Section 1411 — Net Investment Income Tax (Portfolio 873)

Tax Management Portfolio, 873 T.M., Section 1411 — Net Investment Income Tax, analyzes the net investment income tax (NIIT) applicable to individuals, estates, and trusts. To view this Portfolio, visit Bloomberg Tax for a free trial.

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Description

Tax Management Portfolio, 873 T.M., Section 1411 — Net Investment Income Tax, analyzes the net investment income tax (NIIT) applicable to individuals, estates, and trusts. The NIIT is imposed by §1411 of the Internal Revenue Code. The NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts. Section 1402(a)(1) of the Health Care and Education Reconciliation Act of 2010 added §1411 to a new Chapter 2A of Subtitle A (Income Taxes) of the Code effective for tax years beginning after December 31, 2012.

In the case of an individual, §1411(a)(1) imposes a tax (in addition to any other tax imposed by subtitle A, such as AMT or self-employment tax) for each tax year equal to 3.8% of the lesser of: (A) the individual's net investment income for such tax year, or (B) the excess (if any) of: (i) the individual's modified adjusted gross income for such tax year, over (ii) the threshold amount. In the case of an estate or trust, §1411(a)(2) imposes a tax for each tax year equal to 3.8% 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 §67(e)) for such tax year, over (ii) the dollar amount at which the highest tax bracket in §1(e) begins for such tax year.

This Portfolio discusses the general applicability of the NIIT. The Portfolio analyzes the computation of net investment income; the computation of NIIT liability (including special computational provisions for estates and trusts); the interaction of the NIIT with the passive activity rules and the self-employment tax system; the special rules unique to the NIIT for taxpayers with investments in controlled foreign corporations and passive foreign investment companies; special rules unique to the NIIT for dispositions of interests in partnerships and S corporations; and collateral tax issues that arise due to the interaction with the regular federal income tax system.

This Portfolio may be cited as Kirk, 873 T.M., Section 1411 — Net Investment Income Tax.

Authors

David H. Kirk

David H. Kirk CFP, CPA, Esq., B.S., Syracuse University; J.D., University of Pittsburgh; LL.M. in Taxation, Georgetown University Law Center; partner, National Tax Department, Ernst & Young LLP, Washington, DC, 2014–present; adjunct professor, Georgetown University Law Center, 2009–present; member, AICPA Journal of Accountancy Advisory Board; formerly attorney, Passthroughs and Special Industries division of Office of Chief Counsel, Internal Revenue Service, 2008–2014; principal author of the income tax regulations under Section 1411 of the Internal Revenue Code (Net Investment Income Tax) and of Revenue Procedure 2013-30 (Unified Late S Corporation Elections); associate, Arnold & Porter LLP, Washington, DC, 2007–2008; Private Client Advisor, Deloitte Tax LLP, 1998–2007.

