[Federal Register Volume 77, Number 234 (Wednesday, December 5, 2012)]
[Proposed Rules]
[Pages 72612-72652]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2012-29238]
[[Page 72611]]
Vol. 77
Wednesday,
No. 234
December 5, 2012
Part V
Department of the Treasury
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Internal Revenue Service
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26 CFR Part 1
Net Investment Income Tax; Proposed Rule
Federal Register / Vol. 77 , No. 234 / Wednesday, December 5, 2012 /
Proposed Rules
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-130507-11]
RIN 1545-BK44
Net Investment Income Tax
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations that provide
guidance under section 1411 of the Internal Revenue Code (Code).
Section 1402(a)(1) of the Health Care and Education Reconciliation Act
of 2010 added new section 1411 to the Code effective for taxable years
beginning after December 31, 2012. The proposed regulations affect
individuals, estates, and trusts. This document also contains a notice
of a public hearing on these proposed regulations.
DATES: Written or electronic comments must be received by March 5,
2013.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-130507-11), Room
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand-delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
130507-11), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue NW., Washington, DC, or sent electronically, via the Federal
eRulemaking portal at www.regulations.gov (IRS REG-130507-11).
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Michala Irons, (202) 622-3050, or David H. Kirk, (202) 622-3060;
concerning submissions of comments, the hearing, and/or to be placed on
the building access list to attend the hearing, Oluwafunmilayo (Funmi)
Taylor, (202) 622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in this notice of proposed
rulemaking has been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)). Comments on the collection of information should be
sent to the Office of Management and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP,
Washington, DC 20224. Comments on the collection of information should
be received by February 4, 2013. Comments are specifically requested
concerning:
Whether the proposed collection of information is necessary for the
proper performance of the functions of the IRS, including whether the
information will have practical utility;
The accuracy of the estimated burden associated with the proposed
collection of information; and
Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of services to provide information.
There are two collections of information in the proposed
regulations. The first collection is in proposed Sec. 1.1411-7(d) and
the second collection is in proposed Sec. 1.1411-10(g).
The information collected in proposed Sec. 1.1411-7(d) is required
by the IRS to verify the taxpayer's reported adjustment under section
1411(c)(4). This information will be used to determine whether the
amount of tax has been reported and calculated correctly. The likely
respondents are owners of interests in partnerships and S corporations.
Estimated total annual reporting and/or recordkeeping burden:
315,000 hours.
Estimated average annual burden per respondent: 5 hours.
Estimated number of respondents: 63,000.
Estimated annual frequency of responses: On occasion.
The collection of information in proposed Sec. 1.1411-10(g) is
necessary for the IRS to determine whether a taxpayer has made an
election pursuant to proposed Sec. 1.1411-10(g) and to determine
whether the amount of tax has been reported and calculated correctly.
The likely respondents are individuals, estates, and trusts.
Estimated total annual reporting and/or recordkeeping burden:
62,000 hours.
Estimated average annual burden per respondent: 4 hours.
Estimated number of respondents: 15,500.
Estimated annual frequency of responses: Other (one time).
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by section 6103.
Background
Section 1402(a)(1) of the Health Care and Education Reconciliation
Act of 2010 (Pub. L. 111-152, 124 Stat. 1029) added section 1411 to a
new chapter 2A of subtitle A (Income Taxes) of the Code effective for
taxable years beginning after December 31, 2012. Section 1411 imposes a
3.8 percent tax on certain individuals, estates, and trusts. See
section 1411(a)(1) and (a)(2). The tax does not apply to a nonresident
alien or to a trust all of the unexpired interests in which are devoted
to one or more of the purposes described in section 170(c)(2)(B). See
section 1411(e).
In the case of an individual, section 1411(a)(1) imposes a tax (in
addition to any other tax imposed by subtitle A) for each taxable year
equal to 3.8 percent of the lesser of (A) the individual's net
investment income for such taxable year, or (B) the excess (if any) of
(i) the individual's modified adjusted gross income for such taxable
year, over (ii) the threshold amount. Section 1411(b) provides that the
threshold amount is: (1) In the case of a taxpayer making a joint
return under section 6013 or a surviving spouse (as defined in section
2(a)), $250,000; (2) in the case of a married taxpayer (as defined in
section 7703) filing a separate return, $125,000; and (3) in any other
case, $200,000. Section 1411(d) defines modified adjusted gross income
as adjusted gross income increased by the excess of (1) the amount
excluded from gross income under section 911(a)(1), over (2) the amount
of any deductions (taken into account in computing adjusted gross
income) or exclusions disallowed under section 911(d)(6) with respect
to the amount excluded from gross income under section 911(a)(1).
In the case of an estate or trust, section 1411(a)(2) imposes a tax
(in addition to any other tax imposed by subtitle A) for each taxable
year equal to 3.8 percent of the lesser of (A) the estate's or trust's
undistributed net investment income, or (B) the excess (if any) of (i)
the estate's or trust's adjusted gross income (as defined in section
67(e)) for such taxable year, over (ii) the dollar amount at which the
highest tax bracket in section 1(e) begins for such taxable year.
Section 1402(a)(2) of the Health Care and Education Reconciliation
Act of 2010 also amended section 6654 of the Code to provide that the
tax imposed under chapter 2A (which includes
[[Page 72613]]
section 1411) is subject to the estimated tax provisions.
The tax imposed by section 1411 is not deductible in computing any
tax imposed by subtitle A of the Code. See Joint Committee on Taxation,
General Explanation of Tax Legislation Enacted in the 111th Congress
(JCS-2-11) (March 24, 2011), at 364 (JCT 2011 Explanation).
Amounts collected under section 1411 are not designated for the
Medicare Trust Fund. The Joint Committee on Taxation in 2011 stated
that ``[i]n the case of an individual, estate, or trust an unearned
income Medicare contribution tax is imposed. No provision is made for
the transfer of the tax imposed by this provision from the General Fund
of the United States Treasury to any Trust Fund.'' See JCT 2011
Explanation, at 363; see also Joint Committee on Taxation, Description
of the Social Security Tax Base (JCX-36-11) (June 21, 2011), at 24.
Section 1411(c)(1) provides that net investment income means the
excess (if any) of (A) the sum of (i) gross income from interest,
dividends, annuities, royalties, and rents, other than such income
derived in the ordinary course of a trade or business to which the tax
does not apply, (ii) other gross income derived from a trade or
business to which the tax applies, and (iii) net gain (to the extent
taken into account in computing taxable income) attributable to the
disposition of property other than property held in a trade or business
to which the tax does not apply; over (B) the deductions allowed by
subtitle A which are properly allocable to such gross income or net
gain.
Section 1411(c)(1)(A) defines net investment income, in part, by
reference to trades or businesses described in section 1411(c)(2). A
trade or business is described in section 1411(c)(2) if such trade or
business is (A) a passive activity (within the meaning of section 469)
with respect to the taxpayer, or (B) a trade or business of trading in
financial instruments or commodities (as defined in section 475(e)(2)).
Income on the investment of working capital is not treated as
derived from a trade or business for purposes of section 1411(c)(1) and
is subject to tax under section 1411. See section 1411(c)(3).
In the case of the disposition of an interest in a partnership or
an S corporation, section 1411(c)(4) provides that gain or loss from
such disposition is taken into account for purposes of section
1411(c)(1)(A)(iii) only to the extent of the net gain or net loss which
would be so taken into account by the transferor if all property of the
partnership or S corporation were sold at fair market value immediately
before the disposition of such interest.
Net investment income does not include distributions from a plan or
arrangement described in section 401(a), 403(a), 403(b), 408, 408A, or
457(b). Section 1411(c)(5).
Net investment income also does not include any item taken into
account in determining self-employment income for a taxable year on
which a tax is imposed by section 1401(b). Section 1411(c)(6).
Explanation of Provisions
1. Overview of Proposed Regulations
Proposed Sec. 1.1411-1 provides general operating rules applicable
to section 1411. Proposed Sec. 1.1411-2 provides specific rules
applicable to individuals. Proposed Sec. 1.1411-3 provides specific
rules applicable to estates and trusts. Proposed Sec. 1.1411-4
provides rules for defining net investment income. Proposed Sec.
1.1411-5 provides rules for net investment income derived from trades
or businesses that are passive activities or trading in financial
instruments or commodities. Proposed Sec. 1.1411-6 provides rules for
gross income and net gain on the investment of working capital.
Proposed Sec. 1.1411-7 provides rules for dispositions of interests in
partnerships and S corporations. Proposed Sec. 1.1411-8 provides rules
for distributions from certain qualified plans. Proposed Sec. 1.1411-9
provides rules for items taken into account in determining self-
employment income. Proposed Sec. 1.1411-10 provides rules with respect
to controlled foreign corporations and passive foreign investment
companies. Finally, proposed Sec. 1.469-11(b)(3)(iv) provides a
regrouping ``fresh start'' under section 469 for certain taxpayers.
2. In General
Section 1411 (which constitutes chapter 2A of the Code) contains
terms commonly used in Federal income taxation and cross-references
certain provisions of chapter 1 such as sections 67(e), 469, 401(a),
and 475(e)(2). However, other than these specific cross-references to
provisions of chapter 1, and certain specific definitions set forth in
section 1411, section 1411 does not provide definitions of its
operative phrases or terminology. Moreover, there is no indication in
the legislative history of section 1411 that Congress intended, in
every event, that a term used in section 1411 would have the same
meaning ascribed to it for other Federal income tax purposes (such as
chapter 1). Accordingly, the definitional rules set forth in the
proposed regulations are designed to promote the fair administration of
section 1411 while preventing circumvention of the purposes of the
statute. One of the general purposes of section 1411 is to impose a tax
on unearned income or investments of certain individuals, estates, and
trusts.
Under these proposed regulations, except as otherwise provided,
chapter 1 principles and rules apply in determining the tax under
section 1411. Consistent with this general approach, except as
otherwise provided in the proposed regulations, gain that is not
recognized under chapter 1 for a taxable year is not recognized for
that year for purposes of section 1411 (for example, gain deferred or
excluded under section 453 (installment method), section 1031 (like-
kind exchanges), section 1033 (involuntary conversions), or section 121
(sale of principal residence)). Deferral or disallowance provisions of
chapter 1 used in determining adjusted gross income apply to the
determination of net investment income (for example, section 163(d)
(limitation on investment interest), section 265 (expenses and interest
relating to tax-exempt income), section 465(a)(2) (at risk
limitations), section 469(b) (passive activity loss limitations),
section 704(d) (partner loss limitations), section 1212(b) (capital
loss carryover limitations), or section 1366(d)(2) (S corporation
shareholder loss limitations)). A deduction carried over to a taxable
year by reason of section 163(d), section 465(a)(2), section 469(b),
section 704(d), section 1212(b), or section 1366(d)(2) and allowed for
that taxable year in determining adjusted gross income is also allowed
for the determination of net investment income, whether or not the
taxable year from which the deduction is carried precedes the effective
date of section 1411.
However, the proposed regulations modify the chapter 1 rules in
certain respects in order to prevent circumvention of the purposes of
the statute. For example, substitute interest and dividends, which are
included in gross income under chapter 1, are net investment income
even though these amounts are not categorically ``interest'' and
``dividends'' under chapter 1. In addition, while an item of income
that is specifically excluded from gross income under chapter 1
generally also is excluded from net investment income under section
1411 (for example, tax-exempt interest), distributions described in
section 959(d) or section 1293(c), excess distributions under section
1291 that are dividends, and gains that are treated as excess
distributions under section 1291 (which are discussed in
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part 11.B of this preamble) are net investment income under chapter 2A.
Proposed Sec. 1.1411-1(b) provides generally that all references
to an individual's adjusted gross income shall be treated as references
to adjusted gross income (as defined in section 62) and that all
references to an estate's or trust's adjusted gross income shall be
treated as references to adjusted gross income (as defined in section
67(e)). As provided in part 11 of this preamble, there may be
adjustments to adjusted gross income as a result of investments in
controlled foreign corporations and passive foreign investment
companies.
The IRS will closely review transactions that manipulate a
taxpayer's net investment income to reduce or eliminate the amount of
tax imposed by section 1411. In appropriate circumstances, the IRS will
challenge such transactions based on applicable statutes and judicial
doctrines. Thus, for example, if an investment arrangement that in form
gives rise to income that does not constitute net investment income is
in substance properly treated for Federal tax purposes as the holding
of securities by one party as agent for another, the arrangement will
be taxed in accordance with its substance.
3. Application to Individuals
A. In General
Section 1411(a)(1) imposes a tax on individuals, but section
1411(e)(1) provides that section 1411 does not apply to a nonresident
alien. The proposed regulations provide that the term individual for
purposes of section 1411 is any natural person, except for natural
persons who are nonresident aliens. Therefore, section 1411 applies to
any citizen or resident of the United States (within the meaning of
section 7701(a)(30)(A)).
The amount of the tax on individuals is equal to 3.8 percent of the
lesser of two amounts: (A) An individual's net investment income for
such taxable year, or (B) the excess (if any) of (i) the individual's
modified adjusted gross income for such taxable year, over (ii) the
threshold amount. For example, if an unmarried U.S. citizen has
modified adjusted gross income (as defined in section 1411(d) and
proposed Sec. 1.1411-2(c)) of $190,000, which includes $50,000 of net
investment income (as defined in section 1411(c)(1) and proposed Sec.
1.1411-4), there is no tax imposed under section 1411 because the
threshold amount for a single individual is $200,000 (see section
1411(b)(3) and proposed Sec. 1.1411-2(d)(1)(iii)). On the other hand,
if that individual has modified adjusted gross income of $220,000,
which includes net investment income of $50,000, the individual has a
section 1411 tax of $760 (3.8 percent times $20,000).
The proposed regulations also clarify the treatment of (1) grantor
trusts (see proposed Sec. Sec. 1.1411-2(a)(2)(ii), 1.1411-3(b)(5), and
part 4.B.ii of this preamble), (2) certain bankruptcy estates (see
proposed Sec. Sec. 1.1411-2(a)(2)(iii), 1.1411-3(d)(1), and part 4.D
of this preamble), and (3) bona fide residents of the U.S. territories
(see proposed Sec. 1.1411-2(a)(2)(iv) and part 3.C of this preamble).
B. Joint Returns in the Case of a Nonresident Alien Individual Married
to a U.S. Citizen or Resident
Proposed Sec. 1.1411-2(a)(2)(i) addresses certain joint returns
filed by married individuals. Proposed Sec. 1.1411-2(a)(2)(i)(A)
provides that in the case of a U.S. citizen or resident who is married
(as defined in section 7703) to a nonresident alien individual, the
spouses will be treated as married filing separately for purposes of
section 1411. For purposes of calculating the tax imposed under section
1411(a)(1), the U.S. citizen or resident spouse will be subject to the
threshold amount in section 1411(b)(2) ($125,000) for a married
taxpayer filing a separate return, and the nonresident alien spouse
will be exempt from section 1411 taxation under section 1411(e)(1). In
accordance with the rules for married taxpayers filing separate
returns, the U.S. citizen or resident spouse must determine his or her
own net investment income and modified adjusted gross income.
In general, section 6013(a) provides that no joint return may be
made by married taxpayers if either spouse is a nonresident alien at
any time during a taxable year. Section 6013(g), however, generally
permits a nonresident alien individual married to a citizen or resident
of the United States to elect for purposes of chapter 1 and chapter 24
of the Code to be treated as a resident of the United States. Proposed
Sec. 1.1411-2(a)(2)(i)(B) provides that married taxpayers who file a
joint Federal income tax return pursuant to a section 6013(g) election
can also elect to be treated as making a section 6013(g) election for
purposes of chapter 2A of the Code. For purposes of calculating the tax
imposed under section 1411(a)(1), the effect of such an election is to
include the combined income of the U.S. citizen or resident spouse and
the nonresident spouse in the section 1411(a)(1) calculation and
subject that income to the threshold amount in section 1411(b)(1)
($250,000) for a taxpayer filing a joint return. Proposed Sec. 1.1411-
2(a)(2)(i)(B)(2) provides procedural requirements for making this
election.
C. Bona Fide Residents of U.S. Territories
Proposed Sec. 1.1411-2(a)(2)(iv) provides guidance on the
application of section 1411 to individuals who are bona fide residents
(within the meaning of section 937(a)) of possessions of the United
States (U.S. territories) (namely, American Samoa, Guam, the Northern
Mariana Islands, Puerto Rico, and the United States Virgin Islands). An
individual who is a citizen, resident, or nonresident alien with
respect to the United States may qualify as a bona fide resident of a
U.S. territory.
The application of the tax under section 1411 to a bona fide
resident of a U.S. territory depends on whether the U.S. territory has
a mirror code system of taxation, meaning the income tax laws are
generally identical to the Code (except for the substitution of the
name of the relevant territory for the term ``United States'' where
appropriate). Three of the five U.S. territories (Guam, the Northern
Mariana Islands, and the United States Virgin Islands) have a mirror
code.
Bona fide residents of U.S. territories that are mirror code
jurisdictions have no income tax obligation (or related return filing
requirement) with the United States provided, generally, that they
properly report income and pay income tax to the tax administration of
their respective U.S. territory. See generally sections 932, 934, and
935. Therefore, the tax imposed by section 1411(a) generally does not
apply to bona fide residents of mirror code jurisdictions because they
will not have an income tax liability to the United States if they
fully comply with the tax laws of the relevant territory.
Bona fide residents of non-mirror code jurisdictions (American
Samoa and Puerto Rico) generally exclude territory-source income from
U.S. Federal gross income under sections 931 and 933, respectively.
(American Samoa currently is the only territory to which section 931
applies because it is the only territory that has entered into an
implementing agreement under sections 1271(b) and 1277(b) of the Tax
Reform Act of 1986.) Although territory-source income is excluded,
these bona fide residents are subject to U.S. Federal income taxation,
and have a related income tax return filing requirement with the United
States to the extent they have U.S.-source or other non-territory
source income or income from amounts paid for services performed as an
[[Page 72615]]
employee of the United States or any agency thereof (collectively, U.S.
reportable income). See section 931(a) and (d) and section 933.
Furthermore, under section 876 and Sec. 1.876-1, bona fide residents
of non-mirror code jurisdictions who are nonresident aliens with
respect to the United States are subject to net-basis U.S. taxation on
U.S. reportable income under sections 1 and 55, rather than to gross-
basis U.S. taxation with respect to U.S.-source income under sections
871 through 879 (provisions that otherwise generally apply to
nonresident aliens with respect to U.S.-source income).
Therefore, the tax imposed under section 1411(a) is applicable to
bona fide residents of non-mirror code jurisdictions if they have U.S.
reportable income that gives rise to both net investment income and
modified adjusted gross income exceeding the threshold amount in
section 1411. However, section 1411(a) does not apply if such bona fide
residents are nonresident alien individuals with respect to the United
States because section 1411(e)(1) and proposed Sec. 1.1411-2(a)(1)
exclude from section 1411(a) all nonresident alien individuals, which
would include bona fide residents of any U.S. territory. However,
nonresident alien individuals who are bona fide residents of non-mirror
code jurisdictions remain subject to taxation under chapter 1 of
subtitle A pursuant to section 876.
D. Modified Adjusted Gross Income
For purposes of section 1411 and the regulations thereunder, the
term modified adjusted gross income is defined in section 1411(d) and
proposed Sec. 1.1411-2(c)(1) as adjusted gross income increased by the
excess of (1) the amount excluded from gross income under section
911(a)(1), over (2) the amount of any deductions (taken into account in
computing adjusted gross income) or exclusions disallowed under section
911(d)(6) with respect to the amounts excluded from gross income under
section 911(a)(1). See part 11 of this preamble for additional
discussion on adjustments to modified adjusted gross income with
respect to the ownership of interests in controlled foreign
corporations and passive foreign investment companies.
E. Threshold Amount
For purposes of section 1411(a)(1) and (b) and the regulations
thereunder, the term threshold amount for an individual means (1) in
the case of a taxpayer making a joint return under section 6013 or a
surviving spouse (as defined in section 2(a)), $250,000, (2) in the
case of a married taxpayer (as defined in section 7703) filing a
separate return, $125,000, and (3) in any other case, $200,000. For
special rules regarding a nonresident alien individual married to U.S.
citizen or resident, see proposed Sec. 1.1411-2(a)(2)(i) and part 3.B
of this preamble. For rules regarding certain bankruptcy estates, see
proposed Sec. Sec. 1.1411-2(a)(2)(iii), 1.1411-3(d)(1), and part 4.D
of this preamble. The threshold amount is not indexed for inflation.
Under the proposed regulations, the threshold amount is generally
not prorated in the case of a short taxable year of an individual.
However, the proposed regulations provide a special rule in the case of
an individual who has a short taxable year resulting from a change of
annual accounting period. Under section 443(b)(1), a taxpayer that
undergoes a change in annual accounting period under section 442 and
has a short period must annualize its taxable income. The taxpayer's
Federal income tax is the tax computed on the annualized taxable income
by multiplying the taxable income for the short period by twelve and
dividing the result by the number of months in the short period.
Proposed Sec. 1.1411-2(d)(2)(ii) provides that an individual taxpayer
that has a short period resulting from a change of annual accounting
period shall reduce the applicable threshold amount to an amount that
bears the same ratio to the full threshold amount provided under
section 1411(b) as the number of months in the short period bears to
twelve.
4. Application to Estates and Trusts
In general, section 1411(a)(2) imposes a tax of 3.8 percent on
estates and trusts on the lesser of their undistributed net investment
income or the excess of their adjusted gross income (as defined in
section 67(e)) over the dollar amount at which the highest tax bracket
in section 1(e) begins for such taxable year. Proposed Sec. 1.1411-3
provides special rules for applying section 1411 to estates and trusts,
including an estate or trust with a short taxable year resulting from
the formation or termination of the estate or trust or a change in
accounting period.
A. Trusts Subject to Section 1411
Because Congress did not provide a rule specifying the particular
trusts subject to section 1411, the Treasury Department and the IRS
have determined that section 1411 applies to ordinary trusts described
in Sec. 301.7701-4(a). The general rule set forth in proposed Sec.
1.1411-3(a)(1)(i) (that section 1411 applies to all estates and trusts
that are subject to the provisions of part I of subchapter J of chapter
1 of subtitle A of the Code) implements this approach. This rule
excludes from the application of section 1411 business trusts described
in Sec. 301.7701-4(b), which are treated as business entities under
Sec. 301.7701-2 and as eligible entities for purposes of entity
classification in Sec. 301.7701-3. Accordingly, such trusts are not
subject to section 1411 at the entity level.
In addition, the general rule excludes certain state law trusts
that are subject to specific taxation regimes in chapter 1 other than
part I of subchapter J. This exclusion is consistent with the exception
in the entity classification regulations for entities where a specific
provision of the Code provides for special treatment of that
organization. See Sec. 301.7701-1(b). Examples of these trusts include
common trust funds taxed under section 584 and expressly not subject to
taxation under chapter 1 (per section 584(b)) and designated settlement
funds taxed under section 468B in lieu of any other taxation under
subtitle A (per section 468B(b)(4)).
However, section 1411 does apply to trusts subject to the
provisions of part I of subchapter J, even though such trusts may have
special computational rules within those provisions. These trusts
include pooled income funds described in section 642(c)(5), cemetery
perpetual care funds described in section 642(i), and qualified funeral
trusts described in section 685. Similarly, section 1411 applies to
certain Alaska Native settlement trusts described in section 646 (if
that provision is in effect after the effective date of section 1411).
The Treasury Department and the IRS request comments as to whether
there may be administrative reasons to exclude one or more of these
types of trusts from section 1411.
B. Application to Specific Trusts
i. Tax-Exempt Trusts
Section 1411 is in subtitle A. As a result, section 1411 does not
apply to any trust, fund, or other special account that is exempt from
tax imposed under subtitle A. This exclusion applies even if such trust
may be subject to tax under section 511 on its unrelated business
taxable income (and even if the trust's unrelated business taxable
income is comprised of net investment income). Accordingly, the
proposed regulations provide that any account, fund, or trust that is
exempt from taxation under subtitle A (for example, sections 501(a),
664(c)(1), 220(e)(1), 223(e)(1), 529(a), and 530(a)) is also exempt
from section 1411.
[[Page 72616]]
Section 1411(e)(2) specifically excepts from the application of
section 1411 a trust all of the unexpired interests in which are
devoted to one or more of the purposes described in section
170(c)(2)(B). See proposed Sec. 1.1411-3(b)(1).
ii. Grantor Trusts
A grantor trust is a trust or any portion thereof that is treated
as being owned by the grantor or another person under subpart E of
subchapter J (see sections 671 through 679). The owner must compute the
owner's taxable income and credits by including the items of income,
deduction, and credit against the tax attributable to the trust or the
portion thereof treated as being owned by the owner. Thus, a grantor
trust's income is not taxed as trust income but instead is treated as
being the income of (and taxable to) the owner. The same rule applies
for purposes of section 1411, thereby providing a consistent
application of the grantor trust rules. This approach is also
consistent with the IRS's position that the application of section 671
is not limited to chapter 1 of subtitle A. See Notice 97-24 (1997-1 CB
409); see Sec. 601.601(d)(2).
Proposed Sec. 1.1411-3(b)(5) provides that the tax under section
1411 is not imposed on a grantor trust, but if a grantor or another
person is treated as the owner of all or a portion of a trust under
subpart E of part I of subchapter J of chapter 1 any items of income,
deduction, or credit that are included in computing taxable income of
such grantor or other person under section 671 shall be treated as if
such items had been received or paid directly by the grantor or other
person for purposes of calculating such person's net investment income.
iii. Electing Small Business Trusts (ESBTs)
Proposed Sec. 1.1411-3(c)(1) provides special computational rules
for ESBTs. For purposes of chapter 1, section 641(c)(1) provides that
(A) the portion of any ESBT which consists of stock in one or more S
corporations shall be treated as a separate trust, and (B) the amount
of the tax imposed by chapter 1 on such separate trust shall be
determined with certain modifications detailed in section 641(c)(2).
Section 1.641(c)-1(a) provides that an ESBT is treated as two separate
trusts for purposes of chapter 1.
The proposed regulations preserve the chapter 1 treatment of the
ESBT as two separate trusts for computational purposes but consolidates
the ESBT into a single trust for determining the adjusted gross income
threshold in section 1411(a)(2)(B)(ii). This rule applies a single
section 1(e) threshold so as to not inequitably benefit ESBTs over
other taxable trusts.
Proposed Sec. 1.1411-3(c)(1)(ii) provides the method to determine
the ESBT's section 1411 tax base. First, the ESBT will separately
calculate the undistributed net investment income of the S portion and
non-S portion in accordance with the general rules for trusts under
chapter 1, and combine the undistributed net investment income of the S
portion and the non-S portion. Second, the ESBT will determine its
adjusted gross income, solely for purposes of section 1411, by adding
the net income or net loss from the S portion to that of the non-S
portion as a single item of income or loss. Finally, to determine
whether the ESBT is subject to section 1411, and if so, the section
1411 tax base, the ESBT will compare the combined undistributed net
investment income with the excess of its adjusted gross income over the
section 1(e) threshold.
iv. Charitable Remainder Trusts
Proposed Sec. 1.1411-3(c)(2) provides special computational rules
for charitable remainder trusts. Although the trust itself is not
subject to section 1411 as provided in proposed Sec. 1.1411-3(b)(3),
annuity and unitrust distributions may be net investment income to the
non-charitable recipient beneficiary. Proposed Sec. 1.1411-3(c)(2)
provides special rules to maintain the character and distribution
ordering rules of Sec. 1.664-1(d) for purposes of section 1411. The
Treasury Department and the IRS are proposing these rules to determine
whether items of income allocated to annuity or unitrust payments
constitute net investment income to the recipient beneficiary.
Proposed Sec. 1.1411-3(c)(2)(i) provides that distributions from a
charitable remainder trust to a beneficiary for a taxable year consist
of net investment income in an amount equal to the lesser of the total
amount of the distributions for that year, or the current and
accumulated net investment income of the charitable remainder trust.
For charitable remainder trusts with multiple annuity or unitrust
beneficiaries, the trust shall apportion the net investment income
among the beneficiaries based on their respective shares of the total
annuity or unitrust amount paid by the trust for that taxable year.
Proposed Sec. 1.1411-3(c)(2)(ii) defines the term accumulated net
investment income as the total amount of net investment income received
by a charitable remainder trust for all taxable years beginning after
December 31, 2012, less the total amount of net investment income
distributed for all prior taxable years beginning after December 31,
2012.
Thus, under proposed Sec. 1.1411-3(c)(2), current and accumulated
net investment income of the trust is deemed to be distributed before
amounts that are not items of net investment income for purposes of
section 1411. This classification of income as net investment income or
non-net investment income is separate from, and in addition to, the
four tiers under section 664(b), which continue to apply.
The Treasury Department and the IRS considered an alternative
method for determining the distributed amount of net investment income
in which net investment income would be determined on a class-by-class
basis within each of the Sec. 1.664-1(d)(1) enumerated categories.
Under this alternative method, trustees would need to account for
additional classes of income within each category, consistent with
Sec. 1.664-1(d)(1)(i), for taxable years beginning after December 31,
2012. The alternative method would create a sub-class system of net
investment income and non-net investment income within each class and
category of the section 664 framework. Although differentiating between
net investment income and non-net investment income within each class
and category might be considered more consistent with the structure
created for charitable remainder trusts by section 664 and the
corresponding regulations, the Treasury Department and the IRS believe
that the recordkeeping and compliance burden that would be imposed on
trustees by this alternative would outweigh the benefits.
C. Foreign Estates and Foreign Trusts
Section 1411 does not specifically address the treatment of foreign
estates and foreign nongrantor trusts. See part 4.B.ii of this preamble
for the rules that apply if the foreign trust is treated as owned by a
grantor or another person under sections 671 through 679. The Treasury
Department and the IRS believe that section 1411 should not apply to
foreign estates and foreign trusts that have little or no connection to
the United States (for example, if none of the beneficiaries is a
United States person). Accordingly, proposed Sec. Sec. 1.1411-
3(d)(2)(i) and 1.1411-3(b)(6) provide, as a general rule, that foreign
estates and foreign trusts are not subject to section 1411. The
Treasury Department and the IRS believe, however, that net investment
income of
[[Page 72617]]
a foreign estate or foreign trust should be subject to section 1411 to
the extent such income is earned or accumulated for the benefit of, or
distributed to, United States persons. The taxation of United States
beneficiaries receiving current distributions of net investment income
from a foreign estate or foreign nongrantor trust will be consistent
with the general operation of subparts A through D of part I of
subchapter J and will be subject to section 1411. See proposed
Sec. Sec. 1.1411-4(e) and 1.1411-3(e)(3).
Proposed Sec. Sec. 1.1411-3(d)(2)(ii) and 1.1411-3(c)(3) reserve
on the application of section 1411 to foreign estates and foreign
trusts with United States beneficiaries. The Treasury Department and
the IRS request comments on the application of section 1411 to net
investment income of foreign estates and foreign trusts that is earned
or accumulated for the benefit of United States beneficiaries,
including whether section 1411 should be applied to the foreign estate
or foreign trust, or to the United States beneficiaries upon an
accumulation distribution. Regarding the application of section 1411 to
the foreign estate or foreign trust, consideration is being given to
whether the definition of a United States beneficiary should exclude
contingent or future beneficiaries and to adoption of an exclusion from
section 1411 for foreign pension funds that are treated as trusts for
United States tax purposes. To the extent that the final regulations do
not subject foreign estates or foreign trusts to tax under section
1411, the Treasury Department and IRS request comments on how section
1411 should apply to United States persons that receive accumulation
distributions from foreign estates and foreign trusts, including the
means by which to identify such distributions as net investment income.
D. Bankruptcy Estates
A bankruptcy estate of a debtor who is an individual is treated as
an individual for purposes of computing the tax under section 1411.
Section 1398 provides rules for the taxation of bankruptcy estates in
chapter 7 and chapter 11 cases under the Bankruptcy Code in which the
debtor is an individual. In these cases, the bankruptcy estate computes
its tax in the same manner as an individual. Section 1398(c)(2)
provides that the tax rate under section 1 for the bankruptcy estate is
the same as that imposed on a married taxpayer filing separately, and
section 1398(c)(3) provides that the bankruptcy estate is entitled to a
standard deduction of a married taxpayer filing separately. Therefore,
consistent with section 1398, regardless of the actual marital status
of the debtor, a bankruptcy estate of a debtor who is an individual is
treated as a married taxpayer filing separately for purposes of the
thresholds in section 1411(b), and therefore the threshold amount
applicable to such a bankruptcy estate is $125,000.
