Net Investment Income Tax, 72451-72474 [2013-28409]

Agencies

• DEPARTMENT OF THE TREASURY

[Federal Register Volume 78, Number 231 (Monday, December 2, 2013)]
[Proposed Rules]
[Pages 72451-72474]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-28409]



Federal Register / Vol. 78, No. 231 / Monday, December 2, 2013 / 
Proposed Rules

[[Page 72451]]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-130843-13]
RIN 1545-BL74


Net Investment Income Tax

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Withdrawal of notice of proposed rulemaking and notice of 
proposed rulemaking.

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SUMMARY: This document contains proposed regulations under section 1411 
of the Internal Revenue Code (Code). These regulations provide guidance 
on the computation of net investment income. The regulations affect 
individuals, estates, and trusts whose incomes meet certain income 
thresholds.

DATES: The proposed rule published December 5, 2012 (77 FR 72612), is 
withdrawn as of December 2, 2013. Comments on this proposed rule must 
be received by March 3, 2014. Comments on the collection of information 
for this proposed rule should be received by January 31, 2014.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-130843-13), room 
5205, 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-
130843-13), 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-130843-13).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
David H. Kirk or Adrienne M. Mikolashek at (202) 317-6852; concerning 
submissions of comments or to request a hearing, Oluwafunmilayo Taylor, 
(202) 317-6901 (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)) under control number 1545-2227. 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 January 31, 
2014. 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.
    The collection of information in these proposed regulations is in 
Sec.  1.1411-7(g).
    The information collected in proposed Sec.  1.1411-7(g) 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.
    The burden for the collection of information contained in these 
proposed regulations will be reflected in the burden on Form 8960 or 
another form that the IRS designates, which will request the 
information in the proposed regulations.
    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

I. Statutory 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.
    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 the case 
of any other individual, $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 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 that are properly allocable to such gross income or net 
gain.

II. Regulatory Background

    This document contains proposed amendments to 26 CFR part 1 under 
section 1411 of the Code. On December 5, 2012, the Treasury Department 
and the IRS published a notice of proposed rulemaking in the Federal 
Register

[[Page 72452]]

(REG-130507-11; 77 FR 72612) relating to the Net Investment Income Tax. 
On January 31, 2013, corrections to the proposed regulations were 
published in the Federal Register (78 FR 6781) (collectively, the 
``2012 Proposed Regulations''). Final regulations, issued 
contemporaneously with these proposed regulations in the Rules and 
Regulations section of this issue of the Federal Register, contain 
amendments to the Income Tax Regulations (26 CFR Part 1), which 
finalize the 2012 Proposed Regulations (the ``2013 Final 
Regulations''). However, the Treasury Department and the IRS also are 
proposing amendments to the 2013 Final Regulations to provide 
additional clarification and guidance with respect to the application 
of section 1411 to certain specific types of property. Furthermore, the 
Treasury Department and the IRS are also interested in receiving 
comments about other aspects of section 1411 that are not addressed in 
the 2013 Final Regulations or these proposed regulations. If such 
comments are received, the Treasury Department and the IRS will 
consider them for inclusion on future Guidance Priority Lists.
    The Treasury Department and the IRS received comments on the 2012 
Proposed Regulations requesting that they address the treatment of 
section 707(c) guaranteed payments for capital, section 736 payments to 
retiring or deceased partners for section 1411 purposes, and certain 
capital loss carryovers. After consideration of all comments received, 
the Treasury Department and the IRS believe that it is appropriate to 
address the treatment of these items in regulations. Because such 
guidance had not been proposed in the 2012 Proposed Regulations, it is 
being issued for notice and comment in these new proposed regulations.
    The Treasury Department and the IRS also received comments on the 
simplified method for applying section 1411 to income recipients of 
charitable remainder trusts (CRTs) that was proposed in the 2012 
Proposed Regulations. The comments recommended that the section 1411 
classification incorporate the existing category and class system under 
section 664. These proposed regulations provide special rules for the 
application of the section 664 system to CRTs that derive income from 
controlled foreign corporations (CFCs) or passive foreign investment 
companies (PFICs) with respect to which an election under Sec.  1.1411-
10(g) is not in place. Specifically, these proposed regulations 
coordinate the application of the rules applicable to shareholders of 
CFCs and PFICs in Sec.  1.1411-10 with the section 664 category and 
class system adopted in Sec.  1.1411-3(d)(2) of the 2013 Final 
Regulations.
    Furthermore, these proposed regulations allow CRTs to elect to 
apply the section 664 system adopted in the 2013 Final Regulations or 
the simplified method set forth in the 2012 Proposed Regulations. Some 
comments responding to the 2012 Proposed Regulations requested that we 
provide an election. The Treasury Department and the IRS request 
comments with regard to whether or not taxpayers believe this election 
is preferable to the section 664 system adopted in the 2013 Final 
Regulations. If it appears that there is no significant interest in 
having the election, the Treasury Department and the IRS may omit it 
from the regulations when finalized, and the simplified method 
contained in the 2012 Proposed Regulations would no longer be an 
option.
    These proposed regulations also address the net investment income 
tax characterization of income and deductions attributable to common 
trust funds (CTFs), residual interests in real estate mortgage 
investment conduits (REMICs), and certain notional principal contracts.
    The Treasury Department and the IRS also received comments on the 
2012 Proposed Regulations questioning the proposed regulation's 
methodology for adjusting a transferor's gain or loss on the 
disposition of its partnership interest or S corporation stock. In view 
of these comments, the 2013 Final Regulations removed Sec.  1.1411-7 of 
the 2012 Proposed Regulations and reserved Sec.  1.1411-7 in the 2013 
Final Regulations. This notice of proposed rulemaking proposes revised 
rules regarding the calculation of net gain from the disposition of a 
partnership interest or S corporation stock (each a ``Passthrough 
Entity'') to which section 1411(c)(4) may apply.

Explanation of Provisions

1. Overview of Proposed Regulations

    These proposed regulations propose additions and modifications to 
the 2013 Final Regulations, including guidance with respect to certain 
paragraphs that were reserved in the 2013 Final Regulations.
    To coordinate these proposed regulations with the 2013 Final 
Regulations, the proposed regulations are proposed to have the same 
effective date as the 2013 Final Regulations. However, any provisions 
adopted when these proposed regulations are finalized that are more 
restrictive than these proposed regulations would apply prospectively 
only. Taxpayers may rely on these proposed regulations for purposes of 
compliance with section 1411 until the issuance of these regulations as 
final regulations. See Sec.  1.1411-1(f).

2. Special Rules for Certain Partnership Payments

    Section 731(a) treats gain from distributions as gain from the sale 
or exchange of a partnership interest. In general, the section 1411 
treatment of gain to a partner under section 731 is governed by the 
rules of section 1411(c)(1)(A)(iii). Such gain is thus generally 
treated as net investment income for purposes of section 1411 (other 
than as determined under section 1411(c)(4)). However, certain 
partnership payments to partners are treated as not from the sale or 
exchange of a partnership interest. These payments include section 
707(c) guaranteed payments for services or the use of capital and 
certain section 736 distributions to a partner in liquidation of that 
partner's partnership interest. Because these payments are not treated 
as from the sale or exchange of a partnership interest, their treatment 
under section 1411 may differ from the general rule of section 
1411(c)(1)(A)(iii). The proposed regulations therefore provide rules 
for the section 1411 treatment of these payments.
A. Section 707(c) Payments
    Section 707(c) provides that a partnership payment to a partner is 
a ``guaranteed payment'' if the payment is made for services or the use 
of the capital, and the payment amount does not depend on partnership 
income. Section 1.707-1(c) provides that guaranteed payments to a 
partner for services are considered as made to a person who is not a 
partner, but only for the purposes of section 61(a) (relating to gross 
income) and, subject to section 263, section 162(a) (relating to trade 
or business expenses). Section 1.704-1(b)(2)(iv)(o) provides that 
guaranteed payments are not part of a partner's distributive share for 
purposes of section 704(b).
    The proposed regulations' treatment of section 707(c) guaranteed 
payments under section 1411 depends on whether the partner receives the 
payment for services or the use of capital. The proposed regulations 
exclude all section 707(c) payments received for services from net 
investment income, regardless of whether these payments are subject to 
self-employment tax, because payments for services are not included in 
net investment income.

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    The Treasury Department and the IRS believe that guaranteed 
payments for the use of capital share many of the characteristics of 
substitute interest, and therefore should be included as net investment 
income. This treatment is consistent with existing guidance under 
section 707(c) and other sections of the Code in which guaranteed 
payments for the use of capital are treated as interest. See, for 
example, Sec. Sec.  1.263A-9(c)(2)(iii) and 1.469-2(e)(2)(ii).
B. Treatment of Section 736 Payments
i. In General
    Section 736 applies to payments made by a partnership to a retiring 
partner or to a deceased partner's successor in interest in liquidation 
of the partner's entire interest in the partnership. Section 736 does 
not apply to distributions made to a continuing partner, distributions 
made in the course of liquidating a partnership entirely, or to 
payments received from persons other than the partnership in exchange 
for the partner's interest. Section 736 categorizes liquidating 
distributions based on the nature of the payment as in consideration 
for either the partner's share of partnership property or the partner's 
share of partnership income. Section 736(b) generally treats a payment 
in exchange for the retiring partner's share of partnership property as 
a distribution governed by section 731. Section 736(a) treats payments 
in exchange for past services or use of capital as either distributive 
share or a guaranteed payment. Section 736(a) payments also include 
payments to retiring general partners of service partnerships in 
exchange for unrealized receivables (other than receivables described 
in the flush language of section 751(c)) or for goodwill (other than 
payments for goodwill provided for in the partnership agreement) 
(collectively, ``Section 736(a) Property'').
    Because the application of section 1411 depends on the underlying 
nature of the payment received, the section 736 categorization controls 
whether a liquidating distribution is treated as net investment income 
for purposes of section 1411. Thus, the treatment of the payment for 
purposes of section 1411 differs depending on whether the distribution 
is a section 736(b) distribution in exchange for partnership property 
or a section 736(a) distribution in exchange for past services, use of 
capital, or Section 736(a) Property. Among section 736(a) payments, the 
proposed regulations further differentiate the treatment of payments 
depending on: (i) Whether or not the payment amounts are determined 
with regard to the income of the partnership and (ii) whether the 
payment relates to Section 736(a) Property or relates to services or 
use of capital.
    Section 1.469-2(e)(2)(iii) contains rules pertaining to whether 
section 736 liquidating distributions paid to a partner will be treated 
as income or loss from a passive activity. Where payments to a retiring 
partner are made over a period of years, the composition of the assets 
and the status of the partner as passive or nonpassive may change. 
Section 1.469-2(e)(2)(iii) contains rules on the extent to which those 
payments are classified as passive or nonpassive for purposes of 
section 469. The proposed regulations generally align the section 1411 
characterization of section 736 payments with the treatment of the 
payments as passive or nonpassive under Sec.  1.469-2(e)(2)(iii).
ii. Treatment of Section 736(b) Payments
    Section 736(b) payments to retiring partners in exchange for 
partnership property (other than payments to retiring general partners 
of service partnerships in exchange for Section 736(a) Property) are 
governed by the rules generally applicable to partnership 
distributions. Thus, gain or loss recognized on these distributions is 
treated as gain or loss from the sale or exchange of the distributee 
partner's partnership interest under section 731(a).
    The proposed regulations provide that section 736(b) payments will 
be taken into account as net investment income for section 1411 
purposes under section 1411(c)(1)(A)(iii) as net gain or loss from the 
disposition of property. If the retiring partner materially 
participates in a partnership trade or business, then the retiring 
partner must also apply Sec.  1.1411-7 of these proposed regulations to 
reduce appropriately the net investment income under section 
1411(c)(4). Gain or loss relating to section 736(b) payments is 
included in net investment income under section 1411(c)(1)(A)(iii) 
regardless of whether the payments are classified as capital gain or 
ordinary income (for example, by reason of section 751).
    In the case of section 736(b) payments that are paid over multiple 
years, the proposed regulations provide that the characterization of 
gain or loss as passive or nonpassive is determined for all payments as 
though all payments were made at the time that the liquidation of the 
exiting partner's interest commenced and is not retested annually. The 
proposed regulations thus adopt for section 1411 purposes the section 
469 treatment of section 736(b) payments paid over multiple years as 
set forth in Sec.  1.469-2(e)(2)(iii)(A).
iii. Treatment of Section 736(a) Payments
    As described in part 2.B.i., section 736 provides for several 
different categories of liquidating distributions under section 736(a). 
Payments received under section 736(a) may be an amount determined with 
regard to the income of the partnership taxable as distributive share 
under section 736(a)(1) or a fixed amount taxable as a guaranteed 
payment under section 736(a)(2). The categorization of the payment as 
distributive share or guaranteed payment will govern the treatment of 
the payment for purposes of section 1411.
    The determination of whether section 736(a) payments received over 
multiple years are characterized as passive or nonpassive depends on 
whether the payments are received in exchange for Section 736(a) 
Property. With respect to section 736(a)(1) payments in exchange for 
Section 736(a) Property, Sec.  1.469-2(e)(2)(iii)(B) provides a special 
rule that computes a percentage of passive income that would result if 
the partnership sold the retiring partner's entire share of Section 
736(a) Property at the time that the liquidation of the partner's 
interest commenced. The percentage of passive income is then applied to 
each payment received. See Sec.  1.469-2(e)(2)(iii)(B)(1). These rules 
apply to section 736(a)(1) and section 736(a)(2) payments for Section 
736(a) Property. The proposed regulations adopt this treatment as set 
forth in section 469 for purposes of section 1411.
a. Section 736(a)(1) payments taxable as distributive share
    Section 736(a)(1) provides that if the amount of a liquidating 
distribution (other than a payment for partnership property described 
in section 736(b)) is determined with regard to the partnership's 
income, then the payment is treated as a distributive share of income 
to the retiring partner. For purposes of section 1411, the items of 
income, gain, loss, and deduction attributable to the distributive 
share are taken into account in computing net investment income under 
section 1411(c)(1) in a manner consistent with the item's chapter 1 
character and treatment. For example, if the partner's distributive 
share includes income from a trade or business not described in section 
1411(c)(2), that income will be excluded from net investment income. 
However, if the distributive share

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includes, for example, interest income from working capital, then that 
income is net investment income.
    The proposed regulations treat section 736(a)(1) payments unrelated 
to Section 736(a) Property as characterized annually as passive or 
nonpassive by applying the general rules of section 469 to each payment 
in the year received. To the extent that any payment under section 
736(a)(1) is characterized as passive income under the principles of 
section 469, that payment also will be characterized as passive income 
for purposes of section 1411.
b. Section 736(a)(2) payments taxable as guaranteed payments
    Section 736(a)(2) provides that if the amount of a liquidating 
distribution (other than a payment for partnership property described 
in section 736(b)) is determined without regard to the partnership's 
income, then the payment is treated as a guaranteed payment as 
described in section 707(c). Payments under section 736(a)(2) might be 
in exchange for services, use of capital, or Section 736(a) Property. 
The section 1411 treatment of guaranteed payments for services or the 
use of capital follows the general rules for guaranteed payments set 
forth in part 2.A of this preamble. Thus, section 736(a)(2) payments 
for services are not included as net investment income, and section 
736(a)(2) payments for the use of capital are included as net 
investment income.
    Section 736(a)(2) payments in exchange for Section 736 Property are 
treated as gain or loss from the disposition of a partnership interest, 
which is generally included in net investment income under section 
1411(c)(1)(A)(iii). If the retiring partner materially participates in 
a partnership trade or business, then the retiring partner must also 
apply Sec.  1.1411-7 of these proposed regulations to reduce 
appropriately the net investment income under section 1411(c)(4). To 
the extent that section 736(a)(2) payments exceed the fair market value 
of Section 736(a) Property, the proposed regulations provide that the 
excess will be treated as either interest income or as income in 
exchange for services, in a manner consistent with the treatment under 
Sec.  1.469-2(e)(2)(iii).
iv. Application of Section 1411(c)(4) to Section 736 Payments
    The proposed regulations provide that section 1411(c)(4) applies to 
section 736(a)(2) and section 736(b) payments. Thus, the inclusion of 
these payments as net investment income may be limited if the retiring 
partner materially participated in all or a portion of the 
partnership's trade or business. The extent of any limitation is 
determined under the rules of Sec.  1.1411-7.
    The proposed regulations provide that, when section 736 payments 
are made over multiple years, the characterization of gain or loss as 
passive or nonpassive and the values of the partnership assets are 
computed for all payments as though all payments were made at the time 
that the liquidation of the exiting partner's interest commenced, 
similar to the treatment in Sec.  1.469-2(e)(2)(iii)(A).
    If a partner's net investment income is reduced pursuant to section 
1411(c)(4), then the difference between the amount of gain recognized 
for chapter 1 and the amount includable in net investment income after 
the application of section 1411(c)(4) is treated as an addition to 
basis, in a manner similar to an installment sale for purposes of 
calculating the partner's net investment income attributable to these 
payments.
v. Additional Public Comments
    Commentators to the 2012 Proposed Regulations requested that the 
Treasury Department and the IRS issue guidance under section 1411 
regarding the treatment of section 736 payments to retiring and 
deceased partners. Some commentators sought clarification regarding the 
interaction between section 736 payments and the net investment income 
exclusions in sections 1411(c)(5) and 1411(c)(6).
    Section 1411(c)(5) provides that net investment income shall not 
include certain items of income attributable to distributions from 
specifically enumerated qualified plans. One commentator suggested that 
section 736 payments should be excluded from net investment income 
under section 1411(c)(5) as analogous to qualified plan distributions. 
The Treasury Department and the IRS believe that section 1411(c)(5) 
does not apply to section 736 payments because these payments do not 
originate from a qualified plan described in section 1411(c)(5). 
Therefore, section 736 payments are not excluded by reason of section 
1411(c)(5).
    Section 1411(c)(6) provides that net investment income 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). 
In the context of section 1411(c)(6), Sec.  1.1411-9(a) of the 2013 
Final Regulations provides that the term ``taken into account'' for 
self-employment tax purposes does not include amounts excluded from net 
earnings from self-employment under sections 1402(a)(1)-(17). 
Commentators suggested that certain section 736 payments are excluded 
from net earnings from self-employment by reason of section 1402(a)(10) 
and Sec.  1.1402(a)-17, and therefore should be excluded from net 
investment income under section 1411(c)(6) for similar policy reasons. 
The Treasury Department and the IRS believe that section 1411(c)(6) 
does not apply to section 736 payments, except to the extent that such 
payments are taken into account, within the meaning of Sec.  1.1411-
9(a), in determining net earnings from self-employment. In such a case, 
the section 736 payment would be subject to self-employment tax and 
therefore is not included in net investment income by reason of section 
1411(c)(6) and Sec.  1.1411-9(a).
    Commentators also recommended special rules for the interaction 
between section 736 payments and the section 469 material participation 
rules solely for purposes of section 1411. As discussed in this part of 
the preamble, the proposed section 1411 rules rely heavily on the 
chacterization of the section 736 payments under section 469. 
Therefore, the Treasury Department and the IRS do not believe that 
special section 469 rules are necessary solely for purposes of section 
1411.

