return, and more than $200,000 for all other taxpayers, effective for tax years beginning after December 31, Note that the IRS FAQs incorrectly state that the income threshold for a qualifying widow(er) is $200,000, rather than $250,000. See Q&A 3, Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare- Tax. 2. SECA - self- employment tax on net earnings from selfemployment (NESE) includes partnership distributive share unless the partner is a limited partner under 1402(a)(13). 3. FICA - payroll tax on wages (1/2 employer, ½ employee). New extra.9% is not deductible and is part of employee s share of Medicare taxes; comparable treatment for the self-employed. Prop. Reg (b)(2)(ii); Prop. Reg (d). 4. RRTA - Railroad Retirement Tax Act (RRTA) compensation that is subject to Medicare Tax is subject to additional Medicare Tax if it is paid in excess of the applicable threshold for an individual s filing status. All FAQs that discuss the application of the Additional Medicare Tax to wages also apply to RRTA compensation, unless otherwise indicated Nonresident Aliens And U.S. Citizens Living Abroad. Nonresident aliens are not subject to the NII tax. However, nonresident aliens will be subject to the tax if they elect to file a joint return with a resident or citizen spouse under 6013(g). Prop. 1 Preamble to Prop Reg11/30/2012; Prop Reg , Prop Reg , Prop Reg , Prop Reg , Prop Reg , Prop Reg , Prop Reg , Prop Reg , Prop Reg , Prop Reg , and Prop Reg Additional-Medicare-Tax. 3 Q&A 5, v1 2

10 Reg (a)(2). There are no special rules for U.S. citizens living abroad for purposes of this provision. Wages, other compensation, and self-employment income that are subject to Medicare tax will also be subject to Additional Medicare Tax if in excess of the applicable threshold Withholding. Employers must withhold additional Medicare tax from wages paid to an individual in excess of $200,000 in a calendar year, without regard to the individual employee s filing status or other wages/compensation. Prop. Reg (a). Withholding for the new 0.9% tax is based on an individual's own actual (not projected) income, and not a couple's income, as employers do not have the right to request income about a current spouse's year-to-date earnings. Employees who anticipate the Medicare tax as a married couple may request additional withholding to prepare for the tax, but may not request additional FICA/Medicare tax withholding. Instead, employees can merely ask for an increase in overall withholding that can apply for both income and employment tax purposes. Taxpayers who anticipate they will owe Additional Medicare Tax, and who did not request additional income tax withholding, may need to make estimated tax payments; however, taxpayers cannot designate any estimated tax payments specifically for Additional Medicare Tax. 5 B. New 3.8% Medicare Tax On Net Investment Income ( NII ) For Individuals, Trusts & Estates With Income Over Threshold. 1. General. The 2010 Healthcare Reform Act added 1411 to a new chapter 2A of subtitle A (Income Taxes) of the Code effective for taxable years beginning after December 31, Section 1411 subjects net investment income ( NII ) (rather than income derived from labor) for the first time in the history to the Medicare tax for those with income over a threshold amount. However, this revenue does not go to the Medicare Trust Fund. The tax on net investment income is not deductible when computing any tax imposed by subtitle A of the Code (i.e., income taxes) Computation & Thresholds. Section 1411(a)(1) imposes a separate 3.8% tax on the lesser of (a) net investment income or (b) the excess of modified adjusted gross income ( MAGI ) over the threshold amount. For most individuals, MAGI is their adjusted gross income unless they are U.S. citizens or residents living abroad and have foreign earned income. Individuals will owe the tax and report in on Form 1040 if they have Net Investment Income and have modified adjusted gross income over the following thresholds: Filing Status Threshold Amount Married filing jointly $250,000 Married filing separately $125,000 Single $200,000 Head of household (with qualifying person) $200,000 Widow(er) whose spouse died w/i 2 preceding tax years with dependent $250,000 child 4 Id. At Q&A 6. 5 Q&A 11 and 12 at Answers-for-the-Additional-Medicare-Tax. 6 Joint Committee on Taxation, Technical Explanation (JCX-18-10), at v1 3

