Investor's dilemma: the new net investment income tax holds hidden traps.

• Position: Brief

The new Net Investment Income Tax (NIT) enacted pursuant to the Patient Protection and Affordable Care Act contains hidden traps for small business owners operating in an entity treated as a "pass-through entity" for federal income tax purposes--an S corporation, LLC, limited partnership or other entity taxed as a partnership.

The Affordable Care Act added [section]1411 to the Internal Revenue Code (IRC) effective as of January 1, 2013. IRC [section] 1411 imposes a new tax of 3.8 percent on the "net investment income" of taxpayers whose income exceeds $250,000 for married individuals filing jointly and $200,000 for single individuals.

Many business people understand that net investment income subject to the NIIT includes the customary items of investment income such as interest, dividends, annuities, royalties and rents. However, the NIIT also applies to other categories of income, including, in certain circumstances, income generated by a successful operating business. Under IRC [section] 1411, net investment income includes income derived in the ordinary course of a successful, operating business if that business activity is considered a "passive activity" of the individual income recipient.

Passive Players

The income allocated to the individual shareholders of S corporations or to member/partners of pass-through entities, as reported to those individuals on a K-1 each year, will constitute net investment income subject to the additional 3.8 percent tax if that income is deemed to constitute income from a passive activity of that individual.

Such income is deemed to constitute income from a passive activity unless the individual establishes that he or she has "materially participated" in the active business of the entity. The issue of material participation is separately determined for each such individual. IRC [section] 1411 provides that the determination of whether the activity is a passive activity and whether the individual materially participated will be governed by the passive loss rules of IRC [section] 469.

Under IRC [section] 469, each such individual is treated as not materially participating in the business activity unless (i) his or her involvement in the operations of the activity is regular, continuous and substantial, and (ii) only if he or she meets one of seven tests set forth in the IRC [section]469 regulations. Generally, the only one of those seven tests that an individual owner of a pass-through entity will be able...