E. Calculation of Undistributed Net Investment Income
Under section 1411(a)(2), the tax under section 1411 is imposed on
the lesser of (A) the undistributed net investment income of the estate
or trust for such year, or (B) the excess (if any) of the adjusted
gross income (as defined in section 67(e)) for the taxable year, over
the dollar amount at which the highest tax bracket in section 1(e)
begins for such taxable year. Thus, similar to the computation for
individuals, it is the lesser of two amounts. Net investment income is
defined in section 1411(c)(1) and proposed Sec. 1.1411-4, and this
same definition applies to individuals, estates, and trusts.
Undistributed net investment income is a section 1411 term used solely
for estates and trusts (and not individuals), and is not defined in
section 1411. The proposed regulations conform the taxation of estates
and trusts under section 1411 to the rules of part I of subchapter J to
avoid double taxation of net investment income and the taxation of
amounts distributed to charities.
The proposed regulations give effect to the provisions of
subchapter J that treat an estate or trust as a conduit by reducing the
estate's or trust's taxable income to take into account distributions
to beneficiaries and the charitable deduction. The proposed
regulations, accordingly, provide that undistributed net investment
income of an estate or trust is its net investment income (as
determined under proposed Sec. 1.1411-4) reduced by the share of net
investment income included in the deductions of the estate or trust
under section 651 or section 661, and the share of net investment
income allocated to the section 642(c) deduction of the estate or trust
in accordance with Sec. 1.642(c)-2(b) and the allocation and ordering
rules under Sec. 1.662(b)-2. The proposed regulations adopt the class
system of income categorization, generally embodied in sections 651
through 663 and the regulations thereunder, to arrive at the trust's
net investment income reduction in the case of distributions that are
comprised of both net investment income and net excluded income items.
For this purpose, the term excluded income includes items that are not
includible in net investment income by either specific exclusion under
chapter 1 (for example, interest on state and local bonds under section
103(a)); specific exclusion contained in section 1411 (for example,
section 1411(c)(5) or (6)) or the proposed regulations; or are not
specifically included in section 1411(c)(1)(A) or elsewhere in the
proposed regulations.
5. Definition of Net Investment Income
Section 1411(c)(1) defines net investment income as the excess (if
any) of (A) the sum of (i) gross income from interest, dividends,
annuities, royalties, and rents, other than such income derived in the
ordinary course of a trade or business to which the tax does not apply,
(ii) other gross income from trades or businesses to which the tax
applies, and (iii) net gain (to the extent taken into account in
computing taxable income) attributable to the disposition of property
other than property held in a trade or business to which the tax does
not apply, over (B) deductions allowed by subtitle A which are properly
allocable to such gross income or net gain.
If items of net investment income (including the properly allocable
deductions) pass through to an individual, estate, or trust from a
partnership or S corporation, the allocation of such items must be
separately stated under section 702 or section 1366 and the regulations
thereunder.
A. Gross Income Items Described in Section 1411(c)(1)(A)(i)
i. In General
The proposed regulations provide that net investment income
includes, in part, gross income from interest, dividends, annuities,
royalties, and rents. However, such income is excluded from net
investment income if it is derived in the ordinary course of a trade or
business not described in section 1411(c)(2). This exclusion is
described in part 5.A.vi of this preamble.
ii. Interest and Dividends
(a) In General
Gross income from interest includes any item treated as interest
for purposes of chapter 1, and includes substitute interest (as
discussed in part 5.A.ii.(b) of this preamble).
Gross income from dividends includes any item treated as a dividend
for purposes of chapter 1. This includes, but is not limited to,
amounts treated as dividends pursuant to subchapter C that are included
in gross income (including
[[Page 72618]]
constructive dividends); amounts treated as dividends under section
1248(a); amounts treated as dividends under Sec. 1.367(b)-2(e)(2); and
amounts treated as dividends under section 1368(c)(2). In addition, as
discussed in part 5.A.ii.(b) and part 11 of this preamble, substitute
dividends, distributions from previously taxed earnings and profits
(within the meaning of section 959(d) or section 1293(c)), and certain
excess distributions (within the meaning of section 1291(b)) are
included in net investment income.
Gross income from notional principal contracts (within the meaning
of Sec. 1.446-3(c)) is not included in net investment income under
section 1411(c)(1)(A)(i). However, if gross income from notional
principal contracts is derived in a trade or business described in
proposed Sec. 1.1411-5, all of such gross income is included in net
investment income under section 1411(c)(1)(A)(ii). In addition, gain on
a disposition of a notional principal contract is included in net
investment income under either section 1411(c)(1)(A)(ii) or section
1411(c)(1)(A)(iii) (see parts 5.B and 5.C of this preamble).
(b) Substitute Interest and Substitute Dividends
A substitute interest payment or a substitute dividend payment made
to the transferor of a security in a securities lending transaction or
a sale-repurchase transaction is treated as an interest payment or
dividend payment, as applicable, for purposes of section 1411, and thus
as net investment income for purposes of proposed Sec. 1.1411-
4(a)(1)(i). If substitute interest and substitute dividend payments
were not treated in this manner, the Treasury Department and the IRS
believe that taxpayers could easily avoid the section 1411 tax with
respect to interest or dividend income by lending their securities over
a payment date. The Treasury Department and the IRS do not believe that
Congress intended the imposition of the section 1411 tax to turn on
transactional formalities that are so readily manipulated by well-
advised taxpayers. This approach is consistent with other contexts in
which substitute interest and dividend payments have been treated in
the same manner as actual interest or dividend payments in order to
preclude avoidance of tax. For example, regulations under sections 861,
871, and 881 treat substitute interest and dividend payments as having
the same source and the same character as the actual interest or
dividend payments for which they substitute in order to preclude
avoidance of nonresident withholding tax. See Sec. Sec. 1.861-2(a)(7);
1.861-3(a)(6); 1.871-7(b)(2); and 1.881-2(b)(2).
In certain other contexts, substitute payments are not treated in
the same manner as actual interest or dividend payments (for example, a
substitute dividend payment is not eligible for the dividends received
deduction or for the lower rate of tax applicable to qualified
dividends under section 1(h)(11)). In those contexts, however,
disparate treatment serves essentially the same purpose, that is, to
preclude the avoidance of tax through the multiplication of tax
benefits or tax exclusions. The Treasury Department and the IRS believe
that it is appropriate to treat substitute payments in a manner that
precludes their use to facilitate tax avoidance. Accordingly, these
proposed regulations treat substitute interest and substitute dividends
as interest and dividends for purposes of determining net investment
income.
(c) Controlled Foreign Corporations and Passive Foreign Investment
Companies
Special rules apply to a United States shareholder of a controlled
foreign corporation or a United States person who owns stock in a
passive foreign investment company. See part 11 of this preamble.
iii. Annuities
Gross income from annuities includes the amount received as an
annuity under an annuity, endowment, or life insurance contract that is
includible in gross income as a result of the application of section
72(a) and section 72(b), and an amount not received as an annuity under
an annuity contract that is includible in gross income under section
72(e).
The Code does not define the term annuity. Section 72(a) provides
that gross income includes any amount received as an annuity under an
annuity, endowment, or life insurance contract. Section 72(b), however,
excludes from gross income that part of an amount received as an
annuity that bears the same ratio to that amount as the investment in
the contract bears to the expected return under the contract
(determined as of the annuity starting date).
Section 72(e) governs the treatment of amounts received under an
annuity contract that are not received as an annuity (such as lump sum
distributions or surrenders). Section 72(e)(2) provides in general that
such amounts received on or after the annuity starting date are
included in gross income, and that amounts received before the annuity
starting date are included in gross income to the extent allocable to
income on the contract on an income-first basis.
Gain or loss from the sale of an annuity would be treated as net
investment income for purposes of section 1411. To the extent the sales
price of the annuity does not exceed its surrender value, the gain
recognized would be treated as gross income described in section
1411(c)(1)(A)(i) and proposed Sec. 1.1411-4(a)(1)(i). If the sales
price of the annuity exceeds its surrender value, the seller would
treat the gain equal to the difference between the basis in the annuity
and the surrender value as gross income described in section
1411(c)(1)(A)(i) and proposed Sec. 1.1411-4(a)(1)(i), and would treat
the excess of the sales price over the surrender value as gain from the
disposition of property under section 1411(c)(1)(A)(iii) and proposed
Sec. 1.1411-4(a)(1)(iii).
iv. Royalties
Gross income from royalties includes amounts received from mineral,
oil, and gas royalties, and amounts received for the privilege of using
patents, copyrights, secret processes and formulas, goodwill,
trademarks, tradebrands, franchises, and other like property.
v. Rents
Gross income from rents includes amounts paid or to be paid
principally for the use of (or the right to use) tangible property.
vi. Ordinary Course of a Trade or Business Exception
The items described in parts 5.A.ii through 5.A.v of this preamble
are not included in net investment income by reason of section
1411(c)(1)(A)(i) if the item meets the ordinary course of a trade or
business exception. See proposed Sec. 1.1411-4(b). The ordinary course
of a trade or business exception is a two-part test. First, the item
must be ``derived in'' a trade or business not described in section
1411(c)(2). Second, if the item is derived in a trade or business not
described in section 1411(c)(2), then such item must also be derived in
the ``ordinary course'' of such trade or business. As explained in part
6 of this preamble, a trade or business described in section 1411(c)(2)
is either a trade or business that is (A) a passive activity (within
the meaning of section 469) with respect to the taxpayer, or (B)
trading in financial instruments (as defined in proposed Sec. 1.1411-
5(c)(1)) or commodities (as defined in section 475(e)(2)).
[[Page 72619]]
(a) Derived In
In order for an item of gross income described in section
1411(c)(1)(A)(i) to be excluded from section 1411 under the ordinary
course of a trade or business exception, the income must be derived in
a trade or business that is neither a passive activity with respect to
the taxpayer (as described in section 1411(c)(2)(A) and the regulations
thereunder) nor a trade or business of trading in financial instruments
or commodities (as described in section 1411(c)(2)(B) and the
regulations thereunder).
In the case of an individual who is engaged in the conduct of a
trade or business directly (for example, a sole proprietor) or through
ownership of an interest in an entity that is disregarded as an entity
separate from the individual owner under Sec. 301.7701-3, the
determination of whether an item of gross income is derived in a trade
or business described in section 1411(c)(2)(A) or (B) is made at the
individual level. For example, if A, an individual, is engaged in a
trade or business that is not described in section 1411(c)(2) and the
trade or business has gross income (for example, royalties), such gross
income is derived in A's trade or business, and therefore A meets the
first part of the ordinary course of a trade or business exception.
However, if A's trade or business is a passive activity with respect to
A or if A's trade or business is trading in financial instruments or
commodities, the ordinary course of a trade or business exception will
be inapplicable because the income is derived in a trade or business
described in section 1411(c)(2).
In the case of an individual, estate, or trust that owns an
interest in a trade or business through one or more passthrough
entities (a partnership or an S corporation), the determination of
whether an item of gross income described in section 1411(c)(1)(A)(i)
allocated to the individual, estate, or trust from the passthrough
entity is derived in a trade or business described in section
1411(c)(2)(A) (a passive activity with respect to the taxpayer) or
section 1411(c)(2)(B) (trading in financial instruments or commodities)
is made in the following manner. The determination of whether the trade
or business from which the income is derived is a passive activity with
respect to the taxpayer is determined at the taxpayer (individual,
estate, or trust) level in accordance with the general principles of
section 469. For example, if A, an individual, owns an interest in PRS,
a partnership, which is engaged in a trade or business, the
determination of whether PRS's trade or business is a passive activity
with respect to A is made in accordance with section 469 and the
regulations under that section. See part 6.B of this preamble for rules
to determine whether a trade or business is a passive activity with
respect to a taxpayer.
On the other hand, the determination of whether the trade or
business from which the income is derived is a trade or business of
trading in financial instruments or commodities is made at the
passthrough entity level (the partnership or S corporation level). If
the passthrough entity is engaged in a trade or business of trading in
financial instruments or commodities, income from such trade or
business retains its character as it passes from the entity to the
taxpayer. Therefore, regardless of whether the individual is directly
engaged in a trade or business or whether an intervening passthrough
entity is engaged in a trade or business, such income will not qualify
for the ordinary course of a trade or business exception in section
1411(c)(1)(A)(i) because such income is derived in a trade or business
of trading in financial instruments or commodities (as described in
section 1411(c)(2)(B)). See Example 2 of proposed Sec. 1.1411-4(b)(3).
Conversely, if the passthrough entity is not engaged in a trade or
business, income allocated to an individual from such entity will not
qualify for the ordinary course of a trade or business exception even
if the individual or an intervening entity is engaged in a trade or
business. For example, B, 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. Any income described in section 1411(c)(1)(A)(i) passed
through from LTP (through UTP) to B will not be derived in a trade or
business because LTP is not engaged in a trade or business. This
characterization applies even though UTP is engaged in a trade or
business and even if (1) B is engaged in a trade or business, (2) B
provides services with respect to UTP's trade or business, and/or (3) B
provides services to LTP. See Example 1 of proposed Sec. 1.1411-
4(b)(3).
In addition, if the passthrough entity is not engaged in a trade or
business and the passthrough entity has items of income described in
section 1411(c)(1)(A)(i), the individual's status under section 469 is
irrelevant. For example, C, an individual, owns an interest in PRS, a
partnership that is not engaged in a trade or business and earns
dividends and interest. C's distributive share of dividends and
interest from PRS will be subject to section 1411(c)(1)(A)(i) because
they are not derived in a trade or business and therefore cannot be
excluded under the ordinary course of a trade or business exception.
Similar rules regarding whether the trade or business is determined
at the taxpayer level or the entity level apply in determining whether
net gain is attributable to the disposition of property ``held'' in a
trade or business subject to section 1411. See part 5.C of this
preamble.
The interaction of the ordinary course of a trade or business
exception and the trade or business rules under sections 1411(c)(2)(A)
and 1411(c)(2)(B) can be illustrated in the following example. B, an
individual, owns an interest in S, an S corporation, which is a bank. S
earns interest in the ordinary course of its trade or business (which
is not trading in financial instruments or commodities). Accordingly,
the interest B earns through S is not derived in a trade or business
described in section 1411(c)(2)(B). B will then have to determine if
S's trade or business is a passive activity with respect to B. If B is
passive with respect to S's banking business, then even though the
interest was not subject to section 1411(c)(1)(A)(i) because of section
1411(c)(2)(B), B's pro rata share of S's interest is net investment
income under section 1411(c)(1)(A)(ii) because of section
1411(c)(2)(A). See Example 3 of proposed Sec. 1.1411-4(b)(3).
(b) Ordinary Course
Section 1411 does not define ordinary course of a trade or
business, and the proposed regulations do not provide guidance on the
meaning of ordinary course. However, other regulation sections and case
law provide guidance on whether an item of gross income is derived in
the ordinary course of a trade or business. See, for example, Lilly v.
Comm'r, 343 U.S. 90, 93 (1953), rev'g 188 F.2d 269 (4th Cir. 1951),
aff'g 14 T.C. 1066 (1950) (holding that expenses incurred regularly and
arising from transactions that commonly or frequently occur in the type
of business involved are ``ordinary''); Sec. 1.469-2T(c)(3)(ii)
(providing rules for determining whether certain portfolio income is
excluded from the definition of passive activity gross income).
vii. Income From Employment
For purposes of section 1411, an employee is treated as engaged in
the trade or business of being an employee. Therefore, regardless of
whether such amounts are calculated by reference to
[[Page 72620]]
the items described in proposed Sec. 1.1411-4(a), amounts paid by an
employer to an employee that are treated as wages for purposes of
section 3401 are not net investment income because such amounts are
derived in the ordinary course of a trade or business to which section
1411 does not apply. For example, amounts paid to an employee under a
nonqualified deferred compensation plan for such employee (or that
otherwise become includible in income under section 409A, 457(f), 457A,
or other Code section or tax doctrine) that include gross income from
interest or other earnings are not treated as net investment income,
regardless of whether such amounts are not subject to Federal Insurance
Contributions Act tax due to the earlier application of section
3121(v)(2).
viii. Coordination With Portfolio Income Rules in Section 469
Because section 469 treats portfolio income (which includes, for
example, gross income from interest and dividends) as not derived in
the ordinary course of a trade or business, the ordinary course of a
trade or business exception in section 1411(c)(1)(A)(i) does not apply
to such income, and such income will be net investment income under
proposed Sec. 1.1411-4(a)(1)(i). The section 469 portfolio income
rules are discussed in detail in part 6.B.i.(c).(1).(I) of this
preamble.
B. Other Trade or Business Gross Income Described in Section
1411(c)(1)(A)(ii)
Net investment income also includes other gross income derived from
a trade or business described in section 1411(c)(2). See section
1411(c)(1)(A)(ii). The trades or businesses described in section
1411(c)(2) are discussed in part 6 of this preamble.
For a trade or business described in section 1411(c)(2)(A), which
is a trade or business that is a passive activity with respect to the
taxpayer, section 1411(c)(1)(A)(ii) includes other gross income that is
not gross income described in section 1411(c)(1)(A)(i) or net gain
described in section 1411(c)(1)(A)(iii). Thus, if an item of gross
income or net gain is subject to section 1411(c)(1)(A)(i) or (iii), it
is generally not other gross income described in section
1411(c)(1)(A)(ii).
For a trade or business described in section 1411(c)(2)(B), which
is a trade or business of trading in financial instruments or
commodities, section 1411(c)(1)(A)(ii) includes all other gross income
from such trade or business that is not gross income described in
section 1411(c)(1)(A)(i). For example, any gain from marking to market
under section 475(f) or section 1256 and any realized gain from the
disposition of property held in the trade or business of trading in
financial instruments or commodities is classified as other gross
income subject to section 1411(c)(1)(A)(ii) (and not classified as net
gain under section 1411(c)(1)(A)(iii)).
C. Net Gain Described in Section 1411(c)(1)(A)(iii)
Section 1411(c)(1)(A)(iii) states that net investment income
includes net gain (to the extent taken into account in computing
taxable income) attributable to the disposition of property other than
property held in a trade or business not described in section
1411(c)(2). See part 11 of this preamble for additional discussion on
net investment income with respect to controlled foreign corporations
and passive foreign investment companies.
i. Disposition
1. In General
The proposed regulations provide that net investment income
includes net gain (to the extent taken into account in computing
taxable income) attributable to the sale, exchange, transfer,
conversion, cash settlement, cancellation, termination, lapse,
expiration, or other disposition (collectively, referred to as the
disposition) of property other than property held in a trade or
business not described in proposed Sec. 1.1411-5. Except as otherwise
provided, the income tax rules in chapter 1 generally will determine
whether there has been a disposition of property under section 1411.
For example, if a partner receives a distribution of money from a
partnership in excess of the adjusted basis of the partner's interest
in the partnership and recognizes gain under section 731(a), or if an S
corporation shareholder receives a distribution of money from the S
corporation in excess of the adjusted basis of the shareholder's stock
in the corporation and recognizes gain under section 1368(b)(2), the
gain is treated as gain from the sale or exchange of such partnership
interest or S corporation stock for purposes of section
1411(c)(1)(A)(iii). As another example, if stock of an S corporation is
sold and a section 338(h)(10) election is made, each shareholder's pro
rata share of the deemed asset sale gain or loss may be taken into
account in determining net investment income under section
1411(c)(1)(A)(iii). Furthermore, each shareholder may have additional
gain or loss upon the deemed liquidation of the S corporation resulting
from the section 338(h)(10) election, which gain or loss will also
generally be taken into account under section 1411(c)(1)(A)(iii) in
determining net investment income. In addition, capital gain dividends
from regulated investment companies and real estate investment trusts
described in sections 852(b)(3)(C) and 857(b)(3)(C), respectively, and
undistributed capital gains described in sections 852(b)(3)(D) and
857(b)(3)(D), are included in net investment income as net gain under
section 1411(c)(1)(A)(iii), and not as dividend income under section
1411(c)(1)(A)(i).
2. Mark-to-Market Rules for Non-Traders
Under certain statutory or regulatory provisions, a non-trader may
(or may be required to) mark assets to market. For example, under
section 1256, a taxpayer is treated as selling a section 1256 contract
for fair market value at the end of the taxable year, and the taxpayer
includes in gross income any gain and, in certain cases, loss
recognized as a result of the deemed sale. Similarly, as further
discussed in part 11 of this preamble, under section 1296, a United
States person that has made a mark-to-market election with respect to
stock in a passive foreign investment company recognizes income at the
close of each taxable year based on the difference between the fair
market value of the passive foreign investment company stock and the
person's adjusted basis in such stock (or is allowed a deduction equal
to the lesser of the excess of the adjusted basis of such stock over
its fair market value or the unreversed mark-to-market inclusions with
respect to the passive foreign investment company stock). These
proposed regulations treat amounts of gain or loss recognized as a
result of marking to market as net investment income. For rules
regarding section 1296, see part 11 of this preamble. For rules
regarding traders who mark assets to market under sections 475 and
1256, see part 5.B of this preamble.
ii. Determination of Net Gain From Disposition
Except as otherwise expressly provided in the regulations, the
income tax gain and loss recognition rules in chapter 1 apply for
purposes of determining net gain under section 1411. Thus, for example,
to the extent gain from a like-kind exchange is not recognized for
income tax purposes under section 1031, it is not recognized for
purposes of determining net investment income under section 1411.
[[Page 72621]]
Losses properly taken into account in determining net gain include all
losses deductible under section 165, to the extent they are
attributable to property that is either (1) not held in a trade or
business, or (2) held in a trade or business described in proposed
Sec. 1.1411-5.
The amount of net gain on the disposition of an interest in a
partnership or an S corporation taken into account for purposes of
section 1411(c)(1)(A)(iii) may be adjusted in accordance with proposed
Sec. 1.1411-7 (relating to the special rule in section 1411(c)(4) for
the dispositions of certain interests in partnerships or S
corporations).
Because section 1411(c)(1)(A)(iii) uses the term net gain (which
contemplates a positive number), the proposed regulations provide that
the amount of net gain included in net investment income may not be
less than zero. Although capital losses in excess of capital gains are
not recognized for purposes of section 1411, losses allowable under
section 1211(b)(1) and (2) are permitted to offset gain from the
disposition of assets other than capital assets that are subject to
section 1411.
iii. Exception for Property Held in a Trade or Business Not Described
in Section 1411(c)(2)
Section 1411(c)(1)(A)(iii) generally applies if the property
disposed of is either not held in a trade or business, or is held in a
trade or business described in section 1411(c)(2) and proposed Sec.
1.1411-5. See part 6 of this preamble for rules relating to trades or
business subject to section 1411. However, if the property disposed of
is ``held'' in a trade or business and such trade or business is not
described in proposed Sec. 1.1411-5, net investment income would not
include gain attributable to such property.
The determination of whether property is ``held'' in a trade or
business is determined in the same manner as whether gross income is
``derived in'' a trade or business for purposes of section
1411(c)(1)(A)(i). These rules are described in detail in part 5.A.vi of
this preamble. Thus, for individuals directly engaged in a trade or
business, the determination is made at the individual level. If an
individual, estate, or trust holds an interest in a passthrough entity
and such entity disposes of its property, the determination of whether
property is held in a trade or business that is a passive activity is
made at the taxpayer level (that is, the individual, estate, or trust
level), and the determination of whether property is held in a trade or
business of trading in financial instruments or commodities is made at
the entity level. For example, S, an S corporation, is engaged in trade
or business, and A, an individual, owns stock in S. If S sells its
Property 1 for a gain, the determination of whether A's gain from the
disposition of S's Property 1 is subject to section 1411(c)(1)(A)(iii)
depends on (1) whether S held Property 1 in its trade or business, and
(2) if S held Property 1 in its trade or business, whether S's trade or
business is described in proposed Sec. 1.1411-5. If S held Property 1
in its trade or business and S's trade or business is neither a passive
activity with respect to A nor trading in financial instruments or
commodities with respect to S, net gain from the disposition of
Property 1 will not be subject to section 1411(c)(1)(A)(iii).
D. Distributions From Trusts
The proposed regulations provide that net investment income
includes a beneficiary's share of distributable net income, as
described in sections 652(a) and 662(a), to the extent that, under
sections 652(b) and 662(b), the character of such income constitutes
net investment income, with further computations provided in proposed
Sec. 1.1411-3(e).
E. Properly Allocable Deductions
The proposed regulations provide that in determining net investment
income, items of gross income and net gain are reduced by properly
allocable deductions. Principles applied in determining the amount and
timing of a deduction for purposes of Federal income taxation generally
apply for purposes of determining a deduction under section 1411.
However, only amounts paid or incurred by a taxpayer to produce gross
income or net gain described in proposed Sec. 1.1411-4 may be deducted
in determining net investment income.
Net investment income for any taxable year may not be less than
zero. In addition, any otherwise allowable deductions not taken into
account for section 1411 purposes may only be taken into account in
another taxable year to the extent allowed for chapter 1 purposes (such
as a carryforward of investment interest under section 163(d), a
suspended passive activity loss that is allowed in a later year under
section 469(b), or a capital loss carryforward under section 1212).
Section 469(g)(1) provides special rules for the treatment of
suspended passive losses when the taxpayer disposes of its entire
interest in any passive activity (or former passive activity) in a
fully taxable transaction to an unrelated party during the taxable
year. The Treasury Department and the IRS request comments on whether
the losses triggered under section 469(g)(1) upon the disposition
should be considered taken into account in determining the taxpayer's
net gain on the disposition of the activity under section
1411(c)(1)(A)(iii) or whether the losses should be considered properly
allocable deductions to gross income and net gain described in section
1411(c)(1)(A)(i) through (iii).
The proposed regulations provide that net investment income does
not take into account a net operating loss deduction. While some of the
deductions included in the computation of a net operating loss may be
deductions described in proposed Sec. 1.1411-4(f), the character of
each of the various deduction items that comprise a net operating loss
is generally not tracked for purposes of chapter 1 once the item
becomes part of a net operating loss. Thus, when an item becomes part
of a net operating loss that is carried to another year, it generally
is no longer properly allocable to a specific type of income, such as
gross income from interest. In addition, rules to determine the portion
of a net operating loss deduction properly allocable to items of gross
income or net gain subject to section 1411 would be unduly complex and
not administrable. This result is similar to the result for self-
employment income, where section 1402(a)(4) specifically provides that
the deduction for net operating losses provided in section 172 shall
not be allowed in determining net earnings from self-employment. In
determining a taxpayer's modified adjusted gross income (in the case of
an individual) or adjusted gross income (in the case of an estate or
trust), however, net operating losses continue to be taken into
account. The Treasury Department and the IRS invite comments on this
issue.
Gross income from rents or royalties may be reduced by deductions
described in section 62(a)(4) that are allocable to such income. Net
investment income also takes into account the deduction for penalties
associated with the early withdrawal of savings described in section
62(a)(9).
In addition, the proposed regulations permit gross income from a
trade or business described in proposed Sec. 1.1411-5 that constitutes
net investment income to be reduced by deductions described in section
62(a)(1) that are allocable to such income. However, the amount of
deductions allowed under section 1411(c)(1)(B) may be reduced or
eliminated by the application of the self-employment
[[Page 72622]]
income exception in section 1411(c)(6) and proposed Sec. 1.1411-9.
As discussed in part 10 of this preamble, under section 1411(c)(6)
and proposed Sec. 1.1411-9(a), amounts taken into account in
determining self-employment income are excluded from net investment
income. Amounts not taken into account in determining self-employment
income because they are excluded from net earnings from self-employment
are not covered by the self-employment income exception in section
1411(c)(6), and thus may be net investment income. The application of
section 1411(c)(6) and the general rule in proposed Sec. 1.1411-9(a)
to properly allocable deductions under section 1411(c)(1)(B) might
produce an unintended result in the context of traders in financial
instruments or commodities. In many cases, the gross income earned by a
taxpayer engaged in the trade or business of trading financial
instruments or commodities will be subject to section 1411 because the
trading income is not taken into account in determining the taxpayer's
self-employment income due to section 1402(a)(3)(A) (and in cases where
the trader has made a section 475 election, due to the interaction of
sections 475(f)(1)(D) and 1402(a)(3)(A)), and thus the self-employment
income exception in section 1411(c)(6) does not apply to the income.
However, the properly allocable deductions attributable to a trade or
business of trading in financial instruments or commodities would be
taken into account in determining the taxpayer's self-employment income
(even though the gross income was not) and, absent an exception, would
therefore not reduce the taxpayer's gross income under section 1411.
For example, assume A, an individual, is engaged in the trade or
business of trading in commodities, and made an election under section
475(f)(2). A earns $500,000 of gross income (which is subject to
proposed Sec. 1.1411-4(a)(1)(ii)), and A also incurs $100,000 of
expenses relating to the trading business. Under section 1402, none of
the $500,000 of gross income would be taken into account in determining
A's self-employment income (as provided in sections 475(f)(1)(D) and
1402(a)(3)(A)), but all of the $100,000 of expenses would be taken into
account within the meaning of the general rule in proposed Sec.
1.1411-9(a), even though there are no net earnings from self-employment
and thus no self-employment income to reduce. Absent the exception
described in proposed Sec. 1.1411-9(b), the expenses also would not
reduce the taxpayer's $500,000 of gross income under section 1411
because the expenses were taken into account under section 1402 in
determining the taxpayer's self-employment income and would therefore
be excluded under section 1411(c)(6) and the general rule in proposed
Sec. 1.1411-9(a).
The Treasury Department and the IRS believe that a trader should be
able to reduce gross income described in proposed Sec. 1.1411-
4(a)(1)(ii) by properly allocable deductions if the deductions did not
actually reduce net earnings from self-employment, even after
aggregating net earnings from self-employment from other trades or
businesses. Therefore, proposed Sec. 1.1411-9(b) provides a special
rule for traders of financial instruments or commodities. If the trader
has deductions that did not reduce the taxpayer's net earnings from
self-employment (that is, excess deductions), even after aggregating
net earnings from self-employment from other trades or businesses, such
excess deductions are properly allocable deductions under section
1411(c)(1)(B), notwithstanding the exclusion in section 1411(c)(6).
This trader exception and section 1411(c)(6) are also discussed in part
10 of this preamble.
The proposed regulations also provide that several itemized
deductions are properly allocable deductions under section 1411. The
proposed regulations provide that investment interest allowed as a
deduction by reason of section 163(d)(1), investment expenses described
in section 163(d)(4)(C), and taxes imposed on investment income that
are described in section 164(a)(3) are deductible in determining net
investment income. In the case of taxes imposed on both investment
income and non-investment income, the proposed regulations provide that
the portion of taxes properly allocable to investment income may be
determined by taxpayers using any reasonable method. The proposed
regulations further provide that allocating the deduction based on the
ratio of investment income to total gross income is an example of a
reasonable method.
Under the proposed regulations, properly allocable deductions that
are itemized deductions subject to the 2-percent floor on miscellaneous
itemized deductions under section 67 or subject to the overall
limitation on itemized deductions under section 68 may be deducted in
determining net investment income only to the extent that they are
deductible for income tax purposes after the application of the 2-
percent floor and the overall deduction limitation. Some deductions,
such as investment expenses, are subject to limitation under both
sections 67 and 68, while other deductions, such as state taxes, are
subject only to the limitation under section 68. It is necessary to
apportion these deduction limitations between deductions properly
allocable to net investment income and deductions that are not properly
allocable to net investment income. The proposed regulations provide a
method for apportioning these limitations to determine the amount of
deductions allowed in computing net investment income after applying
sections 67 and 68. This method first applies section 67 to all
deductions subject to that limitation. The disallowance is applied
proportionately to each deduction subject to section 67. The proposed
regulations then apply a similar process to deductions subject to
section 68.
Deductions for losses under section 165 are taken into account only
in computing net gain. Therefore, because net gain in section
1411(c)(1)(A)(iii) cannot be less than zero, any excess of losses over
gains are not allowable in the computation of net investment income.
Accordingly, properly allocable deductions do not include deductions
under section 165.
