10 Things We Learned from the New Obamacare Investment Tax Regulations via Forbes.com
Yesterday, the IRS released long-awaited guidance on the additional “Obamacare” tax on net investment income slated to take effect on January 1, 2013. This guidance came in the form of proposed regulations under Section 1411 that, oddly enough, are not effective until tax years beginning after December 31, 2013. However, taxpayers may rely on these proposed regulations until final regulations are issued, which is expected to happen sometime during 2013.
These proposed regulations are both interesting and longer than the Old Testament. I’m kidding of course; they’re not interesting at all. But that doesn’t mean you shouldn’t be aware of several areas of guidance that may not have been covered in the past. Luckily, I’ve got you covered.
But before we get into the meat of the regulations, a quick reminder of the general application of the new investment surtax is in order.
General Rule
Beginning January 1, 2013, taxpayers will pay an additional 3.8% Medicare tax on the lesser of:
- The taxpayer’s “net investment income,” or
- The taxpayer’s “modified adjusted gross income” less the “applicable threshold.”
Clearly, some definitions are in order:
Net Investment income includes:
- Interest, dividends, capital gains, rent and royalty income, and non-qualified annuities,
- Income and gains from passive activities,
- Income and gains from businesses involved in the trading of financial instruments and commodities, and
- Gains from the sale of interests in partnerships and S corporations to the extent the taxpayer is a passive owner.
Net investment income is reduced by deductions properly allocable to the investment income or net gain.
Modified Adjusted Gross Income, assuming a taxpayer has no foreign earned income, will be exactly the same as adjusted gross income.
The applicable threshold is:
- For married taxpayers filing jointly: $250,000.
- For married taxpayers filing separately: $125,000.
- For all other taxpayers: $200,000.
Let’s put it all together with an example:
Example: Hansel, a single taxpayer, earns $195,000 in compensation and $30,000 of dividend and interest income during 2013. These are his only items of income or loss.
Hansel is subject to the 3.8% Medicare tax on the lesser of:
1. Net investment income, or $30,000, or
2. MAGI ($225,000) less the applicable threshold ($200,000) or $25,000.
Thus, Hansel owes tax of 3.8% on $25,000 in addition to his regular income tax responsibility on the same income.
Now that we’ve got the ground rules covered, let’s take a look at what we learned from 80 pages of proposed regulations:
1. It’s patriotic. The new tax is imposed only upon citizens or residents of the U.S; it does not apply to nonresident aliens. If a U.S. citizen is married to a nonresident alien, the spouses will be treated as married filing separately for purposes of the additional tax. As a result, the U.S. citizen or resident spouse will be subject to a $125,000 threshold and must determine his or her own modified adjusted gross income and net investment income.
However, the regulations allow the taxpayers to make an election to file a joint return under Section 6013(g) — which is required if a U.S. citizen or resident wishes to file a joint return with a nonresident alien — for purposes of not only of the income tax, but the investment surtax as well. With this election, the taxpayers will be treated as joint filers for purposes of computing the surtax on net investment income, and can combine their MAGI and net investment income and use the full $250,000 threshold.
2. No proration for (most) short periods. If a taxpayer dies during the year, necessitating the filing of a short period return, the threshold amount is not reduced or prorated. In the unlikely event that a taxpayer changes their annual accounting period, however, the threshold must be prorated based on the number of months in the short period.
3. Four exceptions to business income as net investment income. If a taxpayer owns a sole proprietorship, a single-member LLC disregarded as separate from the owner, or an interest in a partnership or S corporation, any income or gain generated from the activity will be net investment income unless:
- The activity is engaged in an active trade or business, AND
- The income is derived from the ordinary course of that trade or business, AND
- The activity is not a passive activity to the taxpayer (under the definition of Section 469), AND
- The activity is not engaged in the trading of financial instruments.
With regards to the third exception, in simple terms, your interest in an S corporation or partnership is passive unless you meet one of seven “material participation” tests found in the Section 469 regulations. I won’t reproduce them here, as I’ve covered them previously:
An item of income must meet all four exceptions to be excluded from the definition of net investment income. For example, if a taxpayer’s earns income from an activity that is not a trade or business, it is irrelevant whether the taxpayer materially participates in the activity. In addition, placing a trade or business between the taxpayer and an activity that is not a trade or business will not change the results:
Example: Bobby Taylor, an individual, owns an interest in UTP, a partnership, which is engaged in a trade or business. UTP owns an interest in LTP, also a partnership, which is not engaged in a trade or business. LTP receives $10,000 in dividends, $5,000 of which is allocated to Bobby through UTP. The $5,000 of dividends is not derived in a trade or business because LTP is not engaged in a trade or business. This is true even though UTP is engaged in a trade or business. Accordingly, Bobby’s $5,000 of dividends are net investment income.
