CPA Firm Seeks Clarity Under Proposed Net Investment Income Tax Regs

Dear Sir or Madam:

BKD, LLP respectfully submits the following comments concerning the proposed regulations regarding the Net Investment Income Tax (REG-130507-11). BKD, LLP, is one of the largest CPA and advisory firms in the U.S., with 30 offices in 13 states. BKD, LLP appreciates the opportunity to comment.

We are providing comments on the following sections contained within REG-130507-11:

• Application of § 1411 to income from grouped self-rental activities

• Determination of passive activity income for estates and trusts

• Real estate professionals and active trade or businesses

For purposes of computing the 3.8 percent Net Investment Income Tax, Net Investment Income ("NII") under Proposed Regulation § 1.1411-4 includes the sum of gross income from interest, dividends, annuities, royalties, rents and other gross income from a passive activity trade or business . . . less properly allocable deductions.

The proposed regulations under § 1411 are not clear as to whether rental income treated as not derived from a passive activity due to the self-rental recharacterization rule of Reg. § 1.469-2(f)(6) would be treated as NII under Reg. § 1.1411-4, assuming a grouping election is made under Reg. § 1.469-4.

The self-rental recharacterization rule of Reg. § 1.469-2(f)(6) affects taxpayers who rent property to a trade or business in which they materially participate. Under this rule, rental activity losses are passive, but gross rental activity income is treated as not derived from a passive activity (assuming the property is not rented incidental to a development activity).

Under Reg. § 1.469-4(d)(1), a rental activity can be grouped with a trade or business activity so long as the activities grouped together constitute an appropriate economic unit and:

• The rental activity is insubstantial in relation to the trade or business activity;

• The trade or business activity is insubstantial in relation to the rental activity; or

• Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.

To illustrate our uncertainty as to whether the NII tax would apply to non-passive self-rental income from a grouped activity, we first provide an excerpt from Section 6.B.i.c.1.III of the Preamble to the proposed regulations:

Treasury's position in the previous excerpt appears to contradict Section 6.B.i.b.4 of the Preamble to the proposed regulations, which states:

Based on the aforementioned excerpts from the preamble to the proposed regulations, it appears that gross income from a rental activity for which a grouping election has been made will not be converted into passive activity income subject to the 3.8 percent NII tax.

We suggest the final regulations provide that to the extent there is common ownership in a grouped rental activity and trade or business activity, the rental income would be treated as derived from an active trade or business, and not tested independently to determine whether the rental activity itself a trade or business under § 162.

Determination of Passive Activity Income for Estates and Trusts

Under § 1411(a)(2), the 3.8% NII tax for trusts and estates applies to the lesser of:

In light of the new NII tax applicable to passive activity trade or business income in excess of the aforementioned thresholds, we believe Treasury should provide guidance in the proposed § 1411 Regulations indicating what constitutes material participation for estates and trusts. Absent such guidance, taxpayers are left with uncertainty on determining material participation for trusts and estates.

In the Senate Committee Report for the Tax Reform Act of 1986, Congress provides that a trust is, "treated as materially participating in an activity (or as actively participating in a rental real estate activity) if an executor or fiduciary, in his capacity as such, is so participating. However, the Blue Book for the Tax Reform Act of 1986 states, "it is unlikely that a trust as such for Federal income tax purposes will be materially participating in a trade or business activity, within the meaning of the passive loss rule." To the extent a grantor or beneficiary is treated as the owner of the trust, the Joint Committee concludes the material participation of the owner is relevant in determining whether a business activity is passive. In addition, in the case of a qualifying electing Subchapter S Trust, the material participation of the beneficiary is relevant in determining whether the business activity of the S corporation is a passive activity.

In Mattie K. Carter Trust v. U.S., 256 F. Supp. 2d 536, the court held that the ranching activity of a trust was not a passive activity since the trustee met the material participation requirements of § 469. The court concluded the material participation of a trust can be determined based upon the activity of the trustee. The IRS, in TAM 200733023, concluded a trust materially participates in an activity if the fiduciary participates in the operations of the activity on a regular, continuous and substantial basis. Participation is determined solely by reference to a trustee's involvement as a fiduciary. The Service declined to follow the reasoning in the Mattie K. Carter case since the trustee's participation was not in their capacity as a fiduciary.

The above-mentioned guidance is conflicting and leaves taxpayers with uncertainty in determining the material participation of a trust. Imposing a tax on the business activity of a trust without providing a definition of material participation places an undue burden on taxpayers. The rules of § 1411 rely heavily upon the definition of material participation under § 469 to determine if a taxpayer is subject to the 3.8 percent tax on investment income.

Based on the aforementioned ambiguity, we respectfully request Treasury and the IRS to consider providing additional guidance in determining material participation of a trust. One possibility would be to implement a rule that the activity of a trustee in any capacity would count towards the determination of material participation. For example, if a trustee were to spend over 500 hours in the day-to-day operating activities of a trade or business, the trust would materially participate in the activity.

Real Estate Professionals and Active Trade or Businesses

The proposed regulations covering the net income characterizations rules for real estate professionals create confusion as to whether or not rental income of a real estate professional constitutes NII under Reg. § 1.1411-4. Reg. § 1.1411-4 states that gross income from rents is NII except to the extent excluded by the "ordinary course of a trade or business exception." Gross rents are excluded from NII if the income is derived from the ordinary course of a trade or business not described in Reg. § 1.1411-5. Reg. § 1.1411-5 states that income from a trade or business that is a passive activity is NII.

According to the preamble and § 469, the rental real estate activities of a real estate professional are not considered passive activities and would not be subject to Reg. § 1.1411-5. The preamble states, in part:

Based on the foregoing, the determination of whether or not rental income of a real estate professional is net investment income is unclear. We respectfully request Treasury and the IRS provide guidance articulating under what circumstances a real estate professional's activities constitute a trade or business.

If you have any questions on these comments or would like to discuss any of the points raised herein in more detail, please contact Patrick Malayter, Jesse Palmer, Jim Still, Robert Conner or Scott Humphrey at 417.831.7283.