Have you given any thought to how Obamacare’s new 3.8% tax on investment income and gains will apply to sales of interests in partnerships and Subchapter S corporations? No, I didn’t think so.
Here is a general overview, including information on a hidden, and frankly nauseating, compliance burden that may apply at times.
1. The starting point is that gains from such sales are subject to the tax. However, only individuals whose “modified adjusted gross income” (MAGI) exceeds certain thresholds will be subject to the tax – the “Gift of the Magi” for those of you with a literary bent. The joint filing threshold for married spouses is $250,000, $125,000 for married filing separately, and $200,000 for all others. As you can see, there is a substantial marriage penalty built into these thresholds. Over time, more and more taxpayers will be subject to the tax since the thresholds are NOT indexed for inflation.
2. Since gains (and other investment income) from trades or businesses are not subject to the tax, Code §1411(c)(4) and Proposed Reg. §1.1411-7 will allow a partner or stockholder to avoid the tax on gains from the sale of ownership interests in partnerships or S corporations that are engaged in business, at least in part. Before a partner or stockholder can use this exclusion, the following requirements must be met:
a. The entity must be engaged in a trade or business (within the meaning of Code §162);
b. The trade or business must not relate to the trading of financial instruments or commodities; and
c. The selling stockholder or partner must be engaged in at least one trade or business of the partnership or S corporation (generally applying definitions of “material participation” that are used in the passive loss rules.
If the taxpayer wants to use the above exception, this is where the compliance burden kicks in. To use the exception, a deemed sale by the partnership or S corporation of all of its assets (including goodwill) for fair market value must be undertaken, to determine what portion of the gain should be allocated to trade or business gains (as to which the partner or stockholder is deemed to materially participate and which will escape the 3.8% tax) and all other gains (which allocated portion will be subject to the 3.8% tax). Once the gains from such deemed sales are undertaken, adjustments to the amount of gain recognized by the selling owner for purposes of the tax are made.
Deemed sales mean the necessity of obtaining values for the corporate assets at the time of sale. Does this mean that appraisals and valuations of the entity assets will be needed? Probably not. The Proposed Regulations direct taxpayers to apply the principles of Treas. Regs. §1.743-1(d)(2) to make these computations. Such principles are complex and difficult to apply, but generally do not require appraisals. Instead, values of entity assets are obtained by working backwards from the purchase price for the sold ownership interest. However, if the sale is not an arms-length sale, perhaps appraisals will be needed.
How are taxpayers to make these computations if the entity does not cooperate? The IRS is concerned about that, too, and has asked for comments on that issue.
The above analysis and computations will be required all for a 3.8% tax. One can anticipate many circumstances when the accountants fees to undertake the analysis and computations come close to or exceed the tax savings from doing the analysis and computation.
The only saving grace here is that these computations will not be needed in many circumstances involving partnerships and S corporations because either all or none of the gain will be potentially subject to exclusion from tax due to:
a. All assets of the entity are used in the entity’s trades or businesses, and the selling owner materially participates in all of those trades or businesses,
b. None of the assets of the entity are used in the entity’s trades or businesses,
c. The selling owner does not materially participate in any of the entity’s trades or businesses, or
d. The selling owner is under the Obamacare MAGI thresholds.