Self-Employment Tax and NIIT for LLCs and Higher Income Individuals: Navigating the Complex Interplay

Transcription

1 FOR LIVE PROGRAM ONLY Self-Employment Tax and NIIT for LLCs and Higher Income Individuals: Navigating the Complex Interplay TUESDAY, DECEMBER 13, 2016, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: Participate in the program on your own computer connection (no sharing) if you need to register additional people, please call customer service at x10 (or x10). Strafford accepts American Express, Visa, MasterCard, Discover. Listen on-line via your computer speakers. Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be ed to registered attendees. To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service x10 (or x10) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN.

2 Tips for Optimal Quality FOR LIVE PROGRAM ONLY Sound Quality When listening via your computer speakers, please note that the quality of your sound will vary depending on the speed and quality of your internet connection. If the sound quality is not satisfactory, please immediately so we can address the problem.

3 Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

4 Self-Employment Tax and NIIT for LLCs and Higher Income Individuals: Navigating the Complex Interplay Cameron Hess WAGNER KIRKMAN BLAINE KLOMPARENS & YOUMANS LLP Mather, CA x810 James R. Browne Barnes & Thornburg LLP Dallas, TX December 8, 2015

5 Agenda Introduction LLC Members & Self-Employment Tax LLC Members & the 3.8% Net Investment Income Tax Some Thoughts on Trusts Problems & Planning Opportunities Proposals and Changes on the Horizon 5

6 Introduction 6

7 Basics PP&AC Act-H. R FICA/SET/Additional Medicare Tax New: 0.9% Additional Medicare Tax Code Section 1401(b)(2) - SET (Hospital Insurance) Code Section 3121(b)(2) - FICA 100% Employee/Self-Employed Imposed on the excess amount of wages, self-employment, etc. Net Investment income Tax Code Section 1411 (new Chapter 2A) New: 3.8% Net Investment Income Tax Applies to NII Imposed on the lesser of: a) NII or b) excess amount of MAGI 7

8 Basics Why do we care? Planning: higher income individuals. Tax Savings: 20% vs 23.8% Tax Rate; 39.6% vs 42.4% Tax Rate Each $250K not s/t 3.8% tax saves $9,750. One-time events high income for regular folks. Personal residence or rental sale (e.g., bought 30 years ago) Big bonus (e.g. for retirement; relocation, incentive) Nonqualified deferred compensation ( Rabbi Trust ) Early disposition of stock from ISO Involuntary conversions (if taxable) LLC member distributive shares have special planning options 8

9 Basics: 0.9% Additional Medicare Tax 0.9% Additional Medicare Tax Individuals 0.9% Tax on excess (countable income) > Threshold: Countable: Total (H+W) - wages, self-employment income. Threshold - not indexed for inflation Pay - withhold or estimates (to avoid underpayment penalty) Why Plan: Avoid 3.8% in Taxes 0.9% Add l Medicare Tax + 2.9% Medicare Tax* *SET/FICA HI portion continues uncapped over $118,500. 9

10 Basics: 0.9% Additional Medicare Tax 10

11 Basics: 3.8% NIIT 3.8% Net Investment Income Tax Individuals, estates and trusts (not entities) includes Sch K-1 reported income Tax 3.8% x the lesser of: (1) Total NII (net investment income), or (2) Excess MAGI* *Excess MAGI = MAGI minus Threshold Amount. - (Except US persons overseas, MAGI = AGI Line 31 Form 1040.) NII - may deduct related expenses (including alloc. state income taxes) 11

12 Threshold Amount - Individuals Threshold Status Amount Married, filing jointly $250,000 Married, filing separately $125,000 Single $200,000 Head of household $200,000 Qualifying widow(er) with child $250,000 12

13 Threshold Am t Estates/Trusts 2016: $12,400 = Threshold($12, ) Compare: 12,400 vs 125K/200K/250K Beneficiary DNI distributions also create deduction for NII to trust/estate (NII distribution reported to beneficiary) 13