F. Income Inclusion From Tax-Exempt Trusts
Generally, a recipient of a distribution from a tax-exempt trust
(other than non-charitable beneficiary of a charitable remainder trust
as described in part 4.B.iv of this preamble) will not be liable for
Federal income tax on the distribution because the distribution is tax-
exempt income. Accordingly, the recipient (whether an individual,
estate, or trust) will not be liable for tax under section 1411
regardless of whether the distributed amount is comprised of items of
net investment income. However, there may be certain situations in
which the recipient of a distribution from a tax-exempt trust is liable
for Federal income tax on all or a part of the distributed amount. For
example, a distribution from a qualified tuition program under section
529, a Coverdell education savings account, an Archer medical savings
account (Archer MSA), or a health savings account (HSA) may be subject
to Federal income tax if the distributed amounts are not used by the
recipient for qualified expenses. In these situations, it is possible
that a portion of the distribution may be comprised of items of net
investment income generated by the trust corpus. However, in these
cases, a recipient of a distribution from a tax-exempt trust will not
be subject to tax under section 1411 on the distribution (even if the
recipient
[[Page 72623]]
otherwise may be liable for Federal income tax on the distribution)
because of the difficulty in determining whether the distributions from
the corpus of the trust are gross income from items that may constitute
net investment income (such as interest). Distributions from certain
tax-exempt settlement funds covering Indian tribal governments also
will not be subject to tax under section 1411, although income
subsequently generated from distributed funds (for example, after
deposit in an interest-bearing account) may be subject to section 1411.
6. Section 1411 Trades or Businesses
Section 1411(c)(1)(A) defines net investment income, in part, by
reference to trades or businesses described in section 1411(c)(2). The
trades or businesses described in section 1411(c)(2) are (A) a passive
activity (within the meaning of section 469) with respect to the
taxpayer, and (B) trading in financial instruments or commodities (as
defined in section 475(e)(2)).
A. In General
Section 1411's statutory language and legislative history do not
provide a definition of trade or business. The most established
definition of trade or business is found under section 162(a), which
permits a deduction for all the ordinary and necessary expenses paid or
incurred in carrying on a trade or business. The rules under section
162 for determining the existence of a trade or business are well-
established, and there is a large body of case law and administrative
guidance interpreting section 162's meaning of trade or business. The
proposed regulations incorporate the rules under section 162 for
determining whether an activity is a trade or business for purposes of
section 1411 and the proposed regulations. The use of the section 162
definition of trade or business facilitates administration of section
1411 and should simplify taxpayer compliance. See parts 5.A.vi and 5.C
of this preamble for rules relating to the determination of whether
certain items of income are derived in the ordinary course of a trade
or business and whether net gain is attributable to the disposition of
property held in a trade or business, respectively.
B. Trade or Business That Is a Passive Activity With Respect to the
Taxpayer
As described in part 6.A of this preamble, the statutory language
in sections 1411(c)(1)(A) and 1411(c)(2)(A) is intended to take into
account only gross income from and net gain attributable to a passive
activity (within the meaning of section 469) that involves the conduct
of a trade or business (within the meaning of section 162). The
definitions of trade or business and passive activity for section 1411
purposes are more restrictive than for section 469 purposes in two
respects. First, section 469 and the regulations thereunder provide
that a trade or business includes not only a trade or business (within
the meaning of section 162), but also any activity conducted in
anticipation of the commencement of a trade or business and any
activity involving research or experimentation (within the meaning of
section 174). See section 469(c)(5), Sec. Sec. 1.469-1(e)(2), and
1.469-4(b)(1). Second, while section 469 defines passive activity as
any trade or business in which the taxpayer does not materially
participate, it also includes any rental activity in the definition of
passive activity. See section 469(c)(1) and (2). The proposed
regulations provide that the definition of trade or business for
section 1411 purposes is limited to a trade or business within the
meaning of section 162.
Due to the differences in the definitions for purposes of section
1411 and section 469, under the proposed regulations, in some cases
gross income from activities that are passive activities under section
469 will not be taken into account for purposes of section
1411(c)(1)(A)(ii) because the gross income is derived from an activity
that does not rise to the level of a trade or business (within the
meaning of section 162). In such cases, the gross income will not be
taken into account under section 1411 unless it is taken into account
under section 1411(c)(1)(A)(i) or section 1411(c)(1)(A)(iii) and the
proposed regulations. See Example 1 of proposed Sec. 1.1411-5(b)(2).
i. Passive Activities That Are Section 1411 Trades or Businesses
(a) In General
For purposes of section 1411(c)(2)(A) and the proposed regulations,
the taxpayer must determine whether a section 162 trade or business in
which the taxpayer owns an interest is a passive activity. Section
1411(c)(2)(A) provides that the term passive activity has the same
meaning as section 469. Section 469(c)(1) provides that a passive
activity is any activity that involves the conduct of any trade or
business and in which the taxpayer does not materially participate.
Section 469(c)(2) provides that, except as provided in section
469(c)(7), a passive activity also includes any rental activity
(regardless of whether the taxpayer materially participates in the
rental activity). See also Sec. 1.469-1T(e)(3)(ii). For rules
regarding the treatment of working interests in oil or gas property,
see section 469(c)(3).
(b) Application of Existing Section 469 Rules
Section 469 and the regulations thereunder provide rules for
determining whether trade or business activities and certain rental
activities are passive activities with respect to a taxpayer.
Generally, these rules will also apply in determining whether a section
162 trade or business is a passive activity for purposes of section
1411(c)(2)(A). Examples of this principle are discussed in this
preamble, but these examples are not meant to be an exhaustive list of
the rules that apply.
(1) Material Participation
Section 469(h)(1) provides that a taxpayer shall be treated as
materially participating in an activity only if the taxpayer is
involved in the operations of the activity on a basis which is regular,
continuous, and substantial. Section 1.469-5T provides additional
guidance for individuals on the meaning of ``material participation.''
The material participation rules of section 469 will apply for purposes
of determining whether a taxpayer materially participates in a section
162 trade or business for purposes of determining whether such trade or
business is described in section 1411(c)(2)(A).
(2) Real Estate Professionals
Section 469(c)(7) and Sec. 1.469-9 provide special rules for
certain individual taxpayers involved in the conduct of real property
trades or businesses (real estate professionals). 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 no
longer subject to section 469(c)(2), 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 Sec. 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
[[Page 72624]]
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. The ordinary course of a trade or business exception is
described in part 5.A.vi of this preamble.
(3) Rental Activity Exceptions
Section 469(j)(8) and the regulations thereunder provide that a
rental activity is any activity where payments are principally for the
use of tangible property that is used or held for use by customers.
Section 1.469-1T(e)(3)(ii) provides several exceptions to the
definition of a rental activity. If a taxpayer's activity meets one of
these exceptions, the activity is not a rental activity for purposes of
section 469 (that is, it is no longer per se passive), and the activity
will not be a passive activity if the taxpayer materially participates
in that activity. These rental activity exceptions will also apply for
determining whether the activity is a passive activity of a taxpayer
for purposes of section 1411(c)(2)(A). However, a taxpayer who meets
one of these exceptions is not necessarily engaged in a trade or
business (within the meaning of section 162) with respect to the
activity. In other words, even if the taxpayer meets one of the
exceptions in Sec. 1.469-1T(e)(3)(ii), if the taxpayer's activity is
not a section 162 trade or business, gross income from rents from the
activity will be subject to section 1411(c)(1)(A)(i) because the
activity does not meet the ordinary course of a trade or business
exception. The proposed regulations provide examples that illustrate
the interaction of section 1411 and the section 469 rental activity
exceptions. See Examples 3 and 4 of proposed Sec. 1.1411-5(b)(2).
(4) Grouping Rules
Section 1.469-4 provides rules for defining an activity for
purposes of applying the passive activity loss rules of section 469
(grouping rules). The grouping rules will apply in determining the
scope of a taxpayer's trade or business in order to determine whether
such trade or business is a passive activity for purposes of section
1411(c)(2)(A). However, a proper grouping under Sec. 1.469-4(d)(1)
(grouping rental activities with other trade or business activities)
will not convert gross income from rents into other gross income
derived from a trade or business described in proposed Sec. 1.1411-
5(a)(1).
Section 1.469-4(e)(1) provides that, except as provided in
Sec. Sec. 1.469-4(e)(2) and 1.469-11, once a taxpayer has grouped
activities, the taxpayer may not regroup those activities in subsequent
taxable years. The Treasury Department and the IRS have determined on
prior occasions that taxpayers should be given a ``fresh start'' to
redetermine their groupings. The enactment of section 1411 may cause
taxpayers to reconsider their previous grouping determinations, and
therefore the Treasury Department and the IRS have determined that
taxpayers should be given the opportunity to regroup. Thus, the
proposed regulations provide that taxpayers may regroup their
activities in the first taxable year beginning after December 31, 2013,
in which the taxpayer meets the applicable income threshold in proposed
Sec. 1.1411-2(d) and has net investment income (as defined in proposed
Sec. 1.1411-4). The determination in the preceding sentence is made
without regard to the effect of the regrouping. Taxpayers may regroup
their activities in reliance on this proposed regulation for any
taxable year that begins during 2013 if section 1411 would apply to
such taxpayer in such taxable year. A taxpayer may only regroup
activities once pursuant to Sec. 1.469-11(b)(3)(iv)(A), and any such
regrouping will apply to the taxable year for which the regrouping is
done and all subsequent years.
The regrouping must comply with the existing requirements under
Sec. 1.469-4. For example, Sec. 1.469-4(e) provides that taxpayers
must comply with disclosure requirements that the Commissioner may
prescribe with respect to both their original groupings and the
addition and disposition of specific activities within those chosen
groupings in subsequent taxable years. On January 25, 2010, the
Treasury Department and the IRS published Revenue Procedure 2010-13
(2010-4 IRB 329), which requires taxpayers to report to the IRS their
groupings and regroupings of activities and the addition of specific
activities within their existing groupings of activities for purposes
of section 469 and Sec. 1.469-4. Thus, the disclosure requirements of
Sec. 1.469-4(e) and Revenue Procedure 2010-13 require taxpayers who
regroup their activities pursuant to proposed Sec. 1.469-11(b)(3)(iv)
to report their regroupings to the IRS. See Sec. 601.601(d)(2).
(c) Special Rules for Certain Income From Passive Activities
Section 469 and the regulations thereunder provide several rules
that restrict the ability of taxpayers to artificially generate passive
income from certain types of passive activities. Some rules
specifically recharacterize income from a passive activity as income
not from a passive activity (income recharacterization rules). Other
rules recharacterize the activity itself as being a non-passive
activity (activity recharacterization rules).
(1) Income Recharacterization Rules
(I) Portfolio Income
Section 469(e)(1)(A)(i)(I) provides that in determining the income
or loss from any activity there shall not be taken into account any
gross income from interest, dividends, annuities, or royalties not
derived in the ordinary course of a trade or business (portfolio
income). Thus, items of net investment income in section
1411(c)(1)(A)(i) and proposed Sec. 1.1411-4(a)(1)(i) that are
portfolio income will, by definition, be included in section 1411
because these portfolio items are not derived in the ordinary course of
a trade or business. In addition, Sec. 1.469-7 provides an exception
to the portfolio income rules for self-charged interest, which is
treated as passive income, and therefore, the gross income from such
interest would be gross income from interest subject to proposed Sec.
1.1411-4(a)(1)(i).
Similarly, section 469(e)(1)(A)(ii) provides that gain or loss not
derived in the ordinary course of a trade or business which is
attributable to the disposition of property (I) producing portfolio
income, or (II) held for investment, should not be taken into account
in determining income from a passive activity. Thus, gain described in
section 469(e)(1)(A)(ii) will be net investment income if (1) the gain
is attributable to property held in a section 162 trade or business of
trading in financial instruments or commodities, or (2) the gain is
attributable to property not held in a section 162 trade or business.
See part 5.C of this preamble.
(II) Working Capital
Section 469(e)(1)(B) provides special rules for return on working
capital. Section 1411(c)(3) provides that rules similar to section
469(e)(1)(B) also apply for purposes of section 1411. Working capital
is discussed in part 7 of this preamble.
[[Page 72625]]
(III) Net Income Recharacterization Rules
The regulations under section 469 provide special rules that treat
income from certain activities as not from a passive activity. See
Sec. 1.469-2T(f)(2) (special rule for significant participation);
Sec. 1.469-2T(f)(3) (rental of nondepreciable property); Sec. 1.469-
2T(f)(4) (net interest income from passive equity-financed lending
activity); Sec. 1.469-2(f)(5) (net income from certain property rented
incidental to development activity); Sec. 1.469-2(f)(6) (property
rented to a nonpassive activity); Sec. 1.469-2T(f)(7) (special rules
applicable to the acquisition of an interest in a passthrough entity
engaged in the trade or business of licensing intangible property). In
most cases, these items will be subject to section 1411 if the item of
income constitutes gross income from one of the items described in
proposed Sec. 1.1411-4(a)(1)(i) and the item of income is not derived
in the ordinary course of a trade or business. For example, if a
taxpayer has gross income from rents from an activity described in
Sec. 1.469-2(f)(6) that is not derived in the ordinary course of a
trade or business, the gross income from rents will be subject to
section 1411. The ordinary course of a trade or business exception is
described in part 5.A.vi of this preamble.
(IV) Substantially Appreciated Property
Section 1.469-2(c)(2)(iii)(A) generally provides that if an
interest in property used in an activity is substantially appreciated
at the time of its disposition, any gain from the disposition shall be
treated as not from a passive activity. The recharacterized gain may be
taken into account under section 1411(c)(1)(A)(iii) if the gain is
attributable to the disposition of property.
(2) Activity Recharacterization Rules
Section 1.469-1T(e)(6) provides that an activity of trading
personal property for the account of owners of interests in the
activity is not a passive activity (without regard to whether such
activity is a trade or business activity). For this purpose, Sec.
1.469-1T(e)(6)(ii) provides that the term personal property means
personal property (within the meaning of section 1092(d), without
regard to paragraph (3) thereof). Section 1092(d)(1) provides that
personal property means any personal property of a type which is
actively traded. While the gross income from or net gain attributable
to an activity of trading or dealing in property will not be taken into
account under section 1411(c)(2)(A) by virtue of Sec. 1.469-
2T(c)(3)(ii)(D), such gross income or net gain nevertheless will be
taken into account under section 1411(c)(2)(B) if the activity
constitutes a section 162 trade or business of trading in financial
instruments or commodities. Trading in financial instruments or
commodities is discussed in part 6.C of this preamble.
C. Trading in Financial Instruments or Commodities
i. Distinguishing Between Dealers, Traders, and Investors
Determining whether trading in financial instruments or commodities
rises to the level of a section 162 trade or business is a question of
fact. Higgins v. Comm'r, 312 U.S. 212, 217 (1941); Estate of Yaeger v.
Comm'r, 889 F.2d 29, 33 (2d Cir. 1989). In general, section 475(c)(1)
provides that the term dealer in securities means a taxpayer who (A)
regularly purchases securities from or sells securities to customers in
the ordinary course of a trade or business, or (B) regularly offers to
enter into, assume, offset, assign, or otherwise terminate positions in
securities with customers in the ordinary course of a trade or
business. In contrast, a trader seeks profit from short-term market
swings and receives income principally from selling on an exchange
rather than from dividends, interest, or long-term appreciation.
Groetzinger v. Comm'r, 771 F.2d 269, 274-275 (7th Cir. 1985), aff'd 480
U.S. 23 (1987); Moller v. United States, 721 F.2d 810, 813 (Fed. Cir.
1983). A person will be a trader, and therefore engaged in a section
162 trade or business, if his or her trading is frequent and
substantial, which has been rephrased as ``frequent, regular, and
continuous.'' Boatner v. Comm'r, T.C. Memo. 1997-379, aff'd in
unpublished opinion 164 F.3d 629 (9th Cir. 1998).
An investor is a person who purchases and sells securities with the
principal purpose of realizing investment income in the form of
interest, dividends, and gains from appreciation in value over a
relatively long period of time (that is, long-term appreciation). The
management of one's own investments is not considered a section 162
trade or business no matter how extensive or substantial the
investments might be. See Higgins v. Comm'r, 312 U.S. 212, 217 (1941);
King v. Comm'r, 89 T.C. 445 (1987). Therefore, an investor is not
considered to be engaged in a section 162 trade or business of
investing.
For purposes of section 1411(c)(2)(B), in order to determine
whether gross income is derived from a section 162 trade or business of
trading in financial instruments or commodities, the gross income must
be derived from an activity that would constitute trading for purposes
of chapter 1. Therefore, a person that is a trader in commodities or a
trader in financial instruments is engaged in a trade or business for
purposes of section 1411(c)(2)(B). The Treasury Department and the IRS
emphasize that the proposed regulations do not change the state of the
law with respect to classification of traders, dealers, or investors
for purposes of chapter 1.
ii. Definition of Financial Instruments
Section 1411 does not define the term ``financial instrument.''
Section 731(c)(2)(C) provides a definition of financial instrument for
purposes of section 731, and this existing statutory definition is used
as a guideline for the section 1411 definition. The proposed
regulations define the term financial instrument to include stocks and
other equity interests, evidences of indebtedness, options, forward or
futures contracts, notional principal contracts, any other derivatives,
or any evidence of an interest in any of the listed items. An evidence
of an interest in any of these listed items includes, but is not
limited to, short positions or partial units in any of these listed
items.
iii. Definition of Commodities
In accordance with the statutory language in section 1411(c)(2)(B),
the proposed regulations provide that the term commodities has the same
meaning as that provided in section 475(e)(2).
7. Working Capital Exception
Section 1411(c)(3) provides that a rule similar to the rule of
section 469(e)(1)(B) applies for purposes of section 1411 (the working
capital rule). Section 469(e)(1)(B) provides that, for purposes of
determining whether income is treated as from a passive activity, any
income or gain attributable to an investment of working capital shall
be treated as not derived in the ordinary course of a trade or
business.
The term working capital is not defined in either section 469 or
section 1411, but it generally refers to capital set aside for use in
and the future needs of a trade or business. Because the capital may
not be necessary for the immediate conduct of the trade or business,
the amounts are often invested by businesses in income-producing liquid
assets such as savings accounts, certificates of deposit, money market
accounts, short-term government and commercial bonds, and other similar
investments. These investment assets
[[Page 72626]]
will usually produce portfolio-type income, such as interest. Under
section 469(e)(1)(B), portfolio-type income generated by working
capital is not derived in the ordinary course of a trade or business,
and therefore, it is not treated as passive income. Under section
1411(c)(3), gross income from and net gain attributable to the
investment of working capital is not derived in the ordinary course of
a trade or business, and therefore such gross income and net gain is
subject to section 1411.
A taxpayer may take into account the properly allocable deductions
(related to losses or deductions properly allocable to the investment
of such working capital) in determining net investment income. See part
5.E of this preamble regarding properly allocable deductions.
8. Dispositions of Interests in Partnerships and S Corporations
In most cases, an interest in a partnership or S corporation is not
property held in a trade or business. Therefore, gain or loss from the
sale of a partnership interest or S corporation stock will be subject
to section 1411(c)(1)(A)(iii). See also section 731(a) and section
1368(b)(2) (providing that the gain recognized when cash is distributed
in excess of the adjusted basis of, as applicable, a partner's interest
in a partnership or a shareholder's stock in an S corporation is
treated as gain from the sale or exchange of such partnership interest
or S corporation stock).
Section 1411(c)(4)(A) provides that, in the case of a disposition
of an interest in a partnership or S corporation, gain from such
disposition shall be taken into account under section
1411(c)(1)(A)(iii) only to the extent of the net gain which would be so
taken into account by the transferor under section 1411(c)(1)(A)(iii)
if all property of the partnership or S corporation were sold for fair
market value immediately before the disposition of such interest.
Section 1411(c)(4)(B) applies a similar rule to a loss from a
disposition.
For purposes of section 1411, Congress intended section 1411(c)(4)
to put a transferor of an interest in a partnership or S corporation in
a similar position as if the partnership or S corporation had disposed
of all of its properties and the accompanying gain or loss from the
disposition of such properties passed through to its owners (including
the transferor). However, the gain or loss upon the sale of an interest
in the entity and a sale of the entity's underlying properties will not
always match. First, there may be disparities between the transferor's
adjusted basis in the partnership interest or S corporation stock and
the transferor's share of the entity's adjusted basis in the underlying
properties. See Example 2 of proposed Sec. 1.1411-7(e). Second, the
sales price of the interest may not reflect the proportionate share of
the underlying properties' fair market value with respect to the
interest sold.
In order to achieve parity between an interest sale and an asset
sale, section 1411(c)(4) must be applied on a property-by-property
basis, which requires a determination of how the property was held in
order to determine whether the gain or loss to the transferor from the
hypothetical disposition of such property would have been gain or loss
subject to section 1411(c)(1)(A)(iii). As described in proposed Sec.
1.1411-4(a)(1)(iii) and proposed Sec. 1.1411-4(d), section
1411(c)(1)(A)(iii) applies if the property disposed of is either not
held in a trade or business, or held in a trade or business described
in proposed Sec. 1.1411-5. In other words, under the proposed
regulations, the exception in section 1411(c)(4) is only applicable
where the property is held in a trade or business not described in
section 1411(c)(2). See JCT 2011 Explanation, at 364, fn. 976 (and
accompanying text); Joint Committee on Taxation, Technical Explanation
of the Revenue Provisions of the ``Reconciliation Act of 2010,'' as
amended, in combination with the ``Patient Protection and Affordable
Care Act'' (JCX-18-10) (Mar. 21, 2010), at 135 fn. 286 (and
accompanying text) (JCT 2010 Explanation). This means that the
exception in section 1411(c)(4) does not apply where (1) there is no
trade or business, (2) the trade or business is a passive activity
(within the meaning of proposed Sec. 1.1411-5(a)(1)) with respect to
the transferor, or (3) where the partnership or the S corporation is in
the trade or business of trading in financial instruments or
commodities (within the meaning of proposed Sec. 1.1411-5(a)(2)),
because in these cases there would be no change in the amount of net
gain determined under proposed Sec. 1.1411-4(a)(1)(iii) upon an asset
sale under section 1411(c)(4). For example, if the transferor is
passive with respect to the entity's trade or business, the application
of the deemed asset sale rule under section 1411(c)(4), as described in
part 8.A of this preamble, would not adjust the transferor's section
1411(c)(1)(A)(iii) gain on the disposition of the interest. See Example
7 of proposed Sec. 1.1411-7(e) for a situation involving the
transferor of an interest in an S corporation with two trades or
businesses, only one of which is described in proposed Sec. 1.1411-5.
A. Mechanics of Section 1411(c)(4)
i. In General
The proposed regulations provide that, for purposes of section
1411(c)(4), a transferor computes the gain or loss from the sale of the
underlying properties of the partnership or S corporation using a
deemed asset sale method (Deemed Sale), and then determines if, based
on the Deemed Sale, there is an adjustment (either positive or
negative) to the transferor's gain or loss on the disposition of the
partnership or S corporation interest for purposes of section
1411(c)(1)(A)(iii). An adjustment only occurs if the underlying
property is used in a trade or business not described in proposed Sec.
1.1411-5 (a positive adjustment reduces a loss on the disposition of
the interest, and a negative adjustment reduces the gain on the
disposition of the interest). Because the proposed regulations apply a
Deemed Sale by the passthrough entity of all its assets for cash equal
to the fair market value of the entity's properties, any gain or loss
on the interest sale that is not reflected in the underlying properties
of the passthrough entity (as the result of an inside-outside basis
disparity) would not create an adjustment. This is illustrated in
Example 2 of proposed Sec. 1.1411-7(e).
In developing the Deemed Sale, the Treasury Department and the IRS
considered existing hypothetical transactions, such as the hypothetical
transaction to determine a transferee's basis adjustment under section
743(b). See Sec. 1.743-1. The proposed regulations provide that the
Deemed Sale under section 1411(c)(4) applies, in part, rules similar to
Sec. 1.743-1(d)(2). However, the Treasury Department and the IRS
recognize that the Deemed Sale may impose an administrative burden on
owners of partnerships and S corporations in certain circumstances. The
Treasury Department and the IRS request comments on other methods that
would implement the provisions of section 1411(c)(4) without imposing
an undue burden on taxpayers. In addition, the IRS and the Treasury
Department request comments on how to determine a partner's interest in
section 1411 assets upon a distribution in which gain is recognized
pursuant to section 731.
ii. Deemed Sale
The first step of the Deemed Sale is a hypothetical disposition of
all the entity's properties (including goodwill) in a fully taxable
transaction for cash equal to the fair market value of the entity's
properties immediately before the disposition of the interest.
[[Page 72627]]
The second step of the Deemed Sale is to compute the gain or loss
on each of the entity's properties (including goodwill). The
calculation of gain or loss is determined by comparing the fair market
value of each property with such property's adjusted basis. The gain or
loss from each property must be computed separately.
The third step of the Deemed Sale is to allocate the gain or loss
from each property determined in the second step to the transferor. In
the case of a partnership, the amount of gain or loss allocated to the
transferor must take into account the allocations provided in the
partnership agreement and any allocations required by sections 704(b)
and 704(c) (and the regulations thereunder), as well as basis
adjustments under section 743 with respect to the transferor. In the
case of an S corporation, the amount of gain or loss allocated to the
transferor is determined under section 1366(a), and the allocation
should not take into account any reduction in the transferor's
distributive share in section 1366(f)(2) resulting from the
hypothetical imposition of tax under section 1374 as a result of the
Deemed Sale.
The fourth step of the Deemed Sale is to determine whether the
amount of gain or loss allocated to the transferor with respect to each
property under the Deemed Sale would have been taken into account in
determining the transferor's net gain under section 1411(c)(1)(A)(iii)
if it were an actual disposition. If the entity's property is either
held in a trade or business described in section 1411(c)(2) with
respect to the partnership, the S corporation, or the transferor, or is
not held in a trade or business, there will be no adjustment under
section 1411(c)(4) with respect to that property. However, if the
property is held in a trade or business not described in section
1411(c)(2), there is an adjustment under section 1411(c)(4) calculated
in the following manner. First, the transferor's gains or losses from
such property (or properties) are aggregated to create a net gain
(which will be treated as a negative adjustment) or a net loss (which
will be treated as a positive adjustment). Second, based on the
adjustment calculated and subject to certain limitations, the
transferor then must adjust the gain or loss from the disposition of
the partnership or S corporation interest determined in section
1411(c)(1)(A)(iii) (without regard to section 1411(c)(4)) by the
positive or negative adjustment.
For example, if in the Deemed Sale the transferor would have been
allocated a net gain from property held in a trade or business not
described in section 1411(c)(2) (thus, a negative adjustment) and the
transferor had a gain on the disposition of the interest, then the gain
on the disposition of the interest will be reduced for purposes of
determining net investment income. However, in a situation in which a
transferor has a gain (determined without regard to section 1411(c)(4))
from the disposition of the partnership or S corporation interest, a
negative adjustment cannot result in the transferor having a loss on
the disposition of the partnership or S corporation interest for
purposes of section 1411(c)(1)(A)(iii), and a positive adjustment is
not taken into account. For example, if a transferor has a $100,000
gain on the disposition of S corporation stock, the section 1411(c)(4)
adjustment cannot result in a gain for section 1411 purposes greater
than $100,000, and cannot result in a loss for section 1411 purposes.
See Example 3 of proposed Sec. 1.1411-7(e). Similarly, in a situation
where a transferor has a loss (determined without regard to section
1411(c)(4)) from the disposition of the partnership or S corporation
interest, a positive adjustment cannot result in the transferor having
a gain on the disposition of the partnership or S corporation interest
for purposes of section 1411(c)(1)(A)(iii), and a negative adjustment
is not taken into account. For example, if a transferor has a $50,000
loss on the disposition of S corporation stock, the section 1411(c)(4)
adjustment cannot result in a loss for section 1411 purposes greater
than $50,000, and cannot result in a gain for section 1411 purposes.
The proposed regulations provide a special rule for property held
in more than one trade or business during the twelve-month period
ending on the date of the disposition. In such case, the fair market
value and the adjusted basis of such property must be allocated among
the trades or businesses on a basis that reasonably reflects the use of
the property. This allocation rule is illustrated in Example 7 of
proposed Sec. 1.1411-7(e).
The proposed regulations provide rules to determine the treatment
of gain or loss from goodwill for purposes of section 1411(c)(4). If
the entity is engaged in one trade or business, the entire gain or loss
on the goodwill will be treated as gain or loss from the disposition of
property held for use in that trade or business, and no portion of such
gain or loss will be treated as attributable property not held for use
in the trade or business. If the entity is engaged in more than one
trade or business, the gain or loss on the goodwill is allocated
between the trades or businesses based on the relative fair market
value of the property (excluding cash) held for use in each trade or
business. For example, if the entity has total assets with a fair
market value of $110,000 (consisting of assets of $10,000 not held in
any trade or business, $15,000 of assets held for use in Business 1,
$45,000 of assets held for use in Business 2, $10,000 of cash, and
goodwill of $30,000), and if the gain on the goodwill is $20,000,
$5,000 of such gain is allocated to Business 1 and the remaining
$15,000 gain is allocated to Business 2. See Example 8 of proposed
Sec. 1.1411-7(e).
B. Special Situations
i. Interaction of Section 1411(c)(4) and Section 338(h)(10) Election
In the case of a disposition of stock in an S corporation with
respect to which a section 338(h)(10) election is made, section
1411(c)(4) is inapplicable to the deemed asset sale and liquidation
transactions that result from the section 338(h)(10) election. Under
section 338(h)(10), the sale of the S corporation stock is treated as
an actual asset sale by the S corporation. Section 1411(c)(4) is
inapplicable to such an asset sale. In the deemed liquidation of the
former S corporation, section 1411(c)(4) is also inapplicable to the
shareholders because the underlying character of the gain or loss in
the assets at the former S corporation level is already fully taken
into account in the deemed asset sale.
ii. Installment Sales
In the case of a disposition of a partnership or S corporation
interest in an installment sale transaction to which section 453
applies, proposed Sec. 1.1411-7(b)(1)(i) provides that the adjustment
to net gain will be calculated in the year of the disposition. However,
under proposed Sec. 1.1411-4(a)(1)(iii), the gain and any applicable
adjustment are deferred and recognized proportionally pursuant to
section 453.
In the event that the year of the disposition of the interest
occurs before the effective date of section 1411, the adjustment under
section 1411(c)(4) and proposed Sec. 1.1411-7(c) will not be
applicable. However, the proposed regulations allow taxpayers to elect
into the rules of proposed Sec. 1.1411-7 if they receive installment
sale payments attributable to a disposition of an interest in a
partnership or S corporation that occurred before the effective date of
section 1411. This election allows taxpayers that sell their interests
in installment sales before the effective date of section 1411 to be
[[Page 72628]]
treated similarly with taxpayers that sell their interests after the
effective date. In submitting the required statement of adjustment
(described in proposed Sec. 1.1411-7(d)), this election will require
the taxpayer to have the information (such as basis and fair market
value of each property) as of the date of disposition.
iii. Sale by a Qualified Subchapter S Trust (QSST)
If an election is made pursuant to section 1361(d)(2), a QSST can
be an eligible shareholder of an S corporation. Section 1.1361-1(j)(8)
provides rules for coordinating the QSST rules and the grantor trust
rules, and provides that the income beneficiary of the QSST is treated
as the owner, for purposes of section 678(a), of that portion of the
trust that consists of the stock of the S corporation for which the
QSST election was made. However, solely for purposes of this rule, an
income beneficiary who is a deemed section 678 owner only by reason of
section 1361(d)(1) will not be treated as the owner of the S
corporation stock in determining and attributing the Federal income tax
consequences of a disposition of the stock by the QSST. Therefore, if
the QSST sells some (or all) of its S corporation stock, any gain or
loss recognized on the sale will be that of the trust, not the income
beneficiary. (On the other hand, the disposition is treated as a
disposition by the income beneficiary for purposes of applying sections
465 and 469 to the income beneficiary of a QSST.)
The proposed regulations do not address whether special rules are
needed to coordinate the QSST rules regarding dispositions of stock in
an S corporation in Sec. 1.1361-1(j)(8) and section 1411(c)(4). The
Treasury Department and the IRS request comments on whether special
coordination rules are necessary.
C. Required Statements
Any transferor making an adjustment under proposed Sec. 1.1411-
7(c)(5) must attach a statement to the transferor's return for the year
of disposition. The statement must include: (1) A description of the
disposed-of interest; (2) the name and taxpayer identification number
of the entity disposed of; (3) the fair market value of each property
of the entity; (4) the entity's adjusted basis in each property; (5)
the transferor's allocable share of gain or loss with respect to each
property of the entity; (6) information regarding whether the property
was held in a trade or business not described in section 1411(c)(2);
(7) the amount of the section 1411(c)(1)(A)(iii) gain on the
disposition of the interest; and (8) the computation of the adjustment
under proposed Sec. 1.1411-7(c)(5).
