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An In-Depth Look: The 3.8% Net Investment Income Tax
(Parker's Federal Tax Bulletin: December 6, 2012)

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As a result of the Affordable Care Act, a new 3.8 percent net investment income tax under Code Sec. 1411 goes into effect on January 1, 2013. Because no guidance existed other than the Code provision, tax practitioners were unclear as to the impact the new tax might have on their clients. On Friday, November 30, the IRS issued proposed regulations (REG-130507-11) aimed at clarifying how the new tax applies.

One of the biggest areas of practitioner concern has been how the IRS would implement the rules relating to dispositions of partnership interests and S corporation stock. For purposes of calculating the Code Sec. 1411 tax in the case of such dispositions, gain or loss is taken into account as investment income or loss only to the extent of the net gain or loss that would be so taken into account by the transferor as investment income if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest. The proposed regulations provide deemed sale rules (discussed below) that the IRS acknowledges may be cumbersome for some practitioners to apply. Thus, the IRS is seeking comments on other methods that would implement these provisions without imposing an undue burden on taxpayers.

Compliance Tip: The regulations are proposed to be effective for tax years beginning after 2013, with an exception for the portion of the regulations relating to charitable remainder trusts, is proposed to apply to tax years beginning after 2012. However, taxpayers can rely on them for purposes of complying with Code Sec. 1411 until final regulations are issued.

In general, Code Sec. 1411 does not provide definitions of its operative phrases or terminology. Moreover, there is no indication in the legislative history of Code Sec. 1411 that Congress intended, in every event, that a term used in Code Sec. 1411 should have the same meaning ascribed to it for other federal income tax purposes. Accordingly, the proposed regulations provide specific definitions that are to be applied in calculating the Code Sec. 1411 tax. One of the key concepts in calculating the tax deals with the definition of a trade or business. Under the proposed regulations, the rules under Code Sec. 162 apply for determining whether an activity is a trade or business for purposes of Code Sec. 1411. Since the rules for determining a trade or business under Code Sec. 162 are well established and there is a large body of case law, using this definition should help simplify taxpayer compliance.

CAUTION: According to the IRS, it will closely review transactions that manipulate a taxpayer's net investment income to reduce or eliminate the 3.8 percent tax. In appropriate circumstances, the IRS said it will challenge such transactions based on applicable statutes and judicial doctrines. Thus, for example, if an investment arrangement that in form gives rise to income that does not constitute net investment income is in substance properly treated for federal tax purposes as the holding of securities by one party as agent for another, the arrangement will be taxed in accordance with its substance.

Impact of Nonrecognition and Deferral Provisions on Calculating Investment Income

Under the proposed regulations, except as otherwise provided, income tax principles and rules apply in determining the tax under Code Sec. 1411. Thus, gain that is not recognized for income tax purposes for a tax year is not recognized for that year for purposes of Code Sec. 1411 (for example, gain deferred or excluded under Code Sec. 453 (installment method), Code Sec. 1031 (like-kind exchanges), Code Sec. 1033 (involuntary conversions), or Code Sec. 121 (sale of principal residence).

Deferral or disallowance provisions used in determining adjusted gross income apply to determining net investment income (for example, Code Sec. 163(d) (limitation on investment interest), Code Sec. 265 (expenses and interest relating to tax-exempt income), Code Sec. 465(a)(2) (at risk limitations), Code Sec. 469(b) (passive activity loss limitations), Code Sec. 704(d) (partner loss limitations), Code Sec. 1212(b) (capital loss carryover limitations), or Code Sec. 1366(d)(2) (S corporation shareholder loss limitations)). A deduction carried over to a tax year by reason of Code Sec. 163(d), Code Sec. 465(a)(2), Code Sec. 469(b), Code Sec. 704(d), Code Sec. 1212(b), or Code Sec. 1366(d)(2) and allowed for that tax year in determining adjusted gross income is also allowed for the determination of net investment income, whether or not the tax year from which the deduction is carried precedes the effective date of Code Sec. 1411.