If all four exceptions are met, however, income earned in the ordinary course of an activity’s business will not be treated as net investment income:
Navin R. Johnson, an individual, owns stock in an S corporation, S. S is engaged in a trade or business that is not a trade or business of trading in financial instruments or commodities. Navin materially participates in S, so the activity is not passive to him within the meaning of section 469.
S earns $100,000 of interest in the ordinary course of its trade or business, of which $5,000 is Navin’s pro rata share. Because:
- S is engaged in a trade or business,
- The $5,000 of income is earned in the ordinary course of the trade or business,
- The activity is not passive to Navin, and
- The activity is not engaged in the business of trading in financial instruments,
Navin has met all four exceptions and the $5,000 of interest is not included in his net investment income.
Pursuant to Section 469, rental activities are treated as passive by default. As a result, unless a taxpayer meets the “real estate professional” exception (discussed later), income from a rental activity will always be considered net investment income.
4. But there’s a catch:
It would be very easy to take those exceptions and conclude that any income earned from a trade or business in which a taxpayer materially participates is excluded from net investment income, but that would be a mistake. This is because when an activity, such as a partnership or S corporation, earns investment income such as interest or dividends, Section 469 treats this income as portfolio income that is not earned in the ordinary course of a trade or business. As a result, even if a taxpayer materially participates in the partnership or S corporation, because the activity’s portfolio income does not meet the second exception of being earned in the ordinary course of a trade or business, the income continues to meet the definition of net investment income:
Example: Billy Hoyle works 520 hours during 2013 in an S corporation in which he is also the sole shareholder. The S corporation is engaged in a trade or business that does not involve trading in financial instruments. The S corporation earns $40,000 in income in the ordinary course of its trade or business and $15,000 of interest and dividend income.
Even though:
- The S corporation is engaged in a trade or business,
- Billy materially participates in the S corporation, and
- The S corporation is not engaged in the business of trading in financial instruments,
Only the $40,000 of income earned in the ordinary course of the S corporation’s business meets all four exceptions and is excluded from net investment income. The $15,000 of interest and dividend income fails to meet the second exception because portfolio income is not treated as incurred in the ordinary course of a trade or business. Thus, Billy must include the $15,000 of portfolio income in his net investment income.
5. Being an employee is a trade or business. For purposes of the proposed regulations, an employee is treated as engaged in the trade or business of being an employee. Therefore, wages are never considered net investment income. The rule gets more generous, however; because wages are earned in the ordinary course of the taxpayer’s trade or business of being an employee, even if a taxpayer receives interest income from an employer as part of a payment of deferred compensation, the interest is not considered net investment income.
6. Taxpayers get a fresh start with passive activity groupings. As discussed above, in order for a taxpayer to exclude from net investment income the income earned by an activity, the taxpayer must not be a passive investor in the activity. To satisfy this standard, the taxpayer must “materially participate” in the activity under one of the seven tests of Section 469. Because these tests are largely based on hours spent by the taxpayer in the activity, however, as the taxpayer engages in more and more activities, it becomes difficult to satisfy the tests for each venture.
The Section 469 regulations provide relief from such a logistical hurdle by permitting taxpayers to group activities that represent an appropriate economic unit for purposes of measuring material participation. While a discussion of the grouping possibilities and requirements is beyond the scope of this post, it’s important to understand why the grouping rules exist:
Example: Walter White owns an interest in two S corporations. Both corporations are engaged in the active conduct of a trade or business, and neither corporation is a trader in financial instruments. Walter spends 520 hours on S Corporation 1, but only 40 hours on S corporation 2. Under the Section 469 regulations, absent an election to group the two activities, Walter would materially participate in S Corporation 1, but not S Corporation 2.
Assuming the interests in the two corporations represent an appropriate economic unit, Walter may group them together for purposes of testing material participation. Because Walter spends 560 hours on the combined activity, he materially participates in both S corporations and neither activity is passive to Walter. As a result, income earned in the ordinary course of the trade or business of both S Corporation 1 and S Corporation 2 will not be considered net investment income.