In cases involving partnerships without a section 754 election in
effect (or where there is no mandatory section 743 adjustment) and S
corporations, the transferor may not have access to the information
that is necessary to make the adjustment and to file the required
statements. The Treasury Department and the IRS request comments on how
a transferor may acquire the required information in these cases.
9. Exception for Distributions From Qualified Plans
Section 1411(c)(5) provides that net investment income does not
include any distribution from the following plans or arrangements:
(1) A qualified pension, stock bonus, or profit-sharing plan under
section 401(a);
(2) A qualified annuity plan under section 403(a);
(3) A tax-sheltered annuity under section 403(b);
(4) An individual retirement account (IRA) under section 408;
(5) A Roth IRA under section 408A; or
(6) A deferred compensation plan of a State and local government or
a tax-exempt organization under section 457(b).
These proposed regulations provide rules relating to whether an
amount is a distribution from a plan within the meaning of section
1411(c)(5) and, thus, exempt from net investment income. First, the
proposed regulations provide that, for purposes of section 1411, any
amount actually distributed from a qualified plan or arrangement is a
distribution within the meaning of section 1411(c)(5), and thus is not
included in net investment income. The proposed regulations provide
examples of actual distributions, including a rollover to an eligible
retirement plan within the meaning of section 402(c)(8)(B), a
distribution of a plan offset amount within the meaning of Q&A-13(b) of
Sec. 1.72(p)-1, and corrective distributions from a qualified plan or
arrangement to maintain its tax-favored status. The term ``corrective
distribution'' includes any of the following distributions: (1) A
distribution of excess deferrals as described in Sec. 1.402(g)-
1(e)(3); (2) for purposes of section 408 IRAs, a distribution of excess
contributions as described in Sec. 1.408-4(c); (3) for purposes of
section 408A Roth IRAs, a distribution of excess contributions as
described in Q&A-1(d) of Sec. 1.408A-6; and (4) for purposes of
eligible section 457(b) plans, a distribution of excess deferrals as
described in Sec. 1.457-4(e)(2) through (4).
Second, the proposed regulations provide that, for purposes of
section 1411, amounts that are deemed distributions under the Code for
purposes of income tax are distributions for purposes of section
1411(c)(5), even if these distributions are not treated as actual
distributions for purposes of the qualification requirements under
section 401(a). Examples of deemed distributions include conversions to
a Roth IRA described in section 408A and deemed distributions under
section 72(p).
Third, any amount that is not treated as a distribution, but is
otherwise includible in gross income pursuant to a rule relating to
amounts held in a qualified plan or arrangement, is a distribution
within the meaning of section 1411(c)(5), and thus is not included in
net investment income. For example, any income of the trust of a
qualified plan or arrangement that is applied to purchase a
participant's life insurance coverage (the P.S. 58 costs) is a
distribution within the meaning of section 1411(c)(5), and thus is not
included in net investment income.
While distributions from qualified plans or arrangements are not
includible in net investment income, as defined in section 1411(c)(1),
distributions from a qualified plan or arrangement that are includible
in gross income under chapter 1 are taken into account in determining
the taxpayer's modified adjusted gross income or adjusted gross income
for purposes of calculating the amount subject to tax under section
1411(a)(1)(B) or (a)(2)(B).
10. Exception for Items Subject to Self-Employment Tax
Section 1411(c)(6) provides that net investment income shall not
include any item taken into account in determining self-employment
income for such taxable year on which a tax is imposed by section
1401(b). Section 1401(b) imposes a Medicare tax on the self-employment
income of individuals equal to a specified percentage (2.9 percent) of
the amount of the self-employment income for such taxable year and an
Additional Medicare Tax for taxable years beginning after December 31,
2012, equal to 0.9 percent of self-employment income in excess of
certain threshold amounts. Section 1402(b) provides that the term self-
employment income generally means the net earnings from self-employment
(defined under section 1402(a)) derived by an individual except that
such term shall not include the net earnings from self-employment if
such net earnings for
[[Page 72629]]
the taxable year are less than $400. Section 1402(a) generally defines
the term net earnings from self-employment as the gross income derived
by an individual from any trade or business carried on by such
individual, less the deductions allowed which are attributable to such
trade or business, plus his distributive share (whether or not
distributed) of income or loss described in section 702(a)(8) from any
trade or business carried on by a partnership of which he is a member.
Section 1402(a)(1) through (17) includes exceptions from the definition
of net earnings from self-employment as well as other special rules.
The JCT 2011 and 2010 Explanations state that net investment income
does not include ``amounts subject to SECA [Self-Employment
Contribution Act] tax.'' JCT 2011 Explanation, at 365; JCT 2010
Explanation, at 135. Therefore, the proposed regulations provide that
for purposes of section 1411(c)(6), ``items taken into account'' in
determining self-employment income means income included and deductions
allowed in determining net earnings from self-employment under section
1402(a) for purposes of determining self-employment income under
section 1402(b), but does not include amounts excepted from net
earnings from self-employment under section 1402(a)(1) through (17). In
addition, proposed Sec. 1.1411-9(b) provides a special rule for
properly allocable deductions (as defined in proposed Sec. 1.1411-
4(f)(2)(ii)) in the case of a taxpayer engaged in the trade or business
of trading in financial instruments or commodities (as defined in
proposed Sec. 1.1411-5(a)(2)). This exception provides that deductions
described in proposed Sec. 1.1411-4(f)(2)(ii) that do not reduce a
taxpayer's net earnings from self-employment (after aggregating the net
earnings from self-employment from all of the taxpayer's trades or
business) are not considered taken into account for purposes of section
1411(c)(6) and may be considered in determining the taxpayer's net
investment income under section 1411. Generally, this exception will
apply if the taxpayer is engaged in a trade or business of trading in
financial instruments or commodities and does not have any net earnings
from self-employment or the deductions from trading exceed the
taxpayer's net earnings from self-employment.
11. Controlled Foreign Corporations and Passive Foreign Investment
Companies
As noted in part 5 of this preamble, section 1411(c)(1) provides
that net investment income includes dividends and net gain (to the
extent taken into account in computing taxable income) attributable to
the disposition of property other than property held in a trade or
business to which the tax does not apply. Accordingly, income with
respect to investments in foreign corporations generally is included in
the calculation of net investment income for section 1411 purposes.
Specifically, dividends and gains derived with respect to the stock of
a controlled foreign corporation (within the meaning of section 957(a))
(CFC) or a passive foreign investment company (within the meaning of
section 1297(a)) (PFIC) are taken into account in computing net
investment income.
A. CFC or PFIC Amounts Derived From a Trade or Business Described in
Proposed Sec. 1.1411-5
The special rules described in proposed Sec. 1.1411-10 do not
apply to income derived from a trade or business described in section
1411(c)(2) and proposed Sec. 1.1411-5 because such income is included
in net investment income under section 1411(c)(1)(A)(ii) and proposed
Sec. 1.1411-4(a)(1)(ii). Thus, an amount included in gross income
under section 1296(a) that is also income derived from a trade or
business described in section 1411(c)(2) and proposed Sec. 1.1411-5 is
net investment income within the meaning of section 1411(c)(1)(A)(ii)
and proposed Sec. 1.1411-4(a)(1)(ii). Similarly, amounts included in
income under sections 951(a) and 1293(a) that are derived from a trade
or business described in section 1411(c)(2) and proposed Sec. 1.1411-
5, and therefore fall within section 1411(c)(1)(A)(ii) and proposed
Sec. 1.1411-4(a)(1)(ii), are taken into account for purposes of
section 1411 when they are taken into account for purposes of chapter
1, and accordingly, the modifications described in this part of the
preamble are not necessary.
B. Net Investment Income
Under subpart F of the Code, a United States shareholder (as
defined in section 951(b)) of a CFC is required to include certain
amounts in income currently under section 951(a) (section 951
inclusions). Section 951 inclusions are not treated as dividends unless
expressly provided for in the Code, and therefore are not within any of
the categories of income items that comprise net investment income
(unless the amount is derived from a trade or business to which the tax
applies as provided in section 1411(c)(1)(A)(ii) and proposed Sec.
1.1411-4(a)(1)(ii)). See Rodriguez v. Comm'r, 137 T.C. 174 (2011).
Similarly, a United States person owning shares in a PFIC also is
required to include amounts in income currently under section 1293(a)
(section 1293 inclusions) if the person makes a qualified electing fund
(QEF) election under section 1295 with respect to the PFIC. Section
1293 inclusions also are not treated as dividends unless expressly
provided for in the Code, and, therefore, also are not taken into
account for purposes of calculating net investment income (unless the
amount is derived from a trade or business to which the tax applies as
provided in section 1411(c)(1)(A)(ii) and proposed Sec. 1.1411-
4(a)(1)(ii)).
The subpart F and PFIC regimes provide rules that prevent amounts
that have been included in income under sections 951 and 1293 by a
United States person from being subject to tax again when there is an
actual distribution from the foreign corporation. Specifically, section
959(d) provides that distributions from a CFC that are excluded from
gross income for purposes of chapter 1 under section 959(a) (earnings
and profits attributable to section 951 inclusions) are treated for
chapter 1 purposes as distributions that are not dividends. Similarly,
section 1293(c) provides that distributions paid out of earnings and
profits of a PFIC that are attributable to section 1293 inclusions are
treated for chapter 1 purposes as distributions that are not dividends.
However, in the absence of these special rules, which expressly apply
for chapter 1 purposes and are intended to reflect that the relevant
CFC or PFIC earnings have already been taxed for chapter 1 purposes,
the actual distributions would be taxable as dividends under general
Code rules applicable to corporations and their shareholders. Moreover,
as is the case with dividends, such actual distributions reduce the
earnings and profits of the relevant CFC or PFIC. Accordingly, the
proposed regulations reflect the premise that a distribution of
earnings and profits that previously were taxed pursuant to section
951(a) or section 1293(a), and which is not a dividend for chapter 1
purposes under section 959(d) or section 1293(c), remains a dividend
for chapter 2A purposes, and therefore constitutes gross income from
dividends for purposes of section 1411(c)(1)(A)(i) and proposed Sec.
1.1411-4(a)(1)(i).
Nevertheless, in light of the effective date of section 1411 and
the administrative burdens that would be imposed if taxpayers were
required to reconstruct the tax basis of their CFC or QEF stock (and
any intermediate entities) to eliminate the basis adjustments
(described in this part 11) associated with pre-effective date
[[Page 72630]]
income inclusions under sections 951(a) and 1293(a), the proposed
regulations provide a limit on the treatment of distributions of
previously taxed earnings and profits of a CFC or QEF as dividends for
section 1411 purposes. Specifically, under the proposed regulations,
such treatment would apply only with respect to distributions of
earnings and profits that previously were taxed pursuant to section
951(a) or section 1293(a) in a taxable year beginning after December
31, 2012. For purposes of determining whether a distribution is
attributable to earnings and profits that previously were taxed
pursuant to section 951(a) or section 1293(a) in a taxable year
beginning after December 31, 2012 (and thus is treated as a dividend
for section 1411 purposes), a distribution of earnings and profits that
previously were taxed pursuant to section 951(a) or section 1293(a)
will be considered attributable first to such earnings and profits, if
any, derived from the current taxable year, and then from taxable years
beginning with the most recent prior taxable year. In the case of a
distribution from a CFC, such determination shall be made without
regard to whether the earnings and profits are described in section
959(c)(1) or section 959(c)(2). Thus, this classification of
distributions as net investment income or non-net investment income is
separate from, and in addition to, the allocation of distributions to
previously taxed earnings and profits that are described in sections
959(c)(1) and 959(c)(2).
Accordingly, absent an election under proposed Sec. 1.1411-10(g)
(described in part 11.F of this preamble), the timing of income derived
from an investment in a CFC or a QEF may be different for chapter 1 and
chapter 2A purposes. Taxpayers will not include section 951 inclusions
or section 1293 inclusions in net investment income, but generally will
take distributions that are not treated as dividends for chapter 1
purposes under section 959(d) or section 1293(c) into account for
purposes of determining net investment income under section
1411(c)(1)(A)(i) and proposed Sec. 1.1411-4(a)(1)(i).
Including an amount in income only for purposes of chapter 1 or
chapter 2A however, requires special rules to calculate and administer
the tax imposed by section 1411. For example, because the rules
governing previously taxed income under chapter 1 require basis
adjustments to the stock of the CFC or QEF, a United States person will
be required to compute its tax basis in the stock (as well as its basis
in intermediate entities through which it holds the CFC or QEF stock)
differently for chapter 1 and chapter 2A purposes. As described in
detail in part 11.F of this preamble, however, the proposed regulations
seek to minimize complexity arising from the different treatment under
chapter 1 and chapter 2A by providing an election that, if made,
results in consistent treatment for chapter 1 and chapter 2A purposes
with respect to stock of CFCs and QEFs. See proposed Sec. 1.1411-
10(g).
To the extent that a disposition of stock of a CFC or QEF gives
rise to net gain under section 1411(c)(1)(A)(iii), such amount is
included in net investment income. In the absence of an election under
proposed Sec. 1.1411-10(g), the basis increases provided in sections
961(a) and 1293(d) that apply for chapter 1 purposes for amounts
included in gross income for chapter 1 purposes under sections 951(a)
and 1293(a) in taxable years beginning after December 31, 2012, do not
apply to the calculation of gain or loss for purposes of section 1411.
Similarly, in the absence of an election, the basis decreases provided
in sections 961(b) and 1293(d) that apply for chapter 1 purposes do not
apply to the extent that such decreases are attributable to a
distribution of post-effective date earnings and profits that is
treated as a dividend for chapter 2A purposes.
In certain circumstances, section 1248 may apply for chapter 1
purposes to recharacterize all or a portion of gain recognized on the
disposition of stock of a foreign corporation as dividend income.
Section 1248 also may apply to determine whether any portion of the
gain calculated for section 1411 purposes should be recharacterized as
a dividend. If no election is made pursuant to proposed Sec. 1.1411-
10(g), the proposed regulations provide that sections 1248(d)(1) and
1248(d)(6) (relating to amounts excluded from earnings and profits for
purposes of determining the amount of gain recharacterized as a
dividend under section 1248) generally do not apply because the
earnings and profits of the foreign corporation are not attributable to
any amount previously taxed for purposes of section 1411. However, the
proposed regulations provide that sections 1248(d)(1) and 1248(d)(6) do
apply for purposes of section 1411 to the extent the earnings and
profits of the foreign corporation are attributable to an amount that
was included in chapter 1 income in a taxable year that began prior to
December 31, 2012 (the effective date of section 1411).
Proposed Sec. 1.1411-10 also provides special rules that apply to
a United States shareholder of a PFIC who is subject to the tax and
interest charge applicable to excess distributions under section 1291.
The proposed regulations provide that the calculation of net investment
income includes any distribution of earnings and profits by a PFIC that
constitutes a dividend within the meaning section 316(a), or any gain
from a disposition of PFIC stock, even though all or a portion of the
dividend or gain may be treated as an excess distribution and allocated
to prior taxable years for purposes of computing the additional amount
of tax imposed under section 1291(a)(1)(C) (and hence may not be taxed
as a dividend or gain for chapter 1 purposes).
In addition, the proposed regulations provide rules applicable to a
United States person that has elected to mark to market its PFIC stock
under section 1296. In such case, amounts that are included in gross
income under section 1296(a)(1) and, correspondingly, amounts allowable
as a deduction under section 1296(a)(2) are taken into account under
section 1411(c)(1)(A)(iii) and proposed Sec. 1.1411-4(a)(1)(iii) in
computing net gain for purposes of section 1411.
Section 1411(c)(1)(B) provides that, in determining net investment
income, items of gross income and net gain are reduced by properly
allocable deductions. In the absence of an election under proposed
Sec. 1.1411-10(g), differences may occur in the timing of income
derived with respect to CFCs and QEFs for chapter 1 and chapter 2A
purposes. Consequently, the determination of properly allocable
deductions with respect to sections 959(d) and 1293(c) dividend
distributions may require special rules. For example, certain itemized
deductions related to items of net investment income described in
proposed Sec. 1.1411-10(c) (such as the investment interest deduction)
may require special rules to determine when these deductions are
properly allocable deductions for purposes of section 1411. The
Treasury Department and the IRS request comments on whether guidance is
necessary to determine the deductions that are properly allocable to
items of net investment income described in proposed Sec. 1.1411-10(c)
if the election under proposed Sec. 1.1411-10(g) is not made.
C. Modified Adjusted Gross Income
Because of the different timing under chapter 1 and chapter 2A for
including certain income from investments in CFCs and PFICs, the
proposed regulations contain rules coordinating these provisions with
the determination of the calculation of the section 1411 tax, which is
based, in part, in section
[[Page 72631]]
1411(a)(1)(B) on an individual's modified adjusted gross income. Absent
an election under proposed Sec. 1.1411-10(g), the proposed regulations
provide that an individual who owns stock in a CFC or a QEF must
increase or decrease modified adjusted gross income (as defined in
proposed Sec. 1.1411-2(c)) in certain circumstances. For example,
proposed Sec. 1.1411-10(e) provides that modified adjusted gross
income is increased by any section 959(d) or section 1293(c)
distributions that are dividends for chapter 2A purposes. In order to
avoid subjecting the same amount of income to tax twice under section
1411, section 951 inclusions and section 1293 inclusions are excluded
from modified adjusted gross income under proposed Sec. 1.1411-
10(e)(1)(iii) for purposes of section 1411. In addition, modified
adjusted gross income is adjusted to take into account the amount of
gain or loss attributable to a disposition of stock of a CFC or QEF for
section 1411 purposes, which may differ from the amount of gain or loss
calculated for chapter 1 purposes. For purposes of section 1411, in the
absence of an election under proposed Sec. 1.1411-10(g), gain or loss
is determined without taking into account basis increases under
sections 961(a) and 1293(d) that are included in the calculation of
basis for purposes of chapter 1 with respect to amounts included in
gross income for chapter 1 purposes under sections 951(a) and 1293(a)
in taxable years beginning after December 31, 2012. In addition, gain
or loss is determined without taking into account basis decreases under
sections 961(a) and 1293(d) that are included in the calculation of
basis for purposes of chapter 1 to the extent the decreases are
attributable to a distribution of earnings and profits that is treated
as a dividend for chapter 2A purposes.
Modified adjusted gross income is also adjusted with respect to
interests in PFICs that are subject to tax under section 1291.
Specifically, the proposed regulations provide that modified adjusted
gross income for section 1411 purposes is increased by the amount of
any excess distribution (within the meaning of section 1291(b)) to the
extent the distribution constitutes a dividend under section 316(a) and
is not otherwise included in income for chapter 1 purposes under
section 1291(a)(1)(B), and by any gain treated as an excess
distribution under section 1291(a)(2) to the extent not otherwise
included in income for chapter 1 purposes under section 1291(a)(1)(B).
D. Special Rules Where Stock Is Held by Partnerships or S Corporations
The proposed regulations provide rules that apply to an individual,
estate, or trust that owns stock of a CFC or QEF through a domestic
partnership or S corporation. Because of the different timing rules
under chapter 1 and chapter 2A and the fact that partnerships and S
corporations are passthrough entities, the proposed regulations provide
rules on the determination for section 1411 purposes of (1) the
partner's or shareholder's outside basis in his interest, and (2) the
partnership's or S corporation's adjusted basis in its CFC or QEF
stock. The Treasury Department and the IRS believe that the partnership
or S corporation will need to separately state, in addition to a
partner's distributive share of the amounts included in the
partnership's income under section 951(a) or section 1293(a), a
partner's distributive share of any distributions of previously taxed
earnings and profits of a CFC or QEF received by the partnership or S
corporation that are dividends for purposes of chapter 2A. The Treasury
Department and the IRS request comments on appropriate ways to
determine a partner's distributive share of a distribution of
previously taxed earnings and profits given the purpose of section
1411.
The Treasury Department and the IRS request comments on improving
the administrability of these provisions, including the reporting of
CFC or QEF amounts through domestic partnerships or S corporations. In
addition, the Treasury Department and the IRS request comments on the
determination of a partner's basis adjustment under section 743 for
purposes of section 1411 when the partnership holds stock in a CFC or
QEF.
E. Conforming Rules for Estates and Trusts
The proposed regulations also provide conforming rules for estates,
trusts, and their beneficiaries. Proposed Sec. 1.1411-10(c)(5),
(e)(2), and (f) coordinate the rules relating to the computation of net
investment income and any associated increase or decrease to adjusted
gross income with the distributable net income regime and other general
operating rules governing the income taxation of estates and trusts
contained in Subchapter J and proposed Sec. 1.1411-3. The Treasury
Department and the IRS request comments on the interaction of
subchapter J and the PFIC rules in order to address consistency issues
between chapter 1 and chapter 2A.
F. Election
As described in parts 11.B through 11.E of this preamble, certain
adjustments, including adjustments to modified adjusted gross income
for purposes of section 1411, are necessary with respect to inclusions
under sections 951 and 1293. The Treasury Department and the IRS
recognize that these rules may create an additional administrative
burden for certain taxpayers. Thus, proposed Sec. 1.1411-10(g) allows
individuals, estates, and trusts to make an election to include
inclusions under sections 951 and 1293 in net investment income in the
same manner and in the same taxable year as such amounts are included
in income for chapter 1 purposes. If an individual, estate, or trust
makes the election, any section 959(d) or section 1293(c) distributions
that are not treated as dividends for chapter 1 purposes are not
treated as dividends for section 1411 purposes, and thus would not be
included in net investment income for section 1411 purposes. Moreover,
the separate computation of basis for section 1411 purposes would not
be required, and thus distributions under sections 959(d) and 1293(c)
would decrease the taxpayer's basis in its CFC or PFIC stock, and
inclusions under sections 951 and 1293 would increase the taxpayer's
basis in its CFC or PFIC stock, in the same manner as the taxpayer's
basis is adjusted for chapter 1 purposes.
An individual, estate, or trust that wants to make the election
generally must do so for the first taxable year beginning after
December 31, 2013, during which (1) the individual, estate, or trust
owns an interest in a CFC or PFIC, and (2) the individual, estate, or
trust is subject to tax under section 1411 or would be subject to tax
under section 1411 if the election under proposed Sec. 1.1411-10(g) is
made. In addition, the election may be made for a taxable year that
begins before January 1, 2014. The determination of whether an
individual, estate, or trust is subject to tax under section 1411 for a
taxable year is based on whether the individual's modified adjusted
gross, or the estate's or trust's adjusted gross income, exceeds the
applicable threshold set forth in Sec. 1.1411-2(d) or Sec. 1.1411-
3(a)(1)(ii)(B)(2), regardless of whether the individual, estate, or
trust has an income inclusion under section 951(a) or section 1293(a),
or receives a distribution of previously taxed income with respect to
any CFC or QEF in that taxable year. For example, if in 2014, a single
individual acquires an interest in a QEF, has a QEF inclusion of
$5,000,
[[Page 72632]]
and has modified adjusted gross income of $150,000, the individual
would not have to make an election for 2014 because section 1411 is not
applicable. If, in 2015, the individual has modified adjusted gross
income in excess of $200,000, and the individual would like to take QEF
inclusions into account for purposes of section 1411 in the same manner
and in the same taxable year as such amounts are taken into account for
chapter 1 purposes, the individual must make the election for 2015 in
the time and manner described in proposed Sec. 1.1411-10(g).
Once an election is made, it applies to all interests in CFCs and
PFICs, including CFCs and PFICs that subsequently are acquired by the
electing taxpayer. The election cannot be revoked, except with the
Commissioner's consent.
The Treasury Department and the IRS request comments on this
election, including the conditions under which an automatic extension
of time to make the election should be permitted.
12. Taxpayer Reliance on Proposed Regulations
These regulations are proposed to be effective for taxable years
beginning after December 31, 2013, except that Sec. 1.1411-3(c)(2) is
proposed to apply to taxable years beginning after December 31, 2012.
The Treasury Department and IRS intend to finalize regulations under
section 1411 in 2013. Taxpayers are reminded that section 1411 is
effective for taxable years beginning after December 31, 2012.
Taxpayers may rely on these proposed regulations for purposes of
compliance with section 1411 until the effective date of the final
regulations. To the extent these proposed regulations provide taxpayers
with the ability to make an election, taxpayers may make the election,
including regroupings described in Sec. 1.469-11(b)(3)(iv), provided
that the election is made in the manner described in the applicable
provision. Any election made in reliance on these proposed regulations
will be in effect for the year of the election, and will remain in
effect for subsequent taxable years. However, if final regulations
provide for the same or a similar election, taxpayers who opt not to
make an election in reliance on these proposed regulations will not be
precluded from making that election pursuant to the final regulations.
Proposed Effective Date
These regulations are proposed to be effective for taxable years
beginning after December 31, 2013, except that Sec. 1.1411-3(c)(2) is
proposed to apply to taxable years beginning after December 31, 2012.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866, as supplemented by Executive Order 13563. Therefore, a
regulatory assessment is not required. It also has been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
does not apply to the proposed regulations. Pursuant to the Regulatory
Flexibility Act (RFA) (5 U.S.C. chapter 6), it is hereby certified that
the proposed regulations will not have a significant economic impact on
a substantial number of small entities. The applicability of the
proposed regulations are limited to individuals, estates, and trusts,
which are not small entities as defined by the RFA (5 U.S.C. 601).
Accordingly, the RFA does not apply. Therefore, a regulatory
flexibility analysis is not required. Pursuant to section 7805(f) of
the Code, the proposed regulations have been submitted to the Chief
Counsel for Advocacy of the Small Business Administration for comment
on its impact on small business.
Comments and Public Hearing
Before the proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) or electronic comments that are submitted timely
to the IRS. The Treasury Department and the IRS request comments on all
aspects of the proposed rules. All comments will be available for
public inspection and copying.
A public hearing has been scheduled for Tuesday, April 2, 2013,
beginning at 10:00 a.m. in the Auditorium, Internal Revenue Building,
1111 Constitution Avenue NW., Washington, DC. Due to building security
procedures, visitors must enter at the Constitution Avenue entrance. In
addition, all visitors must present photo identification to enter the
building. Because of access restrictions, visitors will not be admitted
beyond the immediate entrance area more than 30 minutes before the
hearing starts. For information about having your name placed on the
building access list to attend the hearing, see the FOR FURTHER
INFORMATION CONTACT section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit electronic or
written comments by March 5, 2013, and an outline of the topics to be
discussed and the time to be devoted to each topic (signed original and
eight (8) copies) by March 5, 2013. A period of 10 minutes will be
allotted to each person for making comments. An agenda showing the
scheduling of the speakers will be prepared after the deadline for
receiving outlines has passed. Copies of the agenda will be available
free of charge at the hearing.
Drafting Information
The principal authors of the proposed regulations are Michala Irons
and David H. Kirk, IRS Office of the Associate Chief Counsel
(Passthroughs and Special Industries). However, other personnel from
the Treasury Department and the IRS participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par 2. Section 1.469-0 is amended by adding the following entries
to the table of contents:
Sec. 1.469-0 Table of contents.
* * * * *
Sec. 1.469-11 Effective date and transition rules.
* * * * *
(b) * * *
(3) * * *
(iv) Regrouping for taxpayers subject to section 1411.
(A) In general.
(B) Effective/applicability date.
* * * * *
Par 3. Section 1.469-11 is amended by adding paragraph (b)(3)(iv)
to read as follows:
Sec. 1.469-11 Effective date and transition rules.
* * * * *
(b) * * *
(3) * * *
(iv) Regrouping for taxpayers subject to section 1411--(A) In
general. If an individual, estate, or trust has net investment income
(as defined in Sec. 1.1411-4) and such individual's (as defined in
Sec. 1.1411-2(a)) modified adjusted gross income (as defined in Sec.
1.1411-2(c)) exceeds the applicable
[[Page 72633]]
threshold in Sec. 1.1411-2(d) or such estate's or trust's (as defined
in Sec. 1.1411-3(a)(1)(i)) adjusted gross income exceeds the amount
described in section 1411(a)(2)(B)(ii) and Sec. 1.1411-
3(a)(1)(ii)(B)(2), such individual, estate, or trust may, in the first
taxable year beginning after December 31, 2013, in which section 1411
would apply to such taxpayer, regroup its activities without regard to
the manner in which the activities were grouped in the preceding
taxable year. For this purpose, the determination whether section 1411
would apply is made without regard to the effect of regrouping. A
taxpayer that is an individual, estate, or trust may regroup its
activities for any taxable year that begins during 2013, if section
1411 would apply to such taxpayer for such year. A taxpayer may regroup
activities only once pursuant to this paragraph (b)(3)(iv), and a
regrouping made pursuant to this paragraph will apply to the taxable
year for which the regrouping is done and all subsequent years.
(B) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013.
* * * * *
Par. 4. Sections 1.1411-0 through 1.1411-10 are added to read as
follows:
Sec. 1.1411-0 Table of contents.
Sec. 1.1411-1 General rules.
(a) General rule.
(b) Adjusted gross income.
(c) Effective/applicability date.
Sec. 1.1411-2 Application to individuals.
(a) Individual defined.
(1) Individuals to whom tax applies.
(2) Special rules.
(i) Joint returns in the case of a nonresident alien individual
married to a U.S. citizen or resident.
(A) Default treatment.
(B) Taxpayer election.
(1) Effect of election.
(2) Procedural requirements for making election.
(ii) Grantor trusts.
(iii) Bankruptcy estates.
(iv) Bona fide residents of U.S. territories.
(A) Applicability.
(B) Coordination with exception for nonresident aliens.
(C) Definitions.
(1) Bona fide resident.
(2) U.S. territory.
(b) Calculation of tax.
(1) In general.
(2) Example.
(c) Modified adjusted gross income.
(1) General rule.
(2) Rules with respect to controlled foreign corporations and
passive foreign investment companies.
(d) Threshold amount.
(1) In general.
(2) Taxable year of less than twelve months.
(i) General rule.
(ii) Change of annual accounting period.
(e) Effective/applicability date.
Sec. 1.1411-3 Application to estates and trusts.
(a) Estates and trusts to which tax applies.
(1) In general.
(i) General application.
(ii) Calculation of tax.
(2) Taxable year of less than twelve months.
(i) General rule.
(ii) Change of annual accounting period.
(3) Rules with respect to controlled foreign corporations and
passive foreign investment companies.
(b) Exception for certain trusts.
(c) Application to specific trusts.
(1) Electing small business trusts (ESBTs).
(i) General application.
(ii) Computation of tax.
(A) Step one.
(B) Step two.
(C) Step three.
(2) Special rules for charitable remainder trusts.
(i) Treatment of annuity or unitrust distributions.
(ii) Apportionment between multiple beneficiaries.
(iii) Accumulated net investment income.
(3) Certain foreign trusts with United States beneficiaries.
[Reserved]
(d) Application to specific estates.
(1) Bankruptcy estates.
(2) Foreign estates.
(i) General rule.
(ii) Certain foreign estates with United States beneficiaries.
[Reserved]
(e) Calculation of undistributed net investment income.
(1) In general.
(2) Undistributed net investment income.
(3) Distributions of net investment income to beneficiaries.
(4) Deduction for amounts paid or permanently set aside for a
charitable purpose.
(5) Excluded income.
(f) Examples.
(g) Effective/applicability date.
Sec. 1.1411-4 Definition of net investment income.
(a) In general.
(b) Ordinary course of a trade or business exception.
(c) Other gross income from a trade or business described in
Sec. 1.1411-5.
(1) Passive activity.
(2) Trading in financial instruments or commodities.
(d) Net gain.
(1) Definition of disposition.
(2) Limitation.
(3) Net gain attributable to the disposition of property.
(i) In general.
(ii) Exception for gain or loss attributable to property held in
a trade or business not described in Sec. 1.1411-5.
(A) General rule.
(B) Special rules for determining whether property is held in a
trade or business.
(C) Example.
(iii) Adjustments to gain or loss attributable to the
disposition of interests in a partnership or S corporation.
(e) Distributions from estates and trusts.
(f) Properly allocable deductions.
(1) General rule.
(i) In general.
(ii) Limitations and carryovers.
(2) Properly allocable deductions described in section 62.
(i) Deductions allocable to gross income from rents and
royalties.
(ii) Deductions allocable to gross income from trades or
businesses described in Sec. 1.1411-5.
