In our previous post, we outlined the basics for those individuals who are subject to the 3.8% Net Investment Income Tax (NIIT) for 2013. In summary, portfolio and passive income are two categories of income subject to the NIIT. It would then seem intuitive that to avoid this additional surtax of 3.8% on net investment income, you would simply need to have income derived from a business, since income derived from a business is neither passive nor portfolio. Unfortunately, there is a key phrase in the Internal Revenue Code which states that income must be earned in an “active” trade or business in order not to be subject to the additional surtax.
Active vs. Passive Income
So, what is active income? To define the term, it is helpful to first contrast it with passive activities. Passive activities are trades or businesses in which the taxpayer does not materially participate, and/or rental activities. Rental activities are inherently passive according to the IRS, pending a few exceptions. Therefore, a taxpayer must materially participate in a trade or business to be considered “active.”
Active Income Test
In order to materially participate, a taxpayer must meet at least one of the following seven tests:
- The taxpayer works more than 500 hours a year in the business.
- The taxpayer does most of the work in the business. In other words, the taxpayer may not meet the 500 hours requirement, but may be the only person working in the business (i.e. – sole proprietors with no employees).
- The taxpayer works more than 100 hours and not less than anyone else in the business.
- There are multiple activities combined and the total number of hours worked exceeds 500 hours. Combining activities is an IRS election .
- The taxpayer materially participated in at least five out of the 10 preceding tax years. The years are not required to be consecutive.
- Taxpayers participating in personal service professions like law, health and accounting have materially participated in any of the three preceding tax years. Again, the years are not required to be consecutive.
- The last test is a matter of facts and circumstances unique to the individual and the business, but the taxpayer must work at least 100 hours in the particular year.
Beyond these seven tests, participation is based on regular, continuous and substantial involvement in the trade or business. Also, the work performed in the activity must be done by an individual who owns an interest in that activity.
Substantiating these tests and proving active participation can be accomplished in many ways, including written documentation, participation logs, appointment books, calendars, etc. Limited partners have even more strict guidelines to prove material participation in an activity.
Active Income and the Net Investment Income Tax
In some cases, it may be beneficial for the taxpayer to combine or group activities together in order to meet one of the seven tests. The IRS has taken this rule into consideration when enforcing the new NIIT regulations. Taxpayers are permitted a fresh start in tax year 2013 with a one-time grouping or re-grouping of activities. However, there is a catch: when making this election to group activities, it cannot be undone.
It is very important to note that there are always exceptions to these rules and an active participation designation may result in other unforeseen tax consequences. In any case, it will be imperative to review your participation with your tax advisor in all of your activities, passive or active, particularly this year, in light of NIIT.
Although the 3.8% tax is a burden, avoidance could cost more in the long-term.
Billy Thomas, CPA