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Tags: passive | investment | tax | activity

New 3.8% Investment Income Tax Creates Passive Activity Trap

Denis Kleinfeld By Monday, 13 May 2013 08:13 AM Current | Bio | Archive

It is becoming all too clear to tax professionals that the new 3.8 percent investment income tax is looking like a house of horrors.

Many people, tax professionals among them, praised the passage of the Affordable Care Act. Few of them fully comprehended the impact of the taxes imposed as part of the payment for the costs.

The new tax applies "to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts," according to the IRS.

As things work out whenever anything related to taxation is enacted by Congress, the complexity of the tax code just got much more complex. The incredibly difficult task of trying to explain the concept of a "passive activity" to relatively rational investors and businesspersons now borders on the nearly impossible when considering the danger of the passive activity tax trap.

Are you or your business receiving income (called unearned income) such as dividends, interest, royalties and other payments received from investments? Is your business a pass-through for tax purposes like an S corporation or partnership? Maybe a trust?

If so, your exposure to tax complications and the tax professional fees to figure them has been greatly magnified.

While few realize it, the regulation that defined the words "passive activity" was 125 pages long. This new tax on investment applies to an individual who is not active in earning the passive type income allocated to a business.

How does anyone figure this out?

It is a three-step process more or less.

The first step is figuring out whether you're S corp., partnership or sole proprietorship is engaged in a "trade or business." Just determining what activities rise to the level of being a trade or business has its own complications.

The second step is determining whether the passive type income was earned in the "ordinary course of business" or not. Of course, this depends on what kind of business you are in and how you earn various classifications of income.

And the last step is making the analysis of whether the income should be classified as passive for income tax purposes to you as the owner of the business.

Putting it together, income earned by a trade or business, in the ordinary course of business, might be treated as active if the owner of the business materially participated to earn that income.

Under the new regulations, the net investment income that will be subject to the 3.8 percent tax comes from either the trade or business of trading in financial instruments or commodities — a passive activity.

There does not seem to be a big problem understanding financial instruments (stock, debt, options, forward or future contracts, notional or principal contracts or derivatives) or commodities. The problem lies with trying to apply the seven tests the regulations say show material participation. Meeting just one of the tests means your activity is actually active and not passive, and thereby the income is free of being additionally taxed at 3.8 percent.

Of course, if you are in real estate, then there are special rules regarding rental activities of a "real estate professional."

A recent private letter ruling from the IRS takes the position that investment income earned by a trust through its ownership of a pass-through entity will be subject to the tax even if the trustee is otherwise active in the entity.

How to apply the new tax is just being figured out by tax pros. What is known is that the cost to the taxpayer is an additional 3.8 percent on taxable investment income plus the professional fees to figure out just how much that translates into real cash money payable to the government.

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It is becoming all too clear to tax professionals that the new 3.8 percent investment income tax is looking like a house of horrors.
Monday, 13 May 2013 08:13 AM
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