This document originally appeared in the November 27, 2013 edition of Tax Notes Today.
The IRS on November 26 released final regulations and a notice of proposed rulemaking regarding the net investment income tax. The final regulations (T.D. 9644) withdrew the method for calculating net gain or loss from the disposition of a passthrough entity and re-proposed new regulations (REG-130843-13) with an optional simplified reporting method.
The regulations included significant changes to the proposed regulations and addressed many concerns taxpayers had raised with the IRS, including rules on regrouping, self-rented property, self-charged interest income, trader's gains and losses, and real estate professionals. The new rules permit a single property to be a rental trade or business.
"The regulations demonstrate a real willingness by the IRS to see the taxpayer's perspective and expand the scope of issues to consider, compared with earlier proposed regulations," said Carol A. Cantrell of Cantrell & Cantrell PLLC. "Overall I think it's an extremely friendly" package of guidance, she said, adding that she was pleased with it.
"The Service provided considerable relief by creating an objective standard for when a real estate investor is subject to the net investment income tax," said Robert S. Keebler of Keebler & Associates LLP. "By using a modified real estate professional definition, they eased the burden considerably on taxpayers and tax preparers."
"It's nice that they've acknowledged" many concerns of commentators, said Jonathan Horn, chair of the American Institute of Certified Public Accountants' Individual and Self-Employed Tax Technical Resource Panel. "When the audits come in two years, it will be encouraging to know that there's not going to be a bright line where they're going to say, 'This is what we said, and you lose.'"
The government punted on some open questions -- the definition of a trade or business, material participation of trusts and estates -- "and some of these questions go beyond the scope of this project," Horn said. He added that the government stuck to its guns on other issues, including subjecting pooled income funds and other esoteric trusts and estates to section 1411. "They've done a good job," he said.
Treasury's efforts at addressing stakeholder concerns were also welcomed. "Not only were they receptive to the comments that were submitted, but . . . they discussed the comments that came in and acknowledged that they were wrong in places when the comments criticized them," said C. Wells Hall III of Nelson Mullins Riley & Scarborough LLP. "It was very refreshing."
After receiving several comments regarding section 469 regrouping under the proposed regulations, the IRS added provisions for regrouping when taxpayers amend their return. It also included examples explaining the rule's mechanics. The IRS also decided against adding partnerships and S corporations as eligible for regrouping (reg. section 1.469-11(b)(3)(iv)).
In the final regulations, the IRS allows a taxpayer to regroup activities if the otherwise nonqualifying taxpayer becomes qualifying upon an amended return. The taxpayer can apply the regroup to the year of the amended return (reg. section 1.469-11(b)(3)(iv)(C)(1)).
Also, if a taxpayer correctly elects to regroup and upon amending the return no longer qualifies for regrouping, the regroup is considered void. The IRS will revert the grouping back to where it was before the regroup (reg. section 1.469-11(b)(3)(iv)(C)(2)).
Many comments on the proposed regs concerned taxpayers ability' to regroup after amending a return that then qualifies them for regrouping. The IRS agreed with the commentators that the regrouping rule would be unfair if the adjustment wasn't allowed.
The IRS also added four examples in reg. section 1.469-11 to explain the regulation's mechanics. All four illustrate how taxpayers should treat amended returns (reg. section 1.469-11(b)(3)(iv)(C)(3)).
Horn said he was glad to see that the government decided to allow another regrouping if a prior regrouping became void because of a change in circumstances. "The idea of penalizing a taxpayer who did a regrouping on facts and circumstances at the time -- it doesn't seem fair to me to void that regrouping, simply because of later facts."
Passthrough Regrouping Not Adopted
The final regulations do not allow regrouping for partnerships and S corporations. Many commentators wanted the regrouping provisions to apply to passthrough entities. "They're holding the line," Hall said.
The IRS agrees that a passthrough entity's owners are part of the community that precipitated allowance of regrouping. However, it does not agree with allowing the entity to regroup because that would extend the regrouping benefit to taxpayers with no section 1411 liability.
Horn said that while he understands the government's reason for not allowing regrouping on an entity level -- because if it were allowed, an individual who wouldn't otherwise qualify for regrouping would get to regroup -- it's still a "disappointment."
No Fresh Start for Some Taxpayers
Many commentators wanted all individuals, estates, and trusts to be allowed to regroup regardless of whether they are subject to section 1411. They believed that restricting the fresh start only to taxpayers subject to 1411 disadvantages lower-income taxpayers. The IRS was not persuaded.
