Self-Employment Tax and NIIT for LLCs and Higher Income Individuals: - - PowerPoint PPT Presentation

Self-Employment Tax and NIIT for LLCs and Higher Income Individuals: Navigating the Complex Interplay

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Self-Employment Tax and NIIT for LLCs and Higher Income Individuals

• Feb. 18, 2015

James R. Browne Strasburger & Price jim.browne@strasburger.com Cameron Hess Wagner Kirkman Blaine Klomparens & Youmans chess@wkblaw.com

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

6

Cameron Hess

WAGNER KIRKMAN BLAINE KLOMPARENS & YOUMANS LLP Mather, CA 916.920-5286 x810 chess@wkblaw.com

Jim Browne

STRASBURGER & PRICE, LLP Dallas, TX 214.651.4420 jim.browne@strasburger.com Feburary 18, 2015

Agenda

 Introduction  Self-employment tax implications for LLC members  Treatment of limited partners under 3.8% taxes  Planning opportunities  Proposals and changes on the horizon

8

Introduction

9

Introduction

 Supplemental Taxes (before 2013)

 FICA/SET  Employment tax on wages (“FICA”)

 15.3% on base amount (indexed)*; 2.9% on excess  Paid ½ by employer and ½ by employee

 Tax on earnings from self-employment (“SET”)

 15.3% on base amount (indexed and adjusted for wages); 2.9% on excess

 Investment income

 No supplemental tax

*$110,100 for 2012 10

Introduction

 Supplemental Taxes (current law 2013)

 FICA/SET/Medicare/NII  Employment tax on wages (“FICA”)

 15.3% on base amount (indexed)*; 2.9% on excess  Paid ½ by employer and ½ by employee  Additional 0.9% employee tax on excess wages of high-income

individuals

 Tax on earnings from self-employment (“SET”)

 15.3% on base amount (indexed and adjusted for wage income); 2.9% on

excess

 Additional 0.9% tax on excess self-employment earnings of high-income

individuals

 Investment income

 3.8% tax on net investment income of certain high-income taxpayers*

*$118,500 for 2014 11

Introduction

 Application of FICA and SET additional tax

 Affected (high-income) taxpayers

 Individuals with wages and/or self-employment income in excess of:

 $250,000 joint  $125,000 separate  $200,000 individual and other

 Additional tax applies only to the aggregate wages and self-

employment income in excess of the specified amounts

 Thresholds are not indexed for inflation  Corporations, estates, and trusts are exempt

 Additional tax is subject to withholding or estimated tax

payments along with regular FICA or SET

12

Introduction - NII “basics”

 Additional Tax – Starting 1/1/2013.  Applies to: individuals, estates and trusts

and: Sch K-1 entity reporting

 Compute 3.8% Additional Tax x the lesser of:

 (1)

Total NII (net investment income), or

 (2)

Excess MAGI*

*Excess MAGI = “MAGI minus Threshold Amount.

• (Except US persons overseas, MAGI = AGI – Line 31 Form 1040.)

Total NII is after deduction for portion of Sched A, Form 1040 expenses (investment expenses, alloc. state income taxes)

13

Individuals - Threshold Amount

Status

Threshold Amount

Married filing jointly

$250,000

Married filing separately

$125,000

Single

$200,000

Head of household

$200,000

Qualifying widow(er) with child

$250,000

14

Trusts/Estates - Threshold Am’t

2014: $12,150 - CPI indexed ($12,300-2015) Compare to individuals:

12,150 vs 125K/200K/250K Beneficiary distributions (of DNI)

generally reduces the NIIT to trust/estate

 NII then passes to beneficiary

15

Example 1 – Individual

Big John (unmarried, in US) has

 $300,000 NII (rental income)  $190,000 AGI (had a business loss)

 3.8% NIIT Computation:

 NII Tax = $0.  3.8% x lesser of (1) $300K NII or (2) $0.0*

*(190K AGI – 200K Threshold)

16

Example 1a – Irrev. Trust

BJ Irrevocable Trust has

 $300K NII; $190K AGI (business loss)  No beneficiary distribution (no DNI Distribution)

 3.8% NIIT Computation:

 NII Tax = $6,758.30.  3.8% x lesser of (1) $300K NII or (2) $177,850* *(190,000 MAGI – 12,150 Threshold)

 But, if $177,850 DNI distributed,

 NII Tax = $0.0 ($12,150 AGI)

17

Introduction

 Application of NIIT (con’t)

 Exempt taxpayers: Corps, foreign trusts, and TE or

charitable trusts

 Partnerships and S corporations are not subject to NIIT, but

the income of such entities may be subject to NIIT in the hands of the owners

 Distributions from foreign trusts may be subject to NIIT in the

hands of the beneficiary

 SET overlap: NII excludes income subject to SE tax  Estimated tax: NIIT included in calculation of required

installments

18

Introduction

NII = “Gross Investment Income (GII)” less: “Allowable Deductions”

 GII Categories:

 1. Portfolio Income § 163 – SAME RULES  2. PAL/PIG § 469 – FEW CHANGES  3. Finance/Commodity traders-SAME RULES

 NOT “day traders”.

