Net Investment Income Tax Applies to Dividends Received by Majority Shareholder

(Parker Tax Publishing May 2021)

The Office of Chief Counsel advised that the dividend income of a taxpayer who was the majority shareholder and an employee of a closely held C corporation was subject to the net investment income tax (NIIT) under Code Sec. 1411. The Chief Counsel's Office reasoned that, since a C corporation is not a passthrough entity or a disregarded entity, dividend income received by a C corporation shareholder generally cannot satisfy the exception to the NIIT in Reg. Sec. 1.1411-4(b) for gross income derived in the ordinary course of a taxpayer's trade or business. CCM 202118009.

Background

The Office of Chief Counsel was asked to advise whether the net investment income tax (NIIT) under Code Sec. 1411 applies to C corporation dividends received by a taxpayer, who is an individual shareholder and an employee of a C corporation, and whether that determination is affected by the C corporation's status as a closely held corporation.

Code Sec. 1411(a)(1) provides that, in the case of an individual, there is a 3.8 percent tax imposed on the lesser of (1) net investment income, or (2) the excess of modified adjusted gross income for the tax year, over a threshold amount. "Net investment income" is defined in Code Sec. 1411(c)(1) as the excess (if any) of the types of income and gain described in Code Sec. 1411(c)(1)(A)(i) through (iii) over the deductions allocable to such income or gain. Under Code Sec. 1411(c)(1)(A)(i), one type of income included in net investment income is interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in Code Sec. 1411(c)(2). Under Code Sec. 1411(c)(2), the NIIT applies to income derived in the ordinary course of a trade or business if such trade or business is: (1) a passive activity (within the meaning of Code Sec. 469) with respect to the taxpayer, or (2) a trade or business involved in trading financial instruments or commodities.

For purposes of the NIIT, Reg. Sec. 1.1411-4(b) provides, in part, that gross income is excluded from net investment income if it is derived in the ordinary course of a trade or business that is not a passive activity of the taxpayer (within the meaning of Code Sec. 469). Reg. Sec. 1.469-2T(c)(3)(ii) provides for seven limited scenarios where certain types of portfolio income will be treated as derived in the ordinary course of a trade or business. Under only two of these scenarios would dividend income be treated as derived in the ordinary course of a trade or business: (1) where the income is from investments made in the ordinary course of a trade or business of furnishing insurance or annuity contracts or reinsuring risks underwritten by insurance companies; and (2) where the income or gain is derived in the ordinary course of an activity of trading or dealing in any property if such activity constitutes a trade or business.

Under Code Sec. 469(h)(4), a closely held C corporation is treated as materially participating in an activity only if one or more shareholders holding stock representing more than 50 percent (by value) of the outstanding stock of such corporation materially participate in such activity, or, in the case of a closely held C corporation other than a personal service corporation, the requirements of Code Sec. 465(c)(7)(C) are met with respect to the activity. Code Sec. 465(c)(7)(C) refers to the ownership requirement in Code Sec. 542(a) under which, during the last half of the tax year, more than 50 percent in value of the corporation's stock is owned by, or for, not more than five individuals.

In the scenario presented to the Chief Counsel's Office, the C corporation paid the taxpayer's personal expenses from corporate accounts and the IRS reclassified those payments as dividend income. As an employee of the corporation, the taxpayer was involved in the day-to-day operations of the corporation's manufacturing trade or business. The facts indicated that the corporation may have been a closely held corporation within the meaning of Code Sec. 469(j)(1), as described in Code Sec. 465(a)(1)(B), since the taxpayer appeared to own a majority of the shares of the corporation. The taxpayer contended that because he materially participated as an employee in the corporation's manufacturing trade or business, the dividend income received from the corporation was not subject to the NIIT because it was derived in the ordinary course of a trade or business that was not a passive activity of the taxpayer within the meaning of Code Sec. 469.