Table of Contents

Detailed Analysis
I. Introduction
A. Statutory Overview
1. Section 1411 Generally
2. The Section 1411 Tax Base
a. Application to Individuals
b. Application to Estates and Trusts
c. Calculation of Net Investment Income
B. Legislative History
C. IRS Guidance and Regulations
1. 2013 Final Regulations
2. 2013 Proposed Regulations
3. IRS.gov Frequently Asked Questions
4. Effective Dates and Taxpayer Reliance
II. General Operating Principles
A. Chapter 1 Principles in Chapter 2A
B. Tax Credits
C. Definitions
1. Net Investment Income
2. Excluded Income
D. Trades or Businesses to Which the NIIT Applies
1. Trade or Business That Is a Passive Activity — §1411(c)(2)(A)
a. Passive Activities Under Section 469
b. Effect of Section 469 Recharacterization Rules
(1) Net Income Recharacterization Rules
(2) Substantially Appreciated Property
(3) Activity Recharacterization Rules
c. Regrouping
d. Trade or Business of Rental Real Estate
e. Farming Operations
2. Trade or Business of Trading in Financial Instruments or Commodities — §1411(c)(2)(B)
a. Definition of Financial Instruments and Commodities
b. Interaction with Passive Activities
III. “Gross” Net Investment Income — §1411(c)(1)(A)
A. Overview
B. Interest, Dividends, Annuities, Royalties and Rents — §1411(c)(1)(A)(i)
1. Income from Investment of Working Capital
2. ‘Derived in the Ordinary Course of a Trade or Business’ Exception
a. Testing for a Trade or Business
b. Derived in the Ordinary Course
c. Role of §1411(c)(3) — Treatment of Working Capital
3. Interest
a. Definition of Interest and Interest-Equivalents
(1) Common Interest Income
(2) Specific Items Treated as Interest for NIIT Purposes
(3) Items Not Treated as Interest
b. Interest Derived in the Ordinary Course of a Trade or Business
c. Self-Charged Interest
(1) Existing Passive Loss Self-Charged Interest Rules
(2) Self-Charged Interest Rules Under NIIT
d. Interest Included in Net Earnings from Self-Employment
4. Dividends
a. Definition of Dividends and Dividend-Equivalents
b. Dividends Derived in the Ordinary Course of a Trade or Business
c. Income from CFCs and PFICs
d. Dividends Included in Net Earnings from Self-Employment
5. Annuities
a. Definition of Annuities
(1) Foreign Pensions
(2) Lottery Winnings
(3) Sales of Annuities, Endowment, and Life Insurance Contracts
b. Annuities Derived in the Ordinary Course of a Trade or Business
c. Information Reporting
6. Royalties
a. Definition of Royalties
b. Royalties Derived in the Ordinary Course of a Trade or Business
(1) Royalties from Intangibles Licensing
(2) Mineral Royalties
c. Self-Charged Royalties
(1) Existing Passive Loss Self-Charged Royalty Rules
(2) Self-Charged Royalty Rules Under NIIT
d. Royalty Income Included in Net Earnings from Self-Employment
7. Rents
a. Definition of Rents
b. Rents Derived in the Ordinary Course of a Trade or Business
c. Self-Charged Rents
(1) Existing Passive Loss Self-Charged Rent Rules
(2) Self-Charged Rent Rules for NIIT Purposes
(a) Excluded Rental Income
(b) Exclusion of Gain on Disposition of Self-Rented Property
d. Rents Received by Real Estate Professionals
(1) Overview of Section 469 Treatment of Real Estate Professionals
(2) Disconnects Between Sections 469 and 1411
(3) Treatment of Real Estate Professionals Who Meet NIIT Safe Harbor
(a) Safe Harbor Requirements
(b) Consequences of Meeting Safe Harbor
(4) Treatment of Real Estate Professionals Who Do Not Meet NIIT Safe Harbor
e. Rental of Farm Land
f. Difference Between ‘Rents’ and Income from a §469 ‘Rental Activity’
C. Other Income Items Derived from §1411(c)(2) Trades or Businesses — §1411(c)(1)(A)(ii)
1. Scope of Category II
2. Income from CFCs and PFICs as Category II Income
