Understanding the 38%T 3.8% Tax on Net Investment Income Washington National Tax, KPMG LLP December 18, 2012 ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG 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. 2 1
Speakers Jon Zelnik, Principal, Financial Products, Washington National Tax Jeanne Sullivan, Director, Passthroughs, Washington National Tax Tracy Stone, Principal, Estates, Gifts, & Trusts, Washington National Tax Karen Field, Principal, Compensation & Benefits, Washington National Tax 3 Agenda Overview Net Investment Income Compensation o & Interaction with SECA Trusts and Estates Partnerships & S Corporations Q&A 4 2
Administrative CPE regulations require online participants take part in online questions You must respond to a minimum of four questions per 50 minutes in order to be eligible for CPE credit Polling questions will appear on your media player on top of the slides Results will be reviewed in aggregate and may be published as a pulse survey of the marketplace in the aggregate. Please note that no responses will be tracked back to any individual or organization To ask a question, use the Ask A Question icon on your media player or send an e-mail to us-taxwatch@kpmg.com Help Desk: 1-877-398-1471 or outside the U.S. at 1-954-969-3342 5 Overview Section 1411 Imposes tax of 3.8% on the lesser of An individual s Net Investment e t Income and, Modified adjusted gross income in excess of the Threshold Amount An estate s or trust s Undistributed Net Investment Income and, Adjusted gross income in excess of the threshold amount Effective e for tax years beginning g after January 31, 2012 Threshold Amount 6 3
CPE Question 1 Section 1411 imposes a 3.8% tax on: a) Just individuals b) Just estates and trusts c) Just individuals, estates and trusts 7 Net Investment Income 4
Net Investment Income (NII) The sum of the following three buckets of income: Gross income from interest, dividends, annuities, royalties, and rents subject to Exception below Gross income from a passive trade or business and from the trade or business of trading financial instruments or commodities (each a Covered T/B ) Net gain from the disposition of property subject to Exception below Exception income and gain which is derived in the ordinary course of a trade or business that is not a Covered T/B Income and gain from the investment of working capital is not derived in the ordinary course of a trade or business 9 First Bucket of NII The Proposed Regulations First Bucket Includes specified portfolio-type income Unclear under the statute whether subpart F inclusions with respect to CFCs under section 951(a) and QEF inclusions with respect to PFICs under section 1293(a) were included in NII Proposed regulations clarify that subpart F and QEF inclusions are included in NII only when the earnings are actually repatriated in the form of distributions of previously taxed income under sections 959(a) and 1293(c) Corresponding adjustments to basis and modified adjusted gross income for purposes of section 1411 are required to reflect that subpart F and QEF inclusions have not yet been included in NII In lieu of deferring the 3.8% tax under section 1411 on subpart Fand QEF inclusions, taxpayers may elect to treat subpart F and QEF inclusions the same for normal tax and section 1411 tax purposes Substitute interest and substitute dividends Not gross income from notional principal contract Exception Derived in the ordinary course of a trade or business that is not a covered T/B Passive T/B determined at the individual or owner level Business of trading determined at the entity level 10 5
First Bucket of NII The Proposed Regulations Examples A B X C Y #1 Assume A is an individual, and X and Y are partnerships. Assume further that X is in a trade or business and Y is not. Y has interest income of $100, $50 of which is allocated to A. #2 Assume in the alternative that Y is in the ordinary course of the business of trading financial instruments. 11 Second Bucket of NII The Proposed Regulations Second Bucket Gross Income from a Covered Business Gross income from a passive activity as defined in section 469 Section 162 T/B Real estate professionals and rental activity Income/activity recharacterization rules, and Gross income from business of trading in financial instruments or commodities. Definition of financial instrument Definition of the trade or business of trading Management of one s own investments not a T/B 12 6
