Net Investment Income Tax, 72611-72652 [2012-29238]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 77, Number 234 (Wednesday, December 5, 2012)]
[Proposed Rules]
[Pages 72611-72652]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-29238]



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Vol. 77

Wednesday,

No. 234

December 5, 2012

Part V





Department of the Treasury





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Internal Revenue Service





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26 CFR Part 1





 Net Investment Income Tax; Proposed Rule

Federal Register / Vol. 77 , No. 234 / Wednesday, December 5, 2012 / 
Proposed Rules

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-130507-11]
RIN 1545-BK44


Net Investment Income Tax

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that provide 
guidance under section 1411 of the Internal Revenue Code (Code). 
Section 1402(a)(1) of the Health Care and Education Reconciliation Act 
of 2010 added new section 1411 to the Code effective for taxable years 
beginning after December 31, 2012. The proposed regulations affect 
individuals, estates, and trusts. This document also contains a notice 
of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by March 5, 
2013.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-130507-11), Room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
130507-11), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking portal at www.regulations.gov (IRS REG-130507-11).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Michala Irons, (202) 622-3050, or David H. Kirk, (202) 622-3060; 
concerning submissions of comments, the hearing, and/or to be placed on 
the building access list to attend the hearing, Oluwafunmilayo (Funmi) 
Taylor, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, 
Washington, DC 20224. Comments on the collection of information should 
be received by February 4, 2013. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    There are two collections of information in the proposed 
regulations. The first collection is in proposed Sec.  1.1411-7(d) and 
the second collection is in proposed Sec.  1.1411-10(g).
    The information collected in proposed Sec.  1.1411-7(d) is required 
by the IRS to verify the taxpayer's reported adjustment under section 
1411(c)(4). This information will be used to determine whether the 
amount of tax has been reported and calculated correctly. The likely 
respondents are owners of interests in partnerships and S corporations.
    Estimated total annual reporting and/or recordkeeping burden: 
315,000 hours.
    Estimated average annual burden per respondent: 5 hours.
    Estimated number of respondents: 63,000.
    Estimated annual frequency of responses: On occasion.
    The collection of information in proposed Sec.  1.1411-10(g) is 
necessary for the IRS to determine whether a taxpayer has made an 
election pursuant to proposed Sec.  1.1411-10(g) and to determine 
whether the amount of tax has been reported and calculated correctly. 
The likely respondents are individuals, estates, and trusts.
    Estimated total annual reporting and/or recordkeeping burden: 
62,000 hours.
    Estimated average annual burden per respondent: 4 hours.
    Estimated number of respondents: 15,500.
    Estimated annual frequency of responses: Other (one time).
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by section 6103.

Background

    Section 1402(a)(1) of the Health Care and Education Reconciliation 
Act of 2010 (Pub. L. 111-152, 124 Stat. 1029) added section 1411 to a 
new chapter 2A of subtitle A (Income Taxes) of the Code effective for 
taxable years beginning after December 31, 2012. Section 1411 imposes a 
3.8 percent tax on certain individuals, estates, and trusts. See 
section 1411(a)(1) and (a)(2). The tax does not apply to a nonresident 
alien or to 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). See 
section 1411(e).
    In the case of an individual, section 1411(a)(1) imposes a tax (in 
addition to any other tax imposed by subtitle A) for each taxable year 
equal to 3.8 percent of the lesser of (A) the individual's net 
investment income for such taxable year, or (B) the excess (if any) of 
(i) the individual's modified adjusted gross income for such taxable 
year, over (ii) the threshold amount. Section 1411(b) provides that the 
threshold amount is: (1) In the case of a taxpayer making a joint 
return under section 6013 or a surviving spouse (as defined in section 
2(a)), $250,000; (2) in the case of a married taxpayer (as defined in 
section 7703) filing a separate return, $125,000; and (3) in any other 
case, $200,000. Section 1411(d) defines modified adjusted gross income 
as adjusted gross income increased by the excess of (1) the amount 
excluded from gross income under section 911(a)(1), over (2) the amount 
of any deductions (taken into account in computing adjusted gross 
income) or exclusions disallowed under section 911(d)(6) with respect 
to the amount excluded from gross income under section 911(a)(1).
    In the case of an estate or trust, section 1411(a)(2) imposes a tax 
(in addition to any other tax imposed by subtitle A) for each taxable 
year equal to 3.8 percent of the lesser of (A) the estate's or trust's 
undistributed net investment income, or (B) the excess (if any) of (i) 
the estate's or trust's adjusted gross income (as defined in section 
67(e)) for such taxable year, over (ii) the dollar amount at which the 
highest tax bracket in section 1(e) begins for such taxable year.
    Section 1402(a)(2) of the Health Care and Education Reconciliation 
Act of 2010 also amended section 6654 of the Code to provide that the 
tax imposed under chapter 2A (which includes

[[Page 72613]]

section 1411) is subject to the estimated tax provisions.
    The tax imposed by section 1411 is not deductible in computing any 
tax imposed by subtitle A of the Code. See Joint Committee on Taxation, 
General Explanation of Tax Legislation Enacted in the 111th Congress 
(JCS-2-11) (March 24, 2011), at 364 (JCT 2011 Explanation).
    Amounts collected under section 1411 are not designated for the 
Medicare Trust Fund. The Joint Committee on Taxation in 2011 stated 
that ``[i]n the case of an individual, estate, or trust an unearned 
income Medicare contribution tax is imposed. No provision is made for 
the transfer of the tax imposed by this provision from the General Fund 
of the United States Treasury to any Trust Fund.'' See JCT 2011 
Explanation, at 363; see also Joint Committee on Taxation, Description 
of the Social Security Tax Base (JCX-36-11) (June 21, 2011), at 24.
    Section 1411(c)(1) provides that net investment income means the 
excess (if any) of (A) the sum of (i) gross income from interest, 
dividends, annuities, royalties, and rents, other than such income 
derived in the ordinary course of a trade or business to which the tax 
does not apply, (ii) other gross income derived from a trade or 
business to which the tax applies, and (iii) net gain (to the extent 
taken into account in computing taxable income) attributable to the 
disposition of property other than property held in a trade or business 
to which the tax does not apply; over (B) the deductions allowed by 
subtitle A which are properly allocable to such gross income or net 
gain.
    Section 1411(c)(1)(A) defines net investment income, in part, by 
reference to trades or businesses described in section 1411(c)(2). A 
trade or business is described in section 1411(c)(2) if such trade or 
business is (A) a passive activity (within the meaning of section 469) 
with respect to the taxpayer, or (B) a trade or business of trading in 
financial instruments or commodities (as defined in section 475(e)(2)).
    Income on the investment of working capital is not treated as 
derived from a trade or business for purposes of section 1411(c)(1) and 
is subject to tax under section 1411. See section 1411(c)(3).
    In the case of the disposition of an interest in a partnership or 
an S corporation, section 1411(c)(4) provides that gain or loss from 
such disposition is taken into account for purposes of section 
1411(c)(1)(A)(iii) only to the extent of the net gain or net loss which 
would be so taken into account by the transferor if all property of the 
partnership or S corporation were sold at fair market value immediately 
before the disposition of such interest.
    Net investment income does not include distributions from a plan or 
arrangement described in section 401(a), 403(a), 403(b), 408, 408A, or 
457(b). Section 1411(c)(5).
    Net investment income also does not include any item taken into 
account in determining self-employment income for a taxable year on 
which a tax is imposed by section 1401(b). Section 1411(c)(6).

Explanation of Provisions

1. Overview of Proposed Regulations

    Proposed Sec.  1.1411-1 provides general operating rules applicable 
to section 1411. Proposed Sec.  1.1411-2 provides specific rules 
applicable to individuals. Proposed Sec.  1.1411-3 provides specific 
rules applicable to estates and trusts. Proposed Sec.  1.1411-4 
provides rules for defining net investment income. Proposed Sec.  
1.1411-5 provides rules for net investment income derived from trades 
or businesses that are passive activities or trading in financial 
instruments or commodities. Proposed Sec.  1.1411-6 provides rules for 
gross income and net gain on the investment of working capital. 
Proposed Sec.  1.1411-7 provides rules for dispositions of interests in 
partnerships and S corporations. Proposed Sec.  1.1411-8 provides rules 
for distributions from certain qualified plans. Proposed Sec.  1.1411-9 
provides rules for items taken into account in determining self-
employment income. Proposed Sec.  1.1411-10 provides rules with respect 
to controlled foreign corporations and passive foreign investment 
companies. Finally, proposed Sec.  1.469-11(b)(3)(iv) provides a 
regrouping ``fresh start'' under section 469 for certain taxpayers.

2. In General

    Section 1411 (which constitutes chapter 2A of the Code) contains 
terms commonly used in Federal income taxation and cross-references 
certain provisions of chapter 1 such as sections 67(e), 469, 401(a), 
and 475(e)(2). However, other than these specific cross-references to 
provisions of chapter 1, and certain specific definitions set forth in 
section 1411, section 1411 does not provide definitions of its 
operative phrases or terminology. Moreover, there is no indication in 
the legislative history of section 1411 that Congress intended, in 
every event, that a term used in section 1411 would have the same 
meaning ascribed to it for other Federal income tax purposes (such as 
chapter 1). Accordingly, the definitional rules set forth in the 
proposed regulations are designed to promote the fair administration of 
section 1411 while preventing circumvention of the purposes of the 
statute. One of the general purposes of section 1411 is to impose a tax 
on unearned income or investments of certain individuals, estates, and 
trusts.
    Under these proposed regulations, except as otherwise provided, 
chapter 1 principles and rules apply in determining the tax under 
section 1411. Consistent with this general approach, except as 
otherwise provided in the proposed regulations, gain that is not 
recognized under chapter 1 for a taxable year is not recognized for 
that year for purposes of section 1411 (for example, gain deferred or 
excluded under section 453 (installment method), section 1031 (like-
kind exchanges), section 1033 (involuntary conversions), or section 121 
(sale of principal residence)). Deferral or disallowance provisions of 
chapter 1 used in determining adjusted gross income apply to the 
determination of net investment income (for example, section 163(d) 
(limitation on investment interest), section 265 (expenses and interest 
relating to tax-exempt income), section 465(a)(2) (at risk 
limitations), section 469(b) (passive activity loss limitations), 
section 704(d) (partner loss limitations), section 1212(b) (capital 
loss carryover limitations), or section 1366(d)(2) (S corporation 
shareholder loss limitations)). A deduction carried over to a taxable 
year by reason of section 163(d), section 465(a)(2), section 469(b), 
section 704(d), section 1212(b), or section 1366(d)(2) and allowed for 
that taxable year in determining adjusted gross income is also allowed 
for the determination of net investment income, whether or not the 
taxable year from which the deduction is carried precedes the effective 
date of section 1411.
    However, the proposed regulations modify the chapter 1 rules in 
certain respects in order to prevent circumvention of the purposes of 
the statute. For example, substitute interest and dividends, which are 
included in gross income under chapter 1, are net investment income 
even though these amounts are not categorically ``interest'' and 
``dividends'' under chapter 1. In addition, while an item of income 
that is specifically excluded from gross income under chapter 1 
generally also is excluded from net investment income under section 
1411 (for example, tax-exempt interest), distributions described in 
section 959(d) or section 1293(c), excess distributions under section 
1291 that are dividends, and gains that are treated as excess 
distributions under section 1291 (which are discussed in

[[Page 72614]]

part 11.B of this preamble) are net investment income under chapter 2A.
    Proposed Sec.  1.1411-1(b) provides generally that all references 
to an individual's adjusted gross income shall be treated as references 
to adjusted gross income (as defined in section 62) and that all 
references to an estate's or trust's adjusted gross income shall be 
treated as references to adjusted gross income (as defined in section 
67(e)). As provided in part 11 of this preamble, there may be 
adjustments to adjusted gross income as a result of investments in 
controlled foreign corporations and passive foreign investment 
companies.
    The IRS will closely review transactions that manipulate a 
taxpayer's net investment income to reduce or eliminate the amount of 
tax imposed by section 1411. In appropriate circumstances, the IRS will 
challenge such transactions based on applicable statutes and judicial 
doctrines. Thus, for example, if an investment arrangement that in form 
gives rise to income that does not constitute net investment income is 
in substance properly treated for Federal tax purposes as the holding 
of securities by one party as agent for another, the arrangement will 
be taxed in accordance with its substance.

3. Application to Individuals

A. In General
    Section 1411(a)(1) imposes a tax on individuals, but section 
1411(e)(1) provides that section 1411 does not apply to a nonresident 
alien. The proposed regulations provide that the term individual for 
purposes of section 1411 is any natural person, except for natural 
persons who are nonresident aliens. Therefore, section 1411 applies to 
any citizen or resident of the United States (within the meaning of 
section 7701(a)(30)(A)).
    The amount of the tax on individuals is equal to 3.8 percent of the 
lesser of two amounts: (A) An individual's net investment income for 
such taxable year, or (B) the excess (if any) of (i) the individual's 
modified adjusted gross income for such taxable year, over (ii) the 
threshold amount. For example, if an unmarried U.S. citizen has 
modified adjusted gross income (as defined in section 1411(d) and 
proposed Sec.  1.1411-2(c)) of $190,000, which includes $50,000 of net 
investment income (as defined in section 1411(c)(1) and proposed Sec.  
1.1411-4), there is no tax imposed under section 1411 because the 
threshold amount for a single individual is $200,000 (see section 
1411(b)(3) and proposed Sec.  1.1411-2(d)(1)(iii)). On the other hand, 
if that individual has modified adjusted gross income of $220,000, 
which includes net investment income of $50,000, the individual has a 
section 1411 tax of $760 (3.8 percent times $20,000).
    The proposed regulations also clarify the treatment of (1) grantor 
trusts (see proposed Sec. Sec.  1.1411-2(a)(2)(ii), 1.1411-3(b)(5), and 
part 4.B.ii of this preamble), (2) certain bankruptcy estates (see 
proposed Sec. Sec.  1.1411-2(a)(2)(iii), 1.1411-3(d)(1), and part 4.D 
of this preamble), and (3) bona fide residents of the U.S. territories 
(see proposed Sec.  1.1411-2(a)(2)(iv) and part 3.C of this preamble).
B. Joint Returns in the Case of a Nonresident Alien Individual Married 
to a U.S. Citizen or Resident
    Proposed Sec.  1.1411-2(a)(2)(i) addresses certain joint returns 
filed by married individuals. Proposed Sec.  1.1411-2(a)(2)(i)(A) 
provides that in the case of a U.S. citizen or resident who is married 
(as defined in section 7703) to a nonresident alien individual, the 
spouses will be treated as married filing separately for purposes of 
section 1411. For purposes of calculating the tax imposed under section 
1411(a)(1), the U.S. citizen or resident spouse will be subject to the 
threshold amount in section 1411(b)(2) ($125,000) for a married 
taxpayer filing a separate return, and the nonresident alien spouse 
will be exempt from section 1411 taxation under section 1411(e)(1). In 
accordance with the rules for married taxpayers filing separate 
returns, the U.S. citizen or resident spouse must determine his or her 
own net investment income and modified adjusted gross income.
    In general, section 6013(a) provides that no joint return may be 
made by married taxpayers if either spouse is a nonresident alien at 
any time during a taxable year. Section 6013(g), however, generally 
permits a nonresident alien individual married to a citizen or resident 
of the United States to elect for purposes of chapter 1 and chapter 24 
of the Code to be treated as a resident of the United States. Proposed 
Sec.  1.1411-2(a)(2)(i)(B) provides that married taxpayers who file a 
joint Federal income tax return pursuant to a section 6013(g) election 
can also elect to be treated as making a section 6013(g) election for 
purposes of chapter 2A of the Code. For purposes of calculating the tax 
imposed under section 1411(a)(1), the effect of such an election is to 
include the combined income of the U.S. citizen or resident spouse and 
the nonresident spouse in the section 1411(a)(1) calculation and 
subject that income to the threshold amount in section 1411(b)(1) 
($250,000) for a taxpayer filing a joint return. Proposed Sec.  1.1411-
2(a)(2)(i)(B)(2) provides procedural requirements for making this 
election.
C. Bona Fide Residents of U.S. Territories
    Proposed Sec.  1.1411-2(a)(2)(iv) provides guidance on the 
application of section 1411 to individuals who are bona fide residents 
(within the meaning of section 937(a)) of possessions of the United 
States (U.S. territories) (namely, American Samoa, Guam, the Northern 
Mariana Islands, Puerto Rico, and the United States Virgin Islands). An 
individual who is a citizen, resident, or nonresident alien with 
respect to the United States may qualify as a bona fide resident of a 
U.S. territory.
    The application of the tax under section 1411 to a bona fide 
resident of a U.S. territory depends on whether the U.S. territory has 
a mirror code system of taxation, meaning the income tax laws are 
generally identical to the Code (except for the substitution of the 
name of the relevant territory for the term ``United States'' where 
appropriate). Three of the five U.S. territories (Guam, the Northern 
Mariana Islands, and the United States Virgin Islands) have a mirror 
code.
    Bona fide residents of U.S. territories that are mirror code 
jurisdictions have no income tax obligation (or related return filing 
requirement) with the United States provided, generally, that they 
properly report income and pay income tax to the tax administration of 
their respective U.S. territory. See generally sections 932, 934, and 
935. Therefore, the tax imposed by section 1411(a) generally does not 
apply to bona fide residents of mirror code jurisdictions because they 
will not have an income tax liability to the United States if they 
fully comply with the tax laws of the relevant territory.
    Bona fide residents of non-mirror code jurisdictions (American 
Samoa and Puerto Rico) generally exclude territory-source income from 
U.S. Federal gross income under sections 931 and 933, respectively. 
(American Samoa currently is the only territory to which section 931 
applies because it is the only territory that has entered into an 
implementing agreement under sections 1271(b) and 1277(b) of the Tax 
Reform Act of 1986.) Although territory-source income is excluded, 
these bona fide residents are subject to U.S. Federal income taxation, 
and have a related income tax return filing requirement with the United 
States to the extent they have U.S.-source or other non-territory 
source income or income from amounts paid for services performed as an

[[Page 72615]]

employee of the United States or any agency thereof (collectively, U.S. 
reportable income). See section 931(a) and (d) and section 933. 
Furthermore, under section 876 and Sec.  1.876-1, bona fide residents 
of non-mirror code jurisdictions who are nonresident aliens with 
respect to the United States are subject to net-basis U.S. taxation on 
U.S. reportable income under sections 1 and 55, rather than to gross-
basis U.S. taxation with respect to U.S.-source income under sections 
871 through 879 (provisions that otherwise generally apply to 
nonresident aliens with respect to U.S.-source income).
    Therefore, the tax imposed under section 1411(a) is applicable to 
bona fide residents of non-mirror code jurisdictions if they have U.S. 
reportable income that gives rise to both net investment income and 
modified adjusted gross income exceeding the threshold amount in 
section 1411. However, section 1411(a) does not apply if such bona fide 
residents are nonresident alien individuals with respect to the United 
States because section 1411(e)(1) and proposed Sec.  1.1411-2(a)(1) 
exclude from section 1411(a) all nonresident alien individuals, which 
would include bona fide residents of any U.S. territory. However, 
nonresident alien individuals who are bona fide residents of non-mirror 
code jurisdictions remain subject to taxation under chapter 1 of 
subtitle A pursuant to section 876.
D. Modified Adjusted Gross Income
    For purposes of section 1411 and the regulations thereunder, the 
term modified adjusted gross income is defined in section 1411(d) and 
proposed Sec.  1.1411-2(c)(1) as adjusted gross income increased by the 
excess of (1) the amount excluded from gross income under section 
911(a)(1), over (2) the amount of any deductions (taken into account in 
computing adjusted gross income) or exclusions disallowed under section 
911(d)(6) with respect to the amounts excluded from gross income under 
section 911(a)(1). See part 11 of this preamble for additional 
discussion on adjustments to modified adjusted gross income with 
respect to the ownership of interests in controlled foreign 
corporations and passive foreign investment companies.
E. Threshold Amount
    For purposes of section 1411(a)(1) and (b) and the regulations 
thereunder, the term threshold amount for an individual means (1) in 
the case of a taxpayer making a joint return under section 6013 or a 
surviving spouse (as defined in section 2(a)), $250,000, (2) in the 
case of a married taxpayer (as defined in section 7703) filing a 
separate return, $125,000, and (3) in any other case, $200,000. For 
special rules regarding a nonresident alien individual married to U.S. 
citizen or resident, see proposed Sec.  1.1411-2(a)(2)(i) and part 3.B 
of this preamble. For rules regarding certain bankruptcy estates, see 
proposed Sec. Sec.  1.1411-2(a)(2)(iii), 1.1411-3(d)(1), and part 4.D 
of this preamble. The threshold amount is not indexed for inflation.
    Under the proposed regulations, the threshold amount is generally 
not prorated in the case of a short taxable year of an individual. 
However, the proposed regulations provide a special rule in the case of 
an individual who has a short taxable year resulting from a change of 
annual accounting period. Under section 443(b)(1), a taxpayer that 
undergoes a change in annual accounting period under section 442 and 
has a short period must annualize its taxable income. The taxpayer's 
Federal income tax is the tax computed on the annualized taxable income 
by multiplying the taxable income for the short period by twelve and 
dividing the result by the number of months in the short period. 
Proposed Sec.  1.1411-2(d)(2)(ii) provides that an individual taxpayer 
that has a short period resulting from a change of annual accounting 
period shall reduce the applicable threshold amount to an amount that 
bears the same ratio to the full threshold amount provided under 
section 1411(b) as the number of months in the short period bears to 
twelve.

4. Application to Estates and Trusts

    In general, section 1411(a)(2) imposes a tax of 3.8 percent on 
estates and trusts on the lesser of their undistributed net investment 
income or the excess of their adjusted gross income (as defined in 
section 67(e)) over the dollar amount at which the highest tax bracket 
in section 1(e) begins for such taxable year. Proposed Sec.  1.1411-3 
provides special rules for applying section 1411 to estates and trusts, 
including an estate or trust with a short taxable year resulting from 
the formation or termination of the estate or trust or a change in 
accounting period.
A. Trusts Subject to Section 1411
    Because Congress did not provide a rule specifying the particular 
trusts subject to section 1411, the Treasury Department and the IRS 
have determined that section 1411 applies to ordinary trusts described 
in Sec.  301.7701-4(a). The general rule set forth in proposed Sec.  
1.1411-3(a)(1)(i) (that section 1411 applies to all estates and trusts 
that are subject to the provisions of part I of subchapter J of chapter 
1 of subtitle A of the Code) implements this approach. This rule 
excludes from the application of section 1411 business trusts described 
in Sec.  301.7701-4(b), which are treated as business entities under 
Sec.  301.7701-2 and as eligible entities for purposes of entity 
classification in Sec.  301.7701-3. Accordingly, such trusts are not 
subject to section 1411 at the entity level.
    In addition, the general rule excludes certain state law trusts 
that are subject to specific taxation regimes in chapter 1 other than 
part I of subchapter J. This exclusion is consistent with the exception 
in the entity classification regulations for entities where a specific 
provision of the Code provides for special treatment of that 
organization. See Sec.  301.7701-1(b). Examples of these trusts include 
common trust funds taxed under section 584 and expressly not subject to 
taxation under chapter 1 (per section 584(b)) and designated settlement 
funds taxed under section 468B in lieu of any other taxation under 
subtitle A (per section 468B(b)(4)).
    However, section 1411 does apply to trusts subject to the 
provisions of part I of subchapter J, even though such trusts may have 
special computational rules within those provisions. These trusts 
include pooled income funds described in section 642(c)(5), cemetery 
perpetual care funds described in section 642(i), and qualified funeral 
trusts described in section 685. Similarly, section 1411 applies to 
certain Alaska Native settlement trusts described in section 646 (if 
that provision is in effect after the effective date of section 1411). 
The Treasury Department and the IRS request comments as to whether 
there may be administrative reasons to exclude one or more of these 
types of trusts from section 1411.
B. Application to Specific Trusts
i. Tax-Exempt Trusts
    Section 1411 is in subtitle A. As a result, section 1411 does not 
apply to any trust, fund, or other special account that is exempt from 
tax imposed under subtitle A. This exclusion applies even if such trust 
may be subject to tax under section 511 on its unrelated business 
taxable income (and even if the trust's unrelated business taxable 
income is comprised of net investment income). Accordingly, the 
proposed regulations provide that any account, fund, or trust that is 
exempt from taxation under subtitle A (for example, sections 501(a), 
664(c)(1), 220(e)(1), 223(e)(1), 529(a), and 530(a)) is also exempt 
from section 1411.

[[Page 72616]]

    Section 1411(e)(2) specifically excepts from the application of 
section 1411 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). See proposed Sec.  1.1411-3(b)(1).
ii. Grantor Trusts
    A grantor trust is a trust or any portion thereof that is treated 
as being owned by the grantor or another person under subpart E of 
subchapter J (see sections 671 through 679). The owner must compute the 
owner's taxable income and credits by including the items of income, 
deduction, and credit against the tax attributable to the trust or the 
portion thereof treated as being owned by the owner. Thus, a grantor 
trust's income is not taxed as trust income but instead is treated as 
being the income of (and taxable to) the owner. The same rule applies 
for purposes of section 1411, thereby providing a consistent 
application of the grantor trust rules. This approach is also 
consistent with the IRS's position that the application of section 671 
is not limited to chapter 1 of subtitle A. See Notice 97-24 (1997-1 CB 
409); see Sec.  601.601(d)(2).
    Proposed Sec.  1.1411-3(b)(5) provides that the tax under section 
1411 is not imposed on a grantor trust, but if a grantor or another 
person is treated as the owner of all or a portion of a trust under 
subpart E of part I of subchapter J of chapter 1 any items of income, 
deduction, or credit that are included in computing taxable income of 
such grantor or other person under section 671 shall be treated as if 
such items had been received or paid directly by the grantor or other 
person for purposes of calculating such person's net investment income.
iii. Electing Small Business Trusts (ESBTs)
    Proposed Sec.  1.1411-3(c)(1) provides special computational rules 
for ESBTs. For purposes of chapter 1, section 641(c)(1) provides that 
(A) the portion of any ESBT which consists of stock in one or more S 
corporations shall be treated as a separate trust, and (B) the amount 
of the tax imposed by chapter 1 on such separate trust shall be 
determined with certain modifications detailed in section 641(c)(2). 
Section 1.641(c)-1(a) provides that an ESBT is treated as two separate 
trusts for purposes of chapter 1.
    The proposed regulations preserve the chapter 1 treatment of the 
ESBT as two separate trusts for computational purposes but consolidates 
the ESBT into a single trust for determining the adjusted gross income 
threshold in section 1411(a)(2)(B)(ii). This rule applies a single 
section 1(e) threshold so as to not inequitably benefit ESBTs over 
other taxable trusts.
    Proposed Sec.  1.1411-3(c)(1)(ii) provides the method to determine 
the ESBT's section 1411 tax base. First, the ESBT will separately 
calculate the undistributed net investment income of the S portion and 
non-S portion in accordance with the general rules for trusts under 
chapter 1, and combine the undistributed net investment income of the S 
portion and the non-S portion. Second, the ESBT will determine its 
adjusted gross income, solely for purposes of section 1411, by adding 
the net income or net loss from the S portion to that of the non-S 
portion as a single item of income or loss. Finally, to determine 
whether the ESBT is subject to section 1411, and if so, the section 
1411 tax base, the ESBT will compare the combined undistributed net 
investment income with the excess of its adjusted gross income over the 
section 1(e) threshold.
iv. Charitable Remainder Trusts
    Proposed Sec.  1.1411-3(c)(2) provides special computational rules 
for charitable remainder trusts. Although the trust itself is not 
subject to section 1411 as provided in proposed Sec.  1.1411-3(b)(3), 
annuity and unitrust distributions may be net investment income to the 
non-charitable recipient beneficiary. Proposed Sec.  1.1411-3(c)(2) 
provides special rules to maintain the character and distribution 
ordering rules of Sec.  1.664-1(d) for purposes of section 1411. The 
Treasury Department and the IRS are proposing these rules to determine 
whether items of income allocated to annuity or unitrust payments 
constitute net investment income to the recipient beneficiary.
    Proposed Sec.  1.1411-3(c)(2)(i) provides that distributions from a 
charitable remainder trust to a beneficiary for a taxable year consist 
of net investment income in an amount equal to the lesser of the total 
amount of the distributions for that year, or the current and 
accumulated net investment income of the charitable remainder trust. 
For charitable remainder trusts with multiple annuity or unitrust 
beneficiaries, the trust shall apportion the net investment income 
among the beneficiaries based on their respective shares of the total 
annuity or unitrust amount paid by the trust for that taxable year.
    Proposed Sec.  1.1411-3(c)(2)(ii) defines the term accumulated net 
investment income as the total amount of net investment income received 
by a charitable remainder trust for all taxable years beginning after 
December 31, 2012, less the total amount of net investment income 
distributed for all prior taxable years beginning after December 31, 
2012.
    Thus, under proposed Sec.  1.1411-3(c)(2), current and accumulated 
net investment income of the trust is deemed to be distributed before 
amounts that are not items of net investment income for purposes of 
section 1411. This classification of income as net investment income or 
non-net investment income is separate from, and in addition to, the 
four tiers under section 664(b), which continue to apply.
    The Treasury Department and the IRS considered an alternative 
method for determining the distributed amount of net investment income 
in which net investment income would be determined on a class-by-class 
basis within each of the Sec.  1.664-1(d)(1) enumerated categories. 
Under this alternative method, trustees would need to account for 
additional classes of income within each category, consistent with 
Sec.  1.664-1(d)(1)(i), for taxable years beginning after December 31, 
2012. The alternative method would create a sub-class system of net 
investment income and non-net investment income within each class and 
category of the section 664 framework. Although differentiating between 
net investment income and non-net investment income within each class 
and category might be considered more consistent with the structure 
created for charitable remainder trusts by section 664 and the 
corresponding regulations, the Treasury Department and the IRS believe 
that the recordkeeping and compliance burden that would be imposed on 
trustees by this alternative would outweigh the benefits.
C. Foreign Estates and Foreign Trusts
    Section 1411 does not specifically address the treatment of foreign 
estates and foreign nongrantor trusts. See part 4.B.ii of this preamble 
for the rules that apply if the foreign trust is treated as owned by a 
grantor or another person under sections 671 through 679. The Treasury 
Department and the IRS believe that section 1411 should not apply to 
foreign estates and foreign trusts that have little or no connection to 
the United States (for example, if none of the beneficiaries is a 
United States person). Accordingly, proposed Sec. Sec.  1.1411-
3(d)(2)(i) and 1.1411-3(b)(6) provide, as a general rule, that foreign 
estates and foreign trusts are not subject to section 1411. The 
Treasury Department and the IRS believe, however, that net investment 
income of

[[Page 72617]]

a foreign estate or foreign trust should be subject to section 1411 to 
the extent such income is earned or accumulated for the benefit of, or 
distributed to, United States persons. The taxation of United States 
beneficiaries receiving current distributions of net investment income 
from a foreign estate or foreign nongrantor trust will be consistent 
with the general operation of subparts A through D of part I of 
subchapter J and will be subject to section 1411. See proposed 
Sec. Sec.  1.1411-4(e) and 1.1411-3(e)(3).
    Proposed Sec. Sec.  1.1411-3(d)(2)(ii) and 1.1411-3(c)(3) reserve 
on the application of section 1411 to foreign estates and foreign 
trusts with United States beneficiaries. The Treasury Department and 
the IRS request comments on the application of section 1411 to net 
investment income of foreign estates and foreign trusts that is earned 
or accumulated for the benefit of United States beneficiaries, 
including whether section 1411 should be applied to the foreign estate 
or foreign trust, or to the United States beneficiaries upon an 
accumulation distribution. Regarding the application of section 1411 to 
the foreign estate or foreign trust, consideration is being given to 
whether the definition of a United States beneficiary should exclude 
contingent or future beneficiaries and to adoption of an exclusion from 
section 1411 for foreign pension funds that are treated as trusts for 
United States tax purposes. To the extent that the final regulations do 
not subject foreign estates or foreign trusts to tax under section 
1411, the Treasury Department and IRS request comments on how section 
1411 should apply to United States persons that receive accumulation 
distributions from foreign estates and foreign trusts, including the 
means by which to identify such distributions as net investment income.
D. Bankruptcy Estates
    A bankruptcy estate of a debtor who is an individual is treated as 
an individual for purposes of computing the tax under section 1411. 
Section 1398 provides rules for the taxation of bankruptcy estates in 
chapter 7 and chapter 11 cases under the Bankruptcy Code in which the 
debtor is an individual. In these cases, the bankruptcy estate computes 
its tax in the same manner as an individual. Section 1398(c)(2) 
provides that the tax rate under section 1 for the bankruptcy estate is 
the same as that imposed on a married taxpayer filing separately, and 
section 1398(c)(3) provides that the bankruptcy estate is entitled to a 
standard deduction of a married taxpayer filing separately. Therefore, 
consistent with section 1398, regardless of the actual marital status 
of the debtor, a bankruptcy estate of a debtor who is an individual is 
treated as a married taxpayer filing separately for purposes of the 
thresholds in section 1411(b), and therefore the threshold amount 
applicable to such a bankruptcy estate is $125,000.
E. Calculation of Undistributed Net Investment Income
    Under section 1411(a)(2), the tax under section 1411 is imposed on 
the lesser of (A) the undistributed net investment income of the estate 
or trust for such year, or (B) the excess (if any) of the adjusted 
gross income (as defined in section 67(e)) for the taxable year, over 
the dollar amount at which the highest tax bracket in section 1(e) 
begins for such taxable year. Thus, similar to the computation for 
individuals, it is the lesser of two amounts. Net investment income is 
defined in section 1411(c)(1) and proposed Sec.  1.1411-4, and this 
same definition applies to individuals, estates, and trusts. 
Undistributed net investment income is a section 1411 term used solely 
for estates and trusts (and not individuals), and is not defined in 
section 1411. The proposed regulations conform the taxation of estates 
and trusts under section 1411 to the rules of part I of subchapter J to 
avoid double taxation of net investment income and the taxation of 
amounts distributed to charities.
    The proposed regulations give effect to the provisions of 
subchapter J that treat an estate or trust as a conduit by reducing the 
estate's or trust's taxable income to take into account distributions 
to beneficiaries and the charitable deduction. The proposed 
regulations, accordingly, provide that undistributed net investment 
income of an estate or trust is its net investment income (as 
determined under proposed Sec.  1.1411-4) reduced by the share of net 
investment income included in the deductions of the estate or trust 
under section 651 or section 661, and the share of net investment 
income allocated to the section 642(c) deduction of the estate or trust 
in accordance with Sec.  1.642(c)-2(b) and the allocation and ordering 
rules under Sec.  1.662(b)-2. The proposed regulations adopt the class 
system of income categorization, generally embodied in sections 651 
through 663 and the regulations thereunder, to arrive at the trust's 
net investment income reduction in the case of distributions that are 
comprised of both net investment income and net excluded income items. 
For this purpose, the term excluded income includes items that are not 
includible in net investment income by either specific exclusion under 
chapter 1 (for example, interest on state and local bonds under section 
103(a)); specific exclusion contained in section 1411 (for example, 
section 1411(c)(5) or (6)) or the proposed regulations; or are not 
specifically included in section 1411(c)(1)(A) or elsewhere in the 
proposed regulations.

