Effective January 1, 2013, Section 1411 of the Internal Revenue Code imposes a 3.8% income tax (“Passive Investor Tax”) on investors who do not materially participate in the operations of a partnership or S Corporation. The Passive Investor Tax applies to any individual making over $200,000 of net investment income in a tax year, or married spouses filing jointly and making $250,000. Additionally, the Passive Investor Tax can apply to a trust or estate with as little as $12,000 in taxable income. 26 U.S.C. 1411(a)(1), (2). Investment income includes, but is not limited to, interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer.
IRS Test for Passive Investor
In order for the Passive Investor Tax to apply, an individual must be considered a “passive investor.” A passive investor is one who does not perform a continuous, regular, or substantial role in the operations of the business. 26 U.S.C. 469(h)(1) .There is no hard and fast rule, but the IRS likely requires investors to perform at least 500 hours of service for the business in a year to avoid the tax, or in excess of 750 hours if it is income derived from real estate rental property.
Ways to Limit Exposure to Passive Investor Tax
The IRS has allowed 2013 and 2014 taxable years to be part of a transition period. As part of the transition, investors may “regroup” multiple related business activities into a single business entity to avoid the Passive Investor Tax. In general, rental income is considered passive income. 26 U.S.C. 1441(a)(1)(A)(i). Rentor and rentee entities may be regrouped to form a single entity where an investor materially participates, and thus one in which the investor’s income is not subject to the Passive Investor Tax.
If it is not possible to meet the service hour requirements, then investors must consider whether it is possible to reduce net investment income below the $200,000 or $250,000 levels for the taxable year. Investors should not, however, expect to work a 40-hour per week job in one city and then claim to be an active investor in a business in an entirely different city or state. Ultimately, the IRS looks at what is reasonable in concluding whether an investor has materially participated in the operation of the business.
The Passive Investor Tax will apply to investors each year going forward as a means to help fund the Affordable Care Act . At $9,500 for every $250,000 of net investment income, the Passive Investor Tax is a significant tax burden. Fortunately, exposure to the Passive Investor Tax can be limited with careful entity formation and investment planning.
For advice on limiting Passive Investor Tax liability, and how to regroup entities into a single economic entity, contact the business law attorneys of Trepanier MacGillis Battina P.A., or visit IRS.gov for more information on whether the Passive Investor Tax applies to you.
About the Author:
Minnesota business law attorney Jim MacGillis advises clients on corporate and business law matters such as business entity formation, business transactions, and corporate governance. Jim may be reached at 612.455.0503 or firstname.lastname@example.org. Trepanier MacGillis Battina is a Minnesota business law firm located in Minneapolis, Minnesota.