The concept of grouping activities is important for two reasons under the proposed regulations. First, a taxpayer’s grouping under the Section 469 regulations will also be used to determine whether a taxpayer materially participates in an activity for purposes of applying the tax on net investment income. More importantly, the Section 469 regulations provide that once a taxpayer has grouped activities, they are stuck with them. The potential impact of the enactment of Section 1411, however, has inspired the IRS to grant all taxpayers a fresh start and the ability to regroup their activities.
The proposed regulations provide that taxpayers may regroup their activities in the first tax year beginning after December 31, 2013, in which the taxpayer has modified adjusted gross income in excess of the threshold and has net investment income. However, taxpayers may rely on the proposed regulations and regroup activities for a tax year beginning in 2013 if they will be subject to the investment surtax during that year.
This ability is quite significant, as it allows taxpayers to reconfigure previous groupings that may no longer be advantageous. Note, however, that a taxpayer electing to regroup their activities must comply with all disclosure requirements.
7. Don’t be fooled by rental/non-rental groupings. In very limited circumstances, the Section 469 regulations permit a taxpayer to group rental and non-rental activities. This does not change the nature of any rental income earned by the rental activity as net investment income, however. Thus, even if a grouping of a rental activity with a trade or business converts the rental activity from passive to non-passive, the rental income will still be considered net investment income.
Winky Dinky Dogs, an S corporation, purchases a building during the current year. The building houses a retail business and also contains several rental apartments. Because the activities are conducted in one building, the taxpayer concludes that they are an appropriate economic unit and groups them together. Because the shareholder materially participates in the combined activity, the net rental income is treated as nonpassive, not as a passive activity. This does not change the fact that the rental income is considered net investment income.
8. Net loss from the sale of property can’t offset other investment income. Similar to the rules discussed at #4 above, if an activity is a trade or business that is neither passive to the taxpayer nor engaged in the activity of trading financial instruments, gain from the sale of assets (other than working capital) are not considered net investment income.
All other gains — for example, those from a passive activity or an activity engaged in financial trading – will be considered net investment income. Under the proposed regulations, the taxpayer cannot use a net loss from the disposition of an asset to offset other net investment income:
Example; Henry Hill, an unmarried individual, realizes a capital loss of $40,000 on the sale of P stock and realizes a capital gain of $10,000 on the sale of Q stock, resulting in a net capital loss of $30,000. Both P and Q are C corporations. Henry has no other capital gain or capital loss. In addition, Henry receives wages of $300,000 and earns $5,000 of gross income from interest. For income tax purposes, Henry may use $3,000 of the net capital loss against other income and the remaining $27,000 is a capital loss carryover.
For purposes of determining Henry’s net investment income, Henry’s gain of $10,000 on the sale of the Q stock is also reduced by his loss of $40,000 on the sale of the P stock. However, because net gain may not be less than zero, Henry may not reduce his interest income of $5,000 by the $3,000 of the excess of capital losses over capital gains allowed for income tax purposes.
Similarly, while a taxpayer’s net operating loss carryforward can be utilized to reduce their taxable income and modified adjusted gross income, the proposed regulations provide that it cannot reduce a taxpayer’s net investment income. The reason for this rule is obvious: it is not practical to trace what portion of a taxpayer’s net operating loss is properly attributable to investment income.
9. Long-awaited clarity on the sale of S corporation stock and partnership interests. Under the proposed regulations, stock in an S corporation or an interest in a partnership is not considered property used in a trade or business, and thus any gain resulting from a sale of such stock or partnership interest is considered net investment income.
There is an exception, however, for a sale when:
- The S corporation or partnership is engaged in at least one trade or business,
- At least one of the activity’s trades or businesses is not the trading of financial instruments, and
- The activity is not passive to the taxpayer.
Read in the negative, one might conclude that if a taxpayer materially participates in an activity that is engaged in a trade or business that is not the trading of financial instruments, any gain would not be net investment income. While that is typically the case, a we’ll see below, the mechanics of the new regulations do not provide a blanket removal of the gain from the computation of investment income, but rather a mechanical adjustment to the gain. In certain circumstances, this may result in some gain being subject to the additional Medicare tax even if the the taxpayer meets the requirements above.