5. Definition of Net Investment Income

    Section 1411(c)(1) defines net investment income as the excess (if 
any) of (A) the sum of (i) gross income from interest, dividends, 
annuities, royalties, and rents, other than such income derived in the 
ordinary course of a trade or business to which the tax does not apply, 
(ii) other gross income from trades or businesses to which the tax 
applies, and (iii) net gain (to the extent taken into account in 
computing taxable income) attributable to the disposition of property 
other than property held in a trade or business to which the tax does 
not apply, over (B) deductions allowed by subtitle A which are properly 
allocable to such gross income or net gain.
    If items of net investment income (including the properly allocable 
deductions) pass through to an individual, estate, or trust from a 
partnership or S corporation, the allocation of such items must be 
separately stated under section 702 or section 1366 and the regulations 
thereunder.
A. Gross Income Items Described in Section 1411(c)(1)(A)(i)
i. In General
    The proposed regulations provide that net investment income 
includes, in part, gross income from interest, dividends, annuities, 
royalties, and rents. However, such income is excluded from net 
investment income if it is derived in the ordinary course of a trade or 
business not described in section 1411(c)(2). This exclusion is 
described in part 5.A.vi of this preamble.
ii. Interest and Dividends
(a) In General
    Gross income from interest includes any item treated as interest 
for purposes of chapter 1, and includes substitute interest (as 
discussed in part 5.A.ii.(b) of this preamble).
    Gross income from dividends includes any item treated as a dividend 
for purposes of chapter 1. This includes, but is not limited to, 
amounts treated as dividends pursuant to subchapter C that are included 
in gross income (including

[[Page 72618]]

constructive dividends); amounts treated as dividends under section 
1248(a); amounts treated as dividends under Sec.  1.367(b)-2(e)(2); and 
amounts treated as dividends under section 1368(c)(2). In addition, as 
discussed in part 5.A.ii.(b) and part 11 of this preamble, substitute 
dividends, distributions from previously taxed earnings and profits 
(within the meaning of section 959(d) or section 1293(c)), and certain 
excess distributions (within the meaning of section 1291(b)) are 
included in net investment income.
    Gross income from notional principal contracts (within the meaning 
of Sec.  1.446-3(c)) is not included in net investment income under 
section 1411(c)(1)(A)(i). However, if gross income from notional 
principal contracts is derived in a trade or business described in 
proposed Sec.  1.1411-5, all of such gross income is included in net 
investment income under section 1411(c)(1)(A)(ii). In addition, gain on 
a disposition of a notional principal contract is included in net 
investment income under either section 1411(c)(1)(A)(ii) or section 
1411(c)(1)(A)(iii) (see parts 5.B and 5.C of this preamble).
(b) Substitute Interest and Substitute Dividends
    A substitute interest payment or a substitute dividend payment made 
to the transferor of a security in a securities lending transaction or 
a sale-repurchase transaction is treated as an interest payment or 
dividend payment, as applicable, for purposes of section 1411, and thus 
as net investment income for purposes of proposed Sec.  1.1411-
4(a)(1)(i). If substitute interest and substitute dividend payments 
were not treated in this manner, the Treasury Department and the IRS 
believe that taxpayers could easily avoid the section 1411 tax with 
respect to interest or dividend income by lending their securities over 
a payment date. The Treasury Department and the IRS do not believe that 
Congress intended the imposition of the section 1411 tax to turn on 
transactional formalities that are so readily manipulated by well-
advised taxpayers. This approach is consistent with other contexts in 
which substitute interest and dividend payments have been treated in 
the same manner as actual interest or dividend payments in order to 
preclude avoidance of tax. For example, regulations under sections 861, 
871, and 881 treat substitute interest and dividend payments as having 
the same source and the same character as the actual interest or 
dividend payments for which they substitute in order to preclude 
avoidance of nonresident withholding tax. See Sec. Sec.  1.861-2(a)(7); 
1.861-3(a)(6); 1.871-7(b)(2); and 1.881-2(b)(2).
    In certain other contexts, substitute payments are not treated in 
the same manner as actual interest or dividend payments (for example, a 
substitute dividend payment is not eligible for the dividends received 
deduction or for the lower rate of tax applicable to qualified 
dividends under section 1(h)(11)). In those contexts, however, 
disparate treatment serves essentially the same purpose, that is, to 
preclude the avoidance of tax through the multiplication of tax 
benefits or tax exclusions. The Treasury Department and the IRS believe 
that it is appropriate to treat substitute payments in a manner that 
precludes their use to facilitate tax avoidance. Accordingly, these 
proposed regulations treat substitute interest and substitute dividends 
as interest and dividends for purposes of determining net investment 
income.
(c) Controlled Foreign Corporations and Passive Foreign Investment 
Companies
    Special rules apply to a United States shareholder of a controlled 
foreign corporation or a United States person who owns stock in a 
passive foreign investment company. See part 11 of this preamble.
iii. Annuities
    Gross income from annuities includes the amount received as an 
annuity under an annuity, endowment, or life insurance contract that is 
includible in gross income as a result of the application of section 
72(a) and section 72(b), and an amount not received as an annuity under 
an annuity contract that is includible in gross income under section 
72(e).
    The Code does not define the term annuity. Section 72(a) provides 
that gross income includes any amount received as an annuity under an 
annuity, endowment, or life insurance contract. Section 72(b), however, 
excludes from gross income that part of an amount received as an 
annuity that bears the same ratio to that amount as the investment in 
the contract bears to the expected return under the contract 
(determined as of the annuity starting date).
    Section 72(e) governs the treatment of amounts received under an 
annuity contract that are not received as an annuity (such as lump sum 
distributions or surrenders). Section 72(e)(2) provides in general that 
such amounts received on or after the annuity starting date are 
included in gross income, and that amounts received before the annuity 
starting date are included in gross income to the extent allocable to 
income on the contract on an income-first basis.
    Gain or loss from the sale of an annuity would be treated as net 
investment income for purposes of section 1411. To the extent the sales 
price of the annuity does not exceed its surrender value, the gain 
recognized would be treated as gross income described in section 
1411(c)(1)(A)(i) and proposed Sec.  1.1411-4(a)(1)(i). If the sales 
price of the annuity exceeds its surrender value, the seller would 
treat the gain equal to the difference between the basis in the annuity 
and the surrender value as gross income described in section 
1411(c)(1)(A)(i) and proposed Sec.  1.1411-4(a)(1)(i), and would treat 
the excess of the sales price over the surrender value as gain from the 
disposition of property under section 1411(c)(1)(A)(iii) and proposed 
Sec.  1.1411-4(a)(1)(iii).
iv. Royalties
    Gross income from royalties includes amounts received from mineral, 
oil, and gas royalties, and amounts received for the privilege of using 
patents, copyrights, secret processes and formulas, goodwill, 
trademarks, tradebrands, franchises, and other like property.
v. Rents
    Gross income from rents includes amounts paid or to be paid 
principally for the use of (or the right to use) tangible property.
vi. Ordinary Course of a Trade or Business Exception
    The items described in parts 5.A.ii through 5.A.v of this preamble 
are not included in net investment income by reason of section 
1411(c)(1)(A)(i) if the item meets the ordinary course of a trade or 
business exception. See proposed Sec.  1.1411-4(b). The ordinary course 
of a trade or business exception is a two-part test. First, the item 
must be ``derived in'' a trade or business not described in section 
1411(c)(2). Second, if the item is derived in a trade or business not 
described in section 1411(c)(2), then such item must also be derived in 
the ``ordinary course'' of such trade or business. As explained in part 
6 of this preamble, a trade or business described in section 1411(c)(2) 
is either a trade or business that is (A) a passive activity (within 
the meaning of section 469) with respect to the taxpayer, or (B) 
trading in financial instruments (as defined in proposed Sec.  1.1411-
5(c)(1)) or commodities (as defined in section 475(e)(2)).

[[Page 72619]]

(a) Derived In
    In order for an item of gross income described in section 
1411(c)(1)(A)(i) to be excluded from section 1411 under the ordinary 
course of a trade or business exception, the income must be derived in 
a trade or business that is neither a passive activity with respect to 
the taxpayer (as described in section 1411(c)(2)(A) and the regulations 
thereunder) nor a trade or business of trading in financial instruments 
or commodities (as described in section 1411(c)(2)(B) and the 
regulations thereunder).
    In the case of an individual who is engaged in the conduct of a 
trade or business directly (for example, a sole proprietor) or through 
ownership of an interest in an entity that is disregarded as an entity 
separate from the individual owner under Sec.  301.7701-3, the 
determination of whether an item of gross income is derived in a trade 
or business described in section 1411(c)(2)(A) or (B) is made at the 
individual level. For example, if A, an individual, is engaged in a 
trade or business that is not described in section 1411(c)(2) and the 
trade or business has gross income (for example, royalties), such gross 
income is derived in A's trade or business, and therefore A meets the 
first part of the ordinary course of a trade or business exception. 
However, if A's trade or business is a passive activity with respect to 
A or if A's trade or business is trading in financial instruments or 
commodities, the ordinary course of a trade or business exception will 
be inapplicable because the income is derived in a trade or business 
described in section 1411(c)(2).
    In the case of an individual, estate, or trust that owns an 
interest in a trade or business through one or more passthrough 
entities (a partnership or an S corporation), the determination of 
whether an item of gross income described in section 1411(c)(1)(A)(i) 
allocated to the individual, estate, or trust from the passthrough 
entity is derived in a trade or business described in section 
1411(c)(2)(A) (a passive activity with respect to the taxpayer) or 
section 1411(c)(2)(B) (trading in financial instruments or commodities) 
is made in the following manner. The determination of whether the trade 
or business from which the income is derived is a passive activity with 
respect to the taxpayer is determined at the taxpayer (individual, 
estate, or trust) level in accordance with the general principles of 
section 469. For example, if A, an individual, owns an interest in PRS, 
a partnership, which is engaged in a trade or business, the 
determination of whether PRS's trade or business is a passive activity 
with respect to A is made in accordance with section 469 and the 
regulations under that section. See part 6.B of this preamble for rules 
to determine whether a trade or business is a passive activity with 
respect to a taxpayer.
    On the other hand, the determination of whether the trade or 
business from which the income is derived is a trade or business of 
trading in financial instruments or commodities is made at the 
passthrough entity level (the partnership or S corporation level). If 
the passthrough entity is engaged in a trade or business of trading in 
financial instruments or commodities, income from such trade or 
business retains its character as it passes from the entity to the 
taxpayer. Therefore, regardless of whether the individual is directly 
engaged in a trade or business or whether an intervening passthrough 
entity is engaged in a trade or business, such income will not qualify 
for the ordinary course of a trade or business exception in section 
1411(c)(1)(A)(i) because such income is derived in a trade or business 
of trading in financial instruments or commodities (as described in 
section 1411(c)(2)(B)). See Example 2 of proposed Sec.  1.1411-4(b)(3).
    Conversely, if the passthrough entity is not engaged in a trade or 
business, income allocated to an individual from such entity will not 
qualify for the ordinary course of a trade or business exception even 
if the individual or an intervening entity is engaged in a trade or 
business. For example, B, an individual, owns an interest in UTP, a 
partnership, which is engaged in a trade or business. UTP owns an 
interest in LTP, also a partnership, which is not engaged in a trade or 
business. Any income described in section 1411(c)(1)(A)(i) passed 
through from LTP (through UTP) to B will not be derived in a trade or 
business because LTP is not engaged in a trade or business. This 
characterization applies even though UTP is engaged in a trade or 
business and even if (1) B is engaged in a trade or business, (2) B 
provides services with respect to UTP's trade or business, and/or (3) B 
provides services to LTP. See Example 1 of proposed Sec.  1.1411-
4(b)(3).
    In addition, if the passthrough entity is not engaged in a trade or 
business and the passthrough entity has items of income described in 
section 1411(c)(1)(A)(i), the individual's status under section 469 is 
irrelevant. For example, C, an individual, owns an interest in PRS, a 
partnership that is not engaged in a trade or business and earns 
dividends and interest. C's distributive share of dividends and 
interest from PRS will be subject to section 1411(c)(1)(A)(i) because 
they are not derived in a trade or business and therefore cannot be 
excluded under the ordinary course of a trade or business exception.
    Similar rules regarding whether the trade or business is determined 
at the taxpayer level or the entity level apply in determining whether 
net gain is attributable to the disposition of property ``held'' in a 
trade or business subject to section 1411. See part 5.C of this 
preamble.
    The interaction of the ordinary course of a trade or business 
exception and the trade or business rules under sections 1411(c)(2)(A) 
and 1411(c)(2)(B) can be illustrated in the following example. B, an 
individual, owns an interest in S, an S corporation, which is a bank. S 
earns interest in the ordinary course of its trade or business (which 
is not trading in financial instruments or commodities). Accordingly, 
the interest B earns through S is not derived in a trade or business 
described in section 1411(c)(2)(B). B will then have to determine if 
S's trade or business is a passive activity with respect to B. If B is 
passive with respect to S's banking business, then even though the 
interest was not subject to section 1411(c)(1)(A)(i) because of section 
1411(c)(2)(B), B's pro rata share of S's interest is net investment 
income under section 1411(c)(1)(A)(ii) because of section 
1411(c)(2)(A). See Example 3 of proposed Sec.  1.1411-4(b)(3).
(b) Ordinary Course
    Section 1411 does not define ordinary course of a trade or 
business, and the proposed regulations do not provide guidance on the 
meaning of ordinary course. However, other regulation sections and case 
law provide guidance on whether an item of gross income is derived in 
the ordinary course of a trade or business. See, for example, Lilly v. 
Comm'r, 343 U.S. 90, 93 (1953), rev'g 188 F.2d 269 (4th Cir. 1951), 
aff'g 14 T.C. 1066 (1950) (holding that expenses incurred regularly and 
arising from transactions that commonly or frequently occur in the type 
of business involved are ``ordinary''); Sec.  1.469-2T(c)(3)(ii) 
(providing rules for determining whether certain portfolio income is 
excluded from the definition of passive activity gross income).
vii. Income From Employment
    For purposes of section 1411, an employee is treated as engaged in 
the trade or business of being an employee. Therefore, regardless of 
whether such amounts are calculated by reference to

[[Page 72620]]

the items described in proposed Sec.  1.1411-4(a), amounts paid by an 
employer to an employee that are treated as wages for purposes of 
section 3401 are not net investment income because such amounts are 
derived in the ordinary course of a trade or business to which section 
1411 does not apply. For example, amounts paid to an employee under a 
nonqualified deferred compensation plan for such employee (or that 
otherwise become includible in income under section 409A, 457(f), 457A, 
or other Code section or tax doctrine) that include gross income from 
interest or other earnings are not treated as net investment income, 
regardless of whether such amounts are not subject to Federal Insurance 
Contributions Act tax due to the earlier application of section 
3121(v)(2).
viii. Coordination With Portfolio Income Rules in Section 469
    Because section 469 treats portfolio income (which includes, for 
example, gross income from interest and dividends) as not derived in 
the ordinary course of a trade or business, the ordinary course of a 
trade or business exception in section 1411(c)(1)(A)(i) does not apply 
to such income, and such income will be net investment income under 
proposed Sec.  1.1411-4(a)(1)(i). The section 469 portfolio income 
rules are discussed in detail in part 6.B.i.(c).(1).(I) of this 
preamble.
B. Other Trade or Business Gross Income Described in Section 
1411(c)(1)(A)(ii)
    Net investment income also includes other gross income derived from 
a trade or business described in section 1411(c)(2). See section 
1411(c)(1)(A)(ii). The trades or businesses described in section 
1411(c)(2) are discussed in part 6 of this preamble.
    For a trade or business described in section 1411(c)(2)(A), which 
is a trade or business that is a passive activity with respect to the 
taxpayer, section 1411(c)(1)(A)(ii) includes other gross income that is 
not gross income described in section 1411(c)(1)(A)(i) or net gain 
described in section 1411(c)(1)(A)(iii). Thus, if an item of gross 
income or net gain is subject to section 1411(c)(1)(A)(i) or (iii), it 
is generally not other gross income described in section 
1411(c)(1)(A)(ii).
    For a trade or business described in section 1411(c)(2)(B), which 
is a trade or business of trading in financial instruments or 
commodities, section 1411(c)(1)(A)(ii) includes all other gross income 
from such trade or business that is not gross income described in 
section 1411(c)(1)(A)(i). For example, any gain from marking to market 
under section 475(f) or section 1256 and any realized gain from the 
disposition of property held in the trade or business of trading in 
financial instruments or commodities is classified as other gross 
income subject to section 1411(c)(1)(A)(ii) (and not classified as net 
gain under section 1411(c)(1)(A)(iii)).
C. Net Gain Described in Section 1411(c)(1)(A)(iii)
    Section 1411(c)(1)(A)(iii) states that net investment income 
includes net gain (to the extent taken into account in computing 
taxable income) attributable to the disposition of property other than 
property held in a trade or business not described in section 
1411(c)(2). See part 11 of this preamble for additional discussion on 
net investment income with respect to controlled foreign corporations 
and passive foreign investment companies.
i. Disposition
1. In General
    The proposed regulations provide that net investment income 
includes net gain (to the extent taken into account in computing 
taxable income) attributable to the sale, exchange, transfer, 
conversion, cash settlement, cancellation, termination, lapse, 
expiration, or other disposition (collectively, referred to as the 
disposition) of property other than property held in a trade or 
business not described in proposed Sec.  1.1411-5. Except as otherwise 
provided, the income tax rules in chapter 1 generally will determine 
whether there has been a disposition of property under section 1411. 
For example, if a partner receives a distribution of money from a 
partnership in excess of the adjusted basis of the partner's interest 
in the partnership and recognizes gain under section 731(a), or if an S 
corporation shareholder receives a distribution of money from the S 
corporation in excess of the adjusted basis of the shareholder's stock 
in the corporation and recognizes gain under section 1368(b)(2), the 
gain is treated as gain from the sale or exchange of such partnership 
interest or S corporation stock for purposes of section 
1411(c)(1)(A)(iii). As another example, if stock of an S corporation is 
sold and a section 338(h)(10) election is made, each shareholder's pro 
rata share of the deemed asset sale gain or loss may be taken into 
account in determining net investment income under section 
1411(c)(1)(A)(iii). Furthermore, each shareholder may have additional 
gain or loss upon the deemed liquidation of the S corporation resulting 
from the section 338(h)(10) election, which gain or loss will also 
generally be taken into account under section 1411(c)(1)(A)(iii) in 
determining net investment income. In addition, capital gain dividends 
from regulated investment companies and real estate investment trusts 
described in sections 852(b)(3)(C) and 857(b)(3)(C), respectively, and 
undistributed capital gains described in sections 852(b)(3)(D) and 
857(b)(3)(D), are included in net investment income as net gain under 
section 1411(c)(1)(A)(iii), and not as dividend income under section 
1411(c)(1)(A)(i).

2. Mark-to-Market Rules for Non-Traders

    Under certain statutory or regulatory provisions, a non-trader may 
(or may be required to) mark assets to market. For example, under 
section 1256, a taxpayer is treated as selling a section 1256 contract 
for fair market value at the end of the taxable year, and the taxpayer 
includes in gross income any gain and, in certain cases, loss 
recognized as a result of the deemed sale. Similarly, as further 
discussed in part 11 of this preamble, under section 1296, a United 
States person that has made a mark-to-market election with respect to 
stock in a passive foreign investment company recognizes income at the 
close of each taxable year based on the difference between the fair 
market value of the passive foreign investment company stock and the 
person's adjusted basis in such stock (or is allowed a deduction equal 
to the lesser of the excess of the adjusted basis of such stock over 
its fair market value or the unreversed mark-to-market inclusions with 
respect to the passive foreign investment company stock). These 
proposed regulations treat amounts of gain or loss recognized as a 
result of marking to market as net investment income. For rules 
regarding section 1296, see part 11 of this preamble. For rules 
regarding traders who mark assets to market under sections 475 and 
1256, see part 5.B of this preamble.
ii. Determination of Net Gain From Disposition
    Except as otherwise expressly provided in the regulations, the 
income tax gain and loss recognition rules in chapter 1 apply for 
purposes of determining net gain under section 1411. Thus, for example, 
to the extent gain from a like-kind exchange is not recognized for 
income tax purposes under section 1031, it is not recognized for 
purposes of determining net investment income under section 1411.

[[Page 72621]]

Losses properly taken into account in determining net gain include all 
losses deductible under section 165, to the extent they are 
attributable to property that is either (1) not held in a trade or 
business, or (2) held in a trade or business described in proposed 
Sec.  1.1411-5.
    The amount of net gain on the disposition of an interest in a 
partnership or an S corporation taken into account for purposes of 
section 1411(c)(1)(A)(iii) may be adjusted in accordance with proposed 
Sec.  1.1411-7 (relating to the special rule in section 1411(c)(4) for 
the dispositions of certain interests in partnerships or S 
corporations).
    Because section 1411(c)(1)(A)(iii) uses the term net gain (which 
contemplates a positive number), the proposed regulations provide that 
the amount of net gain included in net investment income may not be 
less than zero. Although capital losses in excess of capital gains are 
not recognized for purposes of section 1411, losses allowable under 
section 1211(b)(1) and (2) are permitted to offset gain from the 
disposition of assets other than capital assets that are subject to 
section 1411.
iii. Exception for Property Held in a Trade or Business Not Described 
in Section 1411(c)(2)
    Section 1411(c)(1)(A)(iii) generally applies if the property 
disposed of is either not held in a trade or business, or is held in a 
trade or business described in section 1411(c)(2) and proposed Sec.  
1.1411-5. See part 6 of this preamble for rules relating to trades or 
business subject to section 1411. However, if the property disposed of 
is ``held'' in a trade or business and such trade or business is not 
described in proposed Sec.  1.1411-5, net investment income would not 
include gain attributable to such property.
    The determination of whether property is ``held'' in a trade or 
business is determined in the same manner as whether gross income is 
``derived in'' a trade or business for purposes of section 
1411(c)(1)(A)(i). These rules are described in detail in part 5.A.vi of 
this preamble. Thus, for individuals directly engaged in a trade or 
business, the determination is made at the individual level. If an 
individual, estate, or trust holds an interest in a passthrough entity 
and such entity disposes of its property, the determination of whether 
property is held in a trade or business that is a passive activity is 
made at the taxpayer level (that is, the individual, estate, or trust 
level), and the determination of whether property is held in a trade or 
business of trading in financial instruments or commodities is made at 
the entity level. For example, S, an S corporation, is engaged in trade 
or business, and A, an individual, owns stock in S. If S sells its 
Property 1 for a gain, the determination of whether A's gain from the 
disposition of S's Property 1 is subject to section 1411(c)(1)(A)(iii) 
depends on (1) whether S held Property 1 in its trade or business, and 
(2) if S held Property 1 in its trade or business, whether S's trade or 
business is described in proposed Sec.  1.1411-5. If S held Property 1 
in its trade or business and S's trade or business is neither a passive 
activity with respect to A nor trading in financial instruments or 
commodities with respect to S, net gain from the disposition of 
Property 1 will not be subject to section 1411(c)(1)(A)(iii).
D. Distributions From Trusts
    The proposed regulations provide that net investment income 
includes a beneficiary's share of distributable net income, as 
described in sections 652(a) and 662(a), to the extent that, under 
sections 652(b) and 662(b), the character of such income constitutes 
net investment income, with further computations provided in proposed 
Sec.  1.1411-3(e).
E. Properly Allocable Deductions
    The proposed regulations provide that in determining net investment 
income, items of gross income and net gain are reduced by properly 
allocable deductions. Principles applied in determining the amount and 
timing of a deduction for purposes of Federal income taxation generally 
apply for purposes of determining a deduction under section 1411. 
However, only amounts paid or incurred by a taxpayer to produce gross 
income or net gain described in proposed Sec.  1.1411-4 may be deducted 
in determining net investment income.
    Net investment income for any taxable year may not be less than 
zero. In addition, any otherwise allowable deductions not taken into 
account for section 1411 purposes may only be taken into account in 
another taxable year to the extent allowed for chapter 1 purposes (such 
as a carryforward of investment interest under section 163(d), a 
suspended passive activity loss that is allowed in a later year under 
section 469(b), or a capital loss carryforward under section 1212).
    Section 469(g)(1) provides special rules for the treatment of 
suspended passive losses when the taxpayer disposes of its entire 
interest in any passive activity (or former passive activity) in a 
fully taxable transaction to an unrelated party during the taxable 
year. The Treasury Department and the IRS request comments on whether 
the losses triggered under section 469(g)(1) upon the disposition 
should be considered taken into account in determining the taxpayer's 
net gain on the disposition of the activity under section 
1411(c)(1)(A)(iii) or whether the losses should be considered properly 
allocable deductions to gross income and net gain described in section 
1411(c)(1)(A)(i) through (iii).
    The proposed regulations provide that net investment income does 
not take into account a net operating loss deduction. While some of the 
deductions included in the computation of a net operating loss may be 
deductions described in proposed Sec.  1.1411-4(f), the character of 
each of the various deduction items that comprise a net operating loss 
is generally not tracked for purposes of chapter 1 once the item 
becomes part of a net operating loss. Thus, when an item becomes part 
of a net operating loss that is carried to another year, it generally 
is no longer properly allocable to a specific type of income, such as 
gross income from interest. In addition, rules to determine the portion 
of a net operating loss deduction properly allocable to items of gross 
income or net gain subject to section 1411 would be unduly complex and 
not administrable. This result is similar to the result for self-
employment income, where section 1402(a)(4) specifically provides that 
the deduction for net operating losses provided in section 172 shall 
not be allowed in determining net earnings from self-employment. In 
determining a taxpayer's modified adjusted gross income (in the case of 
an individual) or adjusted gross income (in the case of an estate or 
trust), however, net operating losses continue to be taken into 
account. The Treasury Department and the IRS invite comments on this 
issue.
    Gross income from rents or royalties may be reduced by deductions 
described in section 62(a)(4) that are allocable to such income. Net 
investment income also takes into account the deduction for penalties 
associated with the early withdrawal of savings described in section 
62(a)(9).
    In addition, the proposed regulations permit gross income from a 
trade or business described in proposed Sec.  1.1411-5 that constitutes 
net investment income to be reduced by deductions described in section 
62(a)(1) that are allocable to such income. However, the amount of 
deductions allowed under section 1411(c)(1)(B) may be reduced or 
eliminated by the application of the self-employment

[[Page 72622]]

income exception in section 1411(c)(6) and proposed Sec.  1.1411-9.
    As discussed in part 10 of this preamble, under section 1411(c)(6) 
and proposed Sec.  1.1411-9(a), amounts taken into account in 
determining self-employment income are excluded from net investment 
income. Amounts not taken into account in determining self-employment 
income because they are excluded from net earnings from self-employment 
are not covered by the self-employment income exception in section 
1411(c)(6), and thus may be net investment income. The application of 
section 1411(c)(6) and the general rule in proposed Sec.  1.1411-9(a) 
to properly allocable deductions under section 1411(c)(1)(B) might 
produce an unintended result in the context of traders in financial 
instruments or commodities. In many cases, the gross income earned by a 
taxpayer engaged in the trade or business of trading financial 
instruments or commodities will be subject to section 1411 because the 
trading income is not taken into account in determining the taxpayer's 
self-employment income due to section 1402(a)(3)(A) (and in cases where 
the trader has made a section 475 election, due to the interaction of 
sections 475(f)(1)(D) and 1402(a)(3)(A)), and thus the self-employment 
income exception in section 1411(c)(6) does not apply to the income. 
However, the properly allocable deductions attributable to a trade or 
business of trading in financial instruments or commodities would be 
taken into account in determining the taxpayer's self-employment income 
(even though the gross income was not) and, absent an exception, would 
therefore not reduce the taxpayer's gross income under section 1411.
    For example, assume A, an individual, is engaged in the trade or 
business of trading in commodities, and made an election under section 
475(f)(2). A earns $500,000 of gross income (which is subject to 
proposed Sec.  1.1411-4(a)(1)(ii)), and A also incurs $100,000 of 
expenses relating to the trading business. Under section 1402, none of 
the $500,000 of gross income would be taken into account in determining 
A's self-employment income (as provided in sections 475(f)(1)(D) and 
1402(a)(3)(A)), but all of the $100,000 of expenses would be taken into 
account within the meaning of the general rule in proposed Sec.  
1.1411-9(a), even though there are no net earnings from self-employment 
and thus no self-employment income to reduce. Absent the exception 
described in proposed Sec.  1.1411-9(b), the expenses also would not 
reduce the taxpayer's $500,000 of gross income under section 1411 
because the expenses were taken into account under section 1402 in 
determining the taxpayer's self-employment income and would therefore 
be excluded under section 1411(c)(6) and the general rule in proposed 
Sec.  1.1411-9(a).
    The Treasury Department and the IRS believe that a trader should be 
able to reduce gross income described in proposed Sec.  1.1411-
4(a)(1)(ii) by properly allocable deductions if the deductions did not 
actually reduce net earnings from self-employment, even after 
aggregating net earnings from self-employment from other trades or 
businesses. Therefore, proposed Sec.  1.1411-9(b) provides a special 
rule for traders of financial instruments or commodities. If the trader 
has deductions that did not reduce the taxpayer's net earnings from 
self-employment (that is, excess deductions), even after aggregating 
net earnings from self-employment from other trades or businesses, such 
excess deductions are properly allocable deductions under section 
1411(c)(1)(B), notwithstanding the exclusion in section 1411(c)(6). 
This trader exception and section 1411(c)(6) are also discussed in part 
10 of this preamble.
    The proposed regulations also provide that several itemized 
deductions are properly allocable deductions under section 1411. The 
proposed regulations provide that investment interest allowed as a 
deduction by reason of section 163(d)(1), investment expenses described 
in section 163(d)(4)(C), and taxes imposed on investment income that 
are described in section 164(a)(3) are deductible in determining net 
investment income. In the case of taxes imposed on both investment 
income and non-investment income, the proposed regulations provide that 
the portion of taxes properly allocable to investment income may be 
determined by taxpayers using any reasonable method. The proposed 
regulations further provide that allocating the deduction based on the 
ratio of investment income to total gross income is an example of a 
reasonable method.
    Under the proposed regulations, properly allocable deductions that 
are itemized deductions subject to the 2-percent floor on miscellaneous 
itemized deductions under section 67 or subject to the overall 
limitation on itemized deductions under section 68 may be deducted in 
determining net investment income only to the extent that they are 
deductible for income tax purposes after the application of the 2-
percent floor and the overall deduction limitation. Some deductions, 
such as investment expenses, are subject to limitation under both 
sections 67 and 68, while other deductions, such as state taxes, are 
subject only to the limitation under section 68. It is necessary to 
apportion these deduction limitations between deductions properly 
allocable to net investment income and deductions that are not properly 
allocable to net investment income. The proposed regulations provide a 
method for apportioning these limitations to determine the amount of 
deductions allowed in computing net investment income after applying 
sections 67 and 68. This method first applies section 67 to all 
deductions subject to that limitation. The disallowance is applied 
proportionately to each deduction subject to section 67. The proposed 
regulations then apply a similar process to deductions subject to 
section 68.
    Deductions for losses under section 165 are taken into account only 
in computing net gain. Therefore, because net gain in section 
1411(c)(1)(A)(iii) cannot be less than zero, any excess of losses over 
gains are not allowable in the computation of net investment income. 
Accordingly, properly allocable deductions do not include deductions 
under section 165.
F. Income Inclusion From Tax-Exempt Trusts
    Generally, a recipient of a distribution from a tax-exempt trust 
(other than non-charitable beneficiary of a charitable remainder trust 
as described in part 4.B.iv of this preamble) will not be liable for 
Federal income tax on the distribution because the distribution is tax-
exempt income. Accordingly, the recipient (whether an individual, 
estate, or trust) will not be liable for tax under section 1411 
regardless of whether the distributed amount is comprised of items of 
net investment income. However, there may be certain situations in 
which the recipient of a distribution from a tax-exempt trust is liable 
for Federal income tax on all or a part of the distributed amount. For 
example, a distribution from a qualified tuition program under section 
529, a Coverdell education savings account, an Archer medical savings 
account (Archer MSA), or a health savings account (HSA) may be subject 
to Federal income tax if the distributed amounts are not used by the 
recipient for qualified expenses. In these situations, it is possible 
that a portion of the distribution may be comprised of items of net 
investment income generated by the trust corpus. However, in these 
cases, a recipient of a distribution from a tax-exempt trust will not 
be subject to tax under section 1411 on the distribution (even if the 
recipient

[[Page 72623]]

otherwise may be liable for Federal income tax on the distribution) 
because of the difficulty in determining whether the distributions from 
the corpus of the trust are gross income from items that may constitute 
net investment income (such as interest). Distributions from certain 
tax-exempt settlement funds covering Indian tribal governments also 
will not be subject to tax under section 1411, although income 
subsequently generated from distributed funds (for example, after 
deposit in an interest-bearing account) may be subject to section 1411.

