Investment Tax Leaves Advisers Guessing

Arden Dale for the Wall St Journal writes: Financial advisers are concerned the 3.8% tax on investment income could cost some business owners millions of dollars in taxes because they aren't sure how to help their clients minimize the tax hit. 

At issue is how the Internal Revenue Service will tax income generated by businesses owned by trusts, which families set up to pass the enterprise on to heirs.
Advisers say the IRS needs to provide guidance on how it will apply the tax on trusts so they can perform proper tax planning for their clients. 

A tax group at the American Bar Association, and other groups, have asked the IRS for answers. The agency says it carefully reviews all comments and will take them into account as it develops final regulations.
In the meantime, advisers have no choice but to start talking with clients about the tax--which targets dividends, capital gains and other investment--and to try to help estimate the best they can its potential impact for 2013. 

"The adviser world is trying to read between the lines," said Bill Fleming, a managing director at PricewaterhouseCoopers Private Company Services practice. 

A hypothetical client, said Mr. Fleming, might be a family that owns a business that manufactures aircraft parts which is held in five trusts. One son is the trustee of all of the trusts, as well as an owner and an employee. (Mr. Fleming isn't permitted to discuss actual client cases.) 

Mr. Fleming would recommend that the man keep separate logs that document time spent wearing each hat in the business. His reason: the IRS may end up applying the tax based on how active the taxpayer is in helping to run the business. 

In fact, that is the way the IRS imposes the 3.8% tax on businesses set up as S corporations or partnerships. Someone who owns a business in his own name, not a trust, doesn't owe the tax if he can show he worked a certain number of hours on the job, is its sole participant, or meets other criteria. 

Sorting out time spent in different roles isn't so easy, however. When someone sits on a sofa watching television at night and mulls over a business issue, is he or she acting as owner or trustee? Lots of business owners think about the business all the time, said Mr. Fleming, and several of them "have had the middle-of-the-night-staring-at-the-ceiling-discussion with me." 

Advisers are eager to get some answers from the IRS because the stakes are high. Individuals don't have to pay the 3.8% tax--which took effect this year as part of the 2010 Affordable Care Act--unless they have an adjusted gross income of $200,000 or higher ($250,000 filing jointly). But trusts must pay it on undistributed income above $11,950. 

"There's a lot of money at risk," said Richard L. Dees, a partner in the private-client department at law firm McDermott Will & Emery in Chicago. 

Citing how owners of S corporations and partnerships can escape the tax by proving they are active owners, Mr. Dees noted that it is also a good idea for trustees to keep a log detailing their active participation in running the business. Some owners, he added, may even want to think about changing the way they have their businesses set up. 

For example, Michael Krol, a planner at Waldron Wealth Management, an advisory firm in Pittsburgh with around $1.1 billion under management, says he is exploring a defective-grantor trust, rather than other kinds of trusts most often used to hold a business. The business owner, not the trust itself, would owe the tax. 

"Because there are no clear answers, we're exploring different avenues," Mr. Krol said.