Employee-shareholder dividends remain net investment income

Plain-English summary

A C corporation paid an individual shareholder's personal expenses, and an examination reclassified the payments as constructive dividends. The shareholder also worked in and materially participated in the corporation's manufacturing business, and argued that the dividends therefore came from a nonpassive business and escaped the net investment income tax. Chief Counsel rejected that position because a C corporation is neither a passthrough entity nor a disregarded entity, so its shareholder generally cannot treat dividends as earned in the ordinary course of the corporation's business. The limited exceptions for insurance activity and trading or dealing did not apply. The 3.8 percent tax under Section 1411 applied even if the corporation was closely held and the shareholder materially participated in its business.

Ruling snapshot

• Question: Are C corporation dividends exempt from net investment income tax when the employee-shareholder materially participates in the business?
• Outcome: Advice given: no, including when the C corporation is closely held.
• Key authorities: IRC §§ 1411 and 469; Treas. Reg. §§ 1.1411-4(b), 1.469-2T(c)(3), and 1.469-4(d)(5)

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 202118009
       Release Date: 5/7/2021
       CC:PSI:03:ADOXEY
       POSTS-125498-20

UILC: 1411.01-00

date: January 04, 2021

 to:   Deputy Chief Counsel (Operations), Division Counsel (SB/SE), Area Counsel, Los
       Angeles, AAC, Thousand Oaks 1
       (Attn: Justine S. Coleman, Attorney)

from: Adrienne M. Mikolashek, Branch Chief, Branch 3
((Passthroughs & Special Industries))

subject: Application of § 1411 to dividend income

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.


       ISSUES

          1) Whether dividend income received by an individual shareholder from a C
             corporation, in which the shareholder is an employee, is subject to the Net
             Investment Income Tax (NIIT) under § 1411.

          2) Whether the conclusion is affected if the C corporation is a closely-held
             corporation within the meaning of § 469(j)(1) as described in § 465(a)(1)(B).

       CONCLUSIONS

          1) Dividend income received by an individual shareholder from a C corporation in
             which the shareholder is an employee is subject to tax under § 1411.

          2) This conclusion is the same even if the C corporation is a closely-held
             corporation within the meaning of § 469(h)(1) as described in § 465(a)(1)(B).

POSTS-125498-20 2

FACTS

The Taxpayer is a shareholder in a C corporation. It was determined under examination
that the corporation paid Taxpayer’s personal expenses from corporate accounts, and
the payments were reclassified as dividend income paid to the Taxpayer by the
corporation. The Taxpayer is also an employee of the corporation and is involved in the
day-to-day operations of the corporation’s manufacturing trade or business. The facts
further indicate that the corporation may be a closely-held corporation within the
meaning of § 469(h)(1) as described in § 465(a)(1)(B) (the Taxpayer appears to own a
majority of the shares of the corporation). The Taxpayer contends that because the
Taxpayer materially participates in the manufacturing trade or business of the
corporation as an employee, the dividend income that the Taxpayer received from the
corporation is not subject to tax under § 1411, because the dividend income is derived
in the ordinary course of a trade or business that is not a passive activity of the
Taxpayer within the meaning of § 469.

LAW AND ANALYSIS

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 § 1411(c)(2), (ii)
other gross income derived from a trade or business described in § 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 § 1411(c)(2).

Section 1411(c)(2) provides that § 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 § 469) with respect to the taxpayer, or (B) a trade or business of trading
in financial instruments or commodities (as defined in § 475(e)(2)).

Treas. Reg. § 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. § 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 § 1.1411-4(b);
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    (ii) Other gross income derived from a trade or business described in
         § 1.1411-5 (which describes trades or businesses to which § 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 § 1.1411-4(d)(4)(i)(A) for gain or loss
         attributable to property held in a trade or business not described in
         § 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 § 1.1411-4(f)).

Treas. Reg. § 1.1411-4(b) provides, in part, that gross income described in § 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
§ 469)1 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 § 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 § 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. § 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 § 1.469-2T(c)(3)(ii)) that is attributable to interest
(including amounts treated as interest under § 1.469-2T(e)(2)(ii)), relating to certain

1
The rules for determining whether gross income is derived in the ordinary course of a trade or business under §
1.1411-4(b) also apply to the trade or business of trading in financial instruments or commodities. See 1.1411-5.
This memo only focuses on the passive activity rules.
POSTS-125498-20 4

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 § 856), regulated investment company (within the meaning of § 851), real estate
mortgage investment conduit (within the meaning of § 860D), common trust fund (within
the meaning of § 854), controlled foreign corporation (within the meaning of § 957),
qualified electing fund (within the meaning of § 1295(a)), or cooperative (within the
meaning of § 1381(a)).

Treas. Reg. § 1.469-2T(c)(3)(ii) provides for seven limited scenarios where certain types
of portfolio income described in § 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. § 1.469-4(d)(5)(i) provides, generally, that a C corporation subject to § 469,
an S corporation, or a partnership (a § 469 entity) must group its activities under the
rules of § 1.469-4. Once a § 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 § 469 entities, in
accordance with the rules of § 1.469-4. A shareholder or partner may not treat activities
grouped together by a § 469 entity as separate activities.