Calculation of Tax on Individuals

In the case of an individual, the 3.8 percent tax is computed on the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over a threshold amount. The threshold amount is $250,000 in the case of a taxpayer filing a joint return or a surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case. Modified adjusted gross income (AGI) is defined as AGI increased by the excess of (1) the amount excluded from gross income under Code Sec. 911(a)(1) (relating to the foreign earned income exclusion), over (2) the amount of any deductions taken into account in computing AGI or exclusions disallowed under Code Sec. 911(d)(6).

The proposed regulations provide that the term individual for purposes of Code Sec. 1411 is any natural person, except for natural persons who are nonresident aliens. Thus, the 3.8 percent tax applies to any citizen or resident of the United States, but does not apply to a nonresident alien.

Example: Tom is single and a U.S. citizen. He has modified adjusted gross income of $190,000, which includes $50,000 of net investment income. Tom is not subject to the 3.8 percent tax because his modified AGI is under the threshold.

Example: The facts are the same as in the preceding example, except Tom has modified AGI of $220,000, which includes net investment income of $50,000. Tom has a Code Sec. 1411 tax of $760 (3.8 percent of $20,000).

In the case of a U.S. citizen or resident who is married to a nonresident alien individual, the spouses are treated as married filing separately for purposes of Code Sec. 1411. In this case, the U.S. citizen or resident spouse is subject to the threshold amount for a married taxpayer filing a separate return (i.e., $125,000), and the nonresident alien spouse is exempt from 3.8 percent tax. In accordance with the rules for married taxpayers filing separate returns, the U.S. citizen or resident spouse must determine his or her own net investment income and modified AGI.

Calculation of Tax on Estates and Trusts

In general, the 3.8 percent tax applies to estates and trusts on the lesser of undistributed net investment income or the excess of the estate or trust's AGI over the dollar amount at which the highest tax bracket begins for the tax year.

Because Congress did not provide a rule specifying the particular trusts subject to Code Sec. 1411, the IRS has determined that the Code Sec. 1411 tax applies to ordinary trusts described in Reg. Sec. 301.7701-4(a). Thus, business trusts are excluded from the tax because they are treated as business entities.

In addition, the general rule excludes certain state law trusts that are subject to specific tax regimes. Examples of these trusts include common trust funds taxed under Code Sec. 584 and expressly not subject to tax under the income tax provisions, and designated settlement funds taxed under Code Sec. 468B. However, Code Sec. 1411 does apply to trusts subject to certain provisions of subchapter J, even though such trusts may have special computational rules within those provisions. These trusts include pooled income funds, cemetery perpetual care funds, and qualified funeral trusts. Similarly, Code Sec. 1411 applies to certain Alaska Native settlement trusts.

The Code Sec. 1411 tax also does not apply to any trust, fund, or other special account that is exempt from income tax. This exclusion applies even if such a 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).

Grantor Trusts

The proposed regulations provide that the Code Sec. 1411 tax is not imposed on a grantor trust, but if a grantor or another person is treated as the owner of all or a portion of a trust, any items of income, deduction, or credit that are included in computing taxable income of the grantor or other person are treated as if the items had been received or paid directly by the grantor or other person for purposes of calculating that person's net investment income.

ESBTs

The proposed regulations provide special computational rules for Electing Small Business Trusts (ESBTs). For income tax purposes, the portion of any ESBT that consists of stock in one or more S corporations is treated as a separate trust, and the amount of the income tax imposed on that separate trust is determined with certain modifications. Thus, an ESBT is treated as two separate trusts for income tax purposes.

The proposed regulations preserve the income tax treatment of the ESBT as two separate trusts for computational purposes but consolidates the ESBT into a single trust for determining the adjusted gross income threshold to which the tax applies. This rule applies a single Code Sec. 1(e) threshold so as to not inequitably benefit ESBTs over other taxable trusts.

