The Net Investment Income (NII) Tax — part of the Health Care and Education Reconciliation Act of 2010 — continues to affect millions of Americans come tax time.
What Is the NII Tax?
Starting in 2013, individuals with modified adjusted gross income (MAGI) in excess of certain thresholds could be subject to the NII tax. The tax is a 3.8% Medicare tax on investment income that applies to the lesser of:
- Net investment income OR
- The excess of MAGI over the applicable thresholds ($200,000 for single filers and $250,000 for joint filers)
The definition of investment income for purposes of the tax includes passive income from a trade or business. This is a deviation from traditional investment income that typically only includes interest, dividends, rents, royalties, annuities and capital gains. This could create an undesirable outcome for passive business owners.
Understanding Passive vs. Active Activities
A passive activity is a trade or business in which the individual owner does not materially participate. However, rental activities are considered passive regardless of the participation level, with a few exceptions. The general rule is that an individual must materially participate in order to be considered active. If an individual is active in a trade or business, the income or loss will be considered nonpassive, and will not be subject to the NII tax.
In order to materially participate in an activity, an individual must satisfy one of seven material participation tests. Almost all of the tests revolve around hours of participation. The most popular test is the 500-hour test in which an individual is actively involved if he/she participates in the activity for more than 500 hours during a year. This rule is determined at the activity level and is sometimes difficult to achieve for individuals involved in multiple activities.
It is very common for business owners to be involved in multiple activities, all of which may be related to the overall business plan of the owner. An example of this is the restaurant owner who owns two separate restaurants and a catering company. For tax purposes, let’s assume the two restaurants are established as separate S corporations and the catering company is a Limited Liability Company. To the IRS, these are considered three separate activities, and the owner would need to materially participate in each for it to be considered a nonpassive activity. In other words, the owner would have to spend at least 500 hours per year being actively involved in EACH of the three activities. This might be physically impossible for the owner. Lucky for the business owner, there may be a way around this: grouping the activities and treating them collectively as one activity.
Grouping Activities to Create Material Participation
One method for converting passive activities into nonpassive activities is grouping similar activities and treating them as a single activity.
This is achieved through combining the participation hours for all the activities thereby improving one’s ability to achieve the required 500 hours for material participation.
Using our example above, assume the restaurant owner spends 600 hours in each of his restaurants, and 300 hours in the catering activity. Let’s also suppose the catering company generated $50,000 of income and the restaurants each generated $25,000 of losses for the year. Under the material participation rules the owner would be active in the two restaurants since the hours spent in each activity were greater than 500, but would be considered passive in the catering business since hours spent were fewer than 500.
For income tax purposes, the losses could be used to offset the income, but since the catering activity is passive, the $50,000 of income would be included in investment income for the NII tax. If the owner is subject to the NII tax, the entire $50,000 could potentially be subject to the additional 3.8% Medicare tax. This unexpected result would end up costing the owner an additional $1,900 in taxes. However, if the owner instead elects to group the activities together as a single activity, the total hours for the activities would be over 500 and all the activities would be considered nonpassive. This would exclude the $50,000 of catering income from the NII tax and potentially save the owner $1,900 in taxes.
In general, activities can be grouped together if they constitute an appropriate economic unit for measuring gain or loss. A few factors that should be considered in determining whether a group can be reflected as a single activity are:
- Similarities and differences in types of trades or businesses
- Extent of common control and ownership
- Geographic location
- Interdependencies between or among the activities
These factors are not all-inclusive, but are basic guidelines when deciding whether grouping is applicable. Note that rental activities cannot be grouped with other trades or businesses unless certain conditions are met.
Is Grouping Activities the Best Option for You?
There are many issues to consider when it comes to passive / nonpassive income, and grouping activities to create material participation is not always the best option.
Once activities have been grouped together, the grouping cannot be changed in a subsequent tax year without IRS consent, and unless certain circumstances exist.
The IRS realizes that the NII tax may impact previous grouping elections, and therefore will be granting all taxpayers a “fresh start” beginning in 2013 by allowing taxpayers the chance to make the original grouping or change any previous grouping elections without IRS consent.
Interpreting the NII tax law can be complicated. Be sure to consult your tax advisor for specific advice on how the NII affects you.
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