11 3. Kiddie tax investment income that is taxed on a parent s return from Form 8814 is subject to this tax. 7 However, the IRS says that the calculation of the parent s net investment income doesn t include: (a) amounts excluded from the parent s Form 1040 due to the threshold amounts on Form 8814; and (b) amounts attributable to Alaska Permanent Fund Dividends The tax on NII is subject to the estimated tax provisions per the proposed regulations and Code 1411(e)(2). 9 Individuals, estates, and trusts that expect to be subject to the tax in 2013 or thereafter should adjust their income tax withholding or estimated payments to account for the tax increase in order to avoid underpayment penalties Unlike the employer s 1.45% share of the Medicare tax and the comparable portion of the tax on NESE, no part of the tax on NII is deductible. See JCT 2011 Explanation, JCS-2-11, March 24, 2011, at AGI &MAGI. Prop. Reg (b) provides that all references to an individual's adjusted gross income shall be treated as references to adjusted gross income (as defined in 62) under chapter 1. Modified Adjusted Gross Income ("MAGI") is AGI increased by the excess of : (1) the amount excluded from gross income under 911(a)(1) (foreign source income of the taxpayer), over (2) the amount of any deductions for foreign source income (taken into account in computing adjusted gross income) or exclusions disallowed under 911(d)(6) (denial of double benefits) with respect to the amounts excluded from gross income under 911(a)(1). Prop. Reg U.S. Residency. The term individual for purposes of 1411 means any natural person, except for natural persons who are nonresident aliens. Nonresident aliens will be subject to the tax if they elect to file a joint return with a resident or citizen spouse under 6013(g). Prop. Reg (a)(2)). The treatment of bona fide residents of U.S. territories is different depending on whether the individuals are residents of Guam, the Northern Mariana Islands, or the U.S. Virgin Islands, who are not subject to the tax, or Puerto Rico or American Samoa, who may be subject to the tax. Prop. Reg (a)(2)(iv)). C. Three Kinds Of Income In Earned Income. Wages and self-employment income. 2. Net Investment Income (NII) Taxed At 3.8% Where MAGI Above Threshold. These items of income are not subject to the additional 0.9% Medicare tax on earned income. Instead, they are subject to the 3.8% tax for those with MAGI over the relevant threshold. Code 1411(c) defines net investment income as: 7 IRS Q&A # 11 at 8 IRS Q&A # 8 at 9 Joint Committee on Taxation, Technical Explanation (JCX-18-10), at IRS Q&A # 15 at v1 4

12 a. Category (i) Income. Net interest, dividends, capital gains, rents (except rental activities that are a trade or business), royalties, and nonqualified annuities unless derived in the ordinary course of a trade or business to which the 3.8% surtax doesn t apply. Code 1411(c)(1)(A)(i). Code 162 applies to determine whether an activity is a trade or business for Code This is portfolio income under the 469 rules. b. Category (ii) Income; Reg Activities. (i) Net income from business constituting a passive activity as to the taxpayer under 469. (ii) Net income from trading in financial instruments or commodities. This would seem to include a hedge fund manager s income. 11 Code 1411(c)(1)(A)(ii). c. Category (iii) Income. Net gains from a disposition of property other than property held in a trade or business as well as a trade or business that is a passive activity or trading in financial instruments or commodities. Code 1411(c)(1)(A)(iii). Example. Taxpayer, a single filer, has $180,000 of wages. Taxpayer also received $90,000 from a passive partnership interest, which is Net Investment Income. Taxpayer s modified adjusted gross income is $270,000. Taxpayer s modified adjusted gross income exceeds the threshold of $200,000 for single taxpayers by $70,000. Taxpayer s Net Investment Income is $90,000. The Net Investment Income Tax is based on the lesser of $70,000 (the amount that Taxpayer s modified adjusted gross income exceeds the $200,000 threshold) or $90,000 (Taxpayer s Net Investment Income). Taxpayer owes NIIT of $2,660 ($70,000 x 3.8%). 12 If the taxpayer s sages were higher, the wages over the threshold could be subject to the 3.8% Medicare tax on earned income as well. 3. Income Not Subject To Earned Income Or NII Medicare Taxes. As discussed hereafter, certain types of income are not subject to either of the Medicare taxes on earned income of net investment income. Additionally, the proposed regulations state that the regular income tax provisions that apply to limit income and deductions in other parts of the tax code will apply for the purposes of the new Chapter 2A, the IRC 1411 Medicare tax. 4. Trusts & Estates. Certain estates and complex (as opposed to simple) trusts are subject to the NII tax and report it on Form 1041 if they have undistributed net investment income and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for the tax year. For 2012, this amount was $11,650 and is $11, Most hedge funds are considered to be active trades or businesses and not passive. Specifically, Temp. Reg T(e)(6) states that [a]n activity of trading personal property for the account of owners of interests in the activity is not a passive activity. 12 IRS Q&A # 18 at v1 5