(iii) Penalty on early withdrawal of savings.
(3) Properly allocable deductions described in section 63(d).
(i) In general.
(A) Investment interest expense.
(B) Investment expenses.
(C) Taxes described in section 164(a)(3).
(ii) Application of limitations under sections 67 and 68.
(A) Deductions subject to section 67.
(B) Deductions subject to section 68.
(4) Loss deductions.
(g) Special rules for controlled foreign corporations and
passive foreign investment companies.
(h) Examples.
(i) Effective/applicability date.
Sec. 1.1411-5 Trades and businesses to which tax applies.
(a) In general.
(b) Passive activity.
(1) In general.
(2) Examples.
(c) Trading in financial instruments or commodities.
(1) Definition of financial instruments.
(2) Definition of commodities.
(d) Effective/applicability date.
Sec. 1.1411-6 Income on investment of working capital subject to
tax.
(a) General rule.
(b) Example.
(c) Effective/applicability date.
Sec. 1.1411-7 Exception for dispositions of interests in
partnerships and S corporations.
(a) In general.
(1) General application.
(2) Interests to which exception applies.
(i) In general.
(ii) Nonapplication.
(b) Special rules.
(1) Installment sales.
(i) Installment sales after the effective date of section 1411.
(ii) Installment sales prior to the effective date of section
1411.
(2) Sale of an interest by a Qualified Subchapter S Trust.
[Reserved]
(c) Deemed sale.
(1) In general.
(2) Step one: Deemed sale of properties.
(3) Step two: Determination of gain or loss.
(4) Step three: Allocation of gain or loss.
(5) Step four: Adjustment to gain or loss.
(i) In general.
(ii) Special rules.
(A) Property used in more than one trade or business.
(B) Goodwill attributable to property.
(iii) Negative adjustment.
(A) General rule.
(B) Limitations.
[[Page 72634]]
(iv) Positive adjustment.
(A) General rule.
(B) Limitations.
(d) Required statement of adjustment.
(e) Examples.
(f) Effective/applicability date.
Sec. 1.1411-8 Exception for distributions from qualified plans.
(a) General rule.
(b) Rules relating to distributions.
(1) Actual distributions.
(2) Amounts treated as distributed.
(3) Amounts includible in gross income.
(c) Effective/applicability date.
Sec. 1.1411-9 Exception for self-employment income.
(a) General rule.
(b) Special rule for traders.
(c) Examples.
(d) Effective/applicability date.
Sec. 1.1411-10 Controlled foreign corporations and passive foreign
investment companies.
(a) In general.
(b) Amounts derived from a trade or business described in Sec.
1.1411-5.
(c) Calculation of net investment income.
(1) In general.
(2) Dividends.
(i) Distributions of previously taxed earnings and profits.
(ii) Excess distributions constituting dividends.
(3) Net gain.
(i) Gains treated as excess distributions.
(ii) Inclusions and deductions with respect to section 1296 mark
to market elections.
(iii) Gain or loss attributable to the disposition of stock of
controlled foreign corporations and qualified electing funds.
(iv) Gain or loss attributable to the disposition of interests
in domestic partnerships or S corporations that own directly or
indirectly stock of controlled foreign corporations or qualified
electing funds.
(4) Application of section 1248.
(5) Amounts distributed by an estate or trust.
(d) Conforming basis adjustments.
(1) Basis adjustments under sections 961 and 1293.
(i) Stock held by individuals, estates, or trusts.
(ii) Stock held by domestic partnerships or S corporations.
(2) Special rules for partners that own interests in domestic
partnerships that own directly or indirectly stock of controlled
foreign corporations or qualified electing funds.
(3) Special rules for S corporation shareholders that own
interests in S corporations that own directly or indirectly stock of
controlled foreign corporations or qualified electing funds.
(e) Conforming adjustments to modified adjusted gross income and
adjusted gross income.
(1) Individuals.
(2) Estates and trusts.
(f) Application to estates and trusts.
(g) Election with respect to controlled foreign corporations and
qualified electing funds.
(1) In general.
(2) Revocation of election.
(3) Time and manner for making election.
(h) Examples.
(i) Effective/applicability date.
Sec. 1.1411-1 General rules.
(a) General rule. Except as otherwise provided, all Internal
Revenue Code provisions that apply for chapter 1 purposes in
determining taxable income (as defined in section 63(a)) of a taxpayer
also apply in determining the tax imposed by section 1411.
(b) Adjusted gross income. All references to an individual's
adjusted gross income shall be treated as references to adjusted gross
income (as defined in section 62), and all references to an estate's or
trust's adjusted gross income shall be treated as references to
adjusted gross income (as defined in section 67(e)). However, there may
be additional adjustments to adjusted gross income because of
investments in controlled foreign corporations or passive foreign
investment companies. See Sec. 1.1411-10(e).
(c) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013.
Sec. 1.1411-2 Application to individuals.
(a) Individual defined--(1) Individuals to whom tax applies. For
purposes of section 1411 and the regulations thereunder, an individual
is any natural person. However, section 1411 does not apply to
nonresident alien individuals (within the meaning of section
7701(b)(1)(B)). Therefore, for purposes of section 1411 and the
regulations thereunder, an individual to whom the tax imposed under
section 1411(a)(1) applies is any citizen or resident of the United
States (within the meaning of section 7701(a)(30)(A)). See paragraph
(a)(2)(iv) of this section for special rules regarding bona fide
residents of U.S. territories.
(2) Special rules--(i) Joint returns in the case of a nonresident
alien individual married to a U.S. citizen or resident--(A) Default
treatment. In the case of a U.S. citizen or resident who is married (as
defined in section 7703) to a nonresident alien individual, the spouses
will be treated as married filing separately for purposes of section
1411. For purposes of calculating the tax imposed under section
1411(a)(1), the U.S. citizen or resident spouse will be subject to the
threshold amount for a married taxpayer filing a separate return in
paragraph (d)(1)(ii) of this section, and the nonresident alien spouse
will not be subject to tax under section 1411. In accordance with the
rules for married individuals filing separate returns, the spouse that
is a U.S. citizen or resident must determine his or her own net
investment income and modified adjusted gross income.
(B) Taxpayer election. Married taxpayers who file a joint Federal
income tax return pursuant to a section 6013(g) election for purposes
of chapter 1 and chapter 24 may also elect to be treated as making a
section 6013(g) election for purposes of chapter 2A (relating to the
tax imposed by section 1411).
(1) Effect of election. For purposes of calculating the tax imposed
under section 1411(a)(1), the effect of an election under section
6013(g) is to include the combined income of the U.S. citizen or
resident spouse and the nonresident spouse in the section 1411(a)(1)
calculation and apply the threshold amount for a taxpayer making a
joint return as set out in paragraph (d)(1)(i) of this section.
(2) Procedural requirements for making election. Taxpayers with a
section 6013(g) election for chapter 1 and chapter 24 purposes in
effect for any taxable year beginning after December 31, 2012, or
taxpayers making a section 6013(g) election for chapter 1 and chapter
24 purposes in any taxable year beginning after December 31, 2012, who
want to apply their section 6013(g) election to chapter 2A must make
the election for the first taxable year beginning after December 31,
2013, in which the U.S. taxpayer is subject to tax under section 1411.
The determination of whether the U.S. taxpayer is subject to tax under
section 1411 is made without regard to the effect of the section
6013(g) election described in paragraph (a)(2)(i)(B) of this section.
In addition, taxpayers may elect to apply their section 6013(g)
election to chapter 2A for a taxable year that begins before January 1,
2014. In all cases, the election must be made in the manner prescribed
by the Secretary on a timely filed (including extensions) return, or
amended return, for the taxable year for which the election is made.
Further, in all cases, once made, the duration and termination of the
section 6013(g) election for chapter 2A is governed by the rules of
section 6013(g)(2) through (6) and the regulations thereunder.
(ii) Grantor trusts. For rules regarding the treatment of owners of
grantor trusts, see Sec. 1.1411-3(b)(5).
(iii) Bankruptcy estates. A bankruptcy estate administered under
chapter 7 (relating to liquidations) or chapter 11 (relating to
reorganizations) of the Bankruptcy Code (Title 11 of the United States
Code) of a debtor who is an individual shall be treated as a married
taxpayer filing a separate return for
[[Page 72635]]
purposes of section 1411. See Sec. 1.1411-2(d)(1)(ii).
(iv) Bona fide residents of U.S. territories--(A) Applicability. An
individual who is a bona fide resident of a U.S. territory is subject
to the tax imposed by section 1411(a)(1) only if the individual is
required to file an income tax return with the United States upon
application of section 931, 932, 933, or 935 and the regulations
thereunder. With respect to an individual described in this paragraph
(a)(2)(iv)(A), the amount excluded from gross income under section 931
or 933 and any deduction properly allocable or chargeable against
amounts excluded from gross income under section 931 or 933,
respectively, is not taken into account in computing modified adjusted
gross income under paragraph (c) of this section or net investment
income under Sec. 1.1411-4.
(B) Coordination with exception for nonresident aliens. An
individual who is both a bona fide resident of a U.S. territory and a
nonresident alien individual with respect to the United States is not
subject to taxation under section 1411(a)(1).
(C) Definitions. For purposes of this section--
(1) Bona fide resident. The term bona fide resident has the meaning
provided under section 937(a).
(2) U.S. territory. The term U.S. territory means American Samoa,
Guam, the Northern Mariana Islands, Puerto Rico, or the United States
Virgin Islands.
(b) Calculation of tax--(1) In general. In the case of an
individual described in paragraph (a)(1) of this section, the tax
imposed by section 1411(a)(1) for each taxable year is equal to 3.8
percent of the lesser of--
(i) Net investment income (as defined in Sec. 1.1411-4) for such
taxable year; or
(ii) The excess (if any) of--
(A) The modified adjusted gross income (as defined in paragraph (c)
of this section) for such taxable year; over
(B) The threshold amount (as defined in paragraph (d) of this
section).
(2) Example. During Year 1 (a taxable year in which section 1411
is in effect), A, an unmarried U.S. citizen, has modified adjusted
gross income (as defined in paragraph (c) of this section) of
$190,000, which includes $50,000 of net investment income (as
defined in Sec. 1.1411-4). A has a zero tax imposed under section
1411 because the threshold amount for a single individual is
$200,000 (as provided in paragraph (d)(1)(iii) of this section). If
during Year 2, A has modified adjusted gross income of $220,000,
which includes $50,000 of net investment income, then the individual
has a section 1411 tax of $760 (3.8 percent multiplied by $20,000).
(c) Modified adjusted gross income--(1) General rule. For purposes
of section 1411, the term modified adjusted gross income means adjusted
gross income increased by the excess of--
(i) The amount excluded from gross income under section 911(a)(1);
over
(ii) The amount of any deductions (taken into account in computing
adjusted gross income) or exclusions disallowed under section 911(d)(6)
with respect to the amounts described in paragraph (c)(1)(i) of this
section.
(2) Rules with respect to controlled foreign corporations and
passive foreign investment companies. Additional rules in Sec. 1.1411-
10(e)(1) apply to an individual that is a United States shareholder of
a controlled foreign corporation (within the meaning of section 957(a))
or that is a United States person that directly or indirectly owns an
interest in a passive foreign investment company (within the meaning of
section 1297(a)).
(d) Threshold amount--(1) In general. The term threshold amount
means--
(i) In the case of a taxpayer making a joint return under section
6013 or a surviving spouse (as defined in section 2(a)), $250,000;
(ii) In the case of a married taxpayer (as defined in section 7703)
filing a separate return, $125,000; and
(iii) In any other case, $200,000.
(2) Taxable year of less than twelve months--(i) General rule. In
the case of an individual who has a taxable year consisting of less
than twelve months (short taxable year), the threshold amount under
paragraph (d)(1) of this section is not reduced or prorated. For
example, in the case of an unmarried decedent who dies on June 1, the
threshold amount is $200,000 for the decedent's short taxable year that
begins on January 1 and ends on June 1.
(ii) Change of annual accounting period. Notwithstanding paragraph
(d)(2)(i) of this section, an individual who has a short taxable year
resulting from a change of annual accounting period shall reduce the
threshold amount to an amount that bears the same ratio to the full
threshold amount provided under paragraph (d)(1) of this section as the
number of months in the short taxable year bears to twelve.
(e) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013.
Sec. 1.1411-3 Application to estates and trusts.
(a) Estates and trusts to which tax applies--(1) In general--(i)
General application. Section 1411 and the regulations thereunder apply
to all estates and trusts that are subject to the provisions of part I
of subchapter J of chapter 1 of subtitle A of the Internal Revenue
Code, unless specifically exempted by paragraph (b) of this section.
(ii) Calculation of tax. The tax imposed by section 1411(a)(2) for
each taxable year is equal to 3.8 percent of the lesser of--
(A) The estate's or trust's undistributed net investment income for
such taxable year; or
(B) The excess (if any) of--
(1) The estate's or trust's adjusted gross income (as defined in
section 67(e) and adjusted by Sec. 1.1411-10(e)(2), if applicable) for
such taxable year; over
(2) The dollar amount at which the highest tax bracket in section
1(e) begins for such taxable year.
(2) Taxable year of less than twelve months--(i) General rule. In
the case of an estate or trust that has a taxable year consisting of
less than twelve months (short taxable year), the dollar amount
described in paragraph (a)(1)(ii)(B)(2) of this section is not reduced
or prorated.
(ii) Change of annual accounting period. Notwithstanding paragraph
(a)(2)(i) of this section, an estate or trust that has a short taxable
year resulting from a change of annual accounting period (but not from
an individual's death) shall reduce the dollar amount described in
paragraph (a)(1)(ii)(B)(2) of this section to an amount that bears the
same ratio to that dollar amount as the number of months in the short
taxable year bears to twelve.
(3) Rules with respect to controlled foreign corporations and
passive foreign investment companies. Additional rules in Sec. 1.1411-
10 apply to an estate or trust that holds an interest in a controlled
foreign corporation (within the meaning of section 957(a)) or a passive
foreign investment (within the meaning of section 1297(a)).
(b) Exception for certain trusts. The following trusts are not
subject to the tax imposed by section 1411:
(1) A trust all of the unexpired interests in which are devoted to
one or more of the purposes described in section 170(c)(2)(B).
(2) A trust exempt from tax under section 501.
(3) A charitable remainder trust described in section 664. However,
see paragraph (c)(2) of this section for special rules regarding the
treatment of annuity or unitrust distributions from such trust to
persons subject to tax under section 1411.
(4) 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).
[[Page 72636]]
(5) 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. However,
in the case of any such trust or portion thereof, each item of income
or deduction that is included in computing taxable income of a grantor
or another person under section 671 shall be treated as if it had been
received by, or paid directly to, the grantor or other person for
purposes of calculating such person's net investment income.
(6) Except to the extent provided in paragraph (c)(3) of this
section, a foreign trust (as defined in section 7701(a)(31)(B) and
Sec. 301.7701-7(a)(2)).
(c) Application to specific trusts--(1) Electing small business
trusts (ESBTs)--(i) General application. The S portion and non-S
portion (as defined in Sec. 1.641(c)-1(b)(2) and (3), respectively) of
a trust that has made an ESBT election under section 1361(e)(3) and
Sec. 1.1361-1(m)(2) shall be treated as separate trusts for purposes
of the computation of undistributed net investment income in the manner
described in paragraph (e) of this section, but shall be treated as a
single trust for purposes of determining the amount subject to tax
under section 1411. If a grantor or another person is treated as the
owner of a portion of the ESBT, the items of income and deduction
attributable to the grantor portion (as defined in Sec. 1.641(c)-
1(b)(1)) shall be included in the grantor's calculation of net
investment income and shall not be included in the ESBT's computation
of tax described in paragraph (c)(1)(ii) of this section.
(ii) Computation of tax. This paragraph (c)(1)(ii) provides the
method for an ESBT to compute the tax under section 1411. See Example 3
in paragraph (f) of this section.
(A) Step one: The S portion and non-S portion shall compute each
portion's undistributed net investment income as separate trusts in the
manner described in paragraph (e) of this section and then combine
these amounts to calculate the ESBT's undistributed net investment
income.
(B) Step two: The ESBT will calculate its adjusted gross income (as
defined in paragraph (a)(1)(ii)(B)(1) of this section). The ESBT's
adjusted gross income is the non-S portion's adjusted gross income,
increased or decreased by the net income or net loss of the S portion,
after taking into account all deductions, carryovers, and loss
limitations applicable to the S portion, as a single item of ordinary
income (or ordinary loss).
(C) Step three: The ESBT will pay tax on the lesser of--
(1) The ESBT's total undistributed net investment income; or
(2) The excess of the ESBT's adjusted gross income (as calculated
in paragraph (c)(1)(ii)(B) of this section) over the dollar amount at
which the highest tax bracket in section 1(e) begins for the taxable
year.
(2) Special rules for charitable remainder trusts--(i) Treatment of
annuity or unitrust distributions. The net investment income of the
beneficiary attributable to the beneficiary's annuity or unitrust
distribution from a charitable remainder trust shall include an amount
equal to the lesser of--
(A) The total amount of the distributions for that year; or
(B) The current and accumulated net investment income of the
charitable remainder trust.
(ii) Apportionment between multiple beneficiaries. In the case of a
charitable remainder trust with more than one annuity or unitrust
beneficiary, the net investment income shall be apportioned among such
beneficiaries based on their respective shares of the total annuity or
unitrust amount paid by the charitable remainder trust for that taxable
year.
(iii) Accumulated net investment income. The accumulated net
investment income of a charitable remainder trust is the total amount
of net investment income received by a charitable remainder trust for
all taxable years that begin after December 31, 2012, less the total
amount of net investment income distributed for all prior taxable years
of the trust that begin after December 31, 2012.
(3) Certain foreign trusts with United States beneficiaries.
[Reserved]
(d) Application to specific estates--(1) Bankruptcy estates. A
bankruptcy estate in which the debtor is an individual is treated as a
married taxpayer filing a separate return for purposes of section 1411.
See Sec. Sec. 1.1411-2(a)(2)(iii) and 1.1411-2(d)(1)(ii).
(2) Foreign estates--(i) General rule. Except to the extent
provided in paragraph (d)(2)(ii) of this section, the tax imposed by
section 1411 does not apply to a foreign estate (as defined in section
7701(a)(31)(A)).
(ii) Certain foreign estates with United States beneficiaries.
[Reserved]
(e) Calculation of undistributed net investment income--(1) In
general. This paragraph (e)(1) provides special rules for the
computation of certain deductions and for the allocation of net
investment income between an estate or trust and its beneficiaries.
Generally, an estate's or trust's net investment income (as defined in
Sec. 1.1411-4) is calculated in the same manner as that of an
individual. See Sec. 1.1411-10(c) for special rules regarding
controlled foreign corporations, passive foreign investment companies,
and estates and trusts holding interests in such entities.
(2) Undistributed net investment income. An estate's or trust's
undistributed net investment income is the estate's or trust's net
investment income determined under Sec. 1.1411-4 reduced by
distributions of net investment income to beneficiaries and deductions
under section 642(c) in the manner described in paragraphs (e)(3) and
(e)(4) of this section.
(3) Distributions of net investment income to beneficiaries. (i) In
computing the estate's or trust's undistributed net investment income,
net investment income shall be reduced by distributions of net
investment income made to beneficiaries. The deduction allowed under
this paragraph (e)(3) is limited to the lesser of the amount deductible
to the estate or trust under section 651 or section 661, as applicable,
or the net investment income of the estate or trust. In the case of a
deduction under section 651 or section 661 that consists of both net
investment income and excluded income (as defined in paragraph (e)(5)
of this section), the distribution must be allocated between net
investment income and excluded income in a manner similar to Sec.
1.661(b)-1 as if net investment income constituted gross income and
excluded income constituted amounts not includible in gross income. See
Sec. 1.661(c)-1 and Example 1 in paragraph (f) of this section.
(ii) If one or more items of net investment income comprise all or
part of a distribution for which a deduction is allowed under paragraph
(e)(3)(i) of this section, such items retain their character as net
investment income under section 652(b) or section 662(b), as
applicable, for purposes of computing net investment income of the
recipient of the distribution who is subject to tax under section 1411.
The provisions of this paragraph (e)(3)(ii) also apply to distributions
to United States beneficiaries of current year income described in
section 652 or section 662 from foreign nongrantor trusts.
(4) Deduction for amounts paid or permanently set aside for a
charitable purpose. In computing the estate's or trust's undistributed
net investment income, the estate or trust shall be allowed a deduction
for amounts of net investment income that are allocated to amounts
allowable under section 642(c). In the case of an estate or trust that
has items of income consisting of both net investment income and
excluded
[[Page 72637]]
income (as defined in paragraph (e)(5) of this section), the allowable
deduction under this paragraph (e)(4) must be allocated between net
investment income and excluded income in accordance with Sec.
1.642(c)-2(b) as if net investment income constituted gross income and
excluded income constituted amounts not includible in gross income. For
an estate or trust with deductions under both sections 642(c) and 661,
see Sec. 1.662(b)-2 and Example 2 in paragraph (f) of this section.
(5) Excluded income. The term excluded income means--
(i) Items of income excluded from gross income in chapter 1;
(ii) Items of income not included in net investment income, as
determined under Sec. 1.1411-4; and
(iii) Items of gross income and net gain specifically excluded by
section 1411, the regulations thereunder, or other guidance published
in the Internal Revenue Bulletin. See Sec. Sec. 1.1411-7, -8, and -9.
(f) Examples. In each example, unless otherwise indicated, the
taxpayer uses a calendar taxable year, the taxpayer is not a foreign
trust, and Year 1 is a taxable year in which section 1411 is in effect:
Example 1. Calculation of undistributed net investment income
(with no deduction under section 642(c)). (i) In Year 1, Trust has
dividend income of $15,000, interest income of $10,000, capital gain
of $5,000, and $60,000 of taxable income relating to a distribution
from an individual retirement account (as defined under section
408). Trust has no expenses. Trust distributes $10,000 of its
current year trust accounting income to A, a beneficiary of Trust.
For trust accounting purposes, $25,000 of the distribution from the
individual retirement account is attributable to income. Trust
allocates the remaining $35,000 of taxable income from the
individual retirement account and the $5,000 of capital gain to
principal, and therefore these amounts do not enter into the
calculation of Trust's distributable net income for Year 1.
(ii) Trust's distributable net income is $50,000 ($15,000 in
dividends plus $10,000 in interest plus $25,000 of taxable income
from an individual retirement account), from which the $10,000
distribution to A is paid. Trust's deduction under section 661 is
$10,000. Under Sec. 1.662(b)-1, the deduction reduces each class of
income comprising distributable net income on a proportional basis.
The $10,000 distribution equals 20 percent of distributable net
income ($10,000 divided by $50,000). Therefore, the distribution
consists of dividend income of $3,000, interest income of $2,000,
and ordinary income attributable to the individual retirement
account of $5,000. Because the $5,000 of capital gain allocated to
principal for trust accounting purposes did not enter into
distributable net income, no portion of that amount is included in
the $10,000 distribution, nor does it qualify for the deduction
under section 661.
(iii) Trust's net investment income is $30,000 ($15,000 in
dividends plus $10,000 in interest plus $5,000 in capital gain).
Trust's $60,000 of taxable income attributable to the individual
retirement account is excluded income (within the meaning of
paragraph (e)(5) of this section) because it is excluded from net
investment income under Sec. 1.1411-8. Trust's undistributed net
investment income under paragraph (e)(2) of this section is $25,000,
which is Trust's net investment income ($30,000) less the amount of
dividend income ($3,000) and interest income ($2,000) distributed to
A. The $25,000 of undistributed net investment income is comprised
of the capital gain allocated to principal ($5,000), the remaining
undistributed dividend income ($12,000), and the remaining
undistributed interest income ($8,000).
(iv) Under paragraph (e)(3) of this section and pursuant to
Sec. 1.1411-4(a)(1), A's net investment income includes dividend
income of $3,000 and interest income of $2,000, but does not include
the $5,000 of ordinary income attributable to the individual
retirement account because it is excluded from net investment income
under Sec. 1.1411-8.
Example 2. Calculation of undistributed net investment income
(with deduction under section 642(c)). (i) Same facts as Example 1,
except Trust is required to distribute $30,000 to A. In addition,
Trust has a $10,000 deduction under section 642(c) (deduction for
amounts paid for a charitable purpose). Trust also makes an
additional discretionary distribution of $10,000 to B, a beneficiary
of Trust. As in Example 1, Trust's net investment income is $30,000
($15,000 in dividends plus $10,000 in interest plus $5,000 in
capital gain). In accordance with Sec. Sec. 1.661(b)-2 and
1.662(b)-2, the items of income must be allocated between the
mandatory distribution to A, the discretionary distribution to B,
and the $10,000 distribution to a charity.
(ii) For purposes of the mandatory distribution to A, Trust's
distributable net income is $50,000. See Sec. 1.662(b)-2, Example
1(b). Trust's deduction under section 661 for the distribution to A
is $30,000. Under Sec. 1.662(b)-1, the deduction reduces each class
of income comprising distributable net income on a proportional
basis. The $30,000 distribution equals 60 percent of distributable
net income ($30,000 divided by $50,000). Therefore, the distribution
consists of dividend income of $9,000, interest income of $6,000,
and ordinary income attributable to the individual retirement
account of $15,000. A's mandatory distribution thus consists of
$15,000 of net investment income and $15,000 of excluded income.
(iii) Trust's remaining distributable net income is $20,000.
Trust's remaining undistributed net investment income is $15,000.
The $10,000 deduction under section 642(c) is allocated in the same
manner as the distribution to A, where the $10,000 distribution
equals 20 percent of distributable net income ($10,000 divided by
$50,000). For purposes of determining undistributed net investment
income, Trust's net investment income is reduced by $5,000 under
paragraph (e)(4) of this section (dividend income of $3,000,
interest income of $2,000, but with no reduction for amounts
attributable to the individual retirement account of $5,000).
(iv) With respect to the discretionary distribution to B,
Trust's remaining distributable net income is $10,000. Trust's
remaining undistributed net investment income is $10,000. Trust's
deduction under section 661 for the distribution to B is $10,000.
The $10,000 distribution equals 20 percent of distributable net
income ($10,000 divided by $50,000). Therefore, the distribution
consists of dividend income of $3,000, interest income of $2,000,
and ordinary income attributable to the individual retirement
account of $5,000. B's distribution consists of $5,000 of net
investment income and $5,000 of excluded income.
(v) Trust's undistributed net investment income is $5,000 after
taking into account distribution deductions and section 642(c) in
accordance with paragraphs (e)(3) and (e)(4) of this section,
respectively. To arrive at Trust's undistributed net investment
income of $5,000, Trust's net investment income of $30,000 is
reduced by $15,000 of the mandatory distribution to A, $5,000 of the
section 642(c) deduction, and $5,000 of the discretionary
distribution to B.
Example 3. Calculation of an ESBT's tax for purposes of section
1411. (i) In Year 1, the non-S portion of Trust, an ESBT, has
dividend income of $15,000, interest income of $10,000, and capital
gain of $5,000. Trust's S portion has net rental income of $21,000
and a capital loss of $7,000. The Trustee's annual fee of $1,000 is
allocated 60 percent to the non-S portion and 40 percent to the S
portion. Trust makes a distribution from income to a single
beneficiary of $9,000.
(ii) Step one. (A) Trust must compute the undistributed net
investment income for the S portion and non-S portion in the manner
described in paragraph (c)(1) of this section.
The undistributed net investment income for the S portion is
$20,600 and is determined as follows:
Net Rental Income........................................... $21,000
Trustee Annual Fee.......................................... (400)
-----------
Total S portion undistributed net investment income....... 20,600
(B) No portion of the capital loss is allowed because, pursuant
to Sec. 1.1411-4(d)(2), net gain cannot be less than zero and
excess capital losses are not properly allocable deductions under
Sec. 1.1411-4(f). See Example 1 of Sec. 1.1411-4(h). In addition,
pursuant to Sec. 1.641(c)-1(i), no portion of the $9,000
distribution is allocable to the S portion.
The undistributed net investment income for the non-S portion is
$20,400 and is determined as follows:
Dividend Income............................................. $15,000
Interest Income............................................. 10,000
Capital Gain................................................ 5,000
Trustee Annual Fee.......................................... (600)
Distributable net income distribution....................... (9,000)
-----------
[[Page 72638]]
Total non-S portion undistributed net investment income... 20,400
(C) Trust will combine the undistributed net investment income
of the S portion and non-S portion from (ii)(A) and (B) to arrive at
Trust's combined undistributed net investment income.
S portion's undistributed net investment income.............. $20,600
Non-S portion's undistributed net investment income.......... 20,400
----------
Combined undistributed net investment income............... 41,000
(iii) Step two. (A) The ESBT will calculate its adjusted gross
income. Pursuant to paragraph (c)(1)(ii)(B) of this section, the
ESBT's adjusted gross income is the non-S portion's adjusted gross
income increased or decreased by the net income or net loss of the S
portion.
(B) The adjusted gross income for the ESBT is $38,000 and is
determined as follows:
Dividend Income.............................................. $15,000
Interest Income.............................................. 10,000
Capital Gain................................................. 5,000
Trustee Annual Fee........................................... (600)
Distributable net income distribution........................ (9,000)
S Portion Income (see (iii)(C)).............................. 17,600
----------
Adjusted gross income...................................... 38,000
(C) The S portion's single item of ordinary income used in the
ESBT's adjusted gross income calculation is $17,600. This item of
income is determined by starting with net rental income of $21,000
and reducing it--
(1) By the S portion's $400 share of the annual trustee fee; and
(2) As allowed by section 1211(b)(1), $3,000 of the $7,000
capital loss.
(iv) Step three. Trust will pay tax on the lesser of--
(A) The combined undistributed net investment income ($41,000
calculated in (ii)(C)); or
(B) The excess of adjusted gross income ($38,000 calculated in
(iii)(B)) over the dollar amount at which the highest tax bracket in
section 1(e) applicable to a trust begins for the taxable year.
(g) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013, except that paragraph (c)(2)
of this section shall apply to taxable years of charitable remainder
trusts that begin after December 31, 2012.
Sec. 1.1411-4 Definition of net investment income.
(a) In general. For purposes of section 1411 and the regulations
thereunder, net investment income means the excess (if any) of--
(1) The sum of--
(i) Gross income from interest, dividends, annuities, royalties,
rents, substitute interest payments, and substitute dividend payments,
except to the extent excluded by the ordinary course of a trade or
business exception described in paragraph (b) of this section;
(ii) Other gross income derived from a trade or business described
in Sec. 1.1411-5; and
(iii) Net gain (to the extent taken into account in computing
taxable income) attributable to the disposition of property, except to
the extent excluded by the exception described in paragraph
(d)(3)(ii)(A) for gain or loss attributable to property held in a trade
or business not described in Sec. 1.1411-5; over
(2) The deductions allowed by subtitle A that are properly
allocable to such gross income or net gain (as determined in paragraph
(f) of this section).
(b) Ordinary course of a trade or business exception. Gross income
described in paragraph (a)(1)(i) of this section is excluded from net
investment income if it is derived in the ordinary course of a trade or
business not described in Sec. 1.1411-5. See Sec. 1.1411-6 for rules
regarding working capital. To determine whether gross income described
in paragraph (a)(1)(i) of this section is derived in a trade or
business, the following rules apply.
(1) In the case of an individual, estate, or trust that owns or
engages in a trade or business directly (or indirectly through
ownership of an interest in an entity that is disregarded as an entity
separate from its owner under Sec. 301.7701-3), the determination of
whether gross income described in paragraph (a)(1)(i) of this section
is derived in a trade or business is made at the individual level.
(2) In the case of an individual, estate, or trust that owns an
interest in a trade or business through one or more passthrough
entities for Federal tax purposes (for example, through a partnership
or S corporation), the determination of whether gross income described
in paragraph (a)(1)(i) of this section is--
(i) Derived in a trade or business described in Sec. 1.1411-
5(a)(1) is made at the owner level; and
(ii) Derived in a trade or business described in Sec. 1.1411-
5(a)(2) is made at the entity level.
(3) The following examples illustrate the provisions of this
paragraph (b).
Example 1. Multiple passthrough entities. A, 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 A 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, the ordinary course of
a trade or business exception described in paragraph (b) of this
section does not apply, and A's $5,000 of dividends is net
investment income under paragraph (a)(1)(i) of this section.
Example 2. Entity engaged in trading in financial instruments.