14 Example 1 Individual Big John (unmarried, in US) has $300,000 NII (rental income) $190,000 AGI (had a business loss) 3.8% NIIT Computation: NII Tax = $0. 3.8% x lesser of (1) $300K NII or (2) $0.0* *(190K AGI 200K Threshold) 14

15 Example 1a Planning - Irrev. Trust Big John Irrevocable Trust has $300K NII; $190K AGI (business loss) No beneficiary distribution (no DNI Distribution) 3.8% NIIT Computation: NII Tax = $6, % x lesser of (1) $300K NII or (2) $177,600* *(190,000 MAGI 12,400 Threshold) But!: If $177,600 DNI distributed, then NII Tax = $0 NII Tax = $0.0 (3.8% x $0 (190K - $177.6K - $12.4K MAGI)) 15

16 Basics: 3.8% NIIT Taxed Persons Individuals Trusts (standard trusts) Estates Exempt Persons : Foreign Persons C Corporations Foreign Trusts, Tax Exempt Trusts (Pensions, CRATs, CRUTS) Charitable Trusts Partnerships/S corporations No SET overlap: NII excludes income subject to SE tax 16

17 Basics: 3.8% NIIT NII = Gross Investment Income (GII) less: GII Categories: 1. Portfolio Income 163 Allowable Deductions SAME RULES 2. PAL/PIG 469 SOME CHANGES 3. Finance/Commodity traders-same RULES NOT day traders. Reduces value of security/commodity traders tax benefits 4. Net Gain (Dispositions) LOTS OF CHANGES 17

18 LLC Members & Self- Employment Tax 18

19 SET on LLC Members Issue: Can an LLC member treat any portion of the member s distributive share of LLC income as exempt from SET under the exception for limited partner distributive share income? The issue is relevant only for LLC members who materially or substantially participate in the LLC business or can otherwise avoid NIIT on the distributive share income 19

20 SET on LLC Members Historical Background All income from a partnership is included in net earnings from self-employment Prior to 1977, promoters were marketing passive limited partner investments to persons otherwise ineligible for social security benefits; the partnerships promised to generate a predictable stream of self-employment income eligible for social security Congress wanted to curtail this practice of buying social security benefits, so it amended the Code to provide that income received as a limited partner is not self-employment income After 1977, as taxes on self-employment income increased and social security benefits declined, the limited partner rule lost its anti-abuse purpose and became a benefit to taxpayers 20

21 SET on LLC Members The SET limited partner exception (a)(13) In computing net earnings from self-employment: Include the distributive share (whether or not distributed) of income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member Exclude (in addition to normal exclusions for rents, dividends, gains, etc.): the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services Note that the statute expressly contemplates that a limited partner may provide services to the partnership and still have distributive share income excluded from SET 21

22 SET on LLC Members The 1997 proposed regulations Context: Eroding restrictions on limited partner management activities Growing use of alternative forms of tax partnerships with full or partial limited liability for managing members (LLCs, LLPs, and LLLPs) Increasing SET rate relative to benefits General rule: a limited partner is any individual unless the individual: has personal liability as a partner for the partnership s debts, or has authority (under the law of the jurisdiction in which the partnership is formed) to contract for the partnership, or participates in the partnership's business for more than 500 hours during the partnership s taxable year, or is a service partner in a service partnership 22

23 SET on LLC Members The 1997 proposed regulations (con t) Class of Interest Exceptions An individual holding more than one class of interest is a limited partner with respect to a class of interest in which (a) limited partners (as defined above) own a substantial ( 20%), continuing interest and (b) the individual s rights are identical to such limited partners rights An individual holding only one class of interest who is not a limited partner solely because he participates in the business for >500 hours is a limited partner with respect to the interest if (a) and (b) above are true with respect to the class of interest These exceptions are intended to exclude from an individual's net earnings from self-employment amounts that are demonstrably returns on capital invested in the partnership A service partner in a service partnership is never a limited partner to any extent (i.e., no class of interest exception) 23

