Avoiding Net Investment Income Tax on Sale of S-Corporation Stock

by Matthew Cavitch, J.D. *

An S corporation can save certain shareholders—shareholders who are treated as non-passive under Section 469—the 3.8% net investment income tax. The 3.8% net investment income tax is imposed to the extent the taxpayer's modified adjusted gross income exceeds $250,000 for married couples and $200,000 for individuals. So taxpayers do not want income to be characterized as "net investment income."


When a C corporation pays a dividend, that constitutes net investment income. When an S corporation flows through income to a non-passive shareholder, that income is not net investment income. [IRC § 1411(c)(1)(A)(i).] When a shareholder sells stock in a C corporation, the capital gain is net investment income. The tax analysis becomes a little more complicated when the shareholder of an S corporation, who materially participates in the entity, sells his stock. The statute provides that the seller's gain shall be subject to the NIIT only to the extent of the net gain that would have been recognized by him if the S corporation had sold its assets at fair market value. Treasury regulations under Section 1411 were initially proposed on December 5, 2012, including proposed regulations regarding the sale of stock in an S corporation. These regulations were finally adopted on November 27, 2013, but not the regulations regarding the sale of stock. Instead, the initial proposed regulations were revoked, and new regulations were proposed. The new proposed regulations may be relied upon by taxpayers until they are finally adopted or revoked.

The new proposed regulations are clear that if the S corporation has only one activity and has no non-business assets, then the shareholder's capital gain is entirely exempt from the NIIT. If the S corporation has non-business portfolio assets, for example, then the seller's net gain with respect to these assets is subject to the NIIT. Or if the S corporation has multiple activities, some of which the seller does not materially participate in, then the entity's deemed gain on assets used in those passive activities is subject to the NIIT.

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Arguably, when a shareholder owns S corporation stock, the stock is not itself held in a trade or business. So the gain on liquidation could be subject to the NIIT, except as provided in Reg. § 1.1411-7. Unfortunately, that regulation has been proposed but not yet finally adopted, so there is a lot of uncertainty here. If the proposed regulation is adopted, then it will provide that the Shareholder's gain on liquidation is not subject to the NIIT. But again, the regulation is not final, so its effect is uncertain.

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LEXIS users can view the complete commentary HERE. Additional fees may apply. (Approx. 6 pages)

RELATED LINKS: For more on this topic, see:

• 1-3 Tax Planning for Corporations and Shareholders § 3.03