D. Net Gain from Disposition of Property — §1411(c)(1)(A)(iii)
1. Scope of Category III Income
a. Gains and Losses Excluded from Taxable Income
b. Deferred Gain or Loss
c. Installment Sales and Private Annuities
d. Gains and Losses from Entities
e. Pre-2013 Capital Loss Carryforwards
2. Net Gain Attributable to Investment of Working Capital
3. Sale of Partnership Interest or S Corporation Stock
4. ‘Dispositions’
5. Interaction with Properly Allocable Deductions
6. Capital vs. Ordinary Gains and Losses
7. Exception for Gain or Loss Attributable to Property Held in a Non-§1411(c)(2) Trade or Business
a. Held for Use in a Non-§1411(c)(2) Trade or Business
(1) ‘Held’ vs. ‘Used’ vs. ‘Held for Use’
(2) Section 1231 Classification as a Proxy?
(3) Section 167 as a Proxy?
(4) Section 1221(a)(2) as a Proxy?
b. Treatment of Working Capital
c. Application to Certain Nonpassive Activities Arising from §469 Recharacterizations
(1) Income Recharacterizations — Under Reg. §1.469-2(f)(10)
(2) Income Recharacterizations Beyond/Apart from Reg. §1.469-2(f)(10)
(3) Activity Recharacterizations
d. Gains and Losses Taken into Account in Computing Net Earnings from Self-Employment
8. Special Treatment of Carryover Capital Losses
E. Special Rules
1. Treatment of Receipts and Payments on Notional Principal Contracts
a. Notional Principal Contracts Held in a §1411 Trade or Business
b. Notional Principal Contracts Held for Investment
c. Treatment of Income and Deductions
d. Limited Scope of NPCs
2. Treatment of Income or Loss Attributable to Residual Interests in REMICs
3. Treatment of Participants in Common Trust Funds
4. Treatment of §707(c) Guaranteed Payments
a. Subchapter K Treatment
b. Passive Loss Treatment
c. NIIT Treatment
5. Treatment of §736 Payments
a. Subchapter K Treatment
(1) Section 736(b) Payments
(2) Section 736(a) Payments
b. Passive Loss Treatment
(1) Passive Loss Treatment of §736(b) Payments
(2) Passive Loss Treatment of §736(a) Payments
c. NIIT Treatment
(1) NIIT Treatment of §736(b) Payments
(2) NIIT Treatment of §736(a) Payments
(a) NIIT Treatment of §736(a)(1) Payments
(b) NIIT Treatment of §736(a)(2) Payments
IV. Excluded Income
A. General Categories
B. Type 1 — Items Excluded from Gross Income
C. Type 2 — Items Not Included in Net Investment Income
1. Wages and Other Employee Payments
2. Unemployment Compensation and Social Security Benefits
3. Alimony
4. Alaska Permanent Fund Dividends
D. Type 3 — Items Specifically Excluded by §1411 and §1411 Regulations
1. Distributions from Qualified Plans — §1411(c)(5)
2. Section 1411(c)(6) — Earnings Subject to Self-Employment Tax
a. General Rule — Excluded Income
b. Investors in a Limited Partnership Investor Fund
c. Investors in a Trading Fund
d. Treatment of Managers
V. Properly Allocable Deductions — §1411(c)(1)(B)
A. Overview
1. Nondeductible Items
2. Properly Allocable Deductions in Excess of Gross Income
B. Properly Allocable Deductions Allowed Under Reg. §1.1411-4(f)
1. Section 62 — Above-the-Line Deductions
a. Deductions Allocable to Gross Income from Rents and Royalties
(1) Section 62(a)(4) Requirements
(2) Allocable to Rents and Royalties Included in Net Investment Income
b. Trade or Business Deductions Allocable to §1411(c)(2) Trades or Businesses
(1) Section 62(a)(1) Requirements
(2) Properly Allocable to Income from a §1411(c)(2) Trade or Business
(3) Not Taken into Account in Determining Self-Employment Income
(4) Special Rules for Traders in Financial Instruments or Commodities
c. Deductions for Early Withdrawal from Savings
d. Net Operating Losses
2. Section 63 — Itemized Deductions
a. Investment Interest Expense
(1) General Rule
(2) Optional Investment Interest Expense Calculation for CFC/PFIC Related Items