24 SET on LLC Members Congress responds The 1997 proposed regulations sparked a firestorm of criticism Critics claimed that earnings from self-employment must be limited to the fair value of the services actually rendered to the business, and should not sweep in all income derived from the business based on arbitrary factors such as the number or hours worked or the nature of the business Congress promptly passed legislation prohibiting finalization of regulations with respect to the definition of limited partner under 1402(a)(13) until July 1, 1998 The Senate bill expressed the Senate s view that the proposed regulations should be withdrawn and that Congress should determine the tax law governing self-employment income 24

25 SET on LLC Members Case law and rulings Renkemeyer, Campbell & Weaver, LLP v. Comm r, 136 T.C. 137 (2011) Irrelevant: Law firm was a general partnership electing LLP status Abusive facts: transitory corporate holding company; no partnership agreement; failure to allocate income and distributions according to alleged sharing ratios; low or no compensation for services Erroneous and Extraneous Comments: Congress intended to exclude earnings that are basically of an investment nature The legislative history does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners Because the taxpayers distributive share income arose exclusively from legal services performed on behalf of the partnership, and was not of an investment nature, the income was subject to SET 25

26 SET on LLC Members Case law and rulings (con t) Riether v. United States, 919 F. Supp. 2d 1140 (D. NM 2012) LLC operates a medical diagnostic imaging business; members receive wages and distributive share income from the LLC; no SET on distributive share (<$10,000 tax effect) Taxpayers: we can t be self-employed because we received wages No evidence that members lacked management authority, or that wages were reasonable compensation for services Held: distributive share income is subject to SET because taxpayers were effectively general partners Plaintiffs are not members of a limited partnership, nor do they resemble limited partners, which are those who lack management powers but enjoy immunity from liability for debts of the partnership. [Renkemeyer] Thus, whether Plaintiffs were active or passive in the production of the LLC's earnings, those earnings were self-employment income. 26

27 SET on LLC Members Case law and rulings (con t) Howell v. Comm r, 2012 T.C. Memo 303 Medical technology company (LLC) formed by W and B; H (W s spouse) managed the business with B; LLC paid guaranteed payments to H, B, W and others, leaving only small amounts of distributive share income for W and B; no SET paid on guaranteed payments H&W appear to contend that W was a limited partner not active in the business and her guaranteed payments were either limited partner distributive share income or not payments for services Held: Taxpayers are bound by their tax reporting (guaranteed payment) W performed some services for the LLC, but failed to prove what portion of the guaranteed payments were for services Notably, no SET imposed on distributive share income 27

28 SET on LLC Members Case law and rulings (con t) CCA (May 20, 2014) Investment fund management company organized as an LLC; members were paid a salary, a guaranteed payment for parking and health benefits, and a distributive share; no SET on distributive share Members contributed varying amounts of capital to the LLC Held: entire distributive share income is subject to SET because the income is not income which is basically of an investment nature of the sort that Congress sought to exclude from [SET] when it enacted the predecessor to 1402(a)(13). Accordingly, [the members] are not limited partners within the meaning of 1402(a)(13). No analysis whether the salary and guaranteed payments represented reasonable compensation for services No analysis whether the distributive share income was attributable to invested capital, employee labor, or other non-service factors 28

29 SET on LLC Members Case law and rulings (con t) CCA (June 15, 2016) T/P = franchisee of restaurants operated through an LLC (partnership) owned by T/P, his wife, and a family trust; T/P was the sole LLC manager T/P paid SET on guaranteed payments, but excluded distributive share income under the 1402(a)(13) limited partner exception Relying on Renkemeyer and Reither, the IRS concluded that because T/P provided substantial services to the LLC and was not a mere investor, T/P s distributive share income is not exempt from SET, regardless of whether the income is attributable to employee labor or invested capital The IRS s mere investor test directly conflicts with the statute 29

30 SET on LLC Members Where are we now? Reporting position: an LLC member s distributive share income from a manager-managed LLC is exempt from SET if the member is paid reasonable compensation for services as a manager This position is easily reconciled with the statute and legislative history, including the arguments that led to the 1997 Congressional moratorium It is consistent with the treatment of S corporations It consistent with case law (based on applicable facts and IRS litigating position in Howell) IRS position that distributive share income of an active partner is always subject to SET is plainly contrary to the statute, its proposed regulations, and Congressional intent (as expressed in 1997) Service partners in service partnerships have more risk 30

