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Final regs clarify 3.8% surtax on investment income & gains—Part I

December 2, 2013

T.D. 9644, 11/26/2013; Reg. § 1.1411-1, Reg. § 1.1411-2, Reg. § 1.1411-3, Reg. § 1.1411-4, Reg. § 1.1411-5 , Reg. § 1.1411-6, Reg. § 1.1411-8 , Reg. § 1.1411-9, Reg. § 1.469-11

IRS has issued final regs that provide guidance on the 3.8% surtax on investment income and gains imposed by Code Sec. 1411. This article, the first of a multi-part series on the regs, addresses some general rules of applicability for Code Sec. 1411 and clarifies issues dealing with the computation of net investment income. IRS has also published proposed regs (¶ 27) on the 3.8% surtax contemporaneously with the final regs.

Background.For tax years beginning after Dec. 31, 2012, certain unearned income of individuals, trusts, and estates is subject to a surtax (i.e., it’s payable on top of any other tax payable on that income).The surtax, also called the “unearned income Medicare contribution tax” or the “net investment income tax” (NIIT), is 3.8% of the lesser of (1) net investment income (NII) or (2) the excess of modified adjusted gross income (MAGI) over the threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case).(Code Sec. 1411(a)(1), Code Sec. 1411(b)) The threshold amount is not indexed for inflation.MAGI is adjusted gross income (AGI) plus any amount excluded as foreign earned income under Code Sec. 911(a)(1) (net of the deductions and exclusions disallowed with respect to the foreign earned income).(Code Sec. 1411(d))

RIA illustrationFor 2013, a single taxpayer has net investment income of $100,000 and MAGI of $220,000.He pays the surtax only on the $20,000 amount by which his MAGI exceeds his threshold amount of $200,000, because that is less than his NII of $100,000. Thus, the surtax is $760 ($20,000 × 3.8%).

For an estate or trust, the surtax is 3.8% of the lesser of (1) undistributed NII or (2) the excess of AGI (as defined in Code Sec. 67(e)) over the dollar amount at which the highest income tax bracket applicable to an estate or trust begins.(Code Sec. 1411(a)(2))

For 3.8% surtax purposes, NII is investment income less deductions properly allocable to such income.Investment income is:


…gross income from interest, dividends, annuities, royalties, and rents, unless derived in the ordinary course of a trade or business to which the 3.8% surtaxdoesn’tapply;
…other gross income derived from a trade or business to which the Medicare contribution taxdoesapply; and
…net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the Medicare contribution taxdoesn’tapply. (Code Sec. 1411(c))


The 3.8% surtax applies to a trade or business only if it is a Code Sec. 469 passive activity of the taxpayer or a trade or business of trading in Code Sec. 475(e)(2) financial instruments or commodities.(Code Sec. 1411(c)(2)) Investment income doesn’t include amounts subject to self-employment tax (Code Sec. 1411(c)(6)), distributions from tax-favored retirement plans (e.g., qualified employer plans and IRAs) (Code Sec. 1411(c)(5)), or tax-exempt income (e.g. earned on state or local obligations).

The surtax doesn’t apply to trades or businesses conducted by a sole proprietor, partnership, or S corporation (but income, gain, or loss which is attributable to an investment of working capital isn’t treated as derived from a trade or business and thus is subject to the tax).(Code Sec. 1411(c)(3))

Gain or loss from a disposition of an interest in a partnership or S corporation is taken into account by the partner or shareholder as NII only to the extent of the net gain or loss that the transferor would take into account if the entity had sold all its property for fair market value immediately before the disposition.(Code Sec. 1411(c)(4))

The tax does not apply to: nonresident aliens; trusts all the unexpired interests in which are devoted to charitable purposes; trusts exempt from tax under Code Sec. 501; or charitable remainder trusts exempt from tax under Code Sec. 664.(Code Sec. 1411(e))

Final regs.In general, the final regs follow the approach of the proposed regs issued on Dec. 5, 2012 (2012 Proposed Regs) with some modifications in response to comments and questions that have arisen with respect to the application of the 2012 Proposed Regs.

