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How the New Medicare Tax Impacts Your Involvement in Passive Business Activities

As published in the October 2013 issue of The Greater Lansing Business Monthly.

Starting in 2013, enacted as part of the Health Care and Education Reconciliation Act, there is a new 3.8 percent Medicare contribution tax on net investment income (NII). This new tax will raise the stakes for those taxpayers invested in “passive” trades or businesses.

The passive activity rules came into being in 1986 and have been a complex area guided by numerous regulations and court cases. The defining of an activity as passive or non-passive is interpreted based on facts and circumstances and by reference to the statutory, regulatory and judicial guidance. The categorizing of business activities as passive and non-passive will be critical in applying the new 3.8 percent tax. While taxation of activities as passive can by itself create tax complexities, the stakes have been elevated based on the NII.

This new tax will affect taxpayers whose modified adjusted gross income (MAGI) exceeds $250,000 for joint filers and surviving spouses, $200,000 for single taxpayers and heads of household and $125,000 for a married individual filing separately. If your MAGI is above the applicable threshold, the additional 3.8 percent tax will apply to the lesser of (1) your NII for the tax year or (2) the excess of your MAGI for the tax year over your threshold amount.

NII consists of interest, dividends, annuities, royalties, passive rents, net gains and passive business income less deductions allocable to that income. Income from a business of trading financial instruments or commodities (such as hedge funds or master limited partnerships) is also included in NII. Income from tax exempt interest, qualified retirement plans, active trades or businesses, and earned income is not included in NII.

Items of interest, dividends, royalties, rents and gains which pass through a partnership, LLC or S corporation to its owners will retain the character of investment income and be subject to the new tax if they are attributable to an investment of working capital of the business. The operating income from these entities will only be subject to this new tax if the taxpayer is a passive investor and does not materially participate in the activity.

Since the new tax does not apply to income from activities in which an individual materially participates, it is important to understand the material participation rules. The most basic way for an individual to meet the material participation standard is by spending more than 500 hours per year in connection with the activity. This test does not include time spent in the capacity as an investor. Consequently, certain investments that state they are considered an active trade or business will not escape the definition of NII if they are merely financial instruments.

There are other ways to meet the material participation standard and you should consult your tax advisor for additional guidance if you do not meet this basic test. An individual partner or S Corporation shareholder is deemed to participate in an activity only if he or she is involved in the operation of the activity on a regular, continuous, and substantial basis.

Rental activities are subject to special rules.
An individual’s classification as “passive” can change from year to year depending on the facts. Also, businesses can sometimes be grouped together for purposes of the individual meeting the material participation tests if they constitute an “appropriate economic unit.” Unless circumstances change, groupings cannot be modified from year to year without IRS consent. However, the proposed regulations permit taxpayers to elect to regroup their activities for passive loss purposes for the first year the NII tax applies to them.

In summary, because of the impact of the NII tax on passive activities, planning should begin now. Actions taxpayers should take include: (1) consider reviewing their grouping of these activities; (2) pay particular attention to the timing of transactions as it might impact their MAGI and whether the NII tax applies; (3) when evaluating the timing of transactions, consider the classifications of like income, for example passive losses offsetting passive income; and (4) ensure they continue to meet the material participation requirements for non-passive activities. Taxpayers need to begin this planning and continue considering these items to minimize the impact of the NII tax.