IRS proposes regulations implementing the new 3.8% tax on investment income (2024)

Proposed Regulations Implement the New 3.8% Tax on Net Investment Income of Individuals, Estates and Trusts with Income in Excess of Statutory Thresholds

SUMMARY

The IRS recently issued proposed regulations (the “Proposed Regulations”) that implement the new 3.8% tax on the “net investment income” of individuals, estates and trusts with “modified adjusted gross income” in excess of statutory thresholds (the “NIIT”). The Proposed Regulations provide that:

• Income derived in the ordinary course of a trade or business generally is not subject to NIIT unless (i) the trade or business is a “passive activity” with respect to the taxpayer as defined in Section 469 of the Internal Revenue Code (the “Code”) (i.e., the passive loss rules) or (ii) the trade or business is trading in financial instruments and commodities (note, however, that income excluded from NIIT as trade or business income may, in many cases, be subject to the 3.8% tax on net earnings from self-employment);
• Net investment income subject to NIIT is reduced by properly allocable suspended passive losses deductible against current year passive income, carried forward investment interest, capital loss carryforwards and certain applicable itemized deductions, but not by net operating losses (“NOLs”);
• Net gain from the disposition of property is subject to NIIT, unless the property is held in an active trade or business (e.g., gain from the sale of primary residence in excess of statutory exclusions is subject to NIIT);
• Net gain from the disposition of property is not subject to NIIT to the extent such gain is deferred under other provisions of the Code (such as those attributable to like-kind exchanges);
• No portion of the tax on net investment income is deductible for income tax purposes (unlike the 3.8% tax on net earnings from self-employment for which a deduction of 1.45% is permitted);
• U.S. shareholders of controlled foreign corporations (each a “CFC”) and shareholders of passive foreign investment companies (each a “PFIC”) with respect to which a so-called QEF election has been made generally recognize net investment income from such investments upon distributions of previously taxed income (and not when such income otherwise accrues for income tax purposes);
• Taxable distributions from a charitable remainder trust can be subject to the tax; and
• Distributions from most qualified retirement plans and non-qualified deferred compensation plans are not subject to NIIT.

Although NIIT will be imposed for taxable years beginning on or after January 1, 2013, the Proposed Regulations become effective January 1, 2014 (except for the rules applicable to charitable remainder trusts, which are effective January 1, 2013). In the interim, taxpayers may rely on the Proposed Regulations.

The Patient Protection and Affordable Care Act under which NIIT is imposed also increased the uncapped portion of FICA taxes imposed on wages and net earnings from self-employment by 0.9%.

DISCUSSION

A. OVERVIEW OF NIIT

Individuals. Under NIIT, for taxable years beginning on or after January 1, 2013, citizens and residents of the United States (i.e., any individual other than a non-resident alien) must pay an additional 3.8% tax on the lesser of: (1) the taxpayer’s “net investment income” and (2) the excess (if any) of the taxpayer’s “modified adjusted gross income” over the following threshold amounts (not adjusted for inflation):

Click here to view table.

For most taxpayers, “modified adjusted gross income” means the taxpayer’s adjusted gross income (including net capital gains), as calculated for income tax purposes (e.g., modified adjusted gross income generally does not include tax-exempt interest). Special rules apply for determining the modified adjusted gross income of taxpayers living overseas with foreign earned income. In addition, as described in more detail below, the Proposed Regulations provide rules for determining the modified adjusted gross income of U.S. shareholders of a CFC or of a PFIC with respect to which a QEF election has been made.

Consistent with general income tax principles, owners of grantor trusts must take into account the income of the grantor trust when determining NIIT. In addition, unless an exception applies, net investment income includes allocations of net investment income received from a partnership or S-corporation (including income earned from investments of working capital) and distributions of net investment income received from a trust or estate (including certain foreign non-grantor trusts).

Trusts and Estates. Similar to the rules for individual taxpayers, for taxable years beginning on or after January 1, 2013, trusts and estates must pay an additional 3.8% tax on the lesser of: (1) undistributed “net investment income” and (2) the excess of adjusted gross income (as calculated by a trust or estate for other income tax purposes) over the dollar amount of the highest tax bracket for a trust or estate for the applicable taxable year (e.g., $11,650 for 2012). As described in more detail below, the Proposed Regulations include special rules for trusts and estates that are shareholders of CFCs and PFICs that correspond to the rules applicable to individuals.