13 in The proposed regulations provide that only income in the trust that was created in 2013 or later will be treated as net investment income. The rules for estate and trusts are discussed in more detail hereafter. D. Organization Of Proposed Reliance Regulations Effective date and transition rules ((iv) Regrouping for taxpayers subject to section 1411) General rules Application to individuals Application to estates and trusts Definition of net investment income Trades and businesses to which tax applies Income on investment of working capital subject to tax Exception for dispositions of interests in partnerships and S corporations Exception for distributions from qualified plans Exception for self-employment income Controlled foreign corporations and passive foreign investment companies. III. Definition Of Net Investment Income ( NII ). A. Proposed Reliance Regulations. Taxpayers may rely on the proposed 1411 regulations to comply with the new tax, which applies for tax years beginning in and after 2013, including making any election (such as the grouping of passive activities) available under the regulations that is binding on the taxpayer. Taxpayers who do not make elections under the proposed regulations will be able to make these elections pursuant to the final regulations if the final regulations contain the same or a similar election. B. Chapter 1 Definitions. The proposed regulations state that income tax definitions from Chapter 1 of the Code apply to 1411 unless the regulations provide otherwise. Thus, as discussed more below, items not taxed under regular income tax rules are not taxed by To prevent circumvention of the purposes of the statute, the proposed regulations modify the Chapter 1 rules in certain cases. Examples include treating substitute interest and dividends as investment income even though not technically considered dividends or interest under Chapter 1; and treating under Code Sections 959(d), 1293(c), or 1291 as net investment income. Additionally, the definition of adjusted gross income as it relates to investments in controlled foreign corporations and passive foreign investment companies is different for Thus, constructive dividends (payment of a personal expense with corporate funds) would be NII. C. Net Investment Income. NII includes (1) income from interest, dividends, annuities, royalties payments for use of patents, copyrights, goodwill, trademarks, v1 6

14 franchises, etc.), and rents (payments for the right to use tangible property except those from a rental trade or business) other than such income derived in the ordinary course of a trade or business, (2) a trade or business income that is a passive activity in which the taxpayer does not materially participate under 469, and a trade or business income from trading in financial instruments or commodities. 13 (3) It also includes taxable net gain attributable to the disposition of property other than property held in an active trade or business. See IRC 1411(c)(1)(iii). Prop. Reg defines net investment income and its components. Capital gain dividends from regulated investment companies and real estate investment trusts described in 852(b)(3)(C) and 857(b)(3)(C), respectively, and undistributed capital gains described in REIT rules in s 852(b)(3)(D) and 857(b)(3)(D), are included in NII as net gain under 1411(c)(1)(A)(iii) and not as dividend income under 1411(c)(1)(A)(i). Corporate dividends paid in 2013 out of 2012 earnings and profits are NII subject to NII tax in Trade Or Business Of Entity Determined At Entity Level. The individual s status under Code 469 (active or passive participant) is irrelevant if the pass-through entity is not engaged in a trade or business. For the NII, whether something is a trade or business is determined as it is under Code 162. Items of interest, dividends, annuities, royalties, and rents that pass through a partnership, LLC or S corporation to its partners, members or shareholders, will retain their character as NII. Non-passive activity income with respect to the taxpayer from a trade or business is 13 IRC 1411(c) provides that NII means the excess (if any) of (A) the sum of (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2), (ii) other gross income derived from a trade or business described in paragraph (2), and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2), over (B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain. (2) Trades and businesses to which tax applies. A trade or business is described in this paragraph if such trade or business is (A) a passive activity (within the meaning of section 469) with respect to the taxpayer, or (B) a trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2)). (3) Income on investment of working capital subject to tax. A rule similar to the rule of section 469(e)(1)(B) shall apply for purposes of this subsection. (4) Exception for certain active interests in partnerships and S corporations. In the case of a disposition of an interest in a partnership or S corporation (A) gain from such disposition shall be taken into account under clause (iii) of paragraph (1)(A) only to the extent of the net gain which would be so taken into account by the transferor if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest, and (B) a rule similar to the rule of subparagraph (A) shall apply to a loss from such disposition v1 7

