Where Investment Income Tax Regulations and Special Needs Planning Collide

1. WHERE THE NET INVESTMENT INCOMETAX REGULATIONS AND SPECIALNEEDS PLANNING COLLIDE Presented by: James M. McCarten | Partner Burr & Forman LLPNashville, TN Atlanta, GA jim.mccarten@burr.com 615/724-3236 404/532-7236 Prepared for: Special Needs Alliance St. Pete Beach, FL October 19, 2013

2. TODAY'S AGENDA • A Brief Overview of Code § 1411 and the Proposed Regulations. • Section 1411's impact on: • a. Special needs planning. • b. Tax planning in general. • c. Exit planning/business succession/legacy planning. 2

3. An Overview of the Net Investment Income Tax • Enacted as new Chapter 2A and Section 1411 under the Health Care and Education Reconciliation Act of 2010. • Effective for tax years beginning after December 31, 2012. 3

4. The Code § 1411 Proposed Regulations • Issued on November 30, 2012. • 77 Fed. Reg. 72612 • Preamble (IRS Summary itself over40 pages) • Lots of detail; there is a type of logic, but study required! • Simultaneously proposed reg. allowing a "fresh start" for passive activity groupings (Prop. Reg. Section 1.469-11(b)(3)(iv)). 4

5. The Structure of the Proposed Regulations • 1.1411-1 - - - Chapter 1's Rules Apply • 1.1411-2 - - - Application to Individuals • 1.1411-3 - - - Application to Estates & Trusts • 1.1411-4 - - - Definition of Net Investment Income ("NII") • 1.1411-5 - - - Application to Trades and Businesses • 1.1411-6 - - - Investment of Working Capital Rules • 1.1411-7 - - - Dispositions of Interests in Flow Thru Entities • 1.1411-8 - - - Distributions from Qualified Plans • 1.1411-9 - - - SE Tax • 1.1411-10 - - CFC/PFIC Rules 5

6. The Net InvestmentIncome Tax Calculation • The net investment income tax (an additional 3.8% tax) is assessed on the lesser of: • a taxpayer's net investment income ("NII"), - - - or - - - • the amount by which the taxpayer's Modified Adjusted Gross Income ("MAGI") exceeds the taxpayer's threshold amount. • Code § 1411(a)(1). 6

7. MAGI and Its Thresholds • MAGI means the sum of a taxpayer's adjusted gross income plus the net foreign income exclusion amount. • Applicable Thresholds. • Married filing jointly -- $250,000.00 • Married filing separately -- $125,000.00 • Single -- $200,000.00 • Estates and Trusts -- $11,950.00 (for 2013) (only on undistributed NII) 7

8. How The Medicare Surtax Calculation Works • When a taxpayer's MAGI exceeds the applicable threshold amount, the surtax applies to the lesser of the taxpayer's NII or the amount by which the taxpayer's MAGI exceeds the threshold amount. • NOTE that the Medicare surtax is subject to estimated tax payment and penalty provisions. Section 1402(a)(2) of the 2010 legislation. • IRS just issued the new form; Form 8960, but no instructions. 8

9. What is Net Investment Income? NII is the sum of the taxpayer's gross investment income and gain (or loss) less the deductions properly allocable to such income/ gain. Code § 1411(c)(1). 9

10. What Income Is Included? • Interest, dividends, royalties, annuities and rents. • Net capital gains. • Gross income from businesses which constitute passive activities. • Gross income from the trade or business of trading in financial instruments or commodities (whether or not the taxpayer is active in the business). • Code § 1411(c)(1)(A)&(B). 10

11. Sales of Interests in Flow-Thru Entities • The gain or loss from dispositions of interests in a pass-through entity will also be investment income so long as the taxpayer did not actively participate. • However, the portion subject to NII is limited to that portion of the net gain the entity would have recognized if it had sold all of its property for FMV. 11

12. Creating Conceptual Income Categories/Buckets • CATEGORY 1 – Gross Income from interest, dividends, annuities, royalties, and rents (unless earned in the ordinary course of an active trade or business). Code §1411(c)(1)(A)(i). • CATEGORY 2 – Other gross income from passive activities and trading in financial instruments and commodities. Code § 1411(c)(1)(A)(ii). • CATEGORY 3 – Net Gain from the disposition of property, including property held for use in passive activities and trades or businesses of trading in financial instruments or commodities. Code §1411(c)(1)(A)(iii). 12

13. NII Exclusions • Income from, or gain on the sale of, a trade or business in which the taxpayer actively participates as determined under the passive activity rules. Prop. Reg. Sections 1.1411-4 and 1.1411-7. • Distributions from qualified plans and/or IRAs. Code § 1411(c)(5). • Any income treated as self-employment income. Code § 1411(c)(6). • Tax-exempt interest. Prop. Reg. Section 1.1411-1. 13