Second Bucket of NII The Proposed Regulations Effect of Section 469 grouping choices Combination of activities can result in non-passive T/B Consider current groupings Proposed regulations permit a fresh start for groupings Fresh start allowed in the first year that the taxpayer would have NII subject to section 1411 absent a change in grouping Allowed in 2012 Allowed only once Grouping rules under section 469 apply and disclosure required 13 Third Bucket of NII The Proposed Regulations Net gain from disposition of property other than property held in a T/B that is not a Covered T/B Disposition includes sale, exchange, transfer, conversion, cash settlement, t cancellation, termination, ti lapse, expiration, or other disposition. Includes gain on distribution of cash that exceeds basis from a partnership under section 731 and distribution of cash from an S corporation that exceeds basis under section 1368(b)(2) Mark-to-market election of a traders and non-traders 14 7
Properly Allocable Deductions Gross income and net gain included in NII may be reduced by allowable deductions that are properly allocable to the income or gain. Only allowable deductions Not suspended passive losses; not deductions suspended under section 163; year allowed may reduce NII if allocable No deduction for NOLs Properly allocable to earning the NII Net investment income cannot be negative Net gain (bucket t3) cannot be negative 15 CPE Question 2 Regrouping under section 469 is allowed in the first year the taxpayer is subject to section 1411 (without taking into account regrouped activities). Yes or no? 16 8
Application to Estates & Trusts Section 1411: Application to Estates and Trusts Imposes tax (NIIT) of 3.8% on the lesser of: Undistributed net investment income (UNII) or Adjusted gross income (as defined in section 67(e)) in excess of the dollar amount at which the highest income tax bracket begins Currently $11,650 for 2012 Projected to be $11,950 for 2013 Only estates and trusts threshold amount is indexed for inflation (because of reference to indexed Section 1(e) tables) Need to consider the NIIT in making estimated tax payments for 2013 tax year Effective for tax years beginning after January 31, 2012 Estates of 2012 decedents may want to elect a fiscal year ending November 30, 2012, or earlier in order to avoid NIIT on second fiscal year too 18 9
Prop. Reg. 1.1411-3: Application to Estates and Trusts NIIT generally applies to all estates and trusts that are subject to the provisions of subchapter J Applies To: Non-Grantor Trusts Electing Small Business Trusts Non-Grantor Charitable Lead Trusts Pooled Income Funds Cemetery Perpetual Care Funds Qualified Funeral Trusts Alaska Native Settlement Trusts Foreign Trusts w/ U.S. Beneficiaries Domestic Estates Does Not Apply To: Grantor Trusts* Charitable Remainder Trusts** Common Trust Funds Real Estate Investment Trusts Designated Settlement Funds Wholly Charitable Trusts Other Trusts Exempt From Tax Foreign Trusts w/o U.S. Beneficiaries Foreign Estates*** *Applies to grantor/owner instead. **Applies to annuity/unitrust recipient to extent CRT distribution includes NII. ***Proposed Regulations leave open possible application to foreign estates with U.S. beneficiaries. Prop. Reg. 1.1411-3: Definition of UNII UNII is: NII (calculated in same manner as for an individual) less Distributions buto s of NII to beneficiaries e ca es and Deductions under Section 642(c) This approach taxes NII at either the trust level or the individual level but not both Uses already existing trust income tax regime (in sections 651/661 and 652/662) to allocate tax to the appropriate party, to define the trust s deduction, and to define e the beneficiary s e income/character acte May be able to distribute income to beneficiary to avoid paying NIIT 20 10
