thefederalregister.com

Daily Rules, Proposed Rules, and Notices of the Federal Government

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-130507-11]

RIN 1545-BK44

Net Investment Income Tax

AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
SUMMARY: This document contains proposed regulations that provide guidance under section 1411 of the Internal Revenue Code (Code). Section 1402(a)(1) of the Health Care and Education Reconciliation Act of 2010 added new section 1411 to the Code effective for taxable years beginning after December 31, 2012. The proposed regulations affect individuals, estates, and trusts. This document also contains a notice of a public hearing on these proposed regulations.
DATES: Written or electronic comments must be received by March 5, 2013.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-130507-11), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-130507-11), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC, or sent electronically, via the Federal eRulemaking portal atwww.regulations.gov(IRS REG-130507-11).
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Michala Irons, (202) 622-3050, or David H. Kirk, (202) 622-3060; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Oluwafunmilayo (Funmi) Taylor, (202) 622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION: Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of information should be received by February 4, 2013. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information; and

Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of services to provide information.

There are two collections of information in the proposed regulations. The first collection is in proposed § 1.1411-7(d) and the second collection is in proposed § 1.1411-10(g).

The information collected in proposed § 1.1411-7(d) is required by the IRS to verify the taxpayer's reported adjustment under section 1411(c)(4). This information will be used to determine whether the amount of tax has been reported and calculated correctly. The likely respondents are owners of interests in partnerships and S corporations.

Estimated total annual reporting and/or recordkeeping burden:315,000 hours.

Estimated average annual burden per respondent:5 hours.

Estimated number of respondents:63,000.

Estimated annual frequency of responses:On occasion.

The collection of information in proposed § 1.1411-10(g) is necessary for the IRS to determine whether a taxpayer has made an election pursuant to proposed § 1.1411-10(g) and to determine whether the amount of tax has been reported and calculated correctly. The likely respondents are individuals, estates, and trusts.

Estimated total annual reporting and/or recordkeeping burden:62,000 hours.

Estimated average annual burden per respondent:4 hours.

Estimated number of respondents:15,500.

Estimated annual frequency of responses:Other (one time).

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by section 6103.

Background

Section 1402(a)(1) of the Health Care and Education Reconciliation Act of 2010 (Pub. L. 111-152, 124 Stat. 1029) added section 1411 to a new chapter 2A of subtitle A (Income Taxes) of the Code effective for taxable years beginning after December 31, 2012. Section 1411 imposes a 3.8 percent tax on certain individuals, estates, and trusts. See section 1411(a)(1) and (a)(2). The tax does not apply to a nonresident alien or to a trust all of the unexpired interests in which are devoted to one or more of the purposes described in section 170(c)(2)(B). See section 1411(e).

In the case of an individual, section 1411(a)(1) imposes a tax (in addition to any other tax imposed by subtitle A) for each taxable year equal to 3.8 percent of the lesser of (A) the individual's net investment income for such taxable year, or (B) the excess (if any) of (i) the individual's modified adjusted gross income for such taxable year, over (ii) the threshold amount. Section 1411(b) provides that the threshold amount is: (1) In the case of a taxpayer making a joint return under section 6013 or a surviving spouse (as defined in section 2(a)), $250,000; (2) in the case of a married taxpayer (as defined in section 7703) filing a separate return, $125,000; and (3) in any other case, $200,000. Section 1411(d) defines modified adjusted gross income as adjusted gross income increased by the excess of (1) the amount excluded from gross income under section 911(a)(1), over (2) the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section 911(d)(6) with respect to the amount excluded from gross income under section 911(a)(1).

In the case of an estate or trust, section 1411(a)(2) imposes a tax (in addition to any other tax imposed by subtitle A) for each taxable year equal to 3.8 percent of the lesser of (A) the estate's or trust's undistributed net investment income, or (B) the excess (if any) of (i) the estate's or trust's adjusted gross income (as defined in section 67(e)) for such taxable year, over (ii) the dollar amount at which the highest tax bracket in section 1(e) begins for such taxable year.

Section 1402(a)(2) of the Health Care and Education Reconciliation Act of 2010 also amended section 6654 of the Code to provide that the tax imposed under chapter 2A (which includessection 1411) is subject to the estimated tax provisions.

The tax imposed by section 1411 is not deductible in computing any tax imposed by subtitle A of the Code. See Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 111th Congress (JCS-2-11) (March 24, 2011), at 364 (JCT 2011 Explanation).

Amounts collected under section 1411 are not designated for the Medicare Trust Fund. The Joint Committee on Taxation in 2011 stated that “[i]n the case of an individual, estate, or trust an unearned income Medicare contribution tax is imposed. No provision is made for the transfer of the tax imposed by this provision from the General Fund of the United States Treasury to any Trust Fund.” See JCT 2011 Explanation, at 363; see also Joint Committee on Taxation, Description of the Social Security Tax Base (JCX-36-11) (June 21, 2011), at 24.

Section 1411(c)(1) provides that net investment income means the excess (if any) of (A) the sum of (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which the tax does not apply, (ii) other gross income derived from a trade or business to which the tax applies, and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply; over (B) the deductions allowed by subtitle A which are properly allocable to such gross income or net gain.

Section 1411(c)(1)(A) defines net investment income, in part, by reference to trades or businesses described in section 1411(c)(2). A trade or business is described in section 1411(c)(2) if such trade or business is (A) a passive activity (within the meaning of section 469) with respect to the taxpayer, or (B) a trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2)).

Income on the investment of working capital is not treated as derived from a trade or business for purposes of section 1411(c)(1) and is subject to tax under section 1411. See section 1411(c)(3).

In the case of the disposition of an interest in a partnership or an S corporation, section 1411(c)(4) provides that gain or loss from such disposition is taken into account for purposes of section 1411(c)(1)(A)(iii) only to the extent of the net gain or net loss which would be so taken into account by the transferor if all property of the partnership or S corporation were sold at fair market value immediately before the disposition of such interest.

Net investment income does not include distributions from a plan or arrangement described in section 401(a), 403(a), 403(b), 408, 408A, or 457(b). Section 1411(c)(5).