Analysis

In CCM 202118009, the Chief Counsel's Office advised that the dividend income received by the taxpayer is subject to the NIIT and that conclusion applies even if the C corporation is a closely held corporation.

In reaching this conclusion, the Chief Counsel's Office cited Code Sec. 1411(c)(1), under which dividend income received by an individual taxpayer from a C corporation is net investment income unless such income is derived in the ordinary course of a trade or business. As the Chief Counsel's Office noted, to qualify for the "ordinary course of a trade or business" exception, Reg. Sec. 1.1411-4(b) provides that the dividend income must be derived in a trade or business conducted (1) directly by the taxpayer (or indirectly through a disregarded entity) or (2) through a passthrough entity. The Chief Counsel's Office reasoned that, since a C corporation is not a passthrough entity and is also not a disregarded entity, dividend income received by a C corporation shareholder generally cannot satisfy the "ordinary course of trade or business" exception in Reg. Sec. 1.1411-4(b).

Under Code Sec. 469(e)(1)(A) and Reg. Sec. 1.469-2T(c)(3), the Chief Counsel's Office observed, C corporation stock generally produces dividend income to its shareholders and the stock is generally treated as property held for investment unless the dividends are derived in the ordinary course of a trade or business. The Chief Counsel's Office said that under these rules, any dividend income paid by a C corporation would not be derived by a shareholder in the ordinary course of a trade or business unless the shareholder is a dealer or a trader in stock or securities. The Chief Counsel's Office reasoned that being a shareholder in a C corporation in and of itself is not a trade or business that would cause the dividend income received by the shareholder from the C corporation to be properly treated as derived in the ordinary course of a trade or business.

The Chief Counsel's Office rejected the taxpayer's argument that participating in the C corporation's business as an employee was sufficient to meet the exception in Code Sec. 1411(c)(1)(A)(i) relating to income which is derived in the ordinary course of a trade or business not described in Code Sec. 1411(c)(2). The Chief Counsel's Office found that the taxpayer's involvement in the C corporation's trade or business was not relevant and noted that Reg. Sec. 1.469-2T(c)(3)(ii) contains two exceptions that treat dividend income from C corporations as income from a trade or business. Those exceptions are for (1) insurance businesses, and (2) the business of trading or dealing in property. The Chief Counsel's Office found that neither of these two exceptions applied in this case. Therefore, the dividends paid to the taxpayer were net investment income under Code Sec. 1411(c)(1)(A)(i).

The Chief Counsel's Office said that, while C corporations generally are not subject to the passive loss rules under Code 469, Code Sec. 469 does apply to closely held C corporations under Code Sec. 469(a)(2)(B). Special rules under Code Sec. 469 apply to closely held C corporations such that a closely held C corporation generally can only offset its passive losses against its active income. The Chief Counsel's Office noted that closely held C corporations are subject to Code Sec. 469 because Congress feared that individuals would use these entities to incorporate their portfolio investments to avoid Code Sec. 469.

The Chief Counsel's Office found that, as discussed above, Reg. Sec. 1.1411-4(b) does not provide any rules for determining whether gross income derived by a shareholder of a C corporation (including a closely held C corporation) may be properly treated as derived in the ordinary course of a trade or business. The Chief Counsel's Office said that C corporations, including closely held C corporations, are not passthrough entities, and this analysis and conclusion do not change simply because a shareholder may be treated as materially participating, for purposes of Code Sec. 469, in a trade or business activity conducted through a closely held C corporation. Accordingly, the Chief Counsel's Office concluded that any dividend income received by a shareholder from a C corporation is subject to tax under Code Sec. 1411, irrespective of whether the C corporation is a closely held C corporation within the meaning of Code Sec. 469(h)(1) or whether the shareholder is treated as materially participating in the trade or business activity of the C corporation.

For a discussion of the rules for calculating net investment income for purposes of NIIT, see Parker Tax ¶143,130.

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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