Example 1 No Distribution from Trust Non-grantor trust has $111,650 of interest and dividends. Assume no other income or expenses. Sole (single) beneficiary has $100,000 of modified adjusted gross income. Trustee has power to distribute all income to the beneficiary but makes no distributions. Since no distributions were made, trust will pay NIIT on the lesser of: UNII: $111,650, or Excess AGI: $111,650 $11,650 = $100,000 Tax liability is 3.8% tax rate times $100,000 000 (the lesser amount) or $3,800 21 Example 2 Distribution to Beneficiary Assume instead that the trustee in Example 1 distributes $100,000 to the beneficiary Because the beneficiary s AGI does not exceed the $200,000 threshold ($100,000000 distribution ib ti plus $100,000 000 of non-trust ti income), there would be no NIIT due on his return The trust NIIT calculation would impose tax on the lesser of: UNII: $111,650 $100,000 = $11,650 Excess AGI: ($111,650 -$100,000) - $11,650 = $0 Making gthe edst distribution buto tot the ebeneficiary e cayhas asthe eeffect ectof avoiding od payment of NIIT by both the trust and the beneficiary (saving $3,800) 22 11
Special Rules: Passive Activities and Trusts Trusts and estates have struggled with how to determine whether their activities in a trade or business rise to the level of material participation and thereby avoid treatment as a passive activity under section 469 Unclear whether you look to fiduciary s i activities iti only or also take into account activities of employees or agents No section 469 regulations addressing trusts and estates Limited and conflicting authorities (e.g., Mattie Carter case, TAM 200733023, legislative history) The application of the NIIT to income from passive activities will put even more pressure on this issue 23 Special Rules: Charitable Remainder Trusts While CRTs are exempt, beneficiaries of such trusts are not NII of beneficiary attributable to annuity/unitrust distribution includes lesser of total amount of distributions or current and accumulated NII of the CRT CRTs will have to track NII and beneficiaries will be responsible for tax on distributed NII (if applicable) Note that accumulation of NII inside a CRT does not begin until January 1, 2013, as a result, CRTs may wish to consider recognizing gain in the next few weeks in order to avoid the imposition of the NIIT upon distribution to the annuity/unitrust recipient 24 12
Special Rules: Electing Small Business Trusts ESBTs with an S portion and a non-s portion will be treated as separate trusts for purposes of calculating UNII, but will be treated as a single trust for purposes of determining the amount subject to tax Step One: Compute each portion s UNII separately and add them together to get the ESBT s UNII The S portion will not receive a deduction for distributions (just as under the regular income tax rules); therefore, any NII generated by the S portion will be treated as undistributed Step Two: Calculate the ESBT s adjusted gross income by taking the non-s portion s AGI (after distribution deduction) and adding the net income or loss from the S portion (as a single line item) Step Three: ESBT pays tax on the lesser of total UNII or AGI in excess of the dollar amount at which the highest bracket begins Grantor portion, if any, included in grantor s calculation of NII 25 CPE Question 3 There are regulations under section 469 that provide rules for determining whether a trust materially participates in a trade or business activity. Yes or no? 26 13
Application to Compensation, Qualified and Non- Qualified Plans & SECA Compensation Issues Exemptions from Section 1411 All employee compensation (subject to FICA or compensation specifically exempt from FICA). Nonqualified deferred compensation payments (which would have been subjected to FICA on contribution or vesting) Compensation subject to Self Employment taxes (SECA) Amounts paid to 2% owners of S-corps on Form W-2. 28 14
Exclusions (continued) Exemptions from 1411 Qualified plan distributions 401(k) plans 403(b) plans Qualified pension plans IRA and Roth IRA distributions (this also includes SEPs) 29 Other Compensation/Service Issues Amounts paid to partners that are subject to SECA for active service are exempt. Amounts paid to partners that materially participate in a trade or business and are not subject to SECA probably bl active trade or business income and thus exempt. If a person materially participates in a business that manages passive investments, and is paid to manage the passive investments, the income received for managing is likely for service and is likely exempt. However, any income flowing from those passive investments is likely NII. 30 15
CPE Question 4 The following amounts are excluded from the definition of net investment income: a) Compensation, income subject to SECA, distributions from qualified plans b) Passive trade or business income c) Gross income from trading 31 Dispositions of Interests in Partnerships & S Corporations 16