Net investment income also does not include any item taken into account in determining self-employment income for a taxable year on which a tax is imposed by section 1401(b). Section 1411(c)(6).

Explanation of Provisions 1. Overview of Proposed Regulations

Proposed § 1.1411-1 provides general operating rules applicable to section 1411. Proposed § 1.1411-2 provides specific rules applicable to individuals. Proposed § 1.1411-3 provides specific rules applicable to estates and trusts. Proposed § 1.1411-4 provides rules for defining net investment income. Proposed § 1.1411-5 provides rules for net investment income derived from trades or businesses that are passive activities or trading in financial instruments or commodities. Proposed § 1.1411-6 provides rules for gross income and net gain on the investment of working capital. Proposed § 1.1411-7 provides rules for dispositions of interests in partnerships and S corporations. Proposed § 1.1411-8 provides rules for distributions from certain qualified plans. Proposed § 1.1411-9 provides rules for items taken into account in determining self-employment income. Proposed § 1.1411-10 provides rules with respect to controlled foreign corporations and passive foreign investment companies. Finally, proposed § 1.469-11(b)(3)(iv) provides a regrouping “fresh start” under section 469 for certain taxpayers.

2. In General

Section 1411 (which constitutes chapter 2A of the Code) contains terms commonly used in Federal income taxation and cross-references certain provisions of chapter 1 such as sections 67(e), 469, 401(a), and 475(e)(2). However, other than these specific cross-references to provisions of chapter 1, and certain specific definitions set forth in section 1411, section 1411 does not provide definitions of its operative phrases or terminology. Moreover, there is no indication in the legislative history of section 1411 that Congress intended, in every event, that a term used in section 1411 would have the same meaning ascribed to it for other Federal income tax purposes (such as chapter 1). Accordingly, the definitional rules set forth in the proposed regulations are designed to promote the fair administration of section 1411 while preventing circumvention of the purposes of the statute. One of the general purposes of section 1411 is to impose a tax on unearned income or investments of certain individuals, estates, and trusts.

Under these proposed regulations, except as otherwise provided, chapter 1 principles and rules apply in determining the tax under section 1411. Consistent with this general approach, except as otherwise provided in the proposed regulations, gain that is not recognized under chapter 1 for a taxable year is not recognized for that year for purposes of section 1411 (for example, gain deferred or excluded under section 453 (installment method), section 1031 (like-kind exchanges), section 1033 (involuntary conversions), or section 121 (sale of principal residence)). Deferral or disallowance provisions of chapter 1 used in determining adjusted gross income apply to the determination of net investment income (for example, section 163(d) (limitation on investment interest), section 265 (expenses and interest relating to tax-exempt income), section 465(a)(2) (at risk limitations), section 469(b) (passive activity loss limitations), section 704(d) (partner loss limitations), section 1212(b) (capital loss carryover limitations), or section 1366(d)(2) (S corporation shareholder loss limitations)). A deduction carried over to a taxable year by reason of section 163(d), section 465(a)(2), section 469(b), section 704(d), section 1212(b), or section 1366(d)(2) and allowed for that taxable year in determining adjusted gross income is also allowed for the determination of net investment income, whether or not the taxable year from which the deduction is carried precedes the effective date of section 1411.

However, the proposed regulations modify the chapter 1 rules in certain respects in order to prevent circumvention of the purposes of the statute. For example, substitute interest and dividends, which are included in gross income under chapter 1, are net investment income even though these amounts are not categorically “interest” and “dividends” under chapter 1. In addition, while an item of income that is specifically excluded from gross income under chapter 1 generally also is excluded from net investment income under section 1411 (for example, tax-exempt interest), distributions described in section 959(d) or section 1293(c), excess distributions under section 1291 that are dividends, and gains that are treated as excess distributions under section 1291 (which are discussed inpart 11.B of this preamble) are net investment income under chapter 2A.

Proposed § 1.1411-1(b) provides generally that all references to an individual's adjusted gross income shall be treated as references to adjusted gross income (as defined in section 62) and that all references to an estate's or trust's adjusted gross income shall be treated as references to adjusted gross income (as defined in section 67(e)). As provided in part 11 of this preamble, there may be adjustments to adjusted gross income as a result of investments in controlled foreign corporations and passive foreign investment companies.

The IRS will closely review transactions that manipulate a taxpayer's net investment income to reduce or eliminate the amount of tax imposed by section 1411. In appropriate circumstances, the IRS will challenge such transactions based on applicable statutes and judicial doctrines. Thus, for example, if an investment arrangement that in form gives rise to income that does not constitute net investment income is in substance properly treated for Federal tax purposes as the holding of securities by one party as agent for another, the arrangement will be taxed in accordance with its substance.

3. Application to Individuals A. In General

Section 1411(a)(1) imposes a tax on individuals, but section 1411(e)(1) provides that section 1411 does not apply to a nonresident alien. The proposed regulations provide that the termindividualfor purposes of section 1411 is any natural person, except for natural persons who are nonresident aliens. Therefore, section 1411 applies to any citizen or resident of the United States (within the meaning of section 7701(a)(30)(A)).

The amount of the tax on individuals is equal to 3.8 percent of the lesser of two amounts: (A) An individual's net investment income for such taxable year, or (B) the excess (if any) of (i) the individual's modified adjusted gross income for such taxable year, over (ii) the threshold amount. For example, if an unmarried U.S. citizen has modified adjusted gross income (as defined in section 1411(d) and proposed § 1.1411-2(c)) of $190,000, which includes $50,000 of net investment income (as defined in section 1411(c)(1) and proposed § 1.1411-4), there is no tax imposed under section 1411 because the threshold amount for a single individual is $200,000 (see section 1411(b)(3) and proposed § 1.1411-2(d)(1)(iii)). On the other hand, if that individual has modified adjusted gross income of $220,000, which includes net investment income of $50,000, the individual has a section 1411 tax of $760 (3.8 percent times $20,000).

The proposed regulations also clarify the treatment of (1) grantor trusts (see proposed §§ 1.1411-2(a)(2)(ii), 1.1411-3(b)(5), and part 4.B.ii of this preamble), (2) certain bankruptcy estates (see proposed §§ 1.1411-2(a)(2)(iii), 1.1411-3(d)(1), and part 4.D of this preamble), and (3) bona fide residents of the U.S. territories (see proposed § 1.1411-2(a)(2)(iv) and part 3.C of this preamble).

