Posts Tagged ‘Net Investment Income’

Tax Court decision cuts 3.8% Obamacare Net Investment Income Tax for many trusts.

Friday, March 28th, 2014 by Joe Kristan

20120511-2The Tax Court reduced 2013 income taxes for a lot of trusts yesterday.  The court ruled that trustees can “materially participate” in rental real estate activities, and by extension in other activities.  If a taxpayer “materially participates” in an activity, it is not subject to the Obamacare 3.8% “Net investment Income Tax” on that activity’s income.

This is a big deal for trusts because they are subject to this tax at a very low income level — starting at $11,950 in 2013.  The IRS has said that it considers it nearly impossible for trusts to materially participate.  Yesterday’s decision flatly rejects the IRS approach.

The IRS had stated its position in a ruling involving an “Electing Small Business Trust,” which is a type of trust that can hold interests in S corporations — and which tend to get hit hard by the NII tax.  The IRS said that a president of the corporation who was also a trustee of the ESBT was participating in the business not “as trustee,” but as a corporation employee — and therefore the trust didn’t materially participate.  The Tax Court disagreed with IRS thinking yesterday:

The IRS argues that because Paul V. Aragona and Frank S. Aragona had minority ownership interests in all of the entities through which the trust operated real-estate holding and real-estate development projects and because they had minority interests in some of the entities through which the trust operated its rental real-estate business, some of these two trustees’ efforts in managing the jointly held entities are attributable to their personal portions of the businesses, not the trust’s portion. Despite two of the trustees’ holding ownership interests, we are convinced that the trust materially participated in the trust’s real-estate operations. First, Frank S. and Paul V. Aragona’s combined ownership interest in each entity was not a majority interest — for no entity did their combined ownership interest exceed 50%. Second, Frank S. and Paul V. Aragona’s combined ownership interest in each entity was never greater than the trust’s ownership interest. Third, Frank S. and Paul V. Aragona’s interests as owners were generally compatible with the trust’s goals — they and the trust wanted the jointly held enterprises to succeed. Fourth, Frank S. and Paul V. Aragona were involved in managing the day-to-day operations of the trust’s various real-estate businesses.

That would seem to put to rest the IRS “as trustees” catch-22.

The Tax Court decision doesn’t make the NII go away for all trusts.  Trusts with only “investment” income, like interest and dividends, are not helped by this decision.  Also, the decision by its terms only covers situations in which the trustee is materially participating in the trust activity; “We need not and do not decide whether the activities of the trust’s non-trustee employees should be disregarded.”  In this respect the Tax Court doesn’t go as far as a Texas U.S. District Court did it the Mattie Carter Trust case, which counted participation of trust employees in determining whether the trust materially participated in an activity.

Still, even with limitations, the case is a big taxpayer win.  It will especially help ESBTs avoid tax on operating income from S corporations when a trustee is also a corporation employee.  Also, while the case doesn’t say that non-trustee employees can give trusts material participation, it doesn’t rule it out, either.  That means bold trusts with employees that manage trust operations may be able to avoid the 3.8% tax, should the Tax Court adopt the Mattie Carter Trust approach.  Future litigation will have to settle the issue.  The IRS is also likely to appeal this case.

An aside: The IRS asserted its usual outrageously-routine 20% “accuracy-related” penalty — and it lost on its underlying argument.  In a just tax system, the IRS would have to write a check to the taxpayer for the amount of the asserted penalties whenever this happens.   The IRS assertion of penalties is far too routine, and should be reserved for cases in which the taxpayer is actually taking a flaky position, or doesn’t bother to substantiate deductions.  When it asserts a penalty and the taxpayer actually wins on the merits, the IRS loses nothing under current law.  Tax Analysts hosted a seminar yesterday on a Taxpayer Bill of Rights.  Any bill worthy of the name would have a “sauce for the gander” rule that would make the IRS — and even IRS employees — as liable as taxpayers are for flaky positions.

Cite:  Frank Aragona Trust et al. v. Commissioner; 142 T.C. No. 9

Related: Self-rental, business sales benefit from new Net Investment Income Tax regulations.

Also: Paul Neiffer, Taxpayer Victory in Frank Aragona Trust Case, on the implications for farm interests held in trust.

A summary of “material participation” rules is below the fold.



Tax Roundup, 1/8/2014: Instructions for the Net Investment Income Tax! And new foreign account reporting rules.

