A new 3.8 percent Medicare surtax is now imposed on net investment income collected by higher income individuals, estates and trusts. The tax, which the IRS calls the NIIT, is effective for tax years beginning on or after January 1, 2013.

The NIIT can also have an impact on the income, gains and losses from partnerships and S corporations. This article discusses these issues, based on recent guidance from the IRS.

Partnership and S Corporation Income

When an individual, estate, or trust holds an ownership interest in a partnership or S corporation and the entity passes through gross income, the income and related deductions are counted in calculating the partner or shareholder's taxable income for regular federal income tax purposes. The passed-through income and related deductions are also counted in calculating the partner or shareholder's net investment income for purposes of the 3.8 percent net investment income tax (NIIT) unless the income is derived in the ordinary course of a non-passive business activity (other than the business of trading in financial instruments or commodities).

In other words, passed-through income from a non-passive business activity (other than financial instruments or commodities trading) is exempt from the NIIT.

A non-passive activity is one in which the partner or shareholder materially participates. The most straightforward way to meet the material participation standard is by spending more than 500 hours per year in the activity, but there are other ways too. Consult with your tax adviser for details.

Example 1: Tom owns stock in State Bank, an S corporation engaged in the banking industry. The bank passes through $50,000 of interest income to Tom, who materially participates in the business. Because the interest income is derived in the ordinary course of State Bank's business and because Tom materially participates in that business, the interest income is considered derived from a non-passive business activity. Therefore, it is not included in calculating Tom's net investment income for NIIT purposes.

Variation: If Tom doesn't materially participate in State Bank's business, the $50,000 of passed-through interest income must be included in calculating his net investment income.

Gains Passed Through

When an individual, estate, or trust holds an interest in a partnership or S corporation and the entity passes through a gain or loss from selling an asset, it is taken into account in determining the amount of net gain included in the partner or shareholder's net investment income. However, this is not the case if the gain or loss is from an asset held in a non-passive business activity (other than financial instruments or commodities trading).

Example 2: Sturdy Corporation is an S corporation engaged in the construction industry. Alicia owns stock in the business. If Sturdy Corp. sells an asset for a gain, the determination of whether Alicia's passed-through share of the gain is included in calculating her net investment income for NIIT purposes depends on:

  • Whether Sturdy Corp. held the asset in its business and
  • If it did hold the asset in its business, whether Alicia materially participated in that business.

If Sturdy Corp. held the asset in its business and Alicia materially participates in the business, the passed-through gain from the asset sale is not included in calculating her net investment income. If both of those two conditions are not met, however, the passed-through gain from the asset sale must be included in Alicia's net investment income.

Gains from Selling Partnership and S Corp Interests

General Rule: According to the proposed regulations, an interest in a partnership or S corporation is generally considered to be held in passive business activity. In such case, the gain or loss from selling an interest is included in calculating the selling partner or shareholder's amount of net gain that is included in net investment income for NIIT purposes.

Exception for Interests Held in Non-Passive Business: Subject to a complicated special rule explained immediately below, a gain or loss from selling a partnership or S corporation interest that is considered held in a non-passive business activity is not taken into account in determining the selling partner or shareholder's net investment income. One example of a partnership and S corporation interest that would be considered held in a non-passive business activity is a service provider's interest in a personal service partnership or S corporation -- such as a medical or dental practice.

Special Gain/Loss Adjustment Rule

When all or part of the partnership or S corporation interest in question is considered held by the selling partner or shareholder in a non-passive business, a special gain/loss adjustment rule is used to implement the aforementioned exception. The intent of the special rule is to exclude from the selling partner or shareholder's net investment income the portion of the gain or loss that is deemed to come from assets that are held in a non-passive business.

Eligibility: The special gain/loss adjustment rule is only available when the following two conditions are satisfied with respect to the partnership or S corporation interest being sold.

1. The partnership or S corporation is engaged in one or more businesses other than the business of trading in financial instruments or commodities.

2. The selling partner or shareholder materially participates in at least one of those businesses.

Therefore, the special gain/loss adjustment rule is inapplicable when:

  • There is no business at the entity level;
  • The entity's business or businesses are passive activities with respect to the selling partner or shareholder; or
  • The entity's only activity is trading in financial instruments or commodities.

In these situations, the net gain or loss for NIIT purposes from selling the partnership or S corporation interest is calculated in the usual fashion by subtracting the tax basis of the interest from the net sale proceeds -- without any adjustment in the resulting net gain or loss.

Example 3: ABC Landscaping is a general partnership owned by two individuals. Andy owns a 60 percent interest, and Betty owns the remaining 40 percent interest. ABC owns several assets, all of which are used in the landscaping business. Andy materially participates in ABC's business, but Betty does not.

In 2013, Andy sells his ABC interest for a net sale price of $600,000, and Betty sells her ABC interest for a net sale price of $400,000. At the time of sale, Andy's basis in his interest is $120,000, and Betty's basis in her interest is $80,000. For regular federal income tax purposes, Andy has a $480,000 gain from the sale of his interest ($600,000 minus $120,000), and Betty has a $320,000 gain ($400,000 minus $80,000).

Under the eligibility provision explained above, Andy is eligible for the special gain/loss adjustment rule. He should use it to calculate the gain from the sale of his ABC interest for NIIT purposes. If he does, the amount of gain he will have to include in his net investment income will be less than his regular tax gain of $480,000. The reduced gain will result in a lower NIIT bill, which is good news for Andy.

Betty is ineligible for the special rule because she didn't materially participate in the landscaping business. Therefore, she must include her entire $320,000 gain from selling her passive interest in ABC when calculating her net investment income for NIIT purposes.

Mechanics: The special gain/loss adjustment rule is implemented by using an asset-by-asset hypothetical sale gain/loss calculation. The selling partner or shareholder calculates the gains and losses that would result from the hypothetical sale of all the underlying assets of the entity for fair market value.

If the hypothetical sale results in a required adjustment, the gain/loss calculated under the regular federal income tax rules is adjusted to arrive at the net gain/loss amount that must be taken into account in arriving at net investment income for NIIT purposes. (Proposed Treasury Regulation 1.1411-7)

Plan Ahead

You may be able to reduce or avoid the NIIT by taking steps to lower your MAGI and/or lower your net investment income. For example, you may be able to spend enough extra hours in a partnership or S corporation activity to make the income non-passive and therefore exempt from the NIIT. Also, partnerships and S corporations can sell assets that will produce losses to offset gains and thereby reduce their owners' exposure to the tax. In addition, you can lower your MAGI by making larger deductible contributions to tax-favored retirement plans and accounts for the 2013 tax year. Consult with your tax adviser about your situation.

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