3. Treatment of Certain Capital Loss Carryforwards

    In general, under chapter 1, capital losses that exceed capital 
gains are allowed as a deduction against ordinary income only to the 
extent allowed by section 1211(b). In the case of capital losses in 
excess of the amounts allowed by section 1211(b), section 1212(b)(1) 
treats these losses as incurred in the following year. Section 1.1411-
4(d) adopts these principles when computing net gain under section 
1411(c)(1)(A)(iii). Therefore, capital losses incurred in a year prior 
to the effective date of section 1411 may be taken into account in the 
computation of section 1411(c)(1)(A)(iii) net gain by reason of the 
mechanics of section 1212(b)(1). However, certain capital losses may 
not be taken into account in determining net investment income within 
the meaning of section 1411(c)(1)(A)(iii) or by reason of the exception 
in section 1411(c)(4)(B) (generally, an ``excluded capital loss''). In 
the case of section 1411(c)(1)(A)(iii), Sec.  1.1411-4(d)(4)(i) 
provides that capital losses attributable to the disposition of 
property used in a trade or business not described in section 
1411(c)(2) and Sec.  1.1411-5 are excluded from the computation of net 
gain. In the case of section 1411(c)(4)(B), some or all of a capital 
loss resulting from the

[[Page 72455]]

disposition of certain partnerships or S corporations is excluded from 
the determination of net gain. Although these capital losses are 
excluded from the calculation of net gain in the year of recognition by 
reason of Sec.  1.1411-4(d)(4), such losses may not be fully offset by 
capital gains for chapter 1 purposes in the same year. In that case, 
some (or all) of the capital loss carryforward will constitute excluded 
capital losses in the subsequent year(s) by reason of the mechanics of 
section 1212(b)(1). Several commentators identified this issue and 
requested that the Treasury Department and the IRS provide guidance on 
the identification, tracking, and use of embedded, excluded capital 
losses within a capital loss carryforward.
    In response to these comments, proposed Sec.  1.1411-4(d)(4)(iii) 
creates an annual adjustment to capital loss carryforwards to prevent 
capital losses excluded from the net investment income calculation in 
the year of recognition from becoming deductible losses in future 
years. The annual adjustment in Sec.  1.1411-4(d)(4)(iii) provides a 
method of identification and an ordering rule that eliminate the need 
for taxpayers to maintain a separate set of books and records for this 
item to comply with section 1411. However, the rule requires that 
taxpayers perform the calculation annually, regardless of whether they 
have a section 1411 tax liability in a particular year, to maintain the 
integrity of the rule's carryforward adjustment amounts for a 
subsequent year in which they are subject to liability under section 
1411.
    The rule provides that, for purposes of computing net gain in Sec.  
1.1411-4(d) and any properly allocable deduction for excess losses in 
Sec.  1.1411-4(f)(4) (if any), the taxpayer's capital loss carryforward 
from the previous year is reduced by the lesser of: (A) the amount of 
capital loss taken into account in the current year by reason of 
section 1212(b)(1), or (B) the amount of net capital loss excluded from 
net investment income in the immediately preceding year. For purposes 
of (B), the amount of net capital loss excluded from net investment 
income in the previous year includes amounts excluded by reason of 
Sec.  1.1411-4(d)(4) (amount of capital losses recognized in the 
preceding year) plus the amount of the previous year's adjustment 
required by this rule. Section 1.1411-4(d)(4)(iii) provides a multi-
year example to illustrate the application of the rule.
    The mechanics of the capital loss adjustment accomplishes several 
objectives. First, the rule causes all capital losses incurred prior to 
2013 to be allowable losses for the computation of net gain under Sec.  
1.1411-4(d) and any properly allocable deduction for excess losses in 
Sec.  1.1411-4(f)(4) (if any). This result is accomplished by the 
application of part (B) of the rule described in the preceding 
paragraph. Since the adjustment is based on the lesser of (A) or (B), 
the amount of excluded capital losses in the year immediately before 
the effective date of section 1411 is zero, so the loss adjustment in 
the year following the effective date of section 1411 will also be 
zero. Second, the rule only requires an adjustment when a taxpayer has 
excluded losses embedded within a capital loss carryforward. Therefore, 
taxpayers with no excluded capital losses do not have to make any 
adjustment. Third, the rule also provides a mechanism for ordering the 
use of capital losses to offset gains. The rule causes excluded capital 
gains recognized in the current year to be offset by excluded capital 
losses that are embedded in the capital loss carryforward from the 
previous year. This matching is accomplished by the use of the term 
``net capital loss'' in Sec.  1.1411-4(d)(4)(iii)(B). If the excluded 
gain exceeds the amount of excluded capital loss included in the 
carryforward amount and any excluded capital loss amounts recognized in 
the current year, the amount of adjustment will be zero in the 
subsequent year because there was no ``net capital loss'' in the 
preceding year. In this situation, no adjustment is required because 
the previous year's excluded gains were fully absorbed by the excluded 
losses. Finally, the rule allows taxpayers to use capital non-excluded 
losses for purposes of the excess loss deduction in Sec.  1.1411-
4(f)(4) before subjecting excluded losses to the limitation.

4. Treatment of Income and Deductions From Common Trust Funds (CTFs)

    Section 584(c) provides that each participant in a CTF shall 
include in its taxable income, whether or not distributed and whether 
or not distributable, its proportionate share of: (1) short-term 
capital gain or loss, (2) long-term capital gain or loss, and (3) 
ordinary taxable income or the ordinary net loss of the CTF. The flush 
language of section 584(c) further provides that ``the proportionate 
share of each participant in the amount of dividends received by the 
CTF and to which section 1(h)(11) applies shall be considered for 
purposes of such paragraph as having been received by such 
participant.''
    Section 584(d) provides, in relevant part, that ``[t]he taxable 
income of a common trust fund shall be computed in the same manner and 
on the same basis as in the case of an individual, except [hellip]after 
excluding all items of gain and loss from sales or exchanges of capital 
assets, there shall be computed (A) an ordinary taxable income which 
shall consist of the excess of the gross income over deductions; or (B) 
an ordinary net loss which shall consist of the excess of the 
deductions over the gross income.''
    The Treasury Department and the IRS have become aware that 
taxpayers may be considering the use of CTFs to recharacterize income 
items that otherwise would be includable in net investment income under 
section 1411. Because section 584(c)(3) simply requires the participant 
to include in its income its share of ``net ordinary income or loss,'' 
taxpayers may attempt to claim that section 584(c)(3) ordinary income 
or loss inclusions are not explicitly section 1411(c)(1)(A)(i) net 
investment income, and therefore escape taxation under section 1411.
    Using a CTF to recharacterize the underlying character of CTF 
income for section 1411 purposes is closely analogous to the past use 
of CTFs to cleanse unrelated business taxable income (UBTI) for tax-
exempt participants. In 1984, the Treasury Department and the IRS 
promulgated Sec.  1.584-2(c)(3), which created a special look-through 
rule to prevent taxpayers from using CTFs to recharacterize UBTI. 
Section 1.584-2(c)(3) provides, in relevant part, that ``any amount of 
income or loss of the common trust fund which is included in the 
computation of a participant's taxable income for the taxable year 
shall be treated as income or loss from an unrelated trade or business 
to the extent that such amount would have been income or loss from an 
unrelated trade or business if such participant had made directly the 
investments of the common trust fund.''
    Similarly, proposed Sec.  1.1411-4(e)(3) includes a rule that 
provides income or loss from a CTF is net investment income or 
deduction to the extent that such amount would have been net investment 
income or deduction if the participant had made directly the 
investments of the CTF.

5. Treatment of Income and Deductions Related to Residual Interests in 
REMICs

    The 2012 Proposed Regulations did not explicitly address income and 
deductions related to residual interests in REMICs. A REMIC residual 
interest represents an equity-like interest in a REMIC. A REMIC is not 
treated as carrying on a trade or business for purposes of section 162, 
and a REMIC's

[[Page 72456]]

taxable income or net loss generally is derived from dispositions of 
qualified mortgages or permitted investments, interest income from the 
mortgages, and interest expense from the regular interests (treated as 
debt) issued by the REMIC. Section 860C(a)(1) generally requires the 
holder of a REMIC residual interest to take into account the daily 
portion of the REMIC's taxable income or net loss. One commentator 
suggested that the regulations expressly include income from a REMIC 
residual interest in determining net investment income. The Treasury 
Department and the IRS agree with this comment because, if a taxpayer 
directly held the underlying assets of the REMIC, the items of income, 
gain, loss, and deductions attributable to those assets would be taken 
income account in computing net investment income. Therefore, the 
proposed regulations provide that a holder of a residual interest in a 
REMIC takes into account the daily portion of taxable income (or net 
loss) under section 860C in determining net investment income.

6. Treatment of Income and Deductions From Certain Notional Principal 
Contracts (NPCs)

    Under the 2012 Proposed Regulations (and the 2013 Final 
Regulations), gain on the disposition of an NPC is included in net 
investment income, and any other gross income from an NPC (including 
net income attributable to periodic payments on an NPC) is included in 
net investment income if it is derived from a trade or business 
described in Sec.  1.1411-5. Several commentators on the 2012 Proposed 
Regulations suggested that the proper treatment of periodic payments on 
an NPC should not turn solely upon whether the NPC was entered into as 
part of a trading business and recommended that NPC periodic payments 
should be included in net investment income. One commentator indicated 
that the omission of NPC periodic income seems unusual and inconsistent 
with the portions of the 2012 Proposed Regulations (and 2013 Final 
Regulations) that provide for the inclusion in net investment income of 
substitute interest and substitute dividends.
    After consideration of the comments, the Treasury Department and 
the IRS agree that periodic payments on an NPC should be included in 
net investment income even if the net income from such payments is not 
derived in a trade or business described in Sec.  1.1411-5. As a 
result, the proposed regulations provide that net income (or net 
deduction) attributable to periodic and nonperiodic payments on an NPC 
under Sec.  1.446-3(d) is taken into account in determining net 
investment income. However, the proposed regulations only apply to the 
net income (or net deduction) on an NPC described in Sec.  1.446-
3(c)(1) that is referenced to property (including an index) that 
produces (or would produce if the property were to produce income) 
interest, dividends, royalties, or rents if the property were held 
directly by the taxpayer. The proposed regulations would not affect the 
treatment of net income attributable to periodic and nonperiodic 
payments on any NPC derived in a trade or business described in Sec.  
1.1411-5, that is net investment income under section 
1411(c)(1)(A)(ii).

7. Charitable Remainder Trusts (CRTs) With Income From Controlled 
Foreign Corporations (CFCs) or Passive Foreign Investment Companies 
(PFICs)

    Section 1.1411-3(d)(2) of the 2013 Final Regulations provides rules 
on the categorization and distribution of net investment income from a 
CRT based on the existing section 664 category and class system. In 
general, Sec.  1.1411-3(d)(2) provides that, if a CRT has both excluded 
income and accumulated net investment income (ANII) in an income 
category, such excluded income and ANII constitute separate classes of 
income for purposes of Sec.  1.664-1(d)(1)(i)(b). Section 1.1411-10 of 
the 2013 Final Regulations provides rules for calculating net 
investment income when a taxpayer owns a direct or indirect interest in 
a CFC or PFIC.
    The 2013 Final Regulations reserve paragraph Sec.  1.1411-
3(d)(2)(ii) for special rules that the Treasury Department and the IRS 
believe are necessary to apply the section 664 category and class 
system contained in Sec.  1.664-1(d), and adopted by Sec.  1.1411-
3(d)(2), to CRTs that own interests in certain CFCs or PFICs. The 
special rules generally apply to taxpayers that: (i) Own CFCs or 
qualified electing funds (QEFs) with respect to which an election under 
Sec.  1.1411-10(g) is not in place; or (ii) are subject to the rules of 
section 1291 with respect to a PFIC. These proposed regulations provide 
those special rules and are proposed to apply to taxable years 
beginning after December 31, 2013. There are no special rules necessary 
for a United States person that has elected to mark to market its PFIC 
stock under section 1296. See Sec.  1.1411-10(c)(2)(ii).
A. CFCs and QEFs
    For purposes of chapter 1, 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). 
Similarly, a U.S. person that owns shares of a PFIC also is required to 
include amounts in income currently under section 1293(a) (section 1293 
inclusions) if the person makes a QEF election under section 1295 with 
respect to the PFIC.
    For purposes of chapter 1, a CRT's section 951 inclusions and 
section 1293 inclusions are included in the appropriate section 664 
category and class for the year in which those amounts are includable 
in the CRT's income for purposes of chapter 1. The application of the 
ordering rules in Sec.  1.664-1(d)(1) determines the tax character of 
the annuity or unitrust distributions to the CRT's income beneficiary. 
These ordering rules are equally applicable for purposes of section 
1411 under the 2013 Final Regulations. In the case of a CRT that 
directly or indirectly owns an interest in a CFC or QEF, some portion 
of the annual distribution(s) may consist of current or previous years' 
section 951 inclusions or section 1293 inclusions.
    As discussed in the preamble to the 2013 Final Regulations, Sec.  
1.1411-10 generally provides that distributions of previously taxed 
earnings and profits attributable to section 951 inclusions and section 
1293 inclusions that are not treated as dividends for purposes of 
chapter 1 under section 959(d) or section 1293(c) are dividends for 
purposes of section 1411, absent an election under Sec.  1.1411-10(g). 
Without that election, taxpayers generally do not include section 951 
inclusions or section 1293 inclusions in net investment income for 
purposes of section 1411. As a result, the timing of income derived 
from an investment in a CFC or QEF may be different for purposes of 
chapter 1 and section 1411. Thus, Sec.  1.1411-10(e) provides 
adjustments to a taxpayer's modified adjusted gross income (MAGI), or 
to the adjusted gross income (AGI) of an estate or trust, when the 
taxpayer owns a CFC or QEF with respect to which an election is not in 
place to coordinate the rules in Sec.  1.1411-10 with calculation of 
the section 1411 tax, the applicability of which is based, in part, on 
MAGI or AGI.
B. Section 1291 Funds
    The Final 2013 Regulations also provide 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. 
Accordingly, Sec.  1.1411-10(e) also provides adjustments to a 
taxpayer's MAGI, or to the AGI of an

[[Page 72457]]

estate or trust, when the taxpayer owns a PFIC and is subject to these 
special rules. In particular, MAGI (or AGI for an estate or trust) is 
increased by: (i) The amount of any excess distribution to the extent 
the distribution is a dividend under section 316(a) and is not 
otherwise included in income for purposes of chapter 1 under section 
1291(a)(1)(B), and (ii) any gain treated as an excess distribution 
under section 1291(a)(2) to the extent not otherwise included in income 
for purposes of chapter 1 under section 1291(a)(1)(B).
C. Rules in Proposed Regulation Sec.  1.1411-3(d)(2)(ii)
    The rules in proposed Sec.  1.1411-3(d)(2)(ii) coordinate the rules 
of Sec.  1.1411-10 with the section 664 category and class system. 
These proposed regulations contain three rules that generally apply 
when a CRT directly or indirectly owns an interest in a CFC or QEF and 
a Sec.  1.1411-10(g) election is not in effect with respect to the CFC 
or QEF. First, Sec.  1.1411-3(d)(2)(ii)(A) provides that section 951 
inclusions and section 1293 inclusions that are included in gross 
income for purposes of chapter 1 for a calendar year and in one or more 
categories described in Sec.  1.664-1(d)(1) are considered excluded 
income (within the meaning of Sec.  1.1411-1(d)) in the year the amount 
is included in income for purposes of chapter 1.
    Second, proposed Sec.  1.1411-3(d)(2)(ii)(B) provides that, when a 
CRT receives a distribution of previously taxed earnings and profits 
that is not treated as a dividend for purposes of chapter 1 under 
section 953(d) and 1293(c) but that is taken into account as net 
investment income for purposes of section 1411 (referred to as an NII 
Inclusion Amount), the CRT must allocate such amounts among the 
categories described in section 664(b)(1)-(3). For this purpose, the 
NII Inclusion Amount includes net investment income described in Sec.  
1.1411-10(c)(1)(i) (certain distributions from a CFC or QEF), Sec.  
1.1411-10(c)(1)(ii) (certain distributions from a section 1291 fund), 
Sec.  1.1411-10(c)(2)(i) (gain derived from the disposition of a 
section 1291 fund), and Sec.  1.1411-10(c)(4) (distributions from an 
estate or trust attributable to income or gain derived from a CFC or 
QEF with respect to which an election under Sec.  1.1411-10(g) is not 
in effect). Specifically, proposed Sec.  1.1411-3(d)(2)(ii)(B) provides 
that, to the extent the CRT has amounts of excluded income in the 
Ordinary Income Category and the Capital Gain Category under Sec.  
1.664-1(d)(1), the NII Inclusion Amount is allocated to the CRT's 
classes of excluded income in the Ordinary Income Category, and then to 
the classes of excluded income in the Capital Gain Category, in turn, 
until exhaustion of each such class, beginning with the class of 
excluded income within a category with the highest Federal income tax 
rate. Any remaining NII Inclusion Amount not so allocated to classes 
within the Ordinary Income and Capital Gain Categories shall be placed 
in the category described in section 664(b)(3) (the Other Income 
Category). To the extent the CRT distributes amounts from this Other 
Income Category, that distribution shall constitute a distribution 
described in Sec.  1.1411-10(c)(4) and thus Sec.  1.1411-10(e)(1) 
causes the beneficiary to increase its MAGI (or AGI for an estate or 
trust) by the same amount.
    The third rule in proposed Sec.  1.1411-3(d)(2)(ii) addresses the 
differential in gain or loss associated with tax basis disparities 
between chapter 1 and section 1411 that are caused by the recognition 
of income under chapter 1 and of the corresponding net investment 
income in different taxable years. See Sec.  1.1411-10(d) for special 
basis calculation rules for CFC, QEFs, and partnerships and S 
corporations that own interests in CFCs or QEFs. The proposed rules for 
the allocation of such gain or loss within the section 664 categories 
and classes generally are consistent with the allocation rules for NII 
Inclusions Amounts, except that the Capital Gain Category is the first 
category to which the gain or loss is to be allocated, and then the 
Ordinary Income Category. The order of the categories is changed for 
gains and losses to more closely match the adjustments to the income 
that produced the net investment income, and to minimize the need for 
adjustments to MAGI or AGI.
    Proposed Sec.  1.1411-3(d)(2)(ii)(C)(1) provides rules similar to 
proposed Sec.  1.1411-3(d)(2)(ii)(B) for gains that are higher for 
section 1411 purposes than they are for chapter 1 purposes. The 
difference between the rule for gains in proposed Sec. Sec.  1.1411-
3(d)(2)(ii)(C)(1) and 1.1411-3(d)(2)(ii)(B) is that proposed Sec.  
1.1411-3(d)(2)(ii)(C)(1) requires this additional gain to be allocated 
within the Capital Gain Category before any allocation within the 
Ordinary Income Category. The Treasury Department and the IRS believe 
this difference more accurately reflects the nature of the net 
investment income within the section 664 category and class system 
because this NII Inclusion Amount is attributable to a transaction that 
generated capital gain or loss (rather than ordinary income inclusions 
and dividends attributable to proposed Sec.  1.1411-3(d)(2)(ii)(B) 
items).
    Proposed Sec.  1.1411-3(d)(2)(ii)(C)(2) provides rules similar to 
proposed Sec.  1.1411-3(d)(2)(ii)(C)(1) for losses (and gains that are 
lower for section 1411 purposes than they are for chapter 1), but with 
a different ordering rule. In these cases, the tax basis is higher for 
section 1411 (generating a smaller gain or larger loss for 1411 
purposes). However, unlike dividends and gains addressed in proposed 
Sec. Sec.  1.1411-3(d)(2)(ii)(B) and 1.1411-3(d)(2)(ii)(C)(1), 
respectively, which can require an increase in MAGI (or AGI for an 
estate or trust), losses are accompanied by a reduction in MAGI (or AGI 
for an estate or trust) under Sec.  1.1411-10(e). Therefore, proposed 
Sec.  1.1411-3(d)(2)(ii)(C)(2) generally follows the ordering rule for 
gains with one exception. The loss ordering rule in proposed Sec.  
1.1411-3(d)(2)(ii)(C)(2) begins with allocating the decrease to the 
Other Income Category that was created or increased in the current or 
previous year, presumably due to an allocation under Sec.  1.1411-
3(d)(2)(ii)(B). The purpose of the different ordering rule is to 
eliminate the ANII within Other Income Category first in an effort to 
reduce the incidence of required MAGI (or AGI for an estate or trust) 
adjustments by the beneficiary. Once this income is eliminated, the CRT 
or beneficiary will not have to separately account for a MAGI (or AGI 
for an estate or trust) increase because the timing differences caused 
by Sec.  1.1411-10 may have been corrected within the 664 class and 
category system before such income is distributed to the beneficiary.