Wednesday, January 8th, 2014 by Joe Kristan

20140108-1Almost four years after the passage of the Patient Protection and Affordable Care Act, the IRS has issued draft instructions for the act’s “Net Investment Income Tax” form, Form 8960 — which itself has only been issued as a draft so far.  With work already underway on many returns subject to this tax, especially trust returns, the timing is lame.  But this is one aspect of Obamacare that isn’t going to get punted, so we will have to go to war with the forms we have.

The draft instructions provide worksheets for some of the more baroque computations that will be needed to complete the form, including the net loss computation and the allocation of itemized deductions to net investment income.  Still, much of the work will have to be done off-the-forms on preparer worksheets applying the regulations.  Tony Nitti says:

That is my big takeaway from the instructions – there’s no faking it. When we saw that this new, complex area of the law would ultimately be computed on a one-page form, we anticipated that the meat of the computation would be done off-form in worksheets provided by the instructions. And that’s exactly what happened. But that shifts the onus back to us as tax advisors to make sure our inputs are correct, which means we must understand the nuances of the final regulations.

Based on my review of the instructions, it will be virtually impossible for a tax advisor to accurately compute, for example, the Net Gains and Losses worksheet without a solid understanding of the types of gains and losses the final regulations contemplate being included in and excluded from net investment income.

As with the rest of the ACA, what could possibly go wrong?


Russ Fox, FBAR Changes for 2014

First, Form TD F 90-22.1 is no more. The FBAR has a new form number, Form 114.

Second, as of last July the FBAR must be electronically filed. The good news is that as of last October, your tax accountant can file the form for you as long as you complete Form 114a.

Also, notes Russ, the filing requirement now kicks in when the balance of all foreign accounts together exceeds $10,000.  It used to be account-by-account.


William Perez offers Resources for Preparing Form 1099-MISC for Small Businesses

Kay Bell says it’s Time to get organized for your 2014 tax filing tasks

Paul Neiffer advises us to Decant a Trust – Not Wine.


David Brunori on the unwisdom of subjecting business inputs to sales tax:

Indeed, virtually every state tax commission that has studied this issue has concluded that business inputs should be exempt from tax. Why? When you tax business purchases, the tax becomes part of the cost of doing business, and companies try very hard to pass those costs on to consumers. Two bad things then happen. First, consumers unwittingly pay the tax in the form of higher prices. It is a hidden tax and a most cynical way of financing government. Second, consumers often pay sales tax on the tax embedded in the retail price of the goods they purchase. So we are actually taxing a tax. This “cascading” amounts to awful tax policy.

But, as David points out, that doesn’t stop the demagogues:

Several years ago, I had the opportunity to talk to a group of legislators about sales tax policy. I was asked if I had any ideas for reform. I mentioned the common ideas of broadening the base by taxing services and remote sales, and lowering rates. I also said that states should exempt business purchases from the sales tax. One legislator looked at me like I had three heads and asked, “Do you mean letting corporations off the hook for sales taxes?” He asked where the justice was in a system that would make poor working families pay sales tax but let multinational companies go free.

Not all that different from the Iowa Senate’s approach to income taxes.


Andrew Lundeen, The Top 1 Percent Pays More in Taxes than the Bottom 90 Percent (Tax Policy Blog):

An interesting piece of information from the chart below is that after the 01/03 Bush tax cuts, often claimed to be a tax cut for the rich, the tax burden of the top 1 percent actually increased significantly.

Top 1 pays more than bottom 90

No matter how much you jack up taxes on the “top 1%,” the same people always will say “the rich” aren’t paying “their fair share” and need to indulge in some “shared sacrifice.”


Howard Gleckman, Taxing Bitcoin (TaxVox)

What if bitcoin is a currency for tax purposes, the same as, say a euro? In that case, profits from sales would be taxed as ordinary income, with a top rate of 39.6 percent, though all losses could offset other income.

Either way, the mere act of buying something [with Bitcoins] would likely be a taxable event.

Tax Justice Blog, GE Just Lost a Tax Break – and Congress Will Probably Fix That.  That’s what fixers do.

Jack Townsend, Prosecuting the Banks: Does the U.S. Prefer Foreign Banks to U.S. Banks?


TaxProf, The IRS Scandal, Day 244

Programming note: I will be doing a tax update program sponsored by the Institute for Management Accountants over the Iowa Cable Network tomorrow evening at 6:00 p.m.  It’s a chance to get your continuing education for 2014 off to a roaring start.  I figure on talking about an hour, with an emphasis on the new Net Investment Income regulations and other 2013 changes we will see this filing season.  I’ll also cover some of the more interesting cases and rulings of the last year.

In case you were wondering, our friends at Going Concern explain How To Tell if Your Accounting Firm is Really a Car Wash


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

Friday, 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