United States

Many taxpayers can avoid 3.8 percent tax on business income

TAX ALERT  | 

Close examination of recently issued final IRS instructions to Form 8960, along with the final regulations on the section 1411 net investment income tax, indicates that taxpayers whose participation in a trade or business exceeds 100 hours per year will generally not be subject to the new 3.8 percent tax on their allocable share of business income from such activities. This would include income received as a proprietor, partner, limited liability company (LLC) member, or S corporation shareholder. This rule can be used either if there is only one such activity or if there are multiple activities in which the taxpayer works more than 100 hours each. In the latter case, no grouping election is required, and the different activities do not need to be part of an “appropriate economic unit.” This rule provides an opportunity for many taxpayers who do not “materially participate” in an activity to nonetheless avoid application of the net investment income tax where they may have previously assumed the tax would apply.

For example, the semi-retired founder (and S corporation shareholder) of an automobile dealership could exclude all of his or her S corporation income from the 3.8 percent tax if he or she worked on a bona fide basis for more than 100 hours in the business during the year, in work involving the day-to-day operations of the business. In addition, as long as the S corporation income did not constitute a disguised salary for the hours of personal service provided, it would also be exempt from self-employment tax. 

This is significantly more liberal than the generally applicable rule defining material participation as requiring more than 500 hours (either in a single activity or in a properly “grouped” series of activities or in a number of “significant participation” activities). This more liberal standard may put greater pressure on the type of participation that qualifies. In general, an individual must be directly involved in the day-to-day management or operations of the activity, and the work should be of a type that is customarily done by an owner of the entity.

As with the 500-hour rule, the 100-hour rule does not apply to rental business activities (as defined in section 469 – with special rules for real estate professionals) or business income from the trading of financial assets (as defined in section 1411).

In many cases, the income thus excluded from the 3.8 percent tax will also be excluded from self-employment tax. For example, S corporation income is not subject to self-employment tax, and limited partners are exempt from self-employment tax on limited partnership income other than guaranteed payments for services provided to or for the partnership. It is unclear to what extent this exemption also applies to LLC and LLP members. In addition, capital gains (such as gains from the sale of a business) are exempt from self-employment tax and, under this 100-hour rule or other rules, may also be exempt from section 1411.

As a result of this 100-hour rule, a grouping election would generally be needed only if (1) the taxpayer has some activities in which he or she participates for 100 hours or less, and (2) the taxpayer wishes to group them with other activities in order to get the sum total to exceed 500 hours. In that case, a proper grouping election must be made (either on the 2013 return filed in 2014 or on the 2014 return filed in 2015), and the activities must be part of an "appropriate economic unit." Generally, that requires a certain level of economic interrelationship between the activities. 

It is becoming increasingly apparent that taxpayers need to carefully evaluate each of their business activities to determine whether the net investment income tax may apply and, if it does, whether there are elections available that may help minimize the tax. In many cases, exceptions do exist, and, in other cases, elections may be available that can limit taxpayers’ exposure. Since those elections, however, are typically irrevocable, taxpayers need to pay close attention to those elections now to ensure that they are best positioned to minimize the tax in the future.

This document contains general information, may be based on authorities that are subject to change, and is not a substitute for professional advice or services.  This document does not constitute assurance, tax, consulting, business, financial, investment, legal or other professional advice, and you should consult a qualified professional advisor before taking any action based on the information herein.  RSM LLP, its affiliates and related entities are not responsible for any loss resulting from or relating to reliance on this document by any person.

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