 Reduces value of security/commodity traders tax benefits

 4. Net Gain (Dispositions) – LOTS OF CHANGES

19

Allowable Deductions

 Normal related deductions (e.g., expenses for rentals)  “1040 Schedule A” deductions (phase-outs)

 State Income Taxes (allocate)  Investment Interest Expenses (related)  Other investment expenses (e.g., advisor fees) (related)

20

Introduction

 Common types of excluded income

 Interest income on tax exempt bonds  Income from qualified retirement plans  Social security benefits  Alimony  Wages and self-employment income

21

Self-employment tax implications for LLC members

22

SET on LLC Members

 Issue:

 Can an LLC member treat any portion of the member’s

distributive share of LLC income as exempt from SET under the exception for limited partner distributive share income? The issue is relevant only for LLC members who materially participate in the LLC business or can otherwise avoid NIIT on the distributive share income

23

SET on LLC Members

 The SET limited partner exception - 1402(a)(13)

 In computing net earnings from self-employment:

 Include the “distributive share (whether or not distributed) of

income or loss described in section 702(a)(8) from any trade or business carried on by a partnership of which he is a member”

 Exclude (in addition to normal exclusions for rents, dividends,

gains, etc.):

 “the distributive share of any item of income or loss of a limited

partner, as such,

 other than guaranteed payments described in section 707(c) to

that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services”

24

SET on LLC Members

 Purpose for the limited partner exception

 Before enactment of 1402(a)(13) in 1977, persons ineligible for

social security benefits were buying passive, limited liability investments in partnerships that promised to generate self- employment income eligible for such benefits

 Congress enacted 1402(a)(13) to curtail “buying” social

security benefits through limited partner investments

 While the statute targets passive limited partners earning

investment type income, the statute is not limited to such persons

 The statute expressly contemplates that a limited partner may

provide services to the partnership and earn a guaranteed payment for such services and still have distributive share income excluded from SET and related benefit accruals

25

SET on LLC Members

 The 1997 proposed regulations

 Context:

 Traditional restrictions on limited partner management activities

eroding

 Growing use of alternative forms of tax partnerships with full or partial

limited liability for managing members (LLCs, LLPs, and LLLPs)

 Increasing SET rate relative to benefits

 General rule: a “limited partner” is any individual unless the

individual:

 has personal liability as a partner for the partnership’s debts, or  has authority (under the law of the jurisdiction in which the partnership

is formed) to contract for the partnership, or

 participates in the partnership's business for more than 500 hours

during the partnership’s taxable year, or

 is a service partner in a service partnership

26

SET on LLC Members

 The 1997 proposed regulations (con’t)

 Class of Interest Exceptions

 More than one class of interest

 An individual is not a limited partner with respect to a class of

interest in which limited partners (as defined above) own a substantial, continuing interest and in which the individual’s rights are identical to such limited partners

 One class of interest

 Same rule as for multiple classes of interests, but applies only if

the individual fails limited partner status under the 500 hour test

 These exceptions are intended to “exclude from an individual's net

earnings from self-employment amounts that are demonstrably returns on capital invested in the partnership”

 A service partner in a service partnership is never a limited partner to

any extent (i.e., no class of interest exception)

27

SET on LLC Members

 Congress responds

 The 1997 proposed regulations sparked a firestorm of

criticism

 Critics claimed that earnings from self-employment must be limited

to the fair value of the services actually rendered to the business, and should not sweep in all income derived from the business based on arbitrary factors such as the number or hours worked or the nature

• f the business

 Congress promptly passed legislation prohibiting finalization

• f regulations with respect to the definition of limited partner

under 1402(a)(13) until July 1, 1998

 The Senate bill expressed the Senate’s view that the proposed

regulations should be withdrawn and that “Congress should determine the tax law governing self-employment income”

28

SET on LLC Members

 Case law and rulings

 Passive activity loss cases

 A “limited partner” must satisfy a 3-factor test for material participation

(and cannot use the general 7-factor test)

