From 2008 until 2014, David H. Kirk, one of the two principal authors of the proposed and final net investment income tax regulations (T.D. 9644, REG-130843-13, and REG-130507-11), was an attorney in the Passthroughs and Special Industries Division of the Office of Chief Counsel of the IRS.
The net investment income tax, enacted by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, imposes a tax on individuals in tax years beginning after Dec. 31, 2012, of 3.8% of the lesser of net investment income for the year or the amount by which modified adjusted gross income (AGI) exceeds a threshold amount of $200,000 for a single individual or $250,000 for a married couple filing jointly. For estates and trusts, the tax is 3.8% of the lesser of undistributed net investment income or AGI over the dollar amount at which the highest trust and estate tax bracket begins (for 2014, $12,150).
I recently interviewed Kirk about the regulations’ creation and asked him to address some technical questions the new tax poses. Following is an edited transcript of the interview.
Give us a short overview of the net investment income tax.
Kirk: The net investment income tax was created to generate approximately half the revenue needed for the Affordable Care Act [Patient Protection and Affordable Care Act, P.L. 111-148]. I believe the IRS is projecting approximately 3 million taxpayers are subject to this tax, and it will only go up from 2013, partly because the thresholds are not indexed for inflation. Also, a lot of people have capital losses that were generated during the Great Recession that are finally burning off, and that will cause them to start having net investment income subject to the tax.
When did the IRS start working on the regulations? I’ve heard some very big numbers on the number of people who contributed and helped you develop these regulations.
Kirk: I remember picking up the regulations in early November 2010. One morning I just started doing a spreadsheet of all sorts of open items and which divisions or which Code sections it would turn on that would involve other attorneys within the Chief Counsel’s Office—about 50 attorneys, and over on the Treasury side, maybe 15 individuals. I came up with 35 questions that we’d need to answer to make it work—thorny issues or ambiguities that were important to resolve. All the divisions got their input into what were the major things that needed to be tackled and judgment calls that needed to be made. And, generally, I would have to say, the Chief Counsel’s Office and the IRS are not built to do something like that, where you had every single division feeding in. And so the management of the teams in the process was probably one of the most time-consuming pieces, which is why it took two years, two weeks, and two days from when we first picked up the statute until the original proposed regulations came out in late November 2012.
How were the public and the AICPA involved in the development of these regulations?
Kirk: One of the things that we tried to do was to be open and transparent and try to get the word out. There was the normal comment period required in the Administrative Procedure Act; we gave 90 days to comment. The larger organizations—the New York State Bar, American Bar Association, the AICPA—began to appreciate in the development of the comment letters how complicated it is, how many tentacles it has into all the different subject matter areas. From the CPA perspective, we went on the road, as you know, as our own public relations stint. I think in 2013 I did 30 different panels and presentations—speeches around the country, trying to basically show that this is much more complicated than a two-page statute might appear to be. What they saw was that once you started, it was like peeling an onion, and it got more and more complicated as you peeled off each little piece.
The AICPA provided a perspective of on-the-ground tax practitioners, the ones that are doing the forms and are struggling with this during filing season. We needed that perspective and those issues that they bring in to us, either informally or formally via comment letters.
What do you think are the most challenging aspects of all the new rules, the instructions, the forms, the regulations, and the statutes?
Kirk: For CPAs, the most challenging aspect is the sheer volume of rules associated with a tax that is relatively small on an individual taxpayer basis. Now, of course, there are the people that have the $60 million AGIs, although they’re few and far between. The sheer amount of information that CPAs need to know just to fill out the Form 8960 [Net Investment Income Tax—Individuals, Estates, and Trusts] is overwhelming. How can the CPA prepare the tax return with the Form 8960 and not spend an inordinate amount of time and additional cost for the client?
When it comes to technical matters, a challenge is the interaction between Sec. 1411 as a revenue-generating statute with Sec. 469, which was built in 1986 and over the following 10 years or so to identify loss-generating activities. When you put these two systems together, they’re like two tectonic plates crashing together, such that they produce very strange outcomes, something that CPAs are going to have to get their arms around.
Would you say more about that intersection point?
Kirk: Well, we have a passive loss system that was created 25 years ago to identify loss-generating activities. And loss-generating activities sometimes were able to be structured as income-generating activities. And what the regulations did under Sec. 469 was to attempt to strip out from these passive activities certain types of activities that would cloud the overall picture of what the statute was trying to get at. It did this with the idea of trying to isolate these generated losses to properly suspend them. Forward 25 years, we have Sec. 1411 coming in, and what it does is look to Sec. 469 to identify passive income generators. You have 25 years of history of the IRS trying to compartmentalize things, to make them nonpassive in order for them to not mess up the passive activity rules, but then you have Sec. 1411 coming in and trying to identify passive income, and when you put them together, it creates very strange and very complicated offspring.