31

32 LLC Members & 3.8% NIIT 32

33 LLCs Passive Activities NII Includes: 469 PALs/PIGs Some rules changed Presumed passive: limited partner rental real estate NIIT Rules to overcome Somewhat Harder to meet than Section

34 LLCs & Real Estate Professionals Rental Real Estate To avoid 3.8% NIIT must both: Be a real estate professional (> 750 hours) Meet one of the 500 hour tests or convince the Service. Other material participation tests are rejected (may use for 469 but not NIIT) 34

35 LLCs & Real Estate Professionals Rental real estate continued Most related activity safe harbors were rejected. Rejected: Start-up Activities Pre-Development Activities Example: Developer leases back to farmer land held for development. While not passive under Section 469, rental income will be deemed NII. 35

36 LLCs & Real Estate Professional Material Participation in Rental Real Estate ( T(a)(1)) A. Real estate professional (>750 hrs) + B. Either 1. participate = > than 500 hours per year, 2. > than 500 hours/year in 5 of 10 prior years Active T/B, and thus not subject to *Activity Must be Part of That Active Trade or Business 36

37 LLCs & Real Estate Professional Material Participation in Rental Real Estate ( T(a)(1)) Nonsafe harbor Substantial, participate, active trade/business 37

38 LLCs & Limited Partner 3.8% NIIT Regulations follow same Limited Partner rules under Section 469 apply 38

39 LLCs & Limited Partner Problem: No statute defines limited partner If Limited Partner, only have 3 tests to prove active. Affected: LLCs, LPs, LLPs, LLLPs, other entities treated as partnership. 39

40 LLCs & Limited Partner Any interest classified as a limited partner, IRC 469(h)(2) is per se presumed passive. Only Three exceptions: 500 Hours. Taxpayer works 500 hours or more in the particular trade or business activity. Prior 500 Hours. Taxpayer materially participated in the activity in any 5 of the prior 10 years. Service Activity. It is a personal service activity; taxpayer materially participated in that activity in any 3 prior years. 40

41 LLCs & Limited Partner Temp Treas. Reg T(e)(3)(i)...interest [is] a limited partnership interest if (A). designated a limited partnership interest,.; or (B) The liability of the holder is limited,.. interest shall not be treated as a limited partnership interest. if the individual is a general partner. 41

42 LLCs & Limited Partner Good News!: Courts reject LP treatment for LLCs: Gregg v. U.S., 186 F.Supp.2d 1123 (D. Or. 2000). LLC. Garnett v. Com r, 132 T.C. 368 (2009). LLPs and LLCs were not limited partnerships. Thompson v. U.S., 87 Fed. Cl. 728 (2009). 469(h)(2) requires a partnership. An LLC member is not a limited partner. Newell v. Com r, T.C. Memo (h)(2) did not apply to the managing member of an LLC. Member is a general partner under T(e)(3)(ii). Lamas v. Com r, T.C. Memo Several LLCs & S Corp. Rejects no material participation. Aggregates S Corps & LLC activities total hours adequate. 42

43 LLCs & Limited Partner IRS Strikes Back: Prop. Treas. Reg (e)(3)(i) (11/28/11)...interest [is] a limited partnership interest if (A) The entity is classified as a partnership for Federal income tax purposes under ; and (B) The holder of such interest does not have rights to manage the entity.. 43

44 Some Thoughts on Trusts 44

45 Trusts & 3.8% NIIT High income persons do trust planning Income shifting Asset shifting Using both Trusts + LLC is common Careful planning on trust distributions is needed. Highest Trust tax $12,400 NIIT triggered if Trust AGI > $12,400 45

46 Trust Issue for LLCs & 3.8% NIIT Scenario: Trust owns % in LLC. Is Trustee status = limited partner? Can Trustee materially participate? IRS Declined to Issue Regulations 46

