Section 1411 of the Internal Revenue Code of 1986 (the “Code”) (added to the Code as part of the Healthcare and Education Reconciliation Act of 2010 (the “Act”) and effective for tax years beginning in 2013) imposes a 3.8% tax on the “Net Investment Income” of individuals and certain other taxpayers whose income exceeds a certain “threshold amount.” This tax is in addition to the federal income tax such taxpayers will owe on such income. The chapter in which Code § 1411 is contained describes itself as pertaining to an unearned income Medicare contribution; and, consistent with that characterization, the rate of tax thereunder equals the combined rate of tax on employees and employers with respect to the Medicare tax imposed on wages and the corresponding self-employment tax on self-employment income.1
The tax is imposed on the lesser of the taxpayer’s net investment income or the extent to which his “modified adjusted gross income” exceeds the threshold amount. Except for US citizens or residents living abroad, a person’s modified adjusted gross income is the same as his adjusted gross income. For a married couple filing jointly, the threshold amount is $250,000. So, such a couple will be subject to this tax on the lesser of their net investment income or the amount by which their adjusted gross income exceeds $250,000. Contrary to what is the case with respect to the Medicare tax imposed on wages and self-employment income, no part of the tax is excluded or deducted from income.
Code § 1411 defines net investment income as the sum of three different buckets of gross income, reduced by allowable deductions that are properly allocable to such gross income. The three buckets of gross income are the following:
- Gross income from interest, dividends, annuities, royalties, and rents other than such income which is derived in the ordinary course of the trade or business and is not either a passive activity with respect to the taxpayer or a trade or business of trading financial instruments or commodities (a “financial instruments / commodities trading business”);
- Passive activity income (under Code § 469) with respect to the taxpayer and income from financial instruments / commodities trading businesses; and
- Net gain (to the extent taken into account in determining taxable income) from the disposition of property other than property held in a trade or business which was not either a passive activity with respect to the taxpayer or a financial instruments / commodities trading business.
Accordingly, income from a trade or business that is not a passive activity with respect to the taxpayer, and is not from the trade or business of trading in financial instruments or commodities, is not subject to the tax under Code § 1411.2
Even though income from a trade or business that is not a passive activity with respect to the taxpayer — and is not a financial instruments / commodities trading business — will not be subject to tax under Section 1411, such income will often be subject to the tax on net earnings from self-employment that is imposed on self-employed individuals in lieu of the Social Security taxes that are imposed on wages of employees. Notably, however, rents, interests, dividends and gains from the sale of property not includible in inventory or held primarily for sale to customers in the ordinary course of business typically are not subject to the self-employment tax. In addition, income of an S corporation that flows through to its shareholders in excess of that which is paid out to its shareholders as wages or salaries is also not typically subject to self-employment taxes, provided that the wages and salaries paid are adequate. As a result, a key issue for many people will be whether they can navigate between the Scylla of the tax under Code § 1411 and the Charybdis of the tax on self-employment income.
The IRS recently issued proposed regulations under Code § 1411, effective as of January 1, 2014. However, taxpayers may rely on these proposed regulations until they are finalized. Some of the more significant features in the Regulations are the following:
- Capital Losses. The regulations make clear that net gain cannot be a negative number. Consequently, even though a taxpayer may be permitted for regular income tax purposes to apply a (very small) portion of his capital loss against ordinary income, and even if the taxpayer otherwise has such investment income as interest and dividends equal to or greater than the amount of the capital loss so applied, the regulations make clear that the amount of the capital loss so applied to reduce ordinary income cannot be used to reduce such interest and dividends for purposes of determining the tax under Section 1411. Interestingly, however, the regulations do permit such a capital loss to be offset against depreciation recapture treated as ordinary income upon the sale of depreciable property that is otherwise treated as a passive activity asset for purposes of determining net gain under Section 1411.