15 excluded from the definition of NII unless from trading in financial instruments or commodities. Section 1411's statutory language and legislative history do not provide a definition of trade or business. The proposed regulations incorporate the rules under 162 for determining whether an activity is a trade or business for purposes of Prop. Reg (a). Gain from property held in a trade or business is excluded from NII, as long as such trade or business does not fall within the (1) passive activity OR (2) trading in financial instruments and commodities categories. Gross income from activities that are passive activities under 469 will not be considered as derived from a trade or business because the activity does not rise to the level of a trade or business under 162. Example 1 of proposed Reg (b)(2) -Rents. A, an unmarried individual, rents a commercial building to B for $50,000 in Year 1. A's rental activity does not involve the conduct of a 162 trade or business, and under 469(c)(2), A's rental activity is a passive activity. Because paragraph (b)(1)(i), there is no trade or business. A's rental income of $50,000 is not derived from a trade or business. However, A's rental income of $50,000 will still constitute gross income from rents within the meaning of (a)(1)(i) because Reg (a)(1)(i) does not require a trade or business. 2. Category (ii) Income; Regulation Trades or Businesses. The proposed regulations refer to the trades or businesses that are a passive activity or trading in financial instruments or commodities as Regulation Trades or Businesses. Net income from each of these activities is NII. Example Substitute interest or substitute dividends on securities lending is NII under the regulations. a. Passive Activities. The new law considers passive activity trade or business income from K-1 businesses to be investment income. The passive loss rules were not designed to punish people with passive income until now, and the way taxpayers grouped their income activities often never mattered. Now it does. Activity groupings matter because if you can group different operations into one activity, you can combine your participation in determining whether you materially participate in the activity (e.g., 500 hours). Normally one cannot change activity grouping, but the proposed regulations give everybody a free one-time opportunity to change their groupings. Interest, dividends, etc. that are not derived in the ordinary course of a trade or business are treated as portfolio income under Code 469 and are not used to determine whether there is income or loss from an activity. Thus, they are NII. Regulations. (i) The Material Participation Standard; Same As 469 Under the 469 regulations, a taxpayer materially participates in an activity if he or she meets one of seven tests during the taxable year: More than 500 hours of participation; v1 8

16 Substantially all participation in the activity is by the taxpayer: Participation for more than 100 hours, if no other individual participates more; Significant participation activities ( SPAs ), where the taxpayer participates for more than 100 hours ( significant participation"), and the taxpayer s aggregate participation in multiple SPAs exceeds 500 hours. Material participation in an activity in 5 of the last 10 taxable years (covers retired owner) as to year of sale); Material participation in a personal service activity is always material participation (the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, and any other trade or business in which capital is not a material income producing factor); and Regular, continuous, and substantial involvement under the facts and circumstances. (ii) Material Participation by a Partner or S Corporation Shareholder (Determined At Owner Level). An individual partner or S corporation shareholder participates in an entity level activity only if he or she is involved in the operations of the activity on a regular, continuous, and substantial basis. (iii) Material Participation By Limited Partner. Individuals can generally use one of the seven tests provided in the section 469 regulations to establish that they materially participate and that the trade or business is not subject to