The Affordable Care Act and the Sale of S Corporation Stock
January 23, 2014
Many of our clients are concerned with how the sale of stock in an S corporation will affect their net investment income (“NII”). This is extremely important given the new 3.8% NII tax enacted through the Patient Protection and Affordable Care Act (“ACA”). Shareholders that materially participate may not realize that a portion of the gain/loss may be classified as NII and subject to this additional tax. However, given regulation section 1.1411, this is exactly what could happen.
What Happens if You Sell Your Stock in an S Corporation?
Generally, the difference between the selling price and the shareholder’s adjusted basis in the stock would be calculated as the capital gain/loss. Whether or not the income is passive or non-passive is determined by the shareholder’s participation. If a shareholder does not materially participate according to the general passive loss rules, the entire amount would be considered passive and included as NII. Complications arise when:
- The S corporation has multiple trade or business activities.
- The shareholder does not materially participate in ALL activities.
- The S corporation has 1411 property (i.e., marketable securities) that if sold would give rise to a gain/loss to be included in NII.
If any of the above situations exist, a portion of the gain from the sale of stock would be included in NII of a shareholder that materially participates.
How Do You Determine the Amount to Be Included in NII If the Shareholder Materially Participates?
Regulation section 1.1411-7 provides a series of complicated steps to determine what portion of the gain will be included in NII by applying a hypothetical activity-by-activity sale analysis. The portion to be included is the amount of allocated gain calculated as if the S corporation sold all activities that related to 1411 property (property that the shareholder either did not materially participate in, or portfolio assets). As an example, if the shareholder materially participated in the activities of the S corporation, gains from the sale of equipment held by the corporation would not be subject to NII but gains from the sale of securities held by the corporation would be subject to NII.
The first step is to determine the different activities of the S corporation. The shareholder must then apply the passive activity rules to determine the level or participation in each activity. The S corporation is deemed to have hypothetically sold all passive and portfolio activities (1411 property) at FMV. The allocable share of gain from the hypothetical sale of the S corporation’s 1411 property is the amount the shareholder must include in NII.
A owns 50% in C, an S corporation. A sells his stock for $200,000, basis $80,000, generating a capital gain of $120,000. C is engaged in three trade or business activities, X, Y and Z, and owns marketable securities. A materially participates in activity Z, but does not materially participate in X and Y. How much of the $120,000 gain will be included in NII? Assuming A is unable to apply the optional simplified method.
|Adjusted basis||FMV||Gain/(Loss)||A's Share Gain/(Loss)|
|X (Passive to A)||$136,000||$96,000||$(40,000)||$(20,000)|
|Y (Passive to A)||$60,000||$124,000||$64,000||$32,000|
|Z (Non-Passive to A)||$40,000||$160,000||$120,000||$60,000|
A's Share of gain from C's 1411 Property is:
|X (Passive to A)||$(20,000)|
|Y (Passive to A)||$32,000|
Since A’s allocable share of gain from C’s 1411 property is less than the A’s actual gain of $120,000, A will include 20,000 of the gain in NII.
If the stock is sold for a loss, the amount of loss included in NII is the lesser of the actual loss or the shareholder’s allocable loss of 1411 property. For example, A owns 50% in C, an S-Corporation. A sells his stock for $40,000, basis $100,000 for a loss of ($60,000). A materially participates in activities Y and Z.
|Adjusted basis||FMV||Gain/(Loss)||A's Share Gain/(Loss)|
|X (Passive to A)||$136,000||$40,000||$(96,000)||$(48,000)|
|Y (Non-Passive to A)||$60,000||$25,000||$(35,000)||$(17,500)|
|Z (Non-Passive to A)||$40,000||$10,000||$(30,000)||$(15,000)|
A's Share of loss from C's 1411 Property is:
|X (Passive to A)||$(48,000)|
Since A’s allocable share of loss from C’s 1411 property is less than the A’s actual loss of $60,000, A will include ($47,500) of the loss in NII.
Keep in mind the hypothetical sale cannot reduce the actual gain to a loss or create an additional gain. This means if the amount of allocable share of gain from C’s 1411 property is greater than A’s actual gain, A’s entire gain is included in NII. If the hypothetical sale of C’s 1411 property results in a loss, then none of A’s actual gain would be included in NII.
Note that if the S corporation has only one trade or business activity in which the shareholder materially participates, and does not have any other 1411 property, then the entire amount of the gain is excluded from NII.
If applicable, these calculations would cause a heavy administrative burden on the shareholder, S corporation and tax advisors. Luckily there is an optional simplified method described in regulation section 1.1411-7(c).
Optional Simplified Method Rules for S Corporation Shareholders that Materially Participate in Some or All of the Activities
The optional simplified reporting method may be used if either requirement is met:
- “5&5” – (5% and 5 million) The NII allocated to the shareholder during the 1411 holding period1 is 5% or less of all income or loss items allocated to the shareholder during the 1411 holding period (all are positive numbers for purposes of this calculation) AND the gain on disposition is less than $5 million.
- The total gain recognized by the shareholder is $250,000 or less.
If either of these requirements is not met, (or any of the five exclusions set forth in the regulations apply2) the shareholder will not be permitted to use the optional simplified method. The S corporation will be required to undertake the series of time consuming, potentially complicated steps to determine what portion of the gain must be included in NII.
Under the optional simplified method calculation the amount of the gain required to be included in NII is calculated as follows:
|Total Gain/Loss||X||Total of all 1411 items in the year of
disposition and two prior taxable years3
| Total of all taxable items in the year of
disposition and two prior taxable years
If the numerator is positive and there is an overall loss, or the numerator is negative and there is an overall gain, then no portion of the gain/loss is considered net investment income/loss.
If the fraction is greater than 1 or less than 0, the fraction is considered to be 1 and all of the gain or loss is considered net investment income.
A owns 80% of an S corporation and materially participates. It meets all the requirements for the optional simplified method calculation (see Step 1). In the current year, A sells his stock for a gain of $900,000 ($2,000,000 sales price less adjusted basis of $1,100,000).
The allocation of the gain to NII under the optional simplified method is as follows4:
|Year of Sale (K-1)||1,000,000||4,000||1,004,000|
|1st Prior Year (K-1)||450,000||17,000||467,000|
Step 1: “5&5” Test for Optional Simplified Method
NII allocated during holding period (positive numbers): $4,000+$17,000+$11,000 = $32,000
Total income/loss allocated during holding period: $1,800,000 + $32,000 = $1,832,000
= 1.75% (less than 5%)
What If the Stock Was Sold on an Installment Basis Prior to 2013 and the Enactment of the NII Tax?
If a shareholder sold stock prior to 2013 but will receive payments in 2013 and after, the entire amount of proceeds each year will be included as NII, unless the shareholder makes an irrevocable election. This election would allow the shareholder to apply the regulations to the year of sale and exclude a portion of the gain from NII in years they receive payment in 2013 and after. However, this could end up being even more burdensome as the shareholder and S corporation will have to go back to prior years and calculate the hypothetical activity–by-activity sale analysis. This may prove difficult to do. The election must be made on a timely filed (including extensions) original or amended return for the first tax year after 2013 in which the shareholder is subject to the NII tax.
1The 1411 holding period is the shorter of the year of disposition and the two preceding taxable years or the period the interest was owned
2Reg. §1.1411-7(c)(3) provides five rules in which the safe harbor method would not be applicable. One of which is if the shareholder held the stock of the S-Corporation for less than 12 months preceding the disposition.
3This is known as the “3-year look back”
4Reg. §1.1411-7(c)(5) example.