Self-Rented Property and Self-Charged Interest Income
Reg. section 1.1411-4(g) provides special rules for self-rented property and self-charged interest income. The rules regarding the treatment of some non-passive rental activities in reg. section 1.1411-4(g)(6) provide that if gross rental income is not treated as derived from a passive activity, the gross rental income is deemed to be derived in the ordinary course of a trade or business. If the gain or loss from the disposition of property is treated as non-passive gain or loss under some conditions, the gain or loss is deemed to be derived from property used in the ordinary course of business.
Taxpayers had asked the IRS to allow deductions for the amount of rent paid by the taxpayer to itself to be subtracted from the taxpayers' gross rental income. Those arrangements are usually done for liability protection purposes, and taxpayers had argued that subjecting the rental amounts to net investment income tax failed to reflect the economics of the transaction.
Commentators questioned the proposed regs' treatment of self-charged interest, saying that taxpayers not engaged in the trade or business of lending would have net investment income when they receive interest income attributable to a loan made to a passthrough entity that materially participates because the offsetting interest expense allocable to the taxpayer from the non-passive activity would not be a properly allocable deduction under section 1411(c)(1)(B) and reg. section 1.1411-4(f).
Treasury provided a special rule addressing this issue that permits taxpayers to exclude from net investment income the amount of interest income equal to the taxpayer's allocable share of the non-passive deduction. However, this special rule does not apply in situations when the interest deduction is taken into account in determining self-employment income that is subject to tax under section 1401(b).
Amy L. Sutton of Deloitte Tax LLP said that while the self-charged rule for interest is helpful to some, "many of those non-passive trade/businesses they lend to are owned through S corps or limited partner interests, so allowing the self-charged rules only to apply if the interest deduction didn't reduce self-employment tax will limit its applicability." But it's not necessarily the wrong policy answer, she said.
Real Estate Professionals
The final regs also offer limited relief from net investment income tax in the form of a safe harbor for rental income of real estate professionals that is derived in the ordinary course of a trade or business.
The safe harbor provides that if a real estate professional participates in rental real estate activities for more than 500 hours per year (or 500 hours per year in five of the last 10 years), the rental income from the rental activity is deemed to be derived in the ordinary course of a trade or business, and gain or loss resulting from the disposition of property used in the rental activity is also deemed to be derived from property used in the ordinary course of a trade or business.
The 2012 proposed regs had previously held that gross income from rental real estate is not per se excluded from net investment income, even if the taxpayer otherwise meets the real estate professional rules under section 469. Commentators had requested clarification for when real estate activities constituted a trade or business.
In response to the proposed regs, many commentators argued that if taxpayers qualify as a real estate professional under section 469, they are necessarily engaged in a real property trade or business and that rental income derived in that ordinary course of trade or business should be excluded from net investment income. However, the final regs do not treat every real estate professional as necessarily engaged in the trade or business of rental real estate, given the narrowness of the definition of trade or business under section 1411, and given that only a few section 469 activity types used to determine what constitutes a real property trade or business may be related to rental activity.
"It's encouraging that they have acknowledged that there are circumstances where the rental of a single property can rise to the level of a trade or business, because they seemed to be saying that it couldn't under the original proposed regs," Horn said.
Horn said while the government refused to draw a bright line, it stated in the preamble to the final regs that a single property can rise to the level of rental trade or business. "What's interesting though is they added a caveat that if you make that claim that your rental activity is a trade or business, they are going to be watching to make sure that you are making the same determination for all other provisions of the code, and they specifically reference information reporting under section 6041," he said.
Hall pointed out that while the government was explicit in the preamble to the final regs that the rental of a single building might constitute the active conduct of a trade or business, the change it made to reg. section 1.1411-5(b)(3) Example 1 was more nuanced, simply expanding the assumptions in the example. "That is welcome," he said.
Net Losses and Traders
Net losses from the disposition of property are now fully allowed under reg. section 1.1411-4(f)(4). Under the proposed regulations, those losses would have been taxed because allowable deductions did not include losses under section 165. Under the proposed rules, losses that are deductible under section 165 were only deductible in determining net gain, and only to the extent of gain. The final regulations added three examples to illustrate the application of reg. section 1.1411-4(f)(4).