47 Trustee Material Participation IRS: Trustees rarely materially participate must be directly on title, and principal person acting 1 1 Position discussed by IRS in TAM ; PLR ; TAM COURTS REJECT: Carter Trust v. US 256 F. Supp. 2d 536 (N.D. Tex. 2003). Trustee hired ranch manager. Material participation found through employees and trustee. Aragona Trust v. Com r, 142 TC. 9 (3/27/14). 3 of 6 trustees (related) worked FT for R/E management LLC, wholly owned by trust. Trust can materially participate through trusteeemployees; R/E professional exception applied. 47

48 Problems and Planning Opportunities 48

49 Planning Trap #1 Using an S corporation to avoid SET/NIIT The properly determined distributive share income of an S corporation engaged in an active non-trading business is unquestionably exempt from both SET and NIIT BUT S corporations have significant disadvantages. (e.g., one class of stock, no entity or foreign shareholders, no 754 election, no 721/731 exclusion for gain on property contributions and distributions, no inside basis step-up at death, etc.) The perceived SET/NIIT benefits may be overstated A properly structured LLC/LP should achieve similar SET benefits. 49

50 Planning Trap #2 S corporation election for an LLC or LP Tax preparers or other tax advisors often elect S corporation status for an LLC or LP solely to obtain SET and NIIT advantages. This is usually bad advice! Same considerations as any S corporation (see prior slide) Plus additional potential problems if the company agreement is not modified to conform to S corporation requirements; the entity might be classified as a C corporation! 50

51 Planning Trap #3 S corporation blocker Individual A Individual B Individual C S Corp 1 S Corp 2 S Corp 3 S Corp. S Corp. S Corp. LLC Partnership Individuals are employees of LLC or S corp and are paid wages Distributive share income flows through S corporations NB: Cumbersome and does not eliminate all disadvantages of S corporation ownership 51

52

53 Planning Opportunities A properly structured LLC/LP Individual A Individual B Individual C Manager S Corp. (or LLC) Management Fees Manager-Managed LLC Partnership Individuals perform services for LLC as employees of Manager Distributive share income received by individuals as an LLC member having no management rights Same structure can be used for a limited partnership (Manager is the general partner) 53

54 Planning Opportunities Spousal split ownership of LLC/LP Taxpayer Spouse Guaranteed Payment for Services Managing Member 1% OpCo, LLC Member 99% Active non-trading, nonservice business Partnership T s activities are imputed to S for passive activity purposes, but are not imputed to S for purposes of SET limited partner proposed regulations S s distributive share income should avoid SET/NIIT 54

55 Planning Opportunities One class of interest exception Taxpayer Others Guaranteed Payment for Services Managing Member 80% OpCo, LLC Member 20% Active non-trading, nonservice business Partnership T s distributive share income is exempt from SET under one class of interest exception, and is exempt from NIIT based on material participation 55

56 Planning Opportunities Grouping election Under prior law, it was often advantageous to not group activities (to accelerate use of suspended losses on activities sold or terminated) Under current law, it might be beneficial to group activities so that otherwise passive activities that do not generate selfemployment income (but which do generate NII) can become part of a combined Active Non-Trading Business that generates neither NII nor self-employment income Appropriate economic unit for grouping: important factors Similarities or differences in the types of businesses; Extent of common control; Extent of common ownership; Geographical location; and Interdependence of the activities Various limitations apply 56

57 Planning Opportunities Self Charged Interest (Loan to related LLC or LLP) On self-charged interest from an active (non-passive) business entity, a portion of interest income will be excluded. The exclusion amount = the lender s share of the nonpassive deduction. The rule cross-references for the operative mechanics. The limit is inapplicable if the interest deduction is part of a selfemployment income computation (subject to tax under section 1401(b)). 57

58 Planning Opportunities Self Charged Interest. Example. Able Designer loans 10% to an architecture firm in which he owns 15% of the architecture firm located in the same building. Will 100% of the $$ interest paid by the firm be treated as self-charged rent? No. There is only excluded the income = to the % interest deduction born. Only $1,500 of the $10,000 received will be excluded. $8,500 of the interest will remain NII 58

