Editor: Valrie Chambers, Ph.D., CPA
Practice & Procedures
This item discusses provisions addressed in the 3.8% Medicare tax proposed regulations (REG-130507-11) pertaining to the definition of business income as net investment income, grouping of activities, and treatment of the sale of S corporation stock and partnership interests. For a general discussion of the 3.8% net investment income tax, see the preceding item.
If a taxpayer owns shares in an S corporation, a partnership interest, a sole proprietorship, or a single-member LLC (disregarded), any income or gain from the activity is treated as net investment income unless all four of the following requirements are met:
- The activity is an active trade or business with respect to the taxpayer.
- The income is derived in the ordinary course of that trade or business. Note that income derived from working capital (e.g., interest on certain business bank accounts) is not treated as derived from a trade or business and therefore is subject to the net investment income tax (Sec. 1411(c)(4)). The example provided in Prop. Regs. Sec. 1.1411-6(b) illustrates this provision.
- The activity is not a passive activity pursuant to Sec. 469.
- The activity does not consist of trading in financial instruments or commodities.
Therefore, if the income earned is not from a trade or business activity, material participation will not matter. Also, stacking activities in separate passthrough entities will not change the character of the income (see Prop. Regs. Sec. 1.1411-4(b)(3), Example (1)).
Keep in mind Sec. 469 treats a rental activity as passive unless the taxpayer is considered a real estate professional who materially participates in the activity. Note also that Sec. 469 treats investment income, including interest and dividends of S corporations and partnerships, as portfolio income. As such, it is not earned in the ordinary course of a trade or business and, thus, regardless of the other exceptions, is subject to the net investment income tax.
Because one of the above exceptions is that the activity is not classified as passive under Sec. 469, taxpayers should take advantage of a “fresh start” opportunity that the IRS has granted to regroup their activities. The proposed regulations provide that taxpayers may regroup their activities in the first tax year beginning after Dec. 31, 2013, in which they meet the applicable income threshold and have net investment income. Further, taxpayers may regroup activities in reliance on the proposed regulations for any tax year that begins during 2013 if Sec. 1411 would apply.
A taxpayer may regroup activities only once pursuant to Regs. Sec. 1.469-11(b)(3)(iv)(A), and this regrouping will apply for all subsequent years. The regrouping must comply with the existing disclosure requirements. Rev. Proc. 2010-13 requires taxpayers to report their groupings and regroupings to the IRS. Taxpayers should give careful consideration to this opportunity as a means of meeting one of the seven material participation tests of Sec. 469. Also, grouping rental and nonrental activities under Regs. Sec. 1.469-4(d)(1) does not change the nature of any rental income for net investment income purposes; even if the activity is now nonpassive, the rental income will still be considered net investment income.
Stock in an S corporation and an interest in a partnership are not considered property used in a trade or business. As a result, any gain resulting from the sale of these interests is generally considered net investment income. There is an exception from this provision if the S corporation or partnership is engaged in a trade or business, the activity does not consist of trading financial instruments or commodities, and the activity is not passive to the taxpayer (Sec. 1411(c)(1)(A)(iii)). Taking the exceptions on their face, it appears that if a taxpayer materially participates in an activity that constitutes a trade or business other than trading financial instruments or commodities, the gain is not net investment income.
However, Sec. 1411(c)(4) provides that gain is taken into account as net investment income only to the extent of the net gain on the deemed sale of all the S corporation’s or partnership’s property at its fair market value (FMV). The mechanics of this calculation require the taxpayer to calculate the gain or loss on the sale of the stock or partnership interest first, then calculate at the entity level the hypothetical gain or loss on the disposition of all the entity’s assets at FMV, and finally allocate this gain or loss to the taxpayer in accordance with corporate or partnership agreements. Finally, the gain or loss calculated in step one is adjusted to account for any gain not considered net investment income.
The proposed regulations limit any adjustment from resulting in a net loss if the sale produced a gain or a net gain if the sale produced a loss and provide examples (see Prop. Regs. Sec. 1.1411-7(c)(5)(iii) and (iv)). A taxpayer cannot safely assume that because the activity is a nonpassive trade or business, no gain will result, because there may be differences in inside and outside basis.
The proposed regulations also discuss the treatment of installment sales of S corporation stock and partnership interests. The proposed regulations provide that any adjustment to the net gain for purposes of Sec. 1411 computed in the year of sale is taken into account proportionately as payments are received. Taxpayers are permitted to make an election for pre-2013 gains to apply the net gain adjustment rules. This is an important consideration because failure to do so could result in all the gain recognized in subsequent years being considered net investment income. Any transferor making an adjustment must attach a statement described in Prop. Regs. Sec. 1.1411-7(d).
Net investment income does not include income taken into account in determining self-employment income. For purposes of Sec. 1411, “taken into account” means income included and deductions allowed in determining net income from self-employment. If self-employment income consists of earnings from more than one trade or business, all items taken into account in determining the net earnings from self-employment for these trades or businesses are taken into account in determining the amount of self-employment income that is subject to tax and therefore not included in net investment income.
A practitioner can easily observe that the compliance and planning issues associated with the net investment income tax are complex and riddled with interconnecting issues including passive activity loss considerations, self-employment taxes, and entity selection. In the months to come, taxpayers will need to determine if they expect to be subject to the net investment income tax by reviewing all sources of income and the nature of each. Planning will be especially important for taxpayers holding interests in S corporations and partnerships. Of special concern are the rules described above pertaining to the disposition of these ownership interests. Clearly, planning prior to closing any transaction will be essential.
Valrie Chambers is a professor of accounting at Texas A&M University–Corpus Christi in Corpus Christi, Texas. Matthew Yuskewich is the owner of the Winterset Group CPAs Inc. in Columbus, Ohio. Ms. Chambers and Mr. Yuskewich are members of the AICPA IRS Practice & Procedures Committee. For more information about this column, contact Prof. Chambers at email@example.com.