Net Investment Income Tax 3.8% – Net Investment Income – Application to Businesses

26 C.F.R. § 1.1411-5 Trades or businesses to which tax applies.  (a) In general. A trade or business is described in this section if suchtrade or business involves the conduct of a trade or business, and suchtrade or business is either —  (1) A passive activity (within the meaning of paragraph (b)of this section) with respect to the taxpayer; or  (2) The trade or business of a trader trading in financial instruments(as defined in paragraph (c)(1) of this section) or commodities (asdefined in paragraph (c)(2) of this section).  (b) Passive activity— (1) In general. A passive activity is described inthis section if —  (i) Such activity is a trade or business; and  (ii) Such trade or business is a passive activity with respect to thetaxpayer within the meaning of section 469 and the regulations thereunder.  (2) Application of income recharacterization rules— (i) Income and gainrecharacterization. To the extent that any income or gain from a trade orbusiness is recharacterized as “not from a passive activity” by reason of§ § 1.469-2T(f)(2), § 1.469-2(f)(5), or § 1.469-2(f)(6), such trade orbusiness does not constitute a passive activity within the meaning ofparagraph (b)(1)(ii) of this section solely with respect to suchrecharacterized income or gain.  (ii) Gain recharacterization. To the extent that any gain from a tradeor business is recharacterized as “not from a passive activity” by reasonof § 1.469-2(c)(2)(iii) and does not constitute portfolio income under §1.469-2(c)(2)(iii)(F), such trade or business does not constitute apassive activity within the meaning of paragraph (b)(1)(ii) of thissection solely with respect to such recharacterized gain.  (iii) Exception for certain portfolio recharacterizations. To the extentthat any income or gain from a trade or business is recharacterized as”not from a passive activity” and is further characterized as portfolioincome under § 1.469-2T(f)(10) or § 1.469-2(c)(2)(iii)(F), then such tradeor business constitutes a passive activity within the meaning of paragraph(b)(1)(ii) of this section solely with respect to such recharacterizedincome or gain.  (3) Examples. The following examples illustrate the principles ofparagraph (b)(1) of this section and the ordinary course of a trade orbusiness exception in § 1.1411-4(b). In each example, unless otherwiseindicated, the taxpayer uses a calendar taxable year, the taxpayer is aUnited States citizen, and Year 1 and all subsequent years are taxableyears in which section 1411 is in effect:  Example 1. Rental activity. A, an unmarried individual, rents acommercial building to B for $50,000 in Year 1. A is not involved in theactivity of the commercial building on a regular and continuous basis,therefore, A’s rental activity does not involve the conduct of a trade orbusiness, and under section 469(c)(2), A’s rental activity is a passiveactivity. Because paragraph (b)(1)(i) of this section is not satisfied,A’s rental income of $50,000 is not derived from a trade or businessdescribed in paragraph (b)(1) of this section. However, A’s rental incomeof $50,000 still constitutes gross income from rents within the meaning of§ 1.1411-4(a)(1)(i) because rents are included in the determination of netinvestment income under § 1.1411-4(a)(1)(i) whether or not derived from atrade or business described in paragraph (b)(1) of this section.  Example 2. Application of grouping rules under section 469. In Year 1,A, an unmarried individual, owns an interest in PRS, a partnership forFederal income tax purposes. PRS is engaged in two activities, X and Y,which constitute trades or businesses, and neither of which constitutetrading in financial instruments or commodities (within the meaning ofparagraph (a)(2) of this section). Pursuant to § 1.469-4, A has properlygrouped X and Y together as one activity (the grouped activity). Aparticipates in X for more than 500 hours during Year 1 and would betreated as materially participating in activity X within the meaning of §1.469-5T(a)(1) if A’s material participation were determined only withrespect to activity X. A only participates in Y for 50 hours during Year1. If not for the grouping of the X and Y activities together, A would notbe treated as materially participating in Y within the meaning of §1.469-5T(a). However, pursuant to §§ 1.469-4 and 1.469-5T(a)(1), Amaterially participates in the grouped activity. Therefore, for purposesof paragraph (b)(1)(ii) of this section, neither X nor Y is a passiveactivity with respect to A. Accordingly, with respect to A, neither X norY is a trade or business described in paragraph (b)(1) of this section.  