B, an individual, owns an interest in PRS, a partnership, which is
engaged in a trade or business of trading in financial instruments
(as defined in Sec. 1.1411-5(a)(2)). PRS' trade or business is not
a passive activity (within the meaning of section 469) with respect
to B. In addition, B is not directly engaged in a trade or business
of trading in financial instruments or commodities. PRS earns
interest of $50,000, and B's distributive share of the interest is
$25,000. Because PRS is engaged in a trade or business described in
Sec. 1.1411-5(a)(2), the ordinary course of a trade or business
exception described in paragraph (b) of this section does not apply,
and B's $25,000 distributive share of the interest is net investment
income under paragraph (a)(1)(i) of this section.
Example 3. Application of ordinary course of a trade or business
exception. C, an individual, owns stock in S corporation, S. S is
engaged in a banking trade or business (that is not a trade or
business of trading in financial instruments or commodities), and
S's trade or business is not a passive activity (within the meaning
of section 469) with respect to C. S earns $100,000 of interest in
the ordinary course of its trade or business, of which $5,000 is C's
pro rata share. Because S is not engaged in a trade or business
described in Sec. 1.1411-5(a)(2) and because S's trade or business
is not a passive activity with respect to C (as described in Sec.
1.1411-5(a)(1)), the ordinary course of a trade or business
exception described in paragraph (b) of this section applies, and
C's $5,000 of interest is not included under paragraph (a)(1)(i) of
this section.
(c) Other gross income from a trade or business described in Sec.
1.1411-5--(1) Passive activity. For a trade or business described in
Sec. 1.1411-5(a)(1), paragraph (a)(1)(ii) of this section includes
other gross income that is not gross income described in paragraph
(a)(1)(i) of this section or net gain described in paragraph
(a)(1)(iii) of this section. Thus, for a trade or business described in
Sec. 1.1411-5(a)(1), if an item of gross income or net gain is subject
to paragraph (a)(1)(i) or (iii) of this section, it is generally not
other gross income described in paragraph (a)(1)(ii) of this section.
(2) Trading in financial instruments or commodities. For a trade or
business described in Sec. 1.1411-5(a)(2)), paragraph (a)(1)(ii) of
this section includes all other gross income that is not gross income
described in paragraph (a)(1)(i) of this section. For example, any gain
from marking to market under section 475(f) or section 1256 and any
realized gain from the disposition of
[[Page 72639]]
property held in the trade or business is classified as other gross
income subject to paragraph (a)(1)(ii) of this section (and not
classified as net gain under paragraph (a)(1)(iii) of this section).
(d) Net gain. This paragraph (d) describes special rules for
purposes of paragraph (a)(1)(iii) of this section.
(1) Definition of disposition. For purposes of section 1411 and the
regulations thereunder, the term disposition means a sale, exchange,
transfer, conversion, cash settlement, cancellation, termination,
lapse, expiration, or other disposition.
(2) Limitation. The calculation of net gain shall not be less than
zero. Losses allowable under section 1211(b) are permitted to offset
gain from the disposition of assets other than capital assets that are
subject to section 1411.
(3) Net gain attributable to the disposition of property--(i) In
general. Net gain attributable to the disposition of property is the
gain described in section 61(a)(3) recognized from the disposition of
property reduced, but not below zero, by losses deductible under
section 165, including losses attributable to casualty, theft, and
abandonment or other worthlessness. The rules in subchapter O of
chapter 1 and the regulations thereunder apply. See, for example, Sec.
1.61-6(b). Net gain shall include gain or loss attributable to the
disposition of property from the investment of working capital. See
Sec. 1.1411-6.
(ii) Exception for gain or loss attributable to property held in a
trade or business not described in Sec. 1.1411-5--(A) General rule.
Net gain shall not include gain or loss attributable to property (other
than property from the investment of working capital (as described in
Sec. 1.1411-6)) held in a trade or business not described in Sec.
1.1411-5.
(B) Special rules for determining whether property is held in a
trade or business. To determine whether net gain described in paragraph
(a)(1)(iii) of this section is from property held in a trade or
business--
(1) A partnership interest or S corporation stock generally is not
property held in a trade or business. Therefore, gain from the sale of
a partnership interest or S corporation stock is generally gain
described in paragraph (a)(1)(iii) of this section. See Sec. 1.1411-7
for rules relating to dispositions of interests in partnerships or S
corporations.
(2) In the case of an individual, estate, or trust that owns or
engages in a trade or business directly (or indirectly through
ownership of an interest in an entity that is disregarded as an entity
separate from its owner under Sec. 301.7701-3), the determination of
whether net gain described in paragraph (a)(1)(iii) of this section is
attributable to property held in a trade or business is made at the
individual level.
(3) In the case of an individual, estate, or trust that owns an
interest in a trade or business through one or more passthrough
entities for Federal tax purposes (for example, through a partnership
or S corporation), the determination of whether net gain described in
paragraph (a)(1)(iii) of this section from such entity is attributable
to--
(i) Property held in a trade or business described in Sec. 1.1411-
5(a)(1) is made at the owner level; and
(ii) Property held in a trade or business described in Sec.
1.1411-5(a)(2) is made at the entity level.
(C) Example. Gain from rental activity. A, an unmarried
individual, rents a boat to B for $100,000 in Year 1. A's rental
activity does not involve the conduct of a section 162 trade or
business, but under section 469(c)(2), A's rental activity is a
passive activity. In Year 2, A sells the boat to B, and A realizes
and recognizes taxable gain attributable to the disposition of the
boat of $500,000. Because the exception provided in paragraph
(d)(3)(ii)(A) of this section requires a trade or business, this
exception is inapplicable, and therefore, A's $500,000 gain will be
taken into account under Sec. 1.1411-4(a)(1)(iii).
(iii) Adjustments to gain or loss attributable to the disposition
of interests in a partnership or S corporation. Net gain shall be
adjusted as provided in Sec. 1.1411-7 in the case of the disposition
of an interest in a partnership or S corporation.
(e) Distributions from estates and trusts. Net investment income
includes a beneficiary's share of distributable net income, as
described in sections 652(a) and 662(a), to the extent that, under
sections 652(b) and 662(b), the character of such income constitutes
gross income from items described in paragraph (a)(1)(i) and (ii) of
this section or net gain attributable to items described in paragraph
(a)(1)(iii) of this section, with further computations consistent with
the principles of this section, as provided in Sec. 1.1411-3(e).
(f) Properly allocable deductions--(1) General rule--(i) In
general. Unless specifically stated otherwise, only properly allocable
deductions described in this paragraph (f) may be taken into account in
determining net investment income.
(ii) Limitations and carryovers. Deductions allowed under this
paragraph (f) shall not exceed the total amount of gross income and net
gain described in paragraph (a)(1) of this section. Any deductions
described in this paragraph (f) in excess of such gross income and net
gain shall not be taken into account in determining net investment
income in any other taxable year, except as allowed under chapter 1.
However, in no event will a net operating loss deduction allowed under
section 172 be taken into account in determining net investment income
for any taxable year. See Example 3 of paragraph (h) of this section.
(2) Properly allocable deductions described in section 62--(i)
Deductions allocable to gross income from rents and royalties.
Deductions described in section 62(a)(4) allocable to rents and
royalties described in paragraph (a)(1)(i) of this section (and that
therefore constitute net investment income) shall be taken into account
in determining net investment income.
(ii) Deductions allocable to gross income from trades or businesses
described in Sec. 1.1411-5. Deductions described in section 62(a)(1)
allocable to income from a trade or business described in Sec. 1.1411-
5 shall be taken into account in determining net investment income to
the extent the deductions have not been taken into account in
determining self-employment income within the meaning of Sec. 1.1411-
9.
(iii) Penalty on early withdrawal of savings. Net investment income
shall take into account deductions described in section 62(a)(9).
(3) Properly allocable deductions described in section 63(d)--(i)
In general. Net investment income shall take into account the following
itemized deductions:
(A) Investment interest expense. Investment interest (as defined in
section 163(d)(3)) to the extent allowed under section 163(d)(1). Any
investment interest not allowed under section 163(d)(1) shall be
treated as investment interest paid or accrued by the taxpayer in the
succeeding taxable year.
(B) Investment expenses. Investment expenses (as defined in section
163(d)(4)(C)).
(C) Taxes described in section 164(a)(3). In the case of taxes that
are deductible under section 164(a)(3) and imposed on both gross income
(including net gain) described in Sec. 1.1411-4(a)(1) and gross income
(as defined under section 61(a)) that is not described in Sec. 1.1411-
4(a)(1), the portion of the deduction that is properly allocable to
gross income (including net gain) described in Sec. 1.1411-4(a)(1) may
be determined by taxpayers using any reasonable method. For purposes of
the prior sentence, an allocation of the deduction based on the ratio
of the
[[Page 72640]]
amount of a taxpayer's gross income (including net gain) described in
Sec. 1.1411-4(a)(1) to the amount of the taxpayer's gross income (as
defined under section 61(a)) is an example of a reasonable method.
(ii) Application of limitations under sections 67 and 68. Any
deductions described in this paragraph (f)(3) that are subject to
section 67 (the 2-percent floor on miscellaneous itemized deductions)
or section 68 (the overall limitation on itemized deductions) are
allowed in determining net investment income only to the extent the
items are deductible for chapter 1 purposes after the application of
sections 67 and 68. For this purpose, section 67 is applied before
section 68. The amounts that may be deducted in determining net
investment income after the application of sections 67 and 68 shall be
determined as described in paragraph (f)(3)(ii)(A) and (B) of this
section.
(A) Deductions subject to section 67. The amount of miscellaneous
itemized deductions tentatively deductible in determining net
investment income after applying section 67 (but before applying
section 68) is determined by multiplying a taxpayer's miscellaneous
itemized deductions otherwise allowable under this paragraph (f)(3) by
a fraction. The numerator of the fraction is the total miscellaneous
itemized deductions allowed after the application of section 67, but
before the application of section 68. The denominator of the fraction
is the total miscellaneous itemized deductions before the application
of sections 67 and 68. See Example 6 of paragraph (h) of this section.
(B) Deductions subject to section 68. The amount of itemized
deductions allowed in determining net investment income after applying
sections 67 and 68 is determined by multiplying a taxpayer's itemized
deductions otherwise allowable under this paragraph (f)(3), after the
application of section 67, by a fraction. The numerator of the fraction
is the total itemized deductions allowed after the application of
sections 67 and 68. The denominator of the fraction is the total
itemized deductions allowed after the application of section 67, but
before the application of section 68. For this purpose, the term
itemized deductions does not include any deduction described in section
68(c).
(4) Loss deductions. Deductions allowed under this paragraph (f) do
not include losses described in section 165, whether described in
section 62 or section 63(d). Losses deductible under section 165 are
deductible only in determining net gain under paragraph (d) of this
section, and only to the extent of gains.
(g) Special rules for controlled foreign corporations and passive
foreign investment companies. For purposes of calculating net
investment income, additional rules in Sec. 1.1411-10(c) apply to an
individual, an estate, or a trust that is a United States shareholder
that owns an interest in a controlled foreign corporation (within the
meaning of section 957(a)) or that is a United States person that
directly or indirectly owns an interest in passive foreign investment
companies (within the meaning of section 1297(a)).
(h) Examples. The following examples illustrate the provisions of
this section. In each example, unless otherwise indicated, the taxpayer
uses a calendar taxable year, the taxpayer is a U.S. citizen, and Year
1 is a taxable year in which section 1411 is in effect.
Example 1. Calculation of net gain. (i) In Year 1, A, 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. A has no other capital gain or capital loss in Year
1. In addition, A receives wages of $300,000 and earns $5,000 of
gross income from interest. For income tax purposes, under section
1211(b), A may use $3,000 of the net capital loss against other
income. Under section 1212(b)(1), the remaining $27,000 is a capital
loss carryover. For purposes of determining A's Year 1 net gain
under paragraph (a)(1)(iii) of this section, A's gain of $10,000 on
the sale of the Q stock is reduced by A's loss of $40,000 on the
sale of the P stock. However, because net gain may not be less than
zero, A may not reduce net investment income by the $3,000 of the
excess of capital losses over capital gains allowed for income tax
purposes under section 1211(b).
(ii) In Year 2, A has a capital gain of $30,000 on the sale of Y
stock. Y is a C corporation. A has no other capital gain or capital
loss in Year 2. For income tax purposes, A may reduce the $30,000
gain by the Year 1 section 1212(b) $27,000 capital loss carryover.
For purposes of determining A's Year 2 net gain under paragraph
(a)(1)(iii) of this section, A's $30,000 gain may also be reduced by
the $27,000 capital loss carryover from Year 1. Therefore, in Year
2, A has $3,000 of net gain for purposes of paragraph (a)(1)(iii) of
this section.
Example 2. Calculation of net gain. The facts are the same as in
Example 1, except that in Year 1, A also realizes a gain of $20,000
on the sale of Rental Property D, all of which is treated as
ordinary income under section 1250. For income tax purposes, under
section 1211(b), A may use $3,000 of the net capital loss against
other income. Under section 1212(b)(1) the remaining $27,000 is a
capital loss carryover. For purposes of determining A's net gain
under paragraph (a)(1)(iii) of this section, A's gain of $10,000 on
the sale of the Q stock is reduced by A's loss of $40,000 on the
sale of the P stock. A's $20,000 gain on the sale of Rental Property
D is reduced to the extent of the $3,000 loss allowed under section
1211(b). Therefore, A's net gain for Year 1 is $17,000 ($20,000 gain
treated as ordinary income on the sale of Rental Property D reduced
by $3,000 loss allowed under section 1211).
Example 3. Section 172 net operating loss deduction. (i) In Year
1, A, an unmarried individual, has the following items of income and
deduction: $60,000 in wages, $20,000 in gross income from a trade or
business of trading in financial instruments or commodities (as
defined in Sec. 1.1411-5(a)(2)) (trading activity), $70,000 in loss
from his sole proprietorship (which is not a trade or business
described in Sec. 1.1411-5), and $30,000 in trading activity
expense deductions. As a result, for income tax purposes A sustains
a section 172(c) net operating loss of $20,000. A makes an election
under section 172(b)(3) to waive the carryback period for this net
operating loss.
(ii) For purposes of section 1411, A's net investment income for
Year 1 is the excess (if any) of the $20,000 in gross income from
the trading activity over the $30,000 deduction for the trading
activity expenses. Net investment income cannot be less than zero
for a taxable year. Therefore, A's net investment income for Year 1
is $0.
(iii) For Year 2, A has $200,000 of wages, $100,000 of gross
income from the trading activity, $80,000 of income from his sole
proprietorship, and $10,000 in trading activity expense deductions.
For income tax purposes, A's $20,000 net operating loss carryover
from Year 1 will be allowed as a deduction. In addition, under Sec.
1.1411-2(c), A's Year 1 $20,000 net operating loss will be allowed
as a deduction in computing A's Year 2 modified adjusted gross
income.
(iv) For purposes of section 1411, A's $20,000 net operating
loss carryover from Year 1 is not allowed in computing A's Year 2
net investment income. As a result, A's Year 2 net investment income
is $90,000 ($100,000 gross income from the trading activity minus
the $10,000 of trading activity expenses).
Example 4. Section 121(a) exclusion. (i) In Year 1, A, an
unmarried individual, sells a house that he has owned and used as
his principal residence for five years and realizes $200,000 in
gain. In addition to the gain realized from the sale of his
principal residence, A also realizes $7,000 in long-term capital
gain. A has a $5,000 short-term capital loss carryover from a year
preceding the effective date of section 1411.
(ii) For income tax purposes, under section 121(a), A excludes
the $200,000 gain realized from the sale of his principal residence
from his Year 1 gross income. In determining A's Year 1 adjusted
gross income, A also reduces the $7,000 capital gain by the $5,000
capital loss carryover allowed under section 1211(b).
(iii) For section 1411 purposes, under section 121(a), A
excludes the $200,000 gain realized from the sale of his principal
residence from his Year 1 gross income and, consequently, net
investment income. In determining A's Year 1 net gain under
paragraph (a)(1)(iii) of this section, A reduces the $7,000 capital
gain by the $5,000 capital loss carryover allowed under section
1211(b).
[[Page 72641]]
Example 5. Section 163(d) limitation. (i) In Year 1, A, an
unmarried individual, pays interest of $4,000 on debt incurred to
purchase stock. Under Sec. 1.163-8T, this interest is allocable to
the stock and is investment interest within the meaning of section
163(d)(3). A has no investment income as defined by section
163(d)(4). A has $10,000 of income from a trade or business that is
a passive activity (as defined in Sec. 1.1411-5(a)(1)) with respect
to A. For income tax purposes, under section 163(d)(1) A may not
deduct the $4,000 investment interest in Year 1. Under section
163(d)(2), the $4,000 investment interest is a carryforward of
disallowed interest that is treated as investment interest paid by A
in the succeeding taxable year. Similarly, for purposes of
determining A's Year 1 net investment income, A may not deduct the
$4,000 investment interest.
(ii) In Year 2, A has $5,000 of section 163(d)(4) net investment
income. For both income tax purposes and for determining section
1411 net investment income, A's $4,000 carryforward of interest
expense disallowed in Year 1 may be deducted in Year 2.
Example 6. Sections 67 and 68 limitations on itemized
deductions. (i) A, an unmarried individual, has adjusted gross
income in Year 1 as follows:
Wages................................................... $1,600,000
Interest income......................................... 400,000
---------------
Adjusted gross income................................. 2,000,000
In addition, A has the following items of expense qualifying as
itemized deductions:
Investment expenses.......................................... $70,000
Job-related expenses......................................... 30,000
Investment interest expense.................................. 80,000
State income taxes........................................... 120,000
A's investment expenses and job-related expenses are
miscellaneous itemized deductions. In addition, A's investment
interest expense and investment expenses are properly allocable to
net investment income (within the meaning of this section). A's job-
related expenses are not properly allocable to net investment
income. Of the state income tax expense, $20,000 is properly
allocable to net investment income and $100,000 is not properly
allocable to net investment income.
(ii) A's 2-percent floor under section 67 is $40,000 (2 percent
of $2,000,000). For Year 1, assume the section 68 limitation starts
at adjusted gross income of $200,000. The section 68 overall
limitation disallows $54,000 of A's itemized deductions that are
subject to section 68 (3 percent of the excess of $2,000,000
adjusted gross income over the $200,000 limitation threshold).
(iii)(A) A's total miscellaneous itemized deductions allowable
before the application of section 67 is $100,000 ($70,000 in
investment expenses plus $30,000 in job-related expenses), and the
total miscellaneous deductions allowed after the application of
section 67 is $60,000 ($100,000 minus $40,000).
(B) The amount of the deduction allowed for investment expenses
after the application of section 67 is computed as follows:
[GRAPHIC] [TIFF OMITTED] TP05DE12.000
(C) The amount of the deduction allowed for job-related expenses
after the application of section 67 is computed as follows:
[GRAPHIC] [TIFF OMITTED] TP05DE12.001
(iv)(A) Under section 68, the $80,000 deduction for the
investment interest expense is not subject to the section 68
limitation on itemized deductions.
(B) A's itemized deductions subject to the limitation under
section 68 and allowed after application of section 67, but before
the application of section 68, are the following:
Investment expenses.......................................... $42,000
Job-related expenses......................................... 18,000
State income tax............................................. 120,000
----------
Deductions subject to section 68........................... 180,000
(C) Of A's itemized deductions that are subject to the
limitation under section 68, the amount allowed after the
application of section 68 is $126,000 ($180,000 minus the $54,000
disallowed in paragraph (ii) of this Example 6).
(D) The amount of the investment expense deduction allowed after
the application of section 68 is determined as follows:
[GRAPHIC] [TIFF OMITTED] TP05DE12.002
(E) The amount of the state income tax deduction allowed after
the application of section 68 and properly allocable to net
investment income is determined as follows:
[GRAPHIC] [TIFF OMITTED] TP05DE12.003
(F) The itemized deductions allowed after applying sections 67
and 68 and properly allocable to A's net investment income are the
following:
Investment interest expense.................................. $80,000
Investment expenses.......................................... 29,400
State income taxes........................................... 14,000
----------
Itemized deductions properly allocable to net investment 123,400
income....................................................
(G) The amount of the state income tax deduction allowed after
the application of section 68 and not properly allocable to net
investment income is determined as follows:
[[Page 72642]]
[GRAPHIC] [TIFF OMITTED] TP05DE12.004
(H) The job-related expenses deduction and $70,000 of the state
income tax deduction are not properly allocable deductions for
purposes of section 1411.
Example 7. Section 1031 like-kind exchange. (i) In Year 1, A, an
unmarried individual who is not a dealer in real estate, purchases
Greenacre, a piece of undeveloped land, for $10,000. A intends to
hold Greenacre for investment.
(ii) In Year 3, A enters into an exchange in which he transfers
Greenacre, now valued at $20,000, and $5,000 cash for Blackacre,
another piece of undeveloped land, which has a fair market value of
$25,000. The exchange is a transaction for which no gain or loss is
recognized under section 1031.
(iii) In Year 3, for income tax purposes A does not recognize
any gain from the exchange of Greenacre for Blackacre. A's basis in
Blackacre is $15,000 ($10,000 substituted basis in Greenacre plus
$5,000 additional cost of acquisition). For purposes of section
1411, A's net investment income for Year 3 does not include any
realized gain from the exchange of Greenacre for Blackacre.
(iv) In Year 5, A sells Blackacre to an unrelated party for
$35,000 in cash.
(v) In Year 5, for income tax purposes B recognizes capital gain
of $20,000 ($35,000 sale price minus $15,000 basis). For purposes of
section 1411, A's net investment income includes the $20,000 gain
recognized from the sale of Blackacre.
(i) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013.
Sec. 1.1411-5 Trades or businesses to which tax applies.
(a) In general. A trade or business is described in this section if
such trade or business involves the conduct of a trade or business
(within the meaning of section 162), and such trade or business is
either--
(1) A passive activity (within the meaning of paragraph (b) of this
section) with respect to the taxpayer; or
(2) The trade or business of a trader trading in financial
instruments (as defined in paragraph (c)(1) of this section) or
commodities (as defined in paragraph (c)(2) of this section).
(b) Passive activity--(1) In general. A passive activity is
described in this section if--
(i) Such activity is a trade or business (within the meaning of
section 162); and
(ii) Such trade or business is a passive activity within the
meaning of section 469 and the regulations thereunder.
(2) Examples. The following examples illustrate the principles of
paragraph (b)(1) of this section and the ordinary course of a trade or
business exception in Sec. 1.1411-4(b). In each example, unless
otherwise indicated, the taxpayer uses a calendar taxable year, the
taxpayer is a U.S. citizen, and Year 1 is a taxable year in which
section 1411 is in effect:
Example 1. Rental activity. A, an unmarried individual, rents a
commercial building to B for $50,000 in Year 1. A's rental activity
does not involve the conduct of a section 162 trade or business, but
under section 469(c)(2), A's rental activity is a passive activity.
Because paragraph (b)(1)(i) of this section is not satisfied, A's
rental income of $50,000 is not derived from a trade or business
described in paragraph (b)(1) of this section. However, A's rental
income of $50,000 will still constitute gross income from rents
within the meaning of Sec. 1.1411-4(a)(1)(i) because Sec. 1.1411-
4(a)(1)(i) does not require a trade or business.
Example 2. Application of grouping rules under section 469. In
Year 1, A, an unmarried individual, owns an interest in PRS, a
partnership for Federal income tax purposes. PRS is engaged in two
activities, X and Y, which constitute trades or businesses (within
the meaning of section 162), and neither of which constitute trading
in financial instruments or commodities (within the meaning of
paragraph (a)(2) of this section). Pursuant to Sec. 1.469-4, A has
properly grouped X and Y (the grouped activity). A participates in X
for more than 500 hours during Year 1 and would be treated as
materially participating in the activity within the meaning of Sec.
1.469-5T(a)(1). A only participates in Y for 50 hours during Year 1,
and, but for the grouping of the two activities together, A would
not be treated as materially participating in Y within the meaning
of Sec. 1.469-5T(a). However, pursuant to Sec. Sec. 1.469-4 and
1.469-5T(a)(1), A materially participates in the grouped activity,
and therefore, for purposes of paragraph (b)(1)(ii) of this section,
neither X nor Y is a passive activity with respect to A.
Accordingly, with respect to A, neither X nor Y is a trade or
business described in paragraph (b)(1) of this section.
Example 3. Application of the rental activity exceptions. B, an
unmarried individual, is a partner in PRS, which is engaged in an
equipment leasing activity. The average period of customer use of
the equipment is seven days or less (and therefore meets the
exception in Sec. 1.469-1T(e)(3)(ii)(A)). B materially participates
in the equipment leasing activity (within the meaning of Sec.
1.469-5T(a)). The equipment leasing activity constitutes a trade or
business within the meaning of section 162. In Year 1, B has
modified adjusted gross income (as defined in Sec. 1.1411-2(c)) of
$300,000, all of which is derived from PRS. All of the income from
PRS is derived in the ordinary course of the equipment leasing
activity, and all of PRS's property is held in the equipment leasing
activity. Of B's allocable share of income from PRS, $275,000
constitutes gross income from rents (within the meaning of Sec.
1.1411-4(a)(1)(i)). While $275,000 of the gross income from the
equipment leasing activity meets the definition of rents in Sec.
1.1411-4(a)(1)(i), the activity meets one of the exceptions to
rental activity in Sec. 1.469-1T(e)(3)(ii) and B materially
participates in the activity. Therefore, the trade or business is
not a passive activity with respect to B for purposes of paragraph
(b)(1)(ii) of this section, and because the rents are derived in the
ordinary course of a trade or business not described in paragraph
(a) of this section, the ordinary course of a trade or business
exception in Sec. 1.1411-4(b) applies, which means that the rents
are not subject to Sec. 1.1411-4(a)(1)(i). Furthermore, because the
equipment leasing trade or business is not a trade or business
described in paragraph (a)(1) or (a)(2) of this section, the $25,000
of other gross income is not subject to Sec. 1.1411-4(a)(1)(ii).
Finally, gain or loss from the sale of the property held in the
equipment leasing activity will not be subject to Sec. 1.1411-
4(a)(1)(iii) because although it is attributable to a trade or
business, it is not a trade or business to which the section 1411
tax applies.
Example 4. Application of section 469 and other gross income
under Sec. 1.1411-4(a)(1)(ii). Same facts as Example 3, except B
does not materially participate in the equipment leasing trade or
business and therefore the trade or business is a passive activity
with respect to B for purposes of paragraph (b)(1)(ii) of this
section. Accordingly, the $275,000 of gross income from rents is
subject to Sec. 1.1411-4(a)(1)(i) because the rents are derived
from a trade or business described in paragraph (a)(1) of this
section (that is, the ordinary course of a trade or business
exception in Sec. 1.1411-4(b) is inapplicable). Furthermore, the
$25,000 of other gross income from the equipment leasing trade or
business is subject to Sec. 1.1411-4(a)(1)(ii) because the gross
income is derived from a trade or business described in paragraph
(a)(1) of this section. Finally, gain or loss from the sale of the
property used in the equipment leasing trade or business is subject
to Sec. 1.1411-4(a)(1)(iii) because the trade or business is a
passive activity with respect to B, as described in paragraph
(b)(1)(ii) of this section.
Example 5. Application of the portfolio income rule and section
469. C, an unmarried individual, is a partner in PRS, a partnership
engaged in a trade or business (within the meaning of section 162)
that does not involve a rental activity. C does not materially
participate in PRS within the meaning of Sec. 1.469-5T(a), and
therefore the trade or business of PRS is a passive activity with
respect to C for purposes of paragraph (a)(1) of this section. C's
$500,000 allocable share of PRS's income consists of $450,000 of
gross income from a trade or business and $50,000 of gross income
from dividends and interest (within the meaning of Sec. 1.1411-
4(a)(1)(i)) that is not derived in the ordinary course of the trade
or business of PRS. Thus, under
[[Page 72643]]
section 469(e)(1)(A)(i)(I) and the regulations thereunder, C's
allocable share of gross income from dividends and interest consists
of portfolio income. Therefore, C's $500,000 allocable share of
PRS's income is subject to section 1411. C's $50,000 allocable share
of PRS's income from dividends and interest is subject to Sec.
1.1411-4(a)(1)(i) because the share is gross income from dividends
and interest that is not derived in the ordinary course of a trade
or business (that is, the ordinary course of a trade or business
exception in Sec. 1.1411-4(b) is inapplicable). C's $450,000
allocable share of PRS's income is subject to Sec. 1.1411-
4(a)(1)(ii) because it is gross income from a trade or business that
is a passive activity.
(c) Trading in financial instruments or commodities--(1) Definition
of financial instruments. For purposes of section 1411 and the
regulations thereunder, the term financial instruments includes stocks
and other equity interests, evidences of indebtedness, options, forward
or futures contracts, notional principal contracts, any other
derivatives, or any evidence of an interest in any of the items
described in this paragraph (c)(1). An evidence of an interest in any
of the items described in this paragraph (c)(1) includes, but is not
limited to, short positions or partial units in any of the items
described in this paragraph (c)(1).
(2) Definition of commodities. For purposes of section 1411 and the
regulations thereunder, the term commodities refers to items described
in section 475(e)(2).
(d) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013.
Sec. 1.1411-6 Income on investment of working capital subject to tax.
(a) General rule. For purposes of section 1411, any item of gross
income from the investment of working capital will be treated as not
derived in the ordinary course of a trade or business, and any net gain
that is attributable to the investment of working capital will be
treated as not derived in the ordinary course of a trade or business.
In determining whether any item is gross income from or net gain
attributable to an investment of working capital, principles similar to
those described in Sec. 1.469-2T(c)(3)(iii) apply. See Sec. 1.1411-
4(f) for rules regarding properly allocable deductions with respect to
an investment of working capital; Sec. 1.1411-7 for rules relating to
the adjustment to net gain on the disposition of interests in a
partnership or S corporation.
(b) Example. A, an unmarried individual, operates a restaurant,
which is a section 162 trade or business but is not a trade or
business described in Sec. 1.1411-5(a)(1) with respect to A. A owns
and conducts the restaurant business through S, an S corporation
wholly-owned by A. S is able to pay all of the restaurant's current
obligations with cash flow generated by the restaurant. S utilizes
an interest-bearing checking account at a local bank to make daily
deposits of cash receipts generated by the restaurant, and also to
pay the recurring ordinary and necessary business expenses of the
restaurant. The average daily balance of the checking account is
approximately $2,500, but at any given time the balance may be
significantly more or less than this amount depending on the short-
term cash flow needs of the business. In addition, S has set aside
$20,000 for the potential future needs of the business in case the
daily cash flow into and from the checking account becomes
insufficient to pay the restaurant's recurring business expenses. S
does not currently need to spend or use the $20,000 capital to
conduct the restaurant business, and S deposits and maintains the
$20,000 in an interest-bearing savings account at a local bank. Both
the $2,500 average daily balance of the checking account and the
$20,000 savings account balance constitute working capital and,
pursuant to paragraph (a) of this section, the interest generated by
this working capital will not be treated as derived in the ordinary
course of S's restaurant business. Accordingly, the interest income
derived by S from its checking and savings accounts and allocated to
A under section 1366 will be subject to tax under Sec. 1.1411-
4(a)(1)(i).
(c) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013.
Sec. 1.1411-7 Exception for dispositions of interests in partnerships
and S corporations.
(a) In general--(1) General application. In the case of a
disposition of an interest in a partnership or S corporation described
in paragraph (a)(2) of this section, the gain or loss from such
disposition taken into account under Sec. 1.1411-4(a)(1)(iii) shall be
adjusted in accordance with paragraph (c) of this section. The
adjustment reflects the net gain or net loss that would have been taken
into account by the transferor if all property of the partnership or S
corporation were sold for fair market value immediately before the
disposition of such interest (a deemed sale).
(2) Interests to which exception applies--(i) In general. The
adjustment provided by this section applies only to dispositions of
interests in partnerships or S corporations if--
(A) The partnership or S corporation is engaged in one or more
trades or businesses (within the meaning of section 162), and at least
one of its trades or businesses is not described in Sec. 1.1411-
5(a)(2) (trading in financial instruments or commodities); and
(B) With respect to the partnership or S corporation interest
disposed of, the transferor is engaged in at least one trade or
business that is not described in Sec. 1.1411-5(a)(1) (passive
activity with respect to the transferor).
(ii) Nonapplication. This section does not apply to the disposition
of stock in an S corporation if an election under section 338(h)(10) is
made.