8. Simplified Method for Charitable Remainder Trusts

    The 2012 Proposed Regulations provided a method for the CRT to 
track net investment income received after December 31, 2012, and later 
distributed to the beneficiary. Section 1.1411-3(c)(2)(i) of the 2012 
Proposed Regulations provided that distributions from a CRT 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 
CRT.
    As discussed in part 4.C of the preamble to the 2013 Final 
Regulations, multiple commentators asked that the final regulations 
follow the existing rules under section 664 that create subclasses in 
each category of income as the tax rates on certain types of income are 
changed from time to time. However, some of the commentators

[[Page 72458]]

suggested that the final regulations allow the trustee to elect between 
the method described in the 2012 Proposed Regulations and the existing 
rules under section 664.
    These proposed regulations provide CRTs with a choice of methods. 
Section 1.1411-3(d)(2) of the 2013 Final Regulations, along with the 
proposed additions in these proposed regulations, provide guidance on 
the application of the section 664 method of tracking net investment 
income. Proposed Sec.  1.1411-3(d)(3) allows the CRT to elect to use 
the simplified method included in the 2012 Proposed Regulations, with 
one modification. Proposed Sec.  1.1411-3(d)(3)(ii) provides that a CRT 
that elects to use the simplified method is not limited by the general 
excess deduction rule in Sec.  1.1411-4(f)(1)(ii). Section 1.1411-
4(f)(1)(ii) provides that section 1411(c)(1)(B) deductions in excess of 
gross income and net gain described in section 1411(c)(1)(A) are not 
taken into account in determining net investment income in any other 
taxable year, except as allowed under chapter 1. In the case of CRTs, 
for chapter 1 purposes, the section 664(d) regulations allow for losses 
within each income class to be carried forward to offset income earned 
by the CRT within the same class in a future year. Therefore, this 
provision of the simplified method retains the chapter 1 principle that 
a CRT's losses are carried forward and offset income in future years. 
For example, if a CRT has a long-term capital loss of $10,000 in year 1 
and a $11,000 long-term capital gain in year 2, the section 664(d) 
regulations provide that the CRT will have $1,000 of long-term gain 
available for distribution in year 2. Proposed Sec.  1.1411-3(d)(3)(ii) 
is intended to provide the same result such that the CRT would have 
$1,000 of accumulated net investment income available for distribution 
in year 2.
    In the case of a CRT established after December 31, 2012, the CRT's 
election must be made on its income tax return for the taxable year in 
which the CRT is established. In the case of a CRT established before 
January 1, 2013, the CRT's election must be made on its income tax 
return for its first taxable year beginning on or after January 1, 
2013. Additionally, the CRT may make the election on an amended return 
for that year only if neither the taxable year for which the election 
is made, nor any taxable year that is affected by the election, for 
both the CRT and its beneficiaries, is closed by the period of 
limitations on assessments under section 6501. Once made, the election 
is irrevocable.
    If, after consideration of all comments received in response to 
these proposed regulations, it appears that there is no significant 
interest among taxpayers in having the option of using the simplified 
method, the Treasury Department and the IRS may omit this election from 
the regulations when finalized.

9. Calculation of Gain or Loss Attributable to the Disposition of 
Certain Interests in Partnerships and S Corporations

    Section 1411(c)(4)(A) provides that, in the case of a disposition 
of an interest in a partnership or of stock in an S corporation 
(either, a ``Passthrough Entity''), gain from the disposition shall be 
taken into account under section 1411(c)(1)(A)(iii) only to the extent 
of the net gain which would be taken into account by the transferor if 
the Passthrough Entity sold all of its property for fair market value 
immediately before the disposition of the interest. Section 
1411(c)(4)(B) provides a similar rule for losses from dispositions.
    The 2012 Proposed Regulations required that a transferor of a 
partnership interest or S corporation stock first compute its gain (or 
loss) from the disposition of the interest in the Passthrough Entity to 
which section 1411(c)(4) may apply, and then reduce that gain (or loss) 
by the amount of non-passive gain (or loss) that would have been 
allocated to the transferor upon a hypothetical sale of all of the 
Passthrough Entity's assets for fair market value immediately before 
the transfer. The Treasury Department and the IRS received several 
comments questioning this approach based on the commentators' reading 
of section 1411(c)(4) to include gain/loss from the disposition of a 
partnership interest or S corporation stock only to the extent of the 
transferor's share of gain/loss from the Passthrough Entity's passive 
assets.
    The 2013 Final Regulations do not provide rules regarding the 
calculation of net gain from the disposition of an interest in a 
Passthrough Entity to which section 1411(c)(4) may apply. After 
considering the comments received, the Treasury Department and the IRS 
have withdrawn the 2012 Proposed Regulations implementing section 
1411(c)(4) and are issuing this notice of proposed rulemaking to 
propose revised rules for the implementation of section 1411(c)(4) 
adopting the commentators' suggestion. Accordingly, the 2013 Final 
Regulations reserve on this issue.
    Proposed Sec.  1.1411-7(b) provides a calculation to determine how 
much of the gain or loss that is recognized for chapter 1 purposes is 
attributable to property owned, directly or indirectly, by the 
Passthrough Entity that, if sold, would give rise to net gain within 
the meaning of section 1411(c)(1)(A)(iii) (``Section 1411 Property''). 
Section 1411 Property is any property owned by, or held through, the 
Passthrough Entity that, if sold, would result in net gain or loss 
allocable to the partner or shareholder that is includable in 
determining the partner or shareholder's net investment income under 
Sec.  1.1411-4(a)(1)(iii). This definition recognizes that the items of 
property inside the Passthrough Entity that constitute Section 1411 
Property might vary among transferors because a transferor may or may 
not be ``passive'' with respect to the property.
    Proposed Sec.  1.1411-7(c) provides an optional simplified 
reporting method that qualified transferors may use in lieu of the 
calculation described in proposed Sec.  1.1411-7(b). Proposed Sec.  
1.1411-7(d) contains additional rules that apply when a transferor 
disposes of its interest in the Passthrough Entity in a deferred 
recognition transaction to which section 1411 applies. Proposed Sec.  
1.1411-7(f) provides rules for adjusting the amount of gain or loss 
computed under this paragraph for transferors subject to basis 
adjustments required by Sec.  1.1411-10(d). Proposed Sec.  1.1411-7(g) 
provides rules for information disclosures by a Passthrough Entity to 
transferors and for information reporting by individuals, trusts, and 
estates.
A. Applicability of Section 1411(c)(4)
    In the case of an individual, trust, or estate, the proposed 
regulations provide that section 1411(c)(4) applies to ``Section 
1411(c)(4) Dispositions.'' A Section 1411(c)(4) Disposition is the 
disposition of an interest in a Passthrough Entity by an individual, 
estate, or trust if: (i) The Passthrough Entity is engaged in one or 
more trades or businesses, or owns an interest (directly or indirectly) 
in another Passthrough Entity that is engaged in one or more trades or 
businesses, other than the business of trading in financial instruments 
or commodities (within the meaning of Sec.  1.1411-5(a)(2)); and (ii) 
one or more of the trades or businesses of the Passthrough Entity is 
not a passive activity (within the meaning of Sec.  1.1411-5(a)(1)) of 
the transferor. Thus, if the transferor materially participates in one 
or more of the Passthrough Entity's trades or businesses (other than a 
trade or business of trading in financial instruments or commodities), 
then the transferor must use section 1411(c)(4) to calculate how much 
of the

[[Page 72459]]

chapter 1 gain or loss from the disposition to include under section 
1411(c)(1)(A)(iii). Section 1411(c)(4) only applies to dispositions of 
equity interests in partnerships and stock in S corporations, and does 
not apply to gain or loss recognized on, for example, indebtedness owed 
to the taxpayer by a partnership or S corporation.
    Proposed Sec.  1.1411-7(a)(3) also addresses dispositions by 
Passthrough Entities of interests in lower-tier Passthrough Entities (a 
``Subsidiary Passthrough Entity''). Proposed Sec.  1.1411-7(a)(3)(ii) 
provides a ``look through rule'' that treats a partner or shareholder 
as owning a proportionate share of any Subsidiary Passthrough Entity, 
as if the partner or shareholder owned the interest directly. Thus, 
each partner of the upper-tier Passthrough Entity must determine 
whether the disposition of the Subsidiary Passthrough Entity is a 
Section 1411(c)(4) Disposition based on whether the disposition would 
qualify as a Section 1411(c)(4) Disposition if that owner owned its 
interest in the Subsidiary Passthrough Entity directly.
    The Treasury Department and the IRS anticipate that taxpayers who 
dispose of an interest in a partial recognition transaction or partial 
disposition transaction will apply the principles of this section by 
including a pro rata amount of gain or loss from the Passthrough 
Entity's Section 1411 Property. In addition, the Treasury Department 
and the IRS believe that the application of section 1411(c)(4) to gain 
or loss on distributions from a Passthrough Entity is adequately 
addressed in section 469, which is incorporated into section 1411(c)(4) 
through the general definition of passive activity contained in section 
1411(c)(2)(A). Thus, the proposed regulations do not include special 
rules on partial recognition, partial disposition, and distribution 
transactions. However, the Treasury Department and the IRS request 
comments on whether additional rules on these topics are required.
B. Definitions and Special Rules
    Proposed Sec.  1.1411-7(a)(2) contains certain definitions and 
special rules that are unique to determining gain or loss under section 
1411(c)(4) and apply only for purposes of proposed Sec.  1.1411-7.
i. Definitions
    Proposed Sec.  1.1411-7 refers to partnerships or S corporations 
collectively as ``Passthrough Entities'' and the disposition of an 
interest in one of these entities is referred to as a ``Section 
1411(c)(4) Disposition.'' The purpose of section 1411(c)(4) is to allow 
gain attributable to non-passive activities to be excluded from the 
calculation of section 1411 tax upon the disposition of an interest in 
a Passthrough Entity. To accomplish this, section 1411(c)(4)(A) 
provides that gain from the disposition of an interest in a Passthrough 
Entity shall be taken into account in computing net investment income 
only to the extent of the amount of gain the transferor would have 
included under section 1411(c)(1)(A)(iii) if the Passthrough Entity 
sold all of its assets immediately before the Section 1411(c)(4) 
Disposition. The proposed regulations refer to the property that would 
generate gain for inclusion in section 1411(c)(1)(A)(iii) as ``Section 
1411 Property.''
ii. Rules for Certain Liquidations
    Proposed Sec.  1.1411-7(a)(4)(i) provides that if a fully taxable 
disposition of the Passthrough Entity's assets is followed by the 
liquidation of the Passthrough Entity as part of a single plan, then 
the disposition will be treated as an asset sale for purposes of 
section 1411. Thus, no additional gain or loss is included in net 
investment income under Sec.  1.1411-4(a)(1)(iii) on the subsequent 
liquidation of the Passthrough Entity by any transferor provided that 
the transferor would have satisfied proposed Sec.  1.1411-7(a)(3) prior 
to the sale. The proposed regulations also state that, when an S 
corporation makes a section 336(e) or section 338(h)(10) election on 
the sale of its stock, the transaction will be treated under section 
1411 as a fully taxable asset sale by the Passthrough Entity followed 
by a liquidation of the entity. Thus, no additional gain or loss is 
included in net investment income on the subsequent liquidation of the 
S corporation stock, provided a section 336(e) or section 338(h)(10) 
election is in effect.
iii. Rules for S Corporation Shareholders
    Proposed Sec.  1.1411-7(a)(4) provides two special rules for S 
corporation shareholders. First, proposed Sec.  1.1411-7(a)(4)(ii) 
provides that the Passthrough Entity will be considered an S 
corporation for purposes of section 1411 and proposed Sec.  1.1411-7 
even though Sec.  1.1362-3(a) treats the day of the transfer as the 
first date of the Passthrough Entity's C corporation short year (as 
defined therein). Second, proposed Sec.  1.1411-7(a)(4)(iii) provides 
that the calculation under proposed Sec.  1.1411-7(b) does not take 
into account any adjustment resulting from the hypothetical imposition 
of tax under section 1374 as a result of the proposed Sec.  1.1411-7(b) 
deemed sale. This provision was also included in the 2012 Proposed 
Regulations. See also part 9.H of this preamble for a discussion of the 
application of section 1411(c)(4) to Qualified Subchapter S Trusts.
C. Calculation of Gain or Loss Includable in Net Investment Income
i. Primary Method--Proposed Sec.  1.1411-7(b)
    Proposed Sec.  1.1411-7(b) provides the calculation for determining 
the amount of the transferor's gain or loss under section 
1411(c)(1)(A)(iii) from the disposition of an interest in a Passthrough 
Entity. For dispositions resulting in chapter 1 gain, the transferor's 
gain equals the lesser of: (i) The amount of gain the transferor 
recognizes for chapter 1 purposes, or (ii) the transferor's allocable 
share of net gain from a deemed sale of the Passthrough Entity's 
Section 1411 Property (in other words, property which, if sold, would 
give rise to gain or loss that is includable in determining the 
transferor's net investment income under Sec.  1.1411-4(a)(1)(iii)). 
The proposed regulations contain a similar rule when a transferor 
recognizes a loss for chapter 1 purposes.
    The 2012 Proposed Regulations required that a transferor of an 
interest in a Passthrough Entity in which the transferor materially 
participated value each asset held by the Passthrough Entity to 
determine the total amount of gain or loss to include under section 
1411(c)(4). Commentators indicated that this valuation requirement 
imposed undue administrative burdens on the transferor. The Treasury 
Department and the IRS acknowledge that for transferors of certain 
active interests in Passthrough Entities this property-by-property 
valuation requirement could be burdensome. Accordingly, these proposed 
regulations instead direct the transferor to rely on the valuation 
requirements under Sec.  1.469-2T(e)(3), which the materially 
participating transferor should already be applying for purposes of 
chapter 1. These valuation requirements allow the transferor to compute 
gain or loss activity by activity.
    Section 1.469-2T(e)(3) addresses dispositions of partnership 
interests and S corporation stock in the context of the passive 
activity loss rules for purposes of chapter 1. Section 1.469-2T(e)(3) 
provides guidance on allocating disposition gains or losses among the 
activities of the entity. These rules require the taxpayer to determine 
the overall gain or loss from each activity (regardless of whether or 
not the taxpayer materially participates in the