 Temporary regulations define limited partner solely by reference to

limited liability, without regard to participation in management

 Some cases hold that an LLC member is not subject to the limited

partner test because an LLC is not a limited partnership; other cases hold that an LLC member is a general partner under the regulations

 A concern is that the reasoning of those cases could be applied in the

context of 1402(a)(13) to deny LLC members limited partner status

 The reasoning of the cases is dubious and was likely influenced by the

questionable validity of the temporary regulations

 Their holdings should not be extended beyond the passive activity loss

rules

 Note: 2011 proposed regulations redefine a limited partner as a person

lacking local law rights to manage the entity

29

SET on LLC Members

 Case law and rulings (con’t)

 SET cases and rulings



Renkemeyer, Campbell & Weaver, LLP v. Comm’r, 136 T.C. 137 (2011)

 Law firm organized as a general partnership electing LLP status  Court could have summarily disposed of the case on the ground that the

taxpayers were general partners under state law, but it did not

 Abusive facts: transitory corporate holding company; missing partnership

agreement; failure to allocate income and distributions according to alleged sharing ratios; low or no compensation for services

 Court discusses the legislative history of 1402(a)(13)  Intent to exclude “earnings that are basically of an investment nature”  The legislative history “does not support a holding that Congress

contemplated excluding partners who performed services for a partnership in their capacity as partners”

 Because the taxpayers’ distributive share income arose exclusively from legal

services they performed on behalf of the partnership, and was not a return on investment or of an investment nature, the income was subject to SET

30

SET on LLC Members

 Case law and rulings (con’t)

 SET cases and rulings



Riether v. United States, 919 F. Supp. 2d 1140 (D. NM 2012)

 LLC operates a medical diagnostic imaging business; members receive wages

and distributive share income from the LLC; no SET on distributive share

 Taxpayers assert  They can’t be self-employed because they received wages  The distributive share income was not earned income from self-

employment and therefore is exempt from SET;

 No evidence wages were reasonable compensation for services  Held: distributive share income is subject to SET because taxpayers were

effectively general partners

 “Plaintiffs are not members of a limited partnership, nor do they resemble

limited partners, which are those who ‘lack management powers but enjoy immunity from liability for debts of the partnership.’ [Renkemeyer] Thus, whether Plaintiffs were active or passive in the production of the LLC's earnings, those earnings were self-employment income.”

31

SET on LLC Members

 Case law and rulings (con’t)

 SET cases and rulings



Howell v. Comm’r, 2012 T.C. Memo 303

 Medical technology company (LLC) formed by W and B; H (W’s spouse)

managed the business with B; LLC paid guaranteed payments to H, B, W and

• thers, leaving only small amounts of distributive share income for W and B

 IRS assesses SET on guaranteed payments  Notably, there is no indication that the distributive share income was

subjected to SET

 H&W “appear to contend” that W was a limited partner not active in the

business and her guaranteed payments were either limited partner distributive share income or not payments for services

 Held:  Taxpayers are bound by the form of their tax reporting (guaranteed

payment)

 W performed some services for the LLC, but failed to prove what portion of

the guaranteed payments were for services

32

SET on LLC Members

 Case law and rulings (con’t)

 SET cases and rulings

 CCA 201436049 (May 20, 2014)

 Investment fund management company organized as an LLC; members

were paid a salary, a guaranteed payment for parking and health benefits, and a distributive share; no SET on distributive share

 Members contributed varying amounts of capital to the LLC  Held: entire distributive share income is subject to SET because the

income “is not income which is basically of an investment nature of the sort that Congress sought to exclude from [SET] when it enacted the predecessor to § 1402(a)(13). Accordingly, [the members] are not limited partners within the meaning of § 1402(a)(13).”

 No analysis whether the salary and guaranteed payments represented

reasonable compensation for services

 No analysis whether the distributive share income was attributable to

capital contributions, profits on employee labor, or other non-service factors

33

SET on LLC Members

 Where are we now?

 Reporting position: the distributive share income of an LLC

member is exempt from SET provided the LLC member is paid reasonable compensation for services rendered to the LLC

 This position is easily reconciled with the statute and legislative

history, including the arguments that led to the 1997 Congressional moratorium

 It is consistent with the treatment of S corporations  It is consistent with the recent cases on their facts (because in each

case the taxpayers failed to establish that they received reasonable compensation for their services to the LLC)

 IRS position that distributive share income of an active partner is

always subject to SET is plainly contrary to the statute and Congressional intent (as expressed in 1997), and contrary to its litigating position in Howell  Service partners in service partnerships have more risk

34

Slide Intentionally Left Blank

Treatment of Limited Partners Under 3.8% Taxes Including NIIT

36

Review Basics

 Effective 1/1/2013.  Applies to: individuals, estates and trusts

and: Sch K-1 entity reporting

 Compute 3.8% Additional Tax x the lesser of:

 (1)

Total NII (net investment income), or

 (2)

Excess MAGI*

*Excess MAGI = “MAGI minus Threshold Amount.

