The definition of NII includes “interest, dividends, annuities, royalties and rents.”14 However, even these types of income are not subject to the new 14 Section 1411(c)(1)(A)(i).
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Medicare tax on NII if they are “derived in the ordinary course of a trade or business,” as long as that trade or business (i) does not constitute a passive activity with respect to the taxpayer, and (ii) does not constitute “trading in financial instruments or commodities.”
Trade or Business Income. The statutory definition of NII, referring to “trade or business” and ‘passive activity” brings into relevance the line of cases that distinguishes between activities that constitute “trade or business” activities from those that are merely activities entered into for profit15as well as the regulations under section 469 dealing with the material participation standard.
While regulations should provide further clarity, it would appear that interest on customer receivables and interest derived in an active lending business should not be subject to the new Medicare tax. Moreover, royalties earned in the active conduct of a software business should be exempt.16
15 See, e.g., Whipple v. Comm’r, 373 U.S. 193 (1963) (certain investment activities not a
trade or business); McCullen v. Comm’r, T.C. Memo 1997-280 (certain real estate activities not a trade or business); Moller v. United States, 553 F. Supp 1071 (Fed. Cl. 1982) (investment activities qualified as a trade or business); Higgins v. Comm’r, 312 U.S. 212 (1941) (certain real estate activities qualified as a trade or business, while investment activities did not).
16There is a statutory analogue for the characterization of royalties as active rather than passive.
For purposes of the tax on excess passive investment of an S corporation with accumulated earnings and profits, section 1375(b)(3) provides that the term “passive investment income” has the same meaning as when used in section 1362(d)(3). Section 1362(d)(3) defines “passive investment income,” in relevant part, as “gross receipts derived from royalties, rents, dividends, interest, and annuities.” Royalties are generally defined as meaning all royalties, including amounts received for the privilege of using patents, copyrights, and other like property. The regulations, however, exclude certain types of royalties from the type of royalties considered to constitute passive investment income. One exception provides: “Royalties does not include royalties derived in the ordinary course of a trade or business of franchising or licensing property. Royalties received by a corporation are derived in the ordinary course of a trade or business of franchising or licensing property only if, based on all the facts and circumstances, the corporation— (i) Created the property; or (ii) Performed significant services or incurred substantial costs with respect to the development or marketing of the property.” This exception may be interpreted as providing a safe harbor that excepts any royalties received by a corporation if such corporation either (i) creates the property, or (ii) performs significant services or incurs substantial costs with respect to developing or marketing the property. Example (5) of the Regulations provides support for this interpretation in the context of trademark royalties. In example (5), the S Corporation (“S”) created Trademark A but not Trademark B. It concludes that “[b]ecause S created Trademark A, the royalty payments with respect to Trademark A are derived in the ordinary course of S’s business and are not included within the definition of royalties for purposes of determining S’s passive investment income.” The royalty payments with respect to Trademark B, however, were included within the definition of passive investment income. Presumably the proposed regulations dealing with the definition of NII under section 1411 will be consistent with the existing regulations under section 1362 with respect to royalties from intangible assets developed by the corporation.
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The statute expressly provides that net income, gain, or loss in the investment of working capital is treated as not derived in the ordinary course of a trade or business, and will be subject to the tax regardless of whether the taxpayer’s interest in the business is non-passive.17
Subpart F Income. If a taxpayer holds an interest in a foreign entity that is a controlled foreign corporation (“CFC”), a qualified electing fund (“QEF”), or a passive foreign investment company (“PFIC”), it is possible that Subpart F and QEF inclusions are not subject to the 3.8% Medicare tax. The tax specifically applies to “interest, dividends, annuities, royalties and rent,” but Subpart F and QEF inclusions are not listed in the statute. When Congress has intended to treat Subpart F and QEF inclusions as dividends, it has done so expressly.18
On the other hand, the IRS has taken seemingly contrary positions as to whether Subpart F inclusions are dividends. Most recently, in Notice 2004-70 (which deals with whether dividends from foreign corporations qualify as qualified dividend income under section 1(h)(11)(C)), the IRS held that “for purposes of section 1(h)(11), Subpart F inclusions are not dividends and therefore cannot constitute qualified dividend income.” This conclusion was apparently not based on the policies underlying section 1(h)(11), but was based simply and exclusively on the fact that, “[n]either section 951(a)(1) nor the corresponding regulations characterize a Subpart F inclusion as a dividend.”19
However, the IRS has taken the opposite view on the treatment of Subpart F inclusions as dividends when considering whether they give rise to unrelated business taxable income (“UBTI”):
Although the subpart F income will not be distributed and is technically not a dividend, such income can be characterized as a constructive dividend due to the interaction of [sections 951(a)(1)(A)(i) and 951(a)(2), and sections 512(b)(1) and 512(b)(13)] of the Code. These sections produce a situation in which the income would be taxable on the part of shareholders as if it had been distributed by the subsidiary as a dividend, therefore, the income is functionally equivalent to a dividend.
17Section 1411(c)(1)(A)(i), (2).
18See Section 851(b) (flush language) (expressly treating amounts included in gross income under
section 951(a)(1)(A)(i) or section 1293 as dividends to the extent that, under section 959(a)(1) or section 1293(c), there is a distribution out of the earnings and profits of the taxable year which are attributable to the amounts so included).
19The IRS did not address QEF inclusions because section 1(h)(11)(C)(iii) excludes PFICs from
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Consequently, this income will not be treated as unrelated business taxable income under section 512.20
Finally, while NII includes gross income derived from a passive activity or from a business of trading financial instruments or commodities, it appears that the statute contemplates only the passive activities or the trading business of the taxpayer.21Thus, the fact that the PFIC might be engaged in a passive activity or securities trading does not appear to affect the taxpayer, unless the income is treated as from a trade or business of trading in financial instruments or commodities, discussed further below.