Consistent with the income tax rules applicable to trusts, estates and their beneficiaries, the Proposed Regulations provide that a trust or estate is subject to the new 3.8% tax on “undistributed” net investment income, and the beneficiaries are subject to the new 3.8% tax on distributions of net investment income received by them during the year from the trust or estate.

NIIT generally does not apply to tax-exempt charitable trusts and other tax-exempt trusts, qualified retirement plan trusts, and trusts that are classified as other than “ordinary trusts” or that are subject to specific tax regimes for federal income tax purposes (e.g., business trusts and common trust funds). The exclusion for tax-exempt trusts applies even if the trust may be subject to tax on its unrelated business taxable income (and even if the trust’s unrelated business taxable income is comprised of net investment income). Further, distributions from a tax-exempt trust will not be included in net investment income, even in cases where the distribution would otherwise be included in gross income (e.g., a distribution from a qualified tuition program or health savings account if the distributed amounts are not used by the recipient for qualified expenses).

In the case of a charitable remainder trust, although the trust itself is not subject to NIIT, annuity and unitrust distributions of the trust may be investment income to a non-charitable recipient beneficiary.

The Proposed Regulations expressly reserve and do not provide rules with respect to certain foreign trusts and estates with U.S. beneficiaries.

Payment of the Tax. For individuals, NIIT will be reported on, and paid with, the Form 1040. For trusts and estates, the tax will be reported on, and paid with, the Form 1041. The tax is subject to the estimated tax payment requirements.

B. NET INVESTMENT INCOME—GENERAL RULES

Investment Income. Net investment income includes gross income from interest, dividends, annuities, royalties and rents, including substitute interest and substitute dividend payments, unless such income is included in the Trade or Business Exception (described below). The Preamble to the Proposed Regulations (the “Preamble”) states that gross income from notional principal contracts generally is not included in net investment income, but that net gain from the disposition of a notional principal contract is included in net investment income unless an exception applies.

Trade or Business Income That Is Subject to NIIT. Net investment income also includes gross income from two categories of trade or business: (1) a trade or business that is a “passive activity” with respect to the taxpayer and (2) a trade or business of trading in financial instruments or commodities. Income that would not otherwise constitute net investment income, such as income from notional principal contracts, may be included as net investment income under this rule.

The Proposed Regulations apply the principles of Section 469 of the Code to determine whether a trade or business is a passive activity with respect to an individual, estate or trust and, as a result, the determination will be made on the basis of whether the taxpayer is involved in the operations of the activity on a regular, continuous and substantial basis. Thus, in many cases, income from a trade or business that may be exempt from NIIT because the individual is actively engaged in the business will be subject to the 3.8% tax on net earnings from self-employment (for example, income from a general partnership in which the taxpayer materially participates would be subject to the 3.8% tax on self-employment income). There may, however, be some categories of income exempt from both taxes (e.g., income from an S-corporation in excess of reasonable compensation allocable to a shareholder who materially participates in the S-corporation’s qualifying trade or business).

The Section 469 regulations provide rules for defining the scope of an activity for purposes of applying the passive activity loss rules (i.e., “grouping” income). Typically, once a taxpayer has grouped activities for this purpose, the taxpayer may not regroup those activities in subsequent taxable years. The Proposed Regulations permit taxpayers to regroup their activities in the first taxable year after December 31, 2013 in which the taxpayer meets the applicable threshold amount set forth above. In addition, the Preamble states that taxpayers may regroup their activities in reliance on the Proposed Regulation for any taxable year that begins during 2013 if NIIT would apply to such taxpayer in such taxable year. In light of NIIT, a taxpayer who formerly has grouped certain activities as “passive” in order to absorb otherwise unusable passive losses may now prefer to regroup those activities (to the extent permissible) as “active” in order to limit the amount of income subject to NIIT.