59 Planning Opportunities Self-Charged Rent (Rent property to business) Rental income treated as non-passive under (f)(6) (rental income from property used in an activity in which the taxpayer materially participates), including rental property grouped with a non-passive activity, will be deed T/B income. Gain/loss from rental property, if sold with active T/B property will also be treated as nonpassive T/B gain 59

60 Planning Opportunities Property s/t Self-Charged Rent Example. Able Designer owns 100% of a building and 15% of the architecture firm located in the same building. Will 100% of the $$ rent paid by the firm be treated as self-charged rent? Yes, under (f)(6), amount of rent paid by the firm will be treated as non-passive. The self-rental regulations do not require mirror ownership. 60

61 Planning Opportunities Avoiding 3.8% NIIT through material participation Participation by Hours > 500 Time spent (Self/Spouse) Proof of Participation. Appointment book calendar, or narrative summary. To show the services performed & hours. Facts & Circumstances Test (difficult) Activity regular, continuous, and substantial Works at least 100 hours in the activity, No one else works more hours No one else receives compensation for managing the activity AND SERVICE CONVINCED ACTIVE TRADE OR BUSINESS. 61

62 Planning Opportunities Counting +500 hours Per IRS - exclude Admin Time: Review financials, monitor, Work normally be assigned to an employee Travel Time Thomas E. Truskowsky, T.C. Summary Op Per IRS: Few taxpayers can meet the facts and circumstances standard. If there is paid on-site management, the facts and circumstances test cannot be used. Courts. Non-trust Decisions. Most are more taxpayer abuse cases. Some decisions indicate courts will concur that the IRS is overreaching on its position. Major problem is burden of proof. 62

63 Planning Opportunities Avoiding 3.8% NIIT through significant participation Participation in the activity exceeds 100 hours but is less than 500 hours (i.e., is significant but not material) SET: Distributive share income is exempt from SET (unless the individual has management authority or is a service partner in a service partnership) [Prop. Reg (a)-2] NIIT: Distributive share income may be exempt from NIIT under the income recharacterization rules for profitable significant participation activities [Reg (b)(2)(i)] 63

64 Planning Opportunities Net Gain from Dispositions Opportunities to reduce losses by: Strategies to reduce NII by Sec.165 losses: abandonment and worthlessness. Culling of losses. Basic exceptions/limitations/exclusions apply Loss limitations (at risk, basis, but capital loss C/F rules are narrower) Installment sale rules Statutory Exclusions apply 1031/1033/1038/121(home) Look Through Rule: 64

65 Planning: Look-Through Rule Owner s Disposition of Interest in Pship or S Corp 1411(c)(4) & (Prop. Treas. Reg ). Recasts NII gain/loss as business gain/loss. In the case of a disposition of an interest in a partnership or an S corporation (A) gain from such a disposition shall be taken into account only to the extent of the net gain if all property of the partnership or S corporation were sold at 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. 65

66 Planning: Look-Through Rule Why. Owner s pass-through business won t be treated as an investment. If sell interest deemed like asset sale. How: look-through : Had entity its assets ( deemed sale ) at FMV, what portion would be business income? (Prop. Treas. Reg. Section ). Trade/business portion is excluded from NII net gain from disposition. Complicated Computation - difficult to qualify. NOTE!: Does not apply to owner of C Corp! 66

67 Planning: Look Through Rule Summary T s gain from sale of interest is bifurcated: if part of gain from sale relates to trade/business portion sold, total gain included in NII is reduced (negative adjustment) T s loss bifurcated: if part of loss from sale relates to trade/business sold, total loss is reduced offset against other disposition gains is less (positive adjustment) Excess = deemed investment gain/loss Note: Adjustment doesn t increase total gain or total loss from sale of interest. 67

68 Planning: Look-Through Steps 1. Compute total gain/loss from disposition of interest. 2. Compute entity level total gain/loss from deemed FMV sale; 3. Compute gain/loss deemed for each separate entity asset (including goodwill); 4. Multiply % interest sold x each gain/loss (the look through); 5. Sort gain/loss between: (i) net investment income and (ii) excluded income (e.g., trade or business income.) 68