the passive loss limitations of section 469. If the individual holds an interest in a limited partnership as a limited partner, however, the individual is limited to one of three tests to establish material participation. Thus, it is significantly more difficult for limited partners to avoid the passive loss limitations. Several cases have determined that an LLC member is not a limited partner for purposes of section 469 even though the member has limited liability. See e.g. Gregg v. U.S., 186 F.Supp.2d 1123 (D. Or. 2000), Garnett v. Commissioner, 132 T.C. 368 (2009), and Thompson v. U.S., 87 Fed. Cl. 728 (2009), acq d result only AOD Acceding to the trend in the courts, these 2011 proposed regulations eliminate the current section 469 regulations reliance on limited liability for purposes of defining a limited partner. The 2011 section 469 proposed regulations define an interest in a limited partnership as a limited partner as (1) an interest in an entity treated as a partnership for federal income tax purposes where (2) the holder of such interest does not have rights to manage the entity at all times during the entity s tax year under the law of the jurisdiction in which the entity is organized and under the governing agreement. Prop. Treas. Reg. section (e)(3)(i). If the individual holds an interest in a limited partnership as a limited partner, the general rule under Prop. Treas. Reg. section (e)(1) ( General Rule ) is that the individual s share of any income, gain, loss, deduction, or credit from the interest is treated as passive v1 9

17 Two exceptions to this General Rule are provided. First, if the individual satisfies one of three requirements for material participation in an activity during the tax year under Treas. Reg. section T(a)(1)1, (a)(5)2, or (a)(6)3, the General Rule does not apply. See Prop. Treas. Reg. section (e)(2). Under this first exception, even if the partner has no power to manage the partnership, the partner can avoid the characterization of the activity as passive if the partner satisfies one of the three listed material participation tests. A limited partner is treated as materially participating if any one of the following tests is satisfied: The limited partner participates in the activity for more than 500 hours during the year. The limited partner materially participated in the activity for any five of the 10 immediately preceding tax years. The limited partner materially participated in a personal service activity for any three prior years The second exception is that, if the partner holds both a limited and non-limited partnership interest (such as a general partnership interest), the holder is not treated as a limited partner. See Prop. Treas. Reg. section (e)(3)(ii).. (iv) Self-Rental Income Is Passive For NII. The passive loss rules say that net income from self-rental to active businesses that they own is nonpassive. This is to prevent taxpayers from artificially generating passive income to use passive losses. The proposed 1411 regulations make such rental income a form of investment income. The proposed regulations say that such self-rental income must be treated as rental income, rather than as part of the non-passive activity that is paying the rent. (v) Material Participation Rental Income; Real Estate Pros. Normally, real estate rentals are inherently passive regardless of the taxpayer s participation. However, taxpayers who meet a 750-hour and more-time-than-anything-else standard in real estate operations under Code 469(c)(7) and Reg can test for whether their real estate rental is passive using the same material participation standards that apply to other activities. The proposed 1411 regulations say that such income must be trade or business income to avoid the 3.8% tax and that a real estate professional meeting the 469 tests is not necessarily engaged in a trade or business. If the trade or business test is met, the income from rental real estate (including from its sale) would not be treated as net investment income for purposes of the tax under Code Additionally, rental income and gain from the sale of property used in a trade or business is not treated as earnings from selfemployment. Thus, it would also not be subject to self-employment taxes. (vi) Working Interests In Oil & Gas. All the regulations say about this is: For rules regarding the treatment of working interests in oil or gas property, see 469(c)(3). A working interest in an oil and gas property that a taxpayer holds through an entity that does not limit the taxpayer s liability, or one held directly, is v1 10

