In conjunction with the tax reform changes, practitioners should not lose sight of Sec. 1411 and the net investment income tax that is imposed on taxpayers (which was the big headline just a few short years ago). A number of tax planning strategies can still be implemented to minimize clients' exposure to this tax, one of which is the interest recharacterization rules under Regs. Sec. 1.1411-4(g)(5). Before diving into that, this discussion provides a quick refresher on Sec. 469.
Passive vs. active income
Practitioners often find themselves having to distinguish which category of income an item falls into, i.e., whether it should be considered passive income, nonpassive income, or portfolio income. Sec. 469 and its regulations provide guidance on how to classify losses as from an active or a passive activity. This classification hinges on whether the taxpayer's level of participation in the activity can be considered material. The nuances of the tests to determine material participation are not the focus of this discussion, but the distinction between active and passive is important because of its impact on the deductibility of losses, the taxpayer's ability to use the losses to offset other sources of income, and the application of the net investment income tax of Sec. 1411.
Treatment of passive losses
Under Sec. 469, passive losses can be used to offset only passive income and not income from other sources such as portfolio income, wages from salaries, and nonpassive income. Portfolio income includes items such as interest, dividends, annuities, and royalties. As a general rule, portfolio income is positive (i.e., it doesn't generate losses), and as a result, the regulations under Sec. 469 contain special rules that require portfolio income to be treated as income other than passive activity gross income, even if it is received by an entity that is considered to be engaged in a passive activity. Absent this rule, a taxpayer would be able to shelter portfolio income by transferring portfolio assets to passive activities whose losses would then be used to offset the positive portfolio income.
The regulations under Sec. 469 provide an exception for this treatment of interest income in the case of a lending transaction between a taxpayer and a passthrough entity in which the taxpayer owns a direct or indirect interest or between certain passthrough entities (Regs. Sec. 1.469-7). This regulation applies only to certain items of interest income and interest expense that are recognized in the same tax year under one of three scenarios:
- The taxpayer makes a loan to a passthrough entity in which it owns a direct or indirect interest at any time during the entity's tax year (for purposes of this regulation, a "passthrough entity" refers to a partnership or an S corporation).
- The passthrough entity makes a loan to a person or persons that own direct or indirect interests in the passthrough entity.
- A loan is made between two passthrough entities where each of the entities' owners have the same proportionate ownership interests in each entity.
The interest income derived from the three scenarios listed above and the associated interest expense are known as self-charged interest income and self-charged interest expense. The exception under this regulation provides for recharacterizing a portion of the taxpayer's distributive share of self-charged interest income as passive activity gross income and recharacterizing certain deductions for self-charged interest expense that are properly allocable to the self-charged interest income as passive activity deductions. The recharacterization allows for "netting" of income and deductions that otherwise would be placed into separate categories of income and deductions and not offset one another. It should be noted that the passthrough entity (and not the taxpayer) can irrevocably elect out of the recharacterization.
The net investment income tax
The introduction of the 3.8% net investment income tax as part of the passage of the Patient Protection and Affordable Care Act of 2010, P.L. 111-148, as amended by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, reinforced the importance of income classification and determining if a taxpayer is active or passive with respect to an activity. Sec. 1411 imposes a 3.8% surtax on the net investment income of individuals, estates, and trusts whose income exceeds certain defined thresholds. Income that is subject to the net investment income tax is the sum of the following three categories (over the deductions that are properly allocable to the gross income or net gain):
- Gross income from interest, dividends, annuities, royalties, and rents, except to the extent derived in the ordinary course of a trade or business (other than one to which the net investment income tax does not apply);
- Other gross income derived from a trade or business described in Regs. Sec. 1.1411-5 to which the net investment income tax does not apply (i.e., a trade or business that is a passive activity or a business trading in financial instruments or commodities); and
- 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 net investment income tax does not apply).
Since the net investment income tax applies to both portfolio and passive income, the problem that Regs. Sec. 1.469-7 addresses is not present. A taxpayer would be required to include the interest income received from a passive activity for purposes of calculating the net investment income tax regardless of whether it was considered portfolio income or passive income. As a result, the recharacterization rule under Regs. Sec. 1.469-7 does not have as much impact for purposes of calculating the net investment income tax.
An issue does arise, however, when a taxpayer makes a loan to a passthrough entity in which it is considered to be materially participating. Under this scenario, the interest received would be considered net investment income, but the offsetting interest deduction passing through to the taxpayer would not be treated as properly allocable to the interest income and therefore could not offset it. The regulations under Sec. 1411 recognize this unfavorable result for the taxpayer and have provided an exception to the general rule that interest income is net investment income.
Regs. Sec. 1.1411-4(g)(5) states:
Gross income from interest . . . that is received by the taxpayer from a nonpassive activity of such taxpayer, solely for purposes of section 1411, is treated as derived in the ordinary course of a trade or business not described in §1.1411-5. The amount of interest income that is treated as derived in the ordinary course of a trade or business not described in §1.1411-5, and thus excluded from the calculation of net investment income, under this paragraph (g)(5) is limited to the amount that would have been considered passive activity gross income under the rules of §1.469-7 if the payor was a passive activity of the taxpayer.
Put another way, in the case of self-charged interest received from a nonpassive entity, the amount of interest income that can be considered as being derived in the ordinary course of a nonpassive business and thus excluded from net investment income is the taxpayer's allocable share of the nonpassive interest expense deduction being passed through to him or her. The amount of interest income excluded from net investment income is equal to the amount of interest income that would have been considered passive under Regs. Sec. 1.469-7 if the nonpassive activity had been considered passive. Practitioners should be mindful that the rule under Regs. Sec. 1.1411-4(g)(5) does not apply to the extent that the corresponding interest deduction is taken into account in determining self-employment income that is subject to tax under Sec. 1401(b).
Proper characterization of income is key
The issue of classifying income and losses as either being active or passive continues to be an important distinction for not only regular and alternative minimum tax purposes but also for purposes of calculating the net investment income tax. The regulations under Sec. 1411 provide a planning opportunity to taxpayers who have received or paid self-charged interest to a passthrough entity through which they materially participate and hold a direct or indirect interest. Special care should be given upon filing the tax returns to ensure that the income has been properly recharacterized and thus excluded from the calculation of the net investment income tax.
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale or email@example.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.