[[Page 72460]]

activity). For this purpose, Sec.  1.469-2T(e)(3)(ii)(B)(1)(i) requires 
the taxpayer to compute for each activity ``the amount of net gain . . 
. that would have been allocated to the holder of such interest with 
respect thereto if the passthrough entity had sold its entire interest 
in such activity for its fair market value on the applicable valuation 
date.'' Section 1.469-2T(e)(3)(ii)(B)(2)(i) contains a corollary rule 
for dispositions at a loss.
    Thus, the proposed regulations require a materially participating 
transferor to calculate its section 1411(c)(4) gain or loss by 
reference to the activity gain and loss amounts computed for chapter 1 
purposes under Sec. Sec.  1.469-2T(e)(3)(ii)(B)(1)(i) and 
(e)(3)(ii)(B)(2)(i). Specifically for purposes of section 1411, the 
transferor's allocable share of gain or loss from a deemed sale of the 
Passthrough Entity's Section 1411 Property equals the sum of the 
transferor's allocable shares of net gains and net losses (as 
determined under the section 469 principles described above) from a 
hypothetical deemed sale of the activities in which the transferor does 
not materially participate.
    Because section 1411(c)(4) applies to all activities in which a 
transferor in a Section 1411(c)(4) Disposition does not materially 
participate (whether held at a gain or a loss), certain provisions 
under 469 do not apply for purposes of these rules. Proposed Sec.  
1.1411-7(b)(1)(i)(B) and (b)(1)(ii)(B) both apply Sec.  1.469-2T(e)(3) 
without the recharacterization rule of Sec.  1.469-2T(e)(3)(iii) 
because the recharacterization rule in Sec.  1.469-2T(e)(3)(iii) is 
intended to recharacterize gains in certain circumstances as not being 
from a passive activity, and is thus not relevant in the context of 
section 1411.
    The Treasury Department and the IRS request comments on other 
possible methods that would implement section 1411(c)(4) for 
dispositions described in proposed Sec.  1.1411-7(a)(3)(i) 
(individuals, estates, and trusts) and proposed Sec.  1.1411-
7(a)(3)(ii) (tiered Passthrough Entity structures) in a manner 
consistent with the statute while reducing the administrative burden to 
the transferor and the Passthrough Entity.
ii. Optional Simplified Reporting Method--Proposed Sec.  1.1411-7(c)
    The proposed regulations also allow certain transferors to apply an 
optional simplified method in proposed Sec.  1.1411-7(c) for 
calculating gain or loss for purposes of Sec.  1.1411-4(a)(1)(iii). The 
Treasury Department and the IRS believe a simplified method is 
warranted when the amount of gain associated with passive assets owned 
by the Passthrough Entity is likely to be relatively small. To use the 
optional simplified reporting method, the transferor must meet certain 
qualifications under proposed Sec.  1.1411-7(c)(2) and not be otherwise 
excluded under proposed Sec.  1.1411-7(c)(3). Use of this simplified 
method is not mandatory for qualifying transferors. However, as 
discussed in part 10.G of this preamble, the Passthrough Entity may not 
be required under proposed Sec.  1.1411-7(g) to provide (but is not 
precluded from providing) a transferor who qualifies to use the 
simplified method with information that the transferor would need to 
report under the primary method described in proposed Sec.  1.1411-
7(g).
    The simplified reporting method is intended to limit the 
information sharing burden on Passthrough Entities by allowing 
transferors to rely on readily available information to calculate the 
amount of gain or loss included in net investment income under section 
1411(c)(4). For this purpose, the optional simplified method relies on 
historic distributive share amounts received by the transferor from the 
Passthrough Entity to extrapolate a percentage of the assets within the 
Passthrough Entity that are passive with respect to the transferor for 
purposes of section 1411(c)(4). For example, if ten percent of the 
income reported on the applicable Schedules K-1 is of a type that would 
be included in net investment income, then the simplified reporting 
method presumes that ten percent of the chapter 1 gain on the 
disposition of the transferor's interest relates to Section 1411 
Property of the Passthrough Entity for purposes of section 1411(c)(4).
a. Qualifications
    To qualify for the optional simplified reporting method, a 
transferor in a Section 1411(c)(4) Disposition must meet at least one 
of two requirements. A transferor satisfies the first requirement if: 
(i) The sum of the transferor's allocable share during the ``Section 
1411 Holding Period'' (as defined in the following paragraph, but 
generally the year of the disposition and the preceding two years) of 
separately stated items of income, gain, loss, and deduction (with any 
separately stated loss and deduction items included as positive 
numbers) of a type that the transferor would take into account in 
calculating net investment income is five percent or less of the sum of 
all separately stated items of income, gain, loss, and deduction (with 
any separately stated loss and deduction items included as positive 
numbers) allocated to the transferor during the Section 1411 Holding 
Period, and (ii) the gain recognized under chapter 1 by the transferor 
from the disposition of the Passthrough Entity is $5 million or less 
(including gains from multiple dispositions as part of a plan). A 
transferor satisfies the second alternative requirement if the gain 
recognized under chapter 1 by the transferor from the disposition of 
the Passthrough Entity is $250,000 or less (including gains from 
multiple dispositions as part of a plan). All dispositions of interests 
in the Passthrough Entity that occur during the transferor's taxable 
year will be presumed to be part of a plan.
    Section 1411 Holding Period is defined to mean the year of 
disposition and the transferor's two taxable years preceding the 
disposition or the time period the transferor held the interest, 
whichever is less. Where the transferor acquires its interest from 
another Passthrough Entity in a nonrecognition transaction during the 
year of disposition or the prior two taxable years, the transferor must 
include in its Section 1411 Holding Period the period that the previous 
owner or owners held the interest. Also, where the transferor 
transferred an interest in a Subsidiary Passthrough Entity to a 
Passthrough Entity in a nonrecognition transaction during the year of 
the disposition or the prior two taxable years, the transferor must 
include in its Section 1411 Holding Period that period that it held the 
interest in the Subsidiary Passthrough Entity.
b. Nonavailability of Optional Simplified Reporting Method
    Proposed Sec.  1.1411-7(c)(4) provides certain exceptions for 
situations in which a transferor is ineligible to use the optional 
simplified reporting method. These exceptions include situations in 
which the transferor's historical distributive share amounts are less 
likely to reflect the gain in the Passthrough Entity's Section 1411 
Property on the date of the transferor's disposition. The proposed 
regulations provide five exceptions for this purpose: (i) Transferors 
that have held the interest for less than 12 months, (ii) certain 
contributions and distributions during the Section 1411 Holding Period, 
(iii) Passthrough Entities that have significantly modified the 
composition of their assets, (iv) S corporations that have recently 
converted from C corporations, and (v) partial dispositions.

[[Page 72461]]

    The first exception requires that the transferor has held directly 
the interest in the Passthrough Entity (or held the interest indirectly 
in the case of a Subsidiary Passthrough Entity) for the twelve-month 
period preceding the Section 1411(c)(4) Disposition.
    The second exception provides that a transferor is ineligible to 
use the optional simplified reporting method if the transferor 
transferred Section 1411 Property (other than cash or cash equivalents) 
to the Passthrough Entity, or received a distribution of property 
(other than Section 1411 property) from the Passthrough Entity, as part 
of a plan that includes the transfer of the interest in the Passthrough 
Entity. A transferor who contributes, directly or indirectly, Section 
1411 Property (other than cash or cash equivalents) within 120 days of 
the disposition of the interest in the Passthrough Entity is presumed 
to have made the contribution as part of a plan that includes the 
transfer of the interest in the Passthrough Entity.
    The third exception focuses on changes to the composition of the 
Passthrough Entity's assets during the Section 1411 Holding Period. 
Under this exception, the transferor is ineligible to use the optional 
simplified reporting method if the transferor knows or has reason to 
know that the percentage of the Passthrough Entity's gross assets that 
consists of Section 1411 Property (other than cash or cash equivalents) 
has increased or decreased by 25 percentage points or more during the 
transferor's Section 1411 Holding Period due to contributions, 
distributions, or asset acquisitions or dispositions in taxable or 
nonrecognition transactions.
    The fourth exception provides that the optional simplified 
reporting method is not available if the Passthrough Entity was a C 
corporation during the Section 1411 Holding Period, and elected under 
section 1361 during that period to be taxed as an S corporation.
    The final exception provides that a transferor partner cannot use 
the optional simplified reporting method if the transferor transfers 
only a partial interest that does not represent a proportionate share 
of all of the partner's economic rights in the partnership. For 
example, a partner who transfers a preferred interest in a partnership 
while retaining a common interest in that partnership cannot use the 
optional simplified reporting method.
iii. Request for Comments
    The Treasury Department and the IRS request comments on the 
proposed section 1411(c)(4) calculation and on the optional simplified 
reporting method, including recommendations for other simplified means 
of calculating the gain or loss under section 1411(c)(4). The Treasury 
Department and the IRS also request comments regarding all aspects of 
the provisions relating to eligibility for the simplified method, 
including whether the 25 percentage point threshold for changes in the 
asset composition of a Passthrough Entity through is appropriate.
D. Tiered Passthrough Dispositions
    The Treasury Department and the IRS have reserved proposed Sec.  
1.1411-7(e) to further consider a simplified method for determining the 
section 1411(c)(4) gain resulting from the disposition by a Passthrough 
Entity of an interest in a Subsidiary Passthrough Entity as illustrated 
by the following example: A holds an interest in UTP, a Passthrough 
Entity that owns a 50-percent interest in LTP, a Subsidiary Passthrough 
Entity that is a real estate development company. A is a real estate 
developer and elected to group his real estate activities under Sec.  
1.469-9. When UTP sells its interest in LTP, any gain from the sale of 
that interest allocable to A through UTP may qualify under proposed 
Sec.  1.1411-7(a)(2). However, A lacks access to the books of LTP that 
would allow A to compute its section 1411(c)(4) inclusion under the 
general rule of proposed Sec.  1.1411-7(b). Additionally, A receives 
insufficient information from UTP to allow A to determine whether A 
qualifies to apply the Optional Simplified Reporting Method of proposed 
Sec.  1.1411-7(c) or to undertake that computation. The Treasury 
Department and the IRS request comments regarding a simplified method 
for determining the section 1411(c)(4) gain resulting in such cases, 
including a detailed technical analysis with examples.
E. Deferred Recognition Transactions
    To address the application of proposed Sec.  1.1411-7 to deferred 
recognition transactions, such as installment sales and certain private 
annuities, the proposed regulations provide that the calculations under 
proposed Sec. Sec.  1.1411-7(b)(1), 1.1411-7(c)(2) and 1.1411-7(c)(4) 
(as applicable) are performed in the year of disposition as though the 
entire gain was recognized and taken into account in that year. For 
this purpose, it is assumed that any contingencies potentially 
affecting consideration to the transferor that are reasonably expected 
to occur will occur, and in the case of annuities based on the life 
expectancy of one or more individuals, the present value of the annuity 
(using existing Federal tax valuation methods) is used to determine the 
estimated gain. This approach allows the transferor to determine its 
section 1411 inclusion for each future installment. If under this 
approach no gain or loss from the disposition would be included in net 
investment income, then the transferor excludes each payment received 
from the deferred recognition transaction from net investment income. 
If under this approach only a portion of the chapter 1 gain on the 
disposition would be included in net investment income, then the 
difference between the gain recognized for chapter 1 purposes and the 
gain recognized for section 1411 purposes is considered an addition to 
basis, and after taking those basis adjustments into account, gain 
amounts are included in net investment income under Sec.  1.1411-
4(a)(1)(iii) as payments are received in accordance with the existing 
rules for installment sales or private annuities.
F. Adjustment to Gain or Loss Due to Section 1411 Basis Differences
    In addition to the calculation of gain or loss included in net 
investment income by reason of section 1411(c)(4) and proposed Sec.  
1.1411-7, proposed Sec.  1.1411-7(f)(2) adjusts the gain or loss to 
take into account any disparities in the transferor's interest in the 
Passthrough Entity as a result of Sec.  1.1411-10(d) (relating to 
certain income from controlled foreign corporations and passive foreign 
investment companies where no Sec.  1.1411-10(g) election is made). 
These adjustments apply after applying the calculations set forth in 
paragraphs (b) through (e) of proposed Sec.  1.1411-7. Because the 
proposed Sec.  1.1411-7(f)(2) adjustments operate independently of the 
rules in paragraphs (b) through (e) of proposed Sec.  1.1411-7, they 
may result in gain for section 1411 purposes that exceeds chapter 1 
gain (or a loss that exceeds the chapter 1 loss), or may result in a 
section 1411 loss when the transferor recognizes a chapter 1 gain (or 
vice versa).
G. Information Reporting
    Several commentators to the 2012 Proposed Regulations requested 
revisions to the proposed information reporting requirements. Other 
commentators expressed concern that 2012 Proposed Regulations lacked 
provisions to compel a Passthrough Entity to provide the transferor 
with information required to comply with the 2012 Proposed Regulations 
Sec.  1.1411-7. In response, these proposed regulations simplify the 
information reporting

[[Page 72462]]

requirements for transferors of interests in Passthrough Entities and 
impose information reporting requirements on certain Passthrough 
Entities to ensure that the transferor has sufficient information to 
comply with the computational requirements of proposed Sec.  1.1411-7.
i. Information Reporting by the Passthrough Entity
    To compute the amount of gain or loss under proposed Sec.  1.1411-
7(b), the transferors that compute section 1411(c)(4) gain or loss 
under the primary computation method of proposed Sec.  1.1411-7(b) must 
generally obtain from the Passthrough Entity the transferor's allocable 
share of the net gain or loss from the deemed sale of the Passthrough 
Entity's Section 1411 Property. However, the proposed regulations only 
require the Passthrough Entity to provide this information to 
transferors that are ineligible for the optional simplified reporting 
method in proposed Sec.  1.1411-7(c).
    If a transferor qualifies to use the optional simplified reporting 
method in proposed Sec.  1.1411-7(c), but prefers to determine net gain 
or loss under proposed Sec.  1.1411-7(b), then the transferor must 
negotiate with the Passthrough Entity the terms under which the 
information will be supplied.
ii. Information Reporting by the Seller
    Any transferor applying proposed Sec.  1.1411-7, including in 
reliance on the proposed regulations, must attach a statement to the 
transferor's income tax return for the year of disposition. That 
statement must include: (1) The taxpayer's name and taxpayer 
identification number; (2) the name and taxpayer identification number 
of the Passthrough Entity in which the interest was transferred; (3) 
the amount of the transferor's gain or loss on the disposition of the 
interest under chapter 1; and (4) the amount of adjustment to gain or 
loss by reason of basis differences for chapter 1 and section 1411 
purposes. The transferor must also attach a copy of any information 
provided by the Passthrough Entity to the transferor relating to the 
transferor's allocable share of gain or loss from the deemed sale of 
the Passthrough Entity's Section 1411 Property.
H. Qualified Subchapter S Trusts (QSSTs)
    The preamble to the 2012 Proposed Regulations requested comments on 
whether special coordination rules are necessary to address 
dispositions of stock in an S corporation held by a QSST. Specifically, 
the request for comments deals with the application of section 
1411(c)(4) to the existing QSST stock disposition mechanics in Sec.  
1.1361-1(j)(8).
    In general, if an income beneficiary of a trust that meets the QSST 
requirements under section 1361(d)(3) makes a QSST election, the income 
beneficiary is treated as the section 678 owner with respect to the S 
corporation stock held by the trust. Section 1.1361-1(j)(8), however, 
provides that the trust, rather than the income beneficiary, is treated 
as the owner of the S corporation stock in determining the income tax 
consequences of the disposition of the stock by the QSST. Section 
1361(d)(1)(C) and the last sentence of Sec.  1.1361-1(j)(8) provide 
that, solely for purposes of applying sections 465 and 469 to the 
income beneficiary, a disposition of S corporation stock by a QSST is 
treated as a disposition by the income beneficiary. However, in this 
special case, the QSST beneficiary, for chapter 1 purposes, does not 
have any passive activity gain from the disposition. Therefore, the 
entire suspended loss (to the extent not allowed by reason of the 
beneficiary's other passive net income in the disposition year) is a 
section 469(g)(1) loss, and is considered a loss from a nonpassive 
activity.
    For purposes of section 1411, the inclusion of the operating income 
or loss of an S corporation in the beneficiary's net investment income 
is determined in a manner consistent with the treatment of a QSST 
beneficiary in chapter 1 (as explained in the preceding paragraph), 
which includes the determination of whether the S corporation is a 
passive activity of the beneficiary under section 469. However, because 
gain or loss resulting from the sale of S corporation stock by the QSST 
will be reported by the QSST and taxed to the trust by reason of Sec.  
1.1361-1(j)(8), it is not clear whether the beneficiary's section 469 
status with respect to the S corporation is attributed to the trust.
    One commentator recommended that the disposition of S corporation 
stock by a QSST should be treated as a disposition of the stock by the 
income beneficiary for purposes of determining material participation 
for purposes of section 1411. In addition, the commentator recommended 
that the final regulations confirm that the special rule stated in the 
last sentence of Sec.  1.1361-1(j)(8) applies for purposes of section 
1411 as it does for section 469 and 465.
    After consideration of the comments, these proposed regulations 
provide that, in the case of a QSST, the application of section 
1411(c)(4) is made at the trust level. This treatment is consistent 
with the chapter 1 treatment of the QSST by reason of Sec.  1.1361-
1(j)(8). However, these proposed regulations do not provide any special 
computational rules for QSSTs within the context of section 1411(c)(4) 
for two reasons. First, the treatment of the stock sale as passive or 
nonpassive income is determined under section 469, which involves the 
issue of whether there is material participation by the trust. As 
discussed in part 4.F of the preamble to the 2013 Final Regulations, 
the Treasury Department and the IRS believe that the issue of material 
participation by estates and trusts, including QSSTs, is more 
appropriately addressed under section 469.
    Additionally, one commentator noted that the IRS has addressed the 
treatment of certain asset sales as the functional equivalent of stock 
sales for purposes of Sec.  1.1361-1(j)(8) in a limited number of 
private letter rulings. In these cases, the private letter rulings held 
that gain from the sale of assets, which was followed by a liquidation, 
would be taxed at the trust level under Sec.  1.1361-1(j)(8) rather 
than being taxed at the beneficiary level. The commentator recommended 
that an asset sale followed by a liquidation, within the context of 
Sec.  1.1361-1(j)(8), should have a similar result under section 
1411(c)(4). Similar to the issue of material participation by QSSTs 
discussed in the preceding paragraph, the Treasury Department and the 
IRS believe that the issue of whether an asset sale (deemed or actual) 
is the equivalent of a stock sale for purpose of the QSST rules should 
be addressed under the Sec.  1.1361-1(j) QSST regulations, rather than 
in Sec.  1.1411-7. However, the Treasury Department and the IRS believe 
that proposed Sec.  1.1411-7(a)(4)(i), which provides that asset sales 
followed by a liquidation is a disposition of S corporation stock for 
purposes of section 1411(c)(4), address the commentator's QSST issue.
    Second, with respect to the section 1411 treatment of the 
disposition by the beneficiary by reason of section 1361(d)(1)(C) and 
the last sentence of Sec.  1.1361-1(j)(8), the Treasury Department and 
the IRS believe that the general administrative principles enumerated 
in Sec.  1.1411-1(a), when combined with the general treatment of 
section 469(g) losses within Sec.  1.1411-4, provide an adequate 
framework for the treatment of QSSTs beneficiaries without the need for 
a special computational rule within Sec.  1.1411-7.

Proposed Applicability Date

    These regulations are proposed to apply for taxable years beginning 
after

[[Page 72463]]

December 31, 2013, except that Sec.  1.1411-3(d)(3) 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, 
that 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 Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
to the IRS as prescribed in this preamble under the ``ADDRESSES'' 
heading. The Treasury Department and the IRS specifically request 
comments on all aspects of the proposed rules. All comments will be 
available at www.regulations.gov or upon request. A public hearing will 
be scheduled if requested in writing by any person that timely submits 
written comments. If a public hearing is scheduled, notice of the date, 
time, and place for the public hearing will be published in the Federal 
Register.

