Arden Dale for the Wall St Journal writes: Business owners can avoid paying a new 3.8% investment tax on their profits by taking on an active role in running the enterprise. But they need to be able to document their workload and maintain that work level year after year, experts say.
The additional tax on net investment income, which was enacted as part of the Affordable Care Act, took effect in 2013. It is levied on dividends, capital gains and other investment income for most married joint filers who have more than $250,000 in adjusted gross income. (For most singles, the threshold is $200,000.)
The Internal Revenue Service imposes the tax on individuals who are the ultimate owners of entities such as partnerships and S corporations, whose income passes through directly to the owners, when it determines owners are playing more of a passive “investor” role—a judgment based partly on how much time they spend on the job. Active owners don’t have to pay the tax on income from the business.
Financial advisers discussing the tax with clients report that one question keeps coming up: How hard would it be to go from being a passive owner to an active one?
“This is not easy to do,” says Katherine Dean, managing director of wealth planning at Wells Fargo Private Bank, which has $170 billion under management. “Don’t try to convert passive activities if you are not seriously participating in the ongoing running of the business.”
To be deemed active by the IRS, the agency uses a series of tests: Some business owners have to spend at least 500 hours on the job annually, though the owner of a small business may pass the test because he or she is its sole participant. The IRS says it will look for records that show a person’s work efforts have been “regular, continuous and substantial.”
Ms. Dean recently worked with a client who owns two restaurants—established as S corporations—for which he acts as general manager. The client also owns a food-distribution business set up as a limited liability corporation.
She helped the client take advantage of a two-year window the IRS has allowed for 2013 and 2014 to let those who qualify regroup some activities so they can meet the test of being active. The IRS has approved how the client regrouped his activities in the restaurants, so he is considered as active in both.
A good place to start when thinking about becoming more active is to look at how close your income is to the threshold that triggers the tax, says Stephen A. Baxley, a managing director and director of tax and financial planning at Bessemer Trust in New York.
For someone who is close to the threshold, it could be worth it to spend more time in the business to meet the IRS test for material participation, he says.
Some kinds of businesses—such as those that involve rental real estate—make it harder for an owner to meet the activity test. Rental income is generally considered passive, Ms. Dean says. To be considered otherwise, an active owner also must qualify as a real-estate professional who spends more than 750 hours in services related to real estate, she says.
Cathy Schnaubelt, a wealth adviser in the Houston office of wealth-management firm Atlantic Trust, which oversees $24 billion, says it is important for business owners to maintain scrupulous records to prove that they are active participants in their businesses, in case the IRS issues a challenge. “You need contemporaneous records that show you are really doing these things as they happen, versus making it all up after you get the audit letter,” she says.
The IRS looks for other signs that a business owner may be stretching the truth about how much time he or she spends running it, Ms. Schnaubelt adds. A taxpayer who draws a paycheck for a 40-hour-a-week job in one city but claims to be an active participant in a business in another city may raise a red flag.
“The IRS will ask, is that reasonable?” she says.
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