37

NII Tax and Business Entities

 Not a Corporate/Partnership Level Tax

 PSC/Closely Held “C” Corps

 Subject to § 469 – PAL Limitations  But Not NIIT

38

NII Tax and Business Entities

 S Corp Holders/Partners (Indiv/Trusts/Estates)

HAVE NII PASSHROUGH (K-1) Including:

 1. Portfolio Income § 163  2. PAL/PIG § 469  3. Finance/Commodity Traders Income  4. Net Gain (Dispositions)

39

Pass-Through to Partners

 NII results if partner’s T/B income

= passive activity (§469).

 IRS Statement – Will NOT follow all §469 exceptions:

 “Even if the taxpayer meets one of the

exceptions in Section 1.4691-T(e)(3)(ii), if the taxpayer’s activity is not a section 162 trade or business, gross income from rents will be subject to Section 1411(c)(1)(A)(i).

40

Pass-Through to Partners Real Estate Professional

 IRS will not apply following 469 active T/B presum’ns:

 § 1.469-1T(e)(3)(ii) (Deemed T/B - 6 items)

 “Start-up” activity presumed T/B  “Predevelopment revenue”  Not active T/B for NII

Example 3b: Developer leaseback to farmer land held for

• development. While not passive under Section 469, rental

income will be deemed NII.

 Note – expect developers to claim

they are farmers.

41

Pass-Through to Partners Real Estate Professional

 1.469-5T(a)(1) Safe Harbor Allowed:

 Real estate professional (>750 hrs) +

 1. participates in rental real estate activities;  2. time in activity = > than 500 hours per year,  3. income associated with that activity*  Active T/B , and thus not subject to §1411.  *Activity Must be Part of That Active Trade or Business

42

Pass-Through to Partners Real Estate Professional

 Alternate Safe Harbor Allowed:

 Real estate professional (>750 hrs) +

 1. participates in rental real estate activities;  2. > than 500 hours/year in 5 of 10 prior years,  3. income associated with that activity*  Active T/B , and thus not subject to §1411.  *Activity Must be Part of That Active Trade or Business

43

Pass-Through to Partners Real Estate Professional

 Non-Safe - General Rule:

 Real estate professional (>750 hrs) +

 1. participates in rental real estate activities;  2. rental activities are substantial,  3. income associated with that activity*  4. derived in the ordinary course of a trade/business  If prove it’s a T/B , then it’s not subject to §1411.  *Activity Must be Part of That Active Trade or Business

44

Pass-Through to Partners Limited Partner Problem

 BUT: Limited Partners: §469(h)(2)

Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which the taxpayer materially participates.

 And 469(h)(6)(c) says the same thing as to active

participation.

45

Pass-Through to Partners Limited Partner Problem

 Two Part Analysis to Get Around:

1.

Is the interest “classified” as a limited partner interest for tax purposes?

2.

If “classified”, does the limited partner meet one of 3 exceptions?

46

Pass-Through to Partners Limited Partner Problem

 So, to avoid NIIT, partner must both:

 qualify as real estate professional and  either (i) NOT be deemed a limited partner, or

(ii) meet an exception due to substantial activities.

 Affected: Interests in LLCs, LPs, LLPs, LLLPs, other

entities treated as “partnership”.

 Definition of Limited Partners by Statute?

 NO. Not found under Section 469, 7701, or 1402(a)(13)

(self-employment tax exception)

47

Pass-Through to Partners Limited Partner Problem

 How classify/“define” a limited partner.

 State Law vs. Tax Law  Old Kintner Regulations not useful:

 Continuity of Life  Transferability limitations?  Limited liability  Centralized Management

 Littriello v. US (6th Cir. 2007). Treasury does not have to

follow state law for taxpayer-businesses; and can set own rules where Congress not clear and unambiguous.

48

Pass-Through - R/E Professional Limited Partner Problem

 Limited Partner Defined: Temp Reg. 1.469-5T(e)(3)(i)

...interest [is] a limited partnership interest if— (A) …. designated a limited partnership interest in the limited partnership agreement or the certificate of limited partnership, ….; or (B) The liability of the holder … for obligations of the partnership is limited, ….. … interest … shall not be treated as a limited partnership interest …. if the individual is a general partner.

