By Robert S. Keebler, CPA, MST, AEP (Distinguished) | Volume 2, Issue 1 (January 2014)
The Final Regulations for Section 1411 and the NIIT were released on December 2, 2013. Along with the release of the Final Regulations, new 2013 Proposed Regulations were also released. While the Final Regulations generally made the 2012 Proposed Regulations final, there were some very interesting changes and additions made in both the Final Regulations and the 2013 Proposed Regulations. This article will point out some of the more interesting aspects of the Regulations.
Properly Allocable Deductions
Although the Final Regulations retained the requirement that only those properly allocable deductions specifically listed in the Regulations are allowed to be taken into account in determining net investment income (NII), they did provide that the Treasury Department and the IRS can publish additional guidance in the Internal Revenue Bulletin that expands the list of properly allocable deductions.Furthermore, they expanded the list of properly allocable deductions in Reg. § 1.1411-4(f). Below is the list of some of the properly allocable deductions provided for in the Final Regulations:
- Taxes described in § 164(a)(3).
- Losses described in § 165 are allowed to the extent such losses would be allowable in computing taxable income under Chapter 1.
- Deductions described in § 62(a)(4) allocable to rents and royalties.
- Deductions described in § 62(a)(1) allocable to a business subject to the NIIT to the extent the deductions have not been taken into account in determining self-employment income.
- Investment interest expense and investment expenses.
- Deductions for estate and generation-skipping taxes allowed by § 691(c) that are allocable to NII.
- A portion of a NOL deduction is allowed in determining NII.
- Amounts described in § 212(3) to the extent they are allocable to NII.
- In the case of an estate or trust, amounts described in § 1.212-1(i) to the extent they are allocable to NII.
- Items of deduction described in § 691(b), provided that the item otherwise would have been deductible to the decedent under Reg. § 1.1411-4(f).
- See Reg. § 1.1411-4(g)(4) for guidance on amounts described in § 642(h).
There a certain limitations on the amount of deductions that are allowed; for instance, any deductions that are subject to the 2% floor on miscellaneous itemized deductions or the overall limitation on itemized deductions are allowed in determining NII only to the extent deductible for regular income tax purposes after application of §§ 67 and 68. A further limitation noted in the Final Regulations is that deductions for a tax year cannot exceed the amount of NII for the tax year.
Income Deemed as “Derived in the Ordinary Course of a Trade or Business”
The Final Regulations provide guidance on certain income that is deemed to be “derived in the ordinary course of a trade or business” for purposes of § 1411(c)(1)(A), and, thus, excluded from NII. This income includes: 1) self-charged interest; 2) self-charged rental income; 3) income of real estate professionals; and 4) income from former passive activities.
If the self-charged interest is received from a taxpayer’s nonpassive entity, then the amount of interest income excluded from NII will be the same as that taxpayer’s allocable share of the nonpassive entity’s deduction for the interest paid. Therefore, the taxpayer is only subject to NIIT on the interest payable on the portion of the entity allocated to other investors.
Example. Taxpayer makes a loan to a non-passive entity (NPE) owned 75% by the taxpayer. For the current year, Taxpayer received $1,000 in self-charged interest from NPE for the loan. Therefore, since the Taxpayer’s allocable share of the NPE’s deduction for the interest paid is 75%, or $750, Taxpayer will exclude $750 from NII and include the remaining $250 of interest in NII. If Taxpayer instead owned 100% of NPE, then the entire $1,000 in self-charged interest would be excluded from NII.
Self-Charged Rental Income
The final regulations provide two ways in which self-charged rental income is treated as “derived in the ordinary course of a trade or business,” and, thus, not subject to the NIIT.
The first way is in the case of rental income that is treated as nonpassive by reason of Reg. § 1.469-2(f)(6). Under Reg. § 1.469-2(f)(6), a taxpayer’s rental activity income from an item of property is treated as not from a passive activity if the property is rented for use in a trade or business activity in which the taxpayer materially participates and is not described in § 1.469-2T(f)(5). Thus, if the rental activity income would be treated as not from a passive activity under Reg. § 1.469-2(f)(6), then it will be deemed as derived in the ordinary course of a trade or business under § 1411 and not subject to the NIIT.
Example. Taxpayer has two sources of income: 1) $10,000 of rental income from a building he owns and 2) $250,000 of salary income from a business he material participates in. Taxpayer rents the building he owns solely to the business he material participates in. Thus, Taxpayer has no NII because 1) salary is not included in NII, and 2) by reason of the self-charged rental income rules under Reg. § 1.1411-4(g)(6), his rental income of $10,000 from the building he owns is not NII.
