The net investment income (NII) tax under Code Sec. 1411 is imposed on income from investments, certain sales of property, and income from passive activities. NII includes net gains from the sale of property, unless the property is held in a non-passive trade or business. If the property sold is a non-passive interest in a partnership or S corporation, gain from the sale of the interest is NII only to the extent that income from a deemed sale of the entity’s property would be NII. The IRS totally rewrote the regulations for the disposition of interests in a partnership or S corporation, and reissued them in the 2013 proposed regulations. Certain issues nevertheless remain as the NII enters its second tax year, having first been effective in 2013.
There are three general categories of NII. In addition to gross income from portfolio items such as interest, rents and dividends that are not earned in a trade or business (Category 1), NII includes gross income from a trade or business that is a passive activity, as determined under Code Sec. 469 (Category 2). Income from passive activities can include income from pass-through entities (partnerships, S corporations, and trusts and estates).
The NII tax of 3.8 percent is imposed on the lesser of the total NII net income from the three categories, or the amount by which modified adjusted gross income exceeds the applicable threshold amount ($200,000 for single taxpayers; $250,000 for joint taxpayers; $125,000 for married filing separately).
The IRS issued proposed regulations in 2012. On December 2, 2013, the IRS issued final regulations (TD 9644). At the same time, it issued new proposed regulations (NPRM REG-130843-13), which are still pending. Both the final and the 2013 proposed regulations apply to tax years beginning on or after January 1, 2014 and can be applied to 2013 (in part or in whole).
An important feature of the statute and regulations is that they rely on the definition of relevant terms in the income tax provisions (Part 1 of the Tax Code). This is demonstrated by the proposed regs on partnership payments under Code Secs. 701–754. Furthermore, this is relevant because the definition of NII often depends on whether the activity generating the income is a passive activity as determined under Code Sec. 469, the passive activity loss (PAL) rules. However, in some cases the government concluded that the Code Sec. 469 rules did not provide sufficient guidance for the NII tax, such as the treatment of real estate professionals
Criticism of the initial 2012 proposed regulations focused in part on the lack of clear guidance on the treatment of distributions and payments by a partnership to a partner. This included clarification of the application of NII to key partnership provisions within the Internal Revenue Code: Code Sec. 731 distributions, Code Sec. 707(c) guaranteed payments and Code Sec. 736 payments to retiring or deceased partners, in liquidation of their interests. In response, the IRS discussed them in the new proposed rules issued in 2013…but some questions still remain.
Gains from a partnership distribution to a partner are treated under Code Sec. 731 as gain from a sale or exchange of a partnership interest. The proposed regulations treat these distributions as NII under category 3 (sale or exchange of property). However, other categories of payments are not treated as being from the sale or exchange of a partnership interest.
Code Sec. 707(c) payments, or guaranteed payments, are a partnership payment to a current partner for services or the use of capital that do not depend on partnership income. The 2013 proposed regulations exclude payments for services from NII, whether or not subject to self-employment tax, because they are compensation for services. However, they treat guaranteed payments for the use of capital as a substitute for interest and as category 1 NII. This treatment is consistent with the Code Sec. 469 rules that treat payments for capital as portfolio income.
Code Sec. 736 payments
The new proposed regulations clarify how the treatment of payments under Code Sec. 736 determines their treatment under Code Sec. 1411. Under Code Sec. 736(b), a payment for a retiring partner’s share of partnership property is treated in the same manner as a distribution to an existing partner under Code Sec. 731 and as category 3 NII. Payments over multiple years are treated in the same manner and are not retested annually. This is similar to the Code Sec. 469 treatment. However, if the retiring partner materially participates in the partnership trade or business, then the portion of the payment treated as NII is reduced, based on the rules for determining NII on the disposition of a pass-through interest. It does not matter whether the payments are ordinary income or capital gain.
A liquidating distribution under Code Sec. 736(a)(1) can be for services, capital, or certain unrealized receivables. Payments for services that are determined with respect to income are treated as a distributive share. Otherwise, the payment is treated as a guaranteed payment under Code Sec. 736(a)(2). In this case, the treatment follows the treatment of guaranteed payments under Code Sec. 707(c).
The treatment under Code Sec. 1411 depends on the components of the distribution under the income tax rules. Income from a trade or business (other than trading in financial instruments) will be excluded from NII, while income from working capital is treated as interest and is NII.
The 2013 proposed regulations are “reliance” regulations, which means that taxpayers may either use them to compute NII tax exposure or rely on another “reasonable interpretation” of the relevant Internal Revenue Code provisions. Experts nevertheless anticipate that still further changes will be made when the regulations reach “final” status, especially in the area of how partnership tax rules interact with the NII tax. Whether they will be finalized before the 2014 tax year ends for planning purposes remains speculative. In the meantime, partnerships and their partners must work with current distribution rules in efforts to minimize NII tax exposure when possible. Please contact our offices if you have any concerns over how these rules might affect your overall 2014 tax liability.