Question - Whether or not an Affiliate's Dividends are Subject to the 3.8% Net Investment Income Tax (NII)

 

Problem

The crux of the issue appears to be how the activity grouping rules of Reg 1.469(4)(d), relating solely to material participation, interact with Section 1411 active trade or business exception where in income must be derived "in the ordinary" course of that "trade or business." 

 

To the extent the grouping rule treats both a C corporation and S corporation as one active trade or business; it would appear the income flowing from the business is not NII. Much of the Section 1411 deals with pass through entities, while Section 469 does not distinguish.

 

Conclusion

Based upon the foregoing tax research, it is concluded that Grouping Election converts an affiliate's passive activity to active trade or business. Section 1411(c)(2) excludes from NII dividends from non-passive (Active) trade or businesses. An Affiliate's dividends are NOT subject to NII. 

 

Tax Research - Overview

IRC Section 1411 provides that interest, dividend and rents NOT from an active trade or business are subject to the 3.8% NII tax.  Specifically:

 

Section 1411(c)(1)(A)

(i)                  gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2),

 

Section 1411(c)

     (2) Trades and businesses to which tax applies

           A trade or business is described in this paragraph if such trade or business is--

          (A) a passive activity (within the meaning of section 469) with respect to the taxpayer,

 

However, Section 1411(c)(3) states that working capital is subject to tax under rules similar to 469(e)(1)(B). 

 

Reg section 1.469-2T(c)(3)(i)(A) States that C corporation dividends are NOT passive gross income (i.e. they can't be used to offset passive losses..)

 

Tax Research

Reg 1.1411-4(b) states:

(b) Ordinary course of a trade or business exception.

 

     Gross income described in paragraph (a)(1)(i) [i.e. Gross income from interest, dividends, annuities, royalties, and rents] of this section is excluded from net investment income if it is derived in the ordinary course of a trade or business not described in section 1.1411-5. See section 1.1411-6 for rules regarding working capital. To determine whether gross income described in paragraph (a)(1)(i) of this section is derived in a trade or business, the following rules apply.

 

Reg Section 1.469-4 Definition of activity.

(d) Limitation on grouping certain activities.

(5) Activities conducted through section 469 entities

(ii) Cross reference.

 

     An activity that a taxpayer conducts through a C corporation subject to section 469 may be grouped with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially or significantly participates in the other activity. See section 1.469-2T(c)(3)(i)(A) and (c)(4)(i) for the rules regarding dividends on C corporation stock and compensation paid for personal services.

In your CPA firm's experience, what is the most material overlooked deduction in the estate, gift and trust income tax area

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