b. Investment Expenses
c. Section 164(a)(3) — State, Local, and Foreign Taxes
d. Section 72(b)(3) — Annuity Basis
e. Section 691(c) — Deductions for Estate Taxes
f. Section 212(3) and Reg. §1.212-1(l) — Tax Expenses
g. Amortizable Bond Premium
h. Fiduciary Expenses
3. Section 165 — Loss Deductions
4. Ordinary Loss Deductions on Contingent Payment Debt Instruments and Inflation-Indexed Debt Instruments
C. Allocation Between Net Investment Income and Excluded Income
1. Reasonable Methods Specifically Listed in the Regulations
2. Other Possible Reasonable Allocation Methods
a. Specific Identification
b. Specific Identification with Residual Apportionment
c. Simple Apportionment Using Different Bases
d. Accrual Method
3. Unreasonable Allocation Methods
a. Allocations of Deductions Pertaining to Pre-2013 Tax Years
b. Unreasonable Reliance on Regulations
c. Unreasonable Toggling Between Methods
d. Estates and Trusts
D. Application of §67 and §68 Limitations
1. Step 1 — Application of the §67 Limitation
2. Step 2 — Application of the §68 Limitation
3. Planning and Compliance
a. Application of Form 8960 to Regulation Example
b. Example — Allocations Within Deduction Classes
c. Example — Benefits of Stacking
E. Unique Deductions for Decedents, Estates, and Trusts
1. Section 691(b) — Deductions in Respect of a Decedent
2. Section 691(c) — Deductions for Estate Taxes
3. Section 642(h) — Excess Deductions upon Termination
a. Treatment of Capital Losses
b. Treatment of Net Operating Losses
c. Treatment of Excess Properly Allocable Deductions
F. Suspended Deductions
1. Treatment of Suspended Losses Other Than Passive Losses
a. Treatment of Losses Suspended Due to Tax Basis Limitation
b. Treatment of Losses Suspended Under the At-Risk Rules
c. Other Types of Suspended Losses
2. Treatment of Suspended Passive Losses
a. In General
b. General Treatment of Suspended Passive Losses for NIIT Purposes
(1) Year of Suspension
(2) Year of Allowance
(3) Examples
c. Special Rules for Losses Attributable to Former Passive Activities (FPAs)
d. Section 469(g) — Deductions on Final Disposition
G. Recoveries of Prior Year Deductions
1. General Rule on Recoveries
2. Overall Limitation on Amount of Recovery
3. Exceptions to Recovery Inclusions
a. No §1411 Tax Benefit
b. Amounts Already Included in §1411(c)(1)(A)
4. Recovery of Reasonably Allocated Deductions
H. Net Operating Losses
1. Step One — Calculation of Applicable Portion of NOL for Each Loss Year
2. Step Two — Calculation of Total §1411 NOL
a. The §1411 NOL for Each Loss Year
b. The Total §1411 NOL
c. Example
VI. Dispositions of Interests in Partnerships and S Corporations
A. Introduction
B. 2013 Proposed Regulations
1. Interests Subject to §1411(c)(4)
a. Definition of Passthrough Entity
b. Definition of Subsidiary Passthrough Entity
c. Definition of ‘§1411(c)(4) Disposition’
(1) Passive and Nonpassive Activities
(2) Dispositions
d. Definition of ‘Section 1411 Property’
2. Calculation of Gain or Loss Taken into Account in Computing Net Investment Income
a. Primary Method
(1) Transferor's Allocable Share of Net Gain or Loss
(2) Timing of Calculation
(3) Treatment of Losses Suspended by §704(d) and §1366(d)
(4) Examples
b. Optional Simplified Method
(1) Section 1411 Holding Period
(2) Dispositions Eligible for the Optional Simplified Method
(3) Dispositions Not Eligible for the Optional Simplified Method
(4) Calculation of §1411(c)(4) Adjustment Under the Optional Simplified Method
(5) Examples of the Optional Simplified Method
3. Information Reporting
a. Information Reporting by the Passthrough Entity to the Transferor
b. Information Reporting by the Transferor
4. Special Operating Rules
a. Certain Liquidations
