In between fiscal cliff updates, Circuit City deals-of-the-day, and an unnecessarilyharshapplication rejection from AshleyMadison.com, a number of emails concerning the new Obamacare investment tax regulations found their way into my inbox yesterday. Two of the questions were remarkably similar, and thus warrant some attention.
They went like this:
"What if I sell the membership interest in my S corporation or partnership and most of the gain is attributable to self-created intangibles of the businesssuch as goodwill. Is that portion of the gain considerednet investment income?"
Thecorrect answer -- as is always the case in the tax world -- is "it depends." But here's the good news: the proposed regulations provide that as long as the goodwill was generated in a trade or business, the goodwill will be treated as property used in a trade or business. (See Treas. Reg. Section 1.1411-7(c)(5)(ii)(B)). This matters to youbecause in general, provided
1)the corporation or partnership is not in the trade or business oftradingin financial instruments, and
2)the taxpayer materially participates in the trade or business (i.e., it is not a passive activity to the taxpayer),
thenany gain arising from the sale of property used inthe trade or business will not be included in net investment income.This includes any gain arising from the sale of goodwill or other intangibles.
As an aside, if the S corporation or partnership has multiple trades or businesses, theregulations further provide that the goodwill must be allocated to each trade or business based on the relative fair market value of the property (other than cash) in each trade or business.
It works like so:
Example: A owns 50 percent of the stock of an S corporation (S). S is engaged in one trade or business, which does not involve the trading of financial instruments. A materially participates in the trade or business, and is thus treated as a non-passive investor.
In addition to cash and goodwill, S has four properties. On June 1, A sells his S stock to C for $50,000. At the time of the disposition, A’s adjusted basis in his S stock is $25,000. S’s properties have the following adjusted basis and fair market value immediately before the disposition:
Property Adjusted Basis Fair Market Value
1 $5,000 $10,000
2 $5,000 $5,000
3 $20,000 $30,000
4 $10,000 $15,000
Cash $10,000 $10,000
Goodwill $0 $30,000
From this point, the proposed regulations require A to go through thefour-step process (discussed here) necessary to adjust his gainfrom the sale of stock to account for the fact that if the S corporation had sold the assets directly, the gain arising from the asset sales would have been excluded from A's net investment income by virtue of the fact that 1) the assets were used in S's trade or business, 2) S is not in the business of trading financial instruments, and 3) A materially participates in the business of S. (See Prop. Reg. Section 1.1411-4).
Step 1: On the stock sale to C, A recognizes a gain of $25,000 ($50,000 minus $25,000). Under the general rule of Prop. Reg. Section 1.1411-7, this gain would be included in A's computation of net investment income.
Step 2: As mentioned above,A is permitted to reduce his gain to the extent any gain would have been excluded from A's net investment income under Prop. Reg. Section 1.1411-4 had the S corporationsold the assets used in its trade or business for their fair market value.
Upon such a hypothetical disposition of S’s properties, S would recognize the following gain or loss:
Property Adjusted Basis Fair Market Value Gain or Loss
1 $5,000 $10,000 $5,000
2 $5,000 $5,000 $0
3 $20,000 $30,000 $10,000
4 $10,000 $15,000 $5,000
Cash $10,000 $10,000 $0
Goodwill $0 $30,000 $30,000
Step 3: A must now allocate the hypothetical gain from the sale of the assets. Under section 1366, A is allocated a $25,000 gain ($2,500 gain from Property 1, $0 gain from Property 2, $5,000 gain from Property 3, $2,500 gain from Property 4, $0 from cash, and $15,000 from goodwill).
Step 4: Here's where the goodwill comes into play. A must now make an adjustment to the $25,000 of net gain recognized on the sale of the stock, but only to the extent that any gain that would have been recognized by S upon the sale of its assets would not have been included in A's net investment income. Because the assets, including the goodwill, were used in S's trade or business, and because S was not in the trade or business of trading in financial instruments and A materially participated in the trade or business, all of the gain hypothetically recognized by S and allocated to A would have beenexcluded from A's net investment income by virtue ofProposed Regulation Section 1.1411-4.
Thus, A’s share of the gain on the four properties and goodwill are added together ($2,500 plus zero plus $5,000 plus 2,500 plus $15,000), which results in a negative adjustment of $25,000.Amust then reduce his $25,000 overall gain on the sale of the stock by the $25,000 adjustment for purposes of computing his net investment income, leaving him with zero net gain subject to the 3.8% surtax.
Two additional notes:
For an example of a sale of a membership interest in an S corporation with multiple lines of business requiring the allocation of goodwill, see Proposed Regulation Section 1.1411-7(e), Example 8.
Also, note that any gain arising from the sale of the S corporation or partnership's working capital will be included in net investment income, even if the taxpayer materially participates. (See Proposed Regulation Section 1.1411-4(d)(3)(ii).
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