20 Questions (and 20 Answers!): On the New 3.8 Percent Tax
Richard L. Dees
McDermott, Will & Emery
August 12, 2013
Tax Notes, Vol. 140, Nos. 7 & 8, Aug. 12 & 19, 2013
Originally titled: 20 Questions (and Amazingly 20 Answers) on the Application of the New 3.8% Tax to Trusts and Family Businesses; (shortened for publication).
Twenty Questions asks and answers, to the extent answers exist, 20 questions about the application of the new 3.8% tax on net investment income under Code Section 1411 to trusts and family businesses. Because the income threshold for the application of the tax to trusts and estates is only $11,950, nearly every trustee will need to plan to minimize the tax. The tax is particularly harsh on trusts created for middle-income families with beneficiaries that otherwise would escape the tax, making it a substantial tax on "orphans and widows."
The author proposes two changes, one regulatory and one statutory, to mitigate this unfairness. The article will be of greatest utility for planning when S corporation stock or partnership interests are held in trust. K-1 income from an "active" business will escape the 3.8% tax, while income from a "passive" business under Code Section 469 will be subject to the 3.8% tax. If the owner material participates in the business operations using the standard under the passive loss rules adopted in 1986, the business is active. Unfortunately, little guidance exists on how to apply the passive loss rules to trust-owned businesses. Worse, in the last couple of years the IRS has attempted to apply a new anti-taxpayer test different than the one, which has existed for the preceding twenty-five years. The article contests the new test using both tax and fiduciary law. Although the new proposed regulations on the 3.8% tax are not the focus of the article, the author believes that the regulations raise more questions than they answer. The article also delves into obscure legislative history to explain why Congress exempted active business income from the net investment income tax. Despite implications to the contrary, the article explains that active business income can escape both 3.8% taxes: the net investment income tax and the Medicare self-employment tax. The author urges Congress to eliminate the current muddle on the application of the Medicare tax by providing tax partnerships and S corporations with the same self-employment tax treatment. Finally, the author explains how to fix the net investment income tax to actually provide the tax relief that Congress intended when it sought to reduce the higher tax costs imposed on the retained earnings of small businesses compared to those of large public corporations.
Number of Pages in PDF File: 36
Date posted: September 12, 2013