Taxes in Your Practice: IRS chief counsel advice finds net investment income tax applies to C corporation dividends

Scott E. Vincent

Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City. 

The chief counsel advice, legal advisories written by the Chief Counsel’s National Office to advise the IRS, concludes that dividends paid to an individual shareholder of a C corporation are subject to the net investment income tax under Internal Revenue Code § 1411, even if the shareholder is an employee involved in the C corporation’s business and even though the business entity is a closely held C corporation under the code.

Background

The taxpayer seeking chief counsel advice is an individual C corporation shareholder who is an employee involved in the day-to-day operations of the corporation’s manufacturing trade or business. An IRS examination determined the corporation paid personal expenses for the taxpayer from corporate accounts, and the IRS reclassified the payments as dividend income paid to the taxpayer by the corporation (constructive dividends). The advice assumes that the corporation is a closely held corporation under Code § 469 as described in Code § 465 and further assumes the taxpayer is a majority shareholder of the corporation.

In seeking chief counsel advice, the taxpayer contends he or she materially participates in the manufacturing trade or business of the corporation as an employee, and that as a result the dividend income was derived in the ordinary course of the taxpayer’s trade or business that is not a passive activity under Code § 469. As a result, the taxpayer argues the dividend income received from the corporation is not subject to the net investment income tax under Code § 1411.

Applicable Code and Treasury Regulations

The chief counsel advice outlines key Code and Treasury Regulations, as follows:

Section 1411(a)(1) provides that in the case of an individual, there is a 3.8 percent tax imposed on the lesser of (A) net investment income, or (B) the excess of modified adjusted gross income for the taxable year, over the threshold amount.

Section 1411(c)(1) provides that "net investment income" means: (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in Sec. 1411(c)(2), (ii) other gross income derived from a trade or business described in Sec. 1411(c)(2), and (iii) net gain attributable to the disposition of property other than property held in a trade or business not described in Sec. 1411(c)(2).

Section 1411(c)(2) provides that Sec. 1411 applies to income derived in the ordinary course of a trade or business if such trade or business is: (A) a passive activity (within the meaning of Sec. 469) with respect to the taxpayer, or (B) a trade or business of trading in financial instruments or commodities (as defined in Sec. 475(e)(2)).

Treas. Reg. Sec. 1.1411-1(d)(3) provides, in part, that the term gross income from dividends includes amounts treated as dividends pursuant to subchapter C that are included in gross income (including constructive dividends).

Treas. Reg. Sec. 1.1411-4(a) provides that net investment income means the excess any of--

(1) The sum of -

(i) Gross income from interest, dividends, annuities, royalties, and rents, except to the extent excluded by the ordinary course of a trade or business exception described in Sec. 1.1411-4(b);

(ii) Other gross income derived from a trade or business described in Sec. 1.1411-5 (which describes trades or businesses to which Sec. 1411 applies); and (iii) Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property, except to the extent excluded by the exception described in Sec. 1.1411-4(d) (4)(i)(A) for gain or loss attributable to property held in a trade or business not described in Sec. 1.1411-5; over

(2) The deductions allowed by subtitle A that are properly allocable to such gross income or net gain (as determined in Sec. 1.1411-4(f)).

Treas. Reg. Sec. 1.1411-4(b) provides, in part, that gross income described in Sec. 1.1411-4(a) is excluded from net investment income if it is derived in the ordinary course of a trade or business that is not a passive activity of the taxpayer (within the meaning of Sec. 469). To determine whether gross income is derived in the ordinary course of a trade or business, the following rules apply:

(1) In the case of an individual, estate, or trust that owns or engages in a trade or business directly (or indirectly through ownership of a disregarded entity within the meaning of Sec. 301.7701-3), the determination is made an at the individual, estate, or trust level.

(2) In the case of an individual, estate, or trust that owns an interest in a passthrough entity (for example, a partnership or S corporation), and that entity is engaged in a trade or business, the determination of whether gross income is derived from a passive activity is made at the owner level.

Section 469(c)(1) defines a passive activity, in part, as any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate.

Section 469(e)(1)(A)(i)(I) provides that, for purposes of Sec. 469, in determining the income or loss from any activity, there shall not be taken into account any gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business.

Treas. Reg. Sec. 1.469-2T(c)(3)(i)(A) provides that passive activity gross income does not include portfolio income. For purposes of the preceding sentence, portfolio income includes all gross income, other than income derived in the ordinary course of a trade or business (within the meaning of Sec. 1.469-2T(c)(3)(ii)) that is attributable to interest (including amounts treated as interest under Sec. 1.469-2T(e)(2)(ii)), relating to certain payments to partners for the use of capital); annuities; royalties (including fees and other payments for the use of intangible property); dividends on C corporation stock; and income (including dividends) from a real estate investment trust (within the meaning of Sec. 856), regulated investment company (within the meaning of Sec. 851), real estate mortgage investment conduit (within the meaning of Sec. 860D), common trust fund (within the meaning of Sec. 854), controlled foreign corporation (within the meaning of Sec. 957), qualified electing fund (within the meaning of Sec. 1295(a)), or cooperative (within the meaning of Sec. 1381(a)).

