The IRS released proposed regulations governing the 3.8% net investment income tax imposed under Sec. 1411 that was added to the Code by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152 (REG-130507-11). Taxpayers can rely on the proposed regulations for purposes of complying with the tax until final regulations take effect. The IRS has also posted FAQs explaining the tax and how it operates.
Starting in 2013, Sec. 1411(a)(1) imposes a tax equal to 3.8% of the lesser of an individual’s net investment income for the tax year or the excess (if any) of the individual’s modified adjusted gross income for the tax year over a threshold amount. The threshold amounts are $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for other taxpayers. The tax also applies to estates and trusts, with different threshold amounts.
Prop. Regs. Sec. 1.1411-1 provides the general rule that except as otherwise provided, all Code provisions that apply for chapter 1 purposes (i.e., normal income taxes and surtaxes) in determining taxable income of a taxpayer also apply in determining the tax imposed by Sec. 1411. The section also defines “adjusted gross income.”
Prop. Regs. Sec. 1411-2 contains the rules applicable to individuals. It provides that the term “individual” for purposes of Sec. 1411 means any natural person, except for natural persons who are nonresident aliens. Nonresident aliens will be subject to the tax if they elect to file a joint return with a resident or citizen spouse under Sec. 6013(g) (Prop. Regs. Sec. 1.1411-2(a)(2)). The treatment of bona fide residents of U.S. territories is different depending on whether the individuals are residents of Guam, the Northern Mariana Islands, or the U.S. Virgin Islands, who are not subject to the tax, or Puerto Rico or American Samoa, who may be subject to the tax (Prop. Regs. Sec. 1.1411-2(a)(2)(iv)).
Prop. Regs. Sec. 1.1411-3 contains the rules for trusts and estates, including the types of trusts the tax applies to (ordinary trusts, as described in Regs. Sec. 301.7701-4(a)) (Prop. Regs. Sec. 1.1411-3(a)(1)(i)) and those it does not apply to (business trusts under Regs. Sec. 301.7701-4(b), certain state law trusts, pooled income funds, cemetery perpetual care funds, qualified funeral trusts, etc., as well as tax-exempt trusts, excluding even unrelated business income of those trusts) (Prop. Regs. Sec. 1.1411-3(b)(1)).
Grantor trusts pay the tax at the level of the grantor, not at the trust level. Electing small business trusts, which are usually treated as two separate trusts, have their adjusted gross income determined as if they were one trust for purposes of this tax. Charitable remainder trusts are not subject to the tax, but distributions to noncharitable beneficiaries are (Prop. Regs. Sec. 1.1411-3(c)(2)). Foreign trusts and estates are not subject to the tax unless their net investment income is earned or accumulated for the benefit of U.S. persons. If a debtor is an individual, his or her bankruptcy estate is treated as an individual for purposes of computing the tax.
Prop. Regs. Sec. 1.1411-4 defines net investment income and its components. It also explains the exception for income received in the ordinary course of a trade or business. This section also describes the calculation of net investment income, describing the deductions that are properly allocable to the investment income.
Prop. Regs. Sec. 1.1411-5 provides definitions and examples regarding the trade or businesses to which the tax applies, which includes trades or businesses that are passive activities with respect to the taxpayer. The trade or business of trading in financial instruments or commodities is a business that is subject to the tax.
Prop. Regs. Sec. 1.1411-7 provides details on determining the gain or loss on the disposition of interests in partnerships or S corporations.
The remainder of the proposed regulations provides rules for income in investment of working capital (Prop. Regs. Sec. 1.1411-6); exception from the tax for distributions from qualified plans (Prop. Regs. Sec. 1.1411-8); exception from the tax for self-employment income (Prop. Regs. Sec. 1.1411-9); and treatment of controlled foreign corporations and passive foreign investment companies (Prop. Regs. Sec. 1.1411-10).
The regulations are proposed to be effective for tax years beginning after Dec. 31, 2013, except for Prop. Regs. Sec. 1.1411-3(c)(2) (special rules for charitable remainder trusts), which is effective for tax years beginning after Dec. 31, 2012. Taxpayers may rely on the proposed regulations to comply with the new tax, which applies beginning in 2013, including making any election available under the regulations, which will be binding on the taxpayer. Taxpayers who did not make elections under the proposed regulations will be able to make these elections pursuant to the final regulations if they contain the same or a similar election.