Here’s how it works:
Step 1: the taxpayer must compute the gain or loss on the sale of the stock or partnership interest,
Step 2: the taxpayer next looks through to the entity, and the entity is deemed to have disposed of all of its assets in a fully taxable transaction for cash equal to the fair market value,
Step 3: the hypothetical gain or loss is then allocated to the selling shareholder or partner (this is done in accordance with any special allocations required pursuant to a partnership agreement or Sections 704(b) or (c)), and
Step 4: the gain computed in step 1 is then adjusted to account for any gain that is not considered net investment income because it meets the three exceptions above.
There are limitations to the amount of adjustment in Step 4. If a taxpayer recognizes a gain on the sale of the stock or partnership interest, the adjustment cannot result in a net loss for net investment income purposes, nor can a taxpayer recognize more gain for net investment income purposes than he actually realized on the sale. On the opposite side, if the taxpayer recognized a loss on the sale of the stock or the partnership interest, an adjustment cannot result in a net gain for net investment income purposes, nor can a taxpayer recognize a larger loss for net investment income purposes then they actually realized on the sale.
An modified example from the proposed regulations will make some sense of it all:
Individuals A and B are shareholders of S Corporation (S). A owns 75 percent of the stock in S, and B owns 25 percent of the stock in S. During Year 1, S is engaged in a single trade or business. S is not passive to A, nor is S involved in the trading of financial instruments.
S has three properties (1, 2, and 3) held exclusively in S’s trade or business that have an aggregate fair market value of $120,000. On September 1 of Year 1, A sells his S stock to C for $90,000. At the time of the disposition, A’s adjusted basis in his S stock is $75,000. S’s properties have the following adjusted bases and fair market values immediately before the disposition:
Property Adjusted Basis Fair Market Value
1 $10,000 $50,000
2 $70,000 $30,000
3 $20,000 $40,000
Step 1: On the stock sale to C, A recognizes a gain of $15,000 ($90,000 minus $75,000). Because S is not a passive activity to A and is not engaged in the trading of financial instruments, A should not have to include the full gain in his net investment income.
Step 2: Upon a hypothetical disposition of S’s properties for cash equal to fair market value, S would receive $50,000 for Property 1, $30,000 for Property 2, and $40,000 for Property 3. The determination of gain or loss on the deemed sale of S’s properties is as follows:
Property Adjusted Basis Fair Market Value Gain or Loss
1 $10,000 $50,000 $40,000
2 $70,000 $30,000 ($40,000)
3 $20,000 $40,000 $20,000
Step 3: A is allocated $30,000 gain from Property 1, $30,000 loss from Property 2, and $15,000 gain from Property 3.
Step 4: Because all three properties are held in S’s trade or business, which is not passive to A or engaged in the trading of financial instruments, A must make an adjustment to the amount of gain recognized from the sale of the stock. The gain or loss on each of the three properties are added together ($30,000 minus $30,000 plus $15,000), resulting in a negative adjustment of $15,000. A’s gain of $15,000 on the disposition of the interest is thus reduced by $15,000, and A has zero gain with respect to the stock disposition for purposes of computing his net investment income.
As I mentioned above, however, it’s not fair to simply assume that because a taxpayer’s activity is a non-passive trade or business outside the realm of financial trading, no gain will result on the disposition of the stock or partnership interest. As seen below, differences in inside and outside basis can yield a different result:
Same facts as in the previous example, except that A’s adjusted basis in his S stock is $70,000. On the stock sale to C, A recognizes a gain of $20,000 ($90,000 minus $70,000). The deemed sale would result in a negative adjustment of $15,000 ($30,000 minus $30,000 plus $15,000), just as it did previously. Thus, A’s net gain of $20,000 on the disposition of the interest under is reduced by $15,000, and A has $5,000 net gain with respect to the stock disposition for purposes of computing his net investment income.
Another interesting aspect of the disposition rules is the treatment of installment sales. As a reminder, an installment sale is any sale where at least one payment is to be received after the year of sale. If the underlying asset qualifies, the seller can recognize the gain as payments are received, with part of each payment representing gain, and part representing a return of the seller’s basis in the asset.
The proposed regulations provide that if a taxpayer sells an interest in an S corporation or partnership interest on the installment method, any adjustment to net gain is computed in the year of sale and is taken into account proportionately as each payment is received and gain is recognized.
The regulations go on to provide that if a taxpayer sells an interest in an S corporation or partnership prior to the enactment of Section 1411 (i.e., January 1, 2013), the taxpayer can make an irrevocable election to apply the net gain adjustment rules just discussed.
