Impact of sec. 1411 on S corporations and their shareholders.

• Author: Sand, Becki

One of the more significant changes to the tax landscape in recent years is the new 3.8% tax on net investment income under Sec. 1411. This tax, which was further clarified in recently finalized regulations, will affect many entities and taxpayers including S corporations and their shareholders. The following discussion outlines noteworthy aspects of these rules pertaining to S corporations and their owners.

In General

Effective for tax years beginning on or after Jan. 1, 2013, Sec. 1411 imposes a tax of 3.8% on the lesser of (1) an individual's net investment income or (2) the excess (if any) of the taxpayer's modified adjusted gross income over certain thresholds. Sec. 1411(c) defines net investment income as the sum of:

1. Gross income from interest, dividends, annuities, royalties, and rents (other than such items that are derived in the ordinary course of a trade or business that is not a passive activity with respect to the taxpayer or trade or business of trading in financial instruments or commodities);

2. Gross income from passive activities under Sec. 469 with respect to the taxpayer or from the trade or business of trading in financial instruments or commodities; and

3. Net gain attributable to the disposition of property other than property held in a trade or business that is not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities.

   Net investment income is reduced by certain allowable expenses, as detailed in Regs. Sec. 1.1411-4(f).

   Issued on Dec. 2, 2013, the final regulations under Sec. 1411 (T.D. 9644) generally apply to tax years beginning after Dec. 31, 2013. While the final regulations clarify many areas of uncertainty under the prior proposed regulations, several issues remain for S corporations and their shareholders to consider with respect to Sec. 1411.

   Materially Participating vs. Passive Shareholders

   One of the first determinations to be made is whether an S corporation shareholder materially participated in the business. If the shareholder materially participated in the business, the shareholder's share of the trade or business income is not treated as net investment income and is therefore not subject to the additional 3.8% tax. If the shareholder did not materially participate in the business, the shareholder's allocable portion of the business income is considered passive income and is includible as net investment income.

   To materially participate in a business for a particular year, the shareholder must meet one of the following seven tests discussed in Temp. Regs. Sec. 1.469-5T(a):

1. The shareholder participated in the activity for more than 500 hours during the year;

2. The shareholder's participation in the activity constituted substantially all the participation of all individuals in the activity;

3. The shareholder participated for more than 100 hours in the activity, and the shareholder's hours were not less than those of any other participant in the activity;

4. The activity is a significant participation activity for the year, and the shareholder's aggregate participation in all significant participation activities exceeded 500 hours;

5. The shareholder materially participated in the...