Dispositions Partnership & S Corporation Interests Partnership interest and S corporation stock are not considered to be property held in the ordinary course of a T/B Gain is presumptively NII Gain on distributions under section 731 & section 1368(b)(2) Gain portion of installment payment is presumptively NII Year is disposition is not relevant Adjustment of gain or loss on sale permitted if the entity conducts at least one T/B that is not a Covered T/B and the taxpayer makes the computations required under the Proposed Regulations Transferor must materially participate in one T/B that is not the business of trading This rule is not applicable to sale of S corp stock where a section 338(h)(10) election is made In an installment sale, the adjustment is to the net gain determined in the year of disposition and applies thereafter to installments received. 33 Dispositions Partnership & S Corporation Interests Steps in determining the adjustment: Deemed sale of all properties for fair market value in a fully taxable transaction Determination ti of gain or loss Allocation of gain or loss to transferor Adjustment to gain or loss recognized by transferor Aggregate gain and loss allocable to properties held in a trade or business that is not a Covered T/B (e.g., non-passive with respect to transferor) Special rules for property p held in more than one trade or business and for goodwill If the aggregated amount is a net gain, the adjustment to the transferor s net gain (bucket 3) is negative. If the aggregated amount is a net loss, the adjustment to the transferor net gain (bucket 3) is positive. 34 17
Dispositions Adjustments Partnership & S Corporation Interests Negative adjustment A negative adjustment can reduce gain on disposition to zero, but not below zero. If the transferor has a loss on disposition, a negative adjustment is not taken into account Positive adjustment If the transfer or has a loss on disposition, the positive adjustment can reduce the loss to zero, but not above zero If the transferor has a gain on disposition, o the positive adjustment t is not taken into account. 35 S corporation Stock or Partnership Interest Sale Gain on Sale of Interest Loss on Sale of Interest Gain/Loss on Deemed Sale of Properties held in a non-covered T/B per Prop. Treas. Reg. Section 1.1411-7 Gain Deemed Sale Loss Deemed Sale Gain Deemed Sale Loss Deemed Sale (Negative adjustment) (Positive adjustment) (Negative adjustment) (Positive adjustment) Reduce gain on sale of interest --but no loss No adjustment No adjustment Reduce loss on sale of interest --but no gain 36 18
CPE Question 5 Gain on sale of an interest in a partnership or stock in an S corporation is included in net investment income unless an adjustment is made under the regulations. Yes or no? 37 To Do List 19
What To Do in the Coming Months Calculate NII in order to make estimated tax payments Review tax distribution provisions in partnership agreements to take NII into account Review grouping of trade or business activities under section 469 to determine if regrouping is available and advisable Consider whether pre-2013 installment sales of interest in partnership or S corporation stock results in NII and whether to elect to compute adjustments in accordance with Proposed Regulations Estates of 2012 decedents may want to elect a fiscal year ending November 30, 2012, or earlier in order to avoid NIIT on second fiscal year too Consider distributions to beneficiary to avoid paying NIIT CRTs may wish to consider recognizing gain before December 31, 2012, in order to avoid the imposition of the NIIT upon subsequent distribution to the annuity/unitrust recipient 39 CPE Question 6 The 3.8% tax on net investment income is taken into account for purposes of estimated tax payments. Yes or no? 40 20
Polling Question Would you like a KPMG professional to contact you regarding the topics discussed today? Yes No 41 Q&A 21
Q&A (continued) Today s Presenters Karen Field 202 533 4234 kfield@kpmg.com Tracy Stone 202 533 4186 ttstone@kpmg.com Jeannie Sullivan 202 533 6571 jsullivan@kpmg.com Jonathan Zelnik 202 533 4193 jzelnik@kpmg.com 43 Thank you for joining us. Please send any questions to us-taxwatch@kpmg.com Visit www.kpmgtaxwatch.com for a calendar of upcoming events. 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International Cooperative (KPMG International). 22