The proposed regulations provide the method to determine the ESBT's Code Sec. 1411 tax base. First, the ESBT must separately calculate the undistributed net investment income of the S portion and non-S portion in accordance with the general rules for trusts under the income tax provisions, and combine the undistributed net investment income of the S portion and the non-S portion. Second, the ESBT must determine its adjusted gross income, solely for purposes of Code Sec. 1411, by adding the net income or net loss from the S portion to that of the non-S portion as a single item of income or loss. Finally, to determine whether the ESBT is subject to Code Sec. 1411, and if so, the Code Sec. 1411 tax base, the ESBT must compare the combined undistributed net investment income with the excess of its AGI over the threshold for the highest trust income tax bracket.

Charitable Remainder Trusts

Special computational rules are provided in the proposed regulations for charitable remainder trusts. Although the trust itself is not subject to Code Sec. 1411, annuity and unitrust distributions may be net investment income to the noncharitable recipient beneficiary. The proposed regulations provide special rules to maintain the character and distribution ordering rules of Reg. Sec. 1.664-1(d) for purposes of Code Sec.1411.

Foreign Estates and Foreign Trusts

Code Sec. 1411 does not specifically address the treatment of foreign estates and foreign nongrantor trusts. According to the IRS, Code Sec. 1411 should not apply to foreign estates and foreign trusts that have little or no connection to the United States (for example, if none of the beneficiaries is a U.S. person). Accordingly, the proposed regulations provide, as a general rule, that foreign estates and foreign trusts are not subject to Code Sec. 1411. However, the IRS stated, net investment income of a foreign estate or foreign trust should be subject to Code Sec. 1411 to the extent such income is earned or accumulated for the benefit of, or distributed to, U.S. persons. The taxation of U.S. beneficiaries receiving current distributions of net investment income from a foreign estate or foreign nongrantor trust is subject to Code Sec. 1411.

Bankruptcy Estates

A bankruptcy estate of a debtor who is an individual is treated as an individual for purposes of computing the tax under Code Sec. 1411. Code Sec. 1398 provides rules for the taxation of bankruptcy estates in chapter 7 and chapter 11 cases under the Bankruptcy Code in which the debtor is an individual. In these cases, the bankruptcy estate computes its tax in the same manner as an individual. Code Sec. 1398(c)(2) provides that the income tax rate for the bankruptcy estate is the same as that imposed on a married taxpayer filing separately, and Code Sec. 1398(c)(3) provides that the bankruptcy estate is entitled to a standard deduction of a married taxpayer filing separately. Therefore, regardless of the actual marital status of the debtor, a bankruptcy estate of a debtor who is an individual is treated as a married taxpayer filing separately for purposes of the thresholds for calculating the tax, and therefore the threshold amount applicable to such a bankruptcy estate is $125,000.

Calculating Undistributed Net Investment Income

With respect to an estate or trust, net investment income is defined the same as it is for individuals (see discussion below). Undistributed net investment income is a Code Sec. 1411 term used solely for estates and trusts (and not individuals), and is not defined in Code Sec. 1411. The proposed regulations conform the taxation of estates and trusts under Code Sec. 1411 to the income tax rules relating to estates, trusts, and beneficiaries (i.e., Code Sec. 641 to Code Sec. 685) to avoid double taxation of net investment income and the taxation of amounts distributed to charities.

The proposed regulations treat an estate or trust as a conduit by reducing the estate's or trust's taxable income to take into account distributions to beneficiaries and the charitable deduction. The undistributed net investment income of an estate or trust is its net investment income, reduced by the share of net investment income included in the deductions of the estate or trust under Code Sec. 651 or Code Sec. 661, and the share of net investment income allocated to the Code Sec. 642(c) deduction of the estate or trust. The proposed regulations adopt the class system of income categorization (e.g., Code Sec. 651 through Code Sec. 663) to arrive at the trust's net investment income reduction in the case of distributions that are comprised of both net investment income and net excluded income items. For this purpose, the term excluded income includes items that are not includible in net investment income by either specific exclusion (for example, interest on state and local bonds, items taken into account in calculating self-employment income, or distributions from qualified plans) or that are not specifically included in Code Sec. 1411(c)(1)(A) or elsewhere in the proposed regulations.

