Practitioner: Filing NII Returns for 2013 Will Be Complicated by Dividend Elections
As pass-through entities subject to the 3.8 percent net investment income tax file their 2013 tax returns, many partnerships, S corporations, qualified electing funds and controlled foreign corporations may find themselves facing a real challenge to comply with the rules due to an election to treat income inclusion as a dividend, a practitioner said recently.
“The problem is for the 2013 year, the only way an entity can make an election” under Treasury Regulations Section 1.1411-10(g) “is to have the consent of all the shareholders or partners,” Jeanne Sullivan, a director with KPMG LLP's Washington National Tax practice, said Feb. 28.
Sullivan spoke on a panel at the 2014 tax law conference sponsored by the Federal Bar Association Section on Taxation.
The Internal Revenue Service issued final rules (T.D. 9644) on tax code Section 1411 in November, as well as accompanying proposed regulations (REG-130843-13) on computing net gain from the disposition of active interest in a pass-through entity.
NII tax is generally imposed on passive income of certain individuals, trusts and estates whose modified adjusted gross income is above certain threshold amounts. Individuals with MAGI above $200,000 are subject to tax. The threshold MAGI for spouses filing a joint return or for a surviving spouse is $250,000, and $125,000 for spouses filing separate returns. NII tax is paid on the lesser amount of either passive income or the amount by which the NII-subject taxpayer exceeds the applicable NII tax income threshold.
Treas. Reg. Section 1.1411-10 generally provides that distributions of previously taxed earnings and profits attributable to Section 951 inclusions and Section 1293 inclusions that aren't treated as dividends for purposes of Chapter 1 under Section 959(d) or Section 1293(c) will be treated as dividends for NII purposes unless an election under Section 1.1411-10(g).
The Art of Obtaining Consent
Guidance on how to obtain unanimous consent was intentionally left vague, David Kirk, an attorney-adviser in the IRS Office of Chief Counsel, Passthroughs & Special Industries, said during the panel. “How do you get consent? That's an art,” Kirk said. There are generally three methods, including having boilerplate language that says that a general partner, managing member or other individual has the ability to make all tax elections, he said.
Other options include the idea of negative consent, in which a partner or shareholder must counter within a certain period of time a decision to proceed with an election, or to try to get full and unanimous affirmative consent, Kirk said. The latter will prove impossible in most cases, Sullivan said.
“There's going to have to be some judgment calls made,” said Kirk.
Tiered partnerships may consider making protective elections, he said. “When you're the lower-tier partnership and you get comfortable that you can make the election with whatever form of consent you can get comfortable with, the upper-tier partnership might not necessarily have the same confidence that the lower-tier actually made an effective election,” Kirk said.
In such a situation, the partnership may want to make a protective election, he said. “But are you sure that your partnership has the appropriate consent? If not, you do it again in 2014.”
The ability to make protective elections before having any income inclusions, “so you don't have to wait and miss it,” is a very helpful part of the regulations, Sullivan said. Nevertheless, reporting for 2013 will be a challenge for many taxpayers and practitioners, she said.
Bumping Into Working Capital Rules
For the purposes of calculating income that may be excluded from NII tax, practitioners and taxpayers should also keep in mind the interplay between activities considered to be “derived in the ordinary course of a trade or business” and the working capital rule, Kirk said.
The IRS has received a number of questions on what happens when a partnership owns a corporation underneath it. Even if a partnership acquires C corporate stock in a proximately related business, if they are receiving dividends, the income will continue to be treated as dividends, he said.
“Even if you could say that these businesses are so proximately related to each other that it is derived in ordinary course of a trade or business under case law, or whatever it is that you can find” to support your claim, “you step into the working capital rule of 1411(c)(3),” which cross references Section 469(e)(1)(B), as well as additional rules on ways in which an item is derived in the ordinary course of trade or business for purposes of Section 469, Kirk said.
“The only way you are getting dividends out is if you are a dealer” in stock or financial instruments, he said. Entities that own domestic corporations or an interest-charge domestic international sales corporation (IC-DISC) will fall into the category of businesses unable to exclude their dividends from a subsidiary or “brother-sister” structure from NII, said Kirk. “Dividends coming out will always be dividends; interest the same way,” he said.
Kirk, one of the principal drafters of the Section 1411 regulations, will be departing the IRS for a new position with EY LLP's Washington National Tax practice on March 3.
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