69 Planning To Minimize Risks SET/469 Cases often have bad LLC documents and records. Good Documents. Have a clean LLC Formation. Articles, Operating Agreement. Follow well drafted allocation/distribution provisions Guaranteed Payments for Services (non-rental LLCs) Consider two-class memberships or requiring managers. Good Records Track hours/activities for active trade or business Keep good accounting records Good Tax Advice Identify SET/NIIT issues, advise on risks and set strategies Encourage the IRS to challenge someone else. 69

70 Other LLC/High Income Strategies Installment Sales Section 1031 Exchanges Charitable Donation of Appreciated Property Distributing investment assets Successor Trusts (active Trustee) see above Spreading Investment Income (Family Limited Partnerships & LLCs) Suitable Investments Managing Estate or Trust Distributions Creating Material Participation in Passive Activities 70

71 Other LLC/High Income Strategies Family Limited Partnerships Purpose: shift income to other family members How: Form partnership/llc Gift FLP interests wealth shifting; but retain interest in FLP. Capital should be material income producing factor Use trusts for minors Reverse Family Limited Partnership Purpose: Shift income (same as above) & convert OI into LTCG. How: Installment sale to 2 nd generation to retain some income 2 nd Generation contributes property to partnership/llc 1 st Generation no longer manages. Use trusts for minors and to help on down payment 71

72 Other LLC/High Income Strategies Charitable Remainder Trust Why: Avoid tax on appreciation, still need cash flow Why: Interest in reducing NIIT Charitable Intent. Want to make gift during lifetime, but Willing to accept ordinary income (downside) NIIT avoided if AGI kept under $250K/year. Steps: 1. Form Charitable Remainder Trust 2. Make donation charitable contribution deduction of of future interest AGI limit 5/year carry-forward limit. Downside Whether NPV better depends on factors. More effective when CG and OI rates are fairly close. (Ronald Regan era). Other options if not charitably minded. 72

73 Proposals and Changes on the Horizon 73

74 Proposals and Changes Joint Committee SET proposal (2005) Repeal limited partner exception Partner that does not materially participate pays SET only on reasonable compensation for services Investment income of a service partnership is subject to SET S corporation is treated as a partnership for SET purposes 74

75 Proposals and Changes July 31, 2015 IRS Priority Guidance Plan Final Regulations Under Section 469(h)(2) Ltd P ships Finalize open portions of Section 1411 regulations AICPA Proposals to Treasury Clarify material participation Clean up of regulations/statutory reform Buffet Rule (30% min tax on TI > $1 million) H. Clinton Trump eliminate AMT and the 3.8% NIIT. 75

76 Proposals and Changes AICPA asked the Treasury to clarify material participation for trusts and estates: Follow the two court decisions (Carter & Aragona) Count all trustee/executor activities capacity and personal ownership is irrelevant; Count the activities of employees and agents employed; Adopt Temp. Reg T(a) material participation tests for trusts/estates; Deem for a statutory period that estate materially participated if the prior owner materially participated before his or her death; Treat the character of trust/estate s income and beneficiary s distributions the same; Allow beneficiary participation in QSST to determine if QSST gain from a sale of S Corp. stock is active or passive; Allow both the S portion and the non-s portion of an ESBT to be a single trust for 469 rules. Allow a trust/estate to be a real estate professional under 469(c)(7) and state how. 76

77 Proposals and Changes AICPA further proposed for individuals: Threshold Amounts. Allow an inflation CPI adjustment. Simplify Losses. Allow taxpayers to opt to include all gain or excluding all losses under look-through disposition rules for passthrough entities. Create Safe Harbor for Tiered. Add a simplified safe harbor for tiered pass-through dispositions 77

78 Disclaimer This document is not intended to provide advice on any specific legal matter or factual situation, and should not be relied upon without consultation with qualified professional advisors. Any tax advice contained in this document and any attachments was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter. 78