The proposed regulations provide that net investment income includes a beneficiary's share of distributable net income to the extent the character of that income constitutes net investment income.

Calculating Net Investment Income

Code Sec. 1411(c)(1) defines net investment income as the excess (if any) of (1) the sum of (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which the tax does not apply, (ii) other gross income from trades or businesses to which the tax applies, and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply, over (2) deductions allowed for income tax purposes that are properly allocable to such gross income or net gain.

If items of net investment income (including the properly allocable deductions) pass through to an individual, estate, or trust from a partnership or S corporation, the allocation of such items must be separately stated.

The proposed regulations provide that net investment income includes, in part, gross income from interest, dividends, annuities, royalties, and rents. However, such income is excluded from net investment income if it is derived in the ordinary course of a trade or business that did not involve a passive activity or the trading in financial instruments or commodities.

Dividends and Interest

Gross income from interest includes any item treated as interest for income tax purposes, including substitute interest. Gross income from dividends includes any item treated as a dividend for income tax purposes including, but not limited to, corporate distributions treated as dividends (including constructive dividends); amounts treated as dividends under Code Sec. 1248(a); amounts treated as dividends under Reg. Sec. 1.367(b)-2(e)(2); and amounts treated as dividends under Code Sec. 1368(c)(2). In addition, substitute dividends, distributions from previously taxed earnings and profits (within the meaning of Code Sec. 959(d) or Code Sec. 1293(c)), and certain excess distributions (within the meaning of Code Sec. 1291(b)) are included in net investment income.

Annuities

Gross income from annuities includes the amount received as an annuity under an annuity, endowment, or life insurance contract that is includible in gross income, and an amount not received as an annuity under an annuity contract that is includible in gross income under Code Sec. 72(e). Gain or loss from the sale of an annuity is treated as net investment income for purposes of Code Sec. 1411. To the extent the sales price of the annuity does not exceed its surrender value, the gain recognized is treated as gross income under Code Sec. 1411(c)(1)(A)(i). If the sales price of the annuity exceeds its surrender value, the seller treats the gain equal to the difference between the basis in the annuity and the surrender value as gross income for purposes of Code Sec. 1411 and treats the excess of the sales price over the surrender value as gain from the disposition of property under Code Sec. 1411(c)(1)(A)(iii).

Royalties

Gross income from royalties includes amounts received from mineral, oil, and gas royalties, and amounts received for the privilege of using patents, copyrights, secret processes and formulas, goodwill, trademarks, tradebrands, franchises, and other like property.

Rents

Gross income from rents includes amounts paid or to be paid principally for the use of (or the right to use) tangible property.

Ordinary Course of a Trade or Business Exception

The investment income items described above (interest, dividends, etc.) are not included in net investment income if the item meets the ordinary course of a trade or business exception. The ordinary course of a trade or business exception is a two-part test. First, the item must be derived in a trade or business that is not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities. Second, if the item is derived in such a trade or business, the item must also be derived in the ordinary course of such trade or business.

For an item of gross income to be excluded from Code Sec. 1411 under the ordinary course of a trade or business exception, the income must be derived in a trade or business that is neither a passive activity with respect to the taxpayer nor a trade or business of trading in financial instruments or commodities.

In the case of an individual who is engaged in the conduct of a trade or business directly (for example, a sole proprietor) or through ownership of an interest in an entity that is disregarded as an entity separate from the individual owner, the determination of whether an item of gross income is derived in a trade or business is made at the individual level.