In light of the technical uncertainty as to whether Subpart F and QEF inclusions are treated as dividends for purposes of other provisions, regulations or a technical amendment to the statute (similar to the flush language of section 851(b)) may be necessary to determine whether they should be treated as dividends for purposes of the Medicare tax. As a policy matter, it would appear that they should be included, similar to dividends from a C corporation derived in the ordinary course of an active business conducted by the C corporation.22 Otherwise, taxpayers could entirely escape the Medicare tax on investments made through CFCs and QEF PFICs.23
20PLR 8836037 (June 14, 1988) and PLR 9407007 (November 12, 1993); contra, PLR 9043039
(July 30, 1990)). Congress cited the private letter rulings that treat Subpart F inclusions as dividends favorably in the Conference Report to the Small Business Job Protection Act of 1996, H.R. Rep. 104-737, 104th Cong. 2d Sess. p. 294 n. 50 (August 1, 1996).
21Section 1411(c)(1)(ii) refers to “other gross income derived from a trade or business” described
in section 1411(c)(2); section 1411(c)(2) refers to “a passive activity. . . with respect to the taxpayer,” or a trade or business of trading in financial instruments or commodities (emphasis added).
22
On the other hand, an analog exists in the section 1375 and section 1362 regime to characterize dividends from a C corporation as active rather than passive. Section 1362(d)(3)(C)(iv) excludes certain dividends from the term “passive investment income.” Under that section, if an S corporation owns at least 80 percent of the total voting power and value of the stock of a C corporation, then dividends received by such S corporation from the C corporation do not constitute passive investment income to the extent that such dividends are attributable to the earnings and profits (“E&P”) of the C corporation derived from the active conduct of a trade or business. Reg. §1.1362-8(a) further explains that the C corporation’s E&P will be considered active to the extent that such E&P is derived from activities that would not produce passive investment income (as defined in section 1362(d)(3)) if the C corporation were an S corporation. This test constitutes a safe harbor when calculated in accordance with gross receipts derived from such activities and is restated as such in Reg. §1.1362-8(b)(5). Outside of the safe harbor, the regulations provide that an S corporation may use any reasonable method to determine the amount of dividends that are not treated as passive investment income.
23 The Medicare tax applies only to gross income. If Subpart F and QEF inclusions are not
themselves subject to the Medicare tax, distributions by a CFC or PFIC are distributions of previously taxed income that are excluded from gross income and the distributions would also
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Qualified Retirement Plan and IRA Distributions. NII does not include any distribution from a qualified retirement plan or individual retirement account.24 Application of Medicare Tax to Trusts and Estates;Tax Exempt Trusts. Section 1411 applies broadly to “estates and trusts.” The following exception for tax exempt trusts is listed in Section 1411(e)(2):
(e) NONAPPLICATION OF SECTION.--This section shall not apply to-- (2) a trust all of the unexpired interests in which are devoted to one or more of the purposes described in section 170(c)(2)(B).
A section 170(c)(2)(B) trust is a trust “organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals.” The JCT report also indicates that Charitable Remainder Trusts and trusts exempt from tax under section 501 are exempt from NIIT.25Section 501 and section 664 provide that such trusts are not subject to taxes imposed by Subtitle A. Since section 1411 is included in Subtitle A, it would appear inapplicable to such trusts even before confirmation by the JCT report.26
Non-Resident Aliens; Foreign Trusts. Section 1411(e)(1) states that the section “shall not apply to…a nonresident alien.” Section 7701(b) provides a definition of nonresident alien that is applicable “for purposes of this title (other than subtitle B)” which includes only “an individual…neither a citizen of the United States nor a resident of the United States.” As section 1411 falls within subtitle A of “this title” it would seem that only “individuals” can be nonresident aliens, thereby excluding a foreign trust from the definition of a nonresident alien.
escape the Medicare tax. See Section 959(a) (previously taxed income is excluded from gross income); section 1293(c) (if a taxpayer demonstrates that a distribution from a PFIC is paid out of profits of the company which were included in income under section 1293(a), the distribution is treated as a distribution which is not a dividend and, to the extent of the taxpayer’s basis, is not included in gross income).
24
Section 1411(c)(5), excluding from the definition of NII any distribution from a plan or arrangement described in sections 401(a), 403(a), 403(b), 408, 408A, or 457(b).
25“The tax also does not apply to a trust that is exempt from tax under section 501 or a charitable
remainder trust exempt from tax under section 664.” Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 111th Congress, at 364 (Mar. 2011) (the “JCT Technical Explanation”).
26On the other hand, the treatment of unrelated business taxable income (“UBTI”) of a trust may
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Accordingly, NII sourced in the United States would presumably be subject to the Medicare Tax if received by a foreign trust.
The trust distribution throwback rules27 apply where a foreign trust accumulates non-US source income in a given year and then in a future year distributes out more than the income in that year as non-taxable corpus distributions which are essentially comprised of the prior year’s untaxed earnings. The throwback provisions essentially act to treat those as distributions of income rather than corpus and tax it as if it had been distributed in the year earned by the trust. The proposed regulations may provide guidance as to the application of the throwback rules, assuming foreign trusts are subject to the Medicare tax on United States sourced income, for example, in the case where income not passed out in a prior year is distributed after Section 1411 is in effect.
NESE Cannot be NII. There is a specific exclusion from NII of any item taken into account in determining SE income on which the SE tax is imposed under section 1401(b), therefore eliminating the risk that a taxpayer will be subject to Medicare tax on the same items of income under both tax schemes.28