Posts Tagged ‘Section 1411’

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

Friday, December 6th, 2013 by Joe Kristan

The 3.8% Section 1411 Obamacare net investment income tax is absurdly complicated and poorly-designed to start with.  When the Treasury drafted their first set of proposed regulations, they seemed determined to make it even worse.  Taxpayer response was harsh, and the final rules put in place last week fix some of the worst problems in the original rules.

This tax applies to taxpayers with “modified” adjusted gross incomes over threshold levels of $250,000 for joint filers, $125,000 for married taxpayers filing separately, and $200,000 for other individuals.  It also applies to all top-bracket trusts.  It applies to “net investment income” to the lesser of Net Investment Income or the amount modified AGI exceeds the threshold.  It applies to all trust AGI over the top trust tax bracket amount.

Net Investment Income includes interest, dividend, capital gains, passive K-1 and other business income, royalties, non-qualified annuities, and rents.  It excludes non-passive K-1 income, wages, self-employment income, capital gains on the sale of a partnership or S corporation where the seller is non-passive, and “trade or business” rents for non-passive taxpayers.  A few highlights of the changes in the final regulations:

Self-rental.  The proposed regulations said that taxpayers who rent property to their non-passive trade or business have net investment income from the rents.  The final regulations say self-rental income from property rented to non-passive activities is not subject to the tax.

This is very helpful.  Under the old regulations, there would have been a big incentive for businesses that rent property from their owners to restructure so that they own the rental property.  This is no longer necessary.

Material Participation Rental.  The proposed regulations would have imposed the net investment tax on most rental activity income even where the taxpayer is “non-passive” on the rental.  They required taxpayers to demonstrate that their rental activity rose to the level of a “trade or business,” a vague standard, to avoid the tax.  The new regulations add a safe-harbor where taxpayers who work at least 500 hours in a rental activity are deemed to rise to the level of having a “trade or business.”

Sales of a business.  The proposed regulations required taxpayers selling even a small interest in a partnership or S corporation to identify the inherent gain or loss in each asset owned by the partnership or corporation to determine how much of the gain or loss on the sale was passive, and therefore subject to the tax.

They withdrew that proposal and issued a new proposed regulation that includes a safe-harbor that uses historic K-1 information to compute the portion of a gain of an S corporation or partnership interest to compute the “net investment income” portion.  Absent such a provision, compliance would have been impossible in many or most cases involving a sale of a minority interest.  They should add a de-minimus standard to avoid the computation altogether when non-passive amounts are a trivial portion of the K-1 income.

The tax should still be repealed.  It imposes a whole new fiendishly complex tax on a narrow subset of income.   It violates any standards of good tax policy.  But we have to live with it until Congress and the President come to their senses, and there is no sign of that happening.

Other coverage:

Tony Nitti:

The Definitive Questions And Answers On The New Net Investment Income Tax [Updated For Final Regulations]  

Final Net Investment Income Regulations: Self-Charged Interest, Net Operating Losses, And More

Final Net Investment Income Regulations: Losses From The Sale Of Property Become Much More Valuable 

Final Net Investment Income Regulations: IRS Grants Relief To Real Estate Professionals

 

Paul Neiffer:

Losses Can Offset Investment Income

More Good News on Calculating Invesment Gain

Final Net Investment Income Regs Have Good News For Farmers

(more…)

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Tax Roundup, 12/4/2013: Justice Scalia doesn’t believe in the Tax Fairy. And sure, the IRS can run another tax credit!

Wednesday, December 4th, 2013 by Joe Kristan

 

tax fairyThe Supreme Court wrapped a bow around the IRS victories in the turn-of-the-century tax shelter wars by unanimously ruling that the 40% “gross valuation misstatement” penalty applied to a tax understatement caused by the “COBRA” tax shelter.

COBRA relied on contributing long and short currency options to a partnership, but claiming basis for the long position, and ignoring the liability caused by the short position.  The shelter was cooked up in Paul Daugerdas’ tax shelter lab at now-defunct Jenkens & Gilchrist and marketed by Ernst & Young.  The shelter was designed to generate $43.7 million in tax losses for a cash investment of $3.2 million.

COBRA, like so many other shelters of the era,  was ruled a sham and the losses disallowed, but the Fifth Circuit Court of Appeals ruled that the 40% penalty did not apply.  Other circuits ruled that it did, so the Supreme Court took the case to settle the issue.

Writing for a unanimous court, Justice Scalia disposed of the Fifth Circuit’s position (citations omitted, my emphasis):

     In the alternative, Woods argues that any underpayment of tax in this case would be “attributable,” not to the misstatements of outside basis, but rather to the determination that the partnerships were shams — which he describes as an “independent legal ground.”  That is the rationale that the Fifth and Ninth Circuits have adopted for refusing to apply the valuation-misstatement penalty in cases like this, although both courts have voiced doubts about it.

