How to avoid the net investment income tax with material participation

The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act, both enacted in 2010, contain the largest set of tax law changes in more than 20 years. Arguably the most notable of the changes, and certainly the largest revenue raiser, is the net investment income tax (NIIT).

Smart Business spoke with Mark Watson, a partner in Tax and Strategic Business Services at Weaver, about how the NIIT may affect you and what to do about it.

Who is subject to the NIIT?

As of Jan. 1, 2013, certain individuals, estates and trusts are subject to the NIIT. Corporations and partnerships are not.

With individuals, the NIIT is equal to 3.8 percent of the lesser of two amounts — the individual’s net investment income for the taxable year or the individual’s modified adjusted gross income in excess of a specified threshold. The threshold is $200,000 for a single individual, $250,000 for married couples filing jointly and $125,000 for married couples filing separately.

How are net and gross investment income calculated?

An individual’s net investment income is equal to his or her gross investment income less properly allocable deductions. Gross investment income is comprised of five buckets of investment and unearned income:

  1. Interest, dividends, annuities, royalties and rents.
  2. Other income from a trade or business that is a passive activity.
  3. Other income from a trade or business of trading in financial instruments or commodities.
  4. Net gain from the disposition of property.
  5. Income earned on an investment of working capital.

How can taxpayers reduce or eliminate NIIT?

Since NIIT includes income from a passive activity, individuals can reduce or eliminate NIIT by avoiding passive activities. One way to do that is to satisfy the material participation standard.

A passive activity involves the conduct of a trade or business in which the individual does not materially participate. Individuals are treated as material participants only if they are involved in the activity’s operations on a regular, continuous and substantial basis. Specifically, an individual will be treated as materially participating if any of these seven tests is satisfied:

  • The individual participates in the activity for more than 500 hours during the taxable year.
  • The individual’s participation in the activity constitutes substantially all of the participation in the activity of all individuals during the taxable year.
  • The individual participates in the activity for more than 100 hours during the tax year, and participation is not less than that of any other individual.
  • The individual’s aggregate participation in all of their ‘significant participation activities’ — non-rental activities in which the individual participates for more than 100 hours — exceeds 500 hours during the taxable year.
  • The individual materially participated in the activity for any five of the 10 taxable years that immediately precede the current taxable year.
  • The activity is a ‘personal service activity’ — involved in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting or any other trade or business in which capital is not a material income producing factor — and the individual participated in that activity for any three prior taxable years.
  • Based on the facts and circumstances, the individual is regularly, continuously and substantially involved in the activity.

For purposes of these tests, time spent by an individual’s spouse in the activity counts as time spent by the individual. Also, contemporaneous daily time reports, logs or similar documents are not necessary to prove an individual’s hours of participation; any reasonable means of proof may be sufficient.

With the introduction of the NIIT, it is more important than ever to analyze your various trade or business activities and, where the material participation standard is satisfied, classify such activities as non-passive. Doing so may result in substantial tax savings.

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