6. Section 1411 Trades or Businesses

    Section 1411(c)(1)(A) defines net investment income, in part, by 
reference to trades or businesses described in section 1411(c)(2). The 
trades or businesses described in section 1411(c)(2) are (A) a passive 
activity (within the meaning of section 469) with respect to the 
taxpayer, and (B) trading in financial instruments or commodities (as 
defined in section 475(e)(2)).
A. In General
    Section 1411's statutory language and legislative history do not 
provide a definition of trade or business. The most established 
definition of trade or business is found under section 162(a), which 
permits a deduction for all the ordinary and necessary expenses paid or 
incurred in carrying on a trade or business. The rules under section 
162 for determining the existence of a trade or business are well-
established, and there is a large body of case law and administrative 
guidance interpreting section 162's meaning of trade or business. The 
proposed regulations incorporate the rules under section 162 for 
determining whether an activity is a trade or business for purposes of 
section 1411 and the proposed regulations. The use of the section 162 
definition of trade or business facilitates administration of section 
1411 and should simplify taxpayer compliance. See parts 5.A.vi and 5.C 
of this preamble for rules relating to the determination of whether 
certain items of income are derived in the ordinary course of a trade 
or business and whether net gain is attributable to the disposition of 
property held in a trade or business, respectively.
B. Trade or Business That Is a Passive Activity With Respect to the 
Taxpayer
    As described in part 6.A of this preamble, the statutory language 
in sections 1411(c)(1)(A) and 1411(c)(2)(A) is intended to take into 
account only gross income from and net gain attributable to a passive 
activity (within the meaning of section 469) that involves the conduct 
of a trade or business (within the meaning of section 162). The 
definitions of trade or business and passive activity for section 1411 
purposes are more restrictive than for section 469 purposes in two 
respects. First, section 469 and the regulations thereunder provide 
that a trade or business includes not only a trade or business (within 
the meaning of section 162), but also any activity conducted in 
anticipation of the commencement of a trade or business and any 
activity involving research or experimentation (within the meaning of 
section 174). See section 469(c)(5), Sec. Sec.  1.469-1(e)(2), and 
1.469-4(b)(1). Second, while section 469 defines passive activity as 
any trade or business in which the taxpayer does not materially 
participate, it also includes any rental activity in the definition of 
passive activity. See section 469(c)(1) and (2). The proposed 
regulations provide that the definition of trade or business for 
section 1411 purposes is limited to a trade or business within the 
meaning of section 162.
    Due to the differences in the definitions for purposes of section 
1411 and section 469, under the proposed regulations, in some cases 
gross income from activities that are passive activities under section 
469 will not be taken into account for purposes of section 
1411(c)(1)(A)(ii) because the gross income is derived from an activity 
that does not rise to the level of a trade or business (within the 
meaning of section 162). In such cases, the gross income will not be 
taken into account under section 1411 unless it is taken into account 
under section 1411(c)(1)(A)(i) or section 1411(c)(1)(A)(iii) and the 
proposed regulations. See Example 1 of proposed Sec.  1.1411-5(b)(2).
i. Passive Activities That Are Section 1411 Trades or Businesses
(a) In General
    For purposes of section 1411(c)(2)(A) and the proposed regulations, 
the taxpayer must determine whether a section 162 trade or business in 
which the taxpayer owns an interest is a passive activity. Section 
1411(c)(2)(A) provides that the term passive activity has the same 
meaning as section 469. Section 469(c)(1) provides that a passive 
activity is any activity that involves the conduct of any trade or 
business and in which the taxpayer does not materially participate. 
Section 469(c)(2) provides that, except as provided in section 
469(c)(7), a passive activity also includes any rental activity 
(regardless of whether the taxpayer materially participates in the 
rental activity). See also Sec.  1.469-1T(e)(3)(ii). For rules 
regarding the treatment of working interests in oil or gas property, 
see section 469(c)(3).
(b) Application of Existing Section 469 Rules
    Section 469 and the regulations thereunder provide rules for 
determining whether trade or business activities and certain rental 
activities are passive activities with respect to a taxpayer. 
Generally, these rules will also apply in determining whether a section 
162 trade or business is a passive activity for purposes of section 
1411(c)(2)(A). Examples of this principle are discussed in this 
preamble, but these examples are not meant to be an exhaustive list of 
the rules that apply.
(1) Material Participation
    Section 469(h)(1) provides that a taxpayer shall be treated as 
materially participating in an activity only if the taxpayer is 
involved in the operations of the activity on a basis which is regular, 
continuous, and substantial. Section 1.469-5T provides additional 
guidance for individuals on the meaning of ``material participation.'' 
The material participation rules of section 469 will apply for purposes 
of determining whether a taxpayer materially participates in a section 
162 trade or business for purposes of determining whether such trade or 
business is described in section 1411(c)(2)(A).
(2) Real Estate Professionals
    Section 469(c)(7) and Sec.  1.469-9 provide special rules for 
certain individual taxpayers involved in the conduct of real property 
trades or businesses (real estate professionals). If a taxpayer meets 
the requirements to be a real estate professional in section 
469(c)(7)(B), the taxpayer's interests in rental real estate are no 
longer subject to section 469(c)(2), and the rental real estate 
activities of the taxpayer will not be passive activities if the 
taxpayer materially participates in each of those activities. However, 
a taxpayer who qualifies as a real estate professional is not 
necessarily engaged in a trade or business (within the meaning of 
section 162) with respect to the rental real estate activities. If the 
rental real estate activities are section 162 trades or businesses, the 
rules in section 469(c)(7) and Sec.  1.469-9 will apply in determining 
whether a rental real estate activity of a real estate professional is 
a passive activity for purposes of section 1411(c)(2)(A). However, if 
the rental real

[[Page 72624]]

estate activities of the real estate professional are not section 162 
trades or businesses, the gross income from rents derived from such 
activity will not be excluded under section 1411(c)(1)(A)(i) by the 
ordinary course of a trade or business exception. The ordinary course 
of a trade or business exception is inapplicable because the rents are 
not derived from a trade or business and will therefore be subject to 
section 1411. The ordinary course of a trade or business exception is 
described in part 5.A.vi of this preamble.
(3) Rental Activity Exceptions
    Section 469(j)(8) and the regulations thereunder provide that a 
rental activity is any activity where payments are principally for the 
use of tangible property that is used or held for use by customers. 
Section 1.469-1T(e)(3)(ii) provides several exceptions to the 
definition of a rental activity. If a taxpayer's activity meets one of 
these exceptions, the activity is not a rental activity for purposes of 
section 469 (that is, it is no longer per se passive), and the activity 
will not be a passive activity if the taxpayer materially participates 
in that activity. These rental activity exceptions will also apply for 
determining whether the activity is a passive activity of a taxpayer 
for purposes of section 1411(c)(2)(A). However, a taxpayer who meets 
one of these exceptions is not necessarily engaged in a trade or 
business (within the meaning of section 162) with respect to the 
activity. In other words, even if the taxpayer meets one of the 
exceptions in Sec.  1.469-1T(e)(3)(ii), if the taxpayer's activity is 
not a section 162 trade or business, gross income from rents from the 
activity will be subject to section 1411(c)(1)(A)(i) because the 
activity does not meet the ordinary course of a trade or business 
exception. The proposed regulations provide examples that illustrate 
the interaction of section 1411 and the section 469 rental activity 
exceptions. See Examples 3 and 4 of proposed Sec.  1.1411-5(b)(2).
(4) Grouping Rules
    Section 1.469-4 provides rules for defining an activity for 
purposes of applying the passive activity loss rules of section 469 
(grouping rules). The grouping rules will apply in determining the 
scope of a taxpayer's trade or business in order to determine whether 
such trade or business is a passive activity for purposes of section 
1411(c)(2)(A). However, a proper grouping under Sec.  1.469-4(d)(1) 
(grouping rental activities with other trade or business activities) 
will not convert gross income from rents into other gross income 
derived from a trade or business described in proposed Sec.  1.1411-
5(a)(1).
    Section 1.469-4(e)(1) provides that, except as provided in 
Sec. Sec.  1.469-4(e)(2) and 1.469-11, once a taxpayer has grouped 
activities, the taxpayer may not regroup those activities in subsequent 
taxable years. The Treasury Department and the IRS have determined on 
prior occasions that taxpayers should be given a ``fresh start'' to 
redetermine their groupings. The enactment of section 1411 may cause 
taxpayers to reconsider their previous grouping determinations, and 
therefore the Treasury Department and the IRS have determined that 
taxpayers should be given the opportunity to regroup. Thus, the 
proposed regulations provide that taxpayers may regroup their 
activities in the first taxable year beginning after December 31, 2013, 
in which the taxpayer meets the applicable income threshold in proposed 
Sec.  1.1411-2(d) and has net investment income (as defined in proposed 
Sec.  1.1411-4). The determination in the preceding sentence is made 
without regard to the effect of the regrouping. Taxpayers may regroup 
their activities in reliance on this proposed regulation for any 
taxable year that begins during 2013 if section 1411 would apply to 
such taxpayer in such taxable year. A taxpayer may only regroup 
activities once pursuant to Sec.  1.469-11(b)(3)(iv)(A), and any such 
regrouping will apply to the taxable year for which the regrouping is 
done and all subsequent years.
    The regrouping must comply with the existing requirements under 
Sec.  1.469-4. For example, Sec.  1.469-4(e) provides that taxpayers 
must comply with disclosure requirements that the Commissioner may 
prescribe with respect to both their original groupings and the 
addition and disposition of specific activities within those chosen 
groupings in subsequent taxable years. On January 25, 2010, the 
Treasury Department and the IRS published Revenue Procedure 2010-13 
(2010-4 IRB 329), which requires taxpayers to report to the IRS their 
groupings and regroupings of activities and the addition of specific 
activities within their existing groupings of activities for purposes 
of section 469 and Sec.  1.469-4. Thus, the disclosure requirements of 
Sec.  1.469-4(e) and Revenue Procedure 2010-13 require taxpayers who 
regroup their activities pursuant to proposed Sec.  1.469-11(b)(3)(iv) 
to report their regroupings to the IRS. See Sec.  601.601(d)(2).
(c) Special Rules for Certain Income From Passive Activities
    Section 469 and the regulations thereunder provide several rules 
that restrict the ability of taxpayers to artificially generate passive 
income from certain types of passive activities. Some rules 
specifically recharacterize income from a passive activity as income 
not from a passive activity (income recharacterization rules). Other 
rules recharacterize the activity itself as being a non-passive 
activity (activity recharacterization rules).
(1) Income Recharacterization Rules
(I) Portfolio Income
    Section 469(e)(1)(A)(i)(I) provides that in determining the income 
or loss from any activity there shall not be taken into account any 
gross income from interest, dividends, annuities, or royalties not 
derived in the ordinary course of a trade or business (portfolio 
income). Thus, items of net investment income in section 
1411(c)(1)(A)(i) and proposed Sec.  1.1411-4(a)(1)(i) that are 
portfolio income will, by definition, be included in section 1411 
because these portfolio items are not derived in the ordinary course of 
a trade or business. In addition, Sec.  1.469-7 provides an exception 
to the portfolio income rules for self-charged interest, which is 
treated as passive income, and therefore, the gross income from such 
interest would be gross income from interest subject to proposed Sec.  
1.1411-4(a)(1)(i).
    Similarly, section 469(e)(1)(A)(ii) provides that gain or loss not 
derived in the ordinary course of a trade or business which is 
attributable to the disposition of property (I) producing portfolio 
income, or (II) held for investment, should not be taken into account 
in determining income from a passive activity. Thus, gain described in 
section 469(e)(1)(A)(ii) will be net investment income if (1) the gain 
is attributable to property held in a section 162 trade or business of 
trading in financial instruments or commodities, or (2) the gain is 
attributable to property not held in a section 162 trade or business. 
See part 5.C of this preamble.
(II) Working Capital
    Section 469(e)(1)(B) provides special rules for return on working 
capital. Section 1411(c)(3) provides that rules similar to section 
469(e)(1)(B) also apply for purposes of section 1411. Working capital 
is discussed in part 7 of this preamble.

[[Page 72625]]

(III) Net Income Recharacterization Rules
    The regulations under section 469 provide special rules that treat 
income from certain activities as not from a passive activity. See 
Sec.  1.469-2T(f)(2) (special rule for significant participation); 
Sec.  1.469-2T(f)(3) (rental of nondepreciable property); Sec.  1.469-
2T(f)(4) (net interest income from passive equity-financed lending 
activity); Sec.  1.469-2(f)(5) (net income from certain property rented 
incidental to development activity); Sec.  1.469-2(f)(6) (property 
rented to a nonpassive activity); Sec.  1.469-2T(f)(7) (special rules 
applicable to the acquisition of an interest in a passthrough entity 
engaged in the trade or business of licensing intangible property). In 
most cases, these items will be subject to section 1411 if the item of 
income constitutes gross income from one of the items described in 
proposed Sec.  1.1411-4(a)(1)(i) and the item of income is not derived 
in the ordinary course of a trade or business. For example, if a 
taxpayer has gross income from rents from an activity described in 
Sec.  1.469-2(f)(6) that is not derived in the ordinary course of a 
trade or business, the gross income from rents will be subject to 
section 1411. The ordinary course of a trade or business exception is 
described in part 5.A.vi of this preamble.
(IV) Substantially Appreciated Property
    Section 1.469-2(c)(2)(iii)(A) generally provides that if an 
interest in property used in an activity is substantially appreciated 
at the time of its disposition, any gain from the disposition shall be 
treated as not from a passive activity. The recharacterized gain may be 
taken into account under section 1411(c)(1)(A)(iii) if the gain is 
attributable to the disposition of property.
(2) Activity Recharacterization Rules
    Section 1.469-1T(e)(6) provides that an activity of trading 
personal property for the account of owners of interests in the 
activity is not a passive activity (without regard to whether such 
activity is a trade or business activity). For this purpose, Sec.  
1.469-1T(e)(6)(ii) provides that the term personal property means 
personal property (within the meaning of section 1092(d), without 
regard to paragraph (3) thereof). Section 1092(d)(1) provides that 
personal property means any personal property of a type which is 
actively traded. While the gross income from or net gain attributable 
to an activity of trading or dealing in property will not be taken into 
account under section 1411(c)(2)(A) by virtue of Sec.  1.469-
2T(c)(3)(ii)(D), such gross income or net gain nevertheless will be 
taken into account under section 1411(c)(2)(B) if the activity 
constitutes a section 162 trade or business of trading in financial 
instruments or commodities. Trading in financial instruments or 
commodities is discussed in part 6.C of this preamble.
C. Trading in Financial Instruments or Commodities
i. Distinguishing Between Dealers, Traders, and Investors
    Determining whether trading in financial instruments or commodities 
rises to the level of a section 162 trade or business is a question of 
fact. Higgins v. Comm'r, 312 U.S. 212, 217 (1941); Estate of Yaeger v. 
Comm'r, 889 F.2d 29, 33 (2d Cir. 1989). In general, section 475(c)(1) 
provides that the term dealer in securities means a taxpayer who (A) 
regularly purchases securities from or sells securities to customers in 
the ordinary course of a trade or business, or (B) regularly offers to 
enter into, assume, offset, assign, or otherwise terminate positions in 
securities with customers in the ordinary course of a trade or 
business. In contrast, a trader seeks profit from short-term market 
swings and receives income principally from selling on an exchange 
rather than from dividends, interest, or long-term appreciation. 
Groetzinger v. Comm'r, 771 F.2d 269, 274-275 (7th Cir. 1985), aff'd 480 
U.S. 23 (1987); Moller v. United States, 721 F.2d 810, 813 (Fed. Cir. 
1983). A person will be a trader, and therefore engaged in a section 
162 trade or business, if his or her trading is frequent and 
substantial, which has been rephrased as ``frequent, regular, and 
continuous.'' Boatner v. Comm'r, T.C. Memo. 1997-379, aff'd in 
unpublished opinion 164 F.3d 629 (9th Cir. 1998).
    An investor is a person who purchases and sells securities with the 
principal purpose of realizing investment income in the form of 
interest, dividends, and gains from appreciation in value over a 
relatively long period of time (that is, long-term appreciation). The 
management of one's own investments is not considered a section 162 
trade or business no matter how extensive or substantial the 
investments might be. See Higgins v. Comm'r, 312 U.S. 212, 217 (1941); 
King v. Comm'r, 89 T.C. 445 (1987). Therefore, an investor is not 
considered to be engaged in a section 162 trade or business of 
investing.
    For purposes of section 1411(c)(2)(B), in order to determine 
whether gross income is derived from a section 162 trade or business of 
trading in financial instruments or commodities, the gross income must 
be derived from an activity that would constitute trading for purposes 
of chapter 1. Therefore, a person that is a trader in commodities or a 
trader in financial instruments is engaged in a trade or business for 
purposes of section 1411(c)(2)(B). The Treasury Department and the IRS 
emphasize that the proposed regulations do not change the state of the 
law with respect to classification of traders, dealers, or investors 
for purposes of chapter 1.
ii. Definition of Financial Instruments
    Section 1411 does not define the term ``financial instrument.'' 
Section 731(c)(2)(C) provides a definition of financial instrument for 
purposes of section 731, and this existing statutory definition is used 
as a guideline for the section 1411 definition. The proposed 
regulations define the term financial instrument to include stocks and 
other equity interests, evidences of indebtedness, options, forward or 
futures contracts, notional principal contracts, any other derivatives, 
or any evidence of an interest in any of the listed items. An evidence 
of an interest in any of these listed items includes, but is not 
limited to, short positions or partial units in any of these listed 
items.
iii. Definition of Commodities
    In accordance with the statutory language in section 1411(c)(2)(B), 
the proposed regulations provide that the term commodities has the same 
meaning as that provided in section 475(e)(2).

7. Working Capital Exception

    Section 1411(c)(3) provides that a rule similar to the rule of 
section 469(e)(1)(B) applies for purposes of section 1411 (the working 
capital rule). Section 469(e)(1)(B) provides that, for purposes of 
determining whether income is treated as from a passive activity, any 
income or gain attributable to an investment of working capital shall 
be treated as not derived in the ordinary course of a trade or 
business.
    The term working capital is not defined in either section 469 or 
section 1411, but it generally refers to capital set aside for use in 
and the future needs of a trade or business. Because the capital may 
not be necessary for the immediate conduct of the trade or business, 
the amounts are often invested by businesses in income-producing liquid 
assets such as savings accounts, certificates of deposit, money market 
accounts, short-term government and commercial bonds, and other similar 
investments. These investment assets

[[Page 72626]]

will usually produce portfolio-type income, such as interest. Under 
section 469(e)(1)(B), portfolio-type income generated by working 
capital is not derived in the ordinary course of a trade or business, 
and therefore, it is not treated as passive income. Under section 
1411(c)(3), gross income from and net gain attributable to the 
investment of working capital is not derived in the ordinary course of 
a trade or business, and therefore such gross income and net gain is 
subject to section 1411.
    A taxpayer may take into account the properly allocable deductions 
(related to losses or deductions properly allocable to the investment 
of such working capital) in determining net investment income. See part 
5.E of this preamble regarding properly allocable deductions.

8. Dispositions of Interests in Partnerships and S Corporations

    In most cases, an interest in a partnership or S corporation is not 
property held in a trade or business. Therefore, gain or loss from the 
sale of a partnership interest or S corporation stock will be subject 
to section 1411(c)(1)(A)(iii). See also section 731(a) and section 
1368(b)(2) (providing that the gain recognized when cash is distributed 
in excess of the adjusted basis of, as applicable, a partner's interest 
in a partnership or a shareholder's stock in an S corporation is 
treated as gain from the sale or exchange of such partnership interest 
or S corporation stock).
    Section 1411(c)(4)(A) provides that, in the case of a disposition 
of an interest in a partnership or S corporation, gain from such 
disposition shall be taken into account under section 
1411(c)(1)(A)(iii) only to the extent of the net gain which would be so 
taken into account by the transferor under section 1411(c)(1)(A)(iii) 
if all property of the partnership or S corporation were sold for fair 
market value immediately before the disposition of such interest. 
Section 1411(c)(4)(B) applies a similar rule to a loss from a 
disposition.
    For purposes of section 1411, Congress intended section 1411(c)(4) 
to put a transferor of an interest in a partnership or S corporation in 
a similar position as if the partnership or S corporation had disposed 
of all of its properties and the accompanying gain or loss from the 
disposition of such properties passed through to its owners (including 
the transferor). However, the gain or loss upon the sale of an interest 
in the entity and a sale of the entity's underlying properties will not 
always match. First, there may be disparities between the transferor's 
adjusted basis in the partnership interest or S corporation stock and 
the transferor's share of the entity's adjusted basis in the underlying 
properties. See Example 2 of proposed Sec.  1.1411-7(e). Second, the 
sales price of the interest may not reflect the proportionate share of 
the underlying properties' fair market value with respect to the 
interest sold.
    In order to achieve parity between an interest sale and an asset 
sale, section 1411(c)(4) must be applied on a property-by-property 
basis, which requires a determination of how the property was held in 
order to determine whether the gain or loss to the transferor from the 
hypothetical disposition of such property would have been gain or loss 
subject to section 1411(c)(1)(A)(iii). As described in proposed Sec.  
1.1411-4(a)(1)(iii) and proposed Sec.  1.1411-4(d), section 
1411(c)(1)(A)(iii) applies if the property disposed of is either not 
held in a trade or business, or held in a trade or business described 
in proposed Sec.  1.1411-5. In other words, under the proposed 
regulations, the exception in section 1411(c)(4) is only applicable 
where the property is held in a trade or business not described in 
section 1411(c)(2). See JCT 2011 Explanation, at 364, fn. 976 (and 
accompanying text); Joint Committee on Taxation, Technical Explanation 
of the Revenue Provisions of the ``Reconciliation Act of 2010,'' as 
amended, in combination with the ``Patient Protection and Affordable 
Care Act'' (JCX-18-10) (Mar. 21, 2010), at 135 fn. 286 (and 
accompanying text) (JCT 2010 Explanation). This means that the 
exception in section 1411(c)(4) does not apply where (1) there is no 
trade or business, (2) the trade or business is a passive activity 
(within the meaning of proposed Sec.  1.1411-5(a)(1)) with respect to 
the transferor, or (3) where the partnership or the S corporation is in 
the trade or business of trading in financial instruments or 
commodities (within the meaning of proposed Sec.  1.1411-5(a)(2)), 
because in these cases there would be no change in the amount of net 
gain determined under proposed Sec.  1.1411-4(a)(1)(iii) upon an asset 
sale under section 1411(c)(4). For example, if the transferor is 
passive with respect to the entity's trade or business, the application 
of the deemed asset sale rule under section 1411(c)(4), as described in 
part 8.A of this preamble, would not adjust the transferor's section 
1411(c)(1)(A)(iii) gain on the disposition of the interest. See Example 
7 of proposed Sec.  1.1411-7(e) for a situation involving the 
transferor of an interest in an S corporation with two trades or 
businesses, only one of which is described in proposed Sec.  1.1411-5.
A. Mechanics of Section 1411(c)(4)
i. In General
    The proposed regulations provide that, for purposes of section 
1411(c)(4), a transferor computes the gain or loss from the sale of the 
underlying properties of the partnership or S corporation using a 
deemed asset sale method (Deemed Sale), and then determines if, based 
on the Deemed Sale, there is an adjustment (either positive or 
negative) to the transferor's gain or loss on the disposition of the 
partnership or S corporation interest for purposes of section 
1411(c)(1)(A)(iii). An adjustment only occurs if the underlying 
property is used in a trade or business not described in proposed Sec.  
1.1411-5 (a positive adjustment reduces a loss on the disposition of 
the interest, and a negative adjustment reduces the gain on the 
disposition of the interest). Because the proposed regulations apply a 
Deemed Sale by the passthrough entity of all its assets for cash equal 
to the fair market value of the entity's properties, any gain or loss 
on the interest sale that is not reflected in the underlying properties 
of the passthrough entity (as the result of an inside-outside basis 
disparity) would not create an adjustment. This is illustrated in 
Example 2 of proposed Sec.  1.1411-7(e).
    In developing the Deemed Sale, the Treasury Department and the IRS 
considered existing hypothetical transactions, such as the hypothetical 
transaction to determine a transferee's basis adjustment under section 
743(b). See Sec.  1.743-1. The proposed regulations provide that the 
Deemed Sale under section 1411(c)(4) applies, in part, rules similar to 
Sec.  1.743-1(d)(2). However, the Treasury Department and the IRS 
recognize that the Deemed Sale may impose an administrative burden on 
owners of partnerships and S corporations in certain circumstances. The 
Treasury Department and the IRS request comments on other methods that 
would implement the provisions of section 1411(c)(4) without imposing 
an undue burden on taxpayers. In addition, the IRS and the Treasury 
Department request comments on how to determine a partner's interest in 
section 1411 assets upon a distribution in which gain is recognized 
pursuant to section 731.
ii. Deemed Sale
    The first step of the Deemed Sale is a hypothetical disposition of 
all the entity's properties (including goodwill) in a fully taxable 
transaction for cash equal to the fair market value of the entity's 
properties immediately before the disposition of the interest.

[[Page 72627]]

    The second step of the Deemed Sale is to compute the gain or loss 
on each of the entity's properties (including goodwill). The 
calculation of gain or loss is determined by comparing the fair market 
value of each property with such property's adjusted basis. The gain or 
loss from each property must be computed separately.
    The third step of the Deemed Sale is to allocate the gain or loss 
from each property determined in the second step to the transferor. In 
the case of a partnership, the amount of gain or loss allocated to the 
transferor must take into account the allocations provided in the 
partnership agreement and any allocations required by sections 704(b) 
and 704(c) (and the regulations thereunder), as well as basis 
adjustments under section 743 with respect to the transferor. In the 
case of an S corporation, the amount of gain or loss allocated to the 
transferor is determined under section 1366(a), and the allocation 
should not take into account any reduction in the transferor's 
distributive share in section 1366(f)(2) resulting from the 
hypothetical imposition of tax under section 1374 as a result of the 
Deemed Sale.
    The fourth step of the Deemed Sale is to determine whether the 
amount of gain or loss allocated to the transferor with respect to each 
property under the Deemed Sale would have been taken into account in 
determining the transferor's net gain under section 1411(c)(1)(A)(iii) 
if it were an actual disposition. If the entity's property is either 
held in a trade or business described in section 1411(c)(2) with 
respect to the partnership, the S corporation, or the transferor, or is 
not held in a trade or business, there will be no adjustment under 
section 1411(c)(4) with respect to that property. However, if the 
property is held in a trade or business not described in section 
1411(c)(2), there is an adjustment under section 1411(c)(4) calculated 
in the following manner. First, the transferor's gains or losses from 
such property (or properties) are aggregated to create a net gain 
(which will be treated as a negative adjustment) or a net loss (which 
will be treated as a positive adjustment). Second, based on the 
adjustment calculated and subject to certain limitations, the 
transferor then must adjust the gain or loss from the disposition of 
the partnership or S corporation interest determined in section 
1411(c)(1)(A)(iii) (without regard to section 1411(c)(4)) by the 
positive or negative adjustment.
    For example, if in the Deemed Sale the transferor would have been 
allocated a net gain from property held in a trade or business not 
described in section 1411(c)(2) (thus, a negative adjustment) and the 
transferor had a gain on the disposition of the interest, then the gain 
on the disposition of the interest will be reduced for purposes of 
determining net investment income. However, in a situation in which a 
transferor has a gain (determined without regard to section 1411(c)(4)) 
from the disposition of the partnership or S corporation interest, a 
negative adjustment cannot result in the transferor having a loss on 
the disposition of the partnership or S corporation interest for 
purposes of section 1411(c)(1)(A)(iii), and a positive adjustment is 
not taken into account. For example, if a transferor has a $100,000 
gain on the disposition of S corporation stock, the section 1411(c)(4) 
adjustment cannot result in a gain for section 1411 purposes greater 
than $100,000, and cannot result in a loss for section 1411 purposes. 
See Example 3 of proposed Sec.  1.1411-7(e). Similarly, in a situation 
where a transferor has a loss (determined without regard to section 
1411(c)(4)) from the disposition of the partnership or S corporation 
interest, a positive adjustment cannot result in the transferor having 
a gain on the disposition of the partnership or S corporation interest 
for purposes of section 1411(c)(1)(A)(iii), and a negative adjustment 
is not taken into account. For example, if a transferor has a $50,000 
loss on the disposition of S corporation stock, the section 1411(c)(4) 
adjustment cannot result in a loss for section 1411 purposes greater 
than $50,000, and cannot result in a gain for section 1411 purposes.
    The proposed regulations provide a special rule for property held 
in more than one trade or business during the twelve-month period 
ending on the date of the disposition. In such case, the fair market 
value and the adjusted basis of such property must be allocated among 
the trades or businesses on a basis that reasonably reflects the use of 
the property. This allocation rule is illustrated in Example 7 of 
proposed Sec.  1.1411-7(e).
    The proposed regulations provide rules to determine the treatment 
of gain or loss from goodwill for purposes of section 1411(c)(4). If 
the entity is engaged in one trade or business, the entire gain or loss 
on the goodwill will be treated as gain or loss from the disposition of 
property held for use in that trade or business, and no portion of such 
gain or loss will be treated as attributable property not held for use 
in the trade or business. If the entity is engaged in more than one 
trade or business, the gain or loss on the goodwill is allocated 
between the trades or businesses based on the relative fair market 
value of the property (excluding cash) held for use in each trade or 
business. For example, if the entity has total assets with a fair 
market value of $110,000 (consisting of assets of $10,000 not held in 
any trade or business, $15,000 of assets held for use in Business 1, 
$45,000 of assets held for use in Business 2, $10,000 of cash, and 
goodwill of $30,000), and if the gain on the goodwill is $20,000, 
$5,000 of such gain is allocated to Business 1 and the remaining 
$15,000 gain is allocated to Business 2. See Example 8 of proposed 
Sec.  1.1411-7(e).
B. Special Situations
i. Interaction of Section 1411(c)(4) and Section 338(h)(10) Election
    In the case of a disposition of stock in an S corporation with 
respect to which a section 338(h)(10) election is made, section 
1411(c)(4) is inapplicable to the deemed asset sale and liquidation 
transactions that result from the section 338(h)(10) election. Under 
section 338(h)(10), the sale of the S corporation stock is treated as 
an actual asset sale by the S corporation. Section 1411(c)(4) is 
inapplicable to such an asset sale. In the deemed liquidation of the 
former S corporation, section 1411(c)(4) is also inapplicable to the 
shareholders because the underlying character of the gain or loss in 
the assets at the former S corporation level is already fully taken 
into account in the deemed asset sale.
ii. Installment Sales
    In the case of a disposition of a partnership or S corporation 
interest in an installment sale transaction to which section 453 
applies, proposed Sec.  1.1411-7(b)(1)(i) provides that the adjustment 
to net gain will be calculated in the year of the disposition. However, 
under proposed Sec.  1.1411-4(a)(1)(iii), the gain and any applicable 
adjustment are deferred and recognized proportionally pursuant to 
section 453.
    In the event that the year of the disposition of the interest 
occurs before the effective date of section 1411, the adjustment under 
section 1411(c)(4) and proposed Sec.  1.1411-7(c) will not be 
applicable. However, the proposed regulations allow taxpayers to elect 
into the rules of proposed Sec.  1.1411-7 if they receive installment 
sale payments attributable to a disposition of an interest in a 
partnership or S corporation that occurred before the effective date of 
section 1411. This election allows taxpayers that sell their interests 
in installment sales before the effective date of section 1411 to be

[[Page 72628]]

treated similarly with taxpayers that sell their interests after the 
effective date. In submitting the required statement of adjustment 
(described in proposed Sec.  1.1411-7(d)), this election will require 
the taxpayer to have the information (such as basis and fair market 
value of each property) as of the date of disposition.
iii. Sale by a Qualified Subchapter S Trust (QSST)
    If an election is made pursuant to section 1361(d)(2), a QSST can 
be an eligible shareholder of an S corporation. Section 1.1361-1(j)(8) 
provides rules for coordinating the QSST rules and the grantor trust 
rules, and provides that the income beneficiary of the QSST is treated 
as the owner, for purposes of section 678(a), of that portion of the 
trust that consists of the stock of the S corporation for which the 
QSST election was made. However, solely for purposes of this rule, an 
income beneficiary who is a deemed section 678 owner only by reason of 
section 1361(d)(1) will not be treated as the owner of the S 
corporation stock in determining and attributing the Federal income tax 
consequences of a disposition of the stock by the QSST. Therefore, if 
the QSST sells some (or all) of its S corporation stock, any gain or 
loss recognized on the sale will be that of the trust, not the income 
beneficiary. (On the other hand, the disposition is treated as a 
disposition by the income beneficiary for purposes of applying sections 
465 and 469 to the income beneficiary of a QSST.)
    The proposed regulations do not address whether special rules are 
needed to coordinate the QSST rules regarding dispositions of stock in 
an S corporation in Sec.  1.1361-1(j)(8) and section 1411(c)(4). The 
Treasury Department and the IRS request comments on whether special 
coordination rules are necessary.
C. Required Statements
    Any transferor making an adjustment under proposed Sec.  1.1411-
7(c)(5) must attach a statement to the transferor's return for the year 
of disposition. The statement must include: (1) A description of the 
disposed-of interest; (2) the name and taxpayer identification number 
of the entity disposed of; (3) the fair market value of each property 
of the entity; (4) the entity's adjusted basis in each property; (5) 
the transferor's allocable share of gain or loss with respect to each 
property of the entity; (6) information regarding whether the property 
was held in a trade or business not described in section 1411(c)(2); 
(7) the amount of the section 1411(c)(1)(A)(iii) gain on the 
disposition of the interest; and (8) the computation of the adjustment 
under proposed Sec.  1.1411-7(c)(5).
    In cases involving partnerships without a section 754 election in 
effect (or where there is no mandatory section 743 adjustment) and S 
corporations, the transferor may not have access to the information 
that is necessary to make the adjustment and to file the required 
statements. The Treasury Department and the IRS request comments on how 
a transferor may acquire the required information in these cases.