 Drafting Information

    The principal authors of the proposed regulations are David H. Kirk 
and Adrienne M. Mikolashek, 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.

Partial Withdrawal of Notice of Proposed Rulemaking

    Accordingly, under the authority of 26 U.S.C. 7805, Sec.  1.1411-7 
of the notice of proposed rulemaking (REG-130507-11) that was published 
in the Federal Register on December 5, 2012 (77 FR 72612) is withdrawn.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *
0
Par. 2. Section 1.1411-0 is amended by:
0
1. Revising the entries under Sec.  1.1411-3 for paragraphs (d)(2)(ii), 
(d)(3) and adding entries (d)(3)(i) through (iii).
0
2. Revising the entries under Sec.  1.1411-4 for paragraphs 
(d)(4)(iii), (e)(3), and (g)(10) through (13).
0
3. Adding entries to Sec.  1.1411-7.
    The revisions and additions to read as follows:


Sec.  1.1411-0  Table of contents.

* * * * *


Sec.  1.1411-3  Application to estates and trusts.

* * * * *
    (d) * * *
    (2) * * *
    (ii) Special rules for CRTs with income from certain CFCs or PFICs.
    (3) Elective simplified method.
    (i) Treatment of annuity or unitrust distributions.
    (ii) Properly allocable deductions in excess of gross income.
    (iii) Procedural requirements for making election.
* * * * *


Sec.  1.1411-4  Definition of net investment income.

* * * * *
    (d) * * *
    (4) * * *
    (iii) Adjustment for capital loss carryforwards for previously 
excluded income
* * * * *
    (e) * * *
    (3) Treatment of income from common trust funds.
* * * * *
    (g) * * *
    (10) Treatment of section 707(c) guaranteed payments.
    (11) Treatment of section 736 payments.
    (i) In general.
    (ii) Treatment of section 736(a)(1) payments.
    (A) General rule.
    (B) Examples.
    (iii) Treatment of section 736(a)(2) payments.
    (A) Payments for unrealized receivables and goodwill.
    (B) Payments not for unrealized receivables or goodwill.
    (iv) Treatment of section 736(b) payments.
    (v) Application of section 1411(c)(4) to section 736 payments.
    (12) Income and deductions from certain notional principal 
contracts.
    (i) In general.
    (ii) Notional principal contracts.
    (13) Treatment of income or loss from REMIC residual interests.
* * * * *


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

    (a) In general.
    (1) General application.
    (2) Definitions.
    (3) Section 1411(c)(4) dispositions.
    (i) Transfers by individuals, estates, and trusts.
    (ii) Transfers by passthrough entities.
    (4) Special rules.
    (i) Certain liquidations.
    (ii) Excluded gain or loss.
    (iii) Rules applicable to S corporation shareholders.
    (A) Certain S corporation dispositions.
    (B) S corporations subject to section 1374.
    (C) Treatment of Qualified Subchapter S Trusts (QSSTs).
    (b) Calculation.
    (1) In general.
    (i) Gain on disposition of interest.
    (ii) Loss on disposition of interest.
    (2) Examples.
    (c) Optional simplified reporting.
    (1) In general.
    (2) Qualifications.
    (i) Minimal section 1411 property.
    (ii) Minimal gain or loss.
    (3) Nonapplicability.
    (4) Optional simplified reporting calculation.
    (5) Examples.
    (d) Deferred recognition transactions.
    (e) Tiered passthrough disposition. [Reserved]
    (f) Adjustment to net gain or loss.
    (g) Information reporting.
    (1) Information to be provided by passthrough entity to transferor.

[[Page 72464]]

    (2) Information reporting by transferors.
    (h) Effective/applicability date.
0
Par 3. Section 1.1411-3 is amended by:
0
1. Revising paragraph (d)(2)(ii).
0
2. Revising paragraph (d)(2)(iii) by adding Example 2 through Example 
5.
0
3. Revising paragraph (d)(3).
0
4. Revising paragraph (f).
    The revisions and additions read as follows:


Sec.  1.1411-3  Application to estates and trusts.

* * * * *
    (d) * * *
    (2) * * *
    (ii) Special rules for CRTs with income from certain CFCs or PFICs. 
If a CRT is a trust described in Sec.  1.1411-10(a), and the CRT 
includes an amount in gross income under section 951(a) or section 
1293(a) from a CFC or QEF that is not also income derived from a trade 
or business described in section 1411(c)(2) and Sec.  1.1411-5 (except 
as provided in Sec.  1.1411-10(b)(2)) and an election under Sec.  
1.1411-10(g) is not in effect with respect to the CFC or QEF, or the 
CRT is treated as receiving an excess distribution within the meaning 
of section 1291(b) or recognizing gain treated as an excess 
distribution under section 1291(a)(2), then the following rules apply 
for purposes of section 1411 with regard to income derived from the 
CFC, QEF, or PFIC--
    (A) Amounts included in gross income for chapter 1 purposes under 
section 951(a) or section 1293(a) in a calendar year with respect to 
the CFC or QEF, and in one or more categories described in Sec.  1.664-
1(d)(1) are considered excluded income in that calendar year;
    (B) For the year in which the CRT is treated as receiving any of 
the items of net investment income described in paragraphs (c)(1)(i), 
(c)(1)(ii), (c)(2)(i), and (c)(4) of Sec.  1.1411-10 that otherwise are 
not included in gross income for purposes of chapter 1 for that year 
(``NII Inclusion Amount'') with respect to the CFC, QEF, or PFIC, the 
rules of this paragraph (d)(2)(ii)(B) apply; and
    (1) For purposes of determining the character under section 664 of 
a distribution to the unitrust or annuity recipient of a CRT, the NII 
Inclusion Amount treated as received by the CRT shall be allocated 
among the categories described in section 664(b)(1) through (b)(3), and 
among the classes within each category as described in Sec.  1.664-
1(d)(1), in the manner described in this paragraph (d)(2)(ii)(B). 
Specifically, to the extent the CRT has amounts of excluded income in 
the categories described in section 664(b)(1) (the Ordinary Income 
Category) or section 664(b)(2) (the Capital Gain Category), the NII 
Inclusion Amount shall be allocated to the CRT's classes of excluded 
income in the Ordinary Income Category, and then to the classes of 
excluded income in the Capital Gain Category, in turn, until exhaustion 
of each such class, beginning with the class of excluded income within 
a category with the highest Federal income tax rate.
    (2) Any remaining NII Inclusion Amount not so allocated to classes 
within the Ordinary Income and Capital Gain Categories shall be placed 
in the category described in section 664(b)(3) (the Other Income 
Category). To the extent the CRT distributes amounts from this Other 
Income Category, that distribution shall constitute a distribution 
described in Sec.  1.1411-10(c)(4).
    (3) A distribution by the CRT of excluded income first is deemed to 
carry out net investment income to the extent of the NII Inclusion 
Amount that has been allocated to excluded income in that class.
    (4) As a result, a distribution of excluded income will carry out 
to the unitrust or annuity recipient net investment income attributable 
to the items described in this paragraph (d)(2)(ii)(B).
    (C) In the case of a difference between the amount calculated with 
respect to a disposition under paragraph (c)(2)(iii) or (c)(2)(iv) of 
Sec.  1.1411-10 and the amount attributable to the relevant disposition 
for purposes of chapter 1, the following rules apply--
    (1) If the amount of the gain from the disposition for purposes of 
section 1411 is higher (or the loss smaller) than the amount of the 
gain (or loss) calculated for purposes of chapter 1, such difference 
shall be considered an NII Inclusion Amount and shall be allocated as 
described in paragraph (d)(2)(ii)(B) of this section. However, in 
applying paragraph (d)(2)(ii)(B) of this section to this increase, the 
order of the classes and categories to which the allocation is made 
shall be changed as follows: the increase shall be allocated first to 
the class in the Capital Gain Category that reflects the nature of the 
increase (short-term or long-term), then to other classes in that 
category, in turn until exhausted, then to the classes in the Ordinary 
Income Category, and finally to the Other Income Category.
    (2) If the amount of the gain from the disposition for purposes of 
section 1411 is smaller (or the loss higher) than the amount of the 
gain (or loss) calculated for purposes of chapter 1, such difference 
shall reduce accumulated net investment income in the CRT's categories 
and their respective classes as follows--
    (i) To the extent that the CRT has amounts in the Other Income 
Category by reason of the application of paragraph (d)(2)(ii)(B) or 
(d)(2)(ii)(C)(1) of this section for the current or prior years, to the 
Other Income Category; and
    (ii) Any excess difference in the same order as specified in 
paragraph (d)(2)(ii)(C)(1) of this section.
    (iii) * * *

    Example 2. (i) In 2010, A creates a net income with makeup CRT 
(NIMCRUT). A is the sole income beneficiary of the NIMCRUT for 15 
years. As of December 31, 2012, the NIMCRUT had $2,000 of dividend 
income and $180,000 of long-term capital gain within the Ordinary 
Income and Capital Gain Categories, respectively. Because both of 
these amounts were received by the NIMCRUT during a taxable year 
beginning before 2013, both constitute excluded income within the 
meaning of Sec.  1.1411-1(d). In Year 1, the NIMCRUT acquires an 
interest in a CFC. The NIMCRUT does not make the Sec.  1.1411-10(g) 
election with respect to the CFC. In Year 1, the NIMCRUT receives a 
section 951(a) inclusion of $5,000 and makes no distributions to A. 
For all years, income derived with respect to the CFC is not income 
derived in a trade or business described in section 1411(c)(2) and 
Sec.  1.1411-5.
    (ii) In Year 1, Sec.  1.1411-3(d)(2)(ii)(A) treats the section 
951 inclusion as excluded income and allocates it to the class of 
non-NII with a 39.6% tax rate in the Ordinary Income Category under 
Sec.  1.664-1(d)(1).

                                    Year 1 Ending Category and Class Balances
----------------------------------------------------------------------------------------------------------------
                                                                                          Tax rate
              Category                         Class                 Excluded/NII        (percent)      Amount
----------------------------------------------------------------------------------------------------------------
Ordinary Income.....................  Interest and Other       Excluded...............         39.6       $5,000
                                       Income (including
                                       section 951
                                       Inclusions).
                                      Qualified Dividends....  Excluded...............         20.0        2,000
Capital Gain........................  Long-Term..............  NII....................         23.8            0

[[Page 72465]]

 
                                      Long-Term..............  Excluded...............         20.0      180,000
Other Income........................  .......................  .......................  ...........         None
----------------------------------------------------------------------------------------------------------------

    (iii) The NIMCRUT makes no distributions to its sole income 
beneficiary in Year 2. In Year 3, the CFC distributes $4,000 to the 
NIMCRUT (which constitutes net investment income under Sec.  1.1411-
10(c)(1)(i)), the NIMCRUT has a total of $800 of post-2012 interest, 
and the NIMCRUT distributes $4,000 to the beneficiary.

 Category and Class Balances Immediately Before Both the CFC Distribution and the NIMCRUT's Year 3 Distribution
                                                      to A
----------------------------------------------------------------------------------------------------------------
                                                                                          Tax rate
              Category                         Class                 Excluded/NII        (percent)      Amount
----------------------------------------------------------------------------------------------------------------
Ordinary Income.....................  Interest (post-2012)...  NII....................         43.4         $800
                                      Interest and Other       Excluded...............         39.6        5,000
                                       Income (including
                                       section 951
                                       Inclusions).
                                      Qualified Dividends....  Excluded...............         20.0        2,000
Capital Gain........................  Long-Term..............  NII....................         23.8            0
                                      Long-Term..............  Excluded...............         20.0      180,000
Other Income........................  .......................  .......................  ...........         None
----------------------------------------------------------------------------------------------------------------

    Section 1.1411-3(d)(2)(ii)(B) will cause the $4,000 distribution 
from the CFC to be allocated first to the class of excluded income 
within the Ordinary Income Category with the highest Federal tax 
rate (the Interest and Other Income class). The distribution to A 
consists of $800 of post-2012 interest (subject to section 1411) and 
$3,200 from the Interest and Other Income class, of which all $3,200 
constitutes NII by reason of the allocation under Sec.  1.1411-
3(d)(2)(ii)(B). Of the $1,800 remaining in that category after the 
distribution to A, $800 will carry out NII to A, and will be 
includable in A's net investment income, when it is distributed to A 
in the future. Because the $3,200 distributed to A from this class 
is subject to both income tax and tax under section 1411 for Year 3, 
the timing differential attributable to the rules in Sec.  1.1411-10 
has been corrected within the NIMCRUT before the income is 
distributed to A.

                                    Year 3 Ending Category and Class Balances
                                  [Immediately following the distribution to A]
----------------------------------------------------------------------------------------------------------------
                                                                                          Tax rate
              Category                         Class                 Excluded/NII        (percent)      Amount
----------------------------------------------------------------------------------------------------------------
Ordinary Income.....................  Interest (post-2012)...  NII....................         43.4           $0
                                      Interest & Other Income  Excluded...............         39.6       *1,800
                                       (including section 951
                                       Inclusions).
                                      Qualified Dividends....  Excluded...............         20.0        2,000
Capital Gain........................  Long-Term..............  NII....................         23.8            0
                                      Long-Term..............  Excluded...............         20.0      180,000
Other Income........................  .......................  .......................  ...........         None
----------------------------------------------------------------------------------------------------------------
* Of which $800 will carry out NII to A when distributed.

    Example 3. (i) Assume the same facts as in Example 2, except 
that, in Year 2, the NIMCRUT has a section 951 inclusion in the 
amount of $4,000, taxable interest income of $800, tax exempt 
interest of $4,000. Assume the CRT has $1,100 undistributed capital 
gain from a taxable year ending before December 31, 2012.

                   Category and Class Balances Immediately Before the Year 2 Distribution to A
----------------------------------------------------------------------------------------------------------------
                                                                                          Tax rate
              Category                         Class                 Excluded/NII        (percent)      Amount
----------------------------------------------------------------------------------------------------------------
Ordinary Income.....................  Interest (post-2012)...  NII....................         43.4         $800
                                      Interest and Other       Excluded...............         39.6        9,000
                                       Income (including
                                       section 951
                                       Inclusions).
                                      Qualified Dividends....  Excluded...............         20.0        2,000
Capital Gain........................  Long-Term..............  NII....................         23.8            0
                                      Long-Term..............  Excluded...............         20.0        1,100
Other Income........................  .......................  Excluded...............  ...........        4,000
----------------------------------------------------------------------------------------------------------------

    (ii) In Year 2, the NIMCRUT made a $4,800 distribution to A in 
that same year (leaving a net balance in the Interest and Other 
Income class of $5,000 at the end of Year 2).

[[Page 72466]]



                              Category and Class Balances as of December 31, Year 2
                                  [Immediately following the distribution to A]
----------------------------------------------------------------------------------------------------------------
                                                                                          Tax rate
              Category                         Class                 Excluded/NII        (percent)      Amount
----------------------------------------------------------------------------------------------------------------
Ordinary Income.....................  Interest (post-2012)...  NII....................         43.4           $0
                                      Interest and Other       Excluded...............         39.6        5,000
                                       Income (including
                                       section 951
                                       Inclusions).
                                      Qualified Dividends....  Excluded...............         20.0        2,000
Capital Gain........................  Long-Term..............  NII....................         23.8            0
                                      Long-Term..............  Excluded...............         20.0        1,100
Other Income........................  .......................  Excluded...............  ...........        4,000
----------------------------------------------------------------------------------------------------------------

    A's net investment income in Year 2 will include $800 of taxable 
interest income, but will not include the $4,000 of other ordinary 
income.
    (iii) In Year 3, the NIMCRUT received a distribution from the 
CFC of $9,000, and assume, for purposes of this example, that the 
NIMCRUT distributes $6,000 to A. Section 1.1411-3(d)(2)(ii)(B) will 
cause the $9,000 distribution from the CFC to be allocated first to 
the class of excluded income within the Ordinary Income Category 
with the highest Federal tax rate (thus, $5,000 to the Other Income 
class and $2,000 to Qualified Dividends). The $2,000 balance of the 
Year 3 distribution from the CFC is allocated under Sec.  1.1411-
3(d)(2)(ii)(B) as follows: $1,100 to the Long-Term Capital Gain 
class of non-NII (so the distribution to A from this class in the 
future will carry out $1,100 of NII to A), and the remaining $900 to 
the Other Income Category (so the distribution to A from this class 
in the future will carry out $900 of NII to A).
    The distribution to A consists of $5,000 of Interest and Other 
Income class and $1,000 of Qualified Dividends, all of which 
constitutes NII by reason of the allocation under Sec.  1.1411-
3(d)(2)(ii)(B).

                              Category and Class Balances as of December 31, Year 3
                                  [Immediately following the distribution to A]
----------------------------------------------------------------------------------------------------------------
                                                                                          Tax rate
              Category                         Class                 Excluded/NII        (percent)      Amount
----------------------------------------------------------------------------------------------------------------
Ordinary Income.....................  Interest (post-2012)...  NII....................         43.4           $0
                                      Interest & Other Income  Excluded...............         39.6            0
                                       (section 951
                                       inclusion).
                                      Qualified Dividends....  Excluded...............         20.0      * 1,000
Capital Gain........................  Long-Term..............  NII....................         23.8            0
                                      Long-Term..............  Excluded...............         20.0      * 1,100
Other Income........................  .......................  NII....................          3.8          900
Other Income........................  .......................  Excluded...............          0.0        3,100
----------------------------------------------------------------------------------------------------------------
* All of which will carry out NII to A when distributed in the future.

    A's net investment income in Year 3 will include $5,000 of other 
ordinary income and $1,000 of qualified dividend income.
    Example 4. (i) Same facts as in Example 2, except that the 
NIMCRUT distributes $7,000 to A in Year 2. This distribution 
consists of the section 951 inclusion and the accumulated qualified 
dividends.
    (ii) In Year 2, the NIMCRUT will report $5,000 of ordinary 
income and $2,000 of qualified dividends to A. Both amounts will 
constitute excluded income to A. In this case, A does not have to 
adjust MAGI because the section 951 inclusion is treated in the same 
way as any other type of excluded income within the Ordinary Income 
Category.