14. Properly Allocable Deductions • Prop. Reg. Section 1.1411-4(f) (if limited for regular tax, also limited here). • Deductions described in Code § 62(a)(4) allocable to rents and royalties apply. • Deductions described in Code § 62(a)(1) allocable to business income subject to NII are allowed only to the extent the deductions have not been taken into account in determining SE Tax liability. • Deductions for a tax year cannot exceed the amount of NII for the tax year. 14

15. Deductions (con't) • Investment interest expense, investment expenses (Code § 163). • Allocable Schedule A income taxes (state and local). • Penalty for Early Savings Withdrawals (CD's, etc.). • Deductions subject to the 2% floor on miscellaneous itemized deduction or the Pease limitations on itemized deductions, but only to the extent deductible for regular income tax purposes (e.g., after application of Code §§ 67 and 68). 15

16. Clearly Non-Deductible Expenses • Deductions used to offset SE Taxes. • Non-passive trade or business deductions. • Net Operating Losses. • Charitable Deductions under Code § 170. • Deductions that are suspended for regular tax purposes. • "Net" Loss on Disposition of Property (Code § 165). 16

17. Category 2 NII Incorporates "Passive Activity" Rules • Code § 1411(c)(2)(A) and the regs refer to and incorporate the "passive activity" rules under Code § 469. Passive Activities are any trade or business in which the taxpayer does not materially participate. • To materially participate, the taxpayer's involvement must be "regular, continuous and substantial" (Code § 469(h)). • The rules for demonstrating material participation by an individual are found in Reg. Section 1.469-5T. 17

18. The Importance of Trade or Business Classification • So long as an activity is a trade or business and the taxpayer materially participates, the income is not NII and not subject to the tax. • Rental Real Estate Activity(ies) • Always passive under Code § 469(c)(2) • Remember the Real Estate Professional rules of Code § 469(c)(7) --- are an exception. • The NII proposed regs expressly warn that "not all real estate professionals" will qualify for this exception. • Rental of tangible property is generally deemed "passive"; the NII regulations are not as favorable as regular tax rules. Prop. Reg. Section 1.411-5 (and the Preamble). 18

19. Passive Activity Groupings • Prop. Reg. Section 1.469-11(b)(3)(iv) allows a one-time regrouping election (in the first year the taxpayer is subject to the NII tax). • What is "grouping"? • The passive activity rules allow taxpayers to group various passive and non-passive activities provided certain rules have been met. • Under the NII tax, though, "rental" is "rental" and grouping with an activity which is non-passive will not reclassify the income. 19

20. Dispositions of Interests inFlow Thru Entities • Code § 1411(c)(4) and Prop. Reg. Section 1.1411-7 provide that NII does not include certain gains from the dispositions of interests in partnerships and/or S corporations so long as: • The entity is engaged in one or more trades or business; • The trade or business must not relate to the trading of financial instruments or commodities; and • The transferor is active in at least one of the entity's trades or businesses. 20

21. The Deemed Sale Rules • The gain excluded (on the disposition of an interest in a Flow Thru entity) will be the portion of the total gain that is attributable to its active trade(s) or business(es). • To accomplish that result, the Proposed Regulations require an adjustment (either positive or negative) determined as detailed in Prop. Reg. Section 1.1411-7(c). 21

22. Returns With Adjustments • Anytransferor making an adjustment under Prop. Reg. Section 1.411-7(c) must attach a statement to the transferor's income tax return in the year of disposition. The disclosure must contain: • A description of the interest sold/transferred, • The name and EIN of the entity, • The fair market value (FMV) of each property of the entity, • The entity's adjusted basis in each property, • The transferor's allocable share of gain or loss with respect to each property of the entity, • Information regarding whether the property was held in (or attributable to) a trade or business not described in Prop. Reg. Section 1.1411-4(a)(1)(iii) on the disposition of the interest, and • How the adjustment was calculated. 22

23. The Medicare Surtax and Estates and Trusts • As noted earlier, for estates and trusts, the Medicare Surtax is imposed on the lesser of • Undistributed NII, or • MAGI in excess of the Section 1(e) threshold ($11,950 for 2013). • Can an estate or trust materially participate in an activity? • Mattie K. Carter Trust v. Comm'r., 256 F. Supp.2d 536 (N.D. Tex. 2003). • TAM 200733023 • PLR 201029014 23

24. Undistributed Net Investment Income • "Undistributed net investment income" is the NII of the estate or trust less: • NII distributed to any beneficiary, and • NII allocated to Code § 642(c) charitable deductions. • The NII distribution rules follow the structure of the DNI rules: • The 651/661 deduction may (or may not) be the same for NII as for the income tax. • It depends on the composition of the income of the estate or trust. • Unless capital gain is part of DNI calculation, it will not be deemed distributed. • Special Rules for QSSTs and ESBTs. 24

