The 3.8% Medicare tax proposed regulations: guidance or more questions?

• Author: Chambers, Valrie

This item discusses provisions addressed in the 3.8% Medicare tax proposed regulations (REG-130507-11) pertaining to the definition of business income as net investment income, grouping of activities, and treatment of the sale of S corporation stock and partnership interests. For a general discussion of the 3.8% net investment income tax, see the preceding item.

If a taxpayer owns shares in an S corporation, a partnership interest, a sole proprietorship, or a single-member LLC (disregarded), any income or gain from the activity is treated as net investment income unless all four of the following requirements are met:

1. The activity is an active trade or business with respect to the taxpayer.

2. The income is derived in the ordinary course of that trade or business. Note that income derived from working capital (e.g., interest on certain business bank accounts) is not treated as derived from a trade or business and therefore is subject to the net investment income tax (Sec. 1411(c)(4)). The example provided in Prop. Regs. Sec. 1.1411-6(b) illustrates this provision.

3. The activity is not a passive activity pursuant to Sec. 469.

4. The activity does not consist of trading in financial instruments or commodities.

Therefore, if the income earned is not from a trade or business activity, material participation will not matter. Also, stacking activities in separate passthrough entities will not change the character of the income (see Prop. Regs. Sec. 1.1411-4(b) (3), Example (1)).

Keep in mind Sec. 469 treats a rental activity as passive unless the taxpayer is considered a real estate professional who materially participates in the activity. Note also that Sec. 469 treats investment income, including interest and dividends of S corporations and partnerships, as portfolio income. As such, it is not earned in the ordinary course of a trade or business and, thus, regardless of the other exceptions, is subject to the net investment income tax.

Because one of the above exceptions is that the activity is not classified as passive under Sec. 469, taxpayers should take advantage of a "fresh start" opportunity that the IRS has granted to regroup their activities. The proposed regulations provide that taxpayers may regroup their activities in the first tax year beginning after Dec. 31, 2013, in which they meet the applicable income threshold and have net investment income. Further, taxpayers may regroup activities in reliance on the proposed regulations...