                                    Year 2 Ending Category and Class Balances
                                  [Immediately following the distribution to A]
----------------------------------------------------------------------------------------------------------------
                                                                                          Tax rate
              Category                         Class                 Excluded/NII        (percent)      Amount
----------------------------------------------------------------------------------------------------------------
Ordinary Income.....................  Interest and Other       Excluded...............         39.6           $0
                                       Income (including
                                       section 951
                                       Inclusions).
                                      Qualified Dividends....  Excluded...............         20.0            0
Capital Gain........................  Long-Term..............  NII....................         23.8            0
                                      Long-Term..............  Excluded...............         20.0      180,000
Other Income........................  .......................  .......................  ...........         None
----------------------------------------------------------------------------------------------------------------

    (iii) When the CFC distributes $4,000 to the NIMCRUT in Year 3, 
Sec.  1.1411-3(d)(2)(ii)(B)(1) requires the NIMCRUT to allocate that 
$4,000 to the NIMCRUT's accumulated balance of long-term capital 
gains recognized by the NIMCRUT prior to December 31, 2012, so that 
the first $4,000 of the NIMCRUT's long-term capital gains 
distributed to A in the future will carry out NII to A.

[[Page 72467]]



                   Category and Class Balances Immediately Before the Year 3 Distribution to A
----------------------------------------------------------------------------------------------------------------
                                                                                          Tax rate
              Category                         Class                 Excluded/NII        (percent)      Amount
----------------------------------------------------------------------------------------------------------------
Ordinary Income.....................  Interest and Other       Excluded...............         39.6           $0
                                       Income (including
                                       section 951
                                       Inclusions).
                                      Qualified Dividends....  Excluded...............         20.0            0
Capital Gain........................  Long-Term..............  Excluded...............         20.0    * 180,000
Other Income........................  .......................  .......................  ...........         None
----------------------------------------------------------------------------------------------------------------
* Of which $4,000 will carry out NII to A when distributed in the future.

    When the NIMCRUT distributes the $4,000 to A in the future, the 
NIMCRUT will report $4,000 of long-term capital gain to A that also 
constitutes net investment income. No MAGI adjustments associated 
with that distribution will be required by A.

                                    Year 3 Ending Category and Class Balances
                                  [Immediately following the distribution to A]
----------------------------------------------------------------------------------------------------------------
                                                                                          Tax rate
              Category                         Class                 Excluded/NII        (percent)      Amount
----------------------------------------------------------------------------------------------------------------
Ordinary Income.....................  Interest and Other       Excluded...............         39.6           $0
                                       Income (including
                                       section 951
                                       Inclusions).
                                      Qualified Dividends....  Excluded...............         20.0            0
Capital Gain........................  Long-Term..............  Excluded...............         20.0      176,000
Other Income........................  .......................  .......................  ...........         None
----------------------------------------------------------------------------------------------------------------

    Example 5. (i) Same facts as in Example 4, except that the 
NIMCRUT's entire balance of accumulated long-term capital gain was 
received after 2012 and thus is ANII.
    (ii) When the CFC distributes $4,000 to the NIMCRUT in Year 3, 
Sec.  1.1411-3(d)(2)(ii)(B)(1) requires the NIMCRUT to allocate that 
$4,000 to excluded income within the Ordinary Income or Capital Gain 
Categories. In this case, the NIMCRUT does not have any excluded 
income remaining within those categories. As a result, Sec.  1.1411-
3(d)(2)(ii)(B)(2) requires the excess portion of the CFC 
distribution not allocable to excluded income in the Ordinary Income 
or Capital Gain Categories ($4,000 in this case) to be allocated to 
the Other Income Category.

                   Category and Class Balances Immediately Before the Year 3 Distribution to A
----------------------------------------------------------------------------------------------------------------
                                                                                          Tax rate
              Category                         Class                 Excluded/NII        (percent)      Amount
----------------------------------------------------------------------------------------------------------------
Ordinary Income.....................  Interest and Other       Excluded...............         39.6           $0
                                       Income (including
                                       section 951
                                       Inclusions).
                                      Qualified Dividends....  Excluded...............         20.0            0
Capital Gain........................  Long-Term..............  NII....................         23.8      180,000
                                      Long-Term..............  Excluded...............         20.0            0
Other Income........................  .......................  NII....................          3.8        4,000
----------------------------------------------------------------------------------------------------------------

    When the NIMCRUT distributes the $4,000 to A, the NIMCRUT will 
report $4,000 of long-term capital gains to A that also constitute 
net investment income. No MAGI adjustments associated with the 
distribution are required by A.

                                    Year 3 Ending Category and Class Balances
                                  [Immediately following the distribution to A]
----------------------------------------------------------------------------------------------------------------
                                                                                          Tax rate
              Category                         Class                 Excluded/NII        (percent)      Amount
----------------------------------------------------------------------------------------------------------------
Ordinary Income.....................  Interest and Other       Excluded...............         39.6           $0
                                       Income (including
                                       section 951
                                       Inclusions).
                                      Qualified Dividends....  Excluded...............         20.0            0
Capital Gain........................  Long-Term..............  NII....................         23.8      176,000
                                      Long-Term..............  Excluded...............         20.0            0
Other Income........................  .......................  NII....................          3.8        4,000
----------------------------------------------------------------------------------------------------------------

    After the NIMCRUT distributes all income within the Ordinary and 
Capital Gain categories, the NIMCRUT will distribute the $4,000 of 
Other Income to A. Such income will have a zero percent tax rate for 
chapter 1 purposes but will constitute net investment income. In 
this case, Sec.  1.1411-3(d)(2)(ii)(B)(2) provides that the future 
distribution will be considered a distribution of net investment 
income from a trust within the meaning of Sec.  1.1411-10(c)(4). As 
a result, Sec.  1.1411-10(e) requires A to increase MAGI for the 
year of that distribution.

    (3) Elective simplified method--(i) Treatment of annuity or 
unitrust distributions. If a CRT makes a valid election under this 
paragraph (d)(3), the rules of paragraph (d)(2) of this section shall 
not apply, and the net investment

[[Page 72468]]

income of the beneficiary attributable to the beneficiary's annuity or 
unitrust distribution from the CRT shall include an amount equal to the 
lesser of--
    (A) The beneficiary's share of the total amount of the 
distributions for that year; or
    (B) The beneficiary's same share of the accumulated net investment 
income (as defined in paragraph (d)(1)(iii) of this section) of the 
CRT.
    (ii) Properly allocable deductions in excess of gross income. In 
computing the amount described in paragraph (d)(3)(i)(B) of this 
section, notwithstanding Sec.  1.1411-4(f)(1)(ii) (limitations on 
deductions in excess of income), if in a taxable year a CRT's properly 
allocable deductions described in section 1411(c)(1)(B) and the 
regulations thereunder exceed the gross investment income and net gain 
described in section 1411(c)(1)(A) and the regulations thereunder, then 
such excess deductions shall reduce the amount described in paragraph 
(d)(3)(i)(B) of this section for that taxable year and, to the extent 
of any remaining excess deductions, for subsequent taxable years of the 
CRT.
    (iii) Procedural requirements for making election. In the case of a 
CRT established after December 31, 2012, a CRT wanting to make the 
election under paragraph (d)(3) of this section must do so on its 
income tax return for the taxable year in which the CRT is established. 
In the case of a CRT established before January 1, 2013, the CRT 
wanting to make the election under paragraph (d)(3) of this section 
must do so on the return for its first taxable year beginning on or 
after January 1, 2013. Once made, the election is irrevocable. In lieu 
of the relief provisions under Sec.  301.9100-3, the CRT may make the 
election on an amended return for that year only if the taxable year 
for which the election is made, and all taxable years that are affected 
by the election, for both the CRT and its beneficiaries, are not closed 
by the period of limitations on assessments under section 6501.
* * * * *
    (f) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013, except that paragraphs (d)(1), 
(d)(2)(i), Example 1 of (d)(2)(iii), and (d)(3) of this section applies 
to taxable years of CRTs that begin after December 31, 2012. However, 
taxpayers may apply this section to taxable years beginning after 
December 31, 2012, in accordance with Sec.  1.1411-1(f).
* * * * *
0
Par 4. Section 1.1411-4 is amended by revising paragraphs (d)(4)(iii), 
(e)(3), and (g)(10) through (13) to read as follows:


Sec.  1.1411-4  Definition of net investment income.

* * * * *
    (d) * * *
    (4) * * *
    (iii) Adjustment for capital loss carryforwards for previously 
excluded income--(A) General rule. For purposes of calculating net gain 
in paragraph (d) of this section (and any allowable loss described in 
paragraph (f)(4) of this section, if applicable), capital losses are 
reduced by the lesser of--
    (1) The amount of capital loss taken into account in the current 
year by reason of section 1212(b)(1); or
    (2) The amount of net capital loss excluded from net investment 
income in the preceding year by reason of paragraph (d)(4) of this 
section.
    (B) Example. The following example illustrates the provisions of 
this paragraph (d)(4)(iii). For purposes of this example, assume the 
taxpayer is a United States citizen, uses a calendar taxable year, and 
Year 1 and all subsequent years are taxable years in which section 1411 
is in effect:

    Example. (i)(A) In Year 1, A, an unmarried individual, disposes 
of 100 shares of publicly traded stock for a short-term capital gain 
of $4,000. In addition, A disposes of a partnership interest and 
recognizes a long-term capital loss of $19,000. Assume that the 
entire amount of $19,000 loss is not allowed against net investment 
income pursuant to section 1411(c)(4)(B), Sec.  1.1411-7, and 
paragraph (d)(4)(ii) of this section. A has no capital loss 
carryovers from the year preceding Year 1.
    (B) For purposes of chapter 1, A reports net capital loss of 
$15,000, of which $3,000 is allowed as a deduction in computing 
taxable income under section 1211(b)(1), and the remaining $12,000 
is carried forward into Year 2 as a long-term capital loss pursuant 
to section 1212(b)(1).
    (C) For purposes of calculating net investment income, A reports 
$4,000 of net gain. The $19,000 loss taken into account in computing 
A's taxable income in Year 1 is not taken into account in computing 
net gain. Therefore, there are no losses in excess of gains in Year 
1 for which a deduction is allowed under paragraph (f)(4) of this 
section.
    (ii)(A) In Year 2, A has no capital gain or loss transactions.
    (B) For purposes of chapter 1, A reports net capital loss of 
$12,000, of which $3,000 is allowed as a deduction in computing 
taxable income under section 1211(b)(1), and the remaining $9,000 is 
carried forward into Year 3 as a long-term capital loss pursuant to 
section 1212(b)(1).
    (C) For purposes of calculating net investment income, A must 
adjust the $12,000 capital loss carryover from Year 1 pursuant to 
paragraph (d)(4)(iii) of this section. The amount of the adjustment 
is the lesser of--
    (1) The amount of capital loss taken into account in the current 
year by reason of section 1212(b)(1) ($12,000), or
    (2) The amount of net capital loss excluded from net investment 
income in Year 1 by reason of paragraph (d)(4) of this section 
($19,000). The $19,000 loss was the amount disallowed by reason of 
paragraph (d)(4)(ii) of this section, and there were no other 
adjustments under paragraphs (d)(4)(i) or (d)(4)(iii) of this 
section in Year 1.
    (D) The amount of capital loss carryover that is taken into 
account by A in computing net investment income in Year 2 is $0 
($12,000 carryover amount less the adjustment of $12,000). 
Accordingly, when calculating net investment income, A has no losses 
in excess of gains, and no deduction is available to A under 
paragraph (f)(4) of this section.
    (iii)(A) In Year 3, A recognizes a $5,000 short-term capital 
gain from the disposition of property described in paragraph 
(d)(4)(i) of this section, and a $1,000 short-term capital loss from 
the disposition of publicly traded stock.
    (B) For purposes of chapter 1, A reports net capital loss 
carryover from Year 2 of $9,000. In addition, the short-term capital 
gain of $5,000 and $1,000 short-term capital loss net to produce 
$4,000 of short-term capital gain. A reports a net capital loss of 
$5,000 ($5,000--$1,000--$9,000), of which $3,000 is allowed as a 
deduction in computing taxable income under section 1211(b)(1), and 
the remaining $2,000 is carried forward into Year 4 as a long-term 
capital loss pursuant to section 1212(b)(1).
    (C) For purposes of calculating net investment income, A may 
exclude the $5,000 capital gain from the calculation of net gain 
pursuant to paragraph (d)(4)(i) of this section. In addition, A must 
adjust the $9,000 capital loss carryover from Year 2 pursuant to 
paragraph (d)(4)(iii) of this section. The amount of the adjustment 
is the lesser of--
    (1) The amount of capital loss taken into account in the current 
year by reason of section 1212(b)(1) ($9,000); or
    (2) The amount of net capital loss excluded from net investment 
income in Year 2 by reason of paragraph (d)(4) of this section 
($12,000). The $12,000 loss was the amount disallowed by reason of 
paragraph (d)(4)(iii) of this section, and there were no other 
adjustments under paragraphs (d)(4)(i) or (d)(4)(ii) of this section 
in Year 2.
    (D) The amount of capital loss carryover that is taken into 
account by A in computing net investment income in Year 3 is $0 
($9,000 carryover amount less the adjustment of $9,000). 
Accordingly, when calculating net investment income, A excludes 
$5,000 of gain under paragraph (d)(4)(i) of this section and the 
$9,000 capital loss carryover under paragraph (d)(4)(iii) of this 
section. The amount of losses taken into account for purposes of 
computing net gain is $1,000 (attributable to the $1,000 short-term 
capital loss from the disposition of publicly traded stock). 
Pursuant to paragraph (f)(4) of this

[[Page 72469]]

section, A is entitled to a deduction of $1,000 because the $1,000 
capital loss exceeds the gains, and the loss is less than the amount 
of allowable loss for chapter 1 purposes ($3,000).
    (iv)(A) In Year 4, A recognizes a $8,000 long-term capital loss 
on the disposition of raw land to which paragraph (d)(4)(i) of this 
section does not apply.
    (B) For purposes of chapter 1, A reports net capital loss 
carryover from Year 3 of $2,000. The $8,000 long-term capital loss 
is added to the $2,000 capital loss carryforward to produce a 
$10,000 long-term capital loss, of which $3,000 is allowed as a 
deduction in computing taxable income under section 1211(b)(1), and 
the remaining $7,000 is carried forward into Year 5 as a long-term 
capital loss pursuant to section 1212(b)(1).
    (C) For purposes of calculating net investment income, A takes 
into account the $8,000 capital loss from the sale of the land. In 
addition, A must adjust the $2,000 capital loss carryover from Year 
3 pursuant to paragraph (d)(4)(iii) of this section. The amount of 
the adjustment is the lesser of--
    (1) The amount of capital loss taken into account in the current 
year by reason of section 1212(b)(1) ($2,000); or
    (2) The amount of net capital loss excluded from net investment 
income in Year 3 by reason of paragraph (d)(4) of this section 
($4,000). The $4,000 loss is the sum of the $5,000 gain disallowed 
by reason of paragraph (d)(4)(i) of this section and the $9,000 loss 
disallowed by reason of paragraph (d)(4)(iii) of this section, and 
there were no other adjustments under paragraph (d)(4)(ii) of this 
section in Year 3.
    (D) The amount of capital loss carryover that is taken into 
account by A in computing net investment income in Year 3 is $0 
($2,000 carryover amount less the adjustment of $2,000). The amount 
of losses taken into account for purposes of computing net gain is 
$8,000 (attributable to the $8,000 capital loss from the disposition 
of raw land). Pursuant to paragraph (f)(4) of this section, A is 
entitled to a deduction of $3,000 because the $8,000 capital loss 
exceeds the gains, and only $3,000 of the loss is allowable for 
chapter 1 purposes under section 1211(b)(1).
    (v)(A) In Year 5, A has no capital gain or loss transactions.
    (B) For purposes of chapter 1, A reports net capital loss 
carryover from Year 4 of $7,000: $3,000 is allowed as a deduction in 
computing taxable income under section 1211(b)(1), and the remaining 
$4,000 is carried forward into Year 6 as a long-term capital loss 
pursuant to section 1212(b)(1).
    (C) For purposes of calculating net investment income, A must 
adjust the $7,000 capital loss carryover from Year 4 pursuant to 
paragraph (d)(4)(iii) of this section. The amount of the adjustment 
is the lesser of--
    (1) The amount of capital loss taken into account in the current 
year by reason of section 1212(b)(1) ($7,000); or
    (2) The amount of net capital loss excluded from net investment 
income in Year 4 by reason of paragraph (d)(4) of this section 
($2,000). The $2,000 loss was the amount disallowed by reason of 
paragraph (d)(4)(iii) of this section, and there were no other 
adjustments under paragraphs (d)(4)(i) or (d)(4)(ii) of this section 
in Year 4.
    (D) The amount of capital loss carryover that is taken into 
account by A in computing net investment income in Year 5 is $5,000 
($7,000 carryover amount less the adjustment of $2,000). The amount 
of losses taken into account for purposes of computing net gain is 
$5,000 carried over from Year 4. Pursuant to paragraph (f)(4) of 
this section, A is entitled to a deduction of $3,000 because the 
$5,000 capital loss exceeds the gains, and only $3,000 of the loss 
is allowable for chapter 1 purposes under section 1211(b)(1).
    (vi)(A) In Year 6, A has no capital gain or loss transactions.
    (B) For purposes of chapter 1, A reports net capital loss 
carryover from Year 5 of $4,000: $3,000 is allowed as a deduction in 
computing taxable income under section 1211(b)(1), and the remaining 
$1,000 is carried forward into Year 7 as a long-term capital loss 
pursuant to section 1212(b)(1).
    (C) For purposes of calculating net investment income, A must 
adjust the $4,000 capital loss carryover from Year 5 pursuant to 
paragraph (d)(4)(iii) of this section. The amount of the adjustment 
is the lesser of--
    (1) The amount of capital loss taken into account in the current 
year by reason of section 1212(b)(1) ($4,000); or
    (2) The amount of net capital loss excluded from net investment 
income in Year 5 by reason of paragraph (d)(4) of this section 
($2,000). The $2,000 loss was the amount disallowed by reason of 
paragraph (d)(4)(iii) of this section, and there were no other 
adjustments under paragraphs (d)(4)(i) or (d)(4)(ii) of this section 
in Year 5.
    (D) The amount of capital loss carryover that is taken into 
account by A in computing net investment income in Year 6 is $2,000 
($4,000 carryover amount less the adjustment of $2,000). The amount 
of losses taken into account for purposes of computing net gain is 
$2,000 carried over from Year 5. Pursuant to paragraph (f)(4) of 
this section, A is entitled to a deduction of $2,000 because the 
$2,000 capital loss exceeds the gains, and the loss is less than the 
amount of allowable loss for chapter 1 purposes ($3,000). As a 
result, the entire $8,000 loss from the raw land has been taken into 
account in computing A's net investment income ($3,000 in Years 4 
and 5, and $2,000 in Year 6).
    (vii)(A) In Year 7, A has no capital gain or loss transactions.
    (B) For purposes of chapter 1, A reports net capital loss 
carryover from Year 6 of $1,000. The entire $1,000 is allowed as a 
deduction in computing taxable income under section 1211(b)(1). A 
has no capital losses to carry over to Year 8.
    (C) For purposes of calculating net investment income, A must 
adjust the $1,000 capital loss carryover from Year 6 pursuant to 
paragraph (d)(4)(iii) of this section. The amount of the adjustment 
is the lesser of--
    (1) The amount of capital loss taken into account in the current 
year by reason of section 1212(b)(1) ($1,000); or
    (2) The amount of net capital loss excluded from net investment 
income in Year 6 by reason of paragraph (d)(4) of this section 
($2,000). The $2,000 loss was the amount disallowed by reason of 
paragraph (d)(4)(iii) of this section, and there were no other 
adjustments under paragraphs (d)(4)(i) or (d)(4)(ii) of this section 
in Year 6.
    (D) The amount of capital loss carryover that is taken into 
account by A in computing net investment income in Year 6 is $0 
($1,000 carryover amount less the adjustment of $1,000). Therefore, 
when calculating net investment income, A has no losses in excess of 
gains, and no deduction is available to A under paragraph (f)(4) of 
this section.