Example 3. Application of the rental activity exceptions. B, anunmarried individual, is a partner in PRS, which is engaged in anequipment leasing activity. The average period of customer use of theequipment is seven days or less (and therefore meets the exception in §1.469-1T(e)(3)(ii)(A)). B materially participates in the equipment leasingactivity (within the meaning of § 1.469-5T(a)). The equipment leasingactivity constitutes a trade or business. In Year 1, B has modifiedadjusted gross income (as defined in § 1.1411-2(c)) of $300,000, all ofwhich is derived from PRS. All of the income from PRS is derived in theordinary course of the equipment leasing activity, and all of PRS’sproperty is held in the equipment leasing activity. Of B’s allocable shareof income from PRS, $275,000 constitutes gross income from rents (withinthe meaning of § 1.1411-4(a)(1)(i)). While $275,000 of the gross incomefrom the equipment leasing activity meets the definition of rents in §1.1411-4(a)(1)(i), the activity meets one of the exceptions to rentalactivity in § 1.469-1T(e)(3)(ii) and B materially participates in theactivity. Therefore, the trade or business is not a passive activity withrespect to B for purposes of paragraph (b)(1)(ii) of this section. Becausethe rents are derived in the ordinary course of a trade or business notdescribed in paragraph (a) of this section, the ordinary course of a tradeor business exception in § 1.1411-4(b) applies, and the rents are notdescribed in § 1.1411-4(a)(1)(i). Furthermore, because the equipmentleasing trade or business is not a trade or business described inparagraph (a)(1) or (a)(2) of this section, the $25,000 of other grossincome is not net investment income under § 1.1411-4(a)(1)(ii). However,the $25,000 of other gross income may be net investment income by reasonof section 1411(c)(3) and § 1.1411-6 if it is attributable to PRS’sworking capital. Finally, gain or loss from the sale of the property heldin the equipment leasing activity will not be subject to §1.1411-4(a)(1)(iii) because, although it is attributable to a trade orbusiness, it is not a trade or business to which the section 1411 taxapplies.  Example 4. Application of section 469 and other gross income under §1.1411-4(a)(1)(ii). Same facts as Example 3, except B does not materiallyparticipate in the equipment leasing trade or business and therefore thetrade or business is a passive activity with respect to B for purposes ofparagraph (b)(1)(ii) of this section. Accordingly, the $275,000 of grossincome from rents is described in § 1.1411-4(a)(1)(i) because the rentsare derived from a trade or business that is a passive activity withrespect to B. Furthermore, the $25,000 of other gross income from theequipment leasing trade or business is described in § 1.1411-4(a)(1)(ii)because the gross income is derived from a trade or business described inparagraph (a)(1) of this section. Finally, gain or loss from the sale ofthe property used in the equipment leasing trade or business is subject to§ 1.1411-4(a)(1)(iii) because the trade or business is a passive activitywith respect to B, as described in paragraph (b)(1)(ii) of this section.  Example 5. Application of the portfolio income rule and section 469. C,an unmarried individual, is a partner in PRS, a partnership engaged in atrade or business that does not involve a rental activity. C does notmaterially participate in PRS within the meaning of § 1.469-5T(a).Therefore, the trade or business of PRS is a passive activity with respectto C for purposes of paragraph (a)(1) of this section. C’s $500,000allocable share of PRS’s income consists of $450,000 of gross income froma trade or business and $50,000 of gross income from dividends andinterest (within the meaning of § 1.1411-4(a)(1)(i)) that is not derivedin the ordinary course of the trade or business of PRS. Therefore, C’s$500,000 allocable share of PRS’s income is subject to section 1411. C’s$50,000 allocable share of PRS’s income from dividends and interest issubject to § 1.1411-4(a)(1)(i) because the share is gross income fromdividends and interest that is not derived in the ordinary course of atrade or business (that is, the ordinary course of a trade or businessexception in § 1.1411-4(b) is inapplicable). C’s $450,000 allocable shareof PRS’s income is subject to § 1.1411-4(a)(1)(ii) because it is grossincome from a trade or business that is a passive activity.  (c) Trading in financial instruments or commodities— (1) Definition offinancial instruments. For purposes of section 1411 and the regulationsthereunder, the term financial instruments includes stocks and otherequity interests, evidences of indebtedness, options, forward or futurescontracts, notional principal contracts, any other derivatives, or anyevidence of an interest in any of the items described in this paragraph(c)(1). An evidence of an interest in any of the items described in thisparagraph (c)(1) includes, but is not limited to, short positions orpartial units in any of the items described in this paragraph (c)(1).  (2) Definition of commodities. For purposes of section 1411 and theregulations thereunder, the term commodities refers to items described insection 475(e)(2).  (d) Effective/applicability date. This section applies to taxable yearsbeginning after December 31, 2013. However, taxpayers may apply thissection to taxable years beginning after December 31, 2012, in accordancewith § 1.1411-1(f).

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