IRS Issues Final and New Proposed Regulations Implementing the 3.8% Tax on Investment Income: Final Regulations and New Proposed Regulations Implement the 3.8% Tax on Net Investment Income of Individuals, Estates and Trusts with Income in Excess of Statutory Thresholds

Sullivan & Cromwell LLP - December 20, 2013

The Internal Revenue Service (the “IRS”) recently adopted final regulations (the “Final Regulations”) and contemporaneously issued new proposed regulations (the “2013 Proposed Regulations”) related to the 3.8% tax on the “net investment income” of individuals, estates and trusts with “modified adjusted gross income” in excess of statutory thresholds (the “NIIT”) that is first effective for taxable years beginning on or after January 1, 2013. The Final Regulations substantially adopt the proposed regulations issued on December 5, 2012 (including the corrections to the proposed regulations published on January 31, 2013, the “2012 Proposed Regulations”), subject to the clarifications and modifications summarized below. For a more detailed summary of the 2012 Proposed Regulations, see S&C Publication “IRS Proposes Regulations Implementing the New 3.8% Tax on Investment Income”, published December 10, 2012.

The Final Regulations differ from the 2012 Proposed Regulations in certain key respects, including: 

  • The Final Regulations withdraw the portion of the 2012 Proposed Regulations that addressed the imposition of the NIIT on the disposition of interests in partnerships and S corporations.
  • The Final Regulations permit the $3,000 capital loss deduction against net investment income, allow certain net operating losses to offset net investment income and permit trading losses to offset the gross trading gains of a trading business.
  • The Final Regulations include numerous other generally helpful clarifications and modifications with respect to the calculation of net investment income and the taxpayers subject to the tax.
  • The Preamble to the Final Regulations acknowledges that a number of issues remain outstanding and require additional guidance, including the material participation of trusts in a trade or business.

The 2013 Proposed Regulations address: 

  • the calculation of net gain on the disposition of a partnership interest or S corporation stock to which the NIIT may apply (providing rules intended to replace those withdrawn by the Final Regulations);
  • the tracking of capital loss carryforwards for purposes of the NIIT;
  • the treatment of guaranteed payments from a partnership to a partner and payments made from a partnership to a retiring or deceased partner;
  • the inclusion of periodic and nonperiodic payments from certain notional principal contracts (“NPCs”);
  • the inclusion of income or deductions from real estate mortgage investment conduit (“REMIC”) residual interests; and
  • the application of the NIIT to income recipients of charitable remainder trusts (“CRTs”).

The Final Regulations and the 2013 Proposed Regulations are effective for taxable years beginning after December 31, 2013 (except for the rules applicable to CRTs, which are effective for taxable years beginning after December 31, 2012). In addition, taxpayers may generally rely on the 2012 Proposed Regulations and Final Regulations for any taxable year that begins after December 31, 2012, but before January 1, 2014.