    (e) * * *
    (3) Treatment of income from common trust funds. If a taxpayer is a 
participant in a common trust fund and the taxpayer includes under 
section 584 any item of income, deduction, gain, or loss, then section 
1411 and the regulations thereunder apply to that item to the same 
extent as if the participant had made directly the investments of the 
common trust fund to which the items are attributable.
* * * * *
    (g) * * *
    (10) Treatment of section 707(c) guaranteed payments. Net 
investment income does not include section 707(c) payments received for 
services. Except to the extent provided in paragraph (g)(11)(iii)(A) of 
this section, section 707(c) payments received for the use of capital 
are net investment income within the meaning of section 
1411(c)(1)(A)(i) and paragraph (a)(1)(i) of this section.
    (11) Treatment of section 736 payments--(i) In general. The 
treatment of payments received by a retiring partner or a deceased 
partner's successor in interest described in section 736 is determined 
under the rules of this paragraph (g)(11). Section 736 payments are not 
distributions from a plan or arrangement described in section 
1411(c)(5) and Sec.  1.1411-8. To the extent that any portion of a 
section 736 payment is taken into account in computing a taxpayer's net 
earnings from self-employment (within the meaning of Sec.  1.1411-9), 
then such amount is not taken into account in computing net investment 
income by reason of section 1411(c)(6) and Sec.  1.1411-9.
    (ii) Treatment of section 736(a)(1) payments--(A) General rule. In 
the case of a payment described in section 736(a)(1) as a distributive 
share of partnership income, the items of income, gain, loss, and 
deduction attributable to such distributive share are taken into 
account in computing net investment income in section 1411(c) in a 
manner consistent with the item's character and treatment for chapter 1 
purposes. See Sec.  1.469-2(e)(2)(iii) for rules concerning the item's 
character and treatment for chapter 1.
    (B) Examples. The following examples illustrate the provisions of 
this paragraph (g)(11)(ii). For purposes

[[Page 72470]]

of these examples, assume the taxpayer is a United States citizen, uses 
a calendar taxable year, and Year 1 and all subsequent years are 
taxable years in which section 1411 is in effect:

    Example 1. Distributive share for goodwill. (i) A retires from 
PRS, a business entity classified as a partnership for Federal 
income tax purposes, and is entitled, pursuant to the partnership 
agreement, to receive 10% of PRS's net income for 60 months 
commencing immediately following A's retirement in exchange for A's 
fair market value share of PRS's unrealized receivables. PRS is not 
engaged in a trade or business described in section 1411(c)(2)(B) (a 
trading business). A will provide no services to PRS for the 60-
month period following A's retirement. Prior to A's retirement, A 
materially participated in PRS's trade or business within the 
meaning of Sec.  1.469-5T. As a result, PRS is characterized by A as 
a nonpassive activity for section 469 purposes. For purposes of 
section 1411, PRS was not a trade or business described in section 
1411(c)(2)(A) prior to A's retirement.
    (ii) In Year 3, pursuant to the partnership agreement, A 
received a cash payment of $20,000. A's distributive share of PRS 
income in Year 3 included $70,000 of gross income from operations 
and $50,000 of deductions from operations. PRS's status as a passive 
or nonpassive activity is determined under Sec.  1.469-2(e)(2)(iii) 
at the time the liquidation of A's partnership interest commenced, 
and remains fixed for the duration of A's liquidation payments. 
Therefore, PRS is a nonpassive activity with respect to A in Year 3 
pursuant to Sec.  1.469-2(e)(2)(iii). As a result, the gross income 
is not attributable to a trade or business described in section 
1411(c)(2)(A) or Sec.  1.1411-5(a)(1). Accordingly, A's distributive 
share of $70,000 of gross income and $50,000 of associated 
deductions are not includable in A's net investment income in Year 
3.
    (iii) If PRS's distributive share of operational income and 
deductions was attributable to a trade or business described in 
section 1411(c)(2)(B) or Sec.  1.1411-5(a)(2), the $70,000 of gross 
income amounts would be included in A's net investment income under 
section 1411(c)(1)(A)(ii) and paragraph (c) of this section and the 
$50,000 of associated deductions would be properly allocable to such 
income under section 1411(c)(1)(B) and Sec.  1.1411-4(f)(2)(ii).
    Example 2. Excess distributive share payments. Assume the same 
facts as in Example 1 except that PRS provides A an additional 2% of 
PRS's net income for 48 months commencing immediately following A's 
retirement as an incentive for A to retire earlier than planned. In 
the case of the additional 2% distributive share, the section 736(a) 
income characterization rule in Sec.  1.469-2(e)(2)(iii) does not 
apply because the payment exceeds the value of PRS's unrealized 
receivables (which was established to equal 10% of PRS's income for 
60 months in Example 1). As a result, A must determine whether PRS 
is a trade of business described in section 1411(c)(2)(A) and Sec.  
1.1411-5(a)(1) in Year 3 in order to determine whether the 
distributive share of operating income and deductions is includable 
in net investment income. If PRS is engaged in a trade or business 
described in section 1411(c)(2)(A) and Sec.  1.1411-5(a)(1) with 
respect to A in Year 3, then the distributive share will be taken 
into account in computing A's net investment income.

    (iii) Treatment of section 736(a)(2) payments--(A) Payments for 
unrealized receivables and goodwill. In the case of a payment described 
in section 736(a)(2), the portion (if any) of the payment that is 
allocable to the unrealized receivables (within the meaning of section 
751(c)) and goodwill of the partnership (as described and calculated in 
Sec.  1.469-2(e)(2)(iii)(B)) is included in net investment income under 
section 1411(c)(1)(A)(iii) and paragraphs (a)(1)(iii) and (d) of this 
section as gain from the disposition of a partnership interest.
    (B) Payments not for unrealized receivables or goodwill. In the 
case of a section 736(a)(2) payment not described in paragraph 
(g)(11)(iii)(A) of this section, the payment is characterized as a 
payment for services or as the payment of interest in a manner 
consistent with the payment's characterization under Sec.  1.469-
2(e)(2)(ii). See paragraph (g)(9) of this section.
    (iv) Treatment of section 736(b) payments. Gain or loss 
attributable to section 736(b) payments is included in net investment 
income under section 1411(c)(1)(A)(iii) and paragraphs (a)(1)(iii) and 
(d) of this section as gain or loss from the disposition of a 
partnership interest. A taxpayer who elects under Sec.  1.736-1(b)(6) 
must apply the principles that are applied to installment sales in 
Sec.  1.1411-7(d).
    (v) Application of section 1411(c)(4) to section 736 payments. 
Section 1411(c)(4) and Sec.  1.1411-7 apply to gain or loss 
attributable to section 736 payments described in paragraphs 
(g)(11)(iii)(A) and (g)(11)(iv) of this section. In the case of section 
736 payments that are received in more than one taxable year, the rules 
for calculating gain or loss under section 1411(c)(4) and Sec.  1.1411-
7 are applied at the time the liquidation of the partner's interest 
commenced. The principles that are applied to installment sales in 
Sec.  1.1411-7(d) also apply for purposes of this section.
    (12) Income and deductions from certain notional principal 
contracts--(i) In general. Net income for a taxable year taken into 
account by a taxpayer under Sec.  1.446-3(d) that is attributable to a 
notional principal contract described in paragraph (g)(12)(ii) of this 
section is net investment income described in section 1411(c)(1)(A) and 
paragraph (a)(1) of this section. A net deduction for a taxable year 
taken into account by a taxpayer under Sec.  1.446-3(d) that is 
attributable to a notional principal contract described in paragraph 
(g)(12)(ii) of this section is a properly allocable deduction described 
in section 1411(c)(1)(B) and paragraph (f) of this section.
    (ii) Notional principal contracts. For purposes of paragraph 
(g)(12)(i) of this section, a notional principal contract is any 
notional principal contract described in Sec.  1.446-3(c)(1) that is 
referenced to property (including an index) that produces (or would 
produce if the property were to produce income) interest, dividends, 
royalties, or rents if the property were held directly by the taxpayer. 
For purposes of the preceding sentence, an interest rate swap, cap, or 
floor is treated as a notional principal contract that is referenced to 
a debt instrument.
    (13) Treatment of income or loss from REMIC residual interests. The 
daily portion of taxable income determined under section 860C(a)(2) 
taken into account in determining tax under chapter 1 by the holder of 
a residual interest in a REMIC and any inducement fee included in 
income under Sec.  1.446-6(a) are treated as net investment income 
under section 1411(c)(1)(A) and paragraph (a)(1) of this section. The 
daily portion of net loss determined under section 860C(a)(2) taken 
into account in determining tax under Chapter 1 by the holder of a 
residual interest in a REMIC is a properly allocable deduction 
described in section 1411(c)(1)(B) and paragraph (f) of this section.
* * * * *
0
Par. 5. Section 1.1411-7 is added to read as follows:

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

    (a) In general--(1) General application. In the case of a 
transferor that disposes of an interest in a partnership or S 
corporation described in paragraph (a)(3) of this section (transferor), 
the gain or loss from the disposition recognized under chapter 1 that 
is taken into account under Sec.  1.1411-4(a)(1)(iii) shall be 
calculated in accordance with this section. The calculation in 
paragraph (b) of this section reflects the net gain or net loss that 
the transferor would take into account if the partnership or S 
corporation sold all of its Section 1411 Property (as defined in 
paragraph (a)(2)(iv) of this section) for fair market value immediately 
before the disposition of such interest. In certain

[[Page 72471]]

instances, transferors may qualify to use an alternative calculation 
described in paragraph (c) of this section in lieu of the calculation 
described in paragraph (b) of this section. Paragraph (d) of this 
section contains additional rules for Section 1411(c)(4) Dispositions 
(as defined in paragraph (a)(2)(ii) of this section) in deferred 
recognition transactions. Paragraph (f) of this section provides rules 
for adjusting the amount of gain or loss computed under this paragraph 
(a)(1) for transferors subject to basis adjustments required by Sec.  
1.1411-10(d). Paragraph (g) of this section provides rules for 
information disclosures by a partnership or S corporation to 
transferors and for information reporting by individuals, trusts, and 
estates. If a transferor disposes of an interest in a partnership or S 
corporation not described in paragraph (a)(3) of this section, then 
this section does not apply and the full amount of the gain or loss, as 
computed under chapter 1 and adjusted by Sec.  1.1411-10(d) (if 
applicable), is taken into account in computing the transferor's net 
investment income.
    (2) Definitions. For purposes of this section--
    (i) The term Passthrough Entity means an entity taxed as a 
partnership or an S corporation. For purposes of this section, a 
reference to an interest in any S corporation shall mean a reference to 
stock in such S corporation.
    (ii) The term Section 1411(c)(4) Disposition means a disposition of 
an interest in a Passthrough Entity described in paragraph (a)(3) of 
this section.
    (iii) The term Section 1411 Holding Period means the year of 
disposition and the transferor's two taxable years preceding the 
disposition or the time period the transferor held the interest, 
whichever is less; provided, however, that for purposes of applying 
this paragraph (a)(2)(iii), the transferor will--
    (A) Include the period that a previous owner or owners held the 
interest transferred if the transferor acquired its interest from 
another Passthrough Entity in a nonrecognition transaction during the 
year of disposition or the prior two taxable years;
    (B) Include the period that the transferor held an interest in a 
Subsidiary Passthrough Entity if the transferor transferred that 
interest to a Passthrough Entity in a nonrecognition transaction during 
the year of disposition or the prior two taxable years; and
    (C) Include the period that a previous owner or owners held the 
interest transferred if the transferor acquired its interest by gift.
    (iv) The term Section 1411 Property means property owned by or held 
through the Passthrough Entity that, if disposed of by the entity, 
would result in net gain or loss allocable to the transferor of a type 
that is includable in determining net investment income of the 
transferor under Sec.  1.1411-4(a)(1)(iii).
    (v) The term Subsidiary Passthrough Entity means an interest in a 
Passthrough Entity owned, directly or indirectly, by another 
Passthrough Entity.
    (3) Section 1411(c)(4) Dispositions--(i) Transfers by individuals, 
estates, and trusts. The disposition by a transferor of an interest in 
a Passthrough Entity is a Section 1411(c)(4) Disposition only if--
    (A) The Passthrough Entity is engaged in one or more trades or 
businesses (within the meaning of section 162), or owns an interest 
(directly or indirectly) in a Subsidiary Passthrough Entity that is 
engaged in one or more trades or businesses (within the meaning of 
section 162), that is not described in Sec.  1.1411-5(a)(2) (trading in 
financial instruments or commodities); and
    (B) One or more of the trades or businesses of the Passthrough 
Entity described in paragraph (a)(3)(i)(A) of this section is not a 
Sec.  1.1411-5(a)(1) (passive activity) trade or business of the 
transferor.
    (ii) Transfers by Passthrough Entities. Where a Passthrough Entity 
(the ``holder'') disposes of an interest in a Subsidiary Passthrough 
Entity, that disposition qualifies as a Section 1411(c)(4) Disposition 
with respect to a partner or shareholder of the Passthrough Entity if 
the partner or shareholder would satisfy the requirements of paragraph 
(a)(3)(i) of this section if it held the interest in the Subsidiary 
Passthrough Entity directly. For this purpose, the partner or 
shareholder shall be treated as owning a proportionate share of any 
Subsidiary Passthrough Entity in which the partner or shareholder owns 
an indirect interest through one or more tiers of Passthrough Entities.
    (4) Special rules--(i) Certain liquidations. If a fully taxable 
disposition of all of the Passthrough Entity's assets is followed by 
the complete liquidation of the Passthrough Entity as part of a single 
plan, then the disposition will be treated as an asset sale for 
purposes of section 1411, and no additional gain or loss will be 
included in net investment income under Sec.  1.1411-4(a)(1)(iii) on 
the subsequent liquidation of the Passthrough Entity by any transferor 
who would have satisfied paragraph (a)(3) of this section prior to the 
sale. A sale of stock in an S corporation with respect to which an 
election under section 336(e) or section 338(h)(10) is made shall be 
treated as a fully taxable disposition of the Passthrough Entity's 
assets followed by the liquidation of the Passthrough Entity for 
purposes of this paragraph (a)(4)(i).
    (ii) Excluded gain or loss. The difference between the amount of 
gain or loss taken into account in computing taxable income for 
purposes of chapter 1 and the amount of gain or loss taken into account 
after the application of this section shall constitute excluded income 
or excluded loss, as applicable, for purposes of Sec.  1.1411-
4(d)(4)(ii).
    (iii) Rules applicable to S corporation shareholders--(A) Certain S 
corporation dispositions. If the transfer of an interest in an S 
corporation causes the S election to terminate on the day of the 
transfer, then the corporation shall continue to be treated as an S 
corporation for purposes of applying the rules of this section to the 
transferor notwithstanding that Sec.  1.1362-3(a) treats the day of the 
transfer as the first day of the corporation's C corporation short year 
(as defined therein).
    (B) S corporations subject to section 1374. For purposes of the 
calculation under paragraph (b) of this section, the amount of gain or 
loss allocated to the transferor is determined under section 1366(a), 
and the allocation does not take into account any reduction in the 
transferor's pro rata share of gains under section 1366(f)(2) resulting 
from the hypothetical imposition of tax under section 1374 as a result 
of the deemed sale.
    (C) Treatment of Qualified Subchapter S Trusts (QSSTs). In the case 
of a disposition of S corporation stock by a QSST, the rules of this 
section are applied by treating the QSST as the owner of the S 
corporation stock.
    (b) Calculation--(1) In general. A transferor of an interest in a 
Passthrough Entity who disposes of that interest in a Section 
1411(c)(4) Disposition may use the simplified calculation in paragraph 
(c) of this section if it meets the eligibility requirements set forth 
in paragraph (c)(2) of this section. Any other transferor who disposes 
of an interest in a Passthrough Entity in a Section 1411(c)(4) 
Disposition must include gain or loss under Sec.  1.1411-4(a)(1)(iii) 
determined in accordance with this paragraph (b).
    (i) Gain on disposition of interest. If the transferor recognized a 
gain from the disposition, the amount of the net gain included in Sec.  
1.1411-4(a)(1)(iii) is the lesser of--

[[Page 72472]]

    (A) the transferor's gain on the disposition of the interest in the 
Passthrough Entity as determined in accordance with chapter 1; or
    (B) the transferor's allocable share of the chapter 1 net gain from 
a deemed sale of the Passthrough Entity's Section 1411 Property as 
determined using the principles of Sec.  1.469-2T(e)(3) (allocation of 
gain or loss to activities of the Passthrough Entity) where the net 
gain is the sum of the amounts of net gain and net loss allocable to 
the transferor as determined under Sec. Sec.  1.469-
2T(e)(3)(ii)(B)(1)(i) and 1.469-2T(e)(3)(ii)(B)(2)(i) that would 
constitute income to the transferor for purposes of section 1411 if 
sold by the Passthrough Entity. The general rules of Sec.  1.469-
2T(e)(3) apply in calculating the transferor's allocable share of the 
net gain under this section; however, the gain recharacterization rule 
of Sec.  1.469-2T(e)(3)(iii) shall not apply in any case. The 
calculation of net gain in this paragraph (b)(1)(i) shall not be less 
than zero.
    (ii) Loss on disposition of interest. If the transferor recognizes 
a loss from the disposition, the amount of the net loss included in 
Sec.  1.1411-4(a)(1)(iii) is the lesser of--
    (A) The transferor's loss (expressed as a positive number) on the 
disposition of the interest in the Passthrough Entity as determined in 
accordance with chapter 1; or
    (B) The transferor's allocable share of the chapter 1 net loss 
(expressed as a positive number) from the deemed sale of the entity's 
Section 1411 Property as determined in accordance with Sec.  1.469-
2T(e)(3) (allocation of gain or loss to activities of the Passthrough 
Entity) where the net loss is the sum of the amounts of net gain and 
net loss allocable to the transferor as determined under Sec. Sec.  
1.469-2T(e)(3)(ii)(B)(1)(i) and 1.469-2T(e)(3)(ii)(B)(2)(i) that would 
constitute income or loss to the transferor for purposes of section 
1411 if sold by the Passthrough Entity. The general rules of Sec.  
1.469-2T(e)(3) apply in calculating the transferor's allocable share of 
the net gain under this section; however, the gain recharacterization 
rule of Sec.  1.469-2T(e)(3)(iii) shall not apply in any case. The 
calculation of net gain in this paragraph (b)(1)(ii) shall not be less 
than zero. For purposes of this paragraph (b)(1)(ii), the loss 
limitation provisions imposed by sections 704(d) and 1366(d) shall not 
apply.
    (2) Examples. The following examples illustrate the principles of 
paragraph (b)(1) of this section. For purposes of these examples, 
assume that the taxpayer is a United States citizen, uses a calendar 
taxable year, and Year 1 and all subsequent years are taxable years in 
which section 1411 is in effect:

