In December 2012 the IRS issued a set of proposed regulations that will govern how the new net investment income tax is implemented. The American Institute of CPAs covered these new regulations and the possible effects on tax liability in a recent article. In our last post, we explored what constitutes net investment income and who is affected. In today’s post, we’ll look at some special circumstances that affect how net investment income is calculated.

Selling a Property

The entire proceeds from the sale of a property are not subject to this new tax. Only the taxable portion of any gain made when selling a property is possibly subject to the new net investment income. Gain made under the principal residence provisions under Section 121 does not need to be reported as net investment income. If all requirements are met, gain up to $250,000 for those filing separately and $500,000 for those filing jointly is generally exempt from the net investment income tax. As such, a large majority of those selling a personal residence will not experience a tax liability under this new tax. However, gain derived from depreciation adjustments and the sale of second homes must be factored into net investment income tax calculations.

Passive Activities

Now that passive income has been included into net investment income calculations, properly identifying income as coming from passive or nonpassive activities is important. The new net investment income tax may make it necessary to revise income activity groupings from previous tax years. As such, the IRS is allowing individual, estate, or trust tax payers a single opportunity for a “fresh start” for regroupings during the tax year that begins after December 31st, 2013.

S Corporations and Partnerships

The sale of an interest in a passthrough entity like an S corporation or a partnership that resulted in gain would appear to qualify as net investment income under a Category III classification, provided that the interest was not a passive activity on the part of the taxpayer. However, Sec. 1411(c)(4) states that the amount of money made or lost on the sale of an interest in an S corporation or partnership is limited to the amount of gain or loss that would occur using the deemed-sale method of calculation. The deemed-sale method calculates based on the assumption that the entity sold all its assets at fair market value for cash right before the taxpayer sold their interest in the partnership or S corporation.  Net investment income calculations would not need to include gains from the sale of assets used in a nonpassive qualified trade or business. Based on proposed regulations, all assets, including goodwill, must be valued separately and a decision made whether the asset is used in a qualified trade or business. The proposed regulations provide instructions for allocating adjusted basis among the gains and losses for the purpose of adjusting net investment income if the individual shareholder’s or partners basis of in the interest was adjusted outside the entity.

Requirements that the reporting entity must provide fair market value and invest time in detailing asset use information to past partners or S corporation shareholders using their schedule K-1, Shareholder’s [or Partner’s] Share of Income, Deductions, Credits, etc. are not included in the proposed regulations. Sellers using this exception must include a statement along with their tax return for the year they sold their interest that details the calculation of adjustments to net investment income and provides detailed information regarding the use of the exception. Since fair market value information and asset details generally are not easily obtainable by a passthrough entities’ investors and partners, the help of the entity’s accountants will likely be needed.

Because fair market value information and asset details are often time-consuming for the entity’s accountants to prepare and could possibly lead to legal challenges from the entity itself, sellers would be wise to provide the information that will be required to compute the adjustments to net investment income as part of the sale agreement. This will make it easier to accurately calculate their net investment income and avoid potential problems with the IRS later on. If Sec. 338(h)(10) becomes part of the final regulations, the deemed-sale exception will not apply to the sale of an S corporation’s stock.

Foreign Entities

Special rules for the handling the distributions from controlled foreign corporations and passive foreign investment companies can be found in Prop. Regs. Sec. 1.1411-4(g).

Kiddie Tax

When a child’s income from interest, dividends, or capital gains is included on their parents’ Form 1040, the child’s income minus an amount excluded on Form 8814, Parents’ Election to Report Child’s Interest and Dividends must be taken into account when determining the net investment income calculation. However, if a child files their own tax return and uses their parents effective tax rate when calculating their own tax burden, it is likely that the child’s MAGI is the controlling factor when determining if a tax liability exists under the net investment income tax. However, no official IRS publication appears to address this particular instance.

The IRS has announced that it will finalize the regulations controlling the net investment income tax sometime during 2013. Until then the proposed regulations provide the only reliable source of guidance until the final regulations are approved. The methods of calculating a new tax are often subject to change and adjustment. We’ll keep you informed as new information becomes available.