18 not considered a passive activity. 14 Therefore, royalties from this type of investment are not subject to the 1411 tax. Oil and gas production payments, royalties, or other income arrangements are subject to the NII tax if the investment is not a working interest. (vii) Fresh Start Election to Redetermine Passive Activity Groupings (Can Start Over In 2013 (And Again When Regulations Finalized If So Allowed) Even If Did Something Different For 469 In Prior Years). Proposed Reg provides rules for defining an activity for purposes of applying the passive activity loss rule of 469 (the grouping rules ). The grouping rules will applying in determining the scope of a taxpayer s trade or business in order to determine whether the trade or business is a passive activity. Grouping generally helps a taxpayer aggregate gain and loss activities to satisfy the objective material participation tests. Therefore, grouping may enable a taxpayer to avoid treating business income as NII. The proposed regulations confirm that a proper grouping of activities under 469 will not convert gross income from rents into other gross income derived from a trade or business as described in Reg (a)(1). The proposed regulations provide that taxpayers may regroup their activities in the first taxable year beginning after December 31, 2013, in which the taxpayer meets the applicable MAGI threshold (i.e., $150,000, $200,000, or $250,000) and has NII. See Rev. Proc for the requirements for reporting groupings and redetermining groupings. b. Financial Instruments. Section 1411 does not define the term financial instrument. Section 731(c)(2)(C) provides a definition of financial instrument for purposes of 731, and this existing statutory definition is used as a guideline for the 1411 definition. Financial instruments include stocks and other equity interests, evidences of indebtedness, options, forwards or futures contracts, notional principal contracts, any other derivatives, and any evidence of an interest in such items including short positions and partial interests. Treas. Reg (b)(3). Treas. Reg (a)(2)(iii) describes financial instruments to include financial derivatives. c. Commodities. Commodities are defined by Section 1411 with reference to Section 475(e)(2) and include any commodity that is actively traded, notional principal contracts with respect to such commodity interests, certain derivatives, options, futures, forwards or similar instruments. d. Dealers, Traders & Investors. The proposed 1411 regulations do not change the law regarding the classification of dealers, traders or investors and whether they have a trade or business under Code 162. A dealer in securities purchases from customers or sells to customers, or regularly offers to enter into positions with customers, and is involved in a trade or business. A trader seeks profit from 14 IRC 469(c)(3)(A) and Temp. Reg T(e)(4)(i) v1 11

19 market swings and will be engaged in a trade or business if the trading is frequent and substantial. An investor seeks income from interest, dividends, and long-term appreciation. The proposed regulations provide that gross income from a trade or business constituting NII may be reduced by deductions described in 62(a)(1) that are allocable to that income. This rule would permit a trader to deduct ordinary and necessary expenses of the trading business in calculating NII. Under Reg (b), if a trader has deductions that did not reduce the trader s NESE (after aggregating NESE from other trades or businesses) such excess deductions are properly allocable deductions under 1411(c)(1)(B). A person who qualifies as a trader may be engaged in a trade or business for Code 1411(c)(2)(B). However, as noted in the preamble of the 1411 regulations, management of one s own investments is not a Code 162 trade or business no matter how extensive or substantial the investments might be. Thus, income from personal investments is typically category (i) income and subject as such to the NII tax. e. Pass-Through Of Commodity/Financial Asset Income Determined At Entity Level. Whether the trade or business involves trading in financial instruments or commodities is determined at the pass-through entity level. If the entity is involved in this business, the income retains its character when passing through to the taxpayer. Prop. Reg (b)(2). 3. Category (iii) Income; Dispositions. The term net investment income includes any net gain (to the extent taken into account in computing taxable income) from a disposition attributable to (1) the disposition of property, other than property held in a trade or business, and (2) gain from a Regulation Trade or Business (i.e., a passive interest in a trade or business (with respect to the taxpayer) or a business involved in trading financial instruments or commodities. Chapter 1 rules apply to determine if the disposition is taxable NII. A disposition includes the sale, exchange, transfer, conversion, cash settlement, cancellation, termination, lapse, expiration, or other disposition of property as determined under chapter 1 