In November 2013, the Internal Revenue Service issued final regulations on the net investment income tax (NIIT) as well as new proposed regulations. The NIIT is imposed on the net investment income of individuals, estates and trusts at a rate of 3.8 percent and is effective for 2013.. “Net investment income” is defined to include three categories of income: 1) portfolio income, 2) trade or business income from passive activities and income from the business of trading in financial instruments and, 3) gain from the disposition of property. In January 2014, the IRS released draft instructions for Form 8960, Net Investment Income Tax – Individuals, Estates, and Trusts, as well as the final version of Form 8960.
Taxpayers must file their first Form 8960 together with their regular income tax form by April 15, 2014, or Oct. 15, 2014, if extended. Therefore, practitioners should start to develop a strong understanding of the very complex regulations, form and instructions now, as these deadlines will soon be upon us.
The draft instructions closely follow the final regulations and provide about five pages of general instructions followed by detailed line-by- line instructions. The general instructions go through specific examples and detail options for taxpayers who might be subject to the tax. The instructions address unique issues for nonresidents, dual-residents and dual-status residents, as well as issues concerning certain types of trusts and estates, such as qualified funeral trusts, electing small business trusts and bankruptcy estates of an individual.
Two pages of the general instructions are dedicated to passive activities. Practitioners who haven’t yet reviewed the final regulations and don’t have a strong grasp of the passive activity rules should read through the draft instructions to develop a high level understanding of some of the passive activity issues that must be considered for the NIIT before reading through the regulations. For example, the draft instructions highlight the seven material participation tests, rental activities, real estate professionals, the recharacterization of passive income and “fresh start” regrouping election. While the draft instructions provide illustrative worksheets of some of the technical issues, the instructions don’t provide such worksheets for passive activities. The practitioner must have a very strong understanding of the regulations (both the NIIT regulations as well as the Section 469 passive activity regulations) and the taxpayer’s specific facts to complete the necessary line items.
The Line Instructions
Form 8960 is only a one-page form that’s organized into three sections: (1) Part I Investment Income, (2) Part II Investment Expenses Allocable to Investment Income and Modifications, and (3) Part III Tax Computation. Accordingly, the draft instructions mirror the three-section breakout of the form, and the line instructions are dedicated to four complex worksheets that require a strong understanding of the final regulations to properly complete. Furthermore, practitioners will need to complete the appropriate general income tax return (that is, Form 1040 or Form 1041) prior to starting Form 8960 because some of the line items pull directly from the general income tax forms.
The first worksheet, Net Gains and Losses Worksheet, supports lines 5(a) – (d). Starting with the Capital Gains and Capital Losses reported on Form 1040 or Form 1041 and entered on line 5a of the NIIT return, Section two of the worksheet requires taxpayers to make adjustments for net gains or from dispositions for certain non-Section 1411 trade or business, former passive activity net losses, gains from installment sale obligations or a private annuity, net unrealized appreciation in employer securities, long-term capital gains for qualified electing funds, for which a Section 1411-10(g) election hasn’t been made, and allowable capital loss carryover.
Section three of the first worksheet addresses the adjustments that must be made for gains and losses attributable to the disposition of interests in partnerships and S corporations. When the draft regulations were first released in November 2012, the IRS received numerous comments regarding the highly complex steps that taxpayers would have to take to determine what portion, if any, of their gain on the sale of an interest in a partnership or S corporation would be subject to the NIIT. When the final regulations were released in January 2014, the IRS reserved this issue and withdrew the prior guidance. Further, new proposed regulations were simultaneously released addressing these types of dispositions (referred to as the 2013 Proposed Regulations in the draft instructions). The result is that for 2013, taxpayers may choose which set of proposed regulations they would like to follow for calculating net gain or loss on the disposition of an interest in a partnership or S corporation. If taxpayers choose to follow the 2012 Proposed Regulations they must attach a statement outlining specific information from the transaction (see page 5 of the Draft Instructions for a list of required information).
The second worksheet, Deductions Recoveries Worksheet, supports line 7, which reports “other modifications to investments.” An example of a recovered amount is a state income tax refund. The worksheet is intended to capture a recovery or a refund of a previously deducted item, which increases net investment income in the year of the recovery. The worksheet adjusts the recovered amounts by excluding any amounts that relate to a deduction taken before Jan. 1, 2013 or after Jan. 1, 2012 if the taxpayer wasn’t subject to the NIIT because his modified adjusted gross income was below the threshold amount. The worksheet also takes into account the impact of the recovery and net operating losses.
The third worksheet, Application of Itemized Deduction Limitations on Deductions Properly Allocable to Investment Income, supports lines 9 and 10. While deductions associated with a passive activity trade or business or the trade or business of trading in financial instruments or commodities conducted through a pass-through entity are already included in the net investment income amounts reported on line 4a, this worksheet and lines 9 – 11 are generally used to report itemized deductions or, as the NIIT refers to them, “properly allocable deductions.” Examples of properly allocable deductions include: investment interest expense, investment expenses, state and local taxes, tax preparation and planning fees.
The fourth worksheet is specifically for “Traders in Financial Instruments That Maintain More Than One Trade or Business,” which supports line 10. And the final worksheet, MAGI (modified adjusted gross income), which supports line 13, starts with the taxpayer’s adjusted gross income, then takes into account the foreign earned income exclusion and the necessary adjustments for certain controlled foreign corporation and passive foreign investment companies in arriving at MAGI.
Practitioners should expect to spend some time developing a strong understanding of the regulations so that they can complete the worksheets contained in the instructions.