June 5, 2014

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The New Net Investment Income Tax Holds Hidden Traps

June 5, 2014

The new Net Investment Income Tax (NIIT) enacted pursuant to the Patient Protection and Affordable Care Act contains hidden traps for small business owners operating in an entity treated as a “pass-through entity” for federal income tax purposes—an S corporation, LLC, limited partnership or other entity taxed as a partnership.

The Affordable Care Act added §1411 to the Internal Revenue Code (IRC) effective as of January 1, 2013. IRC § 1411 imposes a new tax of 3.8 percent on the “net investment income” of taxpayers whose income exceeds $250,000 for married individuals filing jointly and $200,000 for single individuals.

Many business people understand that net investment income subject to the NIIT includes the customary items of investment income such as interest, dividends, annuities, royalties and rents. However, the NIIT also applies to other categories of income, including, in certain circumstances, income generated by a successful operating business. Under IRC § 1411, net investment income includes income derived in the ordinary course of a successful, operating business if that business activity is considered a “passive activity” of the individual income recipient. 

Passive Players

The income allocated to the individual shareholders of S corporations or to member/partners of pass-through entities, as reported to those individuals on a K-1 each year, will constitute net investment income subject to the additional 3.8 percent tax if that income is deemed to constitute income from a passive activity of that individual.

Such income is deemed to constitute income from a passive activity unless the individual establishes that he or she has “materially participated” in the active business of the entity. The issue of material participation is separately determined for each such individual. IRC § 1411 provides that the determination of whether the activity is a passive activity and whether the individual materially participated will be governed by the passive loss rules of IRC § 469.

Under IRC § 469, each such individual is treated as not materially participating in the business activity unless (i) his or her involvement in the operations of the activity is regular, continuous and substantial, and (ii) only if he or she meets one of seven tests set forth in the IRC §469 regulations. Generally, the only one of those seven tests that an individual owner of a pass-through entity will be able to meet is to establish that he or she participated in the entity’s trade or business for more than 500 hours during the entity’s taxable year.

A taxpayer under audit carries the burden of proof to establish the number of hours spent in materially participating in the business activity on a regular, continuous and substantial basis. The IRC § 469 regulations are clear that the taxpayer’s testimony standing alone will carry no weight. The taxpayer must present documentary proof establishing the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period. Appointment books or calendars, kept up by the taxpayer contemporaneously on a daily basis, would be the preferred form of proof.

The 3.8 percent NITT can really add up. For example, an individual who cannot prove material participation is allocated $200,000 of annual income by the entity. The NIIT of 3.8 percent on that income is $7,600. If that individual is in the new maximum federal income tax bracket of 39.6 percent, the total tax on that income, with the NIIT included, is now 48.4 percent.

A Second Hit

It gets worse for individuals who are unable to establish material participation in the business activity of the entity. In addition to an extra 3.8 percent tax on their annual pass-through income from the entity, the NIIT also applies to the net gain allocated to that individual upon a sale of the business of the entity or a sale of the entity itself.

For example, assume that the business is sold and an individual who cannot prove material participation is allocated $5,000,000 of net gain. The NIIT on that net gain is an extra $190,000.

There are many other issues of relevance. An overview like this cannot begin to explain the subtleties and ramifications of the new NIIT to pass-through entities and their owners. Every small business that operates in a pass-through entity should consult with their tax advisors as soon as possible to undertake the necessary analysis and planning. 


Charles R. Brown heads the tax department at Clyde Snow & Sessions.

 

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