49

Pass-Through - R/E Professional Limited Partner Problem

 But courts declined LP treatment for LLC members:

Gregg v. U.S., 186 F.Supp.2d 1123 (D. Or. 2000). 469(h)(2) was not applicable to LLC members. Garnett v. Com’r, 132 T.C. 368 (2009). LLPs and LLCs were not limited partnerships. Interests fit within the general partner exception. Thompson v. U.S., 87 Fed. Cl. 728 (2009). 469(h)(2) requires a partnership under State law. An LLC member is not a limited partner. Newell v. Comm’r, T.C. Memo. 2010-23. 469(h)(2) did not apply to the managing member of an LLC. Member is a general partner under §1.469-5T(e)(3)(ii).

50

Pass-Through - R/E Professional Limited Partner Problem

 But Proposed Treas. Reg. 1.469-5(e)(3)(i) (11/28/11)

...interest [is] a limited partnership interest if— (A) The entity…is classified as a partnership for Federal income tax purposes under §301.7701-3; and (B) The holder of such interest does not have rights to manage the entity….. IRS listed as 2014-2015 priority project Aug 2014.

51

Pass-Through to Partners Limited Partner Problem

 If interest is “classified” as a limited partner, IRC §

469(h)(2) presumes interest is per se passive.

 Three exceptions:

 Taxpayer works 500 hours or more in the particular

trade or business activity.

 Taxpayer materially participated in the activity in any 5

• f the prior 10 years.

 It is a personal service activity; taxpayer materially

participated in that activity in any 3 prior years.

 Did the IRS eliminate test #3 for NII purposes???

52

Related Issue - Trustees Basics

Same rules Threshold Amount:

2014: $12,150 - CPI indexed 2015 $12,300

Distributions of DNI also pass-through

NII to beneficiaries.

53

Related – Trustees as R/E Professional

Example: Trust owns % in LLC.

Trustee = limited partner? Can Trustee materially participate? IRS Declined to Issue Regulations

 IRS position vs. taxpayers

54

Trustee Material Participation

• IRS: Material participation by nongrantor trust depends on

trustee’s activity, not it’s agents (or special trustee) 1. BUT

1Position discussed by IRS in TAM 200733023; PLR 201029014; TAM 201317010.

 Carter Trust v. US 256 F. Supp. 2d 536 (N.D. Tex. 2003).

Trustee hired ranch manager. Material participation found through employees and trustee.

 Aragona Trust v. Com’r, 142 TC. 9 (3/27/14). 3 of 6 trustees

(related) worked FT for R/E management LLC, wholly owned by trust. Trust can materially participate through trustee- employees; R/E professional exception applied.

55

Limited Partner/Trust Rules

 Same Issue/Same Framework?  Material Participation & Real Estate Professional:

 Partnership - Determined at Partner Level  Trust – Determined at Trustee Level (if trustee does

material activities + agents activities.

 Unclear:

 R/E Pro Exception – Trust. If agents provide services,

are they counted?

 Beneficiaries. If NO NIIT @ Trust Level, is income

treated as “active” for beneficiaries @ distribution?

56

Slide Intentionally Left Blank

Planning Opportunities

58

Planning Opportunities

 S corporations

 The distributive share income of an S corporation is unquestionably

exempt from FICA and SET, and is also unquestionably exempt from NIIT, IF the S corporation is engaged in a Non-Trading Business in which the shareholder materially participates

 BUT

 S corporations have significant disadvantages as compared to tax

partnerships (e.g., one class of stock, no entity or foreign shareholders, no 754 election, no 721/731 exclusion for gain on property contributions and distributions, no inside basis step-up at death, etc.)

 The perceived SET benefits may not materialize, or might not be as

significant as planned

 Professional services businesses may not benefit  A properly structured LLC or LP should be able to achieve similar SET

benefits

59

Planning Opportunities

 S corporation blocker

 What if the LLC/LP interests are owned by single member S corps?  Individuals are employees of LLC or S corp and are paid wages  Distributive share income flows through S corporations  NB: Cumbersome and does not eliminate all disadvantages of S

corporation ownership

Individual A Individual B Individual C S Corp 1 S Corp 2 S Corp 3

S Corp. S Corp. S Corp.

LLC

Partnership

60

Planning Opportunities

 Use of LLCs and LPs

 Reporting position

 The distributive share income of an LLC member or limited partner

(collectively, “LP”) should be exempt from SET provided the LP is paid reasonable compensation for services rendered to the LLC or limited partnership  Planning

 The argument is stronger if the LP provides services and receives

compensation in a capacity other than as an LP (e.g., as an employee

• f a management company acting as the LLC manager or limited

partnership general partner)

 Management fees received by the management company are paid

• ut to the employees as wages, and are set at levels sufficient to

constitute reasonable compensation for services rendered

61

Planning Opportunities

 Use of LLCs and LPs - example

 Individuals perform services for LLC as employees of S corp or LLC

manager

 Distributive share income received by individuals as a member

having no management rights

 Same structure can be used for a limited partnership with an S

corporation or LLC general partner

Individual A Individual B Individual C S Corp Manager

S Corp.