9. Exception for Distributions From Qualified Plans

    Section 1411(c)(5) provides that net investment income does not 
include any distribution from the following plans or arrangements:
    (1) A qualified pension, stock bonus, or profit-sharing plan under 
section 401(a);
    (2) A qualified annuity plan under section 403(a);
    (3) A tax-sheltered annuity under section 403(b);
    (4) An individual retirement account (IRA) under section 408;
    (5) A Roth IRA under section 408A; or
    (6) A deferred compensation plan of a State and local government or 
a tax-exempt organization under section 457(b).
    These proposed regulations provide rules relating to whether an 
amount is a distribution from a plan within the meaning of section 
1411(c)(5) and, thus, exempt from net investment income. First, the 
proposed regulations provide that, for purposes of section 1411, any 
amount actually distributed from a qualified plan or arrangement is a 
distribution within the meaning of section 1411(c)(5), and thus is not 
included in net investment income. The proposed regulations provide 
examples of actual distributions, including a rollover to an eligible 
retirement plan within the meaning of section 402(c)(8)(B), a 
distribution of a plan offset amount within the meaning of Q&A-13(b) of 
Sec.  1.72(p)-1, and corrective distributions from a qualified plan or 
arrangement to maintain its tax-favored status. The term ``corrective 
distribution'' includes any of the following distributions: (1) A 
distribution of excess deferrals as described in Sec.  1.402(g)-
1(e)(3); (2) for purposes of section 408 IRAs, a distribution of excess 
contributions as described in Sec.  1.408-4(c); (3) for purposes of 
section 408A Roth IRAs, a distribution of excess contributions as 
described in Q&A-1(d) of Sec.  1.408A-6; and (4) for purposes of 
eligible section 457(b) plans, a distribution of excess deferrals as 
described in Sec.  1.457-4(e)(2) through (4).
    Second, the proposed regulations provide that, for purposes of 
section 1411, amounts that are deemed distributions under the Code for 
purposes of income tax are distributions for purposes of section 
1411(c)(5), even if these distributions are not treated as actual 
distributions for purposes of the qualification requirements under 
section 401(a). Examples of deemed distributions include conversions to 
a Roth IRA described in section 408A and deemed distributions under 
section 72(p).
    Third, any amount that is not treated as a distribution, but is 
otherwise includible in gross income pursuant to a rule relating to 
amounts held in a qualified plan or arrangement, is a distribution 
within the meaning of section 1411(c)(5), and thus is not included in 
net investment income. For example, any income of the trust of a 
qualified plan or arrangement that is applied to purchase a 
participant's life insurance coverage (the P.S. 58 costs) is a 
distribution within the meaning of section 1411(c)(5), and thus is not 
included in net investment income.
    While distributions from qualified plans or arrangements are not 
includible in net investment income, as defined in section 1411(c)(1), 
distributions from a qualified plan or arrangement that are includible 
in gross income under chapter 1 are taken into account in determining 
the taxpayer's modified adjusted gross income or adjusted gross income 
for purposes of calculating the amount subject to tax under section 
1411(a)(1)(B) or (a)(2)(B).

10. Exception for Items Subject to Self-Employment Tax

    Section 1411(c)(6) provides that net investment income shall not 
include any item taken into account in determining self-employment 
income for such taxable year on which a tax is imposed by section 
1401(b). Section 1401(b) imposes a Medicare tax on the self-employment 
income of individuals equal to a specified percentage (2.9 percent) of 
the amount of the self-employment income for such taxable year and an 
Additional Medicare Tax for taxable years beginning after December 31, 
2012, equal to 0.9 percent of self-employment income in excess of 
certain threshold amounts. Section 1402(b) provides that the term self-
employment income generally means the net earnings from self-employment 
(defined under section 1402(a)) derived by an individual except that 
such term shall not include the net earnings from self-employment if 
such net earnings for

[[Page 72629]]

the taxable year are less than $400. Section 1402(a) generally defines 
the term net earnings from self-employment as the gross income derived 
by an individual from any trade or business carried on by such 
individual, less the deductions allowed which are attributable to such 
trade or business, plus his distributive share (whether or not 
distributed) of income or loss described in section 702(a)(8) from any 
trade or business carried on by a partnership of which he is a member. 
Section 1402(a)(1) through (17) includes exceptions from the definition 
of net earnings from self-employment as well as other special rules.
    The JCT 2011 and 2010 Explanations state that net investment income 
does not include ``amounts subject to SECA [Self-Employment 
Contribution Act] tax.'' JCT 2011 Explanation, at 365; JCT 2010 
Explanation, at 135. Therefore, the proposed regulations provide that 
for purposes of section 1411(c)(6), ``items taken into account'' in 
determining self-employment income means income included and deductions 
allowed in determining net earnings from self-employment under section 
1402(a) for purposes of determining self-employment income under 
section 1402(b), but does not include amounts excepted from net 
earnings from self-employment under section 1402(a)(1) through (17). In 
addition, proposed Sec.  1.1411-9(b) provides a special rule for 
properly allocable deductions (as defined in proposed Sec.  1.1411-
4(f)(2)(ii)) in the case of a taxpayer engaged in the trade or business 
of trading in financial instruments or commodities (as defined in 
proposed Sec.  1.1411-5(a)(2)). This exception provides that deductions 
described in proposed Sec.  1.1411-4(f)(2)(ii) that do not reduce a 
taxpayer's net earnings from self-employment (after aggregating the net 
earnings from self-employment from all of the taxpayer's trades or 
business) are not considered taken into account for purposes of section 
1411(c)(6) and may be considered in determining the taxpayer's net 
investment income under section 1411. Generally, this exception will 
apply if the taxpayer is engaged in a trade or business of trading in 
financial instruments or commodities and does not have any net earnings 
from self-employment or the deductions from trading exceed the 
taxpayer's net earnings from self-employment.

11. Controlled Foreign Corporations and Passive Foreign Investment 
Companies

    As noted in part 5 of this preamble, section 1411(c)(1) provides 
that net investment income includes dividends and net gain (to the 
extent taken into account in computing taxable income) attributable to 
the disposition of property other than property held in a trade or 
business to which the tax does not apply. Accordingly, income with 
respect to investments in foreign corporations generally is included in 
the calculation of net investment income for section 1411 purposes. 
Specifically, dividends and gains derived with respect to the stock of 
a controlled foreign corporation (within the meaning of section 957(a)) 
(CFC) or a passive foreign investment company (within the meaning of 
section 1297(a)) (PFIC) are taken into account in computing net 
investment income.
A. CFC or PFIC Amounts Derived From a Trade or Business Described in 
Proposed Sec.  1.1411-5
    The special rules described in proposed Sec.  1.1411-10 do not 
apply to income derived from a trade or business described in section 
1411(c)(2) and proposed Sec.  1.1411-5 because such income is included 
in net investment income under section 1411(c)(1)(A)(ii) and proposed 
Sec.  1.1411-4(a)(1)(ii). Thus, an amount included in gross income 
under section 1296(a) that is also income derived from a trade or 
business described in section 1411(c)(2) and proposed Sec.  1.1411-5 is 
net investment income within the meaning of section 1411(c)(1)(A)(ii) 
and proposed Sec.  1.1411-4(a)(1)(ii). Similarly, amounts included in 
income under sections 951(a) and 1293(a) that are derived from a trade 
or business described in section 1411(c)(2) and proposed Sec.  1.1411-
5, and therefore fall within section 1411(c)(1)(A)(ii) and proposed 
Sec.  1.1411-4(a)(1)(ii), are taken into account for purposes of 
section 1411 when they are taken into account for purposes of chapter 
1, and accordingly, the modifications described in this part of the 
preamble are not necessary.
B. Net Investment Income
    Under subpart F of the Code, a United States shareholder (as 
defined in section 951(b)) of a CFC is required to include certain 
amounts in income currently under section 951(a) (section 951 
inclusions). Section 951 inclusions are not treated as dividends unless 
expressly provided for in the Code, and therefore are not within any of 
the categories of income items that comprise net investment income 
(unless the amount is derived from a trade or business to which the tax 
applies as provided in section 1411(c)(1)(A)(ii) and proposed Sec.  
1.1411-4(a)(1)(ii)). See Rodriguez v. Comm'r, 137 T.C. 174 (2011). 
Similarly, a United States person owning shares in a PFIC also is 
required to include amounts in income currently under section 1293(a) 
(section 1293 inclusions) if the person makes a qualified electing fund 
(QEF) election under section 1295 with respect to the PFIC. Section 
1293 inclusions also are not treated as dividends unless expressly 
provided for in the Code, and, therefore, also are not taken into 
account for purposes of calculating net investment income (unless the 
amount is derived from a trade or business to which the tax applies as 
provided in section 1411(c)(1)(A)(ii) and proposed Sec.  1.1411-
4(a)(1)(ii)).
    The subpart F and PFIC regimes provide rules that prevent amounts 
that have been included in income under sections 951 and 1293 by a 
United States person from being subject to tax again when there is an 
actual distribution from the foreign corporation. Specifically, section 
959(d) provides that distributions from a CFC that are excluded from 
gross income for purposes of chapter 1 under section 959(a) (earnings 
and profits attributable to section 951 inclusions) are treated for 
chapter 1 purposes as distributions that are not dividends. Similarly, 
section 1293(c) provides that distributions paid out of earnings and 
profits of a PFIC that are attributable to section 1293 inclusions are 
treated for chapter 1 purposes as distributions that are not dividends. 
However, in the absence of these special rules, which expressly apply 
for chapter 1 purposes and are intended to reflect that the relevant 
CFC or PFIC earnings have already been taxed for chapter 1 purposes, 
the actual distributions would be taxable as dividends under general 
Code rules applicable to corporations and their shareholders. Moreover, 
as is the case with dividends, such actual distributions reduce the 
earnings and profits of the relevant CFC or PFIC. Accordingly, the 
proposed regulations reflect the premise that a distribution of 
earnings and profits that previously were taxed pursuant to section 
951(a) or section 1293(a), and which is not a dividend for chapter 1 
purposes under section 959(d) or section 1293(c), remains a dividend 
for chapter 2A purposes, and therefore constitutes gross income from 
dividends for purposes of section 1411(c)(1)(A)(i) and proposed Sec.  
1.1411-4(a)(1)(i).
    Nevertheless, in light of the effective date of section 1411 and 
the administrative burdens that would be imposed if taxpayers were 
required to reconstruct the tax basis of their CFC or QEF stock (and 
any intermediate entities) to eliminate the basis adjustments 
(described in this part 11) associated with pre-effective date

[[Page 72630]]

income inclusions under sections 951(a) and 1293(a), the proposed 
regulations provide a limit on the treatment of distributions of 
previously taxed earnings and profits of a CFC or QEF as dividends for 
section 1411 purposes. Specifically, under the proposed regulations, 
such treatment would apply only with respect to distributions of 
earnings and profits that previously were taxed pursuant to section 
951(a) or section 1293(a) in a taxable year beginning after December 
31, 2012. For purposes of determining whether a distribution is 
attributable to earnings and profits that previously were taxed 
pursuant to section 951(a) or section 1293(a) in a taxable year 
beginning after December 31, 2012 (and thus is treated as a dividend 
for section 1411 purposes), a distribution of earnings and profits that 
previously were taxed pursuant to section 951(a) or section 1293(a) 
will be considered attributable first to such earnings and profits, if 
any, derived from the current taxable year, and then from taxable years 
beginning with the most recent prior taxable year. In the case of a 
distribution from a CFC, such determination shall be made without 
regard to whether the earnings and profits are described in section 
959(c)(1) or section 959(c)(2). Thus, this classification of 
distributions as net investment income or non-net investment income is 
separate from, and in addition to, the allocation of distributions to 
previously taxed earnings and profits that are described in sections 
959(c)(1) and 959(c)(2).
    Accordingly, absent an election under proposed Sec.  1.1411-10(g) 
(described in part 11.F of this preamble), the timing of income derived 
from an investment in a CFC or a QEF may be different for chapter 1 and 
chapter 2A purposes. Taxpayers will not include section 951 inclusions 
or section 1293 inclusions in net investment income, but generally will 
take distributions that are not treated as dividends for chapter 1 
purposes under section 959(d) or section 1293(c) into account for 
purposes of determining net investment income under section 
1411(c)(1)(A)(i) and proposed Sec.  1.1411-4(a)(1)(i).
    Including an amount in income only for purposes of chapter 1 or 
chapter 2A however, requires special rules to calculate and administer 
the tax imposed by section 1411. For example, because the rules 
governing previously taxed income under chapter 1 require basis 
adjustments to the stock of the CFC or QEF, a United States person will 
be required to compute its tax basis in the stock (as well as its basis 
in intermediate entities through which it holds the CFC or QEF stock) 
differently for chapter 1 and chapter 2A purposes. As described in 
detail in part 11.F of this preamble, however, the proposed regulations 
seek to minimize complexity arising from the different treatment under 
chapter 1 and chapter 2A by providing an election that, if made, 
results in consistent treatment for chapter 1 and chapter 2A purposes 
with respect to stock of CFCs and QEFs. See proposed Sec.  1.1411-
10(g).
    To the extent that a disposition of stock of a CFC or QEF gives 
rise to net gain under section 1411(c)(1)(A)(iii), such amount is 
included in net investment income. In the absence of an election under 
proposed Sec.  1.1411-10(g), the basis increases provided in sections 
961(a) and 1293(d) that apply for chapter 1 purposes for amounts 
included in gross income for chapter 1 purposes under sections 951(a) 
and 1293(a) in taxable years beginning after December 31, 2012, do not 
apply to the calculation of gain or loss for purposes of section 1411. 
Similarly, in the absence of an election, the basis decreases provided 
in sections 961(b) and 1293(d) that apply for chapter 1 purposes do not 
apply to the extent that such decreases are attributable to a 
distribution of post-effective date earnings and profits that is 
treated as a dividend for chapter 2A purposes.
    In certain circumstances, section 1248 may apply for chapter 1 
purposes to recharacterize all or a portion of gain recognized on the 
disposition of stock of a foreign corporation as dividend income. 
Section 1248 also may apply to determine whether any portion of the 
gain calculated for section 1411 purposes should be recharacterized as 
a dividend. If no election is made pursuant to proposed Sec.  1.1411-
10(g), the proposed regulations provide that sections 1248(d)(1) and 
1248(d)(6) (relating to amounts excluded from earnings and profits for 
purposes of determining the amount of gain recharacterized as a 
dividend under section 1248) generally do not apply because the 
earnings and profits of the foreign corporation are not attributable to 
any amount previously taxed for purposes of section 1411. However, the 
proposed regulations provide that sections 1248(d)(1) and 1248(d)(6) do 
apply for purposes of section 1411 to the extent the earnings and 
profits of the foreign corporation are attributable to an amount that 
was included in chapter 1 income in a taxable year that began prior to 
December 31, 2012 (the effective date of section 1411).
    Proposed Sec.  1.1411-10 also provides special rules that apply to 
a United States shareholder of a PFIC who is subject to the tax and 
interest charge applicable to excess distributions under section 1291. 
The proposed regulations provide that the calculation of net investment 
income includes any distribution of earnings and profits by a PFIC that 
constitutes a dividend within the meaning section 316(a), or any gain 
from a disposition of PFIC stock, even though all or a portion of the 
dividend or gain may be treated as an excess distribution and allocated 
to prior taxable years for purposes of computing the additional amount 
of tax imposed under section 1291(a)(1)(C) (and hence may not be taxed 
as a dividend or gain for chapter 1 purposes).
    In addition, the proposed regulations provide rules applicable to a 
United States person that has elected to mark to market its PFIC stock 
under section 1296. In such case, amounts that are included in gross 
income under section 1296(a)(1) and, correspondingly, amounts allowable 
as a deduction under section 1296(a)(2) are taken into account under 
section 1411(c)(1)(A)(iii) and proposed Sec.  1.1411-4(a)(1)(iii) in 
computing net gain for purposes of section 1411.
    Section 1411(c)(1)(B) provides that, in determining net investment 
income, items of gross income and net gain are reduced by properly 
allocable deductions. In the absence of an election under proposed 
Sec.  1.1411-10(g), differences may occur in the timing of income 
derived with respect to CFCs and QEFs for chapter 1 and chapter 2A 
purposes. Consequently, the determination of properly allocable 
deductions with respect to sections 959(d) and 1293(c) dividend 
distributions may require special rules. For example, certain itemized 
deductions related to items of net investment income described in 
proposed Sec.  1.1411-10(c) (such as the investment interest deduction) 
may require special rules to determine when these deductions are 
properly allocable deductions for purposes of section 1411. The 
Treasury Department and the IRS request comments on whether guidance is 
necessary to determine the deductions that are properly allocable to 
items of net investment income described in proposed Sec.  1.1411-10(c) 
if the election under proposed Sec.  1.1411-10(g) is not made.
C. Modified Adjusted Gross Income
    Because of the different timing under chapter 1 and chapter 2A for 
including certain income from investments in CFCs and PFICs, the 
proposed regulations contain rules coordinating these provisions with 
the determination of the calculation of the section 1411 tax, which is 
based, in part, in section

[[Page 72631]]

1411(a)(1)(B) on an individual's modified adjusted gross income. Absent 
an election under proposed Sec.  1.1411-10(g), the proposed regulations 
provide that an individual who owns stock in a CFC or a QEF must 
increase or decrease modified adjusted gross income (as defined in 
proposed Sec.  1.1411-2(c)) in certain circumstances. For example, 
proposed Sec.  1.1411-10(e) provides that modified adjusted gross 
income is increased by any section 959(d) or section 1293(c) 
distributions that are dividends for chapter 2A purposes. In order to 
avoid subjecting the same amount of income to tax twice under section 
1411, section 951 inclusions and section 1293 inclusions are excluded 
from modified adjusted gross income under proposed Sec.  1.1411-
10(e)(1)(iii) for purposes of section 1411. In addition, modified 
adjusted gross income is adjusted to take into account the amount of 
gain or loss attributable to a disposition of stock of a CFC or QEF for 
section 1411 purposes, which may differ from the amount of gain or loss 
calculated for chapter 1 purposes. For purposes of section 1411, in the 
absence of an election under proposed Sec.  1.1411-10(g), gain or loss 
is determined without taking into account basis increases under 
sections 961(a) and 1293(d) that are included in the calculation of 
basis for purposes of chapter 1 with respect to amounts included in 
gross income for chapter 1 purposes under sections 951(a) and 1293(a) 
in taxable years beginning after December 31, 2012. In addition, gain 
or loss is determined without taking into account basis decreases under 
sections 961(a) and 1293(d) that are included in the calculation of 
basis for purposes of chapter 1 to the extent the decreases are 
attributable to a distribution of earnings and profits that is treated 
as a dividend for chapter 2A purposes.
    Modified adjusted gross income is also adjusted with respect to 
interests in PFICs that are subject to tax under section 1291. 
Specifically, the proposed regulations provide that modified adjusted 
gross income for section 1411 purposes is increased by the amount of 
any excess distribution (within the meaning of section 1291(b)) to the 
extent the distribution constitutes a dividend under section 316(a) and 
is not otherwise included in income for chapter 1 purposes under 
section 1291(a)(1)(B), and by any gain treated as an excess 
distribution under section 1291(a)(2) to the extent not otherwise 
included in income for chapter 1 purposes under section 1291(a)(1)(B).
D. Special Rules Where Stock Is Held by Partnerships or S Corporations
    The proposed regulations provide rules that apply to an individual, 
estate, or trust that owns stock of a CFC or QEF through a domestic 
partnership or S corporation. Because of the different timing rules 
under chapter 1 and chapter 2A and the fact that partnerships and S 
corporations are passthrough entities, the proposed regulations provide 
rules on the determination for section 1411 purposes of (1) the 
partner's or shareholder's outside basis in his interest, and (2) the 
partnership's or S corporation's adjusted basis in its CFC or QEF 
stock. The Treasury Department and the IRS believe that the partnership 
or S corporation will need to separately state, in addition to a 
partner's distributive share of the amounts included in the 
partnership's income under section 951(a) or section 1293(a), a 
partner's distributive share of any distributions of previously taxed 
earnings and profits of a CFC or QEF received by the partnership or S 
corporation that are dividends for purposes of chapter 2A. The Treasury 
Department and the IRS request comments on appropriate ways to 
determine a partner's distributive share of a distribution of 
previously taxed earnings and profits given the purpose of section 
1411.
    The Treasury Department and the IRS request comments on improving 
the administrability of these provisions, including the reporting of 
CFC or QEF amounts through domestic partnerships or S corporations. In 
addition, the Treasury Department and the IRS request comments on the 
determination of a partner's basis adjustment under section 743 for 
purposes of section 1411 when the partnership holds stock in a CFC or 
QEF.
E. Conforming Rules for Estates and Trusts
    The proposed regulations also provide conforming rules for estates, 
trusts, and their beneficiaries. Proposed Sec.  1.1411-10(c)(5), 
(e)(2), and (f) coordinate the rules relating to the computation of net 
investment income and any associated increase or decrease to adjusted 
gross income with the distributable net income regime and other general 
operating rules governing the income taxation of estates and trusts 
contained in Subchapter J and proposed Sec.  1.1411-3. The Treasury 
Department and the IRS request comments on the interaction of 
subchapter J and the PFIC rules in order to address consistency issues 
between chapter 1 and chapter 2A.
F. Election
    As described in parts 11.B through 11.E of this preamble, certain 
adjustments, including adjustments to modified adjusted gross income 
for purposes of section 1411, are necessary with respect to inclusions 
under sections 951 and 1293. The Treasury Department and the IRS 
recognize that these rules may create an additional administrative 
burden for certain taxpayers. Thus, proposed Sec.  1.1411-10(g) allows 
individuals, estates, and trusts to make an election to include 
inclusions under sections 951 and 1293 in net investment income in the 
same manner and in the same taxable year as such amounts are included 
in income for chapter 1 purposes. If an individual, estate, or trust 
makes the election, any section 959(d) or section 1293(c) distributions 
that are not treated as dividends for chapter 1 purposes are not 
treated as dividends for section 1411 purposes, and thus would not be 
included in net investment income for section 1411 purposes. Moreover, 
the separate computation of basis for section 1411 purposes would not 
be required, and thus distributions under sections 959(d) and 1293(c) 
would decrease the taxpayer's basis in its CFC or PFIC stock, and 
inclusions under sections 951 and 1293 would increase the taxpayer's 
basis in its CFC or PFIC stock, in the same manner as the taxpayer's 
basis is adjusted for chapter 1 purposes.
    An individual, estate, or trust that wants to make the election 
generally must do so for the first taxable year beginning after 
December 31, 2013, during which (1) the individual, estate, or trust 
owns an interest in a CFC or PFIC, and (2) the individual, estate, or 
trust is subject to tax under section 1411 or would be subject to tax 
under section 1411 if the election under proposed Sec.  1.1411-10(g) is 
made. In addition, the election may be made for a taxable year that 
begins before January 1, 2014. The determination of whether an 
individual, estate, or trust is subject to tax under section 1411 for a 
taxable year is based on whether the individual's modified adjusted 
gross, or the estate's or trust's adjusted gross income, exceeds the 
applicable threshold set forth in Sec.  1.1411-2(d) or Sec.  1.1411-
3(a)(1)(ii)(B)(2), regardless of whether the individual, estate, or 
trust has an income inclusion under section 951(a) or section 1293(a), 
or receives a distribution of previously taxed income with respect to 
any CFC or QEF in that taxable year. For example, if in 2014, a single 
individual acquires an interest in a QEF, has a QEF inclusion of 
$5,000,

[[Page 72632]]

and has modified adjusted gross income of $150,000, the individual 
would not have to make an election for 2014 because section 1411 is not 
applicable. If, in 2015, the individual has modified adjusted gross 
income in excess of $200,000, and the individual would like to take QEF 
inclusions into account for purposes of section 1411 in the same manner 
and in the same taxable year as such amounts are taken into account for 
chapter 1 purposes, the individual must make the election for 2015 in 
the time and manner described in proposed Sec.  1.1411-10(g).
    Once an election is made, it applies to all interests in CFCs and 
PFICs, including CFCs and PFICs that subsequently are acquired by the 
electing taxpayer. The election cannot be revoked, except with the 
Commissioner's consent.
    The Treasury Department and the IRS request comments on this 
election, including the conditions under which an automatic extension 
of time to make the election should be permitted.

12. Taxpayer Reliance on Proposed Regulations

    These regulations are proposed to be effective for taxable years 
beginning after December 31, 2013, except that Sec.  1.1411-3(c)(2) is 
proposed to apply to taxable years beginning after December 31, 2012. 
The Treasury Department and IRS intend to finalize regulations under 
section 1411 in 2013. Taxpayers are reminded that section 1411 is 
effective for taxable years beginning after December 31, 2012. 
Taxpayers may rely on these proposed regulations for purposes of 
compliance with section 1411 until the effective date of the final 
regulations. To the extent these proposed regulations provide taxpayers 
with the ability to make an election, taxpayers may make the election, 
including regroupings described in Sec.  1.469-11(b)(3)(iv), provided 
that the election is made in the manner described in the applicable 
provision. Any election made in reliance on these proposed regulations 
will be in effect for the year of the election, and will remain in 
effect for subsequent taxable years. However, if final regulations 
provide for the same or a similar election, taxpayers who opt not to 
make an election in reliance on these proposed regulations will not be 
precluded from making that election pursuant to the final regulations.

Proposed Effective Date

    These regulations are proposed to be effective for taxable years 
beginning after December 31, 2013, except that Sec.  1.1411-3(c)(2) is 
proposed to apply to taxable years beginning after December 31, 2012.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866, as supplemented by Executive Order 13563. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
does not apply to the proposed regulations. Pursuant to the Regulatory 
Flexibility Act (RFA) (5 U.S.C. chapter 6), it is hereby certified that 
the proposed regulations will not have a significant economic impact on 
a substantial number of small entities. The applicability of the 
proposed regulations are limited to individuals, estates, and trusts, 
which are not small entities as defined by the RFA (5 U.S.C. 601). 
Accordingly, the RFA does not apply. Therefore, a regulatory 
flexibility analysis is not required. Pursuant to section 7805(f) of 
the Code, the proposed regulations have been submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Comments and Public Hearing

    Before the proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The Treasury Department and the IRS request comments on all 
aspects of the proposed rules. All comments will be available for 
public inspection and copying.
    A public hearing has been scheduled for Tuesday, April 2, 2013, 
beginning at 10:00 a.m. in the Auditorium, Internal Revenue Building, 
1111 Constitution Avenue NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments by March 5, 2013, and an outline of the topics to be 
discussed and the time to be devoted to each topic (signed original and 
eight (8) copies) by March 5, 2013. A period of 10 minutes will be 
allotted to each person for making comments. An agenda showing the 
scheduling of the speakers will be prepared after the deadline for 
receiving outlines has passed. Copies of the agenda will be available 
free of charge at the hearing.

Drafting Information

    The principal authors of the proposed regulations are Michala Irons 
and David H. Kirk, IRS Office of the Associate Chief Counsel 
(Passthroughs and Special Industries). However, other personnel from 
the Treasury Department and the IRS participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par 2. Section 1.469-0 is amended by adding the following entries 
to the table of contents:


Sec.  1.469-0  Table of contents.

* * * * *
Sec.  1.469-11 Effective date and transition rules.
* * * * *
    (b) * * *
    (3) * * *
    (iv) Regrouping for taxpayers subject to section 1411.
    (A) In general.
    (B) Effective/applicability date.
* * * * *
    Par 3. Section 1.469-11 is amended by adding paragraph (b)(3)(iv) 
to read as follows:


Sec.  1.469-11  Effective date and transition rules.

* * * * *
    (b) * * *
    (3) * * *
    (iv) Regrouping for taxpayers subject to section 1411--(A) In 
general. If an individual, estate, or trust has net investment income 
(as defined in Sec.  1.1411-4) and such individual's (as defined in 
Sec.  1.1411-2(a)) modified adjusted gross income (as defined in Sec.  
1.1411-2(c)) exceeds the applicable

[[Page 72633]]

threshold in Sec.  1.1411-2(d) or such estate's or trust's (as defined 
in Sec.  1.1411-3(a)(1)(i)) adjusted gross income exceeds the amount 
described in section 1411(a)(2)(B)(ii) and Sec.  1.1411-
3(a)(1)(ii)(B)(2), such individual, estate, or trust may, in the first 
taxable year beginning after December 31, 2013, in which section 1411 
would apply to such taxpayer, regroup its activities without regard to 
the manner in which the activities were grouped in the preceding 
taxable year. For this purpose, the determination whether section 1411 
would apply is made without regard to the effect of regrouping. A 
taxpayer that is an individual, estate, or trust may regroup its 
activities for any taxable year that begins during 2013, if section 
1411 would apply to such taxpayer for such year. A taxpayer may regroup 
activities only once pursuant to this paragraph (b)(3)(iv), and a 
regrouping made pursuant to this paragraph will apply to the taxable 
year for which the regrouping is done and all subsequent years.
    (B) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013.
* * * * *
    Par. 4. Sections 1.1411-0 through 1.1411-10 are added to read as 
follows:


Sec.  1.1411-0  Table of contents.

Sec.  1.1411-1 General rules.
    (a) General rule.
    (b) Adjusted gross income.
    (c) Effective/applicability date.
Sec.  1.1411-2 Application to individuals.
    (a) Individual defined.
    (1) Individuals to whom tax applies.
    (2) Special rules.
    (i) Joint returns in the case of a nonresident alien individual 
married to a U.S. citizen or resident.
    (A) Default treatment.
    (B) Taxpayer election.
    (1) Effect of election.
    (2) Procedural requirements for making election.
    (ii) Grantor trusts.
    (iii) Bankruptcy estates.
    (iv) Bona fide residents of U.S. territories.
    (A) Applicability.
    (B) Coordination with exception for nonresident aliens.
    (C) Definitions.
    (1) Bona fide resident.
    (2) U.S. territory.
    (b) Calculation of tax.
    (1) In general.
    (2) Example.
    (c) Modified adjusted gross income.
    (1) General rule.
    (2) Rules with respect to controlled foreign corporations and 
passive foreign investment companies.
    (d) Threshold amount.
    (1) In general.
    (2) Taxable year of less than twelve months.
    (i) General rule.
    (ii) Change of annual accounting period.
    (e) Effective/applicability date.
Sec.  1.1411-3 Application to estates and trusts.
    (a) Estates and trusts to which tax applies.
    (1) In general.
    (i) General application.
    (ii) Calculation of tax.
    (2) Taxable year of less than twelve months.
    (i) General rule.
    (ii) Change of annual accounting period.
    (3) Rules with respect to controlled foreign corporations and 
passive foreign investment companies.
    (b) Exception for certain trusts.
    (c) Application to specific trusts.
    (1) Electing small business trusts (ESBTs).
    (i) General application.
    (ii) Computation of tax.
    (A) Step one.
    (B) Step two.
    (C) Step three.
    (2) Special rules for charitable remainder trusts.
    (i) Treatment of annuity or unitrust distributions.
    (ii) Apportionment between multiple beneficiaries.
    (iii) Accumulated net investment income.
    (3) Certain foreign trusts with United States beneficiaries. 
[Reserved]
    (d) Application to specific estates.
    (1) Bankruptcy estates.
    (2) Foreign estates.
    (i) General rule.
    (ii) Certain foreign estates with United States beneficiaries. 
[Reserved]
    (e) Calculation of undistributed net investment income.
    (1) In general.
    (2) Undistributed net investment income.
    (3) Distributions of net investment income to beneficiaries.
    (4) Deduction for amounts paid or permanently set aside for a 
charitable purpose.
    (5) Excluded income.
    (f) Examples.
    (g) Effective/applicability date.
Sec.  1.1411-4 Definition of net investment income.
    (a) In general.
    (b) Ordinary course of a trade or business exception.
    (c) Other gross income from a trade or business described in 
Sec.  1.1411-5.
    (1) Passive activity.
    (2) Trading in financial instruments or commodities.
    (d) Net gain.
    (1) Definition of disposition.
    (2) Limitation.
    (3) Net gain attributable to the disposition of property.
    (i) In general.
    (ii) Exception for gain or loss attributable to property held in 
a trade or business not described in Sec.  1.1411-5.
    (A) General rule.
    (B) Special rules for determining whether property is held in a 
trade or business.
    (C) Example.
    (iii) Adjustments to gain or loss attributable to the 
disposition of interests in a partnership or S corporation.
    (e) Distributions from estates and trusts.
    (f) Properly allocable deductions.
    (1) General rule.
    (i) In general.
    (ii) Limitations and carryovers.
    (2) Properly allocable deductions described in section 62.
    (i) Deductions allocable to gross income from rents and 
royalties.
    (ii) Deductions allocable to gross income from trades or 
businesses described in Sec.  1.1411-5.
    (iii) Penalty on early withdrawal of savings.
    (3) Properly allocable deductions described in section 63(d).
    (i) In general.
    (A) Investment interest expense.
    (B) Investment expenses.
    (C) Taxes described in section 164(a)(3).
    (ii) Application of limitations under sections 67 and 68.
    (A) Deductions subject to section 67.
    (B) Deductions subject to section 68.
    (4) Loss deductions.
    (g) Special rules for controlled foreign corporations and 
passive foreign investment companies.
    (h) Examples.
    (i) Effective/applicability date.
Sec.  1.1411-5 Trades and businesses to which tax applies.
    (a) In general.
    (b) Passive activity.
    (1) In general.
    (2) Examples.
    (c) Trading in financial instruments or commodities.
    (1) Definition of financial instruments.
    (2) Definition of commodities.
    (d) Effective/applicability date.
Sec.  1.1411-6 Income on investment of working capital subject to 
tax.
    (a) General rule.
    (b) Example.
    (c) Effective/applicability date.
Sec.  1.1411-7 Exception for dispositions of interests in 
partnerships and S corporations.
    (a) In general.
    (1) General application.
    (2) Interests to which exception applies.
    (i) In general.
    (ii) Nonapplication.
    (b) Special rules.
    (1) Installment sales.
    (i) Installment sales after the effective date of section 1411.
    (ii) Installment sales prior to the effective date of section 
1411.
    (2) Sale of an interest by a Qualified Subchapter S Trust. 
[Reserved]
    (c) Deemed sale.
    (1) In general.
    (2) Step one: Deemed sale of properties.
    (3) Step two: Determination of gain or loss.
    (4) Step three: Allocation of gain or loss.
    (5) Step four: Adjustment to gain or loss.
    (i) In general.
    (ii) Special rules.
    (A) Property used in more than one trade or business.
    (B) Goodwill attributable to property.
    (iii) Negative adjustment.
    (A) General rule.
    (B) Limitations.