In the case of an individual, estate, or trust that owns an interest in a trade or business through one or more passthrough entities (a partnership or an S corporation), the determination of whether an item of gross income allocated to the individual, estate, or trust from the passthrough entity is derived in a trade or business that is a passive activity with respect to the taxpayer or is derived from trading in financial instruments or commodities is made as follows:

(1) The determination of whether the trade or business from which the income is derived is a passive activity with respect to the taxpayer is determined at the taxpayer (individual, estate, or trust) level in accordance with the general principles of Code Sec. 469. For example, if Ann owns an interest in PRS, a partnership, which is engaged in a trade or business, the determination of whether PRS's trade or business is a passive activity with respect to Ann is made in accordance with Code Sec. 469.

(2) The determination of whether the trade or business from which the income is derived is a trade or business of trading in financial instruments or commodities is made at the passthrough entity level (the partnership or S corporation level). If the passthrough entity is engaged in a trade or business of trading in financial instruments or commodities, income from such trade or business retains its character as it passes from the entity to the taxpayer. Therefore, regardless of whether the individual is directly engaged in a trade or business or whether an intervening passthrough entity is engaged in a trade or business, such income will not qualify for the ordinary course of a trade or business exception because the income is derived in a trade or business of trading in financial instruments or commodities. Conversely, if the passthrough entity is not engaged in a trade or business, income allocated to an individual from the entity will not qualify for the ordinary course of a trade or business exception even if the individual or an intervening entity is engaged in a trade or business.

Example: Ann owns an interest in UTP, a partnership that is engaged in a trade or business. UTP owns an interest in LTP, also a partnership, which is not engaged in a trade or business. LTP receives $10,000 in dividends, $5,000 of which is allocated to Ann through UTP. The $5,000 of dividends is not derived in a trade or business because LTP is not engaged in a trade or business. This is true even though UTP is engaged in a trade or business. Accordingly, the ordinary course of a trade or business exception does not apply, and Ann's $5,000 of dividends is net investment income.

In addition, if the passthrough entity is not engaged in a trade or business and the passthrough entity has items of income such as dividends, interest, etc., the individual's status under Code Sec. 469 is irrelevant.

Similar rules regarding whether the trade or business is determined at the taxpayer level or the entity level apply in determining whether net gain is attributable to the disposition of property held in a trade or business subject to Code Sec. 1411.

Example: Carl owns stock in ABC, an S corporation. ABC is engaged in a banking trade or business (that is not a trade or business of trading in financial instruments or commodities), and ABC's trade or business is not a passive activity with respect to Carl. ABC earns $100,000 of interest in the ordinary course of its trade or business, of which $5,000 is Carl's pro rata share. Because ABC is not engaged in a trade or business and because ABC's trade or business is not a passive activity with respect to Carl, the ordinary course of a trade or business exception applies and Carl's $5,000 of interest is not included as investment income.

Observation: Code Sec. 1411 does not define ordinary course of a trade or business, and the proposed regulations do not provide guidance on the meaning of ordinary course. Instead, the IRS instructs taxpayers to review other regulation sections and case law for guidance on whether an item of gross income is derived in the ordinary course of a trade or business.

Net Gain Attributable to Dispositions of Certain Property

Net investment income includes net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in Code Sec. 1411(c)(2).

The proposed regulations provide that net investment income includes net gain (to the extent taken into account in computing taxable income) attributable to the sale, exchange, transfer, conversion, cash settlement, cancellation, termination, lapse, expiration, or other disposition (collectively, referred to as the disposition) of property other than property held in a trade or business not described in Code Sec. 1411(c)(2).