- Capital Loss Carryforwards. The regulations make clear that if a taxpayer has capital loss carryforwards from a prior year that are attributable to investment-type assets, such carryforwards may be applied to reduce capital gains from the current year that would otherwise constitute net investment income. Just as importantly, the preamble to the proposed regulations makes clear that such capital loss carryforwards may be so applied even if the carryforwards come from years prior to the effective date of Code § 1411, i.e., from 2012 and prior years.
- Passive Activity Losses Suspended under Code § 469. Net investment income includes passive activity income as defined under Code § 469. As is the case for regular income tax purposes, such passive activity income may be offset for purposes of Section 1411 by passive activity losses from prior years the use of which had been suspended under Code § 469. The preamble to the proposed regulations makes clear that the suspended passive activity losses that may be so used include passive activity losses attributable to periods prior to the effective date of Code § 1411, i.e., passive activity losses attributable to 2012 and prior years.
- Allocable Deductions. As noted above, net investment income consists of three buckets of types of gross income reduced by allocable deductions. The proposed regulations provide various examples to illustrate how deductions are to be allocated to investment income so as to reduce net investment income in light of the threshold that miscellaneous itemized deductions (such as management expenses) must exceed under Code § 67 and the further haircut applied to itemized deductions under Code § 68. Significantly, the proposed regulations make clear that investment interest expense, the deduction of which was limited under Code § 163(d), may be carried forward in determining net investment income to the extent that it was carried forward for regular income tax purposes. In contrast, net operating losses that are carried forward from prior years do not reduce net investment income in the year to which they are carried forward.
- Subpart F and Passive Foreign Investment Company Income. The proposed regulations adopt an exceptionally complicated approach with respect to Subpart F income and income of a QEF (i.e., a passive foreign investment company the income of which, per regulations, is reported on an electing shareholder’s tax return on a current basis rather than when distributed). Under the proposed regulations, such Subpart F and QEF income will not be subject to tax under Code § 1411 as such income is earned. Instead, the tax will be triggered when and if that income is subsequently distributed as a dividend. This is the case even though, as a distribution of previously taxed income, such a dividend would not trigger regular income tax. (Since Section 1411 only applies to income after 2012, the proposed regulations contain an ordering rule pursuant to which distributions of such previously-taxed income are sourced first to the current year and then to previous years in reverse chronological order.) Similarly, in determining the gain from the sale of stock in such corporations that would be subjected to tax under Code § 1411, the basis adjustments available for regular tax purposes to shareholders in such corporations with respect to income on which they have paid tax but which has not been yet distributed to them, will not be taken into account. In recognition of the complexities that would arise as a result of the need of taxpayers to maintain dual schedules of previously taxed income and basis for regular tax purposes and for determining tax under Section 1411, the proposed regulations permit a taxpayer to make an election to be subject to the tax under Code § 1411 with respect to Subpart F and QEF income in a manner consistent with what the rules are for recognizing such income, and for making basis adjustments, for regular income tax purposes. Such an election is irrevocable (unless the IRS consents) and must be made in the first year starting after December 31, 2013 in which the taxpayer has such income.
- Gain from the Sale of Interest in “Pass Through” Entities. As noted above, gain from the sale of property that is used in a trade or business that is not a passive activity with respect to the taxpayer, and is not a financial instruments / and commodities trading business, is not subject to the tax under Code § 1411. Section 1411 provides that if stock in an S corporation or an interest in a partnership (collectively, a “pass-through interest”) is sold instead, gain or loss from such a disposition will be taken into account to the extent that the net gain or loss would have been taken into account under Section 1411 if the assets of the S corporation or partnership had been sold. The proposed regulations give effect to this provision by requiring that, if a pass-through interest is sold, the taxpayer must determine the gain that would have been recognized and allocated to him by the entity if the entity had sold its assets at fair market value. To the extent that the pass-through entity has property that is used in a trade or business that is a passive activity with respect to the taxpayer (or used in a financial instruments / commodities trading business) and other assets that are used in a trade or business that is not a passive activity (and not used in a financial instruments / commodities trading business) with respect to the taxpayer, such gains or losses on such differing property are to be separately computed. Gain or loss from the sale of property used in the trade or business that is not a passive activity with respect to the taxpayer (and is not used in a financial instruments / commodities trading business) is then applied as an adjustment to the gain or loss recognized by the taxpayer on the sale of the pass-through interest. If the result of the deemed sale of such assets is a gain, the adjustment to the gain or loss recognized by the taxpayer upon the sale of such pass-through interest is negative, but not to exceed the gain on such sale. If the deemed sale of such assets results in a loss, such loss is a positive adjustment to the loss recognized by the taxpayer upon the sale of such pass-through interest, but such positive adjustment is not to exceed the loss that the taxpayer recognized upon such sale.