Manager Managed LLC

Partnership Management Fees

62

Planning Opportunities

 Grouping

 One or more business activities may be treated as a single

activity (“grouped”) if the activities constitute an “appropriate economic unit” for the measurement of gain or loss for purposes of Section 469 [Reg. 1.469-4(c)(1)]

 Appropriate economic unit depends on facts and circumstances  Generally, use any reasonable method to group activities  Five factors are given the greatest weight in determining whether

activities constitute an appropriate economic unit:

 Similarities or differences in the types of businesses;  Extent of common control;  Extent of common ownership;  Geographical location; and  Interdependence of the activities 63

Planning Opportunities

 Limitations on grouping

 A rental activity can’t be grouped with a trade or business

activity unless they form an appropriate economic unit and

 Rental activity is insubstantial in relation to business activity;  Business activity is insubstantial in relation to rental activity; or  Common ownership

 Can’t group real property rental activity with personal

property rental activity

 Special rules for special industry activities described in

Section 465(c)(2) (film, depreciable person property leasing, farming, oil and gas, and geothermal property)

64

Planning Opportunities

 Special NIIT re-grouping election

 A one-time regrouping election is available during the

first taxable year that NII exceeds the threshold amounts (first time Form 8960 would be filed) [Reg. 1.469-11(b)(3)(iv)]

 Taxpayers may regroup on an amended return if the

taxpayer was not subject to NIIT on original return (or previously amended return) and, if, due to a change to the original return, the taxpayer owed NIIT for that taxable year

65

Planning Opportunities

 Limitations on grouping

 Final regulations do NOT allow regrouping by partnerships

and S corporations

 Opportunity for regrouping – 2nd Bite (different taxpayer)

 Estate/Trust @ 1st Spouse’s Death  Sub-Trust Funded for Children  Distribution of property out of trust/estate

66

Planning Opportunities

 Planning

 Under prior law, it was often advantageous to not group

activities (to accelerate use of suspended losses on activities sold or terminated)

 Under current law, it might be beneficial to group

activities so that otherwise passive activities that do not generate self-employment income can become part of an Active Non-Trading Business that generates neither NII nor self-employment income

67

Planning Opportunities

 Self Charged Interest.  On self-charged interest from an active (non-passive)

business entity, a portion of interest income will be excluded.

 The exclusion amount = the lender’s “share of the

nonpassive deduction”. The rule cross-references §1.469– 7 for the operative mechanics.

 The limit is inapplicable if the interest deduction is part

• f a self-employment income computation (subject to

tax under section 1401(b)).

68

Planning Opportunities

 Self Charged Interest.  Example. Able Designer loans $100,000 @ 10% to an

architecture firm in which he owns 15% of the architecture firm located in the same building. Will 100% of the $$ interest paid by the firm be treated as self-charged rent?

 No. There is only excluded the income = to the %

interest deduction born. Only $1,500 of the $10,000 received will be excluded. $8,500 of the interest will remain NII

69

Planning Opportunities

 Property s/t “Self-Charged” Rent

 Rental income treated as non-passive under §1.469–

2(f)(6) (rental income from property used in an activity in which the taxpayer materially participates), including rental property grouped with a non-passive activity, will be deed T/B income.

 Gain/loss from rental property, if sold with active T/B

property will also be treated as nonpassive T/B gain

70

Planning Opportunities

 Property s/t “Self-Charged” Rent  Example. Able Designer owns 100% of a building and

15% of the architecture firm located in the same

• building. Will 100% of the $$ rent paid by the firm be

treated as self-charged rent?

Yes, under 1.469-2(f)(6), amount of rent paid by the firm will be treated as non-passive. The self-rental regulations do not require “mirror” ownership.

71

Planning Opportunities

 Avoiding NIIT through material participation

 Participation by Hours > 500

 Time spent (Self/Spouse)  Proof of Participation. Appointment book calendar, or

narrative summary. To show the services performed & hours.