General rules.The final regs provide additional guidance within the reg text for some rules that had been in the 2012 Proposed Regs’ Preamble but weren’t contained in the actual text of the regs.For example, Reg. § 1.1411-1(d) contains additional guidance related to various definitions applicable to multiple sections of the regs, which had appeared only in the Preamble to the 2012 Proposed Regs.In addition, the final regs contain supplemental clarifications and examples.

The final regs do not provide a list of income or deduction items that are excluded from the calculation of NII.However, in certain instances, they provide additional guidance on items of income that are or are not included in net investment income.For example, the definition of “annuity” in Reg. § 1.1411-1(d) clarifies that the term annuities, as used in Code Sec. 1411(c) and Reg. § 1.1411-4, does not include amounts paid in consideration for services rendered even if such amounts are subject to the rules of Code Sec. 72 (dealing with the tax treatment of annuities).This is consistent with U.S. income tax treaties that prescribe one set of rules for “annuities” that are not paid in exchange for services, but another set of rules for pension distributions paid in the form of an annuity.The final regs reaffirm the application of the Code’s general chapter 1 provisions in the absence of special rules for purposes of the NIIT.

The final regs retain the requirement that regrouping under Reg. § 1.469-11 (i.e., the rules which allow taxpayers to reconsider how they group activities for purposes of the passive loss rules) may occur only during the first tax year beginning after Dec. 31, 2012 in which (1) the taxpayer meets the applicable income threshold under Code Sec. 1411, and (2) has NII.If a taxpayer doesn’t have a Code Sec. 1411 tax liability, the reason for allowing the regrouping does not apply.

The final regs allow a taxpayer to regroup under Reg. § 1.469-11(b)(3)(iv) on an amended return, but only if the taxpayer was not subject to Code Sec. 1411 on his original return (or previously amended return), and if, because of a change to the original return, the taxpayer owed tax under Code Sec. 1411 for that tax year.This rule applies equally to changes to MAGI or NII upon an IRS examination.However, if a taxpayer regroups on an original return (or previously amended return) under these rules, and then later determines that the taxpayer isn’t subject to Code Sec. 1411 in that year, the regrouping is void in that year and all later years until a valid regrouping is done.There are two exceptions to such voided elections: (1) a taxpayer can adopt the voided grouping in a later year without filing an amended return if the taxpayer is subject to Code Sec. 1411 in the year; and (2) if the taxpayer is subject to Code Sec. 1411 in a later year, he may file an amended return to regroup in a manner that differs from the previous year’s voided regrouping.

Calculation of net investment income.IRS notes that because the scope of portfolio income as defined in the passive activity loss regs under Code Sec. 469 does not match the scope of NII items in Code Sec. 1411(c)(1)(A)(i) (i.e., gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which the tax does not apply), the final regs do not incorporate that definition.

The final regs provide that the term “trade or business,” when used in Code Sec. 1411 and the final regs, describes a trade or business within the meaning of Code Sec. 162.(Reg. § 1.1411-1(d)) This reference incorporates case law and administrative guidance applicable to Code Sec. 162.IRS doesn’t believe that determining whether a trade or business exists using the activity determinations of Code provisions unrelated to Code Sec. 162 is appropriate.

IRS concedes that, in certain circumstances, the rental of a single property may require regular and continuous involvement such that the rental activity is a trade or business under Code Sec. 162.However, IRS does not believe that the rental of a single piece of property rises to the level of a trade or business in every case as a matter of law.To reflect this, IRS has modified Example 1 in Reg. § 1.1411-5(b)(3).

The definition of working capital in Reg. § 1.1411-6(a) references Reg. § 1.469-2T(c)(3)(ii), which identifies several situations where interest, dividends, royalties, or annuities are derived in the ordinary course of a trade or business, and so aren’t portfolio income.If a trade or business receives interest, dividends, royalties, or annuities, and the income is working capital under Reg. § 1.1411-6(a), then it’s not derived in the ordinary course of a trade or business for purposes of Code Sec. 1411(c)(1)(A)(i) and Reg. § 1.1411-4(b) .Conversely, if a trade or business receives interest, dividends, royalties, or annuities, and the income isn’t working capital under Reg. § 1.1411-6(a) because it falls within one of the situations described in Reg. § 1.469-2T(c)(3)(ii), then the income is derived in the ordinary course of a trade or business for purposes of Code Sec. 469, Code Sec. 1411(c)(1)(A)(i), and Reg. § 1.1411-4(b).