B. Joint Returns in the Case of a Nonresident Alien Individual Married to a U.S. Citizen or Resident

Proposed § 1.1411-2(a)(2)(i) addresses certain joint returns filed by married individuals. Proposed § 1.1411-2(a)(2)(i)(A) provides that in the case of a U.S. citizen or resident who is married (as defined in section 7703) to a nonresident alien individual, the spouses will be treated as married filing separately for purposes of section 1411. For purposes of calculating the tax imposed under section 1411(a)(1), the U.S. citizen or resident spouse will be subject to the threshold amount in section 1411(b)(2) ($125,000) for a married taxpayer filing a separate return, and the nonresident alien spouse will be exempt from section 1411 taxation under section 1411(e)(1). In accordance with the rules for married taxpayers filing separate returns, the U.S. citizen or resident spouse must determine his or her own net investment income and modified adjusted gross income.

In general, section 6013(a) provides that no joint return may be made by married taxpayers if either spouse is a nonresident alien at any time during a taxable year. Section 6013(g), however, generally permits a nonresident alien individual married to a citizen or resident of the United States to elect for purposes of chapter 1 and chapter 24 of the Code to be treated as a resident of the United States. Proposed § 1.1411-2(a)(2)(i)(B) provides that married taxpayers who file a joint Federal income tax return pursuant to a section 6013(g) election can also elect to be treated as making a section 6013(g) election for purposes of chapter 2A of the Code. For purposes of calculating the tax imposed under section 1411(a)(1), the effect of such an election is to include the combined income of the U.S. citizen or resident spouse and the nonresident spouse in the section 1411(a)(1) calculation and subject that income to the threshold amount in section 1411(b)(1) ($250,000) for a taxpayer filing a joint return. Proposed § 1.1411-2(a)(2)(i)(B)(2) provides procedural requirements for making this election.

C. Bona Fide Residents of U.S. Territories

Proposed § 1.1411-2(a)(2)(iv) provides guidance on the application of section 1411 to individuals who are bona fide residents (within the meaning of section 937(a)) of possessions of the United States (U.S. territories) (namely, American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, and the United States Virgin Islands). An individual who is a citizen, resident, or nonresident alien with respect to the United States may qualify as a bona fide resident of a U.S. territory.

The application of the tax under section 1411 to a bona fide resident of a U.S. territory depends on whether the U.S. territory has a mirror code system of taxation, meaning the income tax laws are generally identical to the Code (except for the substitution of the name of the relevant territory for the term “United States” where appropriate). Three of the five U.S. territories (Guam, the Northern Mariana Islands, and the United States Virgin Islands) have a mirror code.

Bona fide residents of U.S. territories that are mirror code jurisdictions have no income tax obligation (or related return filing requirement) with the United States provided, generally, that they properly report income and pay income tax to the tax administration of their respective U.S. territory. See generally sections 932, 934, and 935. Therefore, the tax imposed by section 1411(a) generally does not apply to bona fide residents of mirror code jurisdictions because they will not have an income tax liability to the United States if they fully comply with the tax laws of the relevant territory.

Bona fide residents of non-mirror code jurisdictions (American Samoa and Puerto Rico) generally exclude territory-source income from U.S. Federal gross income under sections 931 and 933, respectively. (American Samoa currently is the only territory to which section 931 applies because it is the only territory that has entered into an implementing agreement under sections 1271(b) and 1277(b) of the Tax Reform Act of 1986.) Although territory-source income is excluded, these bona fide residents are subject to U.S. Federal income taxation, and have a related income tax return filing requirement with the United States to the extent they have U.S.-source or other non-territory source income or income from amounts paid for services performed as anemployee of the United States or any agency thereof (collectively, U.S. reportable income). See section 931(a) and (d) and section 933. Furthermore, under section 876 and § 1.876-1, bona fide residents of non-mirror code jurisdictions who are nonresident aliens with respect to the United States are subject to net-basis U.S. taxation on U.S. reportable income under sections 1 and 55, rather than to gross-basis U.S. taxation with respect to U.S.-source income under sections 871 through 879 (provisions that otherwise generally apply to nonresident aliens with respect to U.S.-source income).

Therefore, the tax imposed under section 1411(a) is applicable to bona fide residents of non-mirror code jurisdictions if they have U.S. reportable income that gives rise to both net investment income and modified adjusted gross income exceeding the threshold amount in section 1411. However, section 1411(a) does not apply if such bona fide residents are nonresident alien individuals with respect to the United States because section 1411(e)(1) and proposed § 1.1411-2(a)(1) exclude from section 1411(a) all nonresident alien individuals, which would include bona fide residents of any U.S. territory. However, nonresident alien individuals who are bona fide residents of non-mirror code jurisdictions remain subject to taxation under chapter 1 of subtitle A pursuant to section 876.

D. Modified Adjusted Gross Income

For purposes of section 1411 and the regulations thereunder, the termmodified adjusted gross incomeis defined in section 1411(d) and proposed § 1.1411-2(c)(1) as adjusted gross income increased by the excess of (1) the amount excluded from gross income under section 911(a)(1), over (2) the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section 911(d)(6) with respect to the amounts excluded from gross income under section 911(a)(1). See part 11 of this preamble for additional discussion on adjustments to modified adjusted gross income with respect to the ownership of interests in controlled foreign corporations and passive foreign investment companies.

E. Threshold Amount

For purposes of section 1411(a)(1) and (b) and the regulations thereunder, the termthreshold amountfor an individual means (1) in the case of a taxpayer making a joint return under section 6013 or a surviving spouse (as defined in section 2(a)), $250,000, (2) in the case of a married taxpayer (as defined in section 7703) filing a separate return, $125,000, and (3) in any other case, $200,000. For special rules regarding a nonresident alien individual married to U.S. citizen or resident, see proposed § 1.1411-2(a)(2)(i) and part 3.B of this preamble. For rules regarding certain bankruptcy estates, see proposed §§ 1.1411-2(a)(2)(iii), 1.1411-3(d)(1), and part 4.D of this preamble. The threshold amount is not indexed for inflation.

