In late November 2013, the Internal Revenue Service issued final regulations on the 3.8 percent Medicare contribution tax on net investment income and the additional 0.9 percent Medicare tax on earned income. The IRS had issued proposed reliance regulations in late 2012. The IRS also issued new proposed reliance regulations in certain areas where significant changes were being made to the 2012 proposed regulations on net investment income.
FINAL REGULATIONS ON NII
In general, the final regulations follow fairly closely the original proposed regulations. A number of clarifications are made and a number of changes proposed by commentators are discussed, along with explanations as to whether each change was adopted or not and why.
In an effort to further define what is included in net investment income, the final regulations discuss what constitutes a trade or business. In general, the regulations still refer to case law and administrative guidance under Code Sec. 162. In the much-discussed area of rental real estate, the final regulations still primarily defer to the facts of a particular case. However, a safe harbor is provided for treatment as a real estate professional. If a taxpayer participates in rental real estate activities for more than 500 hours per year, or if a taxpayer has participated in rental real estate activities for more than 500 hours per year in five of the last 10 years (including prior to the effective date of Code Sec. 1411), then the rental income associated with that activity will be deemed to have been derived in the ordinary course of a trade or business and not subject to NII. Even if the safe harbor is not met, the taxpayer is still free to try to establish under the facts that the rental real estate activities constitute a trade or business and should not be subject to NII.
In determining what constitutes trading in financial instruments or commodities and therefore being subject to NII, concern had been raised that a mismatch could arise with gross income included as income from a trading business (Category II gross income), but trading losses would be subject to the net gain or loss limit on net losses (Category III net gain). To address this concern, the final regulations assign all trading gains and losses to the net gain or loss category (Category III net gain). A dealer using the mark-to-market accounting method under Code Sec. 475 is allowed to deduct excess losses from the trading business against other categories of income. The final regulations also provide a definition of financial instruments and clarify that foreign currency gains and losses are NII unless they are subject to the Self-Employment Contributions Act.
In the case of any taxpayer, the final regulations stick to the position in the 2012 proposed regulations that the net gain calculation under Category III cannot be less than zero. However, the final regulations do effectively loosen the rule in several respects, by allowing the usual $3,000 net capital loss as an offset, and the net gain calculation may consider carryover losses from prior years.
In determining properly allocable deductions for the calculation of NII, the final regulations followed the 2012 proposed regulations fairly closely. Some changes and clarifications were made in the areas of estates and trusts, foreign taxes and tax refunds. With respect to the limitations on properly allocable deductions under Pease limitation and the 2 percent limit on miscellaneous itemized deductions, the final regulations shift from the pro-rata approach of the 2012 proposed regulations to an ordering approach, applying the limitations to reduce the amount of properly allocable itemized deductions only when such deductions exceed the aggregate amount of the overall deductions, regardless of whether they are property allocable or not, that would be allowed after application of the limitations. The final regulations also depart from the 2012 proposed regulations in allowing a computation for a possible limited net operating loss deduction to be properly allocable to gross income included in NII.
In determining whether a trade or business is passive with respect to a taxpayer and therefore subject to NII, the final regulations generally apply the Code Sec. 469 passive-activity rules. However, income that is recharacterized under the rules for significant participation, or property rented incidentally to development activity, and property rented to a non-passive activity, is treated as not being from a passive activity and thus not from a trade or business to which NII applies.
The final regulations also add special rules for self-charged interest and self-charged rental income. Also, the treatment of income, deductions, gains, losses and the use of suspended losses from former passive activities under NII is clarified.
With respect to the taxpayers to whom NII applies, the final regulations discuss its application to dual-resident individuals, dual-status individuals (both a resident alien and a non-resident alien in the same year), electing small-business trusts, charitable remainder trusts, pooled income funds, foreign trusts and estates, and controlled foreign corporations.
PROPOSED REGS ON NII
Where significant changes were being proposed to the 2012 proposed regulations, the IRS issued them in new proposed reliance form.
One significant proposed change is with respect to the treatment of the disposition of a pass-through interest. The 2012 proposed regulations would have required the NII calculation of the gain or loss from the disposition of a pass-through interest to be reduced by the amount of non-passive gain (or loss) that would have been allocated to the transferor upon a hypothetical sale of all of the entity's assets at fair market value. The 2013 proposed regulations instead include gain or loss in NII only to the extent of the gain or loss from the deemed sale of the entity's passive assets. Comments were also invited as to whether special rules are also needed to address partial recognitions, partial dispositions, and distribution transactions. The proposed regulations include a primary calculation method and also an optional simplified method available if the transferor's gain does not exceed $5 million or the transferor's recognized gain on the transaction does not exceed $250,000, with certain exceptions. Comments were also invited on possible alternative simplified methods.
The 2013 proposed regulations would treat Code Sec. 707(b) guaranteed payments received for services as excluded from NII, while guaranteed payments for the use of capital would be included in NII.
Code Sec. 736(b) payments in exchange for a retiring partner's share of partnership property would generally under the 2013 proposed regulations be treated as NII equal to the gain or loss from the disposition of property. If the retiring partner materially participated in the partnership's trade or business, NII could be reduced under the proposed rules for disposition of partnership interests discussed above.
Code Sec. 736(a) payments in exchange for past services or use of capital would be taken into account under NII based on the item's character and treatment for regular income tax purposes.
The 2013 proposed regulations provide an additional special rule for capital loss carryforwards, creating an annual adjustment to prevent excluded capital losses from becoming deductible in future years.
The regulations also provide a look-through rule in an attempt to preclude taxpayers from using common trust funds to recharacterize income that would otherwise be NII.
The 2013 proposed regulations would include the taxable income or net loss of a holder of a REMIC residual interest in NII.
The proposed regulations would treat gross income from a notional principal contract, whether periodic or non-periodic, as NII, but only if the income is derived from a trade or business of trading in financial instruments or commodities.
The 2013 proposed regulations also proposed special rules with respect to charitable remainder trusts that own interests in controlled foreign corporations or passive foreign investment companies.
FINAL REGS ON MEDICARE TAX
The final regulations on the 0.9 percent additional Medicare tax on earned income generally follow the 2012 proposed regulations. Some clarifications are made with respect to handling employer over- and underpayments and employer liability.
EFFECTIVE DATES
Generally, the final regulations and 2013 proposed reliance regulations are effective for tax yeas beginning after Dec. 31, 2013. For tax years beginning before Jan. 1, 2014, taxpayers may rely on either the 2012 proposed regulations or the final regulations and 2013 proposed regulations.
The IRS indicated that any changes made when the 2013 proposed reliance regulations are finalized would be effective prospectively only. As of this writing, final forms for the net investment income tax, Form 8960, and for the 0.9 percent additional Medicare tax, Form 8959, had not been released, but were expected prior to the start of the 2014 tax return filing season.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a part of Wolters Kluwer.