Traders' gains and losses are now assigned to section 1411(c)(1)(A)(iii). Losses in excess of gains from a trading business of a section 475 trader are deductible from other categories of income under the regulations. Consequently, the rule in reg. section 1.1411-4(c) regarding other gross income from a trade or business has been changed from the proposed version. The proposed version distinguished between passive activity and trading in financial instruments or commodities. The finalized subsection (c) does not include a separate rule for traders because of the changes to the rules in reg. section 1.1411-4(f)(4).
"That was a big, big issue, especially for a trader who is using mark-to-market, that they were maybe going to be subject to section 1411 tax on their gains but they weren't going to be able to offset it with any mark-to-market losses they had," Horn said. "That's been corrected."
Gain From Disposition of Partnership Interests
The IRS also issued proposed regulations that include revised rules regarding the calculation of net gain from the disposition of a partnership interest or S corporation stock. The proposed guidance also addresses the treatment of section 707(c) guaranteed payments for capital, section 736 payments to retiring or deceased partners for section 1411 purposes, some capital loss carryovers, and special rules on charitable remainder trusts.
The guidance notes that Treasury and the IRS received comments on the 2012 proposed regs questioning their method for adjusting a transferor's gain or loss on the disposition of its partnership interest or S corporation stock. In view of those comments, reg. section 1.1411-7 was removed from the proposed regs and was reserved in the 2013 final regs released today.
The 2012 proposed regulations required that a transferor of a partnership interest or S corporation stock first compute its gain or loss from the disposition of the interest in the passthrough entity to which section 1411(c)(4) may apply, and then reduce that gain or loss by the amount of non-passive gain or loss that would have been allocated to the transferor upon a hypothetical sale of all the passthrough entity's assets for fair market value immediately before the transfer. However, commentators questioned this approach based on their reading of section 1411(c)(4) to include gain or loss from the disposition of a partnership interest or S corporation stock only to the extent of the transferor's share of gain or loss from the passthrough entity's passive assets.
"It's nice to see that the IRS recognized the burden that taxpayers would have from relatively small percentage ownerships of S corporations and the earlier requirement that they obtain fair market value information from the S corporations in order to calculate their gains not subject to the net investment income tax," said Chris Hesse of CliftonLarsonAllen.
Proposed reg. section 1.1411-7(b) provides a method to determine how much of the gain or loss that is recognized for chapter 1 purposes is attributable to property owned, directly or indirectly, by the passthrough entity that, if sold, would give rise to net gain within the meaning of section 1411(c)(1)(A)(iii) ("section 1411 property"). For dispositions resulting in chapter 1 gain, the proposed regs note that the transferor's gain equals the lesser of (1) the amount of gain the transferor recognizes for chapter 1 purposes, or (2) the transferor's allocable share of net gain from a deemed sale of the passthrough entity's section 1411 property.
To reduce undue administrative burden, the proposed guidance directs the transferor to rely on the valuation requirements under reg. section 1.469-2T(e)(3) that allow the transferor to compute gain or loss activity by activity instead of valuing each asset, as was required in the 2012 proposed regs.
Optional Simplified Method
Proposed reg. section 1.1411-7(c) provides an optional simplified reporting method that qualified transferors may use in lieu of the calculation described in proposed reg. section 1.1411-7(b). The guidance notes that Treasury and the IRS believe that use of the simplified method is warranted when the amount of gain associated with passive assets owned by the passthrough entity is likely to be relatively small. The simplified method relies on historic distributive share amounts received by the transferor from the passthrough entity to extrapolate a percentage of the assets within the passthrough entity that are passive for the transferor for purposes of section 1411(c)(4), the guidance states.
According to the proposed regs, qualifying transferors meet at least one of two requirements. Under the first requirement, the sum of the transferor's allocable share of separately stated items of income, gain, loss, and deduction during the section 1411 holding period, of a type that the transferor would take into account in calculating net investment income, must be 5 percent or less of the sum of all separately stated items of income, gain, loss, and deduction allocated to the transferor during the holding period. The section 1411 holding period is described as being generally the year of the disposition and the preceding two years. Also, chapter 1 gain recognized by the transferor from the disposition of the passthrough entity must be $5 million or less.
A transferor satisfies the second requirement for the simplified method if gain recognized under chapter 1 by the transferor from the disposition of the passthrough entity is $250,000 or less.
The proposed regs state that use of the simplified method is not mandatory for qualifying transferors.
They also provide five exceptions for situations in which a transferor is ineligible to use the optional simplified reporting method: (1) transferors have held the interest for less than 12 months, (2) some contributions and distributions have been made during the section 1411 holding period, (3) passthrough entities have significantly modified the composition of their assets, (4) S corporations have recently converted from C corporations, and (5) partial dispositions.
