Disposing of Partnership Interest or S Corporation Stock
In general, an interest in a partnership or S corporation is not property held for use in a trade or business and, therefore, gain or loss from the sale of a partnership interest or S corporation stock is included in your NII.
Adjustment. For regular income tax purposes, the amount of the gain or loss from the disposition is included on Form 8960, line 5a. If you materially participated (as defined under the passive activity loss rules) in a trade or business activity of the partnership or S corporation (or one of its subsidiaries), then you must calculate the adjustment to report on line 5c (unless the trade or business activity was trading in financial instruments or commodities).
The adjustment described below only applies to dispositions of equity interests in partnerships and stock in S corporations (pass-through entities) and not to gain or loss recognized on, for example, debt owed to the taxpayer by a partnership or S corporation, or on dispositions of stock of a C corporation. For more information on how to calculate the adjustment to report on line 5c, see Treasury Proposed Regulations Section 1.1411-7, Exception for dispositions of certain active interests in partnerships and S corporations.
Note. If there is a difference between the tax basis of the interest in the partnership or S corporation for NIIT purposes and the tax basis for regular income tax purposes due to certain adjustments associated with income from CFCs or qualified electing funds (QEFs), the amount of gain or loss may exceed the amount reported for regular income tax purposes.
Default Method for Calculating the Adjustment. The proposed regulations provide 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 pass-through entity that, if sold, would give rise to net gain within the meaning of Section 1411(c)(1)(A)(iii), Net investment income (“Section 1411 Property”). Section 1411 property is any property owned by, or held through, the pass-through entity that, if sold, would result in net gain or loss allocable to the partner or shareholder that is includible in determining the partner or shareholder’s net investment income.
The calculation, which can be very complicated, requires the selling shareholder/partner to have access to the books and records of the company. In some cases, especially with minority interest holders, access to company records may not be possible. In order to provide some relief in this context, the IRS created a simplified method for calculating the adjustment.
Simplified Method for Calculating the Adjustment. Certain transferors can use an optional simplified reporting method in lieu of the deemed sale method described above. The simplified method uses historic distributive share amounts you received from a pass-through entity to extrapolate a percentage of the assets within the pass-through entity that are passive with respect to you. For example, if 20% of the income reported on Schedule K-1 would be included in NII (e.g., dividends, rents, royalties, etc.), then the simplified method presumes that when you dispose of the partnership interests or S corporation stock, 20% of the ordinary income tax gain on that disposition relates to the pass-through entity’s NII property.
You can qualify for the optional simplified method if:
- The sum of your allocable share of separately stated items of income, gain, loss, and deduction that would be taken into account in calculating your NII is 5% or less of the sum of all separately stated items of income, gain, loss, and deduction allocated to you; and the gain recognized for ordinary income tax purposes from disposing of your partnership interest or S corporation stock is $5,000,000 or less; or
- The gain you recognize for ordinary income tax purposes from the disposition of your partnership or S corporation stock is $250,000 or less
You will not be eligible for the simplified method if:
- You have held the partnership interest or S corporation stock for less than 12 months
- Certain contributions to or distributions from the pass-through entity have been made
- The pass-through entity has significantly modified the composition of its assets
- You hold S corporation stock and the S corporation has recently converted from a C corporation, and
You hold a partnership interest and you transfer a partial interest that does not represent a proportionate share of all of your economic rights in that partnership
Required Statements. Attach a statement to your return for the year of disposition. Your statement must include:
- The name and taxpayer identification number of the partnership or S corporation from which the interest was transferred
- The amount of the transferor’s gain or loss on the disposition of the interest for regular income tax purposes included on line 5a
- The information provided by the partnership or S corporation to the transferor relating to the disposition (if any)
- The amount of adjustment to gain or loss due to basis adjustments attributable to ownership in certain CFCs and QEFs
Deferred Recognition Sales (Installment Sales and Private Annuities). If you disposed of a partnership interest or S corporation stock in an installment sale transaction to which Section 453, Installment method, applies, you need to calculate your adjustment to net gain in the year of the disposition, even if the disposition occurred before 2013. The difference between the amount reported for regular income tax and NIIT will be taken into account when each payment is received. You must attach the statement described above to your return for the first year you are subject to NIIT. In subsequent years, attach a statement to your return stating “Adjustment relates to a deferred recognition sale first reported on line 5c of the [enter year] return.”
Example 1. (i) Facts. Edrick owns a one-half interest in P, a calendar-year partnership. In Year 1, Edrick sells his interest for $200,000. Edrick’s adjusted basis for the interest sold is $120,000. Thus, Edrick recognizes $80,000 of gain from the sale.
P is engaged in three trade or business activities, X, Y, and Z, none of which are trading in financial instruments or commodities trades or businesses. P also owns marketable securities.
For Year 1, Edrick materially participates in activity Z, thus it is not a passive activity trade or business of Edrick. Edrick, however, does not materially participate in activities X and Y, so these activities are passive trades or businesses of Edrick.
Because P is engaged in at least one trade or business and at least one of those trades or businesses is not passive to Edrick (i.e., the transferor), he determines its amount of gain or loss from NII under the deemed-sale rules. Assume for purposes of this example Edrick is not eligible to compute his gain or loss under the optional simplified reporting method. The table below shows the fair market value (FMV) and adjusted basis of the gross assets used in P’s activities:
|
Adjusted Basis |
FMV |
Gain/Loss |
Edrick’s Share of Gain/Loss |
| X (Passive to Edrick) |
$136,000 |
$96,000 |
($40,000) |
($20,000) |
| Y (Passive to Edrick) |
$60,000 |
$124,000 |
$64,000 |
$32,000 |
| Z (nonpassive to Edrick) |
$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. Edrick must determine the portion of gain or loss from the sale of P’s NII property allocable to A. Edrick’s allocable share of gain from P’s NII property is $20,000 (($20,000) from X + $32,000 from Y + $8,000 from the marketable securities). Because the $20,000 allocable to Edrick from a deemed sale of P’s NII property is less than A’s $80,000 chapter 1 gain, A will include $20,000 in NII as net gain.
Example 2. Assume the same facts as above, but Edrick materially participates in activities Y and Z and does not materially participate in activity X. Edrick’s allocable share of P’s NII property is ($12,000) (($20,000) from X + $8,000 from the marketable securities). Because Edrick sold his interest for a gain, the amount allocable to Edrick from a deemed sale of P’s NII property cannot be less than zero. Accordingly, Edrick includes no gain or loss in his NII.
