The AICPA, in a letter from Jeffrey Porter, chair of the AICPA Tax Executive Committee, submitted comments to the IRS, recommending many changes to the proposed regulations on the new net investment income tax.
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 lower threshold amounts. The tax was enacted as part of the 2010 health care reform legislation.
In December 2012, the IRS issued detailed proposed regulations governing the application of the tax (REG-130507-11). The proposed regulations provided rules for individuals, trusts, and estates. They defined net investment income and its components, provided definitions and examples regarding the trade or businesses to which the tax applies, and gave details on determining the gain or loss on the disposition of interests in partnerships or S corporations and various other topics. The regulations were proposed to generally be effective for tax years beginning after Dec. 31, 2013, but taxpayers can rely on them until final regulations are issued.
In his letter, Porter notes that the IRS’s guidance on Sec. 1411 “generally provides a reasonable approach to interpreting, implementing, and complying with the new [net investment income] tax rules.” However, in response to the proposed regulations, the AICPA is making 16 detailed recommendations.
Specifically, the AICPA recommends that the final regulations should:
- Provide additional and clear guidance on when income is derived “in the ordinary course of a trade or business”;
- Clarify when a rental real estate activity is considered to have risen to the level of a Sec. 162 trade or business;
- Clarify that regrouping activities under Sec. 469 only affects whether a specific activity is treated as passive or nonpassive under Sec. 469 and provide other guidance about regrouping;
- Provide additional rules that allow mark-to-market losses of traders to reduce net investment income;
- Clearly provide that distributions to retired partners that qualify as not subject to self-employment tax are excluded from gross income subject to the net investment income tax;
- Provide that dividends received from Alaska Permanent Funds are excluded from gross income subject to the net investment income tax;
- Provide additional guidance on whether the gain or loss from the repayment of reduced basis debt held by an S corporation shareholder is excluded from gross income subject to the net investment income tax;
- Provide for a simplified method and/or a safe harbor for calculating the tax with respect to distributions in excess of basis;
- Clearly provide that income received by Indian tribal members is excluded from gross income subject to the net investment income tax;
- Provide that income from a covenant not to compete is excluded from gross income subject to the net investment income tax;
- Provide additional guidance on the treatment of state and local tax refunds in the current or a subsequent year;
- Provide that Sec. 165 losses and deductions recognized in connection with taxable business and investment activities, the income of which is subject to the net investment income tax, should be considered “properly allocable deductions” for the purposes of the tax;
- Provide clear guidance that suspended passive losses will be considered properly allocable deductions under Sec. 1411(c)(1)(B) in the year allowed under chapter 1 of the Internal Revenue Code;
- Replace the proposed “property by property deemed sale” method with a methodology more consistent with the statutory language of Sec. 1411;
- Include an amendment to the adjustment rules under Prop. Regs. Sec. 1.1411-7 to adjust the gain or loss from a deemed sale of all assets of a partnership or S corporation to include the liquidation gain/loss caused by inside/outside basis differentials; and
- Use either a simplified method or a safe-harbor method when the trustee (transferor) computes the gain or loss from the sale or disposition of an S corporation owned by a qualifying subchapter S trust (QSST) and taken into account for purposes of Sec. 1411.
Under the AICPA’s recommended simplified method for calculating the tax, the amount of gain attributable to assets used in a trade or business by the materially participating seller of an interest in a partnership or S corporation would be calculated using the sales price of the disposed ownership interest in the S corporation or the partnership to determine a reasonable estimate of the fair market value of the entity’s assets. Rules similar to those applicable in the context of Sec. 338(h)(10) could be used to determine the gross selling price (i.e., gross up the sales price based on the percentage interest sold and increase that amount for liabilities).
In conjunction with its recommendation for calculating the gain, the AICPA also recommends that the entity not be required to provide the net investment income gain or a property-by-property analysis unless requested and that the request be received by the due date of the owner’s tax return excluding extensions. The AICPA recommends that the Sec. 1411 gain information should be provided on a newly designed form that may be filed either with the return or as a stand-alone submission.
The AICPA also provided a detailed safe-harbor method based on the information available to both taxpayers and the IRS (e.g., Schedule K-1) to help reduce taxpayers’ compliance burdens.