By Jacquelyn J. Brown, CPA July 2015
The Affordable Care Act included a new 3.8% Medicare tax on net investment income which first took effect for 2013. “Net investment income” for these purposes includes most interest, dividends, rents, royalties, capital gains and passive income from a trade or business. Accordingly, K-1 income from an LLC or S-corp in which you do not materially participate is generally subject to the 3.8% tax, as is gain from a sale of your LLC units or S-corp stock.
“Material participation” for these purposes is defined with reference to the passive activity loss rules which were enacted back in 1986 in attempt to shut down the proliferating tax shelter industry and generally means you work in the business at least 500 hours per year. However, there are a number of exceptions, to this general 500 hours rule. For example, if you materially participated in at least 5 of the immediately preceding 10 years, then you are considered to have materially participated for the current year. Also, you can generally combine your hours from multiple businesses in which you spend between 100 and 500 hours per year in order to get to 500 hours. There is another exception for businesses in which your participation constitutes substantially all of the participation (e.g. a part-time business), and an exception where you participate at least 100 hours and no one else participates more. Also, there is an exception for “regular, continuous and substantial involvement under the facts and circumstances”. Further, you can count the participation of your spouse in determining whether or not you materially participate.
For many taxpayers who are involved in a business on only a limited basis the easiest way to avoid the 3.8% tax may be reliance on what was originally intended to be a “gotcha” rule (referred to as the “SIPPA” rule) in the passive activity loss regulations designed to prevent taxpayers from converting nonpassive income into passive income (in order to offset passive losses against it). The gist of the rule is that if you spend more than 100 hours per year on an activity (but less than 500 hours per year and cannot aggregate those hours with hours from other activities to get to 500 hours), the income from the activity is treated as nonpassive while loss is treated as passive. This rule is generally a “heads we (the government) win, tails you (the taxpayer) lose”. However, with respect to avoiding the 3.8% tax, this old rule appears to be a win for the taxpayer.
Reliance on the SIPPA 100-hour rule will not necessarily enable you to avoid some of the other negative results of not meeting the general material participation standards (e.g. any losses may still be suspended under the passive loss rules and you may have to amortize your share of R&D expenses over 10 years for purposes of the alternative minimum tax), but if you have substantial K-1 income from an LLC or S-corp or are about to realize a significant gain from the sale of such, then this rule could potentially save you significant tax dollars.
Jacquelyn J. Brown, CPA, is an accountant with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.