 Facts & Circumstances Test (difficult)

 Activity regular, continuous, and substantial  Works at least 100 hours in the activity,  No one else works more hours  No one else receives compensation for managing the activity

72

Planning Opportunities

 Exclusions

 Per IRS – Exclude:

 Time to i) review financial statements, ii) analysis for personal use,

and iii) monitoring (non-managerial) capacity does not count

 Owner work that would normally be assigned to an employee  Travel Time Thomas E. Truskowsky, T.C. Summary Op 2003-130

 Per IRS: Few taxpayers can meet the facts and circumstances

• standard. If there is paid on-site management, the facts and

circumstances test cannot be used.

 Are these position over-reaching? An on-site manager for 100

unit apartment defeats active T or B!!???

73

Planning Opportunities

 Net Gain from Dispositions

 Opportunities to reduce losses by:

 Strategies to reduce NII by Sec.165 losses: abandonment and

worthlessness.

 Culling of losses.

 Basic exceptions/limitations/exclusions apply

 Loss limitations (at risk, basis, but capital loss C/F rules are

narrower)

 Installment sale rules  Statutory Exclusions apply – 1031/1033/1038/121(home)

 Look Through Rule:……

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Business Dispo Look-Through Rule

 Owner’s “Disposition” of Interest in Pship or S Corp

 1411(c)(4) & (Prop. Treas. Reg. 1.1411-7).  Recasts NII gain/loss as business gain/loss.

In the case of a disposition of an interest in a partnership or an S corporation –

(A) gain from such a disposition shall be taken into account…only to the extent of the net gain…if all property of the partnership or S corporation were sold at fair market value immediately before the disposition of such interest, and (B) a rule similar to the rule of subparagraph (A) shall apply to a loss from such disposition.

75

Look-Through Rule:

 Why. Owner’s pass-through business won’t be treated as

an investment. If sell interest – deemed like asset sale.

 How: “look-through”: Had entity its assets (“deemed sale”)

at FMV, what portion would be business income? (Prop.

• Treas. Reg. Section 1.1411-7).

 Trade/business portion is excluded from NII “net gain from

disposition”.

 Complicated Computation - difficult to qualify.

 NOTE!: Does not apply to owner of C Corp!

76

Look Through Computation

 Summary

 T’s gain from sale of interest is bifurcated:

 if part of gain from sale relates to trade/business portion sold,

total gain included in NII is reduced (negative adjustment)

 T’s loss bifurcated: if part of loss from sale relates to

trade/business sold, total loss is reduced – offset against

• ther disposition gains is less (positive adjustment)

 “Excess” = deemed investment gain/loss

 Note: Adjustment doesn’t increase total gain or total

loss from sale of interest.

77

Look-Through Steps

 1. Compute total gain/loss from disposition of interest.  2. Compute entity level total gain/loss from deemed FMV

sale;

 3. Compute gain/loss deemed for each separate entity

asset (including goodwill);

 4. Multiply % interest sold x each gain/loss (the look

through);

 5. Sort gain/loss between:

 (i) net investment income and  (ii) excluded income (e.g., trade or business income.)

78

Example – AB P’ship – all T/B

 AB Tax Consultants – B Has Basis of $75,000

79

A (25%)

B (75%) Sells Interest to C for $90,000

AB Partnership A/B Assets = $120K

Example – All T/B

 Step 1. B’s Gain = $15,000. ($90,000 – 75,000)  Step 2. AB Pship Built in Gain=$20,000 ($120 - $100K basis)

 B’s share (75%) = $15,000 (same)

 Step 3. Assume 100% business   If B active in T/B, 100% active T/B Gain; and.  Therefore 100% excluded from NII

 NII from disposition = $0.00

($15,000 minus $15,000 = $0.00).

80

Example < 100% T/B

 Step 1: Same: B’s Gain = $15,000  Step 2: Assume: AB Pship - $10,000 Built In Gain –

adjusted basis = $110.00.  Step 3: Assume has investment

 Assets: Investment $5,000 gain (25%)

Tangible $15,000 gain (75%)

 Step 4: 75% x $5,000 = $3,500

75% x $15,000 = $12,500)

 Step 5: $12,500 of B’s $15,000 Gain excluded T/B

gain.

 NII = $3,500 ($15,000 - $12,500 excluded)

81

Example of Look Through Loss

 Assume B sold at loss instead: $5,000 Loss (e.g.,

B’s basis is $95,000).

 Under either prior example, AB Pship’s (Built in

Gain) = $20,000

 B’s share is $15,000

 $5,000 loss will be treated 100% as investment

loss.

 Deemed sale gain cannot increase the loss.