The second way is in the case of rental income that is treated as nonpassive because the rental activity is properly grouped with a trade or business activity under Reg. § 1.469-4(d)(1) and the grouped activity is a nonpassive activity.
Example. Taxpayer has rental income in the amount of $25,000. The rental income is received from a rental activity that Taxpayer has properly grouped with a trade or business activity of his under Reg. § 1.469-4(d)(1). Therefore, by reason of the self-charged rental income rules under Reg. § 1.1411-4(g)(6), the $25,000 of rental income will not be included in NII.
Also note that the Final Regulations treat gains and losses on assets associated with the rental activity as nonpassive gains or losses to the extent the gains or losses result from the disposition of property that is treated as nonpassive by reason of Reg. § 1.469-2(f)(6) or as a consequence of a taxpayer grouping the rental activity with a trade or business activity under Reg. § 1.469-4(d)(1).
Real Estate Professionals
If the taxpayer has established real estate professional status under § 469(c)(7), the taxpayer will be allowed to treat rental real estate activities as non-passive if:
- The taxpayer satisfies the safe harbor test provided for in the Final Regulations; or
- The rental real estate activities constitute a “trade or business.”
A real estate professional qualifies for the safe harbor if:
- He or she participated more than 500 hours per year, or
- He or she participated more than 500 hours in any five of the past ten years.
The goal for taxpayers would be to fall under the safe harbor alternative provided for in the Final Regulations. This is because the “trade or business” standard that they would have to meet otherwise is not clearly defined.
Example. Taxpayer is an investor in a commercial building rented by unrelated parties. Taxpayer’s share of the net rental income is $100,000. Taxpayer is single, with MAGI of $500,000 and has no other investment activities. Consider the following outcomes:
- Taxpayer is not a real estate professional: The $100,000 is NII.
- Taxpayer is a real estate professional – AND
- Meets the safe harbor: The $100,000 is not NII.
- Doesn’t meet the safe harbor, but it is a trade or business: The $100,000 is not NII
- Doesn’t meet the safe harbor and it is not a trade or business: The $100,00 is NII
Does the NIIT Apply?
|The investor is not a real estate professional nor is the income derived from a trade of business.||YES|
|The investor is a real estate professional, but neither qualifies for the safe harbor nor is the income derived from a trade or business.||YES|
|The investor is a real estate professional and qualifies for the safe harbor.||NO|
|The investor is real estate professional and the income is derived from a trade or business.||NO|
Reg. § 1.469-11(b)(3)(iv) provides taxpayers with a “fresh start” regrouping election. Re-grouping is allowed, without regard to the manner in which the activities were grouped in the preceding taxable year, in the first taxable year after December 31, 2013 in which: 1) the taxpayer meets the applicable income threshold under Section 1411, and 2) has net investment income. Furthermore, the regulations provide that the regrouping may occur during 2013 if the taxpayer is subject to the NIIT. A taxpayer may regroup his or her activities only once, and any such regrouping applies to the taxpayer in the year for which the regrouping is made and all subsequent years.
However, note that there are some limitations. If the taxpayer is subject to the NIIT and then after an amended return (or IRS examination) is no longer subject to the NIIT, the regrouping will be voided (unless one of the exceptions in the regulations is met). Further, if the taxpayer is not subject to the NIIT, but then after an amended return (or IRS examination) is subject to the NIIT, the taxpayer must regroup if the taxpayer wishes to take advantage of this “fresh start” regrouping regulation.
Special Rules for Charitable Remainder Trusts (CRT)
Although a CRT itself is not subject to the NIIT, annuity and unitrust distributions may be NII to the non-charitable beneficiary who receives them. The regulations provide non-charitable beneficiaries who receive CRT payments with two different methods to determine if any part (or all) of the distribution is NII to them:
The first method is the “simplified method.” The “simplified method” provides that distributions from a CRT to a beneficiary for a taxable year consist of NII in an amount equal to the lesser of the total amount of the distributions for that year, or the current and accumulated NII of the CRT.
Example. A CRT has $10,000 in current and accumulated NII. Suppose that this year it makes a $5,000 distribution to a non-charitable beneficiary. If that beneficiary elects to use the simplified method, the entire $5,000 will be subject to the NIIT because it is the lesser of the amount of distributions or the current and accumulated NII of the CRT. If, instead, the CRT made a distribution of $15,000, then only $10,000 would be subject to the NIIT.
Under the second method, the non-charitable beneficiary must categorize and distribute NII based on the existing § 664 category and class (tier) system.