Treas. Reg. Sec. 1.469-2T(c)(3)(ii) provides for seven limited scenarios where certain types of portfolio income described in Sec. 1.469-2T(c)(3)(i) will be treated as derived in the ordinary course of a trade or business. Only under two of these scenarios would dividend income be treated as derived in the ordinary course of a trade or business.

Section 1.469-2T(c)(3)(ii)(C) provides that income from investments made in the ordinary course of a trade or business of furnishing insurance or annuity contracts or reinsuring risks underwritten by insurance companies. Section 1.469-2T(c) (3)(ii)(D) provides that income or gain derived in the ordinary course of an activity of trading or dealing in any property if such activity constitutes a trade or business.

Treas. Reg. Sec. 1.469-4(d)(5)(i) provides, generally, that a C corporation subject to Sec. 469, an S corporation, or a partnership (a Sec. 469 entity) must group its activities under the rules of Sec. 1.469-4. Once a Sec. 469 entity groups its activities, a shareholder or partner may group those activities with each other, with activities conducted directly by the shareholder or partner, and with activities conducted through other Sec. 469 entities, in accordance with the rules of Sec. 1.469-4. A shareholder or partner may not treat activities grouped together by a Sec. 469 entity as separate activities.

Treas. Reg. Sec. 1.469-4(d)(5)(ii) provides that an activity that a taxpayer conducts through a C corporation subject to Sec. 469 may be grouped with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially or significantly participates in the other activity. See Sec. 1.469-2T(c)(3)(i)(A) and (c)(4)(i) for the rules regarding dividends on C corporation stock and compensation paid for personal services.

Chief Counsel Analysis – § 1411 Applies to the Dividends

The Chief Counsel Office first concludes that dividend income received by a shareholder from a C corporation in which the shareholder is an employee is subject to the net investment income tax under Internal Revenue Code § 1411.

The chief counsel notes the general rule that dividend income received by an individual taxpayer from a C corporation is net investment income under § 1411(c)(1) unless the income is derived in the ordinary course of business. For this exception to apply, U.S. Department of Treasury Regulations requires that the dividend income be derived in a trade or business conducted (1) directly by the taxpayer (or through a disregarded entity), or (2) through a passthrough entity (such as a partnership or S corporation). Since a C corporation is a separate taxpayer and not a disregarded or passthrough entity, the chief counsel reasons that dividend income received by a C corporation shareholder generally does not qualify for the “ordinary course of trade or business” exception in the Treasury Regulations.

The chief counsel further observes that C corporation stock producing dividend income is generally treated as property held for investment purposes by the shareholder for purposes of § 469 and the related Treasury Regulations, unless the dividends are derived in the ordinary course of a trade or business. The chief counsel notes that this exception would only apply if the shareholder were a dealer or trader in securities and concludes that the mere act of being a shareholder in a C corporation is not a trade or business. To further illustrate this analysis, the chief counsel explains that a shareholder cannot offset dividend income from a C corporation with any deductions for expenses the C corporation incurred in carrying on its business, because these expenses would not be properly allocable to the shareholder under § 1411(c)(1)(B).

Based on this analysis, the chief counsel concludes that the taxpayer was not able to demonstrate that the dividends were received in the ordinary course of the taxpayer’s trade or business. The taxpayer also argued that participating in the C corporation’s business as an employee qualified for the § 1411(c)(1)(A)((i) exception. However, the chief counsel found that the taxpayer’s employment and involvement in the C corporation’s business was not relevant, distinguishing two narrow exceptions for insurance businesses and property dealers under the § 469 of the Treasury Regulations.

Chief Counsel Analysis – Closely Held Business

The chief counsel next concludes that the dividend income is subject to the net investment income tax under Internal Revenue Code § 1411 even if the C corporation is a closely held corporation under § 469 as described in § 465. While C corporations are not generally subject to the passive loss rules, § 469 does apply to closely held C corporations under § 469(a)(2)(B). The chief counsel notes that special rules under § 469 only allow closely held C corporations to offset passive losses against passive income, with the rationale that Congress feared individuals would use closely held C corporations to incorporate portfolio investments and avoid the § 469 passive loss rules. The chief counsel also acknowledges that § 469 of the Treasury Regulations allows grouping of taxpayer activities, including those conducted through a closely held C corporation, but concludes this is only permissible for purposes of determining whether a taxpayer materially participates in the activities.

The chief counsel notes that § 1411 of the Treasury Regulations does not provide for treating gross income derived from a C corporation, even if closely held, as derived in the ordinary course of a trade or business. Because C corporations are not disregarded or passthrough taxpayers, the chief counsel concludes that the analysis is unchanged by a shareholder’s material participation in trade or business conducted through a closely held C corporation. As a result, the taxpayer’s dividend income was found subject to the net investment income tax under Internal Revenue Code § 1411, even though the taxpayer is an employee involved in the C corporation’s business and even though the C corporation is a closely held corporation.

Conclusion

The chief counsel advice provides a good outline of the IRS position on application of net investment income tax to C corporation dividends. Presumably, the IRS will pursue this issue, and failure to file returns consistent with this advice could be an IRS audit flag. It will remain to be seen whether taxpayers further pursue this issue in litigation to challenge the IRS chief counsel’s position.

Endnotes

1 Scott E. Vincent is the founding member of Vincent Law, LLC, in Kansas City.

2 https://www.irs.gov/pub/irs-wd/202118009.pdf