Under the proposed regulations, the threshold amount is generally not prorated in the case of a short taxable year of an individual. However, the proposed regulations provide a special rule in the case of an individual who has a short taxable year resulting from a change of annual accounting period. Under section 443(b)(1), a taxpayer that undergoes a change in annual accounting period under section 442 and has a short period must annualize its taxable income. The taxpayer's Federal income tax is the tax computed on the annualized taxable income by multiplying the taxable income for the short period by twelve and dividing the result by the number of months in the short period. Proposed § 1.1411-2(d)(2)(ii) provides that an individual taxpayer that has a short period resulting from a change of annual accounting period shall reduce the applicable threshold amount to an amount that bears the same ratio to the full threshold amount provided under section 1411(b) as the number of months in the short period bears to twelve.

4. Application to Estates and Trusts

In general, section 1411(a)(2) imposes a tax of 3.8 percent on estates and trusts on the lesser of their undistributed net investment income or the excess of their adjusted gross income (as defined in section 67(e)) over the dollar amount at which the highest tax bracket in section 1(e) begins for such taxable year. Proposed § 1.1411-3 provides special rules for applying section 1411 to estates and trusts, including an estate or trust with a short taxable year resulting from the formation or termination of the estate or trust or a change in accounting period.

A. Trusts Subject to Section 1411

Because Congress did not provide a rule specifying the particular trusts subject to section 1411, the Treasury Department and the IRS have determined that section 1411 applies to ordinary trusts described in § 301.7701-4(a). The general rule set forth in proposed § 1.1411-3(a)(1)(i) (that section 1411 applies to all estates and trusts that are subject to the provisions of part I of subchapter J of chapter 1 of subtitle A of the Code) implements this approach. This rule excludes from the application of section 1411 business trusts described in § 301.7701-4(b), which are treated as business entities under § 301.7701-2 and as eligible entities for purposes of entity classification in § 301.7701-3. Accordingly, such trusts are not subject to section 1411 at the entity level.

In addition, the general rule excludes certain state law trusts that are subject to specific taxation regimes in chapter 1 other than part I of subchapter J. This exclusion is consistent with the exception in the entity classification regulations for entities where a specific provision of the Code provides for special treatment of that organization. See § 301.7701-1(b). Examples of these trusts include common trust funds taxed under section 584 and expressly not subject to taxation under chapter 1 (per section 584(b)) and designated settlement funds taxed under section 468B in lieu of any other taxation under subtitle A (per section 468B(b)(4)).

However, section 1411 does apply to trusts subject to the provisions of part I of subchapter J, even though such trusts may have special computational rules within those provisions. These trusts include pooled income funds described in section 642(c)(5), cemetery perpetual care funds described in section 642(i), and qualified funeral trusts described in section 685. Similarly, section 1411 applies to certain Alaska Native settlement trusts described in section 646 (if that provision is in effect after the effective date of section 1411). The Treasury Department and the IRS request comments as to whether there may be administrative reasons to exclude one or more of these types of trusts from section 1411.

B. Application to Specific Trusts i. Tax-Exempt Trusts

Section 1411 is in subtitle A. As a result, section 1411 does not apply to any trust, fund, or other special account that is exempt from tax imposed under subtitle A. This exclusion applies even if such trust may be subject to tax under section 511 on its unrelated business taxable income (and even if the trust's unrelated business taxable income is comprised of net investment income). Accordingly, the proposed regulations provide that any account, fund, or trust that is exempt from taxation under subtitle A (for example, sections 501(a), 664(c)(1), 220(e)(1), 223(e)(1), 529(a), and 530(a)) is also exempt from section 1411.

Section 1411(e)(2) specifically excepts from the application of section 1411 a trust all of the unexpired interests in which are devoted to one or more of the purposes described in section 170(c)(2)(B). See proposed § 1.1411-3(b)(1).

ii. Grantor Trusts

A grantor trust is a trust or any portion thereof that is treated as being owned by the grantor or another person under subpart E of subchapter J (see sections 671 through 679). The owner must compute the owner's taxable income and credits by including the items of income, deduction, and credit against the tax attributable to the trust or the portion thereof treated as being owned by the owner. Thus, a grantor trust's income is not taxed as trust income but instead is treated as being the income of (and taxable to) the owner. The same rule applies for purposes of section 1411, thereby providing a consistent application of the grantor trust rules. This approach is also consistent with the IRS's position that the application of section 671 is not limited to chapter 1 of subtitle A. See Notice 97-24 (1997-1 CB 409); see § 601.601(d)(2).

Proposed § 1.1411-3(b)(5) provides that the tax under section 1411 is not imposed on a grantor trust, but if a grantor or another person is treated as the owner of all or a portion of a trust under subpart E of part I of subchapter J of chapter 1 any items of income, deduction, or credit that are included in computing taxable income of such grantor or other person under section 671 shall be treated as if such items had been received or paid directly by the grantor or other person for purposes of calculating such person's net investment income.

iii. Electing Small Business Trusts (ESBTs)

Proposed § 1.1411-3(c)(1) provides special computational rules for ESBTs. For purposes of chapter 1, section 641(c)(1) provides that (A) the portion of any ESBT which consists of stock in one or more S corporations shall be treated as a separate trust, and (B) the amount of the tax imposed by chapter 1 on such separate trust shall be determined with certain modifications detailed in section 641(c)(2). Section 1.641(c)-1(a) provides that an ESBT is treated as two separate trusts for purposes of chapter 1.

The proposed regulations preserve the chapter 1 treatment of the ESBT as two separate trusts for computational purposes but consolidates the ESBT into a single trust for determining the adjusted gross income threshold in section 1411(a)(2)(B)(ii). This rule applies a single section 1(e) threshold so as to not inequitably benefit ESBTs over other taxable trusts.