of the Code. See Prop Reg (d). Examples Sale of (2) C corp stock (publicly traded or privately held), whether owned by an investor or a material participant, or (2) a real estate investment (not a principal residence) is NII. (3) A sale of a boat that is a passive activity as to an owner is NII. The income tax rules in chapter 1 generally will determine whether there has been a disposition of property under For example, if a partner receives a distribution of money from a partnership in excess of the adjusted basis of the partner's interest in the partnership and recognizes gain under 731(a), or if an S corporation shareholder receives a distribution of money from the S corporation in excess of the adjusted basis of the shareholder's stock in the corporation and recognizes gain under 1368(b)(2), the gain is treated as gain from the sale or exchange of such partnership interest or S corporation stock for purposes of 1411(c)(1)(A)(iii). 4. Working Capital Income. Income, gain, or loss from the investment of working capital is treated as not derived in the ordinary course, even in a non-passive v1 12

20 trade or business, and is therefore subject to the 3.8% NII tax. IRC 1411(c)(3). Prop. Reg ). Cash-intensive businesses using interest-bearing accounts, as well as businesses that accumulate funds until a project begins, should be alert to this NII income. On the other hand, interest, dividends, etc. are not net investment income if they are derived in the ordinary course of a trade or business that is not a passive activity with respect to the taxpayer and that is not trading of financial instruments or commodities. This is the ordinary course of trade or business exception. D. Other Code Provisions Apply. 1. Items Not Taxed. The proposed regulations state that chapter 1 Code provisions apply for Chapter 2A NII tax. Thus, gain not taxed under Chapter 1 is not taxed under Chapter 2A. 2. Deductions. Allowable ( properly allocable ) deductions to compute NII include the following: Rents and royalties deductions described in Code 62(a)(4), such as depletion. Prop. Reg (f )(2). Interest income penalties described in Code 62(a)(9) for penalties upon early withdrawals of savings. Trade or business deductions described in Code 62(a)(1). Certain itemized deductions, such as investment interest, investment expenses, and taxes. Prop. Reg (f)(3)(i). Miscellaneous itemized deductions, but only after application of the 2-percent floor under Code 67 and the overall deduction limit under Code 68. Prop. Reg (f)(3)(ii). 3. Losses. Certain losses may also be taken into account in determining net gain. This would apply to losses deductible under Code 165 if the property is not held in a trade or business, or if the property is held in a trade or business category related to net investment income. Capital losses that exceed capital gains are not recognized for Code 1411, but the $3,000 of losses allowable to noncorporate taxpayers may offset gains from the disposition of noncapital assets. Under the proposed regulations, a net operating loss (NOL) deduction reduces MAGI but cannot reduce net investment income because the items comprising the NOL are not tracked, once included in the NOL, and the overall NOL itself is not properly allocable to any specific item of income Prop. Reg (f)(1)(ii). Losses under Code 165 are deductible only in computing net gain from a disposition (Category (iii) income from the disposition of property), and only to the extent of gains, so they are not properly allocable deductions. Prop. Reg (f )(4). The net gain from a disposition cannot be less than zero and that any excess losses are not allowed in computing net investment income. well. 4. Deferral, Disallowance & Carryover Provisions. These apply as v1 13

21 Limitation on investment interest under Code 163(d); Limitation of expense and interest relating to tax-exempt income under Code 265; At risk limitations under Code 465(a)(2); Passive activity loss limitations under Code 469(b); Partner loss limitations under Code 704(d); Capital loss carryover limitations under Code 1212(b); and S corp shareholder loss limitations under Code 1366(d)(2). Further, carryover deductions in connection with these deferral or disallowance provisions otherwise allowed in determining adjusted gross income (AGI) are also allowed in determining NII. 5. Short Tax Years. The proposed reliance regulations explain that a threshold amount is generally not prorated in the case of a short tax year because of death or other reasons. Prop. Reg (d)(2). However, if the short year is the result of a change of annual accounting period, the applicable threshold is reduced to an amount to an amount that bears the same ratio to the full threshold amount as the number of months in the short period bears to twelve. Prop. Reg (d)(2)(ii). 