(b) Special rules--(1) Installment sales--(i) Installment sales on
or after the effective date of section 1411. In the case of a
disposition of an interest in a partnership or S corporation in an
installment sale to which section 453 applies, any adjustment to net
gain under this section is determined in the year of disposition and
shall be taken into account in the same proportion of the total gain as
is taken into account under section 453.
(ii) Installment sales prior to the effective date of section 1411.
In the case of a disposition before the effective date of section 1411
of an interest in a partnership or S corporation in an installment sale
to which section 453 applies, taxpayers that want to make an
irrevocable election to have this section apply must file the
computational statement required by paragraph (d) of this section with
the taxpayer's original or amended return for the first taxable year
beginning after December 31, 2013, in which the taxpayer is subject to
tax under section 1411. The determination of whether the taxpayer is
subject to tax under section 1411 is made without regard to the effect
of the election. In addition, a taxpayer may make an irrevocable
election to have this section apply for a taxable year that begins
before January 1, 2014, by filing the computational statement required
by paragraph (d) of this section with the taxpayer's original or
amended return for the taxable year. If the election is made under this
section, the taxpayer shall calculate the gain or loss adjustment under
this section and such adjustment shall be taken into account under
Sec. 1.1411-4(a)(1)(iii).
(2) Sale of an interest by a Qualified Subchapter S Trust.
[Reserved]
(c) Deemed sale--(1) In general. In the case of a disposition of an
interest in a partnership or S corporation described in paragraph
(a)(2)(i) of this section, the amount of gain or loss from such
disposition taken into account for purposes of Sec. 1.1411-
4(a)(1)(iii) must be adjusted in accordance with this paragraph (c).
(2) Step one: deemed sale of properties. The partnership or S
corporation is deemed to dispose of all of the entity's properties in a
fully taxable transaction (in a manner similar
[[Page 72644]]
to Sec. 1.743-1(d)(2)) for cash equal to the fair market value of the
entity's properties immediately before the disposition of the
partnership or S corporation interest.
(3) Step two: determination of gain or loss. The partnership or S
corporation determines the amount of gain or loss attributable to each
property by comparing the fair market value of each property with the
adjusted basis of each property. The gain or loss for each property
must be treated as a separate item.
(4) Step three: allocation of gain or loss. Applying the rules of
chapter 1, the partnership or S corporation determines the amount of
gain or loss for each property that is allocable to the interest
disposed of by the transferor. An allocation of gain or loss to a
transferor partner must comply with the requirements in sections 704(b)
and 704(c) and the regulations thereunder, and basis adjustments under
section 743 with respect to the transferor must be taken into account.
In the case of an S corporation, the amount of gain or loss allocated
to the transferor is determined under section 1366(a), and the
allocation should not take into account any reduction in the
transferor's distributive share in section 1366(f)(2) resulting from
the hypothetical imposition of tax under section 1374 as a result of
the deemed sale. See Sec. 1.460-4(k)(3)(v)(B) for a rule relating to
the computation of income or loss that would be allocated to the
transferor from a contract accounted for under a long-term contract
method of accounting as a result of the deemed sale of properties.
(5) Step four: adjustment to gain or loss--(i) In general. If the
amount of gain or loss allocable to the transferor in paragraph (c)(4)
of this section is attributable to property held (as modified by
paragraph (c)(5)(ii) of this section, if applicable) in a trade or
business not described in Sec. 1.1411-5(a), such gain or loss is
aggregated to create a net gain (which results in a negative
adjustment) or a net loss (which results in a positive adjustment).
Then, in accordance with paragraph (c)(5)(iii) or (iv) of this section,
the transferor must adjust the transferor's gain or loss from the
disposition of the partnership or S corporation interest as determined
in Sec. 1.1411-4(a)(1)(iii) (without application of this section).
(ii) Special rules--(A) Property used in more than one trade or
business. In the case of the disposition of a partnership or S
corporation interest in which property of the partnership or S
corporation is held in more than one trade or business during the
twelve-month period ending on the date of the disposition, the fair
market value and the adjusted basis of such property must be allocated
among such trades or businesses on a basis that reasonably reflects the
use of such property during such twelve-month period. See Example 7 of
paragraph (e) of this section regarding multiple trades or businesses.
(B) Goodwill attributable to property. If the transferor is
allocated gain or loss from goodwill in the deemed sale under paragraph
(c)(4) of this section and if the entity is engaged in a trade or
business, the transferor shall treat such gain or loss as gain or loss
from the disposition of property held in that trade or business. If the
entity is engaged in more than one trade or business, the transferor's
gain or loss from goodwill will be attributable to the entity's trades
or businesses based on the relative fair market value of the property
(other than cash) held in each trade or business. See Example 8 of
paragraph (e) of this section.
(iii) Negative adjustment--(A) General rule. Subject to the
limitations described in paragraph (c)(5)(iii)(B) of this section, if
the amount determined under paragraph (c)(5)(i) of this section is a
net gain, a negative adjustment of such amount shall be taken into
account in computing the amount of the transferor's net gain in Sec.
1.1411-4(a)(1)(iii).
(B) Limitations. If the transferor has a gain (determined without
regard to section 1411(c)(4) and this paragraph (c)) from the
disposition of the partnership or S corporation interest, the negative
adjustment taken into account is limited to the amount of the gain
(determined without regard to section 1411(c)(4) and this paragraph
(c)). If the transferor has a loss (determined without regard to
section 1411(c)(4) and this paragraph (c)) from the disposition of the
partnership or S corporation interest, the negative adjustment shall
not be taken into account.
(iv) Positive adjustment--(A) General rule. Subject to the
limitations described in paragraph (c)(5)(iv)(B) of this section, if
the amount determined under paragraph (c)(5)(i) of this section is a
net loss, a positive adjustment of such amount shall be taken into
account in computing the amount of the transferor's net gain in Sec.
1.1411-4(a)(1)(iii).
(B) Limitations. If the transferor has a loss (determined without
regard to section 1411(c)(4) and this paragraph (c)) from the
disposition of the partnership or S corporation interest, the positive
adjustment taken into account is limited to the amount of the loss
(determined without regard to section 1411(c)(4) and this paragraph
(c)). If the transferor has a gain (determined without regard to
section 1411(c)(4) and this paragraph (c)) from the disposition of the
partnership or S corporation interest, the positive adjustment shall
not be taken into account.
(d) Required statement of adjustment. Any transferor making an
adjustment under paragraph (c) of this section must attach a statement
to the transferor's return for the year of disposition. The statement
must include--
(1) A description of the disposed-of interest;
(2) The name and taxpayer identification number of the entity
disposed of;
(3) The fair market value of each property of the entity;
(4) The entity's adjusted basis in each property;
(5) The transferor's allocable share of gain or loss with respect
to each property of the entity;
(6) Information regarding whether the property was held in (or
attributable to) a trade or business not described in Sec. 1.1411-5;
(7) The amount of the net gain under Sec. 1.1411-4(a)(1)(iii) on
the disposition of the interest; and
(8) The computation of the adjustment under paragraph (c) of this
section.
(e) Examples. The following examples illustrate the principles of
this section. In each example, unless otherwise indicated, the taxpayer
uses a calendar taxable year, the taxpayer is a U.S. citizen, the
partnership (PRS) or S corporation (S) is not engaged in a trade or
business of trading in financial instruments or commodities (as defined
in Sec. 1.1411-5(a)(2)), and Year 1 is a taxable year in which section
1411 is in effect:
Example 1. Basic application. (i) Facts. 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. With respect to S's trade or
business, A is not engaged in a trade or business described in Sec.
1.1411-5(a)(1), and B is engaged in a trade or business described in
Sec. 1.1411-5(a)(1). 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 and B sell
their S stock to C for the fair market value of S's properties (that
is, A sells for $90,000 and B sells for $30,000). At the time of the
disposition, A's adjusted basis in his S stock is $75,000, and B's
adjusted basis in his S stock is $25,000. S's properties have the
following adjusted bases and fair market values immediately before
the disposition:
[[Page 72645]]
------------------------------------------------------------------------
Fair
Property Adjusted market
basis value
------------------------------------------------------------------------
1............................................... $10,000 $50,000
2............................................... 70,000 30,000
3............................................... 20,000 40,000
------------------------------------------------------------------------
(ii) Calculation of net gain under Sec. 1.1411-4(a)(1)(iii). On
the stock sale to C, A recognizes a gain of $15,000 ($90,000 minus
$75,000), which is subject to Sec. 1.1411-4(a)(1)(iii), and B
recognizes a gain of $5,000 ($30,000 minus $25,000), which is
subject to Sec. 1.1411-4(a)(1)(iii).
(iii) Application of section 1411(c)(4)--(A) In general. Section
1411(c)(4) is applicable to A because with respect to S's trade or
business, A is not engaged in a trade or business described in Sec.
1.1411-5(a)(1). On the other hand, with respect to B, S's trade or
business is described in Sec. 1.1411-5(a)(1) because it is a
passive trade or business with respect to B within the meaning of
Sec. 1.1411-5(a)(1). Accordingly, section 1411(c)(4) is
inapplicable to B, and B may not make any adjustment to his $5,000
gain upon the stock disposition.
(B) Deemed sale--(1) Step one: deemed sale of properties. 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.
(2) Step two: determination of gain or loss. The determination
of gain or loss on the deemed sale of S's properties is as follows:
------------------------------------------------------------------------
Fair
Property Adjusted market Gain or
basis value loss
------------------------------------------------------------------------
1..................................... $10,000 $50,000 $40,000
2..................................... 70,000 30,000 (40,000)
3..................................... 20,000 40,000 20,000
------------------------------------------------------------------------
(3) Step three: allocation of gain or loss. Under section 1366,
A is allocated $30,000 gain from Property 1, $30,000 loss from
Property 2, and $15,000 gain from Property 3.
(4) Step four: adjustment to net gain. Because all three
properties are held in S's trade or business, A must make an
adjustment under paragraph (c)(5) of this section to the amount of
net gain determined under Sec. 1.1411-4(a)(1)(iii). 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. Under paragraph (c)(5) of this section, A's gain of $15,000
on the disposition of the interest under Sec. 1.1411-4(a)(1)(iii)
is reduced by $15,000, and A has zero gain with respect to the stock
disposition for purposes of Sec. 1.1411-4(a)(1)(iii).
Example 2. Inside-outside basis disparity. (i) Facts. Same facts
as Example 1, except that A's adjusted basis in his S stock is
$70,000.
(ii) Analysis. On the stock sale to C, A recognizes a gain of
$20,000 ($90,000 minus $70,000), which is subject to Sec. 1.1411-
4(a)(1)(iii). The deemed sale would result in a negative adjustment
of $15,000 ($30,000 minus $30,000 plus $15,000). Under paragraph
(c)(5) of this section, A's net gain of $20,000 on the disposition
of the interest under Sec. 1.1411-4(a)(1)(iii) is reduced by
$15,000, and A has $5,000 net gain with respect to the stock
disposition for purposes of Sec. 1.1411-4(a)(1)(iii).
Example 3. Limitation of adjustment. (i) Facts. Same facts as
Example 1, except that A's adjusted basis in his S stock is $80,000.
(ii) Analysis. On the stock sale to C, A recognizes a gain of
$10,000 ($90,000 minus $80,000), which is subject to Sec. 1.1411-
4(a)(1)(iii). The deemed sale would result in a negative adjustment
of $15,000 ($30,000 minus $30,000 plus $15,000). Under paragraph
(c)(5) of this section, A's net gain of $10,000 on the disposition
of the interest under Sec. 1.1411-4(a)(1)(iii) is reduced by the
negative adjustment, but the negative adjustment under Sec. 1.1411-
7(c)(5)(iii)(B) is limited to $10,000 (the amount of A's gain
determined without regard to Sec. 1.1411-7). As a result, A has
zero net gain with respect to the stock disposition for purposes of
Sec. 1.1411-4(a)(1)(iii).>
Example 4. Loss on disposition. (i) Facts. Same facts as Example
1, except that (A) A's adjusted basis in his stock is $105,000, (B)
Property 3 has an adjusted basis of $60,000 and fair market value of
$10,000, and (C) A sells his interest for $67,500.
(ii) Analysis. On the stock sale to C, A recognizes a loss of
$37,500 ($67,500 minus $105,000), which is subject to Sec. 1.1411-
4(a)(1)(iii). In the deemed sale, A would be allocated $30,000 gain
from Property 1, $30,000 loss from Property 2, and $37,500 loss from
Property 3. The deemed sale would result in a positive adjustment of
$37,500 ($30,000 minus $30,000 minus $37,500). Under paragraph
(c)(5) of this section, A's loss of $37,500 on the disposition of
the interest under Sec. 1.1411-4(a)(1)(iii) is increased by the
positive adjustment of $37,500, and A has zero loss with respect to
the stock disposition for purposes of Sec. 1.1411-4(a)(1)(iii).
Example 5. Property not held in trade or business. (i) Facts.
Same facts as Example 1, except that S owns a fourth property
(adjusted basis of $20,000 and fair market value of $100,000) that
is not held in S's trade or business and only A sells his S stock to
C for A's proportionate share of the fair market value of S's
properties. At the time of the disposition, A's adjusted basis in
his S stock is $90,000.
(ii) Calculation of net gain under Sec. 1.1411-4(a)(1)(iii). On
the stock sale to C, A recognizes a gain of $75,000 ($165,000 minus
$90,000), which is subject to Sec. 1.1411-4(a)(1)(iii).
(iii) Application of section 1411(c)(4)--(A) In general. Section
1411(c)(4) is applicable to A because S's trade or business is not a
trade or business described in Sec. 1.1411-5(a)(1) with respect to
A.
(B) Deemed sale--(1) Step one: deemed sale of properties. 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, $40,000 for Property 3, and $100,000 for Property 4.
(2) Step two: determination of gain or loss. The determination
of gain or loss on the deemed sale of S's properties is as follows:
------------------------------------------------------------------------
Fair
Property Adjusted market Gain or
basis value loss
------------------------------------------------------------------------
1..................................... $10,000 $50,000 $40,000
2..................................... 70,000 30,000 (40,000)
3..................................... 20,000 40,000 20,000
4..................................... 20,000 100,000 80,000
------------------------------------------------------------------------
(3) Step three: allocation of gain or loss. Under section 1366,
A is allocated $30,000 gain from Property 1, $30,000 loss from
Property 2, $15,000 gain from Property 3, and $60,000 gain from
Property 4.
(4) Step four: adjustment to net gain. Because S's trade or
business is not a trade or business described in Sec. 1.1411-
5(a)(1) with respect to A, A must make an adjustment under paragraph
(c)(5) of this section to the amount of gain determined under Sec.
1.1411-4(a)(1)(iii). Because Property 4 is not held in S's trade or
business, A's $60,000 gain from Property 4 is not taken into account
under paragraph (c)(5) of this section. The gain or loss on Property
1, Property 2, and Property 3 are added together ($30,000 minus
$30,000 plus $15,000), resulting in a negative adjustment of
$15,000. Under paragraph (c)(5) of this section, A's net gain of
$75,000 under Sec. 1.1411-4(a)(1)(iii) on the disposition of the
interest is reduced by $15,000, and A has $60,000 net gain with
respect to the stock disposition for purposes of Sec. 1.1411-
4(a)(1)(iii).
Example 6. Calculation of gain in general. (i) Facts. D and E
are equal partners in PRS, a partnership, and PRS's partnership
agreement provides that allocations are 50 percent to D and 50
percent to E. PRS is engaged in a single trade or business. D
contributed Property 1 with an adjusted basis of $100,000 and a fair
market value of $200,000 at the time of the contribution. E
contributed Property 2 with an adjusted basis of $120,000 and a fair
market value of $200,000 at the time of the contribution. PRS is
engaged in a single trade or business in which both Property 1 and
Property 2 are used. PRS's trade or business is not a trade or
business described in Sec. 1.1411-5(a)(1) with respect to D. On
November 1 of Year 1, D sells his interest in PRS to F for $320,000,
which is based on the fair market value of PRS's properties. At the
time of the sale, D has an adjusted basis in his partnership
interest of $100,000 and the properties of PRS have the following
adjusted bases and fair market values:
------------------------------------------------------------------------
Fair
Property Adjusted market
basis value
------------------------------------------------------------------------
1............................................... $100,000 $240,000
2............................................... 120,000 400,000
------------------------------------------------------------------------
(ii) Calculation of net gain under Sec. 1.1411-4(a)(1)(iii). D
recognizes $220,000 ($320,000 minus $100,000) of gain on the sale of
his partnership interest to F, and such gain is subject to Sec.
1.1411-4(a)(1)(iii).
(iii) Application of section 1411(c)(4)--(A) In general. Section
1411(c)(4) is applicable to D because PRS's trade or business is not
a trade or business described in Sec. 1.1411-5(a)(1) with respect
to A.
(B) Deemed sale--(1) Step one: deemed sale of properties. Upon a
hypothetical
[[Page 72646]]
disposition of PRS's properties for cash equal to fair market value,
PRS would receive $240,000 for Property 1 and $400,000 for Property
2.
(2) Step two: determination of PRS's gain or loss. The
determination of gain or loss on the deemed sale of PRS's properties
is as follows:
------------------------------------------------------------------------
Fair
Property Adjusted market Gain or
basis value loss
------------------------------------------------------------------------
1...................................... $100,000 $240,000 $140,000
2...................................... 120,000 400,000 280,000
------------------------------------------------------------------------
(3) Step three: allocation of gain or loss. Pursuant to section
704(c), D is allocated $120,000 gain from the deemed sale of
Property 1 and $100,000 gain from the deemed sale of Property 2.
(4) Step four: adjustment to net gain. Because both properties
are used in PRS's in trade or business, D must make an adjustment
under paragraph (c)(5)(i) of this section to the amount of net gain
determined under Sec. 1.1411-4(a)(1)(iii). The total gain allocated
to D in the deemed sale is $220,000 ($120,000 plus $100,000),
resulting in a negative adjustment of $220,000. Under paragraph
(c)(5) of this section, D's net gain of $220,000 under Sec. 1.1411-
4(a)(1)(iii) on the disposition of the interest is reduced by
$220,000, and D has zero net gain with respect to the partnership
interest disposition for purposes of Sec. 1.1411-4(a)(1)(iii).
Example 7. Multiple trades or businesses. (i) Facts. Individuals
A and B are shareholders of an S corporation (S). A owns 50 percent
of the stock in S. During Year 2, S is engaged in two trades or
businesses (Business X and Business Y). With respect to Business X,
A is not engaged in a trade or business described in Sec. 1.1411-
5(a)(1), but with respect to Business Y, A is engaged in a trade or
business is described in Sec. 1.1411-5(a)(1). S has five
properties. Property 1 and Property 2 are held exclusively in
Business X, and Property 3 and Property 4 are held exclusively in
Business Y. Property 5 is used half of the time in Business X and
the rest of the time in Business Y. On December 1 of Year 2, A sells
his S stock to C for A's proportionate share of the fair market
value of S's properties. At the time of the disposition, A's
adjusted basis in his S stock is $110,000. S's properties have the
following adjusted bases and fair market values immediately before
the disposition:
------------------------------------------------------------------------
Fair
Property Adjusted market
basis value
------------------------------------------------------------------------
1............................................... $10,000 $30,000
2............................................... 70,000 30,000
3............................................... 20,000 40,000
4............................................... 20,000 100,000
5............................................... 100,000 120,000
------------------------------------------------------------------------
(ii) Calculation of gain under Sec. 1.1411-4(a)(1)(iii). On the
stock sale to C, A recognizes a gain of $50,000 ($160,000 minus
$110,000), which is subject to Sec. 1.1411-4(a)(1)(iii).
(iii) Application of section 1411(c)(4)--(A) In general. Section
1411(c)(4) is applicable to A. However, any adjustment will only
relate to property held in Business X and not to property held in
Business Y (because Business Y is a trade or business described in
Sec. 1.1411-5(a)(1) with respect to A).
(B) Deemed sale--(1) Step one: deemed sale of properties. Upon a
hypothetical disposition of S's properties for cash equal to fair
market value, S would receive $30,000 for Property 1, $30,000 for
Property 2, $40,000 for Property 3, $100,000 for Property 4, and
$120,000 for Property 5.
(2) Step two: determination of gain or loss. The determination
of gain or loss on the deemed sale of S's properties is as follows:
------------------------------------------------------------------------
Fair
Property Adjusted market Gain or
basis value loss
------------------------------------------------------------------------
1..................................... $10,000 $30,000 $20,000
2..................................... 70,000 30,000 (40,000)
3..................................... 20,000 40,000 20,000
4..................................... 20,000 100,000 80,000
5..................................... 100,000 120,000 20,000
------------------------------------------------------------------------
(3) Step three: allocation of gain or loss. Under section 1366,
A is allocated $10,000 gain from Property 1, $20,000 loss from
Property 2, $10,000 gain from Property 3, $40,000 gain from Property
4, and $10,000 gain from Property 5.
(4) Step four: adjustment to net gain. A must make an adjustment
under paragraph (c)(5) of this section to the amount of net gain
determined under Sec. 1.1411-4(a)(1)(iii), but only with respect to
the gain or loss on the properties used in Business X (that is,
Property 1, Property 2, and a portion of Property 5). Because
Property 5 is used 50 percent of the time in Business X, under
paragraph (c)(5)(ii)(A) of this section, 50 percent of the gain
would be attributable to Business X (and A's share would be $5,000).
The gain or loss on Property 1, Property 2, and Property 5 are added
together ($10,000 minus $20,000 plus $5,000), and results in a
positive adjustment of $5,000. Under paragraph (c)(5)(iv)(B) of this
section, because A had a gain of $50,000 on the stock disposition, A
does not take the positive adjustment of $5,000 into account and A
has a $50,000 gain for purposes of Sec. 1.1411-4(a)(1)(iii).
Example 8. Goodwill and multiple trades or businesses. (i)
Facts. Individuals A and B are shareholders of an S corporation (S).
A owns 50 percent of the stock in S. During Year 2, S is engaged in
two trades or businesses (Business X and Business Y). With respect
to Business X, A is not engaged in a trade or business described in
Sec. 1.1411-5(a)(1), but with respect to Business Y, A is engaged
in a trade or business described in Sec. 1.1411-5(a)(1). In
addition to cash and goodwill, S has five properties. Property 1 and
Property 2 are used exclusively in Business X. Property 3 is not
held for use in either Business X or Business Y. Property 4 and
Property 5 are used exclusively in Business Y. On June 1 of Year 2,
A sells his S stock to C for A's proportionate share of the fair
market value of S's properties. At the time of the disposition, A's
adjusted basis in his S stock is $30,000. S's properties have the
following adjusted basis and fair market value immediately before
the disposition:
------------------------------------------------------------------------
Fair
Property Adjusted market
basis value
------------------------------------------------------------------------
1............................................... $5,000 $10,000
2............................................... 5,000 5,000
3............................................... 0 10,000
4............................................... 20,000 30,000
5............................................... 10,000 15,000
Cash............................................ 10,000 10,000
Goodwill........................................ 10,000 30,000
------------------------------------------------------------------------
(ii) Calculation of gain under Sec. 1.1411-4(a)(1)(iii). On the
stock sale to C, A recognizes a gain of $25,000 ($55,000 minus
$30,000), which is subject to Sec. 1.1411-4(a)(1)(iii).
(iii) Application of section 1411(c)(4)--(A) In general. Section
1411(c)(4) is applicable to A. However, any adjustment will only
relate to property used in Business X and not to property used in
Business Y (because Business Y is a trade or business described in
Sec. 1.1411-5(a)(1) with respect to A).
(B) Deemed sale--(1) Step one: deemed sale of properties. Upon a
hypothetical disposition of S's properties for cash equal to fair
market value, S would receive $10,000 for Property 1, $5,000 for
Property 2, $10,000 for Property 3, $30,000 for Property 4, $15,000
for Property 5, $10,000 for the cash, and $30,000 for goodwill.
(2) Step two: determination of gain or loss. The determination
of gain or loss on the deemed sale of S's properties is as follows:
------------------------------------------------------------------------
Fair
Property Adjusted market Gain or
basis value loss
------------------------------------------------------------------------
1..................................... $5,000 $10,000 5,000
2..................................... 5,000 5,000 0
3..................................... 0 10,000 10,000
4..................................... 20,000 30,000 10,000
5..................................... 10,000 15,000 5,000
Cash.................................. 10,000 10,000 0
Goodwill.............................. 10,000 30,000 20,000
------------------------------------------------------------------------
(3) Step three: allocation of gain or loss. Under section 1366,
A is allocated a $25,000 gain ($2,500 gain from Property 1, $0 gain
from Property 2, $5,000 gain from Property 3, $5,000 gain from
Property 4, $2,500 gain from Property 5, $0 from cash, and $10,000
from goodwill).
(4) Step four: adjustment to net gain. A must make an adjustment
under paragraph (c)(5) of this section to the amount of net gain
determined under Sec. 1.1411-4(a)(1)(iii), but only with respect to
the gain or loss on the properties used in Business X (that is,
Property 1, Property 2, and a portion of the goodwill). Under
paragraph (c)(5)(ii)(B) of this section, the goodwill is allocated
to Business X and Business Y based on the relative fair market value
of the property (other than cash) held for use in each trade or
business. For this purpose, the fair market value of the property
held for use in Business X is $15,000, and the fair market value of
the property held for use in Business Y is $45,000. Therefore, 25
percent of A's gain on the goodwill is attributable to Business X
(or $2,500). A's share of the gain on Property 1, Property 2, and
goodwill are added together ($2,500 plus zero plus $2,500), which
results in a negative adjustment of $5,000. Under
[[Page 72647]]
paragraph (c)(5) of this section, A takes into account the negative
adjustment of $5,000, and A has a $20,000 gain ($25,000 minus $5,000
adjustment) for purposes of Sec. 1.1411-4(a)(1)(iii).
(f) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013.
Sec. 1.1411-8 Exception for distributions from qualified plans.
(a) General rule. Net investment income (as defined in Sec.
1.1411-4) does not include any distribution from a qualified plan or
arrangement. For this purpose, the term qualified plan or arrangement
means any plan or arrangement described in section 401(a), 403(a),
403(b), 408, 408A, or 457(b).
(b) Rules relating to distributions. This paragraph (b) provides
rules for purposes of paragraph (a) of this section. For purposes of
section 1411(c)(5) and this section, a distribution means the
following:
(1) Actual distributions. Any amount actually distributed from a
qualified plan or arrangement, as defined in paragraph (a) of this
section, is a distribution within the meaning of section 1411(c)(5),
and thus is not included in net investment income. Examples include a
rollover to an eligible retirement plan within the meaning of section
402(c)(8)(B), a distribution of a plan loan offset amount within the
meaning of Q&A-13(b) of Sec. 1.72(p)-1, and certain corrective
distributions under the Internal Revenue Code.
(2) Amounts treated as distributed. Any amount that is treated as
distributed from a qualified plan or arrangement under the Internal
Revenue Code for purposes of income tax is a distribution within the
meaning of section 1411(c)(5), and thus is not included in net
investment income. Examples include a conversion to a Roth IRA
described in section 408A and a deemed distribution under section
72(p).
(3) Amounts includible in gross income. Any amount that is not
treated as a distribution but is otherwise includible in gross income
pursuant to a rule relating to amounts held in a qualified plan or
arrangement described in paragraph (a) of this section is a
distribution within the meaning of section 1411(c)(5), and thus is not
included in net investment income. For example, any income of the trust
of a qualified plan or arrangement that is applied to purchase a
participant's life insurance coverage (the P.S. 58 costs) is a
distribution within the meaning of section 1411(c)(5), and thus is not
included in net investment income.
(c) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013.
Sec. 1.1411-9 Exception for self-employment income.
(a) General rule. Except as provided in paragraph (b) of this
section, net investment income (as defined in Sec. 1.1411-4) does not
include any item taken into account in determining self-employment
income that is subject to tax under section 1401(b) for such taxable
year. For purposes of section 1411(c)(6) and this section, taken into
account means income included and deductions allowed in determining net
earnings from self-employment. However, amounts excepted in determining
net earnings from self-employment under section 1402(a)(1)-(17), and
thus excluded from self-employment income under section 1402(b), are
not taken into account in determining self-employment income and thus
may be included in net investment income if such amounts are described
in Sec. 1.1411-4. Except as provided in paragraph (b) of this section,
if net earnings from self-employment consist of income or loss from
more than one trade or business, all items taken into account in
determining the net earnings from self-employment with respect to these
trades or businesses (see Sec. 1.1402(a)-2(c)) are considered taken
into account in determining the amount of self-employment income that
is subject to tax under section 1401(b) and therefore not included in
net investment income.
(b) Special rule for traders. In the case of gross income described
in Sec. 1.1411-4(a)(1)(ii) derived from a trade or business of trading
in financial instruments or commodities (as described in Sec. 1.1411-
5(a)(2)), the deductions described in Sec. 1.1411-4(f)(2)(ii) properly
allocable to the taxpayer's trade or business of trading in financial
instruments or commodities are taken into account in determining the
taxpayer's self-employment income only to the extent that such
deductions reduce the taxpayer's net earnings from self-employment
(after aggregating under Sec. 1.1402(a)-2(c) the net earnings from
self-employment from any trade or business carried on by the taxpayer
as an individual or as a member of a partnership). Any deductions
described in Sec. 1.1411-4(f)(2)(ii) that exceed the amount of net
earnings from self-employment, in the aggregate (if applicable), shall
be allowed in determining the taxpayer's net investment income under
section 1411 and the regulations thereunder.
(c) Examples. The following examples illustrate the provisions of
this section:
Example 1. Exclusion from self-employment income. A is a general
partner in PRS, a partnership carrying on a trade or business that
is not a trade or business of trading in financial instruments or
commodities (within the meaning of Sec. 1.1411-5(a)(2)). During
Year 1, A's distributive share from PRS is $1 million, $300,000 of
which is attributable to the gain on the sale of PRS's capital
assets. Section 1402(a)(3)(A) provides an exclusion from net
earnings from self-employment for any gain or loss from the sale or
exchange of a capital asset. For Year 1, A has $700,000 self-
employment income subject to self-employment tax. This $700,000
subject to self-employment tax is not included as part of net
investment income. However, the $300,000 attributable to the gain on
PRS's sale of a capital asset is excluded from net earnings from
self-employment and self-employment income and thus is not covered
by the exception in section 1411(c)(6). The $300,000 attributable to
the gain on PRS's sale of a capital asset is included as part of net
investment income if the other requirements of section 1411 are
satisfied.
Example 2. Two trades or businesses. B is an individual engaged
in two trades or businesses, Business X and Business Y, neither of
which is the trade or business of trading in financial instruments
or commodities (as described in Sec. 1.1411-5(a)(2)). B carries on
Business X as a sole proprietor and B is also a general partner in a
partnership that carries on Business Y. During Year 1, B had net
earnings from self-employment consisting of the aggregate of a
$50,000 loss (that is, after application of the exclusions under
section 1402(a)(1)-(17)) from Business X that is attributable to
passive activities, and $70,000 in income (after application of the
exclusions under section 1402(a)(1)-(17)) from B's distributive
share from the partnership from carrying on Business Y. Thus, B's
net earnings from self-employment in Year 1 are $20,000. For Year 1,
all of B's income, deductions, gains, and losses from Business X and
distributive share from the partnership carrying on Business Y,
other than those amounts excluded due to application of section
1402(a)(1)-(17), are taken into account in determining B's net
earnings from self-employment and self-employment income for such
taxable year. Accordingly, in calculating B's net investment income
(as defined in Sec. 1.1411-4) for Year 1, the items of income,
loss, gain, and deduction that comprise B's $50,000 loss
attributable to Business X (after application of the exclusions
under section 1402(a)(1)-(17)), and the items of income, loss, gain,
and deduction that comprise B's $70,000 distributable share
attributable to B's general partnership interest (after application
of the exclusions under section 1402(a)(1)-(17)), are not
considered. Rather, only items of income, loss, gain, and deduction
from the two separate businesses that were excluded from the
calculation of B's net earnings from self-employment income due to
the application of the exclusions under section 1402(a)(1)-(17),
such as any capital gains and losses excluded under section
1402(a)(3), are considered for
[[Page 72648]]
purposes of calculating B's net investment income for Year 1 in
connection with these two trades or businesses.