[[Page 72634]]

    (iv) Positive adjustment.
    (A) General rule.
    (B) Limitations.
    (d) Required statement of adjustment.
    (e) Examples.
    (f) Effective/applicability date.
Sec.  1.1411-8 Exception for distributions from qualified plans.
    (a) General rule.
    (b) Rules relating to distributions.
    (1) Actual distributions.
    (2) Amounts treated as distributed.
    (3) Amounts includible in gross income.
    (c) Effective/applicability date.
Sec.  1.1411-9 Exception for self-employment income.
    (a) General rule.
    (b) Special rule for traders.
    (c) Examples.
    (d) Effective/applicability date.
Sec.  1.1411-10 Controlled foreign corporations and passive foreign 
investment companies.
    (a) In general.
    (b) Amounts derived from a trade or business described in Sec.  
1.1411-5.
    (c) Calculation of net investment income.
    (1) In general.
    (2) Dividends.
    (i) Distributions of previously taxed earnings and profits.
    (ii) Excess distributions constituting dividends.
    (3) Net gain.
    (i) Gains treated as excess distributions.
    (ii) Inclusions and deductions with respect to section 1296 mark 
to market elections.
    (iii) Gain or loss attributable to the disposition of stock of 
controlled foreign corporations and qualified electing funds.
    (iv) Gain or loss attributable to the disposition of interests 
in domestic partnerships or S corporations that own directly or 
indirectly stock of controlled foreign corporations or qualified 
electing funds.
    (4) Application of section 1248.
    (5) Amounts distributed by an estate or trust.
    (d) Conforming basis adjustments.
    (1) Basis adjustments under sections 961 and 1293.
    (i) Stock held by individuals, estates, or trusts.
    (ii) Stock held by domestic partnerships or S corporations.
    (2) Special rules for partners that own interests in domestic 
partnerships that own directly or indirectly stock of controlled 
foreign corporations or qualified electing funds.
    (3) Special rules for S corporation shareholders that own 
interests in S corporations that own directly or indirectly stock of 
controlled foreign corporations or qualified electing funds.
    (e) Conforming adjustments to modified adjusted gross income and 
adjusted gross income.
    (1) Individuals.
    (2) Estates and trusts.
    (f) Application to estates and trusts.
    (g) Election with respect to controlled foreign corporations and 
qualified electing funds.
    (1) In general.
    (2) Revocation of election.
    (3) Time and manner for making election.
    (h) Examples.
    (i) Effective/applicability date.


Sec.  1.1411-1  General rules.

    (a) General rule. Except as otherwise provided, all Internal 
Revenue Code provisions that apply for chapter 1 purposes in 
determining taxable income (as defined in section 63(a)) of a taxpayer 
also apply in determining the tax imposed by section 1411.
    (b) Adjusted gross income. All references to an individual's 
adjusted gross income shall be treated as references to adjusted gross 
income (as defined in section 62), and all references to an estate's or 
trust's adjusted gross income shall be treated as references to 
adjusted gross income (as defined in section 67(e)). However, there may 
be additional adjustments to adjusted gross income because of 
investments in controlled foreign corporations or passive foreign 
investment companies. See Sec.  1.1411-10(e).
    (c) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013.


Sec.  1.1411-2  Application to individuals.

    (a) Individual defined--(1) Individuals to whom tax applies. For 
purposes of section 1411 and the regulations thereunder, an individual 
is any natural person. However, section 1411 does not apply to 
nonresident alien individuals (within the meaning of section 
7701(b)(1)(B)). Therefore, for purposes of section 1411 and the 
regulations thereunder, an individual to whom the tax imposed under 
section 1411(a)(1) applies is any citizen or resident of the United 
States (within the meaning of section 7701(a)(30)(A)). See paragraph 
(a)(2)(iv) of this section for special rules regarding bona fide 
residents of U.S. territories.
    (2) Special rules--(i) Joint returns in the case of a nonresident 
alien individual married to a U.S. citizen or resident--(A) Default 
treatment. In the case of a U.S. citizen or resident who is married (as 
defined in section 7703) to a nonresident alien individual, the spouses 
will be treated as married filing separately for purposes of section 
1411. For purposes of calculating the tax imposed under section 
1411(a)(1), the U.S. citizen or resident spouse will be subject to the 
threshold amount for a married taxpayer filing a separate return in 
paragraph (d)(1)(ii) of this section, and the nonresident alien spouse 
will not be subject to tax under section 1411. In accordance with the 
rules for married individuals filing separate returns, the spouse that 
is a U.S. citizen or resident must determine his or her own net 
investment income and modified adjusted gross income.
    (B) Taxpayer election. Married taxpayers who file a joint Federal 
income tax return pursuant to a section 6013(g) election for purposes 
of chapter 1 and chapter 24 may also elect to be treated as making a 
section 6013(g) election for purposes of chapter 2A (relating to the 
tax imposed by section 1411).
    (1) Effect of election. For purposes of calculating the tax imposed 
under section 1411(a)(1), the effect of an election under section 
6013(g) is to include the combined income of the U.S. citizen or 
resident spouse and the nonresident spouse in the section 1411(a)(1) 
calculation and apply the threshold amount for a taxpayer making a 
joint return as set out in paragraph (d)(1)(i) of this section.
    (2) Procedural requirements for making election. Taxpayers with a 
section 6013(g) election for chapter 1 and chapter 24 purposes in 
effect for any taxable year beginning after December 31, 2012, or 
taxpayers making a section 6013(g) election for chapter 1 and chapter 
24 purposes in any taxable year beginning after December 31, 2012, who 
want to apply their section 6013(g) election to chapter 2A must make 
the election for the first taxable year beginning after December 31, 
2013, in which the U.S. taxpayer is subject to tax under section 1411. 
The determination of whether the U.S. taxpayer is subject to tax under 
section 1411 is made without regard to the effect of the section 
6013(g) election described in paragraph (a)(2)(i)(B) of this section. 
In addition, taxpayers may elect to apply their section 6013(g) 
election to chapter 2A for a taxable year that begins before January 1, 
2014. In all cases, the election must be made in the manner prescribed 
by the Secretary on a timely filed (including extensions) return, or 
amended return, for the taxable year for which the election is made. 
Further, in all cases, once made, the duration and termination of the 
section 6013(g) election for chapter 2A is governed by the rules of 
section 6013(g)(2) through (6) and the regulations thereunder.
    (ii) Grantor trusts. For rules regarding the treatment of owners of 
grantor trusts, see Sec.  1.1411-3(b)(5).
    (iii) Bankruptcy estates. A bankruptcy estate administered under 
chapter 7 (relating to liquidations) or chapter 11 (relating to 
reorganizations) of the Bankruptcy Code (Title 11 of the United States 
Code) of a debtor who is an individual shall be treated as a married 
taxpayer filing a separate return for

[[Page 72635]]

purposes of section 1411. See Sec.  1.1411-2(d)(1)(ii).
    (iv) Bona fide residents of U.S. territories--(A) Applicability. An 
individual who is a bona fide resident of a U.S. territory is subject 
to the tax imposed by section 1411(a)(1) only if the individual is 
required to file an income tax return with the United States upon 
application of section 931, 932, 933, or 935 and the regulations 
thereunder. With respect to an individual described in this paragraph 
(a)(2)(iv)(A), the amount excluded from gross income under section 931 
or 933 and any deduction properly allocable or chargeable against 
amounts excluded from gross income under section 931 or 933, 
respectively, is not taken into account in computing modified adjusted 
gross income under paragraph (c) of this section or net investment 
income under Sec.  1.1411-4.
    (B) Coordination with exception for nonresident aliens. An 
individual who is both a bona fide resident of a U.S. territory and a 
nonresident alien individual with respect to the United States is not 
subject to taxation under section 1411(a)(1).
    (C) Definitions. For purposes of this section--
    (1) Bona fide resident. The term bona fide resident has the meaning 
provided under section 937(a).
    (2) U.S. territory. The term U.S. territory means American Samoa, 
Guam, the Northern Mariana Islands, Puerto Rico, or the United States 
Virgin Islands.
    (b) Calculation of tax--(1) In general. In the case of an 
individual described in paragraph (a)(1) of this section, the tax 
imposed by section 1411(a)(1) for each taxable year is equal to 3.8 
percent of the lesser of--
    (i) Net investment income (as defined in Sec.  1.1411-4) for such 
taxable year; or
    (ii) The excess (if any) of--
    (A) The modified adjusted gross income (as defined in paragraph (c) 
of this section) for such taxable year; over
    (B) The threshold amount (as defined in paragraph (d) of this 
section).

    (2) Example. During Year 1 (a taxable year in which section 1411 
is in effect), A, an unmarried U.S. citizen, has modified adjusted 
gross income (as defined in paragraph (c) of this section) of 
$190,000, which includes $50,000 of net investment income (as 
defined in Sec.  1.1411-4). A has a zero tax imposed under section 
1411 because the threshold amount for a single individual is 
$200,000 (as provided in paragraph (d)(1)(iii) of this section). If 
during Year 2, A has modified adjusted gross income of $220,000, 
which includes $50,000 of net investment income, then the individual 
has a section 1411 tax of $760 (3.8 percent multiplied by $20,000).

    (c) Modified adjusted gross income--(1) General rule. For purposes 
of section 1411, the term modified adjusted gross income means adjusted 
gross income increased by the excess of--
    (i) The amount excluded from gross income under section 911(a)(1); 
over
    (ii) The amount of any deductions (taken into account in computing 
adjusted gross income) or exclusions disallowed under section 911(d)(6) 
with respect to the amounts described in paragraph (c)(1)(i) of this 
section.
    (2) Rules with respect to controlled foreign corporations and 
passive foreign investment companies. Additional rules in Sec.  1.1411-
10(e)(1) apply to an individual that is a United States shareholder of 
a controlled foreign corporation (within the meaning of section 957(a)) 
or that is a United States person that directly or indirectly owns an 
interest in a passive foreign investment company (within the meaning of 
section 1297(a)).
    (d) Threshold amount--(1) In general. The term threshold amount 
means--
    (i) In the case of a taxpayer making a joint return under section 
6013 or a surviving spouse (as defined in section 2(a)), $250,000;
    (ii) In the case of a married taxpayer (as defined in section 7703) 
filing a separate return, $125,000; and
    (iii) In any other case, $200,000.
    (2) Taxable year of less than twelve months--(i) General rule. In 
the case of an individual who has a taxable year consisting of less 
than twelve months (short taxable year), the threshold amount under 
paragraph (d)(1) of this section is not reduced or prorated. For 
example, in the case of an unmarried decedent who dies on June 1, the 
threshold amount is $200,000 for the decedent's short taxable year that 
begins on January 1 and ends on June 1.
    (ii) Change of annual accounting period. Notwithstanding paragraph 
(d)(2)(i) of this section, an individual who has a short taxable year 
resulting from a change of annual accounting period shall reduce the 
threshold amount to an amount that bears the same ratio to the full 
threshold amount provided under paragraph (d)(1) of this section as the 
number of months in the short taxable year bears to twelve.
    (e) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013.


Sec.  1.1411-3  Application to estates and trusts.

    (a) Estates and trusts to which tax applies--(1) In general--(i) 
General application. Section 1411 and the regulations thereunder apply 
to all estates and trusts that are subject to the provisions of part I 
of subchapter J of chapter 1 of subtitle A of the Internal Revenue 
Code, unless specifically exempted by paragraph (b) of this section.
    (ii) Calculation of tax. The tax imposed by section 1411(a)(2) for 
each taxable year is equal to 3.8 percent of the lesser of--
    (A) The estate's or trust's undistributed net investment income for 
such taxable year; or
    (B) The excess (if any) of--
    (1) The estate's or trust's adjusted gross income (as defined in 
section 67(e) and adjusted by Sec.  1.1411-10(e)(2), if applicable) for 
such taxable year; over
    (2) The dollar amount at which the highest tax bracket in section 
1(e) begins for such taxable year.
    (2) Taxable year of less than twelve months--(i) General rule. In 
the case of an estate or trust that has a taxable year consisting of 
less than twelve months (short taxable year), the dollar amount 
described in paragraph (a)(1)(ii)(B)(2) of this section is not reduced 
or prorated.
    (ii) Change of annual accounting period. Notwithstanding paragraph 
(a)(2)(i) of this section, an estate or trust that has a short taxable 
year resulting from a change of annual accounting period (but not from 
an individual's death) shall reduce the dollar amount described in 
paragraph (a)(1)(ii)(B)(2) of this section to an amount that bears the 
same ratio to that dollar amount as the number of months in the short 
taxable year bears to twelve.
    (3) Rules with respect to controlled foreign corporations and 
passive foreign investment companies. Additional rules in Sec.  1.1411-
10 apply to an estate or trust that holds an interest in a controlled 
foreign corporation (within the meaning of section 957(a)) or a passive 
foreign investment (within the meaning of section 1297(a)).
    (b) Exception for certain trusts. The following trusts are not 
subject to the tax imposed by section 1411:
    (1) 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).
    (2) A trust exempt from tax under section 501.
    (3) A charitable remainder trust described in section 664. However, 
see paragraph (c)(2) of this section for special rules regarding the 
treatment of annuity or unitrust distributions from such trust to 
persons subject to tax under section 1411.
    (4) Any other trust, fund, or account that is statutorily exempt 
from taxes imposed in subtitle A. For example, see sections 220(e)(1), 
223(e)(1), 529(a), and 530(a).

[[Page 72636]]

    (5) A trust, or a portion thereof, that is treated as a grantor 
trust under subpart E of part I of subchapter J of chapter 1. However, 
in the case of any such trust or portion thereof, each item of income 
or deduction that is included in computing taxable income of a grantor 
or another person under section 671 shall be treated as if it had been 
received by, or paid directly to, the grantor or other person for 
purposes of calculating such person's net investment income.
    (6) Except to the extent provided in paragraph (c)(3) of this 
section, a foreign trust (as defined in section 7701(a)(31)(B) and 
Sec.  301.7701-7(a)(2)).
    (c) Application to specific trusts--(1) Electing small business 
trusts (ESBTs)--(i) General application. The S portion and non-S 
portion (as defined in Sec.  1.641(c)-1(b)(2) and (3), respectively) of 
a trust that has made an ESBT election under section 1361(e)(3) and 
Sec.  1.1361-1(m)(2) shall be treated as separate trusts for purposes 
of the computation of undistributed net investment income in the manner 
described in paragraph (e) of this section, but shall be treated as a 
single trust for purposes of determining the amount subject to tax 
under section 1411. If a grantor or another person is treated as the 
owner of a portion of the ESBT, the items of income and deduction 
attributable to the grantor portion (as defined in Sec.  1.641(c)-
1(b)(1)) shall be included in the grantor's calculation of net 
investment income and shall not be included in the ESBT's computation 
of tax described in paragraph (c)(1)(ii) of this section.
    (ii) Computation of tax. This paragraph (c)(1)(ii) provides the 
method for an ESBT to compute the tax under section 1411. See Example 3 
in paragraph (f) of this section.
    (A) Step one: The S portion and non-S portion shall compute each 
portion's undistributed net investment income as separate trusts in the 
manner described in paragraph (e) of this section and then combine 
these amounts to calculate the ESBT's undistributed net investment 
income.
    (B) Step two: The ESBT will calculate its adjusted gross income (as 
defined in paragraph (a)(1)(ii)(B)(1) of this section). The ESBT's 
adjusted gross income is the non-S portion's adjusted gross income, 
increased or decreased by the net income or net loss of the S portion, 
after taking into account all deductions, carryovers, and loss 
limitations applicable to the S portion, as a single item of ordinary 
income (or ordinary loss).
    (C) Step three: The ESBT will pay tax on the lesser of--
    (1) The ESBT's total undistributed net investment income; or
    (2) The excess of the ESBT's adjusted gross income (as calculated 
in paragraph (c)(1)(ii)(B) of this section) over the dollar amount at 
which the highest tax bracket in section 1(e) begins for the taxable 
year.
    (2) Special rules for charitable remainder trusts--(i) Treatment of 
annuity or unitrust distributions. The net investment income of the 
beneficiary attributable to the beneficiary's annuity or unitrust 
distribution from a charitable remainder trust shall include an amount 
equal to the lesser of--
    (A) The total amount of the distributions for that year; or
    (B) The current and accumulated net investment income of the 
charitable remainder trust.
    (ii) Apportionment between multiple beneficiaries. In the case of a 
charitable remainder trust with more than one annuity or unitrust 
beneficiary, the net investment income shall be apportioned among such 
beneficiaries based on their respective shares of the total annuity or 
unitrust amount paid by the charitable remainder trust for that taxable 
year.
    (iii) Accumulated net investment income. The accumulated net 
investment income of a charitable remainder trust is the total amount 
of net investment income received by a charitable remainder trust for 
all taxable years that begin after December 31, 2012, less the total 
amount of net investment income distributed for all prior taxable years 
of the trust that begin after December 31, 2012.
    (3) Certain foreign trusts with United States beneficiaries. 
[Reserved]
    (d) Application to specific estates--(1) Bankruptcy estates. A 
bankruptcy estate in which the debtor is an individual is treated as a 
married taxpayer filing a separate return for purposes of section 1411. 
See Sec. Sec.  1.1411-2(a)(2)(iii) and 1.1411-2(d)(1)(ii).
    (2) Foreign estates--(i) General rule. Except to the extent 
provided in paragraph (d)(2)(ii) of this section, the tax imposed by 
section 1411 does not apply to a foreign estate (as defined in section 
7701(a)(31)(A)).
    (ii) Certain foreign estates with United States beneficiaries. 
[Reserved]
    (e) Calculation of undistributed net investment income--(1) In 
general. This paragraph (e)(1) provides special rules for the 
computation of certain deductions and for the allocation of net 
investment income between an estate or trust and its beneficiaries. 
Generally, an estate's or trust's net investment income (as defined in 
Sec.  1.1411-4) is calculated in the same manner as that of an 
individual. See Sec.  1.1411-10(c) for special rules regarding 
controlled foreign corporations, passive foreign investment companies, 
and estates and trusts holding interests in such entities.
    (2) Undistributed net investment income. An estate's or trust's 
undistributed net investment income is the estate's or trust's net 
investment income determined under Sec.  1.1411-4 reduced by 
distributions of net investment income to beneficiaries and deductions 
under section 642(c) in the manner described in paragraphs (e)(3) and 
(e)(4) of this section.
    (3) Distributions of net investment income to beneficiaries. (i) In 
computing the estate's or trust's undistributed net investment income, 
net investment income shall be reduced by distributions of net 
investment income made to beneficiaries. The deduction allowed under 
this paragraph (e)(3) is limited to the lesser of the amount deductible 
to the estate or trust under section 651 or section 661, as applicable, 
or the net investment income of the estate or trust. In the case of a 
deduction under section 651 or section 661 that consists of both net 
investment income and excluded income (as defined in paragraph (e)(5) 
of this section), the distribution must be allocated between net 
investment income and excluded income in a manner similar to Sec.  
1.661(b)-1 as if net investment income constituted gross income and 
excluded income constituted amounts not includible in gross income. See 
Sec.  1.661(c)-1 and Example 1 in paragraph (f) of this section.
    (ii) If one or more items of net investment income comprise all or 
part of a distribution for which a deduction is allowed under paragraph 
(e)(3)(i) of this section, such items retain their character as net 
investment income under section 652(b) or section 662(b), as 
applicable, for purposes of computing net investment income of the 
recipient of the distribution who is subject to tax under section 1411. 
The provisions of this paragraph (e)(3)(ii) also apply to distributions 
to United States beneficiaries of current year income described in 
section 652 or section 662 from foreign nongrantor trusts.
    (4) Deduction for amounts paid or permanently set aside for a 
charitable purpose. In computing the estate's or trust's undistributed 
net investment income, the estate or trust shall be allowed a deduction 
for amounts of net investment income that are allocated to amounts 
allowable under section 642(c). In the case of an estate or trust that 
has items of income consisting of both net investment income and 
excluded

[[Page 72637]]

income (as defined in paragraph (e)(5) of this section), the allowable 
deduction under this paragraph (e)(4) must be allocated between net 
investment income and excluded income in accordance with Sec.  
1.642(c)-2(b) as if net investment income constituted gross income and 
excluded income constituted amounts not includible in gross income. For 
an estate or trust with deductions under both sections 642(c) and 661, 
see Sec.  1.662(b)-2 and Example 2 in paragraph (f) of this section.
    (5) Excluded income. The term excluded income means--
    (i) Items of income excluded from gross income in chapter 1;
    (ii) Items of income not included in net investment income, as 
determined under Sec.  1.1411-4; and
    (iii) Items of gross income and net gain specifically excluded by 
section 1411, the regulations thereunder, or other guidance published 
in the Internal Revenue Bulletin. See Sec. Sec.  1.1411-7, -8, and -9.
    (f) Examples. In each example, unless otherwise indicated, the 
taxpayer uses a calendar taxable year, the taxpayer is not a foreign 
trust, and Year 1 is a taxable year in which section 1411 is in effect:

    Example 1. Calculation of undistributed net investment income 
(with no deduction under section 642(c)). (i) In Year 1, Trust has 
dividend income of $15,000, interest income of $10,000, capital gain 
of $5,000, and $60,000 of taxable income relating to a distribution 
from an individual retirement account (as defined under section 
408). Trust has no expenses. Trust distributes $10,000 of its 
current year trust accounting income to A, a beneficiary of Trust. 
For trust accounting purposes, $25,000 of the distribution from the 
individual retirement account is attributable to income. Trust 
allocates the remaining $35,000 of taxable income from the 
individual retirement account and the $5,000 of capital gain to 
principal, and therefore these amounts do not enter into the 
calculation of Trust's distributable net income for Year 1.
    (ii) Trust's distributable net income is $50,000 ($15,000 in 
dividends plus $10,000 in interest plus $25,000 of taxable income 
from an individual retirement account), from which the $10,000 
distribution to A is paid. Trust's deduction under section 661 is 
$10,000. Under Sec.  1.662(b)-1, the deduction reduces each class of 
income comprising distributable net income on a proportional basis. 
The $10,000 distribution equals 20 percent of distributable net 
income ($10,000 divided by $50,000). Therefore, the distribution 
consists of dividend income of $3,000, interest income of $2,000, 
and ordinary income attributable to the individual retirement 
account of $5,000. Because the $5,000 of capital gain allocated to 
principal for trust accounting purposes did not enter into 
distributable net income, no portion of that amount is included in 
the $10,000 distribution, nor does it qualify for the deduction 
under section 661.
    (iii) Trust's net investment income is $30,000 ($15,000 in 
dividends plus $10,000 in interest plus $5,000 in capital gain). 
Trust's $60,000 of taxable income attributable to the individual 
retirement account is excluded income (within the meaning of 
paragraph (e)(5) of this section) because it is excluded from net 
investment income under Sec.  1.1411-8. Trust's undistributed net 
investment income under paragraph (e)(2) of this section is $25,000, 
which is Trust's net investment income ($30,000) less the amount of 
dividend income ($3,000) and interest income ($2,000) distributed to 
A. The $25,000 of undistributed net investment income is comprised 
of the capital gain allocated to principal ($5,000), the remaining 
undistributed dividend income ($12,000), and the remaining 
undistributed interest income ($8,000).
    (iv) Under paragraph (e)(3) of this section and pursuant to 
Sec.  1.1411-4(a)(1), A's net investment income includes dividend 
income of $3,000 and interest income of $2,000, but does not include 
the $5,000 of ordinary income attributable to the individual 
retirement account because it is excluded from net investment income 
under Sec.  1.1411-8.
    Example 2. Calculation of undistributed net investment income 
(with deduction under section 642(c)). (i) Same facts as Example 1, 
except Trust is required to distribute $30,000 to A. In addition, 
Trust has a $10,000 deduction under section 642(c) (deduction for 
amounts paid for a charitable purpose). Trust also makes an 
additional discretionary distribution of $10,000 to B, a beneficiary 
of Trust. As in Example 1, Trust's net investment income is $30,000 
($15,000 in dividends plus $10,000 in interest plus $5,000 in 
capital gain). In accordance with Sec. Sec.  1.661(b)-2 and 
1.662(b)-2, the items of income must be allocated between the 
mandatory distribution to A, the discretionary distribution to B, 
and the $10,000 distribution to a charity.
    (ii) For purposes of the mandatory distribution to A, Trust's 
distributable net income is $50,000. See Sec.  1.662(b)-2, Example 
1(b). Trust's deduction under section 661 for the distribution to A 
is $30,000. Under Sec.  1.662(b)-1, the deduction reduces each class 
of income comprising distributable net income on a proportional 
basis. The $30,000 distribution equals 60 percent of distributable 
net income ($30,000 divided by $50,000). Therefore, the distribution 
consists of dividend income of $9,000, interest income of $6,000, 
and ordinary income attributable to the individual retirement 
account of $15,000. A's mandatory distribution thus consists of 
$15,000 of net investment income and $15,000 of excluded income.
    (iii) Trust's remaining distributable net income is $20,000. 
Trust's remaining undistributed net investment income is $15,000. 
The $10,000 deduction under section 642(c) is allocated in the same 
manner as the distribution to A, where the $10,000 distribution 
equals 20 percent of distributable net income ($10,000 divided by 
$50,000). For purposes of determining undistributed net investment 
income, Trust's net investment income is reduced by $5,000 under 
paragraph (e)(4) of this section (dividend income of $3,000, 
interest income of $2,000, but with no reduction for amounts 
attributable to the individual retirement account of $5,000).
    (iv) With respect to the discretionary distribution to B, 
Trust's remaining distributable net income is $10,000. Trust's 
remaining undistributed net investment income is $10,000. Trust's 
deduction under section 661 for the distribution to B is $10,000. 
The $10,000 distribution equals 20 percent of distributable net 
income ($10,000 divided by $50,000). Therefore, the distribution 
consists of dividend income of $3,000, interest income of $2,000, 
and ordinary income attributable to the individual retirement 
account of $5,000. B's distribution consists of $5,000 of net 
investment income and $5,000 of excluded income.
    (v) Trust's undistributed net investment income is $5,000 after 
taking into account distribution deductions and section 642(c) in 
accordance with paragraphs (e)(3) and (e)(4) of this section, 
respectively. To arrive at Trust's undistributed net investment 
income of $5,000, Trust's net investment income of $30,000 is 
reduced by $15,000 of the mandatory distribution to A, $5,000 of the 
section 642(c) deduction, and $5,000 of the discretionary 
distribution to B.
    Example 3. Calculation of an ESBT's tax for purposes of section 
1411. (i) In Year 1, the non-S portion of Trust, an ESBT, has 
dividend income of $15,000, interest income of $10,000, and capital 
gain of $5,000. Trust's S portion has net rental income of $21,000 
and a capital loss of $7,000. The Trustee's annual fee of $1,000 is 
allocated 60 percent to the non-S portion and 40 percent to the S 
portion. Trust makes a distribution from income to a single 
beneficiary of $9,000.
    (ii) Step one. (A) Trust must compute the undistributed net 
investment income for the S portion and non-S portion in the manner 
described in paragraph (c)(1) of this section.
    The undistributed net investment income for the S portion is 
$20,600 and is determined as follows:

Net Rental Income...........................................    $21,000
Trustee Annual Fee..........................................       (400)
                                                             -----------
  Total S portion undistributed net investment income.......     20,600
 

    (B) No portion of the capital loss is allowed because, pursuant 
to Sec.  1.1411-4(d)(2), net gain cannot be less than zero and 
excess capital losses are not properly allocable deductions under 
Sec.  1.1411-4(f). See Example 1 of Sec.  1.1411-4(h). In addition, 
pursuant to Sec.  1.641(c)-1(i), no portion of the $9,000 
distribution is allocable to the S portion.
    The undistributed net investment income for the non-S portion is 
$20,400 and is determined as follows:

Dividend Income.............................................    $15,000
Interest Income.............................................     10,000
Capital Gain................................................      5,000
Trustee Annual Fee..........................................       (600)
Distributable net income distribution.......................     (9,000)
                                                             -----------

[[Page 72638]]

 
  Total non-S portion undistributed net investment income...     20,400
 

    (C) Trust will combine the undistributed net investment income 
of the S portion and non-S portion from (ii)(A) and (B) to arrive at 
Trust's combined undistributed net investment income.

S portion's undistributed net investment income..............    $20,600
Non-S portion's undistributed net investment income..........     20,400
                                                              ----------
  Combined undistributed net investment income...............     41,000
 

    (iii) Step two. (A) The ESBT will calculate its adjusted gross 
income. Pursuant to paragraph (c)(1)(ii)(B) of this section, the 
ESBT's adjusted gross income is the non-S portion's adjusted gross 
income increased or decreased by the net income or net loss of the S 
portion.
    (B) The adjusted gross income for the ESBT is $38,000 and is 
determined as follows:

Dividend Income..............................................    $15,000
Interest Income..............................................     10,000
Capital Gain.................................................      5,000
Trustee Annual Fee...........................................      (600)
Distributable net income distribution........................    (9,000)
S Portion Income (see (iii)(C))..............................     17,600
                                                              ----------
  Adjusted gross income......................................     38,000
 

    (C) The S portion's single item of ordinary income used in the 
ESBT's adjusted gross income calculation is $17,600. This item of 
income is determined by starting with net rental income of $21,000 
and reducing it--
    (1) By the S portion's $400 share of the annual trustee fee; and
    (2) As allowed by section 1211(b)(1), $3,000 of the $7,000 
capital loss.
    (iv) Step three. Trust will pay tax on the lesser of--
    (A) The combined undistributed net investment income ($41,000 
calculated in (ii)(C)); or
    (B) The excess of adjusted gross income ($38,000 calculated in 
(iii)(B)) over the dollar amount at which the highest tax bracket in 
section 1(e) applicable to a trust begins for the taxable year.

    (g) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013, except that paragraph (c)(2) 
of this section shall apply to taxable years of charitable remainder 
trusts that begin after December 31, 2012.


Sec.  1.1411-4  Definition of net investment income.

    (a) In general. For purposes of section 1411 and the regulations 
thereunder, net investment income means the excess (if any) of--
    (1) The sum of--
    (i) Gross income from interest, dividends, annuities, royalties, 
rents, substitute interest payments, and substitute dividend payments, 
except to the extent excluded by the ordinary course of a trade or 
business exception described in paragraph (b) of this section;
    (ii) Other gross income derived from a trade or business described 
in Sec.  1.1411-5; and
    (iii) Net gain (to the extent taken into account in computing 
taxable income) attributable to the disposition of property, except to 
the extent excluded by the exception described in paragraph 
(d)(3)(ii)(A) for gain or loss attributable to property held in a trade 
or business not described in Sec.  1.1411-5; over
    (2) The deductions allowed by subtitle A that are properly 
allocable to such gross income or net gain (as determined in paragraph 
(f) of this section).
    (b) Ordinary course of a trade or business exception. Gross income 
described in paragraph (a)(1)(i) 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 Sec.  1.1411-5. See Sec.  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.
    (1) In the case of an individual, estate, or trust that owns or 
engages in a trade or business directly (or indirectly through 
ownership of an interest in an entity that is disregarded as an entity 
separate from its owner under Sec.  301.7701-3), the determination of 
whether gross income described in paragraph (a)(1)(i) of this section 
is derived in a trade or business is made at the individual level.
    (2) In the case of an individual, estate, or trust that owns an 
interest in a trade or business through one or more passthrough 
entities for Federal tax purposes (for example, through a partnership 
or S corporation), the determination of whether gross income described 
in paragraph (a)(1)(i) of this section is--
    (i) Derived in a trade or business described in Sec.  1.1411-
5(a)(1) is made at the owner level; and
    (ii) Derived in a trade or business described in Sec.  1.1411-
5(a)(2) is made at the entity level.
    (3) The following examples illustrate the provisions of this 
paragraph (b).

    Example 1. Multiple passthrough entities. A, an individual, owns 
an interest in UTP, a partnership, which is engaged in a trade or 
business. UTP owns an interest in LTP, also a partnership, which is 
not engaged in a trade or business. LTP receives $10,000 in 
dividends, $5,000 of which is allocated to A through UTP. The $5,000 
of dividends is not derived in a trade or business because LTP is 
not engaged in a trade or business. This is true even though UTP is 
engaged in a trade or business. Accordingly, the ordinary course of 
a trade or business exception described in paragraph (b) of this 
section does not apply, and A's $5,000 of dividends is net 
investment income under paragraph (a)(1)(i) of this section.
    Example 2. Entity engaged in trading in financial instruments. 
B, an individual, owns an interest in PRS, a partnership, which is 
engaged in a trade or business of trading in financial instruments 
(as defined in Sec.  1.1411-5(a)(2)). PRS' trade or business is not 
a passive activity (within the meaning of section 469) with respect 
to B. In addition, B is not directly engaged in a trade or business 
of trading in financial instruments or commodities. PRS earns 
interest of $50,000, and B's distributive share of the interest is 
$25,000. Because PRS is engaged in a trade or business described in 
Sec.  1.1411-5(a)(2), the ordinary course of a trade or business 
exception described in paragraph (b) of this section does not apply, 
and B's $25,000 distributive share of the interest is net investment 
income under paragraph (a)(1)(i) of this section.
    Example 3. Application of ordinary course of a trade or business 
exception. C, an individual, owns stock in S corporation, S. S is 
engaged in a banking trade or business (that is not a trade or 
business of trading in financial instruments or commodities), and 
S's trade or business is not a passive activity (within the meaning 
of section 469) with respect to C. S earns $100,000 of interest in 
the ordinary course of its trade or business, of which $5,000 is C's 
pro rata share. Because S is not engaged in a trade or business 
described in Sec.  1.1411-5(a)(2) and because S's trade or business 
is not a passive activity with respect to C (as described in Sec.  
1.1411-5(a)(1)), the ordinary course of a trade or business 
exception described in paragraph (b) of this section applies, and 
C's $5,000 of interest is not included under paragraph (a)(1)(i) of 
this section.