82

Other Business Entity Strategies

• Installment Sales
• Section 1031 Exchanges
• Charitable Donation of Appreciated Property
• Distributing investment assets
• Successor Trusts (active Trustee) – see above
• Spreading Investment Income (Family Limited

Partnerships & LLCS)

• Suitable Investments
• Managing Estate or Trust Distributions
• Creating Material Participation in Passive Activities

83

Slide Intentionally Left Blank

Proposals and Changes on the Horizon

85

Proposals and Changes

 Joint Committee SET proposal (2005)

 Repeal limited partner exception  Partner that does not materially participate pays SET

• nly on reasonable compensation for services

 Investment income of a service partnership is subject to

SET

 S corporation is treated as a partnership for SET

purposes

86

Proposals and Changes

 American Jobs and Closing Tax Loopholes Act (2010)

 Impose SET on distributive share income of each shareholder

• f a “disqualified S corporation” who provides substantial

services with respect to the professional service business of the S corporation

 Disqualified S corporation:

 S corporation that is a partner in a partnership engaged in a

professional services business and substantially all activities are in connection with such partnership

 S corporation engaged in a professional services business if the

principal asset is the reputation and skill of three or fewer employees  Impose SET on any limited partner who provides substantial

services with respect to a a partnership engaged in a professional services business

87

Proposals and Changes

 CBO SET proposals (2012)

 Material participation standard

 SET imposed on distributive share income of all partners who

materially participate  Reasonable compensation standard

 SET imposed only on reasonable compensation paid to owners

(same as for S corporations)

 Reduces SET revenues by estimated 58% (based on underreporting

• bserved for S corporations)

 Safe-harbor calculation of capital income

 Apply a prescribed rate of return to balance sheet net operating

assets

 Would not apply to S corporations  No accounting for intangibles and other off-balance sheet income

producing assets

88

Proposals and Changes

 Carried interests

 Would treat a partner’s distributive share of net income

• r net loss with respect to an “investment services

partnership interest” (“ISPI”) as ordinary income or loss

 ISPI = interest held by a person providing a substantial

quantity of investment management services with respect to partnership specified assets (securities, real estate, partnership interests, and commodities)

 Amount characterized as ordinary income or loss is

subject to SET

89

Proposals and Changes

 House Tax Reform Proposals (2013)

 Option 1: revise rules for S corporations and

partnerships

 Does not address SET

 Option 2: repeal existing rules and replace them with a

single set of rules for S corporations and partnerships

 Would require some rule characterizing distributive share

income

90

Proposals and Changes

 August 26, 2014 IRS 2014-2015 Priority Guidance

Plan

 Final Regulations Under Section 469(h)(2) – Limited

Partnerships

 Finalize open portions of Section 1411 regulations

 AICPA Proposals to Treasury

 Clarify material participation  Clean up of regulations/statutory reform

 Obama Proposed Buffet Rule (30% minimum tax on

TI > $1 million (DOA?) – integrate with NII???

91

Proposals and Changes



AICPA requesting clarification on material participation by a trust or estate . AICPA suggests the IRS or Treasury should:



Incorporate the conclusions reached in the two court decisions;



Count the combined activities of any trustee or executor, irrespective of capacity in performing activities and irrespective of whether the individual owns an interest in the same;



Count the activities of employees and agents employed;



Provide that the material participation tests set forth in Temp. Reg. § 1.469-5T(a) apply to trusts/estates;



Deem a period that the estate is materially participating if owner materially participated before death;



Treat character of income by trust or estate and distributed income to beneficiary the same;



Provide the participation of the beneficiary in a qualified subchapter S trust determines if trust’s gain from the sale of the S corporation stock is active or passive;



Provide that the S portion and the non-S portion of an electing small business trust are treated as a single trust for section 469 rules.



Provide that a trust or estate may qualify as a real estate professional under section 469(c)(7) and how a trust or estate may qualify as a real estate professional.

92

Proposals and Changes

 AICPA also requested the following:

 Threshold Amounts. Increasing the threshold amounts

and adjusting them for inflation to make the optional simplified reporting method available to more taxpayers.

 Simplification. Allow taxpayers to opt to include all gain

• r excluding all loss disposition under look-through

disposition rule for pass-through entities.

 Provide a simplified safe harbor method for tiered pass-

through dispositions

93

Questions?

94

Disclaimer

 This document is not intended to provide advice on any

specific legal matter or factual situation, and should not be relied upon without consultation with qualified professional advisors.

 Any tax advice contained in this document and any

attachments was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter.

95

Cameron Hess

WAGNER KIRKMAN BLAINE KLOMPARENS & YOUMANS LLP Mather, CA 916.920-5286 x810 chess@wkblaw.com

Jim Browne

STRASBURGER & PRICE, LLP Dallas, TX 214.651.4420 jim.browne@strasburger.com