Net investment income tax surprise: significant participation rule trumping material participation tests.

• Author: Stamper, Dustin

The new tax on net investment income has crowned a new rule: A once-obscure recharacterization provision is threatening to swallow the broader material participation tests under Sec. 469 for many taxpayers when they apply the passive loss rules to determine whether they owe tax under Sec. 1411.

Sec. 1411 created a new 3.8% tax on net investment income beginning in 2013. Whether income is included in net investment income often hinges on whether it is considered passive under Sec. 469. Because the passive loss rules have historically mattered little for taxpayers without losses, many people are essentially applying Sec. 469 for the first time. The new emphasis on these rules was supposed to make the seven material participation tests used to establish an activity as nonpassive more important than ever. Instead, for net investment income purposes, a smaller recharacterization rule under Temp. Regs. Sec. 1.469-2T(f)(2) is making the seven tests increasingly obsolete.

Net Investment Income and Material Participation

Net investment income generally includes investment income such as interest, dividends, rent, and royalties unless it is derived in the ordinary course of a trade or business that is not passive to the taxpayer under Sec. 469. In addition, any income from a passive trade or business activity is always net investment income regardless of its character. So a taxpayer with income from a partnership or S corporation will generally include all of it in net investment income if the activity is a passive activity with respect to the taxpayer.

The rules in Sec. 469 originally were created to limit a taxpayer's ability to deduct passive losses against nonpassive income. Although there are special rules for items such as rent and other specific situations, the regulations generally provide that an activity will not be passive if the taxpayer materially participates by satisfying any one of seven tests laid out in Temp. Regs. Sec. 1.469-5T(a).The most commonly known test is annual participation in an activity for 500 hours, but there are five other tests based on specific thresholds, and a final test that is a facts-and-circumstances determination of whether participation is regular, continuous, and substantial.

Although these rules are most often applied to determine whether a loss is passive, they also are needed to determine whether income is passive and can be used to offset passive losses.

It can therefore be advantageous to taxpayers to characterize an income-producing activity as passive. In response, the IRS created several rules to recharacterize certain passive income as nonpassive.

Significant Participation Rule

Temp. Regs. Sec. 1.469-2T(f)(2) creates a special rule for significant participation. If passive income arises from an activity in which the taxpayer significantly participates (but does not materially participate), then that income is recharacterized as nonpassive. So what is...