Because the Proposed Regulations rely on Section 469 of the Code, the complexities and uncertainties under current law with respect to Section 469 will be incorporated into the NIIT rules. For example, under current law, the determination of whether an activity is passive with respect to a trust or estate is made by reference to the activities of its executor or trustee, and these complexities will need to be addressed in applying NIIT as well. Similarly, the Proposed Regulations request comments on the proper use of suspended passive losses to offset NIIT on a complete disposition of a passive activity.

The Proposed Regulations define “financial instrument” as equity, debt, options, forwards, futures, notional principal contracts, and any other derivatives or evidence of interest (e.g., short positions in the listed items), and incorporate the definition of “commodity” from the mark-to-market rules (i.e., actively traded commodities, notional principal contracts and other derivatives or interests with respect to actively traded commodities).

Net Gains from Dispositions of Property. Net investment income includes net gain from the disposition of property, unless the Trade or Business Exception applies (described below).

Net gain includes gain recognized under general income tax principles. For example, as described in the Preamble, gain recognized by a partner on a distribution of money from the partnership in excess of basis in the partnership interest will be considered net gain and, thus, net investment income. Similarly, gain from deemed sales (e.g., from an election under Section 338 of the Code upon the sale of an S-corporation share) will be included in net investment income (to the extent the Trade or Business Exception does not apply). Likewise, mark-to-market gains and capital gain dividends and undistributed capital gains from regulated investment companies (i.e., mutual funds) and real estate investment trusts will be included in net investment income as net gain.

Under the Proposed Regulations, the sale of an interest in a partnership or S-corporation is treated by default as the sale of property that is not held in a trade or business. The Proposed Regulations, however, exclude a portion of this gain from net investment income in cases where (1) the partnership or S-corporation is engaged in at least one trade or business other than trading in financial instruments and commodities and (2) with respect to the partnership or S corporation interest disposed of, the transferor is engaged in at least one trade or business that is not a passive activity. Under these rules, as a general matter, upon a disposition of an interest in a partnership or S-corporation, the net gain or loss from such sale (for purposes of determining net investment income) is reduced by the deemed net asset gain (or increased, as the case may be, by the deemed net asset loss) that would have been allocable to the transferor upon a deemed sale by the partnership or S-corporation of the assets held in such trade or business.

In cases where the inside basis of a partnership’s or S-corporation’s assets equals the outside basis in the interests in the entity, this adjustment can have the effect of completely excluding all of the gain from the disposition of an interest in a partnership or S-corporation from net investment income. In cases where an inside-outside basis difference exists, however, a taxpayer could recognize net investment income on the disposition of such an interest, even in cases where the taxpayer actively participates in the entity’s trade or business and that business is not trading financial instruments or commodities.

The Proposed Regulations confirm that to the extent gain from a disposition of property is not recognized under general income tax purposes, such gain will not be recognized in determining net investment income. The deferral and exclusion mechanisms of installment sales, like-kind exchanges, and involuntary conversions generally apply with respect to NIIT.

In addition, a taxpayer’s gain on his or her primary residence is subject to NIIT, except to the extent the gain is otherwise excluded from gross income (e.g., such gain in excess of $500,000 for married taxpayers filing jointly is subject to NIIT).

As discussed below, the Proposed Regulations include special rules for determining net investment income with respect to shares of CFCs and PFICs.

Trade or Business Exception. Gross income and net gain from the disposition of property is not included in net investment income to the extent the income is derived in the ordinary course of, or the asset is held in, a trade or business other than a trade or business that is a passive activity with respect to the taxpayer or a trade or business of trading financial instruments or commodities (the “Trade or Business Exception”). The income of a pass-through entity generally retains its character to its partners, beneficiaries or holders (e.g., S-corporation income from a trade or business that is neither a passive activity nor trading financial instruments or commodities remains non-investment income to the shareholder that materially participates in the S-corporation’s active business). Similarly, in the case of tiered partnerships where an upper-tier partnership with an active business invests in a lower-tier partnership that earns net investment income, the passive income will be treated as such when allocated to the taxpayer—producing net investment income, despite the taxpayer’s direct investment and participation in a partnership with a trade or business. In contrast, where an upper-tier partnership holds numerous portfolio investments conducting active trades or businesses, income allocated by the upper-tier partnership to its partners with respect to active business income of its investments in lower-tier partnerships—including promote allocations to partner-managers—generally will be treated as net investment income because the determination whether there is an active trade or business is made at the lower-tier level and activities of the lower tier entity are not attributed to a partner of the upper-tier partnership. This has the effect of subjecting fund managers to NIIT in respect of allocations from the fund with respect to the fund’s portfolio investments (e.g., carried interest allocations) because the active businesses of the portfolio investments are not attributed to the fund’s managers.