IRS clarifies that amounts received under annuity contracts are subject to the NIIT.This includes amounts received as an annuity under an annuity contract that are includible in income under Code Sec. 72(a) and Code Sec. 72(b), as well as other types of distributions from annuity contracts that are includible in gross income under Code Sec. 72(e).

Under the 2012 Proposed Regs, all gains from the trading activities of a trade or business of trading in financial instruments or commodities (a trading business) were included in NIIT under Code Sec. 1411(c)(1)(A)(ii), while the offsetting trading losses would be taken into account under Code Sec. 1411(c)(1)(A)(iii), with the result that the Code Sec. 1411(c)(1)(A)(iii) loss limitation would prevent a trading business from netting the gains and losses for purposes of the NIIT.To minimize the inconsistencies between chapter 1 and Code Sec. 1411 for traders, the final regs assign all trading gains and trading losses to Code Sec. 1411(c)(1)(A)(iii).The final regs also permit a taxpayer to deduct excess losses from the trading business of a trader who has made a Code Sec. 475(f) mark-to-market election (a Code Sec. 475 trader) from other categories of income.Reg. § 1.1411-4(c) provides that gross income from a trading business is included in NII under Code Sec. 1411(c)(1)(A)(ii) only to the extent that income isn’t included in Code Sec. 1411(c)(1)(A)(i) or Code Sec. 1411(c)(1)(A)(iii).As a result, the final regs now categorize gross gains from the disposition of property associated with a trading business as NII under Code Sec. 1411(c)(1)(A)(iii), which may be offset by losses from trading dispositions.

Reg. § 1.1411-4(d)(2) provides that, because Code Sec. 1411(c)(1)(A)(iii) uses the term “net gain” and not the term “net gain or loss,” the amount of net gain included in NII may not be less than zero.However, Reg. § 1.1411-4(f)(4) provides that losses described in Code Sec. 165, whether described in Code Sec. 62 or Code Sec. 63(d), are allowed as a properly allocable deduction to the extent the losses exceed the amount of gain described in Code Sec. 61(a)(3) and aren’t taken into account in computing net gain by reason of Reg. § 1.1411-4(d).Thus, although Reg. § 1.1411-4(d)(2) imposes an overall limitation on net gain included in NII, Reg. § 1.1411-4(f)(4) allows losses in excess of gains as a properly allocable deduction to the extent the losses would be allowable in computing taxable income under chapter 1. Losses are first applied to calculate net gain under Code Sec. 1.1411-4(d), and then Reg. § 1.1411-4(f)(4) applies to the excess losses.This ordering rule prevents taxpayers from deducting the same loss twice: first in calculating net gain under Reg. § 1.1411-4(d), and then again in Reg. § 1.1411-4(f)(4).Accordingly, Reg. § 1.1411-4(f)(4) allows, as a properly allocable deduction, the $3,000 capital loss ($1,500 in the case of an individual filing as married filing separately) under Code Sec. 1211(b) in all cases.In addition, a taxpayer, such as a Code Sec. 475 trader, that has ordinary losses in excess of ordinary gains and net capital gains, may claim those excess losses as a Reg. § 1.1411-4(f)(4) properly allocable deduction.

The final regs also retain the 2012 Proposed Regs’ provision that, except as otherwise expressly provided, the income tax gain and loss recognition rules in chapter 1 apply for purposes of determining net gain under Code Sec. 1411.

Effective date.The final regs are effective for tax years beginning after Dec. 31, 2013, except that Reg. § 1.1411-3(d) (dealing with charitable remainder trusts) applies to tax years beginning after Dec. 31, 2012.IRS reminds taxpayers that Code Sec. 1411 is effective for tax years beginning after Dec. 31, 2012.