    (c) Other gross income from a trade or business described in Sec.  
1.1411-5--(1) Passive activity. For a trade or business described in 
Sec.  1.1411-5(a)(1), paragraph (a)(1)(ii) of this section includes 
other gross income that is not gross income described in paragraph 
(a)(1)(i) of this section or net gain described in paragraph 
(a)(1)(iii) of this section. Thus, for a trade or business described in 
Sec.  1.1411-5(a)(1), if an item of gross income or net gain is subject 
to paragraph (a)(1)(i) or (iii) of this section, it is generally not 
other gross income described in paragraph (a)(1)(ii) of this section.
    (2) Trading in financial instruments or commodities. For a trade or 
business described in Sec.  1.1411-5(a)(2)), paragraph (a)(1)(ii) of 
this section includes all other gross income that is not gross income 
described in paragraph (a)(1)(i) of this section. For example, any gain 
from marking to market under section 475(f) or section 1256 and any 
realized gain from the disposition of

[[Page 72639]]

property held in the trade or business is classified as other gross 
income subject to paragraph (a)(1)(ii) of this section (and not 
classified as net gain under paragraph (a)(1)(iii) of this section).
    (d) Net gain. This paragraph (d) describes special rules for 
purposes of paragraph (a)(1)(iii) of this section.
    (1) Definition of disposition. For purposes of section 1411 and the 
regulations thereunder, the term disposition means a sale, exchange, 
transfer, conversion, cash settlement, cancellation, termination, 
lapse, expiration, or other disposition.
    (2) Limitation. The calculation of net gain shall not be less than 
zero. Losses allowable under section 1211(b) are permitted to offset 
gain from the disposition of assets other than capital assets that are 
subject to section 1411.
    (3) Net gain attributable to the disposition of property--(i) In 
general. Net gain attributable to the disposition of property is the 
gain described in section 61(a)(3) recognized from the disposition of 
property reduced, but not below zero, by losses deductible under 
section 165, including losses attributable to casualty, theft, and 
abandonment or other worthlessness. The rules in subchapter O of 
chapter 1 and the regulations thereunder apply. See, for example, Sec.  
1.61-6(b). Net gain shall include gain or loss attributable to the 
disposition of property from the investment of working capital. See 
Sec.  1.1411-6.
    (ii) Exception for gain or loss attributable to property held in a 
trade or business not described in Sec.  1.1411-5--(A) General rule. 
Net gain shall not include gain or loss attributable to property (other 
than property from the investment of working capital (as described in 
Sec.  1.1411-6)) held in a trade or business not described in Sec.  
1.1411-5.
    (B) Special rules for determining whether property is held in a 
trade or business. To determine whether net gain described in paragraph 
(a)(1)(iii) of this section is from property held in a trade or 
business--
    (1) A partnership interest or S corporation stock generally is not 
property held in a trade or business. Therefore, gain from the sale of 
a partnership interest or S corporation stock is generally gain 
described in paragraph (a)(1)(iii) of this section. See Sec.  1.1411-7 
for rules relating to dispositions of interests in partnerships or S 
corporations.
    (2) In the case of an individual, estate, or trust that owns or 
engages in a trade or business directly (or indirectly through 
ownership of an interest in an entity that is disregarded as an entity 
separate from its owner under Sec.  301.7701-3), the determination of 
whether net gain described in paragraph (a)(1)(iii) of this section is 
attributable to property held in a trade or business is made at the 
individual level.
    (3) In the case of an individual, estate, or trust that owns an 
interest in a trade or business through one or more passthrough 
entities for Federal tax purposes (for example, through a partnership 
or S corporation), the determination of whether net gain described in 
paragraph (a)(1)(iii) of this section from such entity is attributable 
to--
    (i) Property held in a trade or business described in Sec.  1.1411-
5(a)(1) is made at the owner level; and
    (ii) Property held in a trade or business described in Sec.  
1.1411-5(a)(2) is made at the entity level.

    (C) Example. Gain from rental activity. A, an unmarried 
individual, rents a boat to B for $100,000 in Year 1. A's rental 
activity does not involve the conduct of a section 162 trade or 
business, but under section 469(c)(2), A's rental activity is a 
passive activity. In Year 2, A sells the boat to B, and A realizes 
and recognizes taxable gain attributable to the disposition of the 
boat of $500,000. Because the exception provided in paragraph 
(d)(3)(ii)(A) of this section requires a trade or business, this 
exception is inapplicable, and therefore, A's $500,000 gain will be 
taken into account under Sec.  1.1411-4(a)(1)(iii).

    (iii) Adjustments to gain or loss attributable to the disposition 
of interests in a partnership or S corporation. Net gain shall be 
adjusted as provided in Sec.  1.1411-7 in the case of the disposition 
of an interest in a partnership or S corporation.
    (e) Distributions from estates and trusts. Net investment income 
includes a beneficiary's share of distributable net income, as 
described in sections 652(a) and 662(a), to the extent that, under 
sections 652(b) and 662(b), the character of such income constitutes 
gross income from items described in paragraph (a)(1)(i) and (ii) of 
this section or net gain attributable to items described in paragraph 
(a)(1)(iii) of this section, with further computations consistent with 
the principles of this section, as provided in Sec.  1.1411-3(e).
    (f) Properly allocable deductions--(1) General rule--(i) In 
general. Unless specifically stated otherwise, only properly allocable 
deductions described in this paragraph (f) may be taken into account in 
determining net investment income.
    (ii) Limitations and carryovers. Deductions allowed under this 
paragraph (f) shall not exceed the total amount of gross income and net 
gain described in paragraph (a)(1) of this section. Any deductions 
described in this paragraph (f) in excess of such gross income and net 
gain shall not be taken into account in determining net investment 
income in any other taxable year, except as allowed under chapter 1. 
However, in no event will a net operating loss deduction allowed under 
section 172 be taken into account in determining net investment income 
for any taxable year. See Example 3 of paragraph (h) of this section.
    (2) Properly allocable deductions described in section 62--(i) 
Deductions allocable to gross income from rents and royalties. 
Deductions described in section 62(a)(4) allocable to rents and 
royalties described in paragraph (a)(1)(i) of this section (and that 
therefore constitute net investment income) shall be taken into account 
in determining net investment income.
    (ii) Deductions allocable to gross income from trades or businesses 
described in Sec.  1.1411-5. Deductions described in section 62(a)(1) 
allocable to income from a trade or business described in Sec.  1.1411-
5 shall be taken into account in determining net investment income to 
the extent the deductions have not been taken into account in 
determining self-employment income within the meaning of Sec.  1.1411-
9.
    (iii) Penalty on early withdrawal of savings. Net investment income 
shall take into account deductions described in section 62(a)(9).
    (3) Properly allocable deductions described in section 63(d)--(i) 
In general. Net investment income shall take into account the following 
itemized deductions:
    (A) Investment interest expense. Investment interest (as defined in 
section 163(d)(3)) to the extent allowed under section 163(d)(1). Any 
investment interest not allowed under section 163(d)(1) shall be 
treated as investment interest paid or accrued by the taxpayer in the 
succeeding taxable year.
    (B) Investment expenses. Investment expenses (as defined in section 
163(d)(4)(C)).
    (C) Taxes described in section 164(a)(3). In the case of taxes that 
are deductible under section 164(a)(3) and imposed on both gross income 
(including net gain) described in Sec.  1.1411-4(a)(1) and gross income 
(as defined under section 61(a)) that is not described in Sec.  1.1411-
4(a)(1), the portion of the deduction that is properly allocable to 
gross income (including net gain) described in Sec.  1.1411-4(a)(1) may 
be determined by taxpayers using any reasonable method. For purposes of 
the prior sentence, an allocation of the deduction based on the ratio 
of the

[[Page 72640]]

amount of a taxpayer's gross income (including net gain) described in 
Sec.  1.1411-4(a)(1) to the amount of the taxpayer's gross income (as 
defined under section 61(a)) is an example of a reasonable method.
    (ii) Application of limitations under sections 67 and 68. Any 
deductions described in this paragraph (f)(3) that are subject to 
section 67 (the 2-percent floor on miscellaneous itemized deductions) 
or section 68 (the overall limitation on itemized deductions) are 
allowed in determining net investment income only to the extent the 
items are deductible for chapter 1 purposes after the application of 
sections 67 and 68. For this purpose, section 67 is applied before 
section 68. The amounts that may be deducted in determining net 
investment income after the application of sections 67 and 68 shall be 
determined as described in paragraph (f)(3)(ii)(A) and (B) of this 
section.
    (A) Deductions subject to section 67. The amount of miscellaneous 
itemized deductions tentatively deductible in determining net 
investment income after applying section 67 (but before applying 
section 68) is determined by multiplying a taxpayer's miscellaneous 
itemized deductions otherwise allowable under this paragraph (f)(3) by 
a fraction. The numerator of the fraction is the total miscellaneous 
itemized deductions allowed after the application of section 67, but 
before the application of section 68. The denominator of the fraction 
is the total miscellaneous itemized deductions before the application 
of sections 67 and 68. See Example 6 of paragraph (h) of this section.
    (B) Deductions subject to section 68. The amount of itemized 
deductions allowed in determining net investment income after applying 
sections 67 and 68 is determined by multiplying a taxpayer's itemized 
deductions otherwise allowable under this paragraph (f)(3), after the 
application of section 67, by a fraction. The numerator of the fraction 
is the total itemized deductions allowed after the application of 
sections 67 and 68. The denominator of the fraction is the total 
itemized deductions allowed after the application of section 67, but 
before the application of section 68. For this purpose, the term 
itemized deductions does not include any deduction described in section 
68(c).
    (4) Loss deductions. Deductions allowed under this paragraph (f) do 
not include losses described in section 165, whether described in 
section 62 or section 63(d). Losses deductible under section 165 are 
deductible only in determining net gain under paragraph (d) of this 
section, and only to the extent of gains.
    (g) Special rules for controlled foreign corporations and passive 
foreign investment companies. For purposes of calculating net 
investment income, additional rules in Sec.  1.1411-10(c) apply to an 
individual, an estate, or a trust that is a United States shareholder 
that owns an interest in a controlled foreign corporation (within the 
meaning of section 957(a)) or that is a United States person that 
directly or indirectly owns an interest in passive foreign investment 
companies (within the meaning of section 1297(a)).
    (h) Examples. The following examples illustrate the provisions of 
this section. In each example, unless otherwise indicated, the taxpayer 
uses a calendar taxable year, the taxpayer is a U.S. citizen, and Year 
1 is a taxable year in which section 1411 is in effect.

    Example 1. Calculation of net gain. (i) In Year 1, A, an 
unmarried individual, realizes a capital loss of $40,000 on the sale 
of P stock and realizes a capital gain of $10,000 on the sale of Q 
stock, resulting in a net capital loss of $30,000. Both P and Q are 
C corporations. A has no other capital gain or capital loss in Year 
1. In addition, A receives wages of $300,000 and earns $5,000 of 
gross income from interest. For income tax purposes, under section 
1211(b), A may use $3,000 of the net capital loss against other 
income. Under section 1212(b)(1), the remaining $27,000 is a capital 
loss carryover. For purposes of determining A's Year 1 net gain 
under paragraph (a)(1)(iii) of this section, A's gain of $10,000 on 
the sale of the Q stock is reduced by A's loss of $40,000 on the 
sale of the P stock. However, because net gain may not be less than 
zero, A may not reduce net investment income by the $3,000 of the 
excess of capital losses over capital gains allowed for income tax 
purposes under section 1211(b).
    (ii) In Year 2, A has a capital gain of $30,000 on the sale of Y 
stock. Y is a C corporation. A has no other capital gain or capital 
loss in Year 2. For income tax purposes, A may reduce the $30,000 
gain by the Year 1 section 1212(b) $27,000 capital loss carryover. 
For purposes of determining A's Year 2 net gain under paragraph 
(a)(1)(iii) of this section, A's $30,000 gain may also be reduced by 
the $27,000 capital loss carryover from Year 1. Therefore, in Year 
2, A has $3,000 of net gain for purposes of paragraph (a)(1)(iii) of 
this section.
    Example 2. Calculation of net gain. The facts are the same as in 
Example 1, except that in Year 1, A also realizes a gain of $20,000 
on the sale of Rental Property D, all of which is treated as 
ordinary income under section 1250. For income tax purposes, under 
section 1211(b), A may use $3,000 of the net capital loss against 
other income. Under section 1212(b)(1) the remaining $27,000 is a 
capital loss carryover. For purposes of determining A's net gain 
under paragraph (a)(1)(iii) of this section, A's gain of $10,000 on 
the sale of the Q stock is reduced by A's loss of $40,000 on the 
sale of the P stock. A's $20,000 gain on the sale of Rental Property 
D is reduced to the extent of the $3,000 loss allowed under section 
1211(b). Therefore, A's net gain for Year 1 is $17,000 ($20,000 gain 
treated as ordinary income on the sale of Rental Property D reduced 
by $3,000 loss allowed under section 1211).
    Example 3. Section 172 net operating loss deduction. (i) In Year 
1, A, an unmarried individual, has the following items of income and 
deduction: $60,000 in wages, $20,000 in gross income from a trade or 
business of trading in financial instruments or commodities (as 
defined in Sec.  1.1411-5(a)(2)) (trading activity), $70,000 in loss 
from his sole proprietorship (which is not a trade or business 
described in Sec.  1.1411-5), and $30,000 in trading activity 
expense deductions. As a result, for income tax purposes A sustains 
a section 172(c) net operating loss of $20,000. A makes an election 
under section 172(b)(3) to waive the carryback period for this net 
operating loss.
    (ii) For purposes of section 1411, A's net investment income for 
Year 1 is the excess (if any) of the $20,000 in gross income from 
the trading activity over the $30,000 deduction for the trading 
activity expenses. Net investment income cannot be less than zero 
for a taxable year. Therefore, A's net investment income for Year 1 
is $0.
    (iii) For Year 2, A has $200,000 of wages, $100,000 of gross 
income from the trading activity, $80,000 of income from his sole 
proprietorship, and $10,000 in trading activity expense deductions. 
For income tax purposes, A's $20,000 net operating loss carryover 
from Year 1 will be allowed as a deduction. In addition, under Sec.  
1.1411-2(c), A's Year 1 $20,000 net operating loss will be allowed 
as a deduction in computing A's Year 2 modified adjusted gross 
income.
    (iv) For purposes of section 1411, A's $20,000 net operating 
loss carryover from Year 1 is not allowed in computing A's Year 2 
net investment income. As a result, A's Year 2 net investment income 
is $90,000 ($100,000 gross income from the trading activity minus 
the $10,000 of trading activity expenses).
    Example 4. Section 121(a) exclusion. (i) In Year 1, A, an 
unmarried individual, sells a house that he has owned and used as 
his principal residence for five years and realizes $200,000 in 
gain. In addition to the gain realized from the sale of his 
principal residence, A also realizes $7,000 in long-term capital 
gain. A has a $5,000 short-term capital loss carryover from a year 
preceding the effective date of section 1411.
    (ii) For income tax purposes, under section 121(a), A excludes 
the $200,000 gain realized from the sale of his principal residence 
from his Year 1 gross income. In determining A's Year 1 adjusted 
gross income, A also reduces the $7,000 capital gain by the $5,000 
capital loss carryover allowed under section 1211(b).
    (iii) For section 1411 purposes, under section 121(a), A 
excludes the $200,000 gain realized from the sale of his principal 
residence from his Year 1 gross income and, consequently, net 
investment income. In determining A's Year 1 net gain under 
paragraph (a)(1)(iii) of this section, A reduces the $7,000 capital 
gain by the $5,000 capital loss carryover allowed under section 
1211(b).

[[Page 72641]]

    Example 5. Section 163(d) limitation. (i) In Year 1, A, an 
unmarried individual, pays interest of $4,000 on debt incurred to 
purchase stock. Under Sec.  1.163-8T, this interest is allocable to 
the stock and is investment interest within the meaning of section 
163(d)(3). A has no investment income as defined by section 
163(d)(4). A has $10,000 of income from a trade or business that is 
a passive activity (as defined in Sec.  1.1411-5(a)(1)) with respect 
to A. For income tax purposes, under section 163(d)(1) A may not 
deduct the $4,000 investment interest in Year 1. Under section 
163(d)(2), the $4,000 investment interest is a carryforward of 
disallowed interest that is treated as investment interest paid by A 
in the succeeding taxable year. Similarly, for purposes of 
determining A's Year 1 net investment income, A may not deduct the 
$4,000 investment interest.
    (ii) In Year 2, A has $5,000 of section 163(d)(4) net investment 
income. For both income tax purposes and for determining section 
1411 net investment income, A's $4,000 carryforward of interest 
expense disallowed in Year 1 may be deducted in Year 2.
    Example 6. Sections 67 and 68 limitations on itemized 
deductions. (i) A, an unmarried individual, has adjusted gross 
income in Year 1 as follows:

Wages...................................................      $1,600,000
Interest income.........................................         400,000
                                                         ---------------
  Adjusted gross income.................................       2,000,000
 

    In addition, A has the following items of expense qualifying as 
itemized deductions:

Investment expenses..........................................    $70,000
Job-related expenses.........................................     30,000
Investment interest expense..................................     80,000
State income taxes...........................................    120,000
 

    A's investment expenses and job-related expenses are 
miscellaneous itemized deductions. In addition, A's investment 
interest expense and investment expenses are properly allocable to 
net investment income (within the meaning of this section). A's job-
related expenses are not properly allocable to net investment 
income. Of the state income tax expense, $20,000 is properly 
allocable to net investment income and $100,000 is not properly 
allocable to net investment income.
    (ii) A's 2-percent floor under section 67 is $40,000 (2 percent 
of $2,000,000). For Year 1, assume the section 68 limitation starts 
at adjusted gross income of $200,000. The section 68 overall 
limitation disallows $54,000 of A's itemized deductions that are 
subject to section 68 (3 percent of the excess of $2,000,000 
adjusted gross income over the $200,000 limitation threshold).
    (iii)(A) A's total miscellaneous itemized deductions allowable 
before the application of section 67 is $100,000 ($70,000 in 
investment expenses plus $30,000 in job-related expenses), and the 
total miscellaneous deductions allowed after the application of 
section 67 is $60,000 ($100,000 minus $40,000).
    (B) The amount of the deduction allowed for investment expenses 
after the application of section 67 is computed as follows:
[GRAPHIC] [TIFF OMITTED] TP05DE12.000

    (C) The amount of the deduction allowed for job-related expenses 
after the application of section 67 is computed as follows:
[GRAPHIC] [TIFF OMITTED] TP05DE12.001

    (iv)(A) Under section 68, the $80,000 deduction for the 
investment interest expense is not subject to the section 68 
limitation on itemized deductions.
    (B) A's itemized deductions subject to the limitation under 
section 68 and allowed after application of section 67, but before 
the application of section 68, are the following:

Investment expenses..........................................    $42,000
Job-related expenses.........................................     18,000
State income tax.............................................    120,000
                                                              ----------
  Deductions subject to section 68...........................    180,000
 

    (C) Of A's itemized deductions that are subject to the 
limitation under section 68, the amount allowed after the 
application of section 68 is $126,000 ($180,000 minus the $54,000 
disallowed in paragraph (ii) of this Example 6).
    (D) The amount of the investment expense deduction allowed after 
the application of section 68 is determined as follows:
[GRAPHIC] [TIFF OMITTED] TP05DE12.002

    (E) The amount of the state income tax deduction allowed after 
the application of section 68 and properly allocable to net 
investment income is determined as follows:
[GRAPHIC] [TIFF OMITTED] TP05DE12.003

    (F) The itemized deductions allowed after applying sections 67 
and 68 and properly allocable to A's net investment income are the 
following:

Investment interest expense..................................    $80,000
Investment expenses..........................................     29,400
State income taxes...........................................     14,000
                                                              ----------
  Itemized deductions properly allocable to net investment       123,400
   income....................................................
 

    (G) The amount of the state income tax deduction allowed after 
the application of section 68 and not properly allocable to net 
investment income is determined as follows:

[[Page 72642]]

[GRAPHIC] [TIFF OMITTED] TP05DE12.004

    (H) The job-related expenses deduction and $70,000 of the state 
income tax deduction are not properly allocable deductions for 
purposes of section 1411.
    Example 7. Section 1031 like-kind exchange. (i) In Year 1, A, an 
unmarried individual who is not a dealer in real estate, purchases 
Greenacre, a piece of undeveloped land, for $10,000. A intends to 
hold Greenacre for investment.
    (ii) In Year 3, A enters into an exchange in which he transfers 
Greenacre, now valued at $20,000, and $5,000 cash for Blackacre, 
another piece of undeveloped land, which has a fair market value of 
$25,000. The exchange is a transaction for which no gain or loss is 
recognized under section 1031.
    (iii) In Year 3, for income tax purposes A does not recognize 
any gain from the exchange of Greenacre for Blackacre. A's basis in 
Blackacre is $15,000 ($10,000 substituted basis in Greenacre plus 
$5,000 additional cost of acquisition). For purposes of section 
1411, A's net investment income for Year 3 does not include any 
realized gain from the exchange of Greenacre for Blackacre.
    (iv) In Year 5, A sells Blackacre to an unrelated party for 
$35,000 in cash.
    (v) In Year 5, for income tax purposes B recognizes capital gain 
of $20,000 ($35,000 sale price minus $15,000 basis). For purposes of 
section 1411, A's net investment income includes the $20,000 gain 
recognized from the sale of Blackacre.

    (i) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013.


Sec.  1.1411-5  Trades or businesses to which tax applies.

    (a) In general. A trade or business is described in this section if 
such trade or business involves the conduct of a trade or business 
(within the meaning of section 162), and such trade or business is 
either--
    (1) A passive activity (within the meaning of paragraph (b) of this 
section) with respect to the taxpayer; or
    (2) The trade or business of a trader trading in financial 
instruments (as defined in paragraph (c)(1) of this section) or 
commodities (as defined in paragraph (c)(2) of this section).
    (b) Passive activity--(1) In general. A passive activity is 
described in this section if--
    (i) Such activity is a trade or business (within the meaning of 
section 162); and
    (ii) Such trade or business is a passive activity within the 
meaning of section 469 and the regulations thereunder.
    (2) Examples. The following examples illustrate the principles of 
paragraph (b)(1) of this section and the ordinary course of a trade or 
business exception in Sec.  1.1411-4(b). In each example, unless 
otherwise indicated, the taxpayer uses a calendar taxable year, the 
taxpayer is a U.S. citizen, and Year 1 is a taxable year in which 
section 1411 is in effect:

    Example 1. Rental activity. A, an unmarried individual, rents a 
commercial building to B for $50,000 in Year 1. A's rental activity 
does not involve the conduct of a section 162 trade or business, but 
under section 469(c)(2), A's rental activity is a passive activity. 
Because paragraph (b)(1)(i) of this section is not satisfied, A's 
rental income of $50,000 is not derived from a trade or business 
described in paragraph (b)(1) of this section. However, A's rental 
income of $50,000 will still constitute gross income from rents 
within the meaning of Sec.  1.1411-4(a)(1)(i) because Sec.  1.1411-
4(a)(1)(i) does not require a trade or business.
    Example 2. Application of grouping rules under section 469. In 
Year 1, A, an unmarried individual, owns an interest in PRS, a 
partnership for Federal income tax purposes. PRS is engaged in two 
activities, X and Y, which constitute trades or businesses (within 
the meaning of section 162), and neither of which constitute trading 
in financial instruments or commodities (within the meaning of 
paragraph (a)(2) of this section). Pursuant to Sec.  1.469-4, A has 
properly grouped X and Y (the grouped activity). A participates in X 
for more than 500 hours during Year 1 and would be treated as 
materially participating in the activity within the meaning of Sec.  
1.469-5T(a)(1). A only participates in Y for 50 hours during Year 1, 
and, but for the grouping of the two activities together, A would 
not be treated as materially participating in Y within the meaning 
of Sec.  1.469-5T(a). However, pursuant to Sec. Sec.  1.469-4 and 
1.469-5T(a)(1), A materially participates in the grouped activity, 
and therefore, for purposes of paragraph (b)(1)(ii) of this section, 
neither X nor Y is a passive activity with respect to A. 
Accordingly, with respect to A, neither X nor Y is a trade or 
business described in paragraph (b)(1) of this section.
    Example 3. Application of the rental activity exceptions. B, an 
unmarried individual, is a partner in PRS, which is engaged in an 
equipment leasing activity. The average period of customer use of 
the equipment is seven days or less (and therefore meets the 
exception in Sec.  1.469-1T(e)(3)(ii)(A)). B materially participates 
in the equipment leasing activity (within the meaning of Sec.  
1.469-5T(a)). The equipment leasing activity constitutes a trade or 
business within the meaning of section 162. In Year 1, B has 
modified adjusted gross income (as defined in Sec.  1.1411-2(c)) of 
$300,000, all of which is derived from PRS. All of the income from 
PRS is derived in the ordinary course of the equipment leasing 
activity, and all of PRS's property is held in the equipment leasing 
activity. Of B's allocable share of income from PRS, $275,000 
constitutes gross income from rents (within the meaning of Sec.  
1.1411-4(a)(1)(i)). While $275,000 of the gross income from the 
equipment leasing activity meets the definition of rents in Sec.  
1.1411-4(a)(1)(i), the activity meets one of the exceptions to 
rental activity in Sec.  1.469-1T(e)(3)(ii) and B materially 
participates in the activity. Therefore, the trade or business is 
not a passive activity with respect to B for purposes of paragraph 
(b)(1)(ii) of this section, and because the rents are derived in the 
ordinary course of a trade or business not described in paragraph 
(a) of this section, the ordinary course of a trade or business 
exception in Sec.  1.1411-4(b) applies, which means that the rents 
are not subject to Sec.  1.1411-4(a)(1)(i). Furthermore, because the 
equipment leasing trade or business is not a trade or business 
described in paragraph (a)(1) or (a)(2) of this section, the $25,000 
of other gross income is not subject to Sec.  1.1411-4(a)(1)(ii). 
Finally, gain or loss from the sale of the property held in the 
equipment leasing activity will not be subject to Sec.  1.1411-
4(a)(1)(iii) because although it is attributable to a trade or 
business, it is not a trade or business to which the section 1411 
tax applies.
    Example 4. Application of section 469 and other gross income 
under Sec.  1.1411-4(a)(1)(ii). Same facts as Example 3, except B 
does not materially participate in the equipment leasing trade or 
business and therefore the trade or business is a passive activity 
with respect to B for purposes of paragraph (b)(1)(ii) of this 
section. Accordingly, the $275,000 of gross income from rents is 
subject to Sec.  1.1411-4(a)(1)(i) because the rents are derived 
from a trade or business described in paragraph (a)(1) of this 
section (that is, the ordinary course of a trade or business 
exception in Sec.  1.1411-4(b) is inapplicable). Furthermore, the 
$25,000 of other gross income from the equipment leasing trade or 
business is subject to Sec.  1.1411-4(a)(1)(ii) because the gross 
income is derived from a trade or business described in paragraph 
(a)(1) of this section. Finally, gain or loss from the sale of the 
property used in the equipment leasing trade or business is subject 
to Sec.  1.1411-4(a)(1)(iii) because the trade or business is a 
passive activity with respect to B, as described in paragraph 
(b)(1)(ii) of this section.
    Example 5. Application of the portfolio income rule and section 
469. C, an unmarried individual, is a partner in PRS, a partnership 
engaged in a trade or business (within the meaning of section 162) 
that does not involve a rental activity. C does not materially 
participate in PRS within the meaning of Sec.  1.469-5T(a), and 
therefore the trade or business of PRS is a passive activity with 
respect to C for purposes of paragraph (a)(1) of this section. C's 
$500,000 allocable share of PRS's income consists of $450,000 of 
gross income from a trade or business and $50,000 of gross income 
from dividends and interest (within the meaning of Sec.  1.1411-
4(a)(1)(i)) that is not derived in the ordinary course of the trade 
or business of PRS. Thus, under

[[Page 72643]]

section 469(e)(1)(A)(i)(I) and the regulations thereunder, C's 
allocable share of gross income from dividends and interest consists 
of portfolio income. Therefore, C's $500,000 allocable share of 
PRS's income is subject to section 1411. C's $50,000 allocable share 
of PRS's income from dividends and interest is subject to Sec.  
1.1411-4(a)(1)(i) because the share is gross income from dividends 
and interest that is not derived in the ordinary course of a trade 
or business (that is, the ordinary course of a trade or business 
exception in Sec.  1.1411-4(b) is inapplicable). C's $450,000 
allocable share of PRS's income is subject to Sec.  1.1411-
4(a)(1)(ii) because it is gross income from a trade or business that 
is a passive activity.

    (c) Trading in financial instruments or commodities--(1) Definition 
of financial instruments. For purposes of section 1411 and the 
regulations thereunder, the term financial instruments includes stocks 
and other equity interests, evidences of indebtedness, options, forward 
or futures contracts, notional principal contracts, any other 
derivatives, or any evidence of an interest in any of the items 
described in this paragraph (c)(1). An evidence of an interest in any 
of the items described in this paragraph (c)(1) includes, but is not 
limited to, short positions or partial units in any of the items 
described in this paragraph (c)(1).
    (2) Definition of commodities. For purposes of section 1411 and the 
regulations thereunder, the term commodities refers to items described 
in section 475(e)(2).
    (d) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013.


Sec.  1.1411-6  Income on investment of working capital subject to tax.

    (a) General rule. For purposes of section 1411, any item of gross 
income from the investment of working capital will be treated as not 
derived in the ordinary course of a trade or business, and any net gain 
that is attributable to the investment of working capital will be 
treated as not derived in the ordinary course of a trade or business. 
In determining whether any item is gross income from or net gain 
attributable to an investment of working capital, principles similar to 
those described in Sec.  1.469-2T(c)(3)(iii) apply. See Sec.  1.1411-
4(f) for rules regarding properly allocable deductions with respect to 
an investment of working capital; Sec.  1.1411-7 for rules relating to 
the adjustment to net gain on the disposition of interests in a 
partnership or S corporation.

    (b) Example. A, an unmarried individual, operates a restaurant, 
which is a section 162 trade or business but is not a trade or 
business described in Sec.  1.1411-5(a)(1) with respect to A. A owns 
and conducts the restaurant business through S, an S corporation 
wholly-owned by A. S is able to pay all of the restaurant's current 
obligations with cash flow generated by the restaurant. S utilizes 
an interest-bearing checking account at a local bank to make daily 
deposits of cash receipts generated by the restaurant, and also to 
pay the recurring ordinary and necessary business expenses of the 
restaurant. The average daily balance of the checking account is 
approximately $2,500, but at any given time the balance may be 
significantly more or less than this amount depending on the short-
term cash flow needs of the business. In addition, S has set aside 
$20,000 for the potential future needs of the business in case the 
daily cash flow into and from the checking account becomes 
insufficient to pay the restaurant's recurring business expenses. S 
does not currently need to spend or use the $20,000 capital to 
conduct the restaurant business, and S deposits and maintains the 
$20,000 in an interest-bearing savings account at a local bank. Both 
the $2,500 average daily balance of the checking account and the 
$20,000 savings account balance constitute working capital and, 
pursuant to paragraph (a) of this section, the interest generated by 
this working capital will not be treated as derived in the ordinary 
course of S's restaurant business. Accordingly, the interest income 
derived by S from its checking and savings accounts and allocated to 
A under section 1366 will be subject to tax under Sec.  1.1411-
4(a)(1)(i).

    (c) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013.


Sec.  1.1411-7  Exception for dispositions of interests in partnerships 
and S corporations.