Generally, the income tax rules apply to determine whether there has been a disposition of property for purposes of Code Sec. 1411. Thus, if a partner receives a distribution of money from a partnership in excess of the adjusted basis of the partner's interest in the partnership and recognizes gain, or if an S corporation shareholder receives a distribution of money from the S corporation in excess of the adjusted basis of the shareholder's stock in the corporation and recognizes gain, the gain is treated as gain from the sale or exchange of such partnership interest or S corporation stock and is investment income for purposes of Code Sec. 1411. Similarly, if stock of an S corporation is sold and a Code Sec. 338(h)(10) election is made, each shareholder's pro rata share of the deemed asset sale gain or loss may be taken into account in determining net investment income. Further, each shareholder may have additional gain or loss upon the deemed liquidation of the S corporation resulting from the Code Sec. 338(h)(10) election, which gain or loss will also generally be taken into account in determining net investment income. In addition, capital gain dividends from regulated investment companies and real estate investment trusts, and undistributed capital gains from such entities, are included in net investment income as net gain and not as dividend income.

The amount of net gain on the disposition of an interest in a partnership or an S corporation taken into account as investment income may be adjusted in accordance with special rules provided in Code Sec. 1411(c)(4) for the dispositions of certain interests in partnerships or S corporations.

Because Code Sec. 1411(c)(1)(A)(iii) uses the term net gain (which contemplates a positive number), the proposed regulations provide that the amount of net gain included in net investment income may not be less than zero. Although capital losses in excess of capital gains are not recognized for purposes of Code Sec. 1411, capital losses are permitted to offset gain from the disposition of assets other than capital assets that are subject to Code Sec. 1411.

Code Sec. 1411 Trades or Businesses and Passive Activities

The trades or businesses subject to the Code Sec. 1411 tax are (1) a passive activity (within the meaning of the passive activity loss rules of Code Sec. 469) with respect to the taxpayer, and (2) trading in financial instruments or commodities. The Code Sec. 1411 tax applies to gross income from and net gain attributable to a passive activity (within the meaning of Code Sec. 469) that involves the conduct of a trade or business. The definitions of trade or business and passive activity for Code Sec. 1411 purposes are more restrictive than for Code Sec. 469 purposes in two respects. First, Code Sec. 469 and the regulations thereunder provide that a trade or business includes not only a trade or business (within the meaning of Code Sec. 162), but also any activity conducted in anticipation of the beginning of a trade or business and any activity involving research or experimentation (within the meaning of Code Sec. 174). Second, while Code Sec. 469 defines passive activity as any trade or business in which the taxpayer does not materially participate, it also includes any rental activity in the definition of passive activity. The proposed regulations provide that the definition of trade or business for Code Sec. 1411 purposes is limited to a trade or business within the meaning of Code Sec. 162.

Due to the differences in the definitions for purposes of Code Sec. 1411 and Code Sec. 469, under the proposed regulations, in some cases gross income from activities that are passive activities under Code Sec. 469 will not be taken into account for purposes of Code Sec. 1411(c)(1)(A)(ii) because the gross income is derived from an activity that does not rise to the level of a trade or business (within the meaning of Code Sec. 162). In such cases, the gross income will not be taken into account under Code Sec. 1411 unless it is otherwise taken into account (as interest, dividends, etc).

The grouping rules will apply in determining the scope of a taxpayer's trade or business in order to determine whether that trade or business is a passive activity for purposes of Code Sec. 1411. Once a taxpayer has grouped activities, the taxpayer may not regroup those activities in subsequent tax years. The IRS has determined on prior occasions that taxpayers should be given a fresh start to redetermine their groupings. The enactment of Code Sec. 1411 may cause taxpayers to reconsider their previous grouping determinations, and therefore the IRS has determined that taxpayers should be given the opportunity to regroup. Thus, the proposed regulations provide that taxpayers may regroup their activities in the first tax year beginning after December 31, 2013, in which the taxpayer meets the applicable income threshold in Prop. Reg. Sec. 1.1411-2(d) and has net investment income. This determination is made without regard to the effect of the regrouping. Taxpayers may regroup their activities in reliance on the proposed regulations for any tax year that begins during 2013 if Code Sec. 1411 would apply to such taxpayer in such tax year. A taxpayer may only regroup activities once under this rule, and any such regrouping will apply to the tax year for which the regrouping is done and all subsequent years.