Proposed § 1.1411-3(c)(1)(ii) provides the method to determine the ESBT's section 1411 tax base. First, the ESBT will separately calculate the undistributed net investment income of the S portion and non-S portion in accordance with the general rules for trusts under chapter 1, and combine the undistributed net investment income of the S portion and the non-S portion. Second, the ESBT will determine its adjusted gross income, solely for purposes of section 1411, by adding the net income or net loss from the S portion to that of the non-S portion as a single item of income or loss. Finally, to determine whether the ESBT is subject to section 1411, and if so, the section 1411 tax base, the ESBT will compare the combined undistributed net investment income with the excess of its adjusted gross income over the section 1(e) threshold.

iv. Charitable Remainder Trusts

Proposed § 1.1411-3(c)(2) provides special computational rules for charitable remainder trusts. Although the trust itself is not subject to section 1411 as provided in proposed § 1.1411-3(b)(3), annuity and unitrust distributions may be net investment income to the non-charitable recipient beneficiary. Proposed § 1.1411-3(c)(2) provides special rules to maintain the character and distribution ordering rules of § 1.664-1(d) for purposes of section 1411. The Treasury Department and the IRS are proposing these rules to determine whether items of income allocated to annuity or unitrust payments constitute net investment income to the recipient beneficiary.

Proposed § 1.1411-3(c)(2)(i) provides that distributions from a charitable remainder trust to a beneficiary for a taxable year consist of net investment income in an amount equal to the lesser of the total amount of the distributions for that year, or the current and accumulated net investment income of the charitable remainder trust. For charitable remainder trusts with multiple annuity or unitrust beneficiaries, the trust shall apportion the net investment income among the beneficiaries based on their respective shares of the total annuity or unitrust amount paid by the trust for that taxable year.

Proposed § 1.1411-3(c)(2)(ii) defines the termaccumulated net investment incomeas the total amount of net investment income received by a charitable remainder trust for all taxable years beginning after December 31, 2012, less the total amount of net investment income distributed for all prior taxable years beginning after December 31, 2012.

Thus, under proposed § 1.1411-3(c)(2), current and accumulated net investment income of the trust is deemed to be distributed before amounts that are not items of net investment income for purposes of section 1411. This classification of income as net investment income or non-net investment income is separate from, and in addition to, the four tiers under section 664(b), which continue to apply.

The Treasury Department and the IRS considered an alternative method for determining the distributed amount of net investment income in which net investment income would be determined on a class-by-class basis within each of the § 1.664-1(d)(1) enumerated categories. Under this alternative method, trustees would need to account for additional classes of income within each category, consistent with § 1.664-1(d)(1)(i), for taxable years beginning after December 31, 2012. The alternative method would create a sub-class system of net investment income and non-net investment income within each class and category of the section 664 framework. Although differentiating between net investment income and non-net investment income within each class and category might be considered more consistent with the structure created for charitable remainder trusts by section 664 and the corresponding regulations, the Treasury Department and the IRS believe that the recordkeeping and compliance burden that would be imposed on trustees by this alternative would outweigh the benefits.

C. Foreign Estates and Foreign Trusts

Section 1411 does not specifically address the treatment of foreign estates and foreign nongrantor trusts. See part 4.B.ii of this preamble for the rules that apply if the foreign trust is treated as owned by a grantor or another person under sections 671 through 679. The Treasury Department and the IRS believe that section 1411 should not apply to foreign estates and foreign trusts that have little or no connection to the United States (for example, if none of the beneficiaries is a United States person). Accordingly, proposed §§ 1.1411-3(d)(2)(i) and 1.1411-3(b)(6) provide, as a general rule, that foreign estates and foreign trusts are not subject to section 1411. The Treasury Department and the IRS believe, however, that net investment income ofa foreign estate or foreign trust should be subject to section 1411 to the extent such income is earned or accumulated for the benefit of, or distributed to, United States persons. The taxation of United States beneficiaries receiving current distributions of net investment income from a foreign estate or foreign nongrantor trust will be consistent with the general operation of subparts A through D of part I of subchapter J and will be subject to section 1411. See proposed §§ 1.1411-4(e) and 1.1411-3(e)(3).

Proposed §§ 1.1411-3(d)(2)(ii) and 1.1411-3(c)(3) reserve on the application of section 1411 to foreign estates and foreign trusts with United States beneficiaries. The Treasury Department and the IRS request comments on the application of section 1411 to net investment income of foreign estates and foreign trusts that is earned or accumulated for the benefit of United States beneficiaries, including whether section 1411 should be applied to the foreign estate or foreign trust, or to the United States beneficiaries upon an accumulation distribution. Regarding the application of section 1411 to the foreign estate or foreign trust, consideration is being given to whether the definition of a United States beneficiary should exclude contingent or future beneficiaries and to adoption of an exclusion from section 1411 for foreign pension funds that are treated as trusts for United States tax purposes. To the extent that the final regulations do not subject foreign estates or foreign trusts to tax under section 1411, the Treasury Department and IRS request comments on how section 1411 should apply to United States persons that receive accumulation distributions from foreign estates and foreign trusts, including the means by which to identify such distributions as net investment income.

D. Bankruptcy Estates

A bankruptcy estate of a debtor who is an individual is treated as an individual for purposes of computing the tax under section 1411. Section 1398 provides rules for the taxation of bankruptcy estates in chapter 7 and chapter 11 cases under the Bankruptcy Code in which the debtor is an individual. In these cases, the bankruptcy estate computes its tax in the same manner as an individual. Section 1398(c)(2) provides that the tax rate under section 1 for the bankruptcy estate is the same as that imposed on a married taxpayer filing separately, and section 1398(c)(3) provides that the bankruptcy estate is entitled to a standard deduction of a married taxpayer filing separately. Therefore, consistent with section 1398, regardless of the actual marital status of the debtor, a bankruptcy estate of a debtor who is an individual is treated as a married taxpayer filing separately for purposes of the thresholds in section 1411(b), and therefore the threshold amount applicable to such a bankruptcy estate is $125,000.

