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Firm Seeks Clarity Under Proposed Net Investment Income Tax Regs

MAR. 5, 2013

Firm Seeks Clarity Under Proposed Net Investment Income Tax Regs

DATED MAR. 5, 2013
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March 5, 2013

 

 

Room 5203

 

Internal Revenue Service

 

PO Box 7604, Ben Franklin Station

 

Washington, DC 20044

 

 

Attention: CC:PA:LPD:PR (REG-130507-11)

 

RE: Comments on Proposed Regulations: Net Investment Income

 

To Whom It May Concern:

We are writing to you in response to Notice of Proposed Rule Making REG-130507-11, in which the Internal Revenue Service (the "Service") proposed regulations (the "Proposed Regulations") concerning the imposition of a new tax under Internal Revenue Code (the "Code"; "Section" references throughout are to the corresponding section of the Code) Section 1411. The Notice of Proposed Rulemaking requested comments from interested parties regarding these Proposed Regulations.

In our practice, we represent a wide range of companies and individuals engaged in a broad spectrum of business activities. Given the wide reach of Section 1411, the interests of these companies and individuals will be significantly affected by the rules contained in the Proposed Regulations.

While the Proposed Regulations offer helpful guidance in many areas, we believe that to ensure fair administration of the law -- and to relieve taxpayers of uncertainty in several crucial areas -- further clarification and revision is necessary. Our comments specifically call on the Service to clarify and, where necessary, revise the Proposed Regulations in light of the following:

 

1. Remaining uncertainties in the application of the "derived/held in a trade or business" exceptions for trades or businesses conducted through tiered pass-through entities.

2. The need for further guidance with respect to the terms "annuity" and "working capital" for purposes of Section 1411.

3. Ambiguities in the provisions relating to the timing for making the election provided under Prop. Reg. § 1.1411-10(g).

 

I. The Trade or Business Exceptions Applied to Tiered Passthrough Entities

 

a. The Missing Link: "Derived In" a Trade or Business

 

The Proposed Regulations provide rules and guidance for determining the scope of the "derived in the ordinary course of a trade or business" exception and the "held in a trade or business" exception available under Sections 1411(c)(1)(A)(i) and (iii), respectively (hereafter, "clause (i)" and "clause (iii)"; likewise "clause (ii)" will refer to Section 1411(c)(a)(A)(ii)). These exceptions, which are found in the statute, are crucial for exempting non-investment income from the reach of the net investment income tax. We believe the Proposed Regulations' application of these exceptions in the context of a trade or business conducted through one or more passthrough entities, at Prop. Reg. Section 1.1411-4(b)(2) and (3), could use significant clarification.

Broadly stated, the "ordinary course of a trade or business" exception1 to net investment income characterization under clause (i) can be broken down into three elements. To qualify for the exception, an item of income:

 

1. must be derived in the ordinary course of a trade or business (with the "ordinary course" determination being a sub-element not present in the clause (iii) exception);

2. must not be derived in a trade or business that is passive with respect to the taxpayer; and

3. must not be derived in a trade or business of trading financial instruments or commodities.

 

Proposed Regulation Section 1.1411-4(b)(2)(i) provides that the determination of whether income is derived in a trade or business that is passive with respect to the taxpayer/owner (i.e., the second element of the test) will be determined "at the owner level."

Proposed Regulation Section 1.1411-4(b)(2)(ii) offers guidance on the third element: the determination of whether income is derived in a trade or business of trading in financial instruments or commodities is made at the entity level.

However, oddly absent from the Proposed Regulations is a rule for determining how, and at what level, to apply the first (and arguably, most crucial) element of the test in the case of a trade or business conducted through a chain of one or more passthrough entities. Given that it is not uncommon for taxpayers to engage in one or more trades or businesses through tiered passthrough entities (in which different trades or businesses may be engaged in by different entities in the chain, while some entities may not be engaged in any trade or business), it is critical for taxpayers to have a clear rule for attributing any given item of income to a particular trade or business (or to a non-trade or business activity) in this context. Instead, however, taxpayers are apparently left to infer from Example 1 ("the UTP/LTP example") and Example 3 of Prop. Reg. Section 1.1411-4(b)(3) what the intended rule on this point may be.