    Example 1. (i) Facts. A owns a one-half interest in P, a 
calendar year partnership. In Year 1, A sells its interest for 
$200,000. A's adjusted basis for the interest sold is $120,000. 
Thus, A recognizes $80,000 of gain from the sale (chapter 1 gain). P 
is engaged in three trade or business activities, X, Y, and Z, none 
of which are Sec.  1.1411-5(a)(2) (trading in financial instruments 
or commodities) trades or businesses. P also owns marketable 
securities. For Year 1, A materially participates in activity Z, 
thus it is not a Sec.  1.1411-5(a)(1) (passive activity) trade or 
business of A. A, however, does not materially participate in 
activities X and Y, so these activities are Sec.  1.1411-5(a)(1) 
trades or businesses of A. Because P is engaged in at least one 
trade or business and at least one of those trades or businesses is 
not passive to the transferor A, A determines its amount of Sec.  
1.1411-4(a)(1)(iii) gain or loss from net investment income under 
Sec.  1.1411-7. Assume for purposes of this example, A is not 
eligible to compute its Sec.  1.1411-4(a)(1)(iii) gain or loss under 
the optional simplified reporting method discussed in paragraph (c) 
of this section. The fair market value and adjusted basis of the 
gross assets used in P's activities are as follows:

----------------------------------------------------------------------------------------------------------------
                                                              Adjusted   Fair market                  A's Share
                                                               basis        value       Gain/loss     gain/loss
----------------------------------------------------------------------------------------------------------------
X (Passive as to A).......................................     $136,000      $96,000     ($40,000)     ($20,000)
Y (Passive as to A).......................................       60,000      124,000       64,000        32,000
Z (Non-passive as to A)...................................       40,000      160,000      120,000        60,000
Marketable securities.....................................        4,000       20,000       16,000         8,000
                                                           -----------------------------------------------------
    Total.................................................      240,000      400,000      160,000        80,000
----------------------------------------------------------------------------------------------------------------

    (ii) Analysis. Under paragraph (b)(1) of this section, A must 
determine the portion of gain or loss from the sale of P's Section 
1411 Property allocable to A. Under paragraph (b)(1)(ii) of this 
section, A's allocable share of gain from P's Section 1411 Property 
is $20,000 (($20,000) from X + $32,000 from Y + $8,000 from the 
marketable securities). Because the $20,000 allocable to A from a 
deemed sale of P's Section 1411 Property is less than A's $80,000 
chapter 1 gain, A will include $20,000 under Sec.  1.1411-
4(a)(1)(iii).
    Example 2. Assume the same facts as Example 1, but A materially 
participates in activities Y and Z and does not materially 
participate in activity X. Under paragraph (b)(1)(i) of this 
section, A's allocable share of P's Section 1411 Property is 
($12,000) (($20,000) from X + $8,000 from the marketable 
securities). Because A sold its interest for a chapter 1 gain, the 
amount allocable to A from a deemed sale of P's Section 1411 
Property cannot be less than zero. Accordingly, A includes no gain 
or loss under Sec.  1.1411-4(a)(1)(iii).
    (c) Optional simplified reporting--(1) In general. A transferor of 
an interest in a Passthrough Entity in a Section 1411(c)(4) Disposition 
may use the simplified reporting rules of paragraph (c)(4) of this 
section if it satisfies the eligibility requirements set forth in 
paragraph (c)(2) of this section and is not described in paragraph 
(c)(3) of this section. All other transferors of interests in 
Passthrough Entities in Section 1411(c)(4) Dispositions must use the 
calculation set forth in paragraph (b) of this section. Paragraph (d) 
of this section contains additional rules for Section 1411(c)(4) 
Dispositions in deferred recognition transactions.
    (2) Qualifications. Unless described in paragraph (c)(3) of this 
section, a transferor of an interest in a Passthrough Entity in a 
Section 1411(c)(4) Disposition may determine the amount of net gain or 
net loss that is taken into account under Sec.  1.1411-4(a)(1)(iii) in 
accordance with paragraph (c)(4) of this section if either or both of 
the requirements in paragraph (c)(2)(i) or (c)(2)(ii) of this section 
are satisfied:
    (i) Five percent threshold. The sum of separately stated income, 
gain, loss, and deduction items (with any separately stated loss and 
deduction items included as positive numbers) of a type the transferor 
would take into account in calculating net investment income (as 
defined in Sec.  1.1411-1(d)) that are allocated to the transferor in 
respect of the transferred interest is five percent or less of the sum 
of all separately stated items of income, gain, loss, and deduction 
(with any separately stated loss and deduction items included as 
positive numbers) allocated to the transferor in respect of the 
transferred interest during the Section 1411 Holding Period, and the 
total amount of chapter 1 gain or loss recognized by the transferor 
from the disposition of interests in the Passthrough Entity does not 
exceed $5 million (including gains

[[Page 72473]]

or losses from multiple dispositions as part of a plan). All 
dispositions of interests in the Passthrough Entity that occur during 
the taxable year will be presumed to be part of a plan. In calculating 
the percentage described in the first sentence of this paragraph 
(c)(2)(i), if the transferor acquired the transferred interest in a 
transaction described in paragraph (a)(2)(iii)(A) or (a)(2)(iii)(C) of 
this section, then items of income, gain, loss, or deduction allocated 
to the transferor include any such items allocated to the transferor's 
predecessor (or predecessors) in interest during the Section 1411 
Holding Period. If the transferor transferred an interest in a 
Subsidiary Passthrough Entity to the Passthrough Entity in a 
transaction described in paragraph (a)(2)(iii)(B) of this section, then 
items of income, gain, loss or deduction allocated to the transferor 
include any items allocated to the transferor during the Section 1411 
Holding Period in respect of the interest in the Subsidiary Passthrough 
Entity.
    (ii) $250,000 gain or loss threshold. The total amount of chapter 1 
gain or loss recognized by the transferor from the disposition of 
interests in the Passthrough Entity does not exceed $250,000 (including 
gains or losses from multiple dispositions as part of a plan). All 
dispositions of interests in the Passthrough Entity that occur during 
the taxable year will be presumed to be part of a plan.
    (3) Nonapplicability. A transferor is not eligible to use the 
simplified reporting method of paragraph (c)(4) of this section if any 
of the following conditions are met:
    (i) The transferor has held directly the interest in the 
Passthrough Entity (or held the interest indirectly in the case of a 
Subsidiary Passthrough Entity) for less than twelve months preceding 
the Section 1411(c)(4) Disposition.
    (ii) The transferor transferred, directly or indirectly, Section 
1411 Property (other than cash or cash equivalents) to the Passthrough 
Entity (or a Subsidiary Passthrough Entity described in paragraph 
(a)(2)(v) of this section), or received a distribution of property 
(other than Section 1411 property) from the Passthrough Entity (or a 
Subsidiary Passthrough Entity described in paragraph (a)(2)(v) of this 
section), during the Section 1411 Holding Period as part of a plan that 
includes the transfer of the transferor's interest in the Passthrough 
Entity. A transferor who contributed, directly or indirectly, Section 
1411 Property (other than cash or cash equivalents) within 120 days of 
the disposition of the interest in the Passthrough Entity is presumed 
to have made the contribution as part of a plan that includes the 
transfer of the interest in the Passthrough Entity.
    (iii) The Passthrough Entity is a partnership, and the transferor 
transfers a partial interest that represents other than a proportionate 
share of all of the transferring partner's economic rights in the 
partnership.
    (iv) The transferor knows or has reason to know that the percentage 
of the Passthrough Entity's gross assets that consist of Section 1411 
Property has increased or decreased by 25 percentage points or more 
during the transferor's Section 1411 Holding Period due to 
contributions, distributions, or asset acquisitions or dispositions in 
taxable or nonrecognition transactions.
    (v) The Passthrough Entity, which is the subject of the Section 
1411(c)(4) Disposition, was taxable as a C corporation during the 
Section 1411 Holding Period, but during that period elects under 
section 1362 to be taxable as an S corporation under section 1361.
    (4) Optional simplified reporting calculation. The amount of net 
gain or loss from the transferor's Section 1411(c)(4) Disposition that 
is includable in Sec.  1.1411-4(a)(1)(iii) is determined by multiplying 
the transferor's chapter 1 gain on the disposition by a fraction, the 
numerator of which is the sum of income, gain, loss, and deduction 
items (with any separately stated loss and deduction items netted as 
negative numbers) of a type that are taken into account in the 
calculation of net investment income (as defined in Sec.  1.1411-1(d)) 
that are allocated to the transferor during the Section 1411 Holding 
Period and the denominator of which is the sum of all items of income, 
gain, loss, and deduction allocated to the transferor during the 
Section 1411 Holding Period (with any separately stated loss and 
deduction items netted as negative numbers). If the quotient of the 
fraction is either greater than one or less than zero, then the 
fraction shall be one; provided, however, that if the numerator is a 
negative amount in connection with a computation of overall chapter 1 
gain on the sale or a positive amount in connection with a computation 
of overall chapter 1 loss on the sale, then the fraction shall be zero. 
In calculating the fraction described in the first sentence of this 
paragraph (c)(4), if the transferor acquired the transferred interest 
in a transaction described in paragraph (a)(2)(iii)(A) or (C) of this 
section, then items of income, gain, loss, or deduction allocated to 
the transferor include any such items allocated to the transferor's 
predecessor (or predecessors) in interest during the Section 1411 
Holding Period. If the transferor transferred an interest in a 
Subsidiary Passthrough Entity to the Passthrough Entity in a 
transaction described in paragraph (a)(2)(iii)(B) of this section, then 
items of income, gain, loss or deduction allocated to the transferor 
include any items allocated to the transferor during the Section 1411 
Holding Period in respect of the interest in the Subsidiary Passthrough 
Entity.
    (5) Examples. The following examples illustrate the principles of 
paragraph (c)(4) of this section. For purposes of these examples, 
assume that the taxpayer is a United States citizen, uses a calendar 
taxable year, and Year 1 and all subsequent years are taxable years in 
which section 1411 is in effect:

    Example 1.  Facts. A owns a one-half interest in P, a 
partnership. In Year 1, A sells the interest for $2,000,000. A's 
adjusted basis for the interest sold is $1,100,000. Because P is 
engaged in at least one trade or business and at least one of those 
trades or businesses is not passive to the transferor A, A 
determines its amount of Sec.  1.1411-4(a)(1)(iii) gain or loss from 
net investment income under Sec.  1.1411-7. None of the 
nonapplicability conditions set forth in section 1.1411-7(c)(3) 
apply. The aggregate net income from P's activities allocable to A 
for the year of disposition and the two preceding tax years are as 
follows:

------------------------------------------------------------------------
                                                             Aggregate
                                                          income/ (loss)
------------------------------------------------------------------------
X (Non-Passive as to A).................................      $1,800,000
Y (Passive as to A).....................................        (10,000)
Marketable securities...................................          20,000
------------------------------------------------------------------------

    (ii) Analysis. During A's Section 1411 Holding Period, A was 
allocated $30,000 of gross items of a type taken into account in the 
calculation of net investment income ($10,000 of loss from activity 
Y and $20,000 of income from marketable securities). The total 
amount of A's allocated net items during the Section 1411 Holding 
Period equals $1,810,000 ($1,800,000 income from activity X, $10,000 
loss from activity Y, and $20,000 income from marketable 
securities). Thus, less than 5% ($30,000/1,810,000) of A's 
allocations during the Section 1411 Holding Period are of a type 
that are taken into account in the computation of net investment 
income, and because A's chapter 1 gain recognized of $2,000,000 is 
less than $5,000,000, A qualifies under Sec.  1.1411-7(c)(2)(ii) to 
use the optional simplified method.
    (iii) Under paragraph (c)(4) of this section, A's percentage of 
Section 1411 Property is determined by dividing A's allocable shares 
of income and loss of a type that are taken into account in the 
calculation of net investment income (as defined in Sec.  1.1411-
1(d)) that are allocated to the transferor by the Passthrough Entity 
during the Section 1411 Holding Period is $10,000 ($10,000 loss from 
Y + $20,000 income from marketable securities) by $1,810,000, which 
is the sum of A's share of income and loss from all of P's 
activities ($1,800,000 + ($10,000) +

[[Page 72474]]

20,000). Thus, A's gain for purposes of Sec.  1.1411-4(a)(1)(iii) is 
$4,972.32 ($900,000 chapter 1 gain multiplied by the fraction 
10,000/1,810,000).
    Example 2.  Assume the same facts as Example 1, but A sells the 
interest in P for $900,000. Under paragraph (c)(3) of this section, 
A's percentage of Section 1411 Property is determined by dividing 
A's allocable share of income and loss of a type that are taken into 
account in the calculation of net investment income (as defined in 
Sec.  1.1411-1(d)) that are allocated to the transferor by the 
Passthrough Entity during the Section 1411 Holding Period is $10,000 
($10,000 loss from Y + $20,000 income from marketable securities) by 
$1,810,000, which is the sum of A's share of income and loss from 
all of P's activities ($1,800,000 + ($10,000) + 20,000). Because A's 
allocable share during the Section 1411 Holding Period of income and 
loss of a type that is taken into account in calculating net 
investment income was a positive amount, and A sells its interest 
for an overall chapter 1 loss, A uses a fraction of 0 to compute its 
net investment income under paragraph (c)(4) of this section. Thus, 
A has no gain or loss for purposes of Sec.  1.1411-4(a)(1)(iii) 
($200,000 chapter 1 loss multiplied by a fraction of 0).

    (d) Deferred recognition transactions. In the case of a disposition 
of a Passthrough Entity in an installment sale under section 453 (or in 
exchange for an annuity contract), the calculations described in 
paragraphs (b) and (c) of this section shall be applied in the year of 
the disposition as if the entire amount of gain recognized for chapter 
1 is taken into account by the transferor in the year of the 
disposition. For this purpose, it is assumed that any contingencies 
potentially affecting consideration to the transferor that are 
reasonably expected to occur will occur, and in the case of annuities 
based on the life expectancy of one or more individuals, the present 
value of the annuity (using existing Federal tax valuation methods) is 
used to determine the estimated gain. If the calculations in this 
section result in a transferor excluding only a portion of the chapter 
1 gain from net investment income, the amount of excluded gain will 
constitute an addition to basis for purposes of applying section 453 to 
determine the amount of gain is includable in net investment income 
under Sec.  1.1411-4(a)(1)(iii) as payments are received.
    (e) Disposition of tiered Passthrough Entities. [Reserved]
    (f) Adjustment to net gain or loss. In the case of a disposition of 
an interest in a Passthrough Entity where the transferor's basis in the 
interest for section 1411 purposes does not equal the transferor's 
basis for chapter 1 purposes due to basis adjustments required by Sec.  
1.1411-10(d), then the following rules apply:
    (i) If the transferor's basis for section 1411 purposes is higher 
than the transferor's basis for chapter 1 purposes, then the difference 
reduces the amount of gain or increases the amount of loss, as 
applicable, that is includable in net investment income under this 
section.
    (ii) If the transferor's basis for section 1411 purposes is lower 
than the transferor's basis for chapter 1 purposes, then the difference 
increases the amount of gain or reduces the amount of loss, as 
applicable, that is includable in net investment income under this 
section.
    (iii) The adjustments to gain or loss includable in net investment 
income under this paragraph (f) are taken into account by the 
transferor immediately following the calculation of gain or loss under 
paragraphs (a)(4)(i), (b)(1) or (c)(4) of this section, as applicable.
    (g) Information reporting--(1) Information to be provided by 
passthrough entity to transferor. Where the Passthrough Entity knows, 
or has reason to know, that the transferor satisfies paragraph 
(a)(3)(i) of this section but does not satisfy paragraph (c) of this 
section, then the Passthrough Entity shall provide the transferor with 
information as to the transferor's allocable share of the net gain or 
loss from the deemed sale of the Passthrough Entity's Section 1411 
Property as described in paragraph (b)(1) of this section and such 
other information as may be required by forms, instructions, or in 
other guidance to allow the transferor to compute gain or loss under 
this section.
    (2) Information reporting by transferors. Any transferor making a 
calculation under this section must attach a statement to the 
transferor's return for the year of disposition containing certain 
information as required by this paragraph (g)(2) and any other 
information required by guidance and applicable forms and instructions 
issued by the Commissioner to allow the transferor to compute gain or 
loss under this section. In the case of a disposition in a transaction 
described in paragraph (d) of this section, the information required by 
this paragraph (g)(2) shall apply in the year of the disposition, or in 
the first year the taxpayer is subject to section 1411 (determined 
without regard to the effect of this section), whichever is later. The 
statement must include--
    (i) The name and taxpayer identification number of the Passthrough 
Entity of which the interest was transferred;
    (ii) The amount of the transferor's gain or loss on the disposition 
of the interest for purposes of chapter 1;
    (iii) The information provided by the Passthrough Entity to the 
transferor by reason of paragraph (g)(1) of this section; and
    (iv) The amount of adjustment to gain or loss by reason of 
paragraph (f) of this section, if any.
    (h) Effective/applicability date. This section applies to taxable 
years beginning after December 31, 2013. However, taxpayers may apply 
this section to taxable years beginning after December 31, 2012 in 
accordance with Sec.  1.1411-1(f).

John Dalrymple,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2013-28409 Filed 11-26-13; 4:15 pm]
BILLING CODE 4830-01-P