Let’s transition over to rental real estate. I understand that if I am passive, that will be subject to the net investment income tax. I also understand that there’s a small group of people who will be in the trade or business of real estate who will not be subject to the tax. But then, there’s the rest of America that’s in the middle. Maybe they’re already real estate professionals under Sec. 469, but under the Sec. 1411 regulations, there’s kind of a new status as a net investment income tax real estate professional.
Kirk: As a real estate professional, you need to have one-half of your personal services devoted to trades or businesses that are specifically enumerated in Sec. 469(c)(7)(C). There are 11 different ones. And you also need to spend 750 hours a year in those trades or businesses, as well as being a material participant in them. And then that turns off the per se status of rental real estate being passive. All it does is that it allows the real estate professional to then look at his or her real estate activities and test for material participation.
So we got a lot of comments on the proposed regs. about real estate professionals. A lot of people wanted real estate professionals completely out—to just say that they are deemed to be in a trade or business of rental real estate, in the event that they are a real estate professional. And so, what we found was that since not all real estate professionals are created equal, and not all rental properties are equal, we couldn’t use real estate professional status as a proxy for being in a trade or business. What we did was say was that if you are a real estate professional under Sec. 469, that’s it, just as long as you’re one, and if you spend more than 500 hours during the year on one or more rental real estate activities, you will be deemed to be in a trade or business. And the other part of the test is if you have participated in that rental activity for 500 hours in five of the last 10 years—we borrowed the five-and-10 rule from the material participation test.
Tell us a bit about self-rentals.
Kirk: What we heard loud and clear from tax practitioners almost uniformly across the country was that it is a very common business practice, and rightfully so, to keep real estate and other significant-value property outside the operating trade or business. And the Sec. 469 rules acknowledged that some 20 years ago by treating self-rental as nonpassive income. For rent to be excluded from net investment income, it needs to be nonpassive. So self-charged rental in Regs. Sec. 1.469-2(f)(6) does that. But it also needs to be derived in the ordinary course of a trade or business. And that part was giving practitioners serious heartburn. So in the final regulations, what we did, solely for net investment income tax purposes, was, we deemed that property to be held in the ordinary course of a trade or business, to get taxpayers over this second hurdle. Because what we didn’t want was for taxpayers to be faced with a choice of having to contribute property or otherwise change their business structure solely because of a 3.8% tail that was wagging a much larger dog.
Did the IRS have any specific goals for the net investment income tax system? What was the big picture?
Kirk: My tag line that I used when I went out on the road was that the IRS needed to make a system that was administrable and that an individual could complete and satisfy their tax obligation. If the only thing they had was a Form 1099 from their stock brokerage account, if it was not administrable for those folks and required a tax professional to be involved, then that’s a failure of the system.
On the other end of the spectrum, for the persons, although few, with the AGIs that are stratospheric, we had to make sure that the system was not abused by them. We also realized that coming right down the middle, where most of the rank-and-file taxpayers are, the closely held business owners, could they be treated fairly and be able to understand what their obligations are? That was the point. That’s what the goals are.
Robert S. Keebler ( firstname.lastname@example.org ) is with Keebler & Associates LLP in Green Bay, Wis. He chairs the AICPA Advanced Estate Planning Conference.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at email@example.com or 919-402-4434.
A CPA/PFS, David H. Kirk also holds J.D. and LL.M. degrees and the CFP credential. Within the IRS Chief Counsel’s Office, he specialized in federal income taxation of estates and trusts, S corporations, and partnerships. Before joining the Chief Counsel’s Office, he was an associate in the tax practice of Arnold & Porter LLP in Washington. Before that, he spent eight years in the private client advisers group of Deloitte Tax LLP, including two years in Deloitte’s National Tax Office in Washington. In February 2014, he left the IRS to join the National Tax Office of EY in Washington.
“Higher Stakes for Tax Treatment of Rental Real Estate,” Dec. 2013, page 56
- The 2014 Cumulative Tax Guide (#PTX1308D, online access)
- Tax Planning After the Healthcare Surtax: Tools, Tips, and Tactics (#PTX1302M, online access)
- National Tax Conference, Nov. 3–4, Washington
- Real Estate Conference, Nov. 6–7, Grapevine, Texas
- Sophisticated Tax Planning for Your Wealthy Clients, Nov. 17–18, Philadelphia
For more information or to make a purchase or register, go to cpa2biz.com or call the Institute at 888-777-7077.
The Tax Adviser and Tax Section
The Tax Adviser is available at a reduced subscription price to members of the Tax Section, which provides tools, technologies, and peer interaction to CPAs with tax practices. More than 23,000 CPAs are Tax Section members. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at aicpa.org/tax. The current issue of The Tax Adviser is available at thetaxadviser.com.
PFP Member Section and PFS Credential
Membership in the Personal Financial Planning (PFP) Section provides
access to specialized resources in the area of personal financial
planning, including complimentary access to Forefield Advisor. Visit
the PFP Center at aicpa.org/PFP.
Members with a specialization in personal financial planning may be
interested in applying for the Personal Financial Specialist (PFS)
credential. Information about the PFS credential is available at aicpa.org/PFS.