25. Miscellaneous NII Items • Distributions from Controlled Foreign Corporations (CFC) and Passive Foreign Investment Companies (PFIC) are generally pulled into the NII tax base. See Prop. Reg. Section 1.1411-10(c)(2). • The proposed regulations also include specific tax avoidance rules for "substitute interest" and "substitute dividends". Prop. Reg. Section 1.1411-4(a). 25

26. Tax Factors In Choice of Entity • Income Tax Rates • Single Individuals at $200,000.00 ----- 33% • 39.6% rate begins at $400,000.00 • Married Filing Joint at $250,000.00 ----- 33% • 39.6% rate begins at $450,000.00 • The NII tax --- 3.8% on Net Investment Income • Single taxpayers --- MAGI of $200,000.00 • Married filing joint --- MAGI of $250,000.00 • FICA/Medicare Taxes • 1.45% on first $200,000.00 of wages • 2.35% on wages over $200,000.00 26

27. Choice of Entity Factors (con't) • Self-Employment Tax (SE tax) • 2.9% on first $200,000.00 • 3.8% on excess over $200,000.00 • But, remember, ½ of SE tax is also an above-the-line deduction. • Estate, Gift and GST rates. • 40% transfer tax rate • Capital Gains Rates/Qualified Dividends • If regular income tax rate is below 39.6%, these special rates are 15%. • If regular income tax rate is 39.6%, these special rates are 20%. • Estate Inclusion and Step-up in Basis. 27

28. Initial PlanningStrategies • Traditional Tax Planning Strategies. • Tax Deferred Annuities. • Qualified Retirement Plans. • Non-Qualified Deferred Compensation. • Tax-Smart Investments. • Installment Sales. • Non-Taxable Investments (Municipal Bonds, Life Insurance). 28

29. Next Step: Is The IncomePortfolio, Active or Passive ? • Assume the taxpayer's MAGI exceeds the relevant threshold. • If the income is portfolio or taxpayer does not "materially participate" (e.g., the Passive Loss Rules apply), such income will be subject to the 3.8% NII tax. • If the taxpayer does "materially participate", has the income become subject to SE tax (are the taxpayer's earnings from a "trade or business")? If so, that 3.8% tax rate probably applies. • Unless one of the SE tax exceptions applies. • So let's examine Section 1402 and its regulations. 29

30. SE Taxes • Starting Point. "gross income…from any trade or business carried on by the individual…less deductions…[or] which are attributable to [a] trade or business carried on by a partnership of which he is a member…" Code § 1402(a). • Exceptions: • Rentals from real estate and personal property leased with it, unless received in the course of a trade or business as a real estate developer. Code § 1402(a)(1). • Traditional investment income unless received in the course of a trade or business as a dealer. Code § 1402(a)(2). • Guaranteed payments by a partnership. Prop. Reg. Section 1.1402(a)-1(b). • Certain payments to retired partners (Code § 736 payments) Code § 1402(a)(10). • The distributive share of a limited partner. Code § 1402(a)(13). 30

31. Limited Partner Status • Since 1997, taxpayers have looked to proposed regulations to determine their SE status when an owner in an unincorporated business entity. Prop. Reg. Section 1.1402(a)-2, et seq. • These proposed rules combine concepts from state law and tax law to try and place LLC members on an equal footing with traditional limited partners. 62 Fed. Reg. 1702 (1997). The factors include: • Personal Liability • Authority to contract • 500 hours of participation in the entity's trade or business. • Special rules for bifurcated interests and examples are included. Prop. Reg. Section 1.1402(a)-2(h). 31

32. Interim Summary • Always prefer capital gain to ordinary income. • With ordinary income, looking to avoid: • Passive/Investment Income Treatment; • S.E. tax; and • Compensation. 32

33. Can You Have Your Cake And Eat It Too? • Remember, tax planning often involves choices and the enactment of the Medicare Surtax compounds those complexities, especially with respect to business succession planning. • Tax minimization strategies may not line up with non-tax, estate equalization and transfer tax strategies. 33

34. Some Immediate Planning Observations • Increased use of S Corporations • But, still must avoid "passive" classification. • "Bears and Bulls"; pay some reasonable compensation. • Next come Limited Partnerships and LLCs. • Still must avoid "passive" classification. • Combinations of S corporations and LPs. 34

35. IRS Form 8960 35

36. IRS Form 8960 (con't) 36

37. THE END. Thank you for your kind attention. James M. McCarten | (615) 724-3236 | jmccarten@burr.com