Dispositions of Interests in Partnerships and S Corporations

In most cases, an interest in a partnership or S corporation is not property held in a trade or business. Therefore, gain or loss from the sale of a partnership interest or S corporation stock is subject to the Code Sec. 1411 tax. However, Code Sec. 1411(c)(4) provides an exception for certain active interests in partnerships and S corporations. Code Sec. 1411(c)(4)(A) provides that, in the case of a disposition of an interest in a partnership or S corporation, gain from such disposition is taken into account as investment income only to the extent of the net gain that would be so taken into account by the transferor as investment income if all property of the partnership or S corporation were sold for fair market value immediately before the disposition of such interest. Code Sec. 1411(c)(4)(B) applies a similar rule to a loss from a disposition.

According to the IRS, for purposes of Code Sec. 1411, Congress intended Code Sec. 1411(c)(4) to put a transferor of an interest in a partnership or S corporation in a similar position as if the partnership or S corporation had disposed of all of its properties and the accompanying gain or loss from the disposition of the properties passed through to its owners (including the transferor). However, the gain or loss upon the sale of an interest in the entity and a sale of the entity's underlying properties will not always match. First, there may be disparities between the transferor's adjusted basis in the partnership interest or S corporation stock and the transferor's share of the entity's adjusted basis in the underlying properties. Second, the sales price of the interest may not reflect the proportionate share of the underlying properties' fair market value with respect to the interest sold.

To achieve parity between an interest sale and an asset sale, Code Sec. 1411(c)(4) must be applied on a property-by-property basis, which requires a determination of how the property was held in order to determine whether the gain or loss to the transferor from the hypothetical disposition of such property would have been gain or loss subject to tax under Code Sec. 1411. The tax applies if the property disposed of is either not held in a trade or business, or held in a trade or business that is a passive activity or a trade or business involving financial instruments or commodities. This means that the exception in Code Sec. 1411(c)(4) does not apply where (1) there is no trade or business, (2) the trade or business is a passive activity with respect to the transferor, or (3) the partnership or the S corporation is in the trade or business of trading in financial instruments or commodities, because in these cases there would be no change in the amount of net gain determined upon an asset sale.

The proposed regulations provide that, for purposes of Code Sec. 1411(c)(4), a transferor computes the gain or loss from the sale of the underlying properties of the partnership or S corporation using a deemed asset sale method (Deemed Sale), and then determines if, based on the Deemed Sale, there is an adjustment (either positive or negative) to the transferor's gain or loss on the disposition of the partnership or S corporation interest for purposes of determining if there is investment income. An adjustment occurs only if the underlying property is used in a trade or business not described in Prop. Reg. Sec. 1.1411-5 (a positive adjustment reduces a loss on the disposition of the interest, and a negative adjustment reduces the gain on the disposition of the interest).

Because the proposed regulations apply a Deemed Sale by the passthrough entity of all its assets for cash equal to the fair market value of the entity's properties, any gain or loss on the sale of the interest that is not reflected in the underlying properties of the passthrough entity (as the result of an inside-outside basis disparity) would not create an adjustment.

Observation: In developing the Deemed Sale, the IRS considered existing hypothetical transactions, such as the hypothetical transaction to determine a transferee's basis adjustment under Code Sec. 743(b). The proposed regulations provide that the Deemed Sale under Code Sec. 1411(c)(4) applies, in part, rules similar to Reg. Sec. 1.743-1(d)(2). However, the IRS recognizes that the Deemed Sale may impose an administrative burden on owners of partnerships and S corporations in certain circumstances. Thus, it is requesting comments on other methods that would implement the provisions of Code Sec. 1411(c)(4) without imposing an undue burden on taxpayers. In addition, the IRS is requesting comments on how to determine a partner's interest in Code Sec. 1411 assets upon a distribution in which gain is recognized under Code Sec. 731.