    (a) In general--(1) General application. In the case of a 
disposition of an interest in a partnership or S corporation described 
in paragraph (a)(2) of this section, the gain or loss from such 
disposition taken into account under Sec.  1.1411-4(a)(1)(iii) shall be 
adjusted in accordance with paragraph (c) of this section. The 
adjustment reflects the net gain or net loss that would have been taken 
into account by the transferor if all property of the partnership or S 
corporation were sold for fair market value immediately before the 
disposition of such interest (a deemed sale).
    (2) Interests to which exception applies--(i) In general. The 
adjustment provided by this section applies only to dispositions of 
interests in partnerships or S corporations if--
    (A) The partnership or S corporation is engaged in one or more 
trades or businesses (within the meaning of section 162), and at least 
one of its trades or businesses is not described in Sec.  1.1411-
5(a)(2) (trading in financial instruments or commodities); and
    (B) With respect to the partnership or S corporation interest 
disposed of, the transferor is engaged in at least one trade or 
business that is not described in Sec.  1.1411-5(a)(1) (passive 
activity with respect to the transferor).
    (ii) Nonapplication. This section does not apply to the disposition 
of stock in an S corporation if an election under section 338(h)(10) is 
made.
    (b) Special rules--(1) Installment sales--(i) Installment sales on 
or after the effective date of section 1411. In the case of a 
disposition of an interest in a partnership or S corporation in an 
installment sale to which section 453 applies, any adjustment to net 
gain under this section is determined in the year of disposition and 
shall be taken into account in the same proportion of the total gain as 
is taken into account under section 453.
    (ii) Installment sales prior to the effective date of section 1411. 
In the case of a disposition before the effective date of section 1411 
of an interest in a partnership or S corporation in an installment sale 
to which section 453 applies, taxpayers that want to make an 
irrevocable election to have this section apply must file the 
computational statement required by paragraph (d) of this section with 
the taxpayer's original or amended return for the first taxable year 
beginning after December 31, 2013, in which the taxpayer is subject to 
tax under section 1411. The determination of whether the taxpayer is 
subject to tax under section 1411 is made without regard to the effect 
of the election. In addition, a taxpayer may make an irrevocable 
election to have this section apply for a taxable year that begins 
before January 1, 2014, by filing the computational statement required 
by paragraph (d) of this section with the taxpayer's original or 
amended return for the taxable year. If the election is made under this 
section, the taxpayer shall calculate the gain or loss adjustment under 
this section and such adjustment shall be taken into account under 
Sec.  1.1411-4(a)(1)(iii).
    (2) Sale of an interest by a Qualified Subchapter S Trust. 
[Reserved]
    (c) Deemed sale--(1) In general. In the case of a disposition of an 
interest in a partnership or S corporation described in paragraph 
(a)(2)(i) of this section, the amount of gain or loss from such 
disposition taken into account for purposes of Sec.  1.1411-
4(a)(1)(iii) must be adjusted in accordance with this paragraph (c).
    (2) Step one: deemed sale of properties. The partnership or S 
corporation is deemed to dispose of all of the entity's properties in a 
fully taxable transaction (in a manner similar

[[Page 72644]]

to Sec.  1.743-1(d)(2)) for cash equal to the fair market value of the 
entity's properties immediately before the disposition of the 
partnership or S corporation interest.
    (3) Step two: determination of gain or loss. The partnership or S 
corporation determines the amount of gain or loss attributable to each 
property by comparing the fair market value of each property with the 
adjusted basis of each property. The gain or loss for each property 
must be treated as a separate item.
    (4) Step three: allocation of gain or loss. Applying the rules of 
chapter 1, the partnership or S corporation determines the amount of 
gain or loss for each property that is allocable to the interest 
disposed of by the transferor. An allocation of gain or loss to a 
transferor partner must comply with the requirements in sections 704(b) 
and 704(c) and the regulations thereunder, and basis adjustments under 
section 743 with respect to the transferor must be taken into account. 
In the case of an S corporation, the amount of gain or loss allocated 
to the transferor is determined under section 1366(a), and the 
allocation should not take into account any reduction in the 
transferor's distributive share in section 1366(f)(2) resulting from 
the hypothetical imposition of tax under section 1374 as a result of 
the deemed sale. See Sec.  1.460-4(k)(3)(v)(B) for a rule relating to 
the computation of income or loss that would be allocated to the 
transferor from a contract accounted for under a long-term contract 
method of accounting as a result of the deemed sale of properties.
    (5) Step four: adjustment to gain or loss--(i) In general. If the 
amount of gain or loss allocable to the transferor in paragraph (c)(4) 
of this section is attributable to property held (as modified by 
paragraph (c)(5)(ii) of this section, if applicable) in a trade or 
business not described in Sec.  1.1411-5(a), such gain or loss is 
aggregated to create a net gain (which results in a negative 
adjustment) or a net loss (which results in a positive adjustment). 
Then, in accordance with paragraph (c)(5)(iii) or (iv) of this section, 
the transferor must adjust the transferor's gain or loss from the 
disposition of the partnership or S corporation interest as determined 
in Sec.  1.1411-4(a)(1)(iii) (without application of this section).
    (ii) Special rules--(A) Property used in more than one trade or 
business. In the case of the disposition of a partnership or S 
corporation interest in which property of the partnership or S 
corporation is held in more than one trade or business during the 
twelve-month period ending on the date of the disposition, the fair 
market value and the adjusted basis of such property must be allocated 
among such trades or businesses on a basis that reasonably reflects the 
use of such property during such twelve-month period. See Example 7 of 
paragraph (e) of this section regarding multiple trades or businesses.
    (B) Goodwill attributable to property. If the transferor is 
allocated gain or loss from goodwill in the deemed sale under paragraph 
(c)(4) of this section and if the entity is engaged in a trade or 
business, the transferor shall treat such gain or loss as gain or loss 
from the disposition of property held in that trade or business. If the 
entity is engaged in more than one trade or business, the transferor's 
gain or loss from goodwill will be attributable to the entity's trades 
or businesses based on the relative fair market value of the property 
(other than cash) held in each trade or business. See Example 8 of 
paragraph (e) of this section.
    (iii) Negative adjustment--(A) General rule. Subject to the 
limitations described in paragraph (c)(5)(iii)(B) of this section, if 
the amount determined under paragraph (c)(5)(i) of this section is a 
net gain, a negative adjustment of such amount shall be taken into 
account in computing the amount of the transferor's net gain in Sec.  
1.1411-4(a)(1)(iii).
    (B) Limitations. If the transferor has a gain (determined without 
regard to section 1411(c)(4) and this paragraph (c)) from the 
disposition of the partnership or S corporation interest, the negative 
adjustment taken into account is limited to the amount of the gain 
(determined without regard to section 1411(c)(4) and this paragraph 
(c)). If the transferor has a loss (determined without regard to 
section 1411(c)(4) and this paragraph (c)) from the disposition of the 
partnership or S corporation interest, the negative adjustment shall 
not be taken into account.
    (iv) Positive adjustment--(A) General rule. Subject to the 
limitations described in paragraph (c)(5)(iv)(B) of this section, if 
the amount determined under paragraph (c)(5)(i) of this section is a 
net loss, a positive adjustment of such amount shall be taken into 
account in computing the amount of the transferor's net gain in Sec.  
1.1411-4(a)(1)(iii).
    (B) Limitations. If the transferor has a loss (determined without 
regard to section 1411(c)(4) and this paragraph (c)) from the 
disposition of the partnership or S corporation interest, the positive 
adjustment taken into account is limited to the amount of the loss 
(determined without regard to section 1411(c)(4) and this paragraph 
(c)). If the transferor has a gain (determined without regard to 
section 1411(c)(4) and this paragraph (c)) from the disposition of the 
partnership or S corporation interest, the positive adjustment shall 
not be taken into account.
    (d) Required statement of adjustment. Any transferor making an 
adjustment under paragraph (c) of this section must attach a statement 
to the transferor's return for the year of disposition. The statement 
must include--
    (1) A description of the disposed-of interest;
    (2) The name and taxpayer identification number of the entity 
disposed of;
    (3) The fair market value of each property of the entity;
    (4) The entity's adjusted basis in each property;
    (5) The transferor's allocable share of gain or loss with respect 
to each property of the entity;
    (6) Information regarding whether the property was held in (or 
attributable to) a trade or business not described in Sec.  1.1411-5;
    (7) The amount of the net gain under Sec.  1.1411-4(a)(1)(iii) on 
the disposition of the interest; and
    (8) The computation of the adjustment under paragraph (c) of this 
section.
    (e) Examples. The following examples illustrate the principles of 
this section. In each example, unless otherwise indicated, the taxpayer 
uses a calendar taxable year, the taxpayer is a U.S. citizen, the 
partnership (PRS) or S corporation (S) is not engaged in a trade or 
business of trading in financial instruments or commodities (as defined 
in Sec.  1.1411-5(a)(2)), and Year 1 is a taxable year in which section 
1411 is in effect:

    Example 1. Basic application. (i) Facts. Individuals A and B are 
shareholders of S Corporation (S). A owns 75 percent of the stock in 
S, and B owns 25 percent of the stock in S. During Year 1, S is 
engaged in a single trade or business. With respect to S's trade or 
business, A is not engaged in a trade or business described in Sec.  
1.1411-5(a)(1), and B is engaged in a trade or business described in 
Sec.  1.1411-5(a)(1). S has three properties (1, 2, and 3) held 
exclusively in S's trade or business that have an aggregate fair 
market value of $120,000. On September 1 of Year 1, A and B sell 
their S stock to C for the fair market value of S's properties (that 
is, A sells for $90,000 and B sells for $30,000). At the time of the 
disposition, A's adjusted basis in his S stock is $75,000, and B's 
adjusted basis in his S stock is $25,000. S's properties have the 
following adjusted bases and fair market values immediately before 
the disposition:

[[Page 72645]]



------------------------------------------------------------------------
                                                                 Fair
                    Property                       Adjusted     market
                                                     basis       value
------------------------------------------------------------------------
1...............................................     $10,000     $50,000
2...............................................      70,000      30,000
3...............................................      20,000      40,000
------------------------------------------------------------------------

    (ii) Calculation of net gain under Sec.  1.1411-4(a)(1)(iii). On 
the stock sale to C, A recognizes a gain of $15,000 ($90,000 minus 
$75,000), which is subject to Sec.  1.1411-4(a)(1)(iii), and B 
recognizes a gain of $5,000 ($30,000 minus $25,000), which is 
subject to Sec.  1.1411-4(a)(1)(iii).
    (iii) Application of section 1411(c)(4)--(A) In general. Section 
1411(c)(4) is applicable to A because with respect to S's trade or 
business, A is not engaged in a trade or business described in Sec.  
1.1411-5(a)(1). On the other hand, with respect to B, S's trade or 
business is described in Sec.  1.1411-5(a)(1) because it is a 
passive trade or business with respect to B within the meaning of 
Sec.  1.1411-5(a)(1). Accordingly, section 1411(c)(4) is 
inapplicable to B, and B may not make any adjustment to his $5,000 
gain upon the stock disposition.
    (B) Deemed sale--(1) Step one: deemed sale of properties. Upon a 
hypothetical disposition of S's properties for cash equal to fair 
market value, S would receive $50,000 for Property 1, $30,000 for 
Property 2, and $40,000 for Property 3.
    (2) Step two: determination of gain or loss. The determination 
of gain or loss on the deemed sale of S's properties is as follows:

------------------------------------------------------------------------
                                                      Fair
               Property                  Adjusted    market     Gain or
                                          basis      value       loss
------------------------------------------------------------------------
1.....................................    $10,000    $50,000    $40,000
2.....................................     70,000     30,000    (40,000)
3.....................................     20,000     40,000     20,000
------------------------------------------------------------------------

    (3) Step three: allocation of gain or loss. Under section 1366, 
A is allocated $30,000 gain from Property 1, $30,000 loss from 
Property 2, and $15,000 gain from Property 3.
    (4) Step four: adjustment to net gain. Because all three 
properties are held in S's trade or business, A must make an 
adjustment under paragraph (c)(5) of this section to the amount of 
net gain determined under Sec.  1.1411-4(a)(1)(iii). The gain or 
loss on each of the three properties are added together ($30,000 
minus $30,000 plus $15,000), resulting in a negative adjustment of 
$15,000. Under paragraph (c)(5) of this section, A's gain of $15,000 
on the disposition of the interest under Sec.  1.1411-4(a)(1)(iii) 
is reduced by $15,000, and A has zero gain with respect to the stock 
disposition for purposes of Sec.  1.1411-4(a)(1)(iii).
    Example 2. Inside-outside basis disparity. (i) Facts. Same facts 
as Example 1, except that A's adjusted basis in his S stock is 
$70,000.
    (ii) Analysis. On the stock sale to C, A recognizes a gain of 
$20,000 ($90,000 minus $70,000), which is subject to Sec.  1.1411-
4(a)(1)(iii). The deemed sale would result in a negative adjustment 
of $15,000 ($30,000 minus $30,000 plus $15,000). Under paragraph 
(c)(5) of this section, A's net gain of $20,000 on the disposition 
of the interest under Sec.  1.1411-4(a)(1)(iii) is reduced by 
$15,000, and A has $5,000 net gain with respect to the stock 
disposition for purposes of Sec.  1.1411-4(a)(1)(iii).
    Example 3. Limitation of adjustment. (i) Facts. Same facts as 
Example 1, except that A's adjusted basis in his S stock is $80,000.
    (ii) Analysis. On the stock sale to C, A recognizes a gain of 
$10,000 ($90,000 minus $80,000), which is subject to Sec.  1.1411-
4(a)(1)(iii). The deemed sale would result in a negative adjustment 
of $15,000 ($30,000 minus $30,000 plus $15,000). Under paragraph 
(c)(5) of this section, A's net gain of $10,000 on the disposition 
of the interest under Sec.  1.1411-4(a)(1)(iii) is reduced by the 
negative adjustment, but the negative adjustment under Sec.  1.1411-
7(c)(5)(iii)(B) is limited to $10,000 (the amount of A's gain 
determined without regard to Sec.  1.1411-7). As a result, A has 
zero net gain with respect to the stock disposition for purposes of 
Sec.  1.1411-4(a)(1)(iii).>
    Example 4. Loss on disposition. (i) Facts. Same facts as Example 
1, except that (A) A's adjusted basis in his stock is $105,000, (B) 
Property 3 has an adjusted basis of $60,000 and fair market value of 
$10,000, and (C) A sells his interest for $67,500.
    (ii) Analysis. On the stock sale to C, A recognizes a loss of 
$37,500 ($67,500 minus $105,000), which is subject to Sec.  1.1411-
4(a)(1)(iii). In the deemed sale, A would be allocated $30,000 gain 
from Property 1, $30,000 loss from Property 2, and $37,500 loss from 
Property 3. The deemed sale would result in a positive adjustment of 
$37,500 ($30,000 minus $30,000 minus $37,500). Under paragraph 
(c)(5) of this section, A's loss of $37,500 on the disposition of 
the interest under Sec.  1.1411-4(a)(1)(iii) is increased by the 
positive adjustment of $37,500, and A has zero loss with respect to 
the stock disposition for purposes of Sec.  1.1411-4(a)(1)(iii).
    Example 5. Property not held in trade or business. (i) Facts. 
Same facts as Example 1, except that S owns a fourth property 
(adjusted basis of $20,000 and fair market value of $100,000) that 
is not held in S's trade or business and only A sells his S stock to 
C for A's proportionate share of the fair market value of S's 
properties. At the time of the disposition, A's adjusted basis in 
his S stock is $90,000.
    (ii) Calculation of net gain under Sec.  1.1411-4(a)(1)(iii). On 
the stock sale to C, A recognizes a gain of $75,000 ($165,000 minus 
$90,000), which is subject to Sec.  1.1411-4(a)(1)(iii).
    (iii) Application of section 1411(c)(4)--(A) In general. Section 
1411(c)(4) is applicable to A because S's trade or business is not a 
trade or business described in Sec.  1.1411-5(a)(1) with respect to 
A.
    (B) Deemed sale--(1) Step one: deemed sale of properties. Upon a 
hypothetical disposition of S's properties for cash equal to fair 
market value, S would receive $50,000 for Property 1, $30,000 for 
Property 2, $40,000 for Property 3, and $100,000 for Property 4.
    (2) Step two: determination of gain or loss. The determination 
of gain or loss on the deemed sale of S's properties is as follows:

------------------------------------------------------------------------
                                                      Fair
               Property                  Adjusted    market     Gain or
                                          basis      value       loss
------------------------------------------------------------------------
1.....................................    $10,000    $50,000    $40,000
2.....................................     70,000     30,000    (40,000)
3.....................................     20,000     40,000     20,000
4.....................................     20,000    100,000     80,000
------------------------------------------------------------------------

    (3) Step three: allocation of gain or loss. Under section 1366, 
A is allocated $30,000 gain from Property 1, $30,000 loss from 
Property 2, $15,000 gain from Property 3, and $60,000 gain from 
Property 4.
    (4) Step four: adjustment to net gain. Because S's trade or 
business is not a trade or business described in Sec.  1.1411-
5(a)(1) with respect to A, A must make an adjustment under paragraph 
(c)(5) of this section to the amount of gain determined under Sec.  
1.1411-4(a)(1)(iii). Because Property 4 is not held in S's trade or 
business, A's $60,000 gain from Property 4 is not taken into account 
under paragraph (c)(5) of this section. The gain or loss on Property 
1, Property 2, and Property 3 are added together ($30,000 minus 
$30,000 plus $15,000), resulting in a negative adjustment of 
$15,000. Under paragraph (c)(5) of this section, A's net gain of 
$75,000 under Sec.  1.1411-4(a)(1)(iii) on the disposition of the 
interest is reduced by $15,000, and A has $60,000 net gain with 
respect to the stock disposition for purposes of Sec.  1.1411-
4(a)(1)(iii).
    Example 6. Calculation of gain in general. (i) Facts. D and E 
are equal partners in PRS, a partnership, and PRS's partnership 
agreement provides that allocations are 50 percent to D and 50 
percent to E. PRS is engaged in a single trade or business. D 
contributed Property 1 with an adjusted basis of $100,000 and a fair 
market value of $200,000 at the time of the contribution. E 
contributed Property 2 with an adjusted basis of $120,000 and a fair 
market value of $200,000 at the time of the contribution. PRS is 
engaged in a single trade or business in which both Property 1 and 
Property 2 are used. PRS's trade or business is not a trade or 
business described in Sec.  1.1411-5(a)(1) with respect to D. On 
November 1 of Year 1, D sells his interest in PRS to F for $320,000, 
which is based on the fair market value of PRS's properties. At the 
time of the sale, D has an adjusted basis in his partnership 
interest of $100,000 and the properties of PRS have the following 
adjusted bases and fair market values:

------------------------------------------------------------------------
                                                                 Fair
                    Property                       Adjusted     market
                                                     basis       value
------------------------------------------------------------------------
1...............................................    $100,000    $240,000
2...............................................     120,000     400,000
------------------------------------------------------------------------

    (ii) Calculation of net gain under Sec.  1.1411-4(a)(1)(iii). D 
recognizes $220,000 ($320,000 minus $100,000) of gain on the sale of 
his partnership interest to F, and such gain is subject to Sec.  
1.1411-4(a)(1)(iii).
    (iii) Application of section 1411(c)(4)--(A) In general. Section 
1411(c)(4) is applicable to D because PRS's trade or business is not 
a trade or business described in Sec.  1.1411-5(a)(1) with respect 
to A.
    (B) Deemed sale--(1) Step one: deemed sale of properties. Upon a 
hypothetical

[[Page 72646]]

disposition of PRS's properties for cash equal to fair market value, 
PRS would receive $240,000 for Property 1 and $400,000 for Property 
2.
    (2) Step two: determination of PRS's gain or loss. The 
determination of gain or loss on the deemed sale of PRS's properties 
is as follows:

------------------------------------------------------------------------
                                                       Fair
                Property                  Adjusted    market    Gain or
                                           basis      value       loss
------------------------------------------------------------------------
1......................................   $100,000   $240,000   $140,000
2......................................    120,000    400,000    280,000
------------------------------------------------------------------------

    (3) Step three: allocation of gain or loss. Pursuant to section 
704(c), D is allocated $120,000 gain from the deemed sale of 
Property 1 and $100,000 gain from the deemed sale of Property 2.
    (4) Step four: adjustment to net gain. Because both properties 
are used in PRS's in trade or business, D must make an adjustment 
under paragraph (c)(5)(i) of this section to the amount of net gain 
determined under Sec.  1.1411-4(a)(1)(iii). The total gain allocated 
to D in the deemed sale is $220,000 ($120,000 plus $100,000), 
resulting in a negative adjustment of $220,000. Under paragraph 
(c)(5) of this section, D's net gain of $220,000 under Sec.  1.1411-
4(a)(1)(iii) on the disposition of the interest is reduced by 
$220,000, and D has zero net gain with respect to the partnership 
interest disposition for purposes of Sec.  1.1411-4(a)(1)(iii).
    Example 7. Multiple trades or businesses. (i) Facts. Individuals 
A and B are shareholders of an S corporation (S). A owns 50 percent 
of the stock in S. During Year 2, S is engaged in two trades or 
businesses (Business X and Business Y). With respect to Business X, 
A is not engaged in a trade or business described in Sec.  1.1411-
5(a)(1), but with respect to Business Y, A is engaged in a trade or 
business is described in Sec.  1.1411-5(a)(1). S has five 
properties. Property 1 and Property 2 are held exclusively in 
Business X, and Property 3 and Property 4 are held exclusively in 
Business Y. Property 5 is used half of the time in Business X and 
the rest of the time in Business Y. On December 1 of Year 2, A sells 
his S stock to C for A's proportionate share of the fair market 
value of S's properties. At the time of the disposition, A's 
adjusted basis in his S stock is $110,000. S's properties have the 
following adjusted bases and fair market values immediately before 
the disposition:

------------------------------------------------------------------------
                                                                 Fair
                    Property                       Adjusted     market
                                                     basis       value
------------------------------------------------------------------------
1...............................................     $10,000     $30,000
2...............................................      70,000      30,000
3...............................................      20,000      40,000
4...............................................      20,000     100,000
5...............................................     100,000     120,000
------------------------------------------------------------------------

    (ii) Calculation of gain under Sec.  1.1411-4(a)(1)(iii). On the 
stock sale to C, A recognizes a gain of $50,000 ($160,000 minus 
$110,000), which is subject to Sec.  1.1411-4(a)(1)(iii).
    (iii) Application of section 1411(c)(4)--(A) In general. Section 
1411(c)(4) is applicable to A. However, any adjustment will only 
relate to property held in Business X and not to property held in 
Business Y (because Business Y is a trade or business described in 
Sec.  1.1411-5(a)(1) with respect to A).
    (B) Deemed sale--(1) Step one: deemed sale of properties. Upon a 
hypothetical disposition of S's properties for cash equal to fair 
market value, S would receive $30,000 for Property 1, $30,000 for 
Property 2, $40,000 for Property 3, $100,000 for Property 4, and 
$120,000 for Property 5.
    (2) Step two: determination of gain or loss. The determination 
of gain or loss on the deemed sale of S's properties is as follows:

------------------------------------------------------------------------
                                                      Fair
               Property                  Adjusted    market     Gain or
                                          basis      value       loss
------------------------------------------------------------------------
1.....................................    $10,000    $30,000    $20,000
2.....................................     70,000     30,000    (40,000)
3.....................................     20,000     40,000     20,000
4.....................................     20,000    100,000     80,000
5.....................................    100,000    120,000     20,000
------------------------------------------------------------------------

    (3) Step three: allocation of gain or loss. Under section 1366, 
A is allocated $10,000 gain from Property 1, $20,000 loss from 
Property 2, $10,000 gain from Property 3, $40,000 gain from Property 
4, and $10,000 gain from Property 5.
    (4) Step four: adjustment to net gain. A must make an adjustment 
under paragraph (c)(5) of this section to the amount of net gain 
determined under Sec.  1.1411-4(a)(1)(iii), but only with respect to 
the gain or loss on the properties used in Business X (that is, 
Property 1, Property 2, and a portion of Property 5). Because 
Property 5 is used 50 percent of the time in Business X, under 
paragraph (c)(5)(ii)(A) of this section, 50 percent of the gain 
would be attributable to Business X (and A's share would be $5,000). 
The gain or loss on Property 1, Property 2, and Property 5 are added 
together ($10,000 minus $20,000 plus $5,000), and results in a 
positive adjustment of $5,000. Under paragraph (c)(5)(iv)(B) of this 
section, because A had a gain of $50,000 on the stock disposition, A 
does not take the positive adjustment of $5,000 into account and A 
has a $50,000 gain for purposes of Sec.  1.1411-4(a)(1)(iii).
    Example 8. Goodwill and multiple trades or businesses. (i) 
Facts. Individuals A and B are shareholders of an S corporation (S). 
A owns 50 percent of the stock in S. During Year 2, S is engaged in 
two trades or businesses (Business X and Business Y). With respect 
to Business X, A is not engaged in a trade or business described in 
Sec.  1.1411-5(a)(1), but with respect to Business Y, A is engaged 
in a trade or business described in Sec.  1.1411-5(a)(1). In 
addition to cash and goodwill, S has five properties. Property 1 and 
Property 2 are used exclusively in Business X. Property 3 is not 
held for use in either Business X or Business Y. Property 4 and 
Property 5 are used exclusively in Business Y. On June 1 of Year 2, 
A sells his S stock to C for A's proportionate share of the fair 
market value of S's properties. At the time of the disposition, A's 
adjusted basis in his S stock is $30,000. S's properties have the 
following adjusted basis and fair market value immediately before 
the disposition:

------------------------------------------------------------------------
                                                                 Fair
                    Property                       Adjusted     market
                                                     basis       value
------------------------------------------------------------------------
1...............................................      $5,000     $10,000
2...............................................       5,000       5,000
3...............................................           0      10,000
4...............................................      20,000      30,000
5...............................................      10,000      15,000
Cash............................................      10,000      10,000
Goodwill........................................      10,000      30,000
------------------------------------------------------------------------

    (ii) Calculation of gain under Sec.  1.1411-4(a)(1)(iii). On the 
stock sale to C, A recognizes a gain of $25,000 ($55,000 minus 
$30,000), which is subject to Sec.  1.1411-4(a)(1)(iii).
    (iii) Application of section 1411(c)(4)--(A) In general. Section 
1411(c)(4) is applicable to A. However, any adjustment will only 
relate to property used in Business X and not to property used in 
Business Y (because Business Y is a trade or business described in 
Sec.  1.1411-5(a)(1) with respect to A).
    (B) Deemed sale--(1) Step one: deemed sale of properties. Upon a 
hypothetical disposition of S's properties for cash equal to fair 
market value, S would receive $10,000 for Property 1, $5,000 for 
Property 2, $10,000 for Property 3, $30,000 for Property 4, $15,000 
for Property 5, $10,000 for the cash, and $30,000 for goodwill.
    (2) Step two: determination of gain or loss. The determination 
of gain or loss on the deemed sale of S's properties is as follows:

------------------------------------------------------------------------
                                                      Fair
               Property                  Adjusted    market     Gain or
                                          basis      value       loss
------------------------------------------------------------------------
1.....................................     $5,000    $10,000      5,000
2.....................................      5,000      5,000          0
3.....................................          0     10,000     10,000
4.....................................     20,000     30,000     10,000
5.....................................     10,000     15,000      5,000
Cash..................................     10,000     10,000          0
Goodwill..............................     10,000     30,000     20,000
------------------------------------------------------------------------

    (3) Step three: allocation of gain or loss. Under section 1366, 
A is allocated a $25,000 gain ($2,500 gain from Property 1, $0 gain 
from Property 2, $5,000 gain from Property 3, $5,000 gain from 
Property 4, $2,500 gain from Property 5, $0 from cash, and $10,000 
from goodwill).
    (4) Step four: adjustment to net gain. A must make an adjustment 
under paragraph (c)(5) of this section to the amount of net gain 
determined under Sec.  1.1411-4(a)(1)(iii), but only with respect to 
the gain or loss on the properties used in Business X (that is, 
Property 1, Property 2, and a portion of the goodwill). Under 
paragraph (c)(5)(ii)(B) of this section, the goodwill is allocated 
to Business X and Business Y based on the relative fair market value 
of the property (other than cash) held for use in each trade or 
business. For this purpose, the fair market value of the property 
held for use in Business X is $15,000, and the fair market value of 
the property held for use in Business Y is $45,000. Therefore, 25 
percent of A's gain on the goodwill is attributable to Business X 
(or $2,500). A's share of the gain on Property 1, Property 2, and 
goodwill are added together ($2,500 plus zero plus $2,500), which 
results in a negative adjustment of $5,000. Under

[[Page 72647]]

paragraph (c)(5) of this section, A takes into account the negative 
adjustment of $5,000, and A has a $20,000 gain ($25,000 minus $5,000 
adjustment) for purposes of Sec.  1.1411-4(a)(1)(iii).

    (f) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013.


Sec.  1.1411-8  Exception for distributions from qualified plans.

    (a) General rule. Net investment income (as defined in Sec.  
1.1411-4) does not include any distribution from a qualified plan or 
arrangement. For this purpose, the term qualified plan or arrangement 
means any plan or arrangement described in section 401(a), 403(a), 
403(b), 408, 408A, or 457(b).
    (b) Rules relating to distributions. This paragraph (b) provides 
rules for purposes of paragraph (a) of this section. For purposes of 
section 1411(c)(5) and this section, a distribution means the 
following:
    (1) Actual distributions. Any amount actually distributed from a 
qualified plan or arrangement, as defined in paragraph (a) of this 
section, is a distribution within the meaning of section 1411(c)(5), 
and thus is not included in net investment income. Examples include a 
rollover to an eligible retirement plan within the meaning of section 
402(c)(8)(B), a distribution of a plan loan offset amount within the 
meaning of Q&A-13(b) of Sec.  1.72(p)-1, and certain corrective 
distributions under the Internal Revenue Code.
    (2) Amounts treated as distributed. Any amount that is treated as 
distributed from a qualified plan or arrangement under the Internal 
Revenue Code for purposes of income tax is a distribution within the 
meaning of section 1411(c)(5), and thus is not included in net 
investment income. Examples include a conversion to a Roth IRA 
described in section 408A and a deemed distribution under section 
72(p).
    (3) Amounts includible in gross income. Any amount that is not 
treated as a distribution but is otherwise includible in gross income 
pursuant to a rule relating to amounts held in a qualified plan or 
arrangement described in paragraph (a) of this section is a 
distribution within the meaning of section 1411(c)(5), and thus is not 
included in net investment income. For example, any income of the trust 
of a qualified plan or arrangement that is applied to purchase a 
participant's life insurance coverage (the P.S. 58 costs) is a 
distribution within the meaning of section 1411(c)(5), and thus is not 
included in net investment income.
    (c) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013.


Sec.  1.1411-9  Exception for self-employment income.

    (a) General rule. Except as provided in paragraph (b) of this 
section, net investment income (as defined in Sec.  1.1411-4) does not 
include any item taken into account in determining self-employment 
income that is subject to tax under section 1401(b) for such taxable 
year. For purposes of section 1411(c)(6) and this section, taken into 
account means income included and deductions allowed in determining net 
earnings from self-employment. However, amounts excepted in determining 
net earnings from self-employment under section 1402(a)(1)-(17), and 
thus excluded from self-employment income under section 1402(b), are 
not taken into account in determining self-employment income and thus 
may be included in net investment income if such amounts are described 
in Sec.  1.1411-4. Except as provided in paragraph (b) of this section, 
if net earnings from self-employment consist of income or loss from 
more than one trade or business, all items taken into account in 
determining the net earnings from self-employment with respect to these 
trades or businesses (see Sec.  1.1402(a)-2(c)) are considered taken 
into account in determining the amount of self-employment income that 
is subject to tax under section 1401(b) and therefore not included in 
net investment income.
    (b) Special rule for traders. In the case of gross income described 
in Sec.  1.1411-4(a)(1)(ii) derived from a trade or business of trading 
in financial instruments or commodities (as described in Sec.  1.1411-
5(a)(2)), the deductions described in Sec.  1.1411-4(f)(2)(ii) properly 
allocable to the taxpayer's trade or business of trading in financial 
instruments or commodities are taken into account in determining the 
taxpayer's self-employment income only to the extent that such 
deductions reduce the taxpayer's net earnings from self-employment 
(after aggregating under Sec.  1.1402(a)-2(c) the net earnings from 
self-employment from any trade or business carried on by the taxpayer 
as an individual or as a member of a partnership). Any deductions 
described in Sec.  1.1411-4(f)(2)(ii) that exceed the amount of net 
earnings from self-employment, in the aggregate (if applicable), shall 
be allowed in determining the taxpayer's net investment income under 
section 1411 and the regulations thereunder.
    (c) Examples. The following examples illustrate the provisions of 
this section:

    Example 1. Exclusion from self-employment income. A is a general 
partner in PRS, a partnership carrying on a trade or business that 
is not a trade or business of trading in financial instruments or 
commodities (within the meaning of Sec.  1.1411-5(a)(2)). During 
Year 1, A's distributive share from PRS is $1 million, $300,000 of 
which is attributable to the gain on the sale of PRS's capital 
assets. Section 1402(a)(3)(A) provides an exclusion from net 
earnings from self-employment for any gain or loss from the sale or 
exchange of a capital asset. For Year 1, A has $700,000 self-
employment income subject to self-employment tax. This $700,000 
subject to self-employment tax is not included as part of net 
investment income. However, the $300,000 attributable to the gain on 
PRS's sale of a capital asset is excluded from net earnings from 
self-employment and self-employment income and thus is not covered 
by the exception in section 1411(c)(6). The $300,000 attributable to 
the gain on PRS's sale of a capital asset is included as part of net 
investment income if the other requirements of section 1411 are 
satisfied.
    Example 2. Two trades or businesses. B is an individual engaged 
in two trades or businesses, Business X and Business Y, neither of 
which is the trade or business of trading in financial instruments 
or commodities (as described in Sec.  1.1411-5(a)(2)). B carries on 
Business X as a sole proprietor and B is also a general partner in a 
partnership that carries on Business Y. During Year 1, B had net 
earnings from self-employment consisting of the aggregate of a 
$50,000 loss (that is, after application of the exclusions under 
section 1402(a)(1)-(17)) from Business X that is attributable to 
passive activities, and $70,000 in income (after application of the 
exclusions under section 1402(a)(1)-(17)) from B's distributive 
share from the partnership from carrying on Business Y. Thus, B's 
net earnings from self-employment in Year 1 are $20,000. For Year 1, 
all of B's income, deductions, gains, and losses from Business X and 
distributive share from the partnership carrying on Business Y, 
other than those amounts excluded due to application of section 
1402(a)(1)-(17), are taken into account in determining B's net 
earnings from self-employment and self-employment income for such 
taxable year. Accordingly, in calculating B's net investment income 
(as defined in Sec.  1.1411-4) for Year 1, the items of income, 
loss, gain, and deduction that comprise B's $50,000 loss 
attributable to Business X (after application of the exclusions 
under section 1402(a)(1)-(17)), and the items of income, loss, gain, 
and deduction that comprise B's $70,000 distributable share 
attributable to B's general partnership interest (after application 
of the exclusions under section 1402(a)(1)-(17)), are not 
considered. Rather, only items of income, loss, gain, and deduction 
from the two separate businesses that were excluded from the 
calculation of B's net earnings from self-employment income due to 
the application of the exclusions under section 1402(a)(1)-(17), 
such as any capital gains and losses excluded under section 
1402(a)(3), are considered for

[[Page 72648]]

purposes of calculating B's net investment income for Year 1 in 
connection with these two trades or businesses.
    Example 3. Special rule for trader with single trade or 
business. D is an individual engaged in the trade or business of 
trading in commodities (as described in Sec.  1.1411-5(a)(2)). D 
made an election under section 475(f)(2). D derives $400,000 of 
gross income described in Sec.  1.1411-4(a)(1)(ii) and $150,000 of 
expenses described in Sec.  1.1411-4(f)(2)(ii) from carrying on the 
trade or business. Pursuant to sections 475(f)(1)(D) and 
1402(a)(3)(A), none of the gross income is taken into account in 
determining D's net earnings from self-employment and self-
employment income, and therefore, under paragraph (a) of this 
section, the $400,000 of gross income is not covered by the 
exception in section 1411(c)(6). Under paragraph (b) of this section 
and Sec.  1.1411-4(f)(2)(ii), because the $150,000 of deductions did 
not reduce D's net earnings from self-employment (because D had $0 
net earnings from self-employment), for purposes of section 
1411(c)(6), the $150,000 of deductions are not taken into account in 
determining D's net earnings from self-employment and self-
employment income, and therefore the $150,000 of deductions may 
reduce D's gross income of $400,000 for purposes of section 1411.
    Example 4. Special rule for trader with multiple trades or 
businesses. E is an individual engaged in two trades or businesses, 
Business X (which is not a trade or business of trading in financial 
instruments or commodities) and Business Y (which is a trade or 
business of trading in financial instruments or commodities (as 
described in Sec.  1.1411-5(a)(2))). E has made an election under 
section 475(f) with respect to Business Y. During Year 1, E had net 
earnings from self-employment from Business X of $35,000. During 
Year 1, E also had $300,000 of gross income described in Sec.  
1.1411-4(a)(1)(ii) and $75,000 of expenses described in Sec.  
1.1411-4(f)(2)(ii) from Business Y. E's $300,000 of gross income 
from Business Y is excluded from net earnings from self-employment 
and self-employment income pursuant to sections 475(f)(1)(D) and 
1402(a)(3)(A). E's $75,000 of deductions from Business Y reduce E's 
$35,000 of net earnings from self-employment from Business X to $0. 
Pursuant to paragraph (b) of this section and Sec.  1.1411-
4(f)(2)(ii), the remaining $40,000 of deductions from Business Y are 
taken into account in determining E's net investment income (by 
reducing E's gross income of $300,000 from Business Y to $260,000) 
for purposes of section 1411.

