In Chief Counsel Advice 202118009[1] the IRS addresses the question of whether tax dividends received by a shareholder who is also employed by the C corporation is subject to the net investment income tax, as well as if the answer changes if the corporation is closely held.

Net Investment Income Under IRC §1411

The Affordable Care Act added IRC §1411 which imposes a tax on the lesser of the net investment income of a taxpayer or the taxpayer’s adjusted gross income in excess of threshold amounts that vary by filing status.

Under IRC §1411(c)(1), net investment income includes gross income from dividends other than those that are derived in the ordinary course of a trade or business.

The advice looks at the following situation:

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.[2]

So, is the taxpayer correct in his view that being involved in day to day operations of the corporation removes the dividend income from the investment income category found at IRC §1411(c)(1)?  Or do the dividends retain their status as investment income, and are not considered derived in the ordinary course of a trade or business?

Employment Does Not Change the Nature of the Dividends

The IRS’s conclusion is that these dividends retain their status as part of investment income.

Since dividends are defined by statute as part of investment income unless derived in the ordinary course of a trade or business, the CCA looks at the regulations that define this concept:

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 shareholder generally cannot satisfy the “ordinary course of trade or business” exception in § 1.1411-4(b). (emphasis added)[3]

The memo then looks at the specific case of when dividends are deemed received in the ordinary course of a trade or business, which the CCA provides would only be the case if the taxpayer were a dealer or trader in stock or securities—not merely an employee of the corporation that issued the stock:

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.[4]

The CCA rejects the taxpayer’s argument that employment by the corporation changes the treatment of the dividends:

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.[5]

Essentially, the IRS views the taxpayer as receiving that dividend not due to being an employee of the corporation, but rather related to being an investor in the corporation.

Closely Held Corporations

But is the rule different for a closely-held C corporation?  Should a 100% shareholder in a small manufacturing concern be looked at differently in this regard than an employee of Microsoft that happens to have purchased some shares of his/her employer on the open market?

The CCA answers that question with a clear no.

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.[6]

What if This Had Been an S Corporation?

The CCA’s analysis looks at the situation for a C corporation.  But S corporations are far more common for small, closely held corporations.  What changes in that situation?

Likely nothing if the shareholder receives a distribution that is treated as coming out of earnings and profits of the S corporation—that is just as much a tax dividend as if it had come from the C corporation.  And such a distribution would end up in investment income under the analysis found in the CAA.

The more normal case of distributions from the S corporation that come from accumulated earnings and profits are not considered taxable dividends for income tax purposes, and thus are not in the list of investment income found in IRC §1411. 

Flow through income from the K-1 retains its status as trade or business income, and thus only runs afoul of the net investment income tax if the trade or business is a passive activity with regard to the taxpayer or it is a trade or business of trading in financial instruments or commodities.[7]

[1] CCA 202118009, May 7, 2021, https://www.taxnotes.com/research/federal/irs-private-rulings/legal-memorandums/shareholder%25e2%2580%2599s-income-from-closely-held-c-corp-subject-to-nii/5jwrz (retrieved May 7, 2021)

[2] CCA 202118009, May 7, 2021

[3] CCA 202118009, May 7, 2021

[4] CCA 202118009, May 7, 2021

[5] CCA 202118009, May 7, 2021

[6] CCA 202118009, May 7, 2021

[7] IRC §1411(c)(2)