The first step of the Deemed Sale is a hypothetical disposition of all the entity's properties (including goodwill) in a fully taxable transaction for cash equal to the fair market value of the entity's properties immediately before the disposition of the interest. The second step of the Deemed Sale is to compute the gain or loss on each of the entity's properties (including goodwill). The calculation of gain or loss is determined by comparing the fair market value of each property with such property's adjusted basis. The gain or loss from each property must be computed separately. The third step of the Deemed Sale is to allocate the gain or loss from each property determined in the second step to the transferor. In the case of a partnership, the amount of gain or loss allocated to the transferor must take into account the allocations provided in the partnership agreement and any required allocations, as well as basis adjustments under Code Sec.743 with respect to the transferor.

In the case of an S corporation, the amount of gain or loss allocated to the transferor is determined under Code Sec. 1366(a), and the allocation should not take into account any reduction in the transferor's distributive share in Code Sec. 1366(f)(2) resulting from the hypothetical imposition of tax under Code Sec. 1374 as a result of the Deemed Sale. The fourth step of the Deemed Sale is to determine whether the amount of gain or loss allocated to the transferor with respect to each property under the Deemed Sale would have been taken into account in determining the transferor's net gain if it were an actual disposition. If the entity's property is either held in a trade or business described in Code Sec. 1411(c)(2) with respect to the partnership, the S corporation, or the transferor, or is not held in a trade or business, there will be no adjustment under Code Sec. 1411(c)(4) with respect to that property.

However, if the property is held in a trade or business not described in Code Sec. 1411(c)(2), an adjustment must be made. First, the transferor's gains or losses from such property (or properties) are aggregated to create a net gain (which is treated as a negative adjustment) or a net loss (which is treated as a positive adjustment). Second, based on the adjustment calculated and subject to certain limitations, the transferor then must adjust the gain or loss from the disposition of the partnership or S corporation interest by the positive or negative adjustment.

Thus, if in the Deemed Sale the transferor would have been allocated a net gain from property held in a trade or business not described in Code Sec. 1411(c)(2) (thus, a negative adjustment) and the transferor had a gain on the disposition of the interest, then the gain on the disposition of the interest is reduced for purposes of determining net investment income. However, in a situation in which a transferor has a gain (determined without regard to Code Sec. 1411(c)(4)) from the disposition of the partnership or S corporation interest, a negative adjustment cannot result in the transferor having a loss on the disposition of the partnership or S corporation interest, and a positive adjustment is not taken into account. Thus, for example, if a transferor has a $100,000 gain on the disposition of S corporation stock, the adjustment cannot result in a gain for Code Sec. 1411 purposes greater than $100,000, and cannot result in a loss for Code Sec. 1411 purposes. Similarly, in a situation where a transferor has a loss from the disposition of the partnership or S corporation interest, a positive adjustment cannot result in the transferor having a gain on the disposition of the partnership or S corporation interest, and a negative adjustment is not taken into account. For example, if a transferor has a $50,000 loss on the disposition of S corporation stock, the adjustment cannot result in a loss for Code Sec. 1411 purposes greater than $50,000, and cannot result in a gain for Code Sec. 1411 purposes.

The proposed regulations provide a special rule for property held in more than one trade or business during the 12-month period ending on the date of the disposition. In such case, the fair market value and the adjusted basis of the property must be allocated among the trades or businesses on a basis that reasonably reflects the use of the property.

The proposed regulations provide rules to determine the treatment of gain or loss from goodwill for purposes of Code Sec. 1411(c)(4). If the entity is engaged in one trade or business, the entire gain or loss on the goodwill is treated as gain or loss from the disposition of property held for use in that trade or business, and no portion of such gain or loss is treated as attributable property not held for use in the trade or business. If the entity is engaged in more than one trade or business, the gain or loss on the goodwill is allocated between the trades or businesses based on the relative fair market value of the property (excluding cash) held for use in each trade or business.

(Staff Editor at Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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