The UTP/LTP example explains that where dividends are directly received by a lower tier partnership (LTP) not engaged in a trade or business, those dividends are not derived in a trade or business with respect to a partner, A, of an upper tier partnership (UTP) owning an interest in LTP, even if UTP itself is engaged in a trade or business. Neither of the rules in Prop. Reg. Section 1.1411-4(b)(2) appear to speak to this result -- the example does not specify whether any of A, UTP or LTP is engaged in the trade or business of trading financial instruments or commodities, and it is not specified whether any trade or business that is relevant to a determination under the UTP/LTP example is a passive activity for A -- although the Proposed Regulations indicate that the example is an "illustration" of the principles set forth under the rules of Prop. Reg. Section 1.1411-4(b)(2). The Preamble notes this result holds "even if (1) [A] is engaged in a trade or business, (2) [A] provides services with respect to UTP's trade or business, and/or (3) [A] provides services to LTP." Preamble Section 5.A.vi.(a). The unstated inference is that for an item of income to be "derived in" a trade or business for purposes of the first element, it must be that the income is incurred in the ordinary course of a trade or business engaged in by the passthrough entity that first recognizes the income.

Example 3 of Prop. Reg. Section 1.1411-4(b)(3) provides a counterpoint to Example 1. There, S (an S corporation) is engaged in a banking trade or business that is not a passive activity with respect to S-shareholder C. C's proportionate income from S is not deemed net investment income, even though the example does not specify whether C herself is engaged in a trade or business, which under a naive reading of Prop. Reg. Section 1.1411-4(b)(2)(i) would otherwise appear to be a crucial fact.

It appears to us that the rule intended to be illustrated by the examples is that whether income is "derived in" a trade or business (whether or not such trade or business is trading in financial instruments or commodities) is determined "at the entity level" and the determination of whether such trade or business is a passive activity is determined "at the owner level." We would thus propose, as further outlined below, that the final regulations reflect a rule that is consistent with this approach and with the examples of the Proposed Regulations.

 

b. Overbreadth in the UTP/LTP Example

 

Assuming that the Service intends to determine "derived in a trade or business" in all cases at the entity level as discussed above, we remain concerned that the UTP/LTP example was too broadly drawn, especially in light of certain language in the Preamble suggesting an expansive reading of this example. The Preamble notes that "[a]ny income described in Section 1411(c)(1)(A)(i) passed through from LTP (through UTP) to B will not be derived in a trade or business because LTP is not engaged in a trade or business" (emphasis added). We are concerned that this language suggests that an intervening non-trade-or-business passthrough entity can "taint" an otherwise good trade or business in which a taxpayer is active under Section 469 principles where a taxpayer happens to hold its interest in the trade or business through an entity that is not itself engaged in a trade or business.

For example, assume individual A operates and owns 50% of two restaurants R1 and R2 in partnerships LTP1 and LTP2, respectively. Because both entities are engaged in a trade or business, the Proposed Regulations provide that so long as the businesses are not passive activities with respect to A, the net investment income tax will not apply. But now suppose A, for valid business reasons (for example, for liability insulation and to raise capital for the combined operations), forms a new holding partnership UTP with passive investor B. A contributes his interests in LTP1 and LTP2 to UTP, B contributes capital, and A continues to operate the restaurants in a way that qualifies A as non-passive with respect to the trade or business under the Section 469 rules.2

As we note above, the Preamble can be read to suggest that because income passes through from LPT1 and LPT2 to UTP, and in turn, to A, items of A's income from the restaurant trade or business may become subject to the net investment income tax under either clause (i) or clause (iii). This strikes us as an illogical and unwarranted result -- we do not believe that Congress intended the results under Section 1411 to turn on nuances in investment structure when a taxpayer receives income in the ordinary course of his trade or business.

Furthermore, if an intervening entity can "taint" all of the income that passes through it for purposes of clause (i) and clause (iii), taxpayers may seek to argue that the same intervening entity can "cleanse" income for purposes of clause (ii). In other words, B in our example could argue that because UTP is not engaged in a trade or business, B should not be taxed on "other gross income derived from a trade or business described in paragraph (2)" because -- as the UTP/LTP example indicates -- there is no "trade or business" at all after the incomes passes through the holding partnership UTP. We believe that Congress intended precisely the opposite, and that the correct result under our example is that B is taxed under Section 1411, but A is not.

 

c. Recommendations

 

Consistent with the observations above, we recommend that Prop, Reg. Section 1.1411-4(b)(2) be revised to indicate that in determining whether the "derived in the ordinary course of a trade or business" exception applies: (1) whether income is "derived in" any trade or business should be determined the first non-disregarded passthrough entity that recognizes the income in question, and (2) whether the trade or business in which the income is derived is a passive activity with respect to an owner should be determined at the owner level. We recommend further that the final regulations provide an example confirming that the presence of a "holding partnership" does not taint otherwise good trade or business income.

