Making it hard for nothing: The Net Investment Income Proposed Regulations

December 7th, 2012 by Joe Kristan

The IRS issued proposed regulations on the Obamacare Net Investment Income tax last Friday.  The tax imposes a 3.8% tax on “net investment income” when a taxpayers adjusted gross income exceeds $200,000 for single filers and $250,000 for joint filers.  New Sec. 1411, taking effect for 2013, uses a new definition of “investment income” not found anywhere else.

The whole idea of only taxing a certain part of the income of “the rich” in a novel way is stupid to begin with, and you can’t blame the regulations for that.  Still, the regulations could avoid picayune complexity in implementing a stupid law.  Alas…

First, some good news from the regs.  The new law considers “passive activity” income from K-1 businesses to be “investment” income.  The passive loss rules were never designed to punish people with passive income until now, and the way taxpayers “grouped” their income activities often never mattered.  Now it does.  Activity “groupings” matter because if you can group different operations into one “activity,” you can combine your participation in determining whether you “materially participate” in the activity (e.g., 500 hours).  Normally you can’t change your activity “groupings,” but the proposed regulations give everybody a free one-time opportunity to change their groupings.

The proposals also makes it easy for taxpayers to allocate state income taxes on investment income to the income items for determining “net” investment income — you can simply allocate allowable deductions for state taxes in proportion of investment income to gross income.

But there is still lots to dislike. Some quick hits:

Self-rental.  The passive loss rules say that net income from “self-rental” to active businesses that they own is non-passive.  This is to prevent taxpayers from artificially generating “passive” income to use “passive” losses.  The new law makes “rental” income a form of investment income.  The proposed regulations say that such “self-rental” income must be treated as rental income, rather than as part of the non-passive activity that is paying the rent.  If the rented items were directly owned by the non-passive activity, they wouldn’t generate “bad” income.  This rule whimsically punishes taxpayers for the way they happen to hold their real estate.

Material Participation Rental.  The passive loss rules originally made rental activities automatically passive. Taxpayers who meet a demanding 750-hour and more-time-than-anything-else standard in real estate operations can test for whether their real estate rental is “passive” using the same “material participation” standards that apply to other activities.

The proposed regulations weasel around whether the non-passive income of such real estate pros is investment income.  They say that such income has to also be “trade or business” income to avoid the 3.8% tax.  Why make it so hard and so vague?  If you materially participate, it should be exempt from the tax, period.

Sales of businesses.  Section 1411 exempts capital gain from the sale of a non-passive business from the 3.8% tax.  The proposed regulations add enormous complexity to computing the gain from a sale of S corporation stock to qualify.  You have to go through an elaborate four-step computation valuing and determining a hypothetical gain for each corporate asset, even if you sell stock.  You then have to comply with an eight-step disclosure regime — all for a stupid 3.8%.

By applying reasonable de-minimus rules to non-business assets, they could eliminate all of that.  They should just  say that if say, 80% or more of the assets of the business are trade or business assets, all of the gain to non-passive owners is also non-passive.  Simple anti-stuffing rules could address pre-sale asset contributions. Even simpler rules should apply to pre-2013 installment sales taxed in 2013 and later — if the taxpayer was non-passive at the time of the stock sale, the gain should all be non passive.

Keep it as simple as possible.  It’s hard to write smart regulations for a stupid law, but you can at least not make it worse.  A perfect example is the way the proposed regulations say can’t apply the $3,000 net capital loss allowed for computing personal taxes against your net investment income.  That makes no sense, it adds complexity, and it artificially inflates the tax base.

Yes, the Sec. 1411 tax is stupid and should be repealed.  But that screw isn’t coming unscrewed anytime soon.  Still, there’s no reason to make a bad law worse through regulations.

More reading:

Anthony Nitti, The Elf On A Shelf Will Haunt Your Kid’s Dreams, And More Thoughts On The Obamacare Investment Tax and Ten Things We Learned From The New Obamacare Investment Tax Regulations

Paul Neiffer, IRS Issues Proposed Regs on 3.8% Medicare Surtax, IRS Wants All Rents Subject to new 3.8% Medicare Tax and How to Calculate The New 3.8% Medicare Surtax

 

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