I take this to mean that that if a taxpayer does not make this election, then all of the gain recognized by the taxpayer in subsequent years under the installment method for sales taking place prior to 2013 will be considered net investment income, with no allowable reduction for the adjustment mandated by the proposed regulations, because those regulations are not effective until January 1, 2013.
If this is indeed the case, taxpayers who have already entered into installment sales that will generate gain beyond 2012 would be well advised to make this election on their 2013 tax return, compute and adjust the net gain resulting from the sale under the proposed regulations, and ensure that they are only including in net investment income the amount of gain that would be recognized after adjustment for the exceptions discussed above.
Here’s how I see this clause of the regulations playing out. Keep in mind, at this point, this is simply my interpretation:
Example: A sells his S corporation stock in December 2012. The S corporation is non-passive to A, it conducts a trade or business, and is not engaged in trading financial instruments. A has basis of $100 in his S stock and sells the stock for $500, resulting in $400 of gain. A sells the stock for five annual payments of $100 each.
Under the installment method, A would recognize $80 of gain when each of the five payments are received. Pursuant to the proposed regulations, A is permitted to reduce his net gain of $400 by the amounts excludable by virtue of the fact that S conducts an active trade or business that is nonpassive to A and is not engaged in the trading of financial instruments. Assume that after following the four-step process discussed above, A is entitled to $400 negative adjustment to his gain for purposes of Section 1411, and thus has no net investment income.
I interpret these regulations as dictating that because the sale occurred prior to the effective date of Section 1411, if A fails to make an election in 2013 to apply the regulations to the installment sale gain, the $80 of gain received during that year — and in each subseuqent year — will be considered net investment income. If this is true, it is in the best interest of A to make the election on his 2013 return and compute the negative adjustment to his gain for net investment income purposes. In that case, each year, when A recognizes $80 of installment sale gain, he will be permitted to reduce the gain by the applicable negative $80 adjustment.
I plan to call the author of the regulations on Monday to confirm my understanding.
In perhaps the most annoying aspects of these proposed regulations, a taxpayer is required to attach a lengthy list of disclosures to his tax return in each year that a taxpayer disposes of S corporation stock or a partnership interest subject to these rules.
10. What to do with real estate professionals. If there’s one area that appears to remain unclear, it’s the treatment of “real estate professionals.” As I mentioned in #3 above, rental activities are considered passive by default unless a taxpayer qualifies as a “real estate professional” under Section 469(c)(7). In general, this requires satisfying two tests:
1. More than one-half of the taxpayer’s personal services performed throughout the year must be performed in real property trades or businesses in which the taxpayer materially participates, and
2. The taxpayer must perform more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.
It has been anticipated that if a taxpayer met these requirements, any rental income would not be subject to the 3.8% surtax. In the preamble to the regulations, however, the IRS ominously states the following:
If a taxpayer meets the requirements to be a real estate professional in section 469(c)(7)(B), the taxpayer’s interests in rental real estate are not (passive), and the rental real estate activities of the taxpayer will not be passive activities if the taxpayer materially participates in each of those activities. However, a taxpayer who qualifies as a real estate professional is not necessarily engaged in a trade or business (within the meaning of section 162) with respect to the rental real estate activities. If the rental real estate activities are section 162 trades or businesses, the rules in section 469(c)(7) and §1.469-9 will apply in determining whether a rental real estate activity of a real estate professional is a passive activity for purposes of section 1411(c)(2)(A). However, if the rental real estate activities of the real estate professional are not section 162 trades or businesses, the gross income from rents derived from such activity will not be excluded under section 1411(c)(1)(A)(i) by the ordinary course of a trade or business exception. The ordinary course of a trade or business exception is inapplicable because the rents are not derived from a trade or business and will therefore be subject to section 1411.
This appears to call into play the age-old question of whether a rental activity rises to the level of a trade or business. If it does, the rental income, by virtue of the exceptions discussed at #4 above for non-passive trades or businesses, will not be considered net investment income. To the contrary, if the rental activity does not rise to the level of a trade or business, the fact that it is no longer treated as passive courtesy of the real estate professional rules will not change the fact that the rental income is considered net investment income.
Unfortunately, there is no bright-line test for whether a rental activity constitutes a trade or business; rather, it requires a facts and circumstances analysis. But in general, the more active and involved the property owner is in the rental, the better chance that it rises to the level of a trade or business. Regardless, this level of ambiguity with such an important issue is concerning.
I plan to follow up with the IRS on Monday with some of these remaining issues. In the meantime, I hope you found this helpful.