The guidance states that the exceptions include instances when the transferor's historical distributive share amounts are less likely to reflect the gain in the passthrough entity's section 1411 property on the date of the transferor's disposition.
"Clearly they've recognized that what they had proposed was onerous and not really in the interest of compliance because it was going to create so many complications; it just was not going to work," Hall said. He pointed out that while the government gave much thought to the issue, it decided to reserve for future guidance the treatment of dispositions of tiered passthrough entities.
"The burdens that were being imposed on both the individuals and the entities under the original proposed regulations were just astronomical," Horn said. "We were talking about having the cost of calculating the net gain or loss [being] greater than the tax."
Regarding whether the optional simplified method went far enough, Laura Howell-Smith of Deloitte Tax LLP said that in general she thought the concerns of commentators had been addressed. "By allowing taxpayers to use either [the original or the optional] method, I think that gives some flexibility," she said, adding that one of the "sticky issues" addressed in the new proposed regs involves guaranteed payments to retiring or deceased partners.
The proposed regs will have the same effective date as the final regulations, but any provisions adopted at finalization that are more restrictive than the proposed regulations would apply prospectively. Taxpayers may rely on the proposed guidance.
Application to Trusts and Estates Modified in Final Rules
The issue of the proposed regs' application to trusts and estates has also been raised over the past year. Section 1411(a)(2) imposes the 3.8 percent tax on estates and trusts on the lesser of their undistributed net investment income or the excess of their adjusted gross income over the dollar amount at the highest tax bracket in section 1(e).
The proposed regulations explained that section 1411(a)(2) applies to ordinary trusts described in section 301.7701-4(a) that are subject to the provisions of part 1 of subchapter J of chapter 1 of subtitle A of the code, even if the trusts have special computational rules within part 1 of subchapter J. The proposed regs also identified four types of trusts that would be subject to the net investment income tax: (1) pooled income funds described in section 642(c)(5), (2) cemetery perpetual care funds described in section 642(i), (3) qualified funeral trusts described in section 685, and (4) Alaska Native settlement trusts (ANSTs) described in section 646.
The IRS requested public comments on whether there were administrative reasons to exclude those trusts from section 1411, and it received numerous suggestions. Some commentators advocated excluding each of the listed trusts from section 1411.
The IRS rejected a proposal to exclude pooled income funds. Commentators argued that applying section 1411 to those funds was tantamount to taxing a charity that ultimately receives the property after the expiration of the income interest and because pooled income funds should not be treated differently than charitable remainder trusts.
In rejecting the suggestion, Treasury explained that section 1411 limits its exclusion to wholly charitable trusts and that charitable remainder trusts were excluded from section 1411 by the express language of section 664. Treasury said no similar provision permitted excluding pooled income funds from section 1411.
The IRS reversed its position in the proposed regs and agreed to exclude cemetery perpetual care funds from section 1411. Commentators argued that including cemetery trusts would be inconsistent with section 1411's purpose. They also said that under section 642(i), the only "beneficiary" of a cemetery perpetual care trust is a taxable cemetery company and that imposing section 1411 on cemetery perpetual care trusts would tax a business.
Treasury agreed that those trusts benefit an operating company and that the trusts were similar to business trusts that are excluded under section 1411.
Treasury also agreed with commentators who argued that section 1411 should not apply to ANSTs under section 646. Commentators said the statutory framework for taxing ANSTs reflects important policy considerations established by Congress in the Alaska Native Claims Settlement Act. (See 43 U.S.C. section 1601.) Treasury agreed that excluding ANSTs from section 1411 would be consistent with the chapter 1 taxation of these entities at the lowest individual tax rate.
Treasury rejected arguments seeking to exclude qualified funeral trusts (QFTs) from section 1411, but it clarified that the section 1411 tax will be calculated consistent with the taxation of QFTs in chapter 1. Commentators argued that section 1411 would not apply to QFTs because the investment income in the QFTs would be below the section 1411(a)(2)(B)(ii) threshold amount.
A commentator noted that charitable purpose estates are subject to section 1411 while charitable purpose trusts are statutorily exempt. Treasury agreed with the commentator's recommendations and modified reg. section 1.1411-3(b)(1) of the final regulations to exclude from the application of section 1411 an estate in which all of the unexpired interests are devoted to one or more of the purposes described in section 170(c)(2)(B).