E. Calculation of Undistributed Net Investment Income

Under section 1411(a)(2), the tax under section 1411 is imposed on the lesser of (A) the undistributed net investment income of the estate or trust for such year, or (B) the excess (if any) of the adjusted gross income (as defined in section 67(e)) for the taxable year, over the dollar amount at which the highest tax bracket in section 1(e) begins for such taxable year. Thus, similar to the computation for individuals, it is the lesser of two amounts. Net investment income is defined in section 1411(c)(1) and proposed § 1.1411-4, and this same definition applies to individuals, estates, and trusts. Undistributed net investment income is a section 1411 term used solely for estates and trusts (and not individuals), and is not defined in section 1411. The proposed regulations conform the taxation of estates and trusts under section 1411 to the rules of part I of subchapter J to avoid double taxation of net investment income and the taxation of amounts distributed to charities.

The proposed regulations give effect to the provisions of subchapter J that treat an estate or trust as a conduit by reducing the estate's or trust's taxable income to take into account distributions to beneficiaries and the charitable deduction. The proposed regulations, accordingly, provide that undistributed net investment income of an estate or trust is its net investment income (as determined under proposed § 1.1411-4) reduced by the share of net investment income included in the deductions of the estate or trust under section 651 or section 661, and the share of net investment income allocated to the section 642(c) deduction of the estate or trust in accordance with § 1.642(c)-2(b) and the allocation and ordering rules under § 1.662(b)-2. The proposed regulations adopt the class system of income categorization, generally embodied in sections 651 through 663 and the regulations thereunder, to arrive at the trust's net investment income reduction in the case of distributions that are comprised of both net investment income and net excluded income items. For this purpose, the term excluded income includes items that are not includible in net investment income by either specific exclusion under chapter 1 (for example, interest on state and local bonds under section 103(a)); specific exclusion contained in section 1411 (for example, section 1411(c)(5) or (6)) or the proposed regulations; or are not specifically included in section 1411(c)(1)(A) or elsewhere in the proposed regulations.

5. Definition of Net Investment Income

Section 1411(c)(1) defines net investment income as the excess (if any) of (A) the sum of (i) gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which the tax does not apply, (ii) other gross income from trades or businesses to which the tax applies, and (iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply, over (B) deductions allowed by subtitle A which are properly allocable to such gross income or net gain.

If items of net investment income (including the properly allocable deductions) pass through to an individual, estate, or trust from a partnership or S corporation, the allocation of such items must be separately stated under section 702 or section 1366 and the regulations thereunder.

A. Gross Income Items Described in Section 1411(c)(1)(A)(i) i. In General

The proposed regulations provide that net investment income includes, in part, gross income from interest, dividends, annuities, royalties, and rents. However, such income is excluded from net investment income if it is derived in the ordinary course of a trade or business not described in section 1411(c)(2). This exclusion is described in part 5.A.vi of this preamble.

ii. Interest and Dividends (a) In General

Gross income from interest includes any item treated as interest for purposes of chapter 1, and includes substitute interest (as discussed in part 5.A.ii.(b) of this preamble).

Gross income from dividends includes any item treated as a dividend for purposes of chapter 1. This includes, but is not limited to, amounts treated as dividends pursuant to subchapter C that are included in gross income (includingconstructive dividends); amounts treated as dividends under section 1248(a); amounts treated as dividends under § 1.367(b)-2(e)(2); and amounts treated as dividends under section 1368(c)(2). In addition, as discussed in part 5.A.ii.(b) and part 11 of this preamble, substitute dividends, distributions from previously taxed earnings and profits (within the meaning of section 959(d) or section 1293(c)), and certain excess distributions (within the meaning of section 1291(b)) are included in net investment income.

Gross income from notional principal contracts (within the meaning of § 1.446-3(c)) is not included in net investment income under section 1411(c)(1)(A)(i). However, if gross income from notional principal contracts is derived in a trade or business described in proposed § 1.1411-5, all of such gross income is included in net investment income under section 1411(c)(1)(A)(ii). In addition, gain on a disposition of a notional principal contract is included in net investment income under either section 1411(c)(1)(A)(ii) or section 1411(c)(1)(A)(iii) (see parts 5.B and 5.C of this preamble).

(b) Substitute Interest and Substitute Dividends

A substitute interest payment or a substitute dividend payment made to the transferor of a security in a securities lending transaction or a sale-repurchase transaction is treated as an interest payment or dividend payment, as applicable, for purposes of section 1411, and thus as net investment income for purposes of proposed § 1.1411-4(a)(1)(i). If substitute interest and substitute dividend payments were not treated in this manner, the Treasury Department and the IRS believe that taxpayers could easily avoid the section 1411 tax with respect to interest or dividend income by lending their securities over a payment date. The Treasury Department and the IRS do not believe that Congress intended the imposition of the section 1411 tax to turn on transactional formalities that are so readily manipulated by well-advised taxpayers. This approach is consistent with other contexts in which substitute interest and dividend payments have been treated in the same manner as actual interest or dividend payments in order to preclude avoidance of tax. For example, regulations under sections 861, 871, and 881 treat substitute interest and dividend payments as having the same source and the same character as the actual interest or dividend payments for which they substitute in order to preclude avoidance of nonresident withholding tax. See §§ 1.861-2(a)(7); 1.861-3(a)(6); 1.871-7(b)(2); and 1.881-2(b)(2).

In certain other contexts, substitute payments are not treated in the same manner as actual interest or dividend payments (for example, a substitute dividend payment is not eligible for the dividends received deduction or for the lower rate of tax applicable to qualified dividends under section 1(h)(11)). In those contexts, however, disparate treatment serves essentially the same purpose, that is, to preclude the avoidance of tax through the multiplication of tax benefits or tax exclusions. The Treasury Department and the IRS believe that it is appropriate to treat substitute payments in a manner that precludes their use to facilitate tax avoidance. Accordingly, these proposed regulations treat substitute interest and substitute dividends as interest and dividends for purposes of determining net investment income.

(c) Controlled Foreign Corporations and Passive Foreign Investment Companies

Special rules apply to a United States shareholder of a controlled foreign corporation or a United States person who owns stock in a passive foreign investment company. See part 11 of this preamble.

iii. Annuities

Gross income from annuities includes the amount received as an annuity under an annuity, endowment, or life insurance contract that is includible in gross income as a result of the application of section 72(a) and section 72(b), and an amount not received as an annuity under an annuity contract that is includible in gross income under section 72(e).