6. Capital Gains. Capital gains are generally included in net investment income subject to the 3.8% surtax. To the extent that gains aren t otherwise offset by capital losses, the IRS notes that the following gains are common examples of items taken into account in computing net investment income: Gains from the sale of stocks, bonds, and mutual funds; Capital gain distributions from mutual funds (i.e., regulated investment companies (RICs)); Gain from the sale of investment real estate (including gain from the sale of a second home that isn t a primary residence); Gains from the sale of interests in partnerships and S corporations (to the extent the taxpayer was a passive owner). 15 In addition, capital gain dividends from real estate investment trusts (REITs) and undistributed capital gains from RICs and REITs are included in net investment income as net gain under Code 1411(c)(1)(A)(iii), and not as dividend income under Code 1411(c)(1)(A)(i). 7. Capital Losses. Under the 1411 proposed regulations, net gain can t be less than zero. Losses allowable under Code 1211(b) are allowed to offset gain from the disposition of assets other than capital assets that are subject to Code Prop Reg (d)(2). Net gain attributable to the disposition of property is the gain under Code 61(a)(3) (i.e., dealings in property) recognized from the disposition of property reduced, but not below zero, by losses deductible under Code 165, including losses from casualty, theft, and abandonment or other worthlessness. Net gain doesn t include gain or 15 Id. Q&A # v1 14

22 loss attributable to the disposition of property from the investment of working capital. Prop Reg (d)(3)(i). The proposed regulations provide that additional $3,000 ordinary loss permitted for capital losses ordinary income tax purposes is not allowed for the Medicare tax unless there are other noncapital gains (e.g., related to the disposition of a business or business assets) against which they can be applied. To the extent that disallowed losses are carried forward under the regular tax code, they can be carried forward for the Medicare tax (with the notable exception of business net operating loss carryforwards, which do not apply unless the underlying income/loss category can be determined and applied separately). Capital loss carryforwards are permitted as well. In addition, existing capital or other loss carryforwards (e.g., from 2012 or prior) can be applied against 2013 gains (and reduce 2013 net investment income and potential taxes due). Example 1: In Year 1, Jane realizes a $40,000 capital loss on the sale of C corporation A stock and a $10,000 capital gain of on the sale of C corporation B stock, resulting in a net capital loss of $30,000. Jane has $300,000 of wages and earns $5,000 in interest. Under Code 1211(b), Jane can use $3,000 of the net capital loss against other income, with the remaining $27,000 being a capital loss carryover. For Code 1411 purposes, Jane s $10,000 gain on the B stock sale is reduced by the $40,000 loss on the corporation A stock sale. However, because net gain can t be less than zero, she can t reduce the net investment income by the $3,000 of the excess of capital losses over capital gains allowed for income tax purposes under Code 1211(b). In Year 2, Jane has a $30,000 capital gain on the sale of C corporation C stock. For income tax purposes, Jane can reduce the $30,000 gain by the Year 1 Code 1212(b) $27,000 capital loss carryover. For Code 1411 purposes, Jane s $30,000 gain may also be reduced by the $27,000 capital loss carryover from Year 1. Therefore, in Year 2, Jane has $3,000 of net gain under Prop Reg (a)(1)(iii). Example 2: Assume the same facts as in #1 above for Year 1, but Jane also realizes $20,000 of gain on the sale of rental property D (all of which is treated as ordinary income under Code 1250). Jane could use $3,000 of the net capital loss against other income for income tax purposes, with the remaining $27,000 being a capital loss carryover. For Code 1411 purposes, Jane s $10,000 gain on the B stock sale is reduced by the $40,000 loss on the sale of the corporation A stock. The $20,000 gain on the sale of rental property D is reduced to the extent of the $3,000 loss allowed under Code 1211(b). Accordingly, Jane s net gain for Year 1 is $17,000, i.e., the $20,000 gain treated as ordinary income on the sale of rental property D reduced by $3,000 loss allowed under Code CFCs & PFICs (Controlled Foreign Corporations And Passive Foreign Investment Companies); Funds that are Traders in Financial Instruments or Commodities. Inclusions to a U.S. shareholder under the CFC rules are not dividends unless expressly provided in the Code. Similarly, inclusions to a U.S. person owning shares in a PFIC are not dividends. As a result, these amounts are not net investment income unless the v1 15