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IRS Finally Releases Draft Instructions for Form 8960; Plays Down Gaps in Net Investment Income Tax Guidance. (Parker Tax Publishing January 2014)

Effective for tax years beginning after 2012, Code Sec. 1411 imposes a 3.8 percent net investment income tax on individuals and trusts and estates where certain criteria are met. In August, the IRS released a draft of Form 8960, Net Investment Income Tax Individuals, Estates, and Trusts, upon which the calculation of this tax is reported. Finally, last week, the IRS issued a draft of the instructions to go with the form.

While the Form 8960 draft instructions do little to clarify some of the bigger issues taxpayers have with respect to the net investment income tax - for example, whether an activity rises to the level of a non-Code Sec. 1411 trade or business such that the income from the activity is exempt from the tax - they do provide several worksheets that are helpful in calculating some of the line items on Form 8960. The worksheets use information from other forms to calculate the amounts reported on Form 8960 for (1) net gains and losses; (2) deduction recoveries; (3) the itemized deduction limitation on deductions allocable to investment income; (4) the income of a trader in financial instruments that maintain more than one trade or business; and (5) modified adjusted gross income. The instructions also include a detailed example for using net operating losses (NOLs) in the calculation of the net investment income tax. However, use of NOLs will not apply to the 2013 tax year because only NOLs incurred after 2012 are available to be used against the net investment income tax.

At 19 pages, the draft instructions are dwarfed by the hundreds of pages of final and proposed regulations on the net investment income tax. Thus, it is almost impossible for anyone to rely solely on the Form 8960 instructions to correctly calculate the tax.

Form 8960 is modeled after the final regulations. While taxpayers can use either the final regulations or the 2012 proposed regulations in calculating the net investment income tax for the 2013 tax year, the 2013 regulations are such an improvement over the 2012 proposed regulations that there would be few situations, if any, that using the 2012 proposed regulations would result in a better answer for taxpayers.

Form 8960 must be attached to any return where Line 16 is greater than zero (individuals) or Line 20 is greater than zero (estates and trusts).

No Time for an IRS Publication This Year

IRS officials have noted that it has been challenging for them to try to come up with regulations to implement the net investment income tax provisions, while also distilling those regulations into 19 pages of instructions and worksheets that can be read at an eighth-grade level, the criteria the IRS uses when writing forms instructions. According to the IRS, a lengthy net investment income tax publication will eventually be released. But, the short amount of time the IRS had to come up with final regulations, a form, and form instructions did not leave any time for an IRS publication for the 2013 tax year.

Glitch in Instructions

One of the more favorable changes in the final regulations was the allowance of losses in excess of gains as a properly allocable deduction to the extent the losses would be allowable in computing taxable income for income tax purposes. Thus, for example, the $3,000 capital loss ($1,500 in the case of an individual filing as married filing separately) is allowed as a properly allocable deduction. The total net gains and losses are calculated on the Net Gains and Losses Worksheet in the Form 8960 instructions. However, there is a glitch in that worksheet in which the lines that pull in the capital loss carryovers result in more income being taxed than is appropriate. The IRS has acknowledged this and said that this section of the worksheet will be revised.

Application to Estates and Trusts

The net investment income tax applies to estates and trusts with income above a certain threshold. The only revision to Form 1041 is the addition of a line to Schedule G on the Form 1041 for the input of the net investment income tax calculated on the Form 8960. Otherwise, the bulk of the calculations for estates and trusts are done on the Form 8960 and the worksheets in the instructions.

Interaction of Passive Activity Recharacterization Rules and Code Section 1411

The net investment income tax rules of Code Sec. 1411 rely heavily on the passive activity loss rules of Code Sec. 469 and, without a solid understanding of the rules under Code Sec. 469, practitioners may have a difficult time computing a client's net investment income tax. The general rule is that, if an activity is nonpassive for purposes of Code Sec. 469, it's nonpassive for purposes of the net investment income tax. Once an activity is characterized as nonpassive, then the next step is to determine whether income from the activity rises to the level of being derived in the ordinary course of a trade or business and, thus, exempt from the net investment income tax.

The IRS has specified three areas where income and gain recharacterized under Code Sec. 469 as "not from a passive activity" will not be considered a Code Sec. 1411 trade or business and thus will be exluded from being subject to the net investment income tax. These three areas are: (1) the developer rule in Reg. Sec. 1.469-2T(f)(5); (2) the self rented property rule in Reg. Sec. 1.469-2(f)(5); and (3) the significant participation rule in Reg. Sec. 1.469-2T(f)(2).