The Code does not define the term annuity. Section 72(a) provides that gross income includes any amount received as an annuity under an annuity, endowment, or life insurance contract. Section 72(b), however, excludes from gross income that part of an amount received as an annuity that bears the same ratio to that amount as the investment in the contract bears to the expected return under the contract (determined as of the annuity starting date).

Section 72(e) governs the treatment of amounts received under an annuity contract that are not received as an annuity (such as lump sum distributions or surrenders). Section 72(e)(2) provides in general that such amounts received on or after the annuity starting date are included in gross income, and that amounts received before the annuity starting date are included in gross income to the extent allocable to income on the contract on an income-first basis.

Gain or loss from the sale of an annuity would be treated as net investment income for purposes of section 1411. To the extent the sales price of the annuity does not exceed its surrender value, the gain recognized would be treated as gross income described in section 1411(c)(1)(A)(i) and proposed § 1.1411-4(a)(1)(i). If the sales price of the annuity exceeds its surrender value, the seller would treat the gain equal to the difference between the basis in the annuity and the surrender value as gross income described in section 1411(c)(1)(A)(i) and proposed § 1.1411-4(a)(1)(i), and would treat the excess of the sales price over the surrender value as gain from the disposition of property under section 1411(c)(1)(A)(iii) and proposed § 1.1411-4(a)(1)(iii).

iv. Royalties

Gross income from royalties includes amounts received from mineral, oil, and gas royalties, and amounts received for the privilege of using patents, copyrights, secret processes and formulas, goodwill, trademarks, tradebrands, franchises, and other like property.

v. Rents

Gross income from rents includes amounts paid or to be paid principally for the use of (or the right to use) tangible property.

vi. Ordinary Course of a Trade or Business Exception

The items described in parts 5.A.ii through 5.A.v of this preamble are not included in net investment income by reason of section 1411(c)(1)(A)(i) if the item meets the ordinary course of a trade or business exception. See proposed § 1.1411-4(b). The ordinary course of a trade or business exception is a two-part test. First, the item must be “derived in” a trade or business not described in section 1411(c)(2). Second, if the item is derived in a trade or business not described in section 1411(c)(2), then such item must also be derived in the “ordinary course” of such trade or business. As explained in part 6 of this preamble, a trade or business described in section 1411(c)(2) is either a trade or business that is (A) a passive activity (within the meaning of section 469) with respect to the taxpayer, or (B) trading in financial instruments (as defined in proposed § 1.1411-5(c)(1)) or commodities (as defined in section 475(e)(2)).

(a) Derived In

In order for an item of gross income described in section 1411(c)(1)(A)(i) to be excluded from section 1411 under the ordinary course of a trade or business exception, the income must be derived in a trade or business that is neither a passive activity with respect to the taxpayer (as described in section 1411(c)(2)(A) and the regulations thereunder) nor a trade or business of trading in financial instruments or commodities (as described in section 1411(c)(2)(B) and the regulations thereunder).

In the case of an individual who is engaged in the conduct of a trade or business directly (for example, a sole proprietor) or through ownership of an interest in an entity that is disregarded as an entity separate from the individual owner under § 301.7701-3, the determination of whether an item of gross income is derived in a trade or business described in section 1411(c)(2)(A) or (B) is made at the individual level. For example, if A, an individual, is engaged in a trade or business that is not described in section 1411(c)(2) and the trade or business has gross income (for example, royalties), such gross income is derived in A's trade or business, and therefore A meets the first part of the ordinary course of a trade or business exception. However, if A's trade or business is a passive activity with respect to A or if A's trade or business is trading in financial instruments or commodities, the ordinary course of a trade or business exception will be inapplicable because the income is derived in a trade or business described in section 1411(c)(2).

In the case of an individual, estate, or trust that owns an interest in a trade or business through one or more passthrough entities (a partnership or an S corporation), the determination of whether an item of gross income described in section 1411(c)(1)(A)(i) allocated to the individual, estate, or trust from the passthrough entity is derived in a trade or business described in section 1411(c)(2)(A) (a passive activity with respect to the taxpayer) or section 1411(c)(2)(B) (trading in financial instruments or commodities) is made in the following manner. The determination of whether the trade or business from which the income is derived is a passive activity with respect to the taxpayer is determined at the taxpayer (individual, estate, or trust) level in accordance with the general principles of section 469. For example, if A, an individual, owns an interest in PRS, a partnership, which is engaged in a trade or business, the determination of whether PRS's trade or business is a passive activity with respect to A is made in accordance with section 469 and the regulations under that section. See part 6.B of this preamble for rules to determine whether a trade or business is a passive activity with respect to a taxpayer.

On the other hand, the determination of whether the trade or business from which the income is derived is a trade or business of trading in financial instruments or commodities is made at the passthrough entity level (the partnership or S corporation level). If the passthrough entity is engaged in a trade or business of trading in financial instruments or commodities, income from such trade or business retains its character as it passes from the entity to the taxpayer. Therefore, regardless of whether the individual is directly engaged in a trade or business or whether an intervening passthrough entity is engaged in a trade or business, such income will not qualify for the ordinary course of a trade or business exception in section 1411(c)(1)(A)(i) because such income is derived in a trade or business of trading in financial instruments or commodities (as described in section 1411(c)(2)(B)). SeeExample 2of proposed § 1.1411-4(b)(3).

Conversely, if the passthrough entity is not engaged in a trade or business, income allocated to an individual from such entity will not qualify for the ordinary course of a trade or business exception even if the individual or an intervening entity is engaged in a trade or business. For example, B, an individual, owns an interest in UTP, a partnership, which is engaged in a trade or business. UTP owns an interest in LTP, also a partnership, which is not engaged in a trade or business. Any income described in section 1411(c)(1)(A)(i) passed through from LTP (through UTP) to B will not be derived in a trade or business because LTP is not engaged in a trade or business. This characterization applies even though UTP is engaged in a trade or business and even if (1) B is engaged in a trade or business, (2) B provides services with respect to UTP's trade or business, and/or (3) B provides services to LTP. SeeExample 1of proposed § 1.1411-4(b)(3).

