Other Issues in NII
Tax Refunds
Since prorated taxes are allowed as a deduction against NII, then any subsequent refund of those taxes must be appropriately allocated to NII in the year the refund is received.
Self-Charged Interest
Can be recharacterized as passive interest and offset by passive interest expense.
Guaranteed Payments to Partners (Section 707(c) Payments)
If for services (subject to SE taxes), the payments are not subject to NIIT. Otherwise the IRS believes guaranteed payments for use of capital has the characteristic of interest and is subject to the NIIT. IRS Form 1065 Schedule K-1 was modified, starting with 2019, to conveniently provide separate boxes for entering the guaranteed payments for services and for capital.
Partner Liquidating Distributions (Sec 736 Payments)
Sec 736 applies to distributions to a retiring or deceased partner’s entire interest. The distributions must be segregated into those subject and not subject to the NIIT through some complicated Reg. Sec. 1.469-2(e)(2)(iii) allocations.
SE Income
Any income subject to self-employment tax will not be subject to the 3.8% tax. The same income cannot be subject to both taxes (Reg. Section 1.1411-9).
Kiddie Tax
The
amounts of Net Investment Income that are included in a taxpayer’s income by
reason of Form 8814,
Parents' Election to Report Child's Interest and Dividends, are included in calculating the taxpayer’s Net Investment Income for the surtax. But NII does not include (a) amounts excluded due to the threshold amounts on Form 8814 and (b) amounts attributable to Alaska Permanent Fund Dividends.
Common Trust Funds (CTF)
Proposed §1.1411-4(e)(3) includes a rule that provides income or loss from a CTF is net investment income or deduction to the extent that such amount would have been net investment income or deduction if the participant had made directly the investments of the CTF.
REMIC Residual Interests
A REMIC is not considered as being in a trade or business. The 2013 proposed regulations provide that a holder of a residual interest in a REMIC takes into account the daily portion of taxable income (or net loss) under section 860C in determining net investment income. (Proposed Regs 1.1411-4(g)(13)) This issue was “reserved” in the final regulations.
Working Capital Investment
Generally the working capital of a company is invested in short-term income producing assets. The NII rules reference the working capital rules in Code Sec. 469. Any income from the investment of working capital is treated as not derived in the ordinary course of a trade or business and is treated as investment income.
Hobby Loss and At-Risk Rules
Are not considered when making the determination of a trade or business for purposes of the NIIT.
Disposition of Partnership or S-Corporation Interests
Proposed Reg §1.1411-7(b) (“reserved” in the final regulations) provides a calculation to determine how much of the gain or loss that must be recognized is investment gain or loss. This definition recognizes that the items of property inside the passthrough entity that constitute Section 1411 property might vary among transferors because a transferor may or may not be "passive" with respect to the property. The proposed regulations include two methods, the primary method and the optional simplified method for certain smaller dispositions. See also the instructions to Form 8960, page 4 (2022).
-
Primary Method – Requires a materially participating transferor to determine what part, if any, of the gain represents the sale of investment property and therefore subject to the NIIT., To determine what part of gain represents the sale of investment property, a deemed (hypothetical) sale of the investment assets at FMV must be computed and the lesser of the resulting deemed-sale gain or the amount of gain recognized for regular income tax purposes is subject to the NIIT. The balance of the sale is not subject to the NIIT., Gain with respect to passive or trading activities would also be subject to the NIIT.
-
Simplified Method - The optional simplified method relies on historic distributive share amounts received by the transferor from the passthrough entity to extrapolate a percentage of the assets within the passthrough entity that are passive with respect to the transferor for purposes of section 1411(c)(4). Generally, to qualify under the simplified method:
-
A transferor’s investment income is 5% or less of the total of all investment income allocated to the transferor during the Section 1411 Holding Period,
(1)and the transferor’s recognized gain is $5 million (including multiple dispositions) or less, or -
A transferor’s share of the gain is $250,000 (including multiple dispositions) or less.
-
There are several exceptions when the simplified method does not apply even if it otherwise qualifies, including :
-
If the transferor did not hold the interest for 12 months prior to the disposition.
-
If the transferor transferred Section 1411 Property to or received a distribution of property (other than Section 1411 Property) from the entity in the 12-month period prior to the disposition.
-
The entity’s Section 1411 property increased or decreased more than 25% during the Section 1411 holding period.
-
If the S-Corporation was a C-Corporation during the Section 1411 holding period.
-
-
(1) Section 1411 Holding Period is defined to mean the year of
disposition and the transferor's two taxable years preceding the disposition or
the time period the transferor held the interest, whichever is less.
Deferral or Disallowance Provisions
Used in determining AGI to apply to the determination of NII, including:
-
Limitation on investment interest (Sec 163(d)), or
-
Passive activity loss limitations (Sec 469(b)).
A deduction carried over to a tax year under certain provisions and allowed for that year in determining AGI is also allowed for the determination of NII, whether or not the year from which the deduction is carried precedes the surtax effective date.
Individuals
The term “individual” for this surtax purpose is any natural person, except those who are nonresident aliens—in other words, any citizen or resident of the U.S.
U.S. Citizen Married to a Non-resident Alien
• Filing MS - The U.S. Citizen or resident spouse will be subject to the $125,000 threshold and the nonresident alien is exempt.
-
Filing Joint (Sec 6013(g) Election) – Couple is subject to the surtax on their combined worldwide income and use the $250,000 threshold.,
Residents of U.S. Territories
-
Residents of Guam, the Northern Mariana Islands, and the U.S. Virgin Islands generally will not be subject to the surtax if they fully comply with their territory’s tax laws.
-
Residents of American Samoa and Puerto Rico may be subject to the surtax if they have U.S. reportable income that gives rise to both NII and MAGI exceeding the threshold amount. However, if the bona fide resident is also a nonresident alien individual with respect to the U.S, then the surtax doesn't apply.
Short Tax Years
The threshold amount generally isn't prorated in the case of an individual's short tax year, such as in the case of death. (Reg § 1.1411-2(d)(2)(i)) A special rule applies for individuals who have a short tax year resulting from a change of annual accounting period and who must annualize taxable income. For these taxpayers, the applicable threshold amount is prorated. (Reg § 1.1411-2(d)(2)(ii))
Grantor Trusts
Items of income, deduction, and credit attributed accordingly is taxed to the owner. Thus, these amounts are taken into account in calculating the owner's NII. (Reg § 1.1411-3(b)(1)(v))
Charitable Remainder Trusts (CRTs)
CRTs are subject to special computational rules. The trust itself isn't subject to the surtax, but the annuity and unitrust distributions may constitute NII to a noncharitable recipient. (Reg § 1.1411-3(d))
Bankruptcy Estates
A bankruptcy estate of a debtor who is an individual is treated as an individual for purposes of the surtax. Under Code Sec. 1398, which provides the rules for the taxation of Chapter 7 and 11 bankruptcy estates where the debtor is an individual, the bankruptcy estate computes its tax in the same manner as an individual, and the rate is the same as that imposed on a married taxpayer filing separately. Accordingly, regardless of the debtor's actual marital status, the bankruptcy estate is treated as married filing separately for purposes of the thresholds and the $125,000 threshold applies. (Reg § 1.1411-2(a)(2)(v))