Additionally, we believe the final regulations should include an example applying the term "derived from a trade or business" under clause (ii) in the tiered partnership setting. Specifically, this example should illustrate that a distributive share of partnership income will be treated as "derived from" a trade or business which is a passive activity with respect to the partner-taxpayer only if: (i) the first non-disregarded pass-through entity which recognizes earns income in the ordinary course of its trade or business, and (ii) the taxpayer is not active with respect to such lowest-tier trade or business. As noted above, absent guidance on this point, taxpayers may seek to argue in some instances that income received through a chain of passthrough entities is "derived from" the trade or business of a higher-tier partnership in which they are active, and hence not "derived from" the underlying trade or business of a lower-tier partnership with respect to which they are passive.

Finally, although the Preamble (at paragraph 6.B) currently acknowledges that certain types of income may not be subject to tax at all under Section 1411, even if such income is not explicitly excepted from the tax under clauses (i) and (iii) or incurred in a trade of business which is not a passive activity, we believe it would be helpful if the final regulations confirmed this proposition. We believe the best way to illustrate this principle is inclusion of one or more examples of income not subject to tax under Section 1411 despite the fact such income is not incurred in connection with a non-passive trade or business of the taxpayer. Potential examples could include hobby income, income derived from incidental or occasional activities of a taxpayer that do not amount to a trade or business (e.g. speaking fees), gambling income, etc.

II. A Lack of Precision: "Annuity" and "Working Capital"

 

A. Annuity

 

The Proposed Regulations do not define the term "annuity" for purposes of Section 1411. Instead, the Proposed Regulations rely on the Chapter 1 principles to determine whether a financial instrument constitutes an annuity. Treas. Reg. Section 1.72-2(b)(2) provides three elements in determining whether an item is an "amount received as an annuity":

 

1. A fixed "annuity starting date";

2. Payable in periodic installments at regular intervals;

3. A determinable amount payable.

 

This expansive definition of "annuity" may be justifiable when confined to Chapter 1, where Section 72 serves as a helpful backdrop to more specific Chapter 1 provisions governing other types of income that arguably constitute "annuities" (for example, social security under Section 86, and alimony under Section 71, and amounts paid out as an accident or health benefit under Sections 104 and 105). But the concept of an "annuity" imported from Chapter 1 into Chapter 2a may prove to be more powerful and more expansive than the Service intends. Chapter 1 is filled with safety mechanisms to ensure that many payments fitting the definition of "annuity" are separately addressed under more specific provisions of the code.

The Proposed Regulations attempt to adopt a few of these limitations by importing Chapter 1 exclusions of items that might otherwise constitute "annuities." Thus, the exclusion of proceeds of life insurance contracts, for example, which are exempted from taxable income under Section 101, will not trigger the net investment income tax.

But this isn't enough. Exclusions from income are only half of the story when it comes to annuities. Chapter 1 also provides for ordering principles to ensure that many items of income falling within the expansive technical definition of "annuity" are not actually taxed as annuities under Chapter 1, which means that streams of income like social security and alimony -- while generally meeting the definition of an annuity under the Section 72 regulations -- are not swallowed up. The same cannot be said of Chapter 2a when the Proposed Regulations import only a portion of the limitations on annuity treatment under Chapter 1.

Given the lack of appropriate limiting provisions in Section 1411, we respectfully request that the final regulations provide that only items of income for which a taxpayer is liable under Section 72(a) are subject to the 3.8% tax on net investment income. In turn, any item of income not taxed under Section 72(a) falls outside of the ambit of Section 1411.

 

B. "Working Capital"

 

As the Service acknowledges in the Preamble to the Proposed Regulations, "The term working capital is not defined in either section 469 or section 1411." The only guidance provided in the Proposed Regulations sends taxpayers to Treas. Reg. Section 1.469-2T(c)(3)(iii), which indicates that income derived from working capital is a per se active item of income without offering a definition of "working capital."

Once again, the Service is introducing a needlessly expansive provision into Chapter 2a without providing appropriate safeguards. In nearly every case under Section 469, working capital -- however that term is understood -- is unlikely to result in a change to the characterization of income as active or passive. Under the passive activity rules, working capital is almost always going to produce portfolio income, which is itself per se active under Section 469(e)(1)(a)(i)(I). And so, because it merely duplicates work done by the portfolio income rules, the specific provision in the Section 469 rules addressing working capital will, as a practical matter, almost never impact a taxpayer's position under the passive activity rules.

