3.8% Net Investment Income Tax Regulations

Regulations

The IRS issued final and proposed regulations giving guidance on the application and computation of the 3.8% net investment income tax imposed by Sec. 1411 (T.D. 9644 and REG-130843-13). The final regulations adopt, with changes, proposed regulations issued late in 2012.

Effective in 2013, Sec. 1411 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.

In December 2012, the IRS released proposed regulations on the net investment income tax (REG-130507-11). The new final regulations generally follow the proposed regulations, but with changes adopted in response to the numerous comments the IRS received about the proposed regulations. The comments addressed five main issues:

1. Calculation of net investment income;
2. Treatment of several special types of trusts;
3. Interaction between various aspects of the Sec. 469 passive activity rules with the calculation of net investment income;
4. The method of gain calculation regarding a sale of an interest in a partnership or S corporation; and
5. Multiple areas where the proposed regulations could be simplified.

The final regulations retain the general structure for calculating the net investment income tax from the proposed regulations, with a few changes. Despite requests of commentators, the final regulations do not contain a list of income or deduction items that are excluded from the calculation of net investment income. They also do not exempt the net investment income tax from the estimated tax payment requirements, even though many investors cannot know until the end of the year whether a passthrough investment will generate net investment income. In addition, the IRS clarifies that foreign income taxes are not creditable against the net investment income tax because it is not contained in chapter 1 of the Internal Revenue Code. Regs. Sec. 1.1411-1 contains general rules pertaining to the net investment income tax. Regs. Sec. 1.1411-2 describes the application of the tax to individuals. Regs. Sec. 1.1411-3 describes its application to trusts and estates. Regs. Sec. 1.1411-4 defines net investment income. Regs. Sec. 1.1411-5 describes the trades and businesses to which the tax applies, including treatment of passive activities. Regs. Sec. 1.1411-6 deals with income from investments of working capital. Regs. Sec. 1.1411-8 provides exceptions for distributions from qualified plans. Regs. Sec. 1.1411-9 provides exceptions for self-employment income. Regs. Sec. 1.1411-10 covers controlled foreign corporations and passive foreign investment companies.

From the comments it received on the 2012 proposed regulations, the IRS has identified two issues that it will study further. They are the treatment of accumulation distributions from foreign trusts and material participation of estates and trusts.

The proposed regulations issued with the final regulations propose various additions and modifications to the final regulations, including guidance on certain reserved paragraphs in the final regulations. They provide special rules for certain partnership payments; govern the treatment of certain capital loss carryforwards; and deal with the treatment of income and deductions from common trust funds, related to residual interests in real estate mortgage investment conduits (REMICs), and from certain notional principal contracts. They also provide rules for the use of the Sec. 664 system for applying Sec. 1411 to income recipients for charitable remainder trusts with income from controlled foreign corporations or passive foreign investment companies but allow the use of the simplified method that was included in the 2012 proposed regulations for these purposes. The topic of determining the gain or loss on the disposition of interests in partnerships or S corporations is reserved in the final regulations and is dealt with in the proposed regulations.

The final regulations generally apply to tax years beginning after Dec. 31, 2013. For tax years beginning before Jan. 1, 2014, taxpayers can rely on the proposed regulations or on the final regulations, but if a taxpayer takes a position in a tax year beginning before Jan. 1, 2014, that is inconsistent with the final regulations, and that position affects the treatment of one or more items in a tax year beginning after Dec. 31, 2013, then the taxpayer must make reasonable adjustments to ensure that the taxpayer’s tax liability under Sec. 1411 is not “inappropriately distorted” in tax years beginning after Dec. 31, 2013.