The new “net investment income tax” (NIIT) is going into effect for 2013. Well probably. From what I can glean of the “fiscal cliff” negotiations, the 3.8% tax is not in play. It is certain enough for me to have invested the time into reading the 145 pages of new regulations and have a long talk with my friend Lucien Gauthier of the Boston Tax Institute. Lu is like me in that he tries to read everything, but he stays much more practically focused, not being distracted by celebrity underwear and mercenaries. He will be offering courses on the 3.8% tax for the benefit of New England tax practitioners who are not as bookish and introverted as I am.
So here is the word from Lucien Gauthier. “The name of the game will be the passive activity grouping rules.” Granted it is not very helpful if you are not a tax geek, but I will endeavor to explain. If you are trying to minimize the Section 1411 investment income tax, you will need to understand the passive activity loss rules or, better yet, hire somebody who does. People who have had losses from trade or business activities have had to cope with these rules since 1987. If you had the Midas touch, though, so that all your endeavors were always profitable, they were merely of academic interest. No more. How an activity is characterized under the passive activity loss rules is relevant to whether the income from it is subject to the 3.8% tax.
Brief Description Of The Tax
I look on the NIIT as an extension of the medicare tax on wages and self employment income. There are some subtle reasons why this is a less than perfect view. For example, the proceeds of the tax are not dedicated to the Medicare trust fund. The Medicare tax is 2.9% (equally split between employer and employee in the case of wages) although it goes to 3.8% after crossing a threshold. And of course, the investment income tax does not kick in until you are over a threshold of adjusted gross income ($250,000 on a married joint return). Finally, half the Medicare tax is deductible against adjusted gross income in computing regular income tax, while none of the NIIT is deductible. You need some pretty big numbers before the deductibility difference will have planning significance.
The big reason that my “extension of the medicare tax” is apt is because the same income is not subject to both taxes. At first glance it seems that when it comes to flow-through income you will end up paying one tax or the other. Reminds me of the Kingston Tree song
“.. better keep a’movin and don’t stand still. If the skeeters don’t get him then the gators will.” There are a couple of ways out though, which are worth considering. Before we get to that here is the income that is subject to the new tax:
(i) gross income from interest, dividends, annuities, royalties, and rents, other than such income derived in the ordinary course of a trade or business to which the tax does not apply,
(ii) other gross income derived from a trade or business to which the tax applies,
(iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the tax does not apply;
over (B) the deductions allowed by subtitle A which are properly allocable to such gross income or net gain.
A trade or business is described in section 1411(c)(2) if such trade or business is (A) a passive activity (within the meaning of section 469) with respect to the taxpayer, or (B) a trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2)).
Trade or business income that hits your return will often be subject to self-employment tax. One of the big exceptions to that is flow through income from S corporations. Therein lies the key to the Newt Gingrich way out of the tax.
How Newt May Beat The Tax ?
A major preoccupation of the tax blogosphere in the past year has been presidential candidate tax compliance. The thing that Newt got hammered on was his S corporation. He had taken a salary of about $250,000 and had nearly two and a half million flow through to him. Some commentators argued that the salary was unreasonably low and he was thereby chiseling on the Medicare tax. The big weakness in the argument of the commentators is that most of the cases where the IRS has challenged unreasonably low salaries were ones in which no salary at all was paid. I am fairly certain that there has never been a case where someone who paid over the FICA maximum ($113,700 for 2013) was found to have not had a sufficient salary.
So if the investment income tax were in effect would it have applied to Newt’s flow through income from the S corporation ? Probably not. It would depend on whether he “materially participated” in the activity. If he did “materially participate”, then the 3.8% tax would not apply.
What Is Material Participation ?
There are a number of ways to show material participation in an activity. The gold standard is 500 hours. Let’s stick with that for talking purposes, because before you starting counting up hours in your activities, you need to figure out what your activities are. It might seem that a real entrepreneur would have a serious problem with the 500 hours, since she might have eight or nine activities going on. Well the regulations allow you to group your activities for purposes of measuring material participation. You have significant latitude, but you are required to be consistent in your grouping.
Once you have decided how to group your activities you need to keep track of your time in order to prove material participation. There is a lot of case law on this. (Remember these rules have been around a long time for limiting losses.) The IRS tends to be very tough on time records that are not kept contemporaneously and the Tax Court tends to back the IRS in this area. The term they use is “ballpark guestimates”. And they don’t mean it a nice way.
So if you have significant income from multiple S corporations or even a single S corporation that has multiple activities, you need to sit down with your adviser to figure out how you should be grouping things. You also need to start logging your time, the more detail the better. And forget about not taking any salary at all.
I have not forgotten and you should not forget that on the first $113,700 of self-employment income or wages there is also social security tax. Remember, though, that the social security taxes may increase your benefits in the future. (Don’t get me started with how complicated that is. Check out this benefit calculator if you are interested.) Further having those type of earnings will allow you to get money into qualified plans, which is another way to escape the tax.
But I’m Below The Threshold So I Don’t Have To Worry ?
Not so fast. If year after year after year your adjusted gross income is below $200,000 do you need to be concerned about this ? You may. The reason is that you may sell your business someday. In that year, your adjusted gross income might be very high. Will the gain from the sale of the business be subject to NIIT ? It depends on whether you have materially participated in the business or not. If you have never worried about material participation, up to that point, it may be tough to prove. As we used to say at the close of the meetings of Troop 193 – Be Prepared
You can follow me on twitter @peterreillycpa.
Originally published on Forbes.com Dec 9th, 2012