b. Coordinating Rules for S Corporations
(1) Sales That Terminate the Passthrough Entity's S Corporation Election
(2) Treatment of Hypothetical §1374 Built-In Gain Taxes
(3) Treatment of §1411 Dispositions by Qualified Subchapter S trusts (QSSTs)
c. Sales Involving Installment Sales and Private Annuities
(1) General Rule
(2) Treatment of Contingent Payment Installment Sales and Private Annuities Based on Life Expectancy
5. Tiered Passthrough Dispositions
a. Computational Issues
b. Reporting in Tiered Structures
C. 2012 Proposed Regulations
1. Deemed Sale Approach
2. Taxpayer Reliance on 2012 Proposed Regulations — 2013 Tax Year
VII. Income from Controlled Foreign Corporations and Passive Foreign Investment Companies
Introductory Material
A. Overview of Regular Income Taxation of Controlled Foreign Corporations and Passive Foreign Investment Companies
1. Controlled Foreign Corporations (CFCs)
2. Passive Foreign Investment Companies (PFICs)
a. Section 1291 Funds
b. QEFs
c. Mark-to-Market Funds
B. Application of NIIT to §1296 Mark-to-Market Funds
C. Application of NIIT to §1291 Funds
1. Net Investment Income Inclusion
2. Required Adjustment to MAGI
3. Compliance Considerations for §1291 Funds
D. Application of NIIT to CFCs and QEFs Without a Reg. §1.1411-10(g) Election
1. Overview and Reasoning for Rules
2. Timing of Net Investment Income Inclusion
a. Imputed Items Included in Gross Income but Excluded from Investment Income
b. Items Excluded from Gross Income but Included in Investment Income
c. Resulting Basis Adjustments and Differences in Gains and Losses
3. Required Adjustment to MAGI
a. Situations That Require a Decrease to MAGI
b. Situations That Require an Increase to MAGI
c. Situations That May Result in an Increase or Decrease in MAGI
4. Example
E. The 10(g) Election
1. Consequences of Election
2. Election Requirements
3. Elections by Individuals, Estates and Trusts
a. Timing of Election
b. Tax Compliance
c. Special Rules for Charitable Remainder Trusts
4. Elections by Domestic Partnerships, S Corporations, or Common Trust Funds
a. Timing of Election
b. Tax Compliance
c. Special Rules Applicable to 2013 Taxable Year
5. Protective ‘Blanket 10(g) Elections’
6. Intentionally Not Making the 10(g) Election
F. Special Consideration for Estates and Trusts
VIII. Application to Individuals
Introductory Material
A. Modified Adjusted Gross Income
B. Threshold Amounts
C. Special Rules Applicable to Individuals
1. Application to Nonresident Aliens
a. Nonresidents Aliens Married to U.S. Residents or Citizens
(1) Section 6013(h) Election
(2) Section 6013(g) Election
b. Part-Year Nonresident Aliens
2. Application of Bona Fide Residents of Territories and Possessions
a. Mirror Code Jurisdictions
b. Non-Mirror Code Jurisdictions
3. Interaction Between Section 1411 and the ‘Kiddie Tax’
IX. Application to Estates and Trusts
Introductory Material
A. Excluded Trusts and Estates
B. Nongrantor Trusts and Estates
1. Overview
2. Undistributed Net Investment Income
a. Income Distribution Deduction
(1) Deduction to the Estate or Trust
(2) Net Investment Income to the Beneficiary
b. Section 642(c) Deductions
3. Compliance Considerations
a. Estate and Trust
b. Beneficiary
4. Importance of Material Participation of Estates and Trusts in the NIIT Regime
5. Estates and Trusts that Own Interests in Certain CFCs or Certain PFICs
a. Reg. §1.1411-10(f): Aligning NIIT Timing with Subchapter J
b. Examples of the Application of Reg. §1.1411-10(f)
6. Special Nongrantor Trusts and Estates
a. Qualified Funeral Trusts (QFTs)
b. Bankruptcy Estates
c. Foreign Trusts and Estates
C. Special Rules for Electing Small Business Trusts
1. Calculation of Undistributed Net Investment Income
