In our last few tax letters we have discussed passive activities versus nonpassive activities in the context of the 3.8 percent net investment income (NII) tax. This article focuses on a nuance in the passive activity rules that, in the right circumstances, may allow taxpayers to avoid the 3.8 percent net investment income tax on certain income. However, this opportunity cannot be viewed solely within the confines of the NII tax. Taxpayers must consider the impact of other passive activities as well.
NII includes interest, dividends, royalties, rents, capital gains, and passive income from trade or business activities. Passive activities are trade or business activities in which the taxpayer does not materially participate.
There are seven tests in the tax regulations used to determine if an individual materially participates in an activity. Under the “significant participation” test, an individual materially participates in an activity if the activity is a significant participation activity (SPA) and the individual's combined participation in all SPAs during the year exceeds 500 hours.
A SPA is a trade or business activity (but not a rental activity) in which an individual participates for more than 100 hours during the taxable year. If a taxpayer has multiple SPAs, but does not clear the 500-hour combined participation threshold, each of those activities is known as a significant participation passive activity (SPPA).
Income and loss from SPPAs are subject to a recharacterization rule. If the aggregation of the SPPAs is a loss, the loss is a passive activity loss. However, if the aggregation of the SPPAs is income, the income is nonpassive activity income. The purpose of this rule is to prevent taxpayers from artificially creating passive income to offset suspended passive losses from other sources. But the flip side (i.e., the opportunity), is that SPPA income will not be subject to the NII tax.
Example: Charlie founded a family auto dealership many years ago. He is retired from the business but is still a company director. He receives a director’s fee (reported on Schedule C and subject to self-employment tax) as well as an S corporation Schedule K-1 with $2 million of ordinary income. This is his only income, and he has no passive losses. Charlie participates 60 hours per year as a director. This level of participation (less than 100 hours) does not make the activity an SPA. He does not materially participate in the business under any other test, so the $2 million is passive income and is subject to the NII tax. Charlie pays $76,000 a year of NII tax (assuming no state tax allocation) on the $2 million ordinary income.
The family business has received an offer to sell at the end of 2016. Charlie’s share of the gain on the sale would be $10 million.
Starting in 2015, Charlie is reemployed by the company to help streamline the business operations in anticipation of the sale. He receives a $30,000 W-2 for 150 hours of service in 2015 and 2016, and continues to receive his $2 million K-1. Charlie now has an SPA (more than 100 hours participation) but he still does not materially participate in the activity. The activity is treated as an SPPA, and the income is recharacterized as nonpassive. As a result, the $2 million—and the $10,000,000 gain on sale—are not subject to the NII tax.
Caution! If Charlie has more than a nominal amount of passive losses, SPPA treatment may lead to an unwelcome result. If the SPPA recharacterization rule applies, the passive losses cannot offset the nonpassive income. If the passive losses are suspended (due to the recharacterization of the income) more of Charlie’s income will be subject to the 39.6 percent ordinary rate. This will more than wipe out any current savings from avoiding the NII tax.
What kind of hours “count” for participation?
In the limited and specific fact pattern above, Charlie has an opportunity for substantial tax savings. He should document his hours in detail, and ensure that his time is qualified time (i.e., not time as an investor). This raises the question—what kinds of activities and hours “count” toward participation in an SPA?
The list below (not all-inclusive) provides some examples of activities that taxpayers may be involved in with regards to their trade or business. Hours spent participating in these activities should qualify for purposes of the 100-hour test.
Caution! Simply engaging in any of the activities below is not prima facie evidence that the taxpayer participates in an SPA. As always, contemporaneous documentation is critical. Taxpayers must document their participation, and the best way to do this is to maintain contemporaneous records (calendars, time logs, etc.). In addition, see the discussion below regarding investor hours and hours spent on work not customarily performed by an owner.
Examples of qualifying activities for SPAs
- Conduct due diligence for acquisitions, joint ventures, and/or transactions
- Negotiate terms of purchase and sale agreements
- Prepare financial projections, budgets, and/or business plans
- Analyze overall returns on business investments (e.g., product lines, etc.)
- Meet with lenders; negotiate financing terms and conditions
- Meet with suppliers, distributors, franchisees; negotiate contracts and agreements
- Prepare and analyze financial statements for business/product lines in a management capacity
- Analyze and manage company operations, supply chains, distribution, etc.
- Manage vendor relationships
- Research markets for new products, new customers
- Test new products
- Meet with insurance agents, negotiate insurance premiums, respond to insurance claims
- Direct and manage equipment purchases and capital improvement plans
- Direct and manage repair and maintenance activities
- Analyze zoning rules and potential zoning changes
- Prepare and analyze operating reports in a management capacity
- Direct, manage, and monitor cash flow
- Recruit and hire employees; manage personnel
- Meet with attorneys; deal with litigation and other legal matters
- Analyze marketing and advertising strategies
Investor hours do not qualify. Work done by an individual in his capacity as an investor is not treated as participation in the activity unless the individual is directly involved in the day-to-day management or operations of the activity. Work done as an investor includes:
- studying and reviewing financial statements or reports on operations of the activity;
- preparing or compiling summaries or analyses of the finances or operations of the activity for the individual's own use; and
- monitoring the finances or operations of the activity in a non-managerial capacity.
Work not customarily performed by owners. If work done in connection with an activity isn't of a type customarily done by the owner of that activity, and one of the principal purposes for performing the work is to avoid the disallowance under the passive activity loss rules of any loss or credit from the activity, then the work is not treated as participation.
- If a taxpayer has passive income but no passive losses, SPPA status does no harm outside of the context of the NII tax. The recharacterization rule would apply, and the income would not be subject to the 3.8 percent tax.
- Obtaining SPPA status probably works best for time spent working for S corporations since some risk exists in a partnership structure that the ordinary annual income is self-employment income (thereby exposing the taxpayer to substantial self-employment taxes and the .9% Medicare Surtax). However, care should also be exercised to pay a reasonable salary from the S corporation.
- Taxpayers with numerous activities with low levels of participation may want to consider grouping those activities together to create an SPA. If the grouped activity generates income, and the combined time is less than 500 hours, the taxpayer could avoid the 3.8 percent NII tax on the recharacterized income (all else being equal). Of course, the normal grouping rules apply—the grouped activity must be an appropriate economic unit, and the taxpayer must be eligible to regroup.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.