Former Passive Activities

The instructions address the impact of losses previously disallowed because they were from a passive activity that is no longer passive with respect to the taxpayer. For example, a student who owns shares in a family S corporation business, but did not participate in the business because he or she was going to school, may have suspended losses from the activity. If the student then graduates and goes into the family business, the activity is no longer a passive activity. The instructions provide that, in such a case, a prior tax year's unallowed loss from the former passive activity is allowed to the extent of current year income from the activity. For purposes of determining the taxpayer's net investment income, suspended losses from such former passive activities are allowed as a properly allocable deduction, but only to the extent nonpassive income from the same activity is included in the taxpayer's net investment income in that year.

Installment Sales

The Form 8960 instructions clarify what happens when a taxpayer that had an installment sale of an interest in an S corporation or a partnership in a year before the net investment income tax took effect receives payments in a year in which the net investment income tax is in effect. In such cases the taxpayer must adjust his or her net gain amount in the year of disposition, even if the disposition occurred before 2013. The difference between the amount reported for regular tax and for purposes of the net investment income tax is then taken into account when each payment is received. A statement must be attached to the taxpayer's return in the first year the taxpayer is subject to the net investment income tax, but doesn't need to be attached in subsequent years.

Safe Harbor for Real Estate Professionals

The final regulations added a safe harbor rule for certain real estate professionals. Under this rule, if a real estate professional participates in rental real estate activities for more than 500 hours per year, the rental income associated with that activity is deemed to be derived in the ordinary course of a trade or business. Alternatively, if the taxpayer has participated in rental real estate activities for more than 500 hours per year in five of the last 10 tax years (one or more of which may be tax years before the effective date of Code Sec. 1411), then the rental income associated with that activity is deemed to be derived in the ordinary course of a trade or business. The safe harbor test also provides that, if the hour requirements are met, the real property is considered as used in a trade or business for purposes of calculating net gain under the net investment income tax provisions. Under Reg. Sec. 1.469-9, taxpayers may group their rental activities for purposes of meeting the 500 hour tests.

The Form 8960 instructions on the safe harbor requirements are somewhat misleading in that they state that a real estate professional qualifies for the safe harbor if the professional participated in each rental real estate activity for more than 500 hours during the tax year. What is not mentioned is the grouping rule that allows taxpayers to combine their rental activities for purposes of the 500-hour tests. It is also helpful to remember that, under Reg. Sec. 1.469-5T(f)(3), a taxpayer can count his or her spouse's participation in the activity in determining if the 500-hour test is met.

Issues with Regrouping Rules

While the instructions discuss when a taxpayer can use the regrouping rules, they do not address any of the many questions that practitioners have about how those rules will operate in certain situations.

Under an economic grouping rule in Code Sec. 469, a taxpayer can treat one or more trade or business activities, or rental activities, as a single activity if those activities form an appropriate economic unit for measuring gain or loss under the passive activity loss rules. The grouping rules are important because they determine the scope of a taxpayer's trade or business and whether or not that trade or business is a passive activity for purposes of the net investment income tax.

The final regulations allow a taxpayer to regroup activities during the first tax year beginning after 2012, in which (1) the taxpayer meets the applicable income threshold to be subject to the net investment income tax, and (2) has net investment income. According to the IRS, if a taxpayer does not have a net investment income tax liability, the reason for allowing the regrouping does not apply. The IRS decided not to expand the scope of the regulations to allow regrouping by partnerships and S corporations, because if it did, then taxpayers with no tax liability under Code Sec. 1411 indirectly would be allowed to regroup.

The final regulations added a provision allowing a taxpayer to regroup on an amended return, but only if the taxpayer was not subject to Code Sec. 1411 on his or her original return (or previously amended return), and if, because of a change to the original return, the taxpayer owes net investment income tax for that tax year. This rule applies equally to changes to modified adjusted gross income or net investment income upon an IRS examination.

However, regrouping on an amended return can lead to multiple issues for which the IRS has not released any guidance. For example, what if a taxpayer amends a 2014 tax return and is allowed to regroup because he or she is subject to the net investment income tax in that year for the first time. Then, in 2017, the taxpayer has a loss that he or she carries back to 2014 and that loss eliminates the net investment income tax, so that regrouping would not have been allowed. Or what if a taxpayer has an open return being audited and is allowed to regroup in a way that would favorably impact subsequent year but those years are closed?

The IRS has stated that practitioners can expect to see a series of guidance in the form of revenue rulings, revenue procedures, and regulation projects over the coming years aimed at clarifying the many questions practitioners have about the net investment income tax. For many tax professionals, the additional guidance can't come soon enough. (Staff Contributor Parker Tax Publishing)

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Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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