Not so under Section 1411. In the text of the statute Congress provides that income from active business assets are not subject to Section 1411, while income from working capital is subject to Section 1411. The result is that a dividing line that was largely immaterial and easily forgotten for Chapter 1 purposes becomes incredibly important under Chapter 2a.

Take, for example, the taxpayer described in Example 3 of Prop. Reg. Section 1.1411-4(b)(3). There, C is engaged in a banking trade or business that qualifies for the "ordinary course of a trade or business" exception. Suppose, however, that in his business, C customarily makes loans ranging in term from five to twenty years. Suppose further that C keeps uncommitted funds in low-risk investments lasting two years or less. Are these shorter term investments "working capital" within the meaning of Section 1411? What if the investments had a term of 9 months? What if they had a term of a single day? Without guidance on this point, taxpayers are left to speculate about where the divide lies.

The lack of definition for "working capital" in the Proposed Regulations thus imposes significant uncertainty on taxpayers earning interest, dividends, annuities, rents, or royalties in the ordinary course of an active trade or business. We therefore respectfully request that the Service provide further guidance with respect to the definition of "working capital" in the final regulations.

III. Ambiguity in the Timing for Making a Section 1.1411-10(g) Election

As a final matter, we recommend that the Service clarify the timing for making an election under Prop. Reg. Section 1.1.1411-10(g), which provides that:

 

Except as otherwise provided in this paragraph (g)(3), an individual, estate, or trust that wants to make the election under this paragraph (g) must make the election for the first taxable year beginning after December 31, 2013, during which the individual, estate, or trust directly or indirectly holds stock of a controlled foreign corporation or qualified electing fund and the individual, estate, or trust is subject to tax under section 1411 or would be subject to tax under section 1411 if the election were made with respect to the stock of the controlled foreign corporation or qualified electing fund.

 

We are concerned that the plain language of this provision poses a serious problem: as currently written, the Prop. Reg. Section 1.1411-10(g) election must be made the first year the taxpayer is "subject to tax" under Section 1411, irrespective of the type of income that gives rise to the Section 1411 tax liability. As such, Section 1411 liability wholly unrelated to the CFC or QEF rules could trigger the election timing requirement as written, leading to patently unfair (and likely unintended) results in a multitude of situations.

For example, suppose a taxpayer purchases the stock of a domestic corporation (DC) and the stock of a controlled foreign corporation (CFC) in Year 1. If the taxpayer is "subject to tax" under Section 1411 on a $100 dividend from DC in Year 1, but does not have any Chapter I inclusion with respect to CFC until Year 20, the Proposed Regulations still require the Prop. Reg. Section 1.1411-10(g) election to be made in Year 1. This strikes us as a trap for the unwary without any practical justification.

Given the complexity of the QEF and CFC rules under Chapter 1 of the Code -- especially in light of the fact that a taxpayer is unlikely to focus on the Code section 1411 consequences of owning CFC stock until he recognizes subpart F inclusions with respect to such stock -- we believe that the better approach is to allow a taxpayer to wait until a Chapter 1 inclusion before requiring an election under Prop. Reg. Section 1.1411-10(g). We therefore respectfully request that the Service modify the timing provisions under Prop. Reg. Section 1.1411-10(g) such that a taxpayer is not expected to make the election under Prop. Reg. Section 1.1411-10(g) until the year ownership of stock in a QEF or CFC gives rise to a Chapter 1 inclusion.

Sincerely,

 

 

Joel Peters-Fransen

 

Adam Michael Kool

 

Kirkland & Ellis LLP

 

Chicago, IL

 

FOOTNOTES

 

 

1 The discussion below, for ease of reference, generally refers only to the clause (i) "derived in the ordinary course of a trade or business" exception, but is intended also to apply to the "held in" trade or business exception under clause (iii), with appropriate modifications.

2 While this example is not strictly inconsistent with the language quoted from the preamble, adding an additional partnership tier ("TTP") between A and UTP through which A ultimately derived the LTP1/LTP2 income would cause such income to be "passed through from [U]TP (through [T]TP) to A" and hence apparently "not derived in a trade or business because [U]TP is not engaged in a trade or business."

Furthermore, it does not appear to us that it would be appropriate to impute the trade or business of LTP to UTP. See Rev. Rul. 2008-39; Rev. Rul. 2008-12.

 

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