2. Calculation of Adjusted Gross Income
3. Section 469 Regrouping
D. Special Rules for Charitable Remainder Trusts
1. Overview — Final 2013 Regulations
2. 2012 Proposed Regulations
3. Operational Rules for CRTs
a. NIIT Definitions
b. Section 469 Regrouping
4. Interaction with Section 664 Category and Class System
a. Additional Rate
b. Special Rules for CRTs with Income from Certain CFCs and Certain PFICs
(1) Rule One: Regular Tax, but No Net Investment Income
(2) Rule Two: Net Investment Income, but No Regular Tax
(3) Rule Three: Treatment of Gains and Losses Attributable to Basis Differences
5. Optional Simplified Method
6. Comparison Between Section 664 Method and Simplified Method
a. Pure Netting
b. Differences in Distribution Ordering Rules and Loss Netting Rules
(1) Ordering of Distributions from Ordinary Income
(2) Ordering of Distributions from Capital Gains
(3) Capital Gain and Loss Netting Rules
(4) Application of the Loss Carryover Rules
c. Decision Factors for Simplified Method
(1) New CRTs — Current and Future Income Likely to Be Net Investment Income
(2) CRTs with Unrealized Losses
(3) CRTs with Direct or Indirect Ownership in CFCs/PFICs
(4) NIMCRUTs Nearing End of Stated Term
(5) CRTs with No Undistributed Income
(6) CRTs with Non-Net Investment Income Deductible Expenses and No Excluded Income
7. Compliance Considerations
X. Application of §1411 Outside of Chapter 2A
A. Tax Penalties, Interest and Estimated Taxes
1. Interest and Estimated Taxes
a. Estimated Taxes
b. Interest on Underpayments
c. Interest on Overpayments
2. Penalties
a. Section 6662 Accuracy-Related Penalty
b. Tax Return Preparer Penalty Under Section 6694
B. Deferred Interest Charge Regimes
1. Interest Charge — Domestic International Sales Corporations (IC-DISCs)
2. Nondealer Installment Sales Under Section 453A
3. Section 1291 Funds
4. Accumulation Distributions from Foreign Trusts
5. Look-Back Rules — Sections 460(b) and 167(g)
a. Section 460(b) — Long-Term Contracts
(1) Inclusion of NIIT in Section 460(b) Look-Back Calculation
(a) Traditional Method
(b) Simplified Marginal Impact Method
(2) Interest Received and Interest Paid
b. Section 167(g) Income Forecast Method of Depreciation
(1) Inclusion of NIIT in Section 167(g)(2) Look-Back Calculation
(2) Interest Received and Interest Paid
C. Application of Income Tax Treaties and Totalization Agreements
1. Application of Income Tax Treaties
a. Overview of Income Tax Treaties and Tax Return Disclosures
b. Treatment of Foreign Tax Credit
(1) Preamble Statement Regarding U.S. Model Treaty
(2) Specific Model Treaty Language and Technical Explanation
(a) Covered Tax
(b) Article 23
(c) Article 24
(3) Sample Analysis of Income Tax Treaty Without Model Language
(4) Reporting the Treaty Position
c. Residency Treaty Tiebreakers
(1) General Rule — Nonresidents
(2) General Residency Tiebreaker in Income Tax Treaties
d. Income Exclusions
2. Totalization Agreements
a. Overview
b. Medicare Tax?
(1) Revenue Not Included in Medicare Trust Fund
(2) Analysis of Reading Title of Chapter 2A into Statute

Working Papers

Table of Worksheets
Worksheet 1 Table of Federal Tax Credits Creditable Against NIIT
Worksheet 2 Comparison of Self-Charged Rents, Self-Charged Interest, and Self-Charged Royalties
Worksheet 3 Section 469/Section 1411 Interaction Charts
Worksheet 4 Estate and Trust Distribution Reconciliation
Worksheet 5 Prop. Reg. §1.1411-7(g)(1) Entity Statement (Single Trade or Business — No Section 1411 Property)
Worksheet 6 Sample Line 5c Statement for Tiered Entities
Worksheet 7 Partnership Information Reporting for Installment Sales of LTP Interests
Worksheet 8 10(g) Election — 2013 Taxable Year
Worksheet 9 10(g) Election — Post-2013 Taxable Year