Example 3. Special rule for trader with single trade or
business. D is an individual engaged in the trade or business of
trading in commodities (as described in Sec. 1.1411-5(a)(2)). D
made an election under section 475(f)(2). D derives $400,000 of
gross income described in Sec. 1.1411-4(a)(1)(ii) and $150,000 of
expenses described in Sec. 1.1411-4(f)(2)(ii) from carrying on the
trade or business. Pursuant to sections 475(f)(1)(D) and
1402(a)(3)(A), none of the gross income is taken into account in
determining D's net earnings from self-employment and self-
employment income, and therefore, under paragraph (a) of this
section, the $400,000 of gross income is not covered by the
exception in section 1411(c)(6). Under paragraph (b) of this section
and Sec. 1.1411-4(f)(2)(ii), because the $150,000 of deductions did
not reduce D's net earnings from self-employment (because D had $0
net earnings from self-employment), for purposes of section
1411(c)(6), the $150,000 of deductions are not taken into account in
determining D's net earnings from self-employment and self-
employment income, and therefore the $150,000 of deductions may
reduce D's gross income of $400,000 for purposes of section 1411.
Example 4. Special rule for trader with multiple trades or
businesses. E is an individual engaged in two trades or businesses,
Business X (which is not a trade or business of trading in financial
instruments or commodities) and Business Y (which is a trade or
business of trading in financial instruments or commodities (as
described in Sec. 1.1411-5(a)(2))). E has made an election under
section 475(f) with respect to Business Y. During Year 1, E had net
earnings from self-employment from Business X of $35,000. During
Year 1, E also had $300,000 of gross income described in Sec.
1.1411-4(a)(1)(ii) and $75,000 of expenses described in Sec.
1.1411-4(f)(2)(ii) from Business Y. E's $300,000 of gross income
from Business Y is excluded from net earnings from self-employment
and self-employment income pursuant to sections 475(f)(1)(D) and
1402(a)(3)(A). E's $75,000 of deductions from Business Y reduce E's
$35,000 of net earnings from self-employment from Business X to $0.
Pursuant to paragraph (b) of this section and Sec. 1.1411-
4(f)(2)(ii), the remaining $40,000 of deductions from Business Y are
taken into account in determining E's net investment income (by
reducing E's gross income of $300,000 from Business Y to $260,000)
for purposes of section 1411.
(d) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013.
Sec. 1.1411-10 Controlled foreign corporations and passive foreign
investment companies.
(a) In general. This section provides rules that apply to an
individual, estate, or trust that is a United States shareholder
(within the meaning of section 951(b)) of a controlled foreign
corporation (within the meaning of section 957(a)), or that is a United
States person that directly or indirectly owns an interest in a passive
foreign investment company (within the meaning of section 1297(a)). In
addition, this section provides rules that apply to an individual,
estate, or trust that owns an interest in a domestic partnership or an
S corporation that either is a United States shareholder of a
controlled foreign corporation or that has made an election under
section 1295 to treat a passive foreign investment company as a
qualified electing fund.
(b) Amounts derived from a trade or business described in Sec.
1.1411-5. An amount included in gross income under section 951(a) or
section 1293(a) that is income derived from a trade or business
described in section 1411(c)(2) and Sec. 1.1411-5 is taken into
account as net investment income under section 1411(c)(1)(A)(ii) and
Sec. 1.1411-4(a)(1)(ii) for purposes of section 1411 when it is taken
into account for purposes of chapter 1, and the rules in paragraphs (c)
through (g) of this section do not apply to such amounts. For purposes
of section 1411, an amount included in gross income under section
1296(a) that is also income derived from a trade or business described
in section 1411(c)(2) and Sec. 1.1411-5 is net investment income
within the meaning of section 1411(c)(1)(A)(ii) and Sec. 1.1411-
4(a)(1)(ii), and the rules in paragraphs (c) through (f) of this
section do not apply to such amount.
(c) Calculation of net investment income--(1) In general. For
purposes of section 1411 and the regulations thereunder, net investment
income means net investment income as defined in Sec. 1.1411-4,
adjusted pursuant to the rules described in this paragraph (c).
(2) Dividends. For purposes of section 1411(c)(1)(A)(i) and Sec.
1.1411-4(a)(1)(i), net investment income is calculated by taking into
account the amount of dividends described in this paragraph (c)(2).
(i) Distributions of previously taxed earnings and profits. If no
election is made pursuant to paragraph (g) of this section, a
distribution of earnings and profits that is not treated as a dividend
for chapter 1 purposes under section 959(d) or section 1293(c) is a
dividend for purposes of section 1411(c)(1)(A)(i) and Sec. 1.1411-
4(a)(1)(i) if the distribution is attributable to amounts that are or
have been included in gross income for chapter 1 purposes under section
951(a) or section 1293(a) in a taxable year beginning after December
31, 2012. For this purpose, distributions of earnings and profits
attributable to amounts that are or have been included in gross income
for chapter 1 purposes under section 951(a) or section 1293(a) shall be
considered first attributable to such earnings and profits, if any,
derived from the current taxable year, and then from prior taxable
years beginning with the most recent prior taxable year. With respect
to such distributions from controlled foreign corporations, a
distribution shall be attributable first to earnings and profits
derived from the current taxable year and then from prior taxable years
beginning with the most recent prior taxable year, without regard to
whether the earnings and profits are described in section 959(c)(1) or
section 959(c)(2).
(ii) Excess distributions constituting dividends. To the extent an
excess distribution within the meaning of section 1291(b) constitutes a
dividend within the meaning of section 316(a), the amount is included
in net investment income for purposes of section 1411(c)(1)(A)(i) and
Sec. 1.1411-4(a)(1)(i).
(3) Net gain. For purposes of section 1411(c)(1)(A)(iii) and Sec.
1.1411-4(a)(1)(iii), the rules in this paragraph (c)(3) apply in
determining net gain attributable to the disposition of property.
(i) Gains treated as excess distributions. Gains treated as excess
distributions under section 1291(a)(2) are included in determining net
gain attributable to the disposition of property for purposes of
section 1411(c)(1)(A)(iii) and Sec. 1.1411-4(a)(1)(iii).
(ii) Inclusions and deductions with respect to section 1296 mark to
market elections. Amounts included in gross income under section
1296(a)(1) and amounts allowed as a deduction under section 1296(a)(2)
are taken into account in determining net gain attributable to the
disposition of property for purposes of section 1411(c)(1)(A)(iii) and
Sec. 1.1411-4(a)(1)(iii).
(iii) Gain or loss attributable to the disposition of stock of
controlled foreign corporations and qualified electing funds. If no
election is made pursuant to paragraph (g) of this section, for
purposes of calculating net gain in Sec. Sec. 1.1411-4(a)(1)(iii) and
1.1411-4(d)(3) attributable to the direct or indirect disposition of
stock of a controlled foreign corporation or qualified electing fund
(including for purposes of determining gain or loss on the direct or
indirect disposition of stock of a controlled foreign corporation or a
qualified electing fund by a domestic partnership or S corporation),
basis shall be determined in accordance with
[[Page 72649]]
the provisions of paragraph (d) of this section.
(iv) Gain or loss attributable to the disposition of interests in
domestic partnerships or S corporations that own directly or indirectly
stock of controlled foreign corporations or qualified electing funds.
If no election is made pursuant to paragraph (g) of this section, for
purposes of calculating net gain in Sec. Sec. 1.1411-4(a)(1)(iii) and
1.1411-4(d)(3) attributable to the disposition of an interest in a
domestic partnership or S corporation that directly or indirectly owns
stock of a controlled foreign corporation or a qualified electing fund,
basis shall be determined in accordance with the provisions of
paragraph (d) of this section.
(4) Application of section 1248. If no election is made pursuant to
paragraph (g) of this section, for purposes of section 1411 and Sec.
1.1411-4:
(i) For purposes of determining the gain recognized on the sale or
exchange of a foreign corporation for section 1248(a) purposes, basis
is determined in accordance with the provisions of paragraph (d) of
this section; and
(ii) Section 1248(a) applies without regard to the exclusion for
certain earnings and profits under section 1248(d)(1) and (d)(6),
except that such exclusions will apply with respect to the earnings and
profits of a foreign corporation that are attributable to amounts
previously included in gross income for chapter 1 purposes under
section 951(a) or section 1293(a) in a taxable year beginning before
December 31, 2012, and that have not yet been distributed. For this
purpose, the determination of whether earnings and profits attributable
to amounts previously taxed in a taxable year beginning before December
31, 2012, have been distributed shall be determined based on the rules
described in paragraph (c)(2)(i) of this section.
(5) Amounts distributed by an estate or trust. Net investment
income of a beneficiary of an estate or trust includes the
beneficiary's share of distributable net income, as described in
sections 652 and 662 and as modified by paragraph (f) of this section,
to the extent that the beneficiary's share of distributable net income
includes items that, if they had been received directly by the
beneficiary, would have been described in this paragraph (c).
(d) Conforming basis adjustments--(1) Basis adjustments under
sections 961 and 1293--(i) Stock held by individuals, estates, or
trusts. If no election is made by an individual, estate or trust
pursuant to paragraph (g) of this section:
(A) The basis increases made by the individual, estate or trust
pursuant to sections 961(a) and 1293(d) for amounts included in gross
income for chapter 1 purposes under sections 951(a) and 1293(a) in
taxable years beginning after December 31, 2012, are not taken into
account for purposes of section 1411; and
(B) The basis decreases made by the individual, estate or trust
pursuant to sections 961(b) and 1293(d) attributable to distributions
treated as dividends for purposes of section 1411 under paragraph
(c)(2)(i) of this section are not taken into account for purposes of
section 1411.
(ii) Stock held by domestic partnerships or S corporations. If an
individual, estate, or trust is a shareholder of an S corporation, or
if an individual, estate, or trust directly, or through one or more
tiers of passthrough entities (including an S corporation), owns an
interest in a domestic partnership, the domestic partnership or S
corporation, as the case may be, will not take into account for
purposes of section 1411 the basis increases made by the domestic
partnership or S corporation pursuant to sections 961(a) and 1293(d)
for amounts included in gross income for chapter 1 purposes under
sections 951(a) and 1293(a) for taxable years beginning after December
31, 2012, and the basis decreases made by the domestic partnership or S
corporation pursuant to sections 961(b) and 1293(d) attributable to
amounts that are treated as dividends for section 1411 purposes under
paragraph (c)(2)(i) of this section (the section 1411 recalculated
basis). If the domestic partnership or S corporation disposes of its
stock of a controlled foreign corporation or qualified electing fund,
the section 1411 recalculated basis will be used to determine the
distributive share or pro rata share of the gain or loss for section
1411 purposes for partners or shareholders that do not make an election
pursuant to paragraph (g) of this section. If a partner or shareholder
makes an election pursuant to paragraph (g) of this section, the
partner's distributive share or the shareholder's pro rata share of the
gain or loss for section 1411 purposes is the same as the distributive
share or pro rata share of the gain or loss calculated for chapter 1
purposes. See Example 6 of paragraph (h) of this section.
(2) Special rules for partners that own interests in domestic
partnerships that own directly or indirectly stock of controlled
foreign corporations or qualified electing funds. If no election is
made by a partner pursuant to paragraph (g) of this section, the basis
increases provided in section 705(a)(1)(A) to that partner for chapter
1 purposes that are attributable to amounts that a domestic partnership
included in gross income under section 951(a) or section 1293(a) for a
taxable year beginning after December 31, 2012, are not taken into
account for purposes of section 1411. In such case, the partner's
adjusted basis in the partnership interest is increased by the
distributions to the partnership from the controlled foreign
corporation or qualified electing fund that are treated as dividends
for purposes of section 1411 under paragraph (c)(2)(i) of this section.
The amount of the basis increase is calculated based on the partner's
share of the distribution received by the domestic partnership. Similar
rules apply when the stock of the controlled foreign corporation or
qualified electing fund is held in a tiered partnership structure. For
purposes of determining net investment income under section 1411 and
the regulations thereunder, the partner's adjusted basis in the
partnership interest as calculated under this paragraph (d)(2) shall be
used to determine all tax consequences related to tax basis (for
example, loss limitation rules and the characterization of partnership
distributions).
(3) Special rules for S corporation shareholders that own interests
in S corporations that own directly or indirectly stock of controlled
foreign corporations or qualified electing funds. If no election is
made by a shareholder pursuant to paragraph (g) of this section, the
basis increases provided in section 1367(a)(1)(A) to the shareholder
for chapter 1 purposes that are attributable to amounts that an S
corporation included in gross income for chapter 1 purposes under
section 951(a) or section 1293(a) for taxable years beginning after
December 31, 2012, are not taken into account for purposes of section
1411. In such case, the shareholder's adjusted basis of stock in the S
corporation is increased by the distributions to the S corporation from
the controlled foreign corporation or qualified electing fund that are
treated as dividends for purposes of section 1411 under paragraph
(c)(2)(i) of this section. The amount of the basis increase is
calculated based on the shareholder's pro rata share of the
distribution received by the S corporation. Similar rules apply when
the S corporation holds an interest in a controlled foreign corporation
or qualified electing fund through a partnership. For purposes of
determining net investment income under section 1411 and the
regulations thereunder, the shareholder's adjusted
[[Page 72650]]
basis in the stock of the S corporation as calculated under this
paragraph (d)(3) shall be used to determine all tax consequences
related to tax basis (for example, loss limitation rules and the
characterization of S corporation distributions).
(e) Conforming adjustments to modified adjusted gross income and
adjusted gross income--(1) Individuals. Solely for purposes of section
1411(a)(1)(B)(i) and the regulations thereunder, the term modified
adjusted gross income means modified adjusted gross income as defined
in Sec. 1.1411-2(c)(1)--
(i) Increased by amounts included in net investment income under
paragraphs (c)(2)(i), (c)(2)(ii), (c)(3)(i), and (c)(5) of this section
that are not otherwise included in gross income for chapter 1 purposes;
(ii) Increased or decreased, as applicable, by the difference
between the amount calculated with respect to a disposition under
paragraphs (c)(3)(iii) and (c)(3)(iv) of this section and the amount of
the gain or loss attributable to the relevant disposition as calculated
for chapter 1 purposes; and
(iii) Decreased by any amount included in gross income for chapter
1 purposes under section 951(a) or section 1293(a) if no election is
made pursuant to paragraph (g) of this section.
(2) Estates and trusts. Solely for purposes of section
1411(a)(2)(B)(i) and the regulations thereunder, the term adjusted
gross income means adjusted gross income as defined in Sec. 1.1411-
3(a)(1)(ii)(B)(1) adjusted by the following amounts to the extent those
amounts are not distributed by the estate or trust--
(i) Increased by amounts included in net investment income under
paragraphs (c)(2)(i), (c)(2)(ii), (c)(3)(i), and (c)(5) of this section
that are not otherwise included in gross income for chapter 1 purposes;
(ii) Increased or decreased, as applicable, by the difference
between the amount calculated with respect to a disposition under
paragraphs (c)(3)(iii) and (c)(3)(iv) of this section and the amount of
the gain or loss attributable to the relevant disposition as calculated
for chapter 1 purposes; and
(iii) Decreased by any amount included in gross income for chapter
1 purposes under section 951(a) or section 1293(a) if no election is
made pursuant to paragraph (g) of this section.
(f) Application to estates and trusts. All of the items described
in paragraph (c) of this section shall be included in the net
investment income of an estate or trust or its beneficiaries. The
amounts described in paragraphs (e)(2)(i), (e)(2)(ii), and (e)(2)(iii)
of this section, regardless of whether the estate or trust receives
those amounts directly or indirectly through another estate or trust,
shall increase or decrease, as applicable, the estate's or trust's
distributable net income. The estate or trust, or the beneficiaries
thereof, shall take such amounts into account in a manner reasonably
consistent with the general operating rules for estates and trusts in
Sec. 1.1411-3 and subchapter J in computing the undistributed net
investment income of the estate or trust and the net investment income
of the beneficiaries.
(g) Election with respect to controlled foreign corporations and
qualified electing funds--(1) In general. An individual, estate, or
trust may make an election under this paragraph (g) with respect to all
interests in controlled foreign corporations and qualified electing
funds held directly or indirectly by the individual, estate, or trust
(other than as provided in paragraph (b) of this section) in the year
of the election or acquired in subsequent years. The election, if made,
for an estate or trust shall be made by the fiduciary of that estate or
trust. If the election is made, amounts included in gross income under
section 951(a) or section 1293(a)(1)(A) in taxable years beginning with
the year for which the election is made are treated as net investment
income for purposes of Sec. 1.1411-4(a)(1)(i), and amounts included in
gross income under section 1293(a)(1)(B) in taxable years beginning
with the year for which the election is made are taken into account in
calculating net gain attributable to the disposition of property under
Sec. 1.1411-4(a)(1)(iii).
(2) Revocation of election. An election under paragraph (g) of this
section may only be revoked if the Commissioner, in the Commissioner's
discretion, consents to the individual's, estate's, or trust's request
to revoke the election.
(3) Time and manner for making election. Except as otherwise
provided in this paragraph (g)(3), an individual, estate, or trust that
wants to make the election under this paragraph (g) must make the
election for the first taxable year beginning after December 31, 2013,
during which the individual, estate, or trust directly or indirectly
holds stock of a controlled foreign corporation or qualified electing
fund and the individual, estate, or trust is subject to tax under
section 1411 or would be subject to tax under section 1411 if the
election were made with respect to the stock of the controlled foreign
corporation or qualified electing fund. In addition, an individual,
estate, or trust may make an election under this paragraph (g)(3) for a
taxable year that begins before January 1, 2014. In all cases, the
election must be made in the manner prescribed by the Secretary on or
before the due date, determined with regard to any extension of time,
for filing the individual's, estate's, or trust's income tax return for
the taxable year for which the election is made. Further, in all cases,
once made, the election applies to the taxable year for which it is
made and all subsequent years unless revoked pursuant to paragraph
(g)(2) of this section.
(h) Examples. The following examples illustrate the rules of this
section. In each example, unless otherwise indicated, the individuals,
the foreign corporation (FC), the qualified electing fund (QEF), and
the partnership (PRS) use a calendar taxable year. Further, the gross
income or gain with respect to an interest in FC is not derived in a
trade or business described in Sec. 1.1411-5.
Example 1. (i) Facts. A, a U.S. citizen, is the sole shareholder
of FC, a controlled foreign corporation (within the meaning of
section 957). A is a United States shareholder (within the meaning
of section 951(b)) with respect to FC. On December 31, 2012, A's
basis in the stock of FC for chapter 1 purposes is $500,000, which
includes an increase to basis under section 961(a) of $40,000.The
amount of FC's earnings and profits that are described in section
959(c)(2) is $40,000, the amount of FC's earnings and profits that
are described in section 959(c)(3) is $20,000, and FC does not have
any earnings and profits that are described in section 959(c)(1). No
election is made pursuant to paragraph (g) of this section. During
2013, A does not include any amounts in income under section 951(a)
with respect to FC, A does not receive any distributions from FC,
and there is no change in the amount of FC's earnings and profits.
In 2014, A includes $10,000 in gross income for chapter 1 purposes
under section 951(a)(1)(A) with respect to FC. As a result, A's
basis in the stock of FC for chapter 1 purposes increases by $10,000
to $510,000 pursuant to section 961(a). During 2015, FC distributes
$30,000 to A, which is not treated as a dividend for purposes of
chapter 1 under section 959(d). As a result, A's basis in the stock
of FC for chapter 1 purposes is decreased by $30,000 to $480,000
pursuant to section 961(b).
(ii) Results for section 1411 purposes. In 2014, A does not
include the $10,000 section 951(a) income inclusion in A's net
investment income under section 1411(c)(1)(A)(i) and Sec. 1.1411-
4(a)(1)(i). Pursuant to paragraph (e)(1)(iii) of this section, A
decreases A's modified adjusted gross income for section 1411
purposes by $10,000 in 2014, and pursuant to paragraph (d)(1)(i) of
this section, A's adjusted basis is not increased by $10,000 and
remains at $500,000. In 2015, pursuant to paragraph (c)(2)(i) of
this section, A includes $10,000 of the distribution of previously
taxed earnings and profits as a dividend for purposes of
[[Page 72651]]
determining A's net investment income because $10,000 of the $30,000
distribution is attributable to amounts that A included in gross
income for chapter 1 purposes under section 951(a) in a tax year
that began after December 31, 2012. Pursuant to paragraph (e)(1)(i)
of this section, A increases A's modified adjusted gross income for
section 1411 purposes by $10,000 in 2015. Under paragraph (d)(1)(i)
of this section, A's adjusted basis is not decreased by the $10,000
that is treated as a dividend for section 1411 purposes, and thus,
A's adjusted basis in FC for section 1411 purposes is decreased
under section 961 only by $20,000 to $480,000.
Example 2. (i) Facts. Same facts as Example 1. In addition,
during 2016, A includes $15,000 in gross income for chapter 1
purposes under section 951(a)(1)(A) with respect to FC. As a result,
A's basis in the stock of FC for chapter 1 purposes increases by
$15,000 to $495,000 pursuant to section 961(a). During 2017, A sells
all of A's shares of FC for $550,000 and, prior to the application
of section 1248, recognizes $55,000 ($550,000 minus $495,000) of
long-term capital gain for chapter 1 purposes. For purposes of
calculating the amount included in income as a dividend pursuant to
section 1248(a) for chapter 1 purposes, the earnings and profits of
FC attributable to A's shares in FC which were accumulated after
December 31,1962 and during the period which A held the stock while
FC was a controlled foreign corporation is $55,000, $35,000 of which
is excluded pursuant to section 1248(d)(1). Therefore, after the
application of section 1248, for chapter 1 purposes, upon the sale
of the FC stock, A recognizes $35,000 of long-term capital gain and
a $20,000 dividend.
(ii) Results for section 1411 purposes. (A) In 2016, A does not
include the $15,000 section 951(a)(1)(A) income inclusion in A's net
investment income under section 1411(c)(1)(A)(i) and Sec.
1411(c)(1)(A)(i). Pursuant to paragraph (e)(1)(ii) of this section,
A decreases A's modified adjusted gross income for section 1411
purposes by $15,000, and, pursuant to paragraph (d)(1)(i) of this
section, A's adjusted basis remains at $480,000.
(B) During 2017, prior to the application of section 1248, A
recognizes $70,000 ($550,000 minus $480,000) of gain for section
1411 purposes. Pursuant to paragraph (c)(4) of this section, for
section 1411 purposes, section 1248(a) applies to the gain on the
sale of FC calculated for section 1411 purposes ($70,000) and
section 1248(d)(1) does not apply, except with respect to the
$20,000 of earnings and profits of FC that are attributable to
amounts previously included in income for chapter 1 purposes under
section 951 for a taxable year beginning before December 31, 2012.
Accordingly, for purposes of calculating the amount of income
includible as a dividend under section 1248(a), A has $55,000 of
earnings and profits, $20,000 of which is excluded pursuant to
section 1248(d)(1). Therefore, after the application of section
1248, for section 1411 purposes A has $35,000 of long term capital
gain and a $35,000 dividend. For purposes of calculating net
investment income in 2016, A includes $35,000 as a dividend under
section 1411(c)(1)(A)(i) and Sec. 1.1411-4(a)(1)(i) and $35,000 as
a gain under section 1411(c)(1)(A)(iii) and Sec. 1.1411-
4(a)(1)(iii).
Example 3. (i) Facts. Same facts as Example 2, except that A
timely makes an election pursuant to paragraph (g) of this section
for 2014 (and thus for all subsequent years).
(ii) Results for section 1411 purposes. A does not have any
adjustments to A's modified adjusted gross income for section 1411
purposes for 2014, 2015, 2016 or 2017 because the election under
paragraph (g) of this section was timely made. Pursuant to paragraph
(g)(1) of this section, for purposes of calculating A's net
investment income in 2014, the $10,000 that A included in income for
chapter 1 purposes under section 951(a) is net investment income for
purposes of section 1411(c)(1)(A)(i) and Sec. 1.1411-4(a)(1)(i). A
has no amount of net investment income with respect to FC in 2015.
Pursuant to paragraph (g)(1) of this section, for purposes of
calculating A's net investment income in 2016, the $15,000 that A
included in income for chapter 1 purposes under section 951(a) is
net investment income for purposes of section 1411(c)(1)(A)(i) and
Sec. 1.1411-4(a)(1)(i). For purposes of calculating A's net
investment income in 2017, the amount of gain on the disposition of
the FC shares is the same as the amount calculated for chapter 1
purposes. Applying section 1248, A includes $35,000 as a gain under
section 1411(c)(1)(A)(iii) and Sec. 1.1411-4(a)(1)(iii), and
$20,000 as a dividend under section 1411(c)(1)(A)(i) and Sec.
1.1411-4(a)(1)(i).
Example 4. Domestic partnership holding QEF stock. (i) Facts.
(A) C, a U.S. citizen, owns a 50 percent interest in PRS, a domestic
partnership. D, a U.S. citizen, and E, a U.S. citizen, each own a 25
percent interest in PRS. All allocations of partnership income and
losses are pro rata based on ownership interests. PRS owns an
interest in QEF, a foreign corporation that is a passive foreign
investment company (within the meaning of section 1297(a)). PRS, a
United States person, made an election under section 1295 with
respect to QEF applicable to the first year of its holding period in
QEF. As of December 31, 2012, for chapter 1 purposes, C's basis in
his partnership interest is $100,000, D's basis in his partnership
interest is $50,000, E's basis in his partnership interest is
$50,000, and PRS's adjusted basis in its QEF stock is $80,000, which
includes an increase in basis under section 1293(d) of $40,000. As
of December 31, 2012, the amount of QEF's earnings that have been
included in income by PRS under section 1293(a), but have not been
distributed by QEF, is $40,000. PRS also has cash of $60,000 and
domestic C corporation stock with an adjusted basis of $60,000.
During 2013, PRS does not include any amounts in income under
section 1293(a) with respect to QEF, PRS does not receive any
distributions from QEF, and there are no adjustments to the basis of
C, D, or E in their interests in PRS.
(B) During 2014, PRS has income of $40,000 under section 1293(a)
with respect to QEF and has no other partnership income. C makes an
election under paragraph (g) of this section, and D and E do not
make an election under paragraph (g) of this section.
(C) During 2015, QEF distributes $60,000 to PRS. PRS has no
income for the year.
(ii) Results for 2014. (A) For chapter 1 purposes, as a result
of the $40,000 income inclusion under section 1293(a), PRS's basis
in its QEF stock is increased by $40,000 under section 1293(d)(1) to
$120,000. Under Sec. 1.1293-1(c)(1) and section 702, C's, D's, and
E's distributive shares of the section 1293(a) income inclusion are
$20,000, $10,000, and $10,000, respectively. Under section
705(a)(1)(A), C increases his adjusted basis in his partnership
interest by $20,000 to $120,000, and D and E each increase his
adjusted basis in his partnership interest by $10,000 to $60,000.
(B) For section 1411 purposes, pursuant to paragraph (d)(1)(ii)
of this section, PRS's basis in QEF is not increased by the $40,000
income inclusion (it remains at $80,000). Because C made an election
under paragraph (g) of this section, C has net investment income of
$20,000 as a result of the income inclusion, and his adjusted basis
in his interest in PRS is increased by $20,000 to $120,000. C does
not make any adjustments to his modified adjusted gross income.
Because D and E did not make an election under paragraph (g) of this
section, D and E do not have net investment income with respect to
the income inclusion, and pursuant to paragraph (d)(2) of this
section, they do not increase their adjusted bases in their
interests in PRS (each remains at $50,000). Pursuant to paragraph
(e)(1)(ii) of this section, D and E each reduce their modified
adjusted gross income by $10,000.
(iii) Results for 2015. (A) For chapter 1 purposes, the
distribution of $60,000 from QEF to PRS is not a dividend under
section 1293(c), and PRS decreases its basis in QEF by $60,000 under
section 1293(d)(2) to $60,000.
(B) Pursuant to paragraph (c)(2)(i) of this section, $40,000 of
the distribution is a dividend for section 1411 purposes because PRS
included $40,000 in gross income for chapter 1 purposes under
section 1293(a) in a tax year that began after December 31, 2012.
For section 1411 purposes, pursuant to paragraph (d)(1)(ii) of this
section, section 1293(d) will not apply to reduce PRS's basis in QEF
to the extent of the $40,000 of the distribution that is treated as
a dividend under paragraph (c)(2)(i) of this section. Thus, PRS's
basis in QEF is decreased only by $20,000 for purposes of section
1411 and is $60,000. The $40,000 distribution of previously taxed
earnings and profits that is treated as a dividend for section 1411
purposes is allocated $20,000 to C, $10,000 to D, and $10,000 to E.
Because C made an election under paragraph (g) of this section, C
has zero net investment income as a result of the distribution of
previously taxed amounts of $20,000, his adjusted basis in his
interest in PRS remains at $120,000, and he does not make any
adjustments to his modified adjusted gross income. Because D and E
did not make an election under paragraph (g) of this section,
pursuant to paragraph (c)(2)(i) of this section, D and E each has
$10,000 of net investment income as a result of the distribution by
QEF, and
[[Page 72652]]
pursuant to paragraph (d)(2) of this section, D and E each increases
his adjusted basis in PRS by $10,000 to $60,000. Pursuant to
paragraph (e)(1)(i) of this section, D and E each increases his
modified adjusted gross income by $10,000.
Example 5. Sale of partnership interest. (i) Facts. Same facts
as Example 4. In addition, in 2016, D sells his entire interest in
PRS to F for $100,000.
(ii) Results for 2016. For chapter 1 purposes, D has a gain of
$40,000 ($100,000 minus $60,000). For section 1411 purposes, D has a
gain of $40,000 ($100,000 minus $60,000), and thus, has net
investment income of $40,000. No adjustments to modified adjusted
gross income are necessary under paragraph (e) of this section.
Example 6. Domestic partnership's sale of QEF stock. (i) Facts.
Same facts as Example 4. In addition, in 2016 PRS has income of
$60,000 under section 1293(a) with respect to QEF, and in 2017, PRS
sells its entire interest in QEF for $170,000.
(ii) Results for 2016. (A) For chapter 1 purposes, as a result
of the $60,000 income inclusion under section 1293(a), PRS's basis
in its QEF stock is increased by $60,000 under section 1293(d)(1) to
$120,000. Under Sec. 1.1293-1(c)(1) and section 702, C's, D's, and
E's distributive shares of the section 1293(a) income inclusion are
$30,000, $15,000, and $15,000 respectively. Under section
705(a)(1)(A), C increases his adjusted basis in his partnership
interest by $30,000 to $150,000, and D and E each increases his
adjusted basis in his partnership interest by $15,000 to $75,000.
(B) For section 1411 purposes, pursuant to paragraph (d)(1)(ii)
of this section, PRS's basis in QEF is not increased by the $60,000
income inclusion (it remains at $60,000). Because C made an election
under paragraph (g) of this section, C has net investment income of
$30,000 as a result of the income inclusion, and his adjusted basis
in his interest in PRS is increased by $30,000 to $150,000. C does
not make any adjustments to his modified adjusted gross income.
Because D and E did not make an election under paragraph (g) of this
section, D and E do not have net investment income with respect to
the income inclusion, and pursuant to paragraph (d)(2) of this
section, they do not increase their adjusted bases in their
interests in PRS (each remains at $60,000). Pursuant to paragraph
(e)(1)(ii) of this section, D and E each reduce their modified
adjusted gross income by $15,000.
(iii) Results for 2017. (A) For chapter 1 purposes, PRS has a
gain of $50,000 ($170,000 minus $120,000), which is allocated 50
percent ($25,000) to C, 25 percent ($12,500) to D, and 25 percent
($12,500) to E.
(B) Based on PRS's basis in the stock of QEF for section 1411
purposes, PRS has a gain for section 1411 purposes of $110,000
($170,000 minus $60,000), which in the absence of a partner election
under paragraph (g) of this section, would result in gain of $55,000
to C, $27,500 to D, and $27,500 to E. However, pursuant to paragraph
(d)(1)(ii) of this section, because C made an election under
paragraph (g) of this section, C's gain for section 1411 purposes is
the same as his gain for chapter 1 purposes ($25,000). Because
neither D nor E made an election under paragraph (g) of this
section, D and E each have a gain of $27,500 and therefore net
investment income of $27,500. Pursuant to paragraph (e)(1)(ii) of
this section, D and E each increase their modified adjusted gross
income by $15,000.
(i) Effective/applicability date. This section applies to taxable
years beginning after December 31, 2013.
Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2012-29238 Filed 11-30-12; 2:00 pm]
BILLING CODE 4830-01-P