Net Investment Income Reporting by Partnerships

Beginning in 2013 individuals, estates and trusts are subject to a surtax of 3.8% on net investment income above statutory threshold amounts ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case).

Net investment income (“NII”) is generally unearned income from investments less investment expenses and includes, but is not limited to, interest, dividends, net capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities (e.g., trader hedge funds), and businesses that are passive activities to a taxpayer. Investment income does not include income subject to self-employment tax, distributions from certain retirement plans, such as qualified employer plans and individual retirement accounts, or tax-exempt income, such as interest from state and other municipal obligations. There has been a lot of guidance issued on the net investment income tax (“NIIT”) and the tax has resulted in a new IRS form, Form 8960, Net Investment Income Tax – Individuals, Estates, and Trusts. Applying the new rules will be challenging to those subject to the tax and individuals, estates, and trusts with interests in partnerships will need additional information not typically reported on Schedule K-1 to calculate NII. This article focuses on the additional reporting required by partnerships (which includes LLCs and S Corporations for this discussion) and unique issues facing investment partnerships.

The instructions for 2013 Form 1065, U.S. Return of Partnership Income, provides guidance on the information partnerships are required to report to their partners regarding NII. Schedules K and K-1 of Form 1065 have been updated to include new code 20Y (code 20U for Form 1120S) to report information that may be relevant for partners to compute their net investment income. It is important to note that the partnership is not required to calculate net investment income allocable to each partner, but only to provide such relevant information (not otherwise identifiable on Schedule K-1) which is necessary for the partner to complete Form 8960 and calculate his or her net investment income.

Partnerships must inform their partners of adjustments to income, expense, gains, and losses to the extent such items are excluded from the calculation of NII. Generally, most adjustments will be to separate trade or business activity from investment activity. The draft instructions to Form 1065 and Form 8960 provide examples of ‘relevant information’ that is needed by an individual or trust who receives income from a partnership to properly calculate its NII. The portion of a gain attributable to the disposition of property held in a trade or business, for example, would need to be disclosed to a partner who must then reduce the amount of flow-through gain from the partnership includible in NII.

For the majority of hedge fund and private equity investors, nearly all of the flow-through items reported on Schedule K-1 will be included in NII since net income or loss from a trade or business in which a taxpayer does not materially participate and net income or loss from the trade or business of trading in financial instruments and commodities are specifically included in NII. If an investor in a fund receives an allocable share of net income or loss from a (Internal Revenue Code Section 162) trade or business in which the investor materially participates, an adjustment should be made to remove such income or loss from the calculation of the investor's NII. It would, therefore, appear that partnerships would need to disclose on each partner’s Schedule K-1 an itemized list of the allocable share of net income or loss from every trade or business in which the partnership directly or indirectly invests.

Interests in CFCs and PFICs

The regulations provide that income from controlled foreign corporations (“CFC”) and passive foreign investment companies (“PFIC”) that elect to be treated as qualifying electing funds (“QEF”) is includible in the calculation of NII. However, the timing of when income from CFCs and QEFs is recognized is different for income tax purposes and NIIT because distributions received from a CFC or QEF may be included in NII even if not included for income tax purposes. An individual may make an election to include income from a CFC and QEF as part of NII at the same time as they would for regular tax purposes, and as such, any distributions from a CFC or QEF that are not treated as dividends for income tax purposes will not be included in NII. The election is made by checking the check-box for “Regulations section 1.1411-10(g) election” on Form 8960 and attaching a statement to your return that identifies each CFC and QEF for which an election is made and providing the EIN or reference ID number of the CFC or QEF. Absent an election, a taxpayer’s tax basis in a CFC and QEF may be different for income tax purposes versus NII and must be tracked to report adjustments for NII at the time of disposition.

Domestic partnerships that are U.S. shareholders of a CFC or QEF can make the same election to treat income from a CFC or QEF as part of NII in the same tax year as such amounts are included in income for regular tax purposes. Domestic partnerships can make the election for taxable years beginning in 2014. An election can be made for taxable years beginning before 2014 only if consent is obtained from all the partners and beneficial owners of the partnership. Provisions contained in the limited partnership agreement may permit the general partner to make the election on behalf of its limited partners.

If a domestic partnership does not make an election, it must provide information related to such income inclusions from each CFC and QEF for which it directly or indirectly has an interest and must also provide information related to the following:

  • distributions from a CFC subject to NIIT;
  • distributions from a QEF subject to NIIT;
  • the amount of additional gain or loss derived with respect to dispositions of the stock of CFCs and QEFs that is taken into account for NII; and,
  • amounts that are derived with respect to the disposition of the stock of CFCs and QEFs and included in income as a dividend under Sec. 1248 for Sec. 1411 purposes.

Additionally, partners in a partnership that have a direct or indirect ownership in a PFIC for which a QEF election was not made must be provided with information, on an entity-by-entity basis, relating to excess distributions made by the PFIC and gains or losses derived from disposition of PFIC stock. Investment partnerships with many direct or indirect interests in PFICs will find these requirements very burdensome.

IRS has provided certain additional guidance in the final and newly proposed regulations released in December 2013 to assist taxpayers with the calculation of NII with respect to various specialized transactions and situations. A provision in the final regulations clarifies that net losses from investor and trader funds, including those making elections under Sec. 475(f), are includible in NII. Previous guidance seemed to indicate that excess losses from the business of trading in financial instruments and commodities would be disallowed for NII purposes even if allowed for regular tax purposes. The newly proposed regulations provide for the exclusion of partnership guaranteed payments for services from NII, even when such payments are not subject to self-employment tax. According to the proposed regulations, payments to retiring or deceased partners that represent such partner’s share of partnership income, other than from trading in financial instruments and commodities, fall under the trade or business exclusion from NII. Interest or other investment income from working capital included in such payments, however, would be includible in NII.

The NIIT has added a new and significant element to reporting requirements for individuals, estates, trusts, and pass-through entities. Although it has not yet been fully vetted in practice and its true impact has yet to be determined, the NIIT may turn out to be as complex as the alternative minimum tax given the nature and complexity of its reporting requirements. Investors in alternatives and the partnerships themselves will be put to task during the upcoming filing season to provide all relevant information needed by their partners to properly compute net investment income. Contact a WTAS professional today to help you understand how the new NIIT and reporting requirements will affect you and your business.