Business owner sorts passive, active income


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Q: I sold the assets of a business in March. The buyer and I agreed to allocate the price to specific assets and I computed a gain of $1,232,657. My question relates to the 3.8% net investment income surtax. If I have to pay that tax, it will be almost $47,000. That’s in addition to the tax I owe for federal and state on the gain. I consulted with someone who told me the only way to avoid this tax is to show it is not investment income, which requires that I “materially participate” in the business in 2022. I usually work 80 hours per month in this business, so for a full year I would have close to 1,000 hours. I am told that this would be material participation. But since my work this year is less than 300 hours, and I need to have more than 500 hours, I do not materially participate in 2022. I do have full-time workers and this is why I was told I have to work more than 500 hours. I can’t now undo what was done, but if I knew this rule I may have been able to push the sale off until June or July, or even work more hours earlier in the year. I understand the tax law can be crazy but this really makes no sense to me that I am treated as running an investment simply because of when in the year I sold. The real rub is