We reject the argument’s premise: The economic substance determination and the basis misstatement are not “independent” of one another. This is not a case where a valuation misstatement is a mere side effect of a sham transaction. Rather, the overstatement of outside basis was the linchpin of the COBRA tax shelter and the mechanism by which Woods and McCombs sought to reduce their taxable income. As Judge Prado observed, in this type of tax shelter, “the basis misstatement and the transaction’s lack of economic substance are inextricably inter twined,” so “attributing the tax underpayment only to the artificiality of the transaction and not to the basis over valuation is making a false distinction.”  In short, the partners underpaid their taxes because they overstated their outside basis, and they overstated their outside basis because the partnerships were shams. We therefore have no difficulty concluding that any underpayment resulting from the COBRA tax shelter is attributable to the partners’ misrepresentation of outside basis (a valuation misstatement). 

tack shelterI see the basis-shifting shelters of the 1990s as elaborate incantations designed to to get the Tax Fairy to magically wish away tax liabilities.  Like any good witch doctor, the shelter designers relied on lots of elaborate hand-waving and dark magic to do their work, and they collected a lot of cash for their work.  But there is no Tax Fairy.  Justice Scalia has let Tax Fairy believers know that pursuing her is not just futile, but potentially very expensive.

 

Cite: United States v. Woods, Sup. Ct. No. 12-562.

The TaxProf has a roundup and an update.  Stephen Olsen weighs in at Procedurally Taxing.

 

 

Blue Book Blues.   One digression by Justice Scalia in Woods is worth a little extra attention.   From the opinion (citations omitted, my emphasis):

Woods contends, however, that a document known as the “Blue Book” compels a different result…Blue Books are prepared by the staff of the Joint Committee on Taxation as commentaries on recently passed tax laws. They are “written after passage of the legislation and therefore d[o] not inform the decisions of the members of Congress who vot[e] in favor of the [law].” While we have relied on similar documents in the past, …our more recent precedents disapprove of that practice. Of course the Blue Book, like a law review article, may be relevant to the extent it is persuasive.

Back in the early national firm days of my career, one of my bosses was a former national firm lobbyist who was exiled to The Field when a merger with another firm left room in Washington for only one lobbyist in the combined firm.  I remember him telling clients that he could get around unpleasantness in the tax code by arranging for helpful language in the Blue Book.  From what Justice Scalia says, he would have done as well by writing a law review article.

Jack Townsend also noticed this.

 

A new tax credit for the IRS to administer.  What could possibly go wrong?  A lot, as the IRS’s experience with the fraud-ridden refundable credits and ID-theft fraud has shown.  Now a new Treasury Inspector General’s report warns that IRS systems aren’t yet prepared to stop premium tax credit fraud under Obamacare, reports Tax Analysts ($link):

EITC error chart     While the IRS has existing practices to address ACA-related fraud, the agency’s approach is not part of an established fraud mitigation strategy for ACA systems, the report says. The IRS has two systems under development to lessen ACA tax refund fraud risk, but until those systems are completed and tested, “TIGTA remains concerned that the IRS’s existing fraud detection system may not be capable of identifying ACA refund fraud or schemes prior to the issuance of tax return refunds,” it says.

IRS Chief Technology Officer Terence Milholland said in a response included in the report that fraud prevention plans will be put in place as ACA systems are released.

The IRS loses $10 billion annually to Earned Income Tax Credit Fraud alone.  This isn’t reassuring.

 

Paul Neiffer, Losses Can Offset Investment Income:

  1. If you have a net capital loss for the year, the regular tax laws limit this loss to $3,000.  The final regulations allow this up to $3,000 loss to offset other investment income.
  2. If you have a passive loss such as Section 1231 losses, as long as that loss is allowed for regular income tax purposes, you will be allowed to offset that against other investment income.
  3. Finally, if you have a net operating loss carry forward that contains some amount of net investment losses, you will be allowed to use that portion of the NOL to offset other investment income.

A big improvement over the propsed regulations.

 

20120920-3Jason Dinesen,  Same-Sex Marriage, IRAs and After-Tax Basis:

It’s clear that for 2013 and going forward, couples in same-sex marriage will only need to apply “married person” rules to IRAs (and to everything else relating to their taxes).

What’s less clear is what happens with differences between federal and state basis for prior years.

 

Robert D. Flach,  A YEAR END TIP FOR MUTUAL FUND INVESTMENTS.  ”If you want to purchase shares in a mutual fund during the fourth quarter of the year, wait until after the capital gain dividend has been issued, and the NAV has dropped, before purchasing the shares.”

 

Janet Novack,  Insurance Agent To Forbes 400 Concedes Understating Taxable Income By $50 Million

David Brunori, Indexing the State Income Tax Brackets Makes Sense (Tax Analysts Blog)

Missouri Rep Paul Curtman (R) wants to index his state’s income tax brackets to inflation. Of all the tax ideas presented this year, this is among the best. Missouri imposes its top rate of 6 percent on all incomes over $9,000. Nine grand was a lot of money in 1931 – and the top tax rate was aimed at the very wealthiest Missourians. But that threshold hasn’t changed since Herbert Hoover was president. 

Or they could just go with one flat rate.

 

TaxProf, The IRS Scandal, Day 209

William McBride, Summary of Baucus Discussion Draft to Reform International Business Taxation (Tax Policy Blog)

Kay Bell, Where do your residential property taxes rank nationally? 

Howard Gleckman,  The Supreme Court Opens The Door to Sales Tax Collections by Online Sellers (TaxVox)

They were too busy fighting the shelter wars to notice.  The Cold War Is Over, but No One Told the IRS  (Joseph Thorndike, Tax Analysts Blog)

Career Corner: A Friendly Reminder to Slobbering Drunks: Be Less Slobbery and Drunk at Your Company Holiday Party (Going Concern)

 

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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

 

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