Properly Allocable Deductions. In determining net investment income, items of gross income are reduced by deductions properly allocable to such income, using general income tax principles to determine the amount and timing of a deduction—except that NOLs are not taken into account when calculating net investment income. (NOLs do apply, however, when calculating a taxpayer’s modified adjusted gross income.) The Proposed Regulations specify certain itemized deductions that are properly allocable to gross investment income, including investment interest, investment expenses and state and local taxes imposed on investment income. Under the Proposed Regulations, the limitations on itemized deductions (i.e., the limitation of such deductions to 2% of adjusted gross income and the overall limitation) must be apportioned between net investment income and other income.

Because net gains from property cannot be a negative number under the Proposed Regulations, net losses on dispositions of property cannot be used to reduce other net investment income—not even by the standard $3,000 capital loss deduction allowed for general income tax purposes.

In addition, the Preamble clarifies that unused deductions may only be taken into account in another year to the extent otherwise allowed by the Code (such as a carryforward of investment interest, a suspended passive activity loss or a capital loss carryforward).

C. NET INVESTMENT INCOME—SPECIAL RULES

Working Capital Exception. Under the Proposed Regulations, any income attributable to an investment of working capital is taxable as net investment income. The Proposed Regulations do not define working capital for this purpose.

Real Estate Professionals. Under the passive loss rules, a taxpayer meeting certain requirements with respect to a real estate business (e.g., performs more than 750 hrs/year in the business, etc.) will not be treated as passive with respect to the business (i.e., a “real estate professional”). The Preamble, however, states that (1) even in such a case, rents earned from such business will be subject to NIIT, unless earned in the ordinary course of a trade or business and (2) a real estate rental business may not qualify as a “trade or business” for income tax purposes.

Exception for Distributions from Retirement Plans. Net investment income does not include distributions (or amounts treated as distributions) from qualified pension, stock bonus, profit-sharing plans, 401k plans and IRAs. Distributions are taken into account, however, in determining the taxpayer’s modified adjusted gross income for the purposes of calculating the threshold amount described above. Because compensation is treated as income earned in the ordinary course of a trade or business, distributions from non-qualified retirement plans also should not be subject to NIIT.

Exception for Items Subject to Self-Employment Income. Net investment income does not include any item included in income or deduction allowed in determining self-employment income for such taxable year. In the case of a taxpayer in the business of trading financial instruments and commodities, any deduction from such business that does not reduce self-employment income may be used to reduce the taxpayer’s other items of net investment income.

Controlled Foreign Corporations and Passive Foreign Investment Companies. Under the Proposed Regulations, net investment income generally does not include current Subpart F income inclusions from a CFC or income inclusions from a PFIC with respect to which a so-called QEF election has been made (unless such income is attributable to a trade or business that is a passive activity with respect to the taxpayer or a trade or business of trading financing instruments or commodities). Rather, net investment income generally includes only distributions of previously taxed income from a CFC or such a PFIC. Because this modification can create a timing difference between the general CFC and PFIC rules and NIIT, the Proposed Regulations establish a complex set of rules for determining, among other things, a taxpayer’s basis in CFCs and PFICs for purposes of NIIT as well as modified adjusted gross income (for individuals) and adjusted gross income (for trusts and estates). The Proposed Regulations permit taxpayers to avoid these complexities by electing to take into account subpart F inclusions and PFIC inclusions as they accrue for purposes of determining net investment income.

Further attempting to ease administrative burden of these rules, the Proposed Regulations provide that the special rules with respect to CFCs and PFICs apply only with respect to distributions of earnings and profits that were taxed as current inclusions in taxable years beginning after December 31, 2012.

D. EFFECTIVE DATE

The Proposed Regulations are intended to be effective for taxable years beginning after December 31, 2013, except for the rules applicable to charitable remainder trusts which are intended to be effective for taxable years beginning after December 31, 2012.