Treas. Reg. § 1.469-4(d)(5)(ii) provides that an activity that a taxpayer conducts through
a C corporation subject to § 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 § 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.

A. Section 1411 applies to dividends received by a shareholder of a C
Corporation.

    Section 1411(c)(1) generally provides that dividend income received by an

individual taxpayer from a C corporation is net investment income unless such income
is derived in the ordinary course of a trade or business. To qualify for the “ordinary
course of a trade or business” exception, § 1.1411-4(b) provides that the dividend
income must be derived in a trade or business conducted (1) directly by the taxpayer (or
through a disregarded entity owned by the taxpayer), or (2) through a passthrough
entity (partnership or S corporation). Since a C corporation is not a passthrough entity
and is also not a disregarded entity, dividend income received by a C corporation
POSTS-125498-20 5

shareholder generally cannot satisfy the “ordinary course of trade or business”
exception in § 1.1411-4(b).

   C corporation stock generally produces dividend income to its shareholders and

the stock is generally treated as property held for investment for purposes of
§ 469(e)(1)(A) and § 1.469-2T(c)(3), unless the dividends are derived in the ordinary
course of a trade or business. Under these rules, any dividend income paid by a C
corporation would not be derived by a shareholder in the ordinary course of a trade or
business unless the shareholder is a dealer or a trader in stock or securities. Being a
shareholder in a C corporation in and of itself is not a trade or business that would
cause the dividend income received by the shareholder from the C corporation to be
properly treated as derived in the ordinary course of a trade or business.

   To further illustrate this point, it should be noted that a shareholder generally

cannot offset dividend income from a C corporation with any deductions for expenses
the C corporation incurred in carrying on its business, because such expenses would
not be properly allocable deductions within the meaning and for purposes of
§ 1411(c)(1)(B). If, for argument’s sake, dividend income could be properly treated as
derived in the ordinary course of the trade or business conducted by the C corporation,
it would seem that, for purposes of calculating the net investment income of the
shareholder under § 1411(c)(1)(B), such deductible expenses of the C corporation
would be properly allocable deductions against such income (because the income and
deductible expenses would have been derived in the ordinary course of the same trade
or business). This clearly is not the proper result under § 1411 or under the tax law
generally.
In this case, Taxpayer holds C corporation stock and has not shown that the
dividends were received in the ordinary course of the Taxpayer’s trade or business.
Rather, Taxpayer argues that participating in the C corporation’s business as an
employee is sufficient to meet the exception in § 1411(c)(1)(A)(i). Taxpayer’s
involvement in the C corporation’s trade or business is not relevant. Further, § 1.469-
2T(c)(3)(ii) contain two exceptions that treat dividend income from C corporations as
income from a trade or business. See § 1.469-2T(c)(3)(ii)(D) and (E). Those exceptions
are for insurance businesses, and for the business of trading or dealing in property.
Neither of these two exceptions apply in this case. The dividends paid to Taxpayer are
net investment income under § 1411(c)(1)(A)(i).

B. The conclusion is not affected if the C corporation is a closely-held
corporation within the meaning of § 469(h)(1) as described in § 465(a)(1)(B).
C corporations generally are not subject to the passive loss rules under § 469.
Section 469 does, however, apply to closely held C corporations. See 469(a)(2)(B).
Special rules under § 469 apply to closely-held C corporations such that a closely held
C corporation generally can only offset its passive losses against its active income.
Closely held C corporations are subject to § 469 because Congress feared that
individuals would use these entities to incorporate their portfolio investments to avoid
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§ 469. S. Rep. No. 313, 99th Cong. 2d Sess. 722 (1986). The passive loss rules to the
entity and limit the closely held C corporation’s use of passive losses.
Section 1.469-4 provides rules for grouping a taxpayer's activities for purposes of
applying § 469. Section 1.469-4(d)(5)(ii) provides an activity that a taxpayer conducts
through a closely held C corporation subject to section 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, Gregg v. U.S.,
186 F. Supp.2d 1123 (D. OR 2000), Senra v. CIR, T.C. Memo 2009-79.
As discussed above, § 1.1411-4(b) does not provide any rules for determining
whether gross income derived by a shareholder of a C corporation (including a closely
held C corporation) may be properly treated as derived in the ordinary course of a trade
or business. C Corporations, including closely held C corporations, are not passthrough
entities. This analysis and conclusion do not change simply because a shareholder
may be treated as materially participating, for purposes of § 469, in a trade or business
activity conducted through a closely held C corporation. Accordingly, any dividend
income received by a shareholder from a C corporation will be subject to tax under
§ 1411, irrespective of whether the C corporation is a closely held C corporation within
the meaning of § 469(h)(1) or whether the shareholder is treated as materially
participating in the trade or business activity of the C corporation.

Please call (312) 777-5279 if you have any further questions.