I will probably be doing a few posts this week on the net investment income tax regulations issued by the IRS last week. The IRS also issued new proposed regulations regarding how to calculate the amount of gain required to be included in investment income when you sell a partnership or S corporation interest. In today's post, we will discuss these new proposed regulations.
The old proposed regulations required a taxpayer to take their gain from selling an interest in a partnership or S corporation and then subtract the part of gain that was attributable to non-passive assets to arrive at the amount of gain that should be included in investment income. If the hypothetical gain inside of the entity was greater than your actual gain, then none of the gain would be reported as investment income (assuming no passive or investment assets in the entity). However, if the gain inside of the entity is less than your share of the gain, then part of the gain would be considered investment even though all of the assets are material. Here is a quick example:
Assume John sold a partnership interest for $300,000 and his gain is $100,000 resulting in a $200,000 gain. If his share of the gain inside of the partnership (based on a hypothetical sale) was $200,000 or more, then none of the gain would be considered investment income (assuming all assets are non-investment and non-passive). However, if his share of the gain inside the partnership was $100,000, then $100,000 of his gain would be considered investment income and subject to the 3.8% tax.
Many commentators caught this anomaly plus the administrative burden of trying to determine the gain from a hypothetical sale of all assets inside of the entity caused the IRS to change their proposed methodology to require you to only include gain attributable to investment or passive assets inside the entity. They also provide for an optional simplified method of calculating your gain if you meet one of the following two tests:
Test # 1: Your total gain is less than $250,000, or
Test # 2: Your total gain is less than $5 million and your share of investment income flowing through from the entity is less than 5% of total income (losses are shown as a positive) for the current year plus the last two years.
Here is an example:
Farmer Bean sells his 50% interest in Farmco, Inc. (an S corporation that he materially participates in) for $500,000. His basis is $100,000 resulting in a $400,000 gain. Since his gain is greater than $250,000, we have to look at the items of income flowing to him on his k1 for this year and the previous two years. Assume his ordinary income from farming was $750,000 and he received interest income of $15,000. Since $15,000 is less than 5% of $765,000, he can use the optional simplified method.
Once we determine that we can use this method, we now have to calculate the amount of gain that is investment under this method. We take $15,000 / $765,000 which is 1.961% which is then multiplied by the total gain of $400,000 to arrive at $7,844 of investment gain to report.
For most taxpayers, this may not seem tooooo simplified, but for tax advisors this is much easier for us to calculate than the old proposed regulations requirement.
I will cover other aspects of the new final regulations later this week.