In addition, if the passthrough entity is not engaged in a trade or business and the passthrough entity has items of income described in section 1411(c)(1)(A)(i), the individual's status under section 469 is irrelevant. For example, C, an individual, owns an interest in PRS, a partnership that is not engaged in a trade or business and earns dividends and interest. C's distributive share of dividends and interest from PRS will be subject to section 1411(c)(1)(A)(i) because they are not derived in a trade or business and therefore cannot be excluded under the ordinary course of a trade or business exception.

Similar rules regarding whether the trade or business is determined at the taxpayer level or the entity level apply in determining whether net gain is attributable to the disposition of property “held” in a trade or business subject to section 1411. See part 5.C of this preamble.

The interaction of the ordinary course of a trade or business exception and the trade or business rules under sections 1411(c)(2)(A) and 1411(c)(2)(B) can be illustrated in the following example. B, an individual, owns an interest in S, an S corporation, which is a bank. S earns interest in the ordinary course of its trade or business (which is not trading in financial instruments or commodities). Accordingly, the interest B earns through S is not derived in a trade or business described in section 1411(c)(2)(B). B will then have to determine if S's trade or business is a passive activity with respect to B. If B is passive with respect to S's banking business, then even though the interest was not subject to section 1411(c)(1)(A)(i) because of section 1411(c)(2)(B), B's pro rata share of S's interest is net investment income under section 1411(c)(1)(A)(ii) because of section 1411(c)(2)(A). SeeExample 3of proposed § 1.1411-4(b)(3).

(b) Ordinary Course

Section 1411 does not define ordinary course of a trade or business, and the proposed regulations do not provide guidance on the meaning of ordinary course. However, other regulation sections and case law provide guidance on whether an item of gross income is derived in the ordinary course of a trade or business. See, for example,Lillyv.Comm'r,343 U.S. 90, 93 (1953),rev'g188 F.2d 269 (4th Cir. 1951),aff'g14 T.C. 1066 (1950) (holding that expenses incurred regularly and arising from transactions that commonly or frequently occur in the type of business involved are “ordinary”); § 1.469-2T(c)(3)(ii) (providing rules for determining whether certain portfolio income is excluded from the definition of passive activity gross income).

vii. Income From Employment

For purposes of section 1411, an employee is treated as engaged in the trade or business of being an employee. Therefore, regardless of whether such amounts are calculated by reference tothe items described in proposed § 1.1411-4(a), amounts paid by an employer to an employee that are treated as wages for purposes of section 3401 are not net investment income because such amounts are derived in the ordinary course of a trade or business to which section 1411 does not apply. For example, amounts paid to an employee under a nonqualified deferred compensation plan for such employee (or that otherwise become includible in income under section 409A, 457(f), 457A, or other Code section or tax doctrine) that include gross income from interest or other earnings are not treated as net investment income, regardless of whether such amounts are not subject to Federal Insurance Contributions Act tax due to the earlier application of section 3121(v)(2).

viii. Coordination With Portfolio Income Rules in Section 469

Because section 469 treats portfolio income (which includes, for example, gross income from interest and dividends) as not derived in the ordinary course of a trade or business, the ordinary course of a trade or business exception in section 1411(c)(1)(A)(i) does not apply to such income, and such income will be net investment income under proposed § 1.1411-4(a)(1)(i). The section 469 portfolio income rules are discussed in detail in part 6.B.i.(c).(1).(I) of this preamble.

B. Other Trade or Business Gross Income Described in Section 1411(c)(1)(A)(ii)

Net investment income also includes other gross income derived from a trade or business described in section 1411(c)(2). See section 1411(c)(1)(A)(ii). The trades or businesses described in section 1411(c)(2) are discussed in part 6 of this preamble.

For a trade or business described in section 1411(c)(2)(A), which is a trade or business that is a passive activity with respect to the taxpayer, section 1411(c)(1)(A)(ii) includes other gross income that is not gross income described in section 1411(c)(1)(A)(i) or net gain described in section 1411(c)(1)(A)(iii). Thus, if an item of gross income or net gain is subject to section 1411(c)(1)(A)(i) or (iii), it is generally not other gross income described in section 1411(c)(1)(A)(ii).

For a trade or business described in section 1411(c)(2)(B), which is a trade or business of trading in financial instruments or commodities, section 1411(c)(1)(A)(ii) includes all other gross income from such trade or business that is not gross income described in section 1411(c)(1)(A)(i). For example, any gain from marking to market under section 475(f) or section 1256 and any realized gain from the disposition of property held in the trade or business of trading in financial instruments or commodities is classified as other gross income subject to section 1411(c)(1)(A)(ii) (and not classified as net gain under section 1411(c)(1)(A)(iii)).

C. Net Gain Described in Section 1411(c)(1)(A)(iii)

Section 1411(c)(1)(A)(iii) states that net investment income includes net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in section 1411(c)(2). See part 11 of this preamble for additional discussion on net investment income with respect to controlled foreign corporations and passive foreign investment companies.

i. Disposition 1. In General

The proposed regulations provide that net investment income includes net gain (to the extent taken into account in computing taxable income) attributable to the sale, exchange, transfer, conversion, cash settlement, cancellation, termination, lapse, expiration, or other disposition (collectively, referred to as the disposition) of property other than property held in a trade or business not described in proposed § 1.1411-5. Except as otherwise provided, the income tax rules in chapter 1 generally will determine whether there has been a disposition of property under section 1411. For example, if a partner receives a distribution of money from a partnership in excess of the adjusted basis of the partner's interest in the partnership and recognizes gain under section 731(a), or if an S corporation shareholder receives a distribution of money from the S corporation in excess of the adjusted basis of the shareholder's stock in the corporation and recognizes gain under section 1368(b)(2), the gain is treated as gain from the sale or exchange of such partnership interest or S corporation stock for purposes of section 1411(c)(1)(A)(iii). As another example, if stock of an S corporation is sold and a section 338(h)(10) election is made, each shareholder's pro rata share of the deemed asset sale gain or loss may be taken into account in determining net investment income under section 1411(c)(1)(A)(iii). Furthermore, each shareholder may have additional gain or loss upon the deemed liquidation of the S corporation resulting from the section 338(h)(10) e