Qualifying as a Trade or Business Under the Final Net Investment Income Tax Regulations

• Publication year: 2014
• Author: By Thomas W. Shaver, Esq.*

QUALIFYING AS A TRADE OR BUSINESS UNDER THE FINAL NET INVESTMENT INCOME TAX REGULATIONS

By Thomas W. Shaver, Esq.*

I. INTRODUCTION

The 3.8% surtax on net investment income (NII) became effective on January 1, 2013. This article reviews the final federal tax regulations for the NII surtax with a focus on helping clients to plan their business operations to address the surtax. Under those regulations, income from an active trade or business is excluded from the definition of net investment income and therefore exempt from the NII surtax.

Income from a passive activity, as defined in Internal Revenue Code (IRC) section 469, is excluded from the definition of a trade or business and remains subject to the NII surtax. Advising clients with operating businesses to plan for the NII surtax therefore requires working knowledge of the passive activity rules under that section. The final NII regulations incorporate the Treasury regulations defining passive activities by reference. The most significant activity under these coordinated sets of regulations would be the management and operation of rental real property in which the taxpayer may or may not materially participate.

The characterization of a business as a passive activity follows from a determination of the "material participation" of the taxpayer. This article discusses the opportunities and pitfalls for the owners of pass-through entities that such a determination under the final NII regulations poses. Practitioners will need to help their clients plan at the entity level for an NII surtax that may fall unevenly on the individual owners of such businesses.

This article further discusses the specific issues that apply when a trustee holds and administers an operating business. The determination of whether a business held as a trust asset is a passive activity may create a significant liability for the NII surtax because the income threshold for imposing that tax at the fiduciary level is lower than for an individual taxpayer. The final regulations defer this issue to future rulemaking. Nevertheless, recent case law and published guidance provide authority from which practitioners can advise trustees operating a business.

II. TRADE OR BUSINESS

The surtax is imposed on the NII of individuals, estates and trusts above specified thresholds.¹ For married taxpayers filing joint returns, the surtax is imposed on total NII for the taxable year or modified adjusted gross income for that year in excess of $250,000, whichever is less. For all other individual taxpayers, the income threshold is $200,000.² Trusts and estates may be liable for the surtax if net income is subject to the highest fiduciary income tax bracket (beginning at $12,150 in 2014).³

On December 2, 2013, the government issued final regulations that provide additional guidance on the NII surtax.⁴ The regulations affect planning for estates, trustees, and owners of pass-through entities. The final NII regulations confirm that the NII surtax applies to investment income—interest, dividends, annuities, royalties, capital gains, and other passive activity income.⁵ The surtax does not apply to income derived in the ordinary course of a trade or business.⁶ The regulatory definition establishes and expands on two separate criteria for income to be exempt from the NII surtax: "derived in the ordinary course," and "trade or business." These criteria limit NII tax-exempt income to only the income generated by the active trade or business of the company or taxpayer.

The final regulations define a "trade or business" by incorporating the case law and regulations under IRC section 162 as to a trade or business.⁷ The extensive case law and regulatory guidance defining a trade or business under section 162 are intended to provide additional certainty regarding the imposition of the NII surtax. For example, the preamble to the regulations states that the rental of a single real property may qualify as a trade or business, provided that the taxpayer is actively, regularly and continuously involved in rental management. Key facts that may be relevant to qualification as a trade or business would include the type of property (e.g., commercial versus a residential condominium), day-to-day involvement of the taxpayer owner or agent, and the type of lease (e.g., traditional versus triple net lease, longer term versus shorter term lease).

A trade or business may generate both income subject to the NII surtax and income exempt from the tax. The statute and regulations provide that a business's income from "working capital" is not generated by a trade or business for purposes of the exemption and is therefore subject to the NII surtax. Working capital includes not only reserves for future expansion of the business but also the daily average balance of a checking account used to pay ongoing expenses.⁸ A business owner may address the potential NII surtax by investing long-term reserves in accounts that generate deferred or nontaxable investment income.

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III. PASSIVE ACTIVITIES

A. Income from Passive Activities Subject to NII Surtax

A determination that income is generated in the ordinary course of a trade or business does not guarantee exemption from the NII surtax. Income from two types of trades or businesses is always subject to the NII surtax: passive activities with respect to the taxpayer and trading in financial instruments or commodities.⁹ Whether income is "derived in the ordinary course of" a trade or business requires an analysis of both the activities of the business and the participation of each owner.

The statute incorporates the definition of a "passive activity" from IRC section 469 and its regulations.¹⁰ For purposes of the NII surtax, income from a passive activity is defined as income not derived in a trade or business. Under this passive activity limitation, assessment of the NII surtax depends upon a determination of whether the taxpayer materially participates in the business. The requirement of material participation by a taxpayer in the trade or business excludes related income from the passive activity rules, and thereby also exempts it from the NII surtax.

B. Material Participation

For sole proprietorships and disregarded entities (for example, a single member LLC or grantor trust), the determination of whether activities constitute an active trade or business is made at the level of the individual taxpayer.¹¹ This result comports with income tax law that treats the business and the taxpayer-owner as the same. For activities of an estate, trust, or individual in a pass-through entity, that determination is also made at the "individual taxpayer-owner level" and not at the entity level.¹²

The actions of each taxpayer-owner should be reviewed to determine if that taxpayer materially participates in the business to avoid having that taxpayer's share of the business income treated as passive. Income of a company may be deemed to be derived from an active trade or business with respect to one owner but not as to another owner because of differences in the levels of the owners' respective activities. This "owner level" determination may raise potential conflicts between the owners of pass-through entities who are differently affected by the NII surtax. Passive owners who are not actively involved in management may be encouraged by the surtax rules to seek to increase related expenses and thereby reduce the income from the business activities that is reportable on their individual returns,¹³ while the active managers may be more inclined to reserve income if the surtax does not apply to their distributive shares.

Active managers may face competing tax choices in making decisions about compensation or guaranteed payments received from a pass-through entity. Self-employment income is excluded from the NII surtax.¹⁴ Reporting the income as self-employment income, rather than passive income, requires a self-employed business owner to trade a 3.8% surtax for a 15.3% self-employment tax, subject to the deduction against adjusted gross income. Characterizing income as passive may be the lesser of two evils.

One welcome provision in the final regulations is the safe harbor for real estate professionals.¹⁵ A taxpayer who spends at least 500 hours annually materially...