The proposed regulations contain an example that illustrates that, if the gain the taxpayer recognizes on the sale of such pass through is greater than the negative adjustment thereto per the calculations described above, the remaining gain will be treated as net investment income. (Such a situation could arise if the taxpayer purchased the stock of an S corporation for an amount less than the S corporation’s net inside basis.) If the deemed asset sale gives rise to a potential negative adjustment that is greater than the gain the taxpayer recognized upon the sale of the pass-through interest, the negative adjustment is limited to the amount of the gain recognized upon the sale of such interest. This raises the possibility that a taxpayer facing such circumstances might want to consider a sale of assets of the pass-through entity, which would give rise to gain that was not subject to the tax under Section 1411, followed by a taxable liquidation of the pass-through interest, which would give rise to a capital loss that might offset other net investment income.
If a pass-through entity has multiple businesses, each of which has goodwill, the goodwill is apportioned among the businesses in proportion to the fair market values of the assets used in such businesses. Such an allocation may have little basis in economic fact.
- Treatment of Passive Activity Loss Triggered Upon Complete Termination of Interest in Passive Activity in a Taxable Transaction. When a taxpayer completely disposes of his interest in a passive activity in a taxable transaction, any previously-suspended passive activity losses and losses from the disposition are, to the extent not otherwise applied against passive activity income in that year, treated as a loss which is not from a passive activity. In other words, at that point, the unused passive activity losses attributable to that activity may be applied against other income. In the preamble to the proposed regulations, the IRS requests comments as to whether the losses so triggered should be taken into account in determining the taxpayer’s net gain from the disposition of property for purposes of calculating net gain under Section 1411 or whether it should be treated as a deduction properly allocable to the gross income in the nature of interest, dividends, etc. Because of the limitations on carryovers of different types, there could be some significant consequences under Section 1411, depending on the treatment accorded such losses.
- Planning Opportunities for Real Estate Professionals. Many real estate professionals are able to take advantage of the special provisions set forth in Code § 469(c)(7) so that the limitations on the ability to deduct losses with respect to rental real estate under the passive activity loss limitation rules found in Section 469 do not apply to them. Some real estate professionals have not taken advantage of the favorable treatment afforded under Code § 469(c)(7) because rental income is not otherwise subject to self-employment tax and passive income was not a material concern. In light of Code § 1411, however, these persons may be able to navigate past the Code § 1411 tax by taking the position that they are engaged in a trade or business that is not a passive activity with respect them. In such circumstances, the income from rental real estate (including from its sale) would not be treated as net investment income for purposes of the tax under Code § 1411. And since rental income and gain from the sale of property used in a trade or business is not treated as earnings from self-employment, it would not be subject to self-employment taxes either.3
A second opportunity may apply to previously made “grouping” decisions. Traditionally, taxpayers grouped activities under Code § 469 to maximize the ability to claim that certain income was passive activity income which could be offset by passive activity losses. The proposed regulations, recognizing that taxpayers had previously made “grouping” decisions for Code § 469 purposes, permit taxpayers to make a one-time election to adopt a different grouping.4
Third, many real estate professionals employ private REITs as a mechanism for holding real estate projects. In light of the Code §1411 rules, dividends from a REIT would be subject to this tax while, as stated above, a real estate professional in a partnership may be able to structure around Code § 1411. Thus, these taxpayers should consider whether, for the future, they would be better served by using partnerships without a REIT in the structure if that would still satisfy the tax needs of their investors.