Example. Under § 664, a CRT has ordinary income of $10,000 in tier 1 and capital gains of $10,000 in tier 2. Assume that 50% of the ordinary income in tier 1 and capital gains in tier 2 is also NII. If the CRT makes a distribution to a non-charitable beneficiary of $5,000, then that distribution will be taxed as ordinary income and also as NII. If, instead, the CRT makes a distribution of $10,000, then the entire $10,000 will be taxed as ordinary income but only $5,000 will be subject to the NIIT. If, instead, the CRT makes a distribution of $15,000, then $10,000 is taxed as ordinary income, $10,000 is subject to the NIIT ($5,000 from tier 1 and $5,000 from tier 2), and $5,000 is taxed as capital gains.
Currently under the Final Regulations, Reg. § 1.1411-3(d)(3) is reserved for a rule allowing the CRT to elect between the two methods and such an election is currently allowed. The IRS is taking comments on whether to keep the election and the “simplified method.” If such an election is allowed, the analysis of which method the CRT should elect to use could become quite complicated but it might be worth the effort.
Estates and Trusts Not Subject to the NIIT
The Final Regulations provides a list of estates and trusts not subject to the NIIT:
- A trust all of the unexpired interests in which are devoted to one or more of the charitable purposes described in IRC §170(c)(2)(B).
- Trusts exempt from tax under section 501.
- Charitable Remainder Trusts described in IRC § 664.
- Any other trust, fund, or account that is statutorily exempt from taxes imposed in subtitle A. For example, see sections 220(e)(1), 223(e)(1), 529(a), and 530(a).
- A trust, or a portion thereof, that is treated as a grantor trust under subpart E of part I of subchapter J of chapter 1.
- Electing Alaska Native Settlement Trusts subject to taxation under section 646.
- Cemetery Perpetual Care Funds to which section 642(i) applies.
- Foreign trusts (but see Reg. Section 1.1411-3(b)(1)(viii)).
- Foreign estates (but see Reg. Section 1.1411-3(b)(1)(ix)).
This article only scratches the surface on the topics addressed herein and the entire set of Section 1411 Regulations. Consider this for a moment: The entire Section 1411 fits on less than one page but so far has needed 57 pages of Final Regulations and 24 pages of newly Proposed Regulations to explain how this Section 1411 NIIT works –and, it just went into effect in 2013. There is and will be much more to read, write, and analyze when it comes to the NIIT.
 Reg. § 1.1411-4(f)(6).
 Reg. § 1.1411-4(f)(3)(iii). Generally state and local, and foreign income tax.
 Reg. § 1.1411-4(f)(4). Thus, the $3,000 capital loss allowed by § 1211(b) is allowed. See the Final Regulations for examples.
 Reg. § 1.1411-4(f)(2).
 Reg. § 1.1411-4(f)(3)(i)-(ii).
 Reg. § 1.1411-4(f)(3)(v).
 Reg. § 1.1411-4(f)(2)(iv); see also Reg. § 1.1411-4(h). See the Final Regulations for extensive examples on how to calculate the portion of NOL allowed (“the Section 1411 NOL”).
 Reg. § 1.1411-4(f)(3)(vi).
 Reg. § 1.1411-4(f)(3)(viii).
 Reg. § 1.1411-4(g)(3). See the Final Regulations for examples.
 Reg. § 1.1411-4(f)(7).
 Reg. § 1.1411-4(g)(5).
 Reg. § 1.1411-4(g)(6).
 Reg. § 1.1411-4(g)(7).
 Reg. § 1.1411-3(c)(2)(i) of the 2012 Proposed Regulations.
 Reg. § 1.1411-3(d)(2).
 Reg. § 1.1411-3(b).
 This also includes section 678 trusts treated as owned by a person other than the grantor.
RELATED PRODUCTS & EDUCATIONAL MATERIALS
- A Detailed Analysis of the 3.8% Net Investment Income Tax on Trusts and Estates, After the Final Regs
- The Top 25 Tax, Financial and Estate Planning Techniques for 2014 (with 2014 Advisor Success Tool Kit)
ABOUT THE AUTHOR
Robert S. Keebler is a partner with Keebler & Associates, LLP. He has received the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels and has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States. Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and has received over 150 favorable private letter rulings. Mr. Keebler is nationally recognized as an expert in family wealth transfer and preservation planning, charitable giving, retirement distribution planning and estate administration and works collaboratively with other professionals on academic reviews and papers, as well as client matters. He can be reached at (920)593-1701 or at [email protected].