    (d) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013.


Sec.  1.1411-10  Controlled foreign corporations and passive foreign 
investment companies.

    (a) In general. This section provides rules that apply to an 
individual, estate, or trust that is a United States shareholder 
(within the meaning of section 951(b)) of a controlled foreign 
corporation (within the meaning of section 957(a)), or that is a United 
States person that directly or indirectly owns an interest in a passive 
foreign investment company (within the meaning of section 1297(a)). In 
addition, this section provides rules that apply to an individual, 
estate, or trust that owns an interest in a domestic partnership or an 
S corporation that either is a United States shareholder of a 
controlled foreign corporation or that has made an election under 
section 1295 to treat a passive foreign investment company as a 
qualified electing fund.
    (b) Amounts derived from a trade or business described in Sec.  
1.1411-5. An amount included in gross income under section 951(a) or 
section 1293(a) that is income derived from a trade or business 
described in section 1411(c)(2) and Sec.  1.1411-5 is taken into 
account as net investment income under section 1411(c)(1)(A)(ii) and 
Sec.  1.1411-4(a)(1)(ii) for purposes of section 1411 when it is taken 
into account for purposes of chapter 1, and the rules in paragraphs (c) 
through (g) of this section do not apply to such amounts. For purposes 
of section 1411, an amount included in gross income under section 
1296(a) that is also income derived from a trade or business described 
in section 1411(c)(2) and Sec.  1.1411-5 is net investment income 
within the meaning of section 1411(c)(1)(A)(ii) and Sec.  1.1411-
4(a)(1)(ii), and the rules in paragraphs (c) through (f) of this 
section do not apply to such amount.
    (c) Calculation of net investment income--(1) In general. For 
purposes of section 1411 and the regulations thereunder, net investment 
income means net investment income as defined in Sec.  1.1411-4, 
adjusted pursuant to the rules described in this paragraph (c).
    (2) Dividends. For purposes of section 1411(c)(1)(A)(i) and Sec.  
1.1411-4(a)(1)(i), net investment income is calculated by taking into 
account the amount of dividends described in this paragraph (c)(2).
    (i) Distributions of previously taxed earnings and profits. If no 
election is made pursuant to paragraph (g) of this section, a 
distribution of earnings and profits that is not treated as a dividend 
for chapter 1 purposes under section 959(d) or section 1293(c) is a 
dividend for purposes of section 1411(c)(1)(A)(i) and Sec.  1.1411-
4(a)(1)(i) if the distribution is attributable to amounts that are or 
have been included in gross income for chapter 1 purposes under section 
951(a) or section 1293(a) in a taxable year beginning after December 
31, 2012. For this purpose, distributions of earnings and profits 
attributable to amounts that are or have been included in gross income 
for chapter 1 purposes under section 951(a) or section 1293(a) shall be 
considered first attributable to such earnings and profits, if any, 
derived from the current taxable year, and then from prior taxable 
years beginning with the most recent prior taxable year. With respect 
to such distributions from controlled foreign corporations, a 
distribution shall be attributable first to earnings and profits 
derived from the current taxable year and then from prior taxable years 
beginning with the most recent prior taxable year, without regard to 
whether the earnings and profits are described in section 959(c)(1) or 
section 959(c)(2).
    (ii) Excess distributions constituting dividends. To the extent an 
excess distribution within the meaning of section 1291(b) constitutes a 
dividend within the meaning of section 316(a), the amount is included 
in net investment income for purposes of section 1411(c)(1)(A)(i) and 
Sec.  1.1411-4(a)(1)(i).
    (3) Net gain. For purposes of section 1411(c)(1)(A)(iii) and Sec.  
1.1411-4(a)(1)(iii), the rules in this paragraph (c)(3) apply in 
determining net gain attributable to the disposition of property.
    (i) Gains treated as excess distributions. Gains treated as excess 
distributions under section 1291(a)(2) are included in determining net 
gain attributable to the disposition of property for purposes of 
section 1411(c)(1)(A)(iii) and Sec.  1.1411-4(a)(1)(iii).
    (ii) Inclusions and deductions with respect to section 1296 mark to 
market elections. Amounts included in gross income under section 
1296(a)(1) and amounts allowed as a deduction under section 1296(a)(2) 
are taken into account in determining net gain attributable to the 
disposition of property for purposes of section 1411(c)(1)(A)(iii) and 
Sec.  1.1411-4(a)(1)(iii).
    (iii) Gain or loss attributable to the disposition of stock of 
controlled foreign corporations and qualified electing funds. If no 
election is made pursuant to paragraph (g) of this section, for 
purposes of calculating net gain in Sec. Sec.  1.1411-4(a)(1)(iii) and 
1.1411-4(d)(3) attributable to the direct or indirect disposition of 
stock of a controlled foreign corporation or qualified electing fund 
(including for purposes of determining gain or loss on the direct or 
indirect disposition of stock of a controlled foreign corporation or a 
qualified electing fund by a domestic partnership or S corporation), 
basis shall be determined in accordance with

[[Page 72649]]

the provisions of paragraph (d) of this section.
    (iv) Gain or loss attributable to the disposition of interests in 
domestic partnerships or S corporations that own directly or indirectly 
stock of controlled foreign corporations or qualified electing funds. 
If no election is made pursuant to paragraph (g) of this section, for 
purposes of calculating net gain in Sec. Sec.  1.1411-4(a)(1)(iii) and 
1.1411-4(d)(3) attributable to the disposition of an interest in a 
domestic partnership or S corporation that directly or indirectly owns 
stock of a controlled foreign corporation or a qualified electing fund, 
basis shall be determined in accordance with the provisions of 
paragraph (d) of this section.
    (4) Application of section 1248. If no election is made pursuant to 
paragraph (g) of this section, for purposes of section 1411 and Sec.  
1.1411-4:
    (i) For purposes of determining the gain recognized on the sale or 
exchange of a foreign corporation for section 1248(a) purposes, basis 
is determined in accordance with the provisions of paragraph (d) of 
this section; and
    (ii) Section 1248(a) applies without regard to the exclusion for 
certain earnings and profits under section 1248(d)(1) and (d)(6), 
except that such exclusions will apply with respect to the earnings and 
profits of a foreign corporation that are attributable to amounts 
previously included in gross income for chapter 1 purposes under 
section 951(a) or section 1293(a) in a taxable year beginning before 
December 31, 2012, and that have not yet been distributed. For this 
purpose, the determination of whether earnings and profits attributable 
to amounts previously taxed in a taxable year beginning before December 
31, 2012, have been distributed shall be determined based on the rules 
described in paragraph (c)(2)(i) of this section.
    (5) Amounts distributed by an estate or trust. Net investment 
income of a beneficiary of an estate or trust includes the 
beneficiary's share of distributable net income, as described in 
sections 652 and 662 and as modified by paragraph (f) of this section, 
to the extent that the beneficiary's share of distributable net income 
includes items that, if they had been received directly by the 
beneficiary, would have been described in this paragraph (c).
    (d) Conforming basis adjustments--(1) Basis adjustments under 
sections 961 and 1293--(i) Stock held by individuals, estates, or 
trusts. If no election is made by an individual, estate or trust 
pursuant to paragraph (g) of this section:
    (A) The basis increases made by the individual, estate or trust 
pursuant to sections 961(a) and 1293(d) for amounts included in gross 
income for chapter 1 purposes under sections 951(a) and 1293(a) in 
taxable years beginning after December 31, 2012, are not taken into 
account for purposes of section 1411; and
    (B) The basis decreases made by the individual, estate or trust 
pursuant to sections 961(b) and 1293(d) attributable to distributions 
treated as dividends for purposes of section 1411 under paragraph 
(c)(2)(i) of this section are not taken into account for purposes of 
section 1411.
    (ii) Stock held by domestic partnerships or S corporations. If an 
individual, estate, or trust is a shareholder of an S corporation, or 
if an individual, estate, or trust directly, or through one or more 
tiers of passthrough entities (including an S corporation), owns an 
interest in a domestic partnership, the domestic partnership or S 
corporation, as the case may be, will not take into account for 
purposes of section 1411 the basis increases made by the domestic 
partnership or S corporation pursuant to sections 961(a) and 1293(d) 
for amounts included in gross income for chapter 1 purposes under 
sections 951(a) and 1293(a) for taxable years beginning after December 
31, 2012, and the basis decreases made by the domestic partnership or S 
corporation pursuant to sections 961(b) and 1293(d) attributable to 
amounts that are treated as dividends for section 1411 purposes under 
paragraph (c)(2)(i) of this section (the section 1411 recalculated 
basis). If the domestic partnership or S corporation disposes of its 
stock of a controlled foreign corporation or qualified electing fund, 
the section 1411 recalculated basis will be used to determine the 
distributive share or pro rata share of the gain or loss for section 
1411 purposes for partners or shareholders that do not make an election 
pursuant to paragraph (g) of this section. If a partner or shareholder 
makes an election pursuant to paragraph (g) of this section, the 
partner's distributive share or the shareholder's pro rata share of the 
gain or loss for section 1411 purposes is the same as the distributive 
share or pro rata share of the gain or loss calculated for chapter 1 
purposes. See Example 6 of paragraph (h) of this section.
    (2) Special rules for partners that own interests in domestic 
partnerships that own directly or indirectly stock of controlled 
foreign corporations or qualified electing funds. If no election is 
made by a partner pursuant to paragraph (g) of this section, the basis 
increases provided in section 705(a)(1)(A) to that partner for chapter 
1 purposes that are attributable to amounts that a domestic partnership 
included in gross income under section 951(a) or section 1293(a) for a 
taxable year beginning after December 31, 2012, are not taken into 
account for purposes of section 1411. In such case, the partner's 
adjusted basis in the partnership interest is increased by the 
distributions to the partnership from the controlled foreign 
corporation or qualified electing fund that are treated as dividends 
for purposes of section 1411 under paragraph (c)(2)(i) of this section. 
The amount of the basis increase is calculated based on the partner's 
share of the distribution received by the domestic partnership. Similar 
rules apply when the stock of the controlled foreign corporation or 
qualified electing fund is held in a tiered partnership structure. For 
purposes of determining net investment income under section 1411 and 
the regulations thereunder, the partner's adjusted basis in the 
partnership interest as calculated under this paragraph (d)(2) shall be 
used to determine all tax consequences related to tax basis (for 
example, loss limitation rules and the characterization of partnership 
distributions).
    (3) Special rules for S corporation shareholders that own interests 
in S corporations that own directly or indirectly stock of controlled 
foreign corporations or qualified electing funds. If no election is 
made by a shareholder pursuant to paragraph (g) of this section, the 
basis increases provided in section 1367(a)(1)(A) to the shareholder 
for chapter 1 purposes that are attributable to amounts that an S 
corporation included in gross income for chapter 1 purposes under 
section 951(a) or section 1293(a) for taxable years beginning after 
December 31, 2012, are not taken into account for purposes of section 
1411. In such case, the shareholder's adjusted basis of stock in the S 
corporation is increased by the distributions to the S corporation from 
the controlled foreign corporation or qualified electing fund that are 
treated as dividends for purposes of section 1411 under paragraph 
(c)(2)(i) of this section. The amount of the basis increase is 
calculated based on the shareholder's pro rata share of the 
distribution received by the S corporation. Similar rules apply when 
the S corporation holds an interest in a controlled foreign corporation 
or qualified electing fund through a partnership. For purposes of 
determining net investment income under section 1411 and the 
regulations thereunder, the shareholder's adjusted

[[Page 72650]]

basis in the stock of the S corporation as calculated under this 
paragraph (d)(3) shall be used to determine all tax consequences 
related to tax basis (for example, loss limitation rules and the 
characterization of S corporation distributions).
    (e) Conforming adjustments to modified adjusted gross income and 
adjusted gross income--(1) Individuals. Solely for purposes of section 
1411(a)(1)(B)(i) and the regulations thereunder, the term modified 
adjusted gross income means modified adjusted gross income as defined 
in Sec.  1.1411-2(c)(1)--
    (i) Increased by amounts included in net investment income under 
paragraphs (c)(2)(i), (c)(2)(ii), (c)(3)(i), and (c)(5) of this section 
that are not otherwise included in gross income for chapter 1 purposes;
    (ii) Increased or decreased, as applicable, by the difference 
between the amount calculated with respect to a disposition under 
paragraphs (c)(3)(iii) and (c)(3)(iv) of this section and the amount of 
the gain or loss attributable to the relevant disposition as calculated 
for chapter 1 purposes; and
    (iii) Decreased by any amount included in gross income for chapter 
1 purposes under section 951(a) or section 1293(a) if no election is 
made pursuant to paragraph (g) of this section.
    (2) Estates and trusts. Solely for purposes of section 
1411(a)(2)(B)(i) and the regulations thereunder, the term adjusted 
gross income means adjusted gross income as defined in Sec.  1.1411-
3(a)(1)(ii)(B)(1) adjusted by the following amounts to the extent those 
amounts are not distributed by the estate or trust--
    (i) Increased by amounts included in net investment income under 
paragraphs (c)(2)(i), (c)(2)(ii), (c)(3)(i), and (c)(5) of this section 
that are not otherwise included in gross income for chapter 1 purposes;
    (ii) Increased or decreased, as applicable, by the difference 
between the amount calculated with respect to a disposition under 
paragraphs (c)(3)(iii) and (c)(3)(iv) of this section and the amount of 
the gain or loss attributable to the relevant disposition as calculated 
for chapter 1 purposes; and
    (iii) Decreased by any amount included in gross income for chapter 
1 purposes under section 951(a) or section 1293(a) if no election is 
made pursuant to paragraph (g) of this section.
    (f) Application to estates and trusts. All of the items described 
in paragraph (c) of this section shall be included in the net 
investment income of an estate or trust or its beneficiaries. The 
amounts described in paragraphs (e)(2)(i), (e)(2)(ii), and (e)(2)(iii) 
of this section, regardless of whether the estate or trust receives 
those amounts directly or indirectly through another estate or trust, 
shall increase or decrease, as applicable, the estate's or trust's 
distributable net income. The estate or trust, or the beneficiaries 
thereof, shall take such amounts into account in a manner reasonably 
consistent with the general operating rules for estates and trusts in 
Sec.  1.1411-3 and subchapter J in computing the undistributed net 
investment income of the estate or trust and the net investment income 
of the beneficiaries.
    (g) Election with respect to controlled foreign corporations and 
qualified electing funds--(1) In general. An individual, estate, or 
trust may make an election under this paragraph (g) with respect to all 
interests in controlled foreign corporations and qualified electing 
funds held directly or indirectly by the individual, estate, or trust 
(other than as provided in paragraph (b) of this section) in the year 
of the election or acquired in subsequent years. The election, if made, 
for an estate or trust shall be made by the fiduciary of that estate or 
trust. If the election is made, amounts included in gross income under 
section 951(a) or section 1293(a)(1)(A) in taxable years beginning with 
the year for which the election is made are treated as net investment 
income for purposes of Sec.  1.1411-4(a)(1)(i), and amounts included in 
gross income under section 1293(a)(1)(B) in taxable years beginning 
with the year for which the election is made are taken into account in 
calculating net gain attributable to the disposition of property under 
Sec.  1.1411-4(a)(1)(iii).
    (2) Revocation of election. An election under paragraph (g) of this 
section may only be revoked if the Commissioner, in the Commissioner's 
discretion, consents to the individual's, estate's, or trust's request 
to revoke the election.
    (3) Time and manner for making election. Except as otherwise 
provided in this paragraph (g)(3), an individual, estate, or trust that 
wants to make the election under this paragraph (g) must make the 
election for the first taxable year beginning after December 31, 2013, 
during which the individual, estate, or trust directly or indirectly 
holds stock of a controlled foreign corporation or qualified electing 
fund and the individual, estate, or trust is subject to tax under 
section 1411 or would be subject to tax under section 1411 if the 
election were made with respect to the stock of the controlled foreign 
corporation or qualified electing fund. In addition, an individual, 
estate, or trust may make an election under this paragraph (g)(3) for a 
taxable year that begins before January 1, 2014. In all cases, the 
election must be made in the manner prescribed by the Secretary on or 
before the due date, determined with regard to any extension of time, 
for filing the individual's, estate's, or trust's income tax return for 
the taxable year for which the election is made. Further, in all cases, 
once made, the election applies to the taxable year for which it is 
made and all subsequent years unless revoked pursuant to paragraph 
(g)(2) of this section.
    (h) Examples. The following examples illustrate the rules of this 
section. In each example, unless otherwise indicated, the individuals, 
the foreign corporation (FC), the qualified electing fund (QEF), and 
the partnership (PRS) use a calendar taxable year. Further, the gross 
income or gain with respect to an interest in FC is not derived in a 
trade or business described in Sec.  1.1411-5.

    Example 1. (i) Facts. A, a U.S. citizen, is the sole shareholder 
of FC, a controlled foreign corporation (within the meaning of 
section 957). A is a United States shareholder (within the meaning 
of section 951(b)) with respect to FC. On December 31, 2012, A's 
basis in the stock of FC for chapter 1 purposes is $500,000, which 
includes an increase to basis under section 961(a) of $40,000.The 
amount of FC's earnings and profits that are described in section 
959(c)(2) is $40,000, the amount of FC's earnings and profits that 
are described in section 959(c)(3) is $20,000, and FC does not have 
any earnings and profits that are described in section 959(c)(1). No 
election is made pursuant to paragraph (g) of this section. During 
2013, A does not include any amounts in income under section 951(a) 
with respect to FC, A does not receive any distributions from FC, 
and there is no change in the amount of FC's earnings and profits. 
In 2014, A includes $10,000 in gross income for chapter 1 purposes 
under section 951(a)(1)(A) with respect to FC. As a result, A's 
basis in the stock of FC for chapter 1 purposes increases by $10,000 
to $510,000 pursuant to section 961(a). During 2015, FC distributes 
$30,000 to A, which is not treated as a dividend for purposes of 
chapter 1 under section 959(d). As a result, A's basis in the stock 
of FC for chapter 1 purposes is decreased by $30,000 to $480,000 
pursuant to section 961(b).
    (ii) Results for section 1411 purposes. In 2014, A does not 
include the $10,000 section 951(a) income inclusion in A's net 
investment income under section 1411(c)(1)(A)(i) and Sec.  1.1411-
4(a)(1)(i). Pursuant to paragraph (e)(1)(iii) of this section, A 
decreases A's modified adjusted gross income for section 1411 
purposes by $10,000 in 2014, and pursuant to paragraph (d)(1)(i) of 
this section, A's adjusted basis is not increased by $10,000 and 
remains at $500,000. In 2015, pursuant to paragraph (c)(2)(i) of 
this section, A includes $10,000 of the distribution of previously 
taxed earnings and profits as a dividend for purposes of

[[Page 72651]]

determining A's net investment income because $10,000 of the $30,000 
distribution is attributable to amounts that A included in gross 
income for chapter 1 purposes under section 951(a) in a tax year 
that began after December 31, 2012. Pursuant to paragraph (e)(1)(i) 
of this section, A increases A's modified adjusted gross income for 
section 1411 purposes by $10,000 in 2015. Under paragraph (d)(1)(i) 
of this section, A's adjusted basis is not decreased by the $10,000 
that is treated as a dividend for section 1411 purposes, and thus, 
A's adjusted basis in FC for section 1411 purposes is decreased 
under section 961 only by $20,000 to $480,000.
    Example 2. (i) Facts. Same facts as Example 1. In addition, 
during 2016, A includes $15,000 in gross income for chapter 1 
purposes under section 951(a)(1)(A) with respect to FC. As a result, 
A's basis in the stock of FC for chapter 1 purposes increases by 
$15,000 to $495,000 pursuant to section 961(a). During 2017, A sells 
all of A's shares of FC for $550,000 and, prior to the application 
of section 1248, recognizes $55,000 ($550,000 minus $495,000) of 
long-term capital gain for chapter 1 purposes. For purposes of 
calculating the amount included in income as a dividend pursuant to 
section 1248(a) for chapter 1 purposes, the earnings and profits of 
FC attributable to A's shares in FC which were accumulated after 
December 31,1962 and during the period which A held the stock while 
FC was a controlled foreign corporation is $55,000, $35,000 of which 
is excluded pursuant to section 1248(d)(1). Therefore, after the 
application of section 1248, for chapter 1 purposes, upon the sale 
of the FC stock, A recognizes $35,000 of long-term capital gain and 
a $20,000 dividend.
    (ii) Results for section 1411 purposes. (A) In 2016, A does not 
include the $15,000 section 951(a)(1)(A) income inclusion in A's net 
investment income under section 1411(c)(1)(A)(i) and Sec.  
1411(c)(1)(A)(i). Pursuant to paragraph (e)(1)(ii) of this section, 
A decreases A's modified adjusted gross income for section 1411 
purposes by $15,000, and, pursuant to paragraph (d)(1)(i) of this 
section, A's adjusted basis remains at $480,000.
    (B) During 2017, prior to the application of section 1248, A 
recognizes $70,000 ($550,000 minus $480,000) of gain for section 
1411 purposes. Pursuant to paragraph (c)(4) of this section, for 
section 1411 purposes, section 1248(a) applies to the gain on the 
sale of FC calculated for section 1411 purposes ($70,000) and 
section 1248(d)(1) does not apply, except with respect to the 
$20,000 of earnings and profits of FC that are attributable to 
amounts previously included in income for chapter 1 purposes under 
section 951 for a taxable year beginning before December 31, 2012. 
Accordingly, for purposes of calculating the amount of income 
includible as a dividend under section 1248(a), A has $55,000 of 
earnings and profits, $20,000 of which is excluded pursuant to 
section 1248(d)(1). Therefore, after the application of section 
1248, for section 1411 purposes A has $35,000 of long term capital 
gain and a $35,000 dividend. For purposes of calculating net 
investment income in 2016, A includes $35,000 as a dividend under 
section 1411(c)(1)(A)(i) and Sec.  1.1411-4(a)(1)(i) and $35,000 as 
a gain under section 1411(c)(1)(A)(iii) and Sec.  1.1411-
4(a)(1)(iii).
    Example 3. (i) Facts. Same facts as Example 2, except that A 
timely makes an election pursuant to paragraph (g) of this section 
for 2014 (and thus for all subsequent years).
    (ii) Results for section 1411 purposes. A does not have any 
adjustments to A's modified adjusted gross income for section 1411 
purposes for 2014, 2015, 2016 or 2017 because the election under 
paragraph (g) of this section was timely made. Pursuant to paragraph 
(g)(1) of this section, for purposes of calculating A's net 
investment income in 2014, the $10,000 that A included in income for 
chapter 1 purposes under section 951(a) is net investment income for 
purposes of section 1411(c)(1)(A)(i) and Sec.  1.1411-4(a)(1)(i). A 
has no amount of net investment income with respect to FC in 2015. 
Pursuant to paragraph (g)(1) of this section, for purposes of 
calculating A's net investment income in 2016, the $15,000 that A 
included in income for chapter 1 purposes under section 951(a) is 
net investment income for purposes of section 1411(c)(1)(A)(i) and 
Sec.  1.1411-4(a)(1)(i). For purposes of calculating A's net 
investment income in 2017, the amount of gain on the disposition of 
the FC shares is the same as the amount calculated for chapter 1 
purposes. Applying section 1248, A includes $35,000 as a gain under 
section 1411(c)(1)(A)(iii) and Sec.  1.1411-4(a)(1)(iii), and 
$20,000 as a dividend under section 1411(c)(1)(A)(i) and Sec.  
1.1411-4(a)(1)(i).
    Example 4. Domestic partnership holding QEF stock. (i) Facts. 
(A) C, a U.S. citizen, owns a 50 percent interest in PRS, a domestic 
partnership. D, a U.S. citizen, and E, a U.S. citizen, each own a 25 
percent interest in PRS. All allocations of partnership income and 
losses are pro rata based on ownership interests. PRS owns an 
interest in QEF, a foreign corporation that is a passive foreign 
investment company (within the meaning of section 1297(a)). PRS, a 
United States person, made an election under section 1295 with 
respect to QEF applicable to the first year of its holding period in 
QEF. As of December 31, 2012, for chapter 1 purposes, C's basis in 
his partnership interest is $100,000, D's basis in his partnership 
interest is $50,000, E's basis in his partnership interest is 
$50,000, and PRS's adjusted basis in its QEF stock is $80,000, which 
includes an increase in basis under section 1293(d) of $40,000. As 
of December 31, 2012, the amount of QEF's earnings that have been 
included in income by PRS under section 1293(a), but have not been 
distributed by QEF, is $40,000. PRS also has cash of $60,000 and 
domestic C corporation stock with an adjusted basis of $60,000. 
During 2013, PRS does not include any amounts in income under 
section 1293(a) with respect to QEF, PRS does not receive any 
distributions from QEF, and there are no adjustments to the basis of 
C, D, or E in their interests in PRS.
    (B) During 2014, PRS has income of $40,000 under section 1293(a) 
with respect to QEF and has no other partnership income. C makes an 
election under paragraph (g) of this section, and D and E do not 
make an election under paragraph (g) of this section.
    (C) During 2015, QEF distributes $60,000 to PRS. PRS has no 
income for the year.
    (ii) Results for 2014. (A) For chapter 1 purposes, as a result 
of the $40,000 income inclusion under section 1293(a), PRS's basis 
in its QEF stock is increased by $40,000 under section 1293(d)(1) to 
$120,000. Under Sec.  1.1293-1(c)(1) and section 702, C's, D's, and 
E's distributive shares of the section 1293(a) income inclusion are 
$20,000, $10,000, and $10,000, respectively. Under section 
705(a)(1)(A), C increases his adjusted basis in his partnership 
interest by $20,000 to $120,000, and D and E each increase his 
adjusted basis in his partnership interest by $10,000 to $60,000.
    (B) For section 1411 purposes, pursuant to paragraph (d)(1)(ii) 
of this section, PRS's basis in QEF is not increased by the $40,000 
income inclusion (it remains at $80,000). Because C made an election 
under paragraph (g) of this section, C has net investment income of 
$20,000 as a result of the income inclusion, and his adjusted basis 
in his interest in PRS is increased by $20,000 to $120,000. C does 
not make any adjustments to his modified adjusted gross income. 
Because D and E did not make an election under paragraph (g) of this 
section, D and E do not have net investment income with respect to 
the income inclusion, and pursuant to paragraph (d)(2) of this 
section, they do not increase their adjusted bases in their 
interests in PRS (each remains at $50,000). Pursuant to paragraph 
(e)(1)(ii) of this section, D and E each reduce their modified 
adjusted gross income by $10,000.
    (iii) Results for 2015. (A) For chapter 1 purposes, the 
distribution of $60,000 from QEF to PRS is not a dividend under 
section 1293(c), and PRS decreases its basis in QEF by $60,000 under 
section 1293(d)(2) to $60,000.
    (B) Pursuant to paragraph (c)(2)(i) of this section, $40,000 of 
the distribution is a dividend for section 1411 purposes because PRS 
included $40,000 in gross income for chapter 1 purposes under 
section 1293(a) in a tax year that began after December 31, 2012. 
For section 1411 purposes, pursuant to paragraph (d)(1)(ii) of this 
section, section 1293(d) will not apply to reduce PRS's basis in QEF 
to the extent of the $40,000 of the distribution that is treated as 
a dividend under paragraph (c)(2)(i) of this section. Thus, PRS's 
basis in QEF is decreased only by $20,000 for purposes of section 
1411 and is $60,000. The $40,000 distribution of previously taxed 
earnings and profits that is treated as a dividend for section 1411 
purposes is allocated $20,000 to C, $10,000 to D, and $10,000 to E. 
Because C made an election under paragraph (g) of this section, C 
has zero net investment income as a result of the distribution of 
previously taxed amounts of $20,000, his adjusted basis in his 
interest in PRS remains at $120,000, and he does not make any 
adjustments to his modified adjusted gross income. Because D and E 
did not make an election under paragraph (g) of this section, 
pursuant to paragraph (c)(2)(i) of this section, D and E each has 
$10,000 of net investment income as a result of the distribution by 
QEF, and

[[Page 72652]]

pursuant to paragraph (d)(2) of this section, D and E each increases 
his adjusted basis in PRS by $10,000 to $60,000. Pursuant to 
paragraph (e)(1)(i) of this section, D and E each increases his 
modified adjusted gross income by $10,000.
    Example 5. Sale of partnership interest. (i) Facts. Same facts 
as Example 4. In addition, in 2016, D sells his entire interest in 
PRS to F for $100,000.
    (ii) Results for 2016. For chapter 1 purposes, D has a gain of 
$40,000 ($100,000 minus $60,000). For section 1411 purposes, D has a 
gain of $40,000 ($100,000 minus $60,000), and thus, has net 
investment income of $40,000. No adjustments to modified adjusted 
gross income are necessary under paragraph (e) of this section.
    Example 6. Domestic partnership's sale of QEF stock. (i) Facts. 
Same facts as Example 4. In addition, in 2016 PRS has income of 
$60,000 under section 1293(a) with respect to QEF, and in 2017, PRS 
sells its entire interest in QEF for $170,000.
    (ii) Results for 2016. (A) For chapter 1 purposes, as a result 
of the $60,000 income inclusion under section 1293(a), PRS's basis 
in its QEF stock is increased by $60,000 under section 1293(d)(1) to 
$120,000. Under Sec.  1.1293-1(c)(1) and section 702, C's, D's, and 
E's distributive shares of the section 1293(a) income inclusion are 
$30,000, $15,000, and $15,000 respectively. Under section 
705(a)(1)(A), C increases his adjusted basis in his partnership 
interest by $30,000 to $150,000, and D and E each increases his 
adjusted basis in his partnership interest by $15,000 to $75,000.
    (B) For section 1411 purposes, pursuant to paragraph (d)(1)(ii) 
of this section, PRS's basis in QEF is not increased by the $60,000 
income inclusion (it remains at $60,000). Because C made an election 
under paragraph (g) of this section, C has net investment income of 
$30,000 as a result of the income inclusion, and his adjusted basis 
in his interest in PRS is increased by $30,000 to $150,000. C does 
not make any adjustments to his modified adjusted gross income. 
Because D and E did not make an election under paragraph (g) of this 
section, D and E do not have net investment income with respect to 
the income inclusion, and pursuant to paragraph (d)(2) of this 
section, they do not increase their adjusted bases in their 
interests in PRS (each remains at $60,000). Pursuant to paragraph 
(e)(1)(ii) of this section, D and E each reduce their modified 
adjusted gross income by $15,000.
    (iii) Results for 2017. (A) For chapter 1 purposes, PRS has a 
gain of $50,000 ($170,000 minus $120,000), which is allocated 50 
percent ($25,000) to C, 25 percent ($12,500) to D, and 25 percent 
($12,500) to E.
    (B) Based on PRS's basis in the stock of QEF for section 1411 
purposes, PRS has a gain for section 1411 purposes of $110,000 
($170,000 minus $60,000), which in the absence of a partner election 
under paragraph (g) of this section, would result in gain of $55,000 
to C, $27,500 to D, and $27,500 to E. However, pursuant to paragraph 
(d)(1)(ii) of this section, because C made an election under 
paragraph (g) of this section, C's gain for section 1411 purposes is 
the same as his gain for chapter 1 purposes ($25,000). Because 
neither D nor E made an election under paragraph (g) of this 
section, D and E each have a gain of $27,500 and therefore net 
investment income of $27,500. Pursuant to paragraph (e)(1)(ii) of 
this section, D and E each increase their modified adjusted gross 
income by $15,000.

    (i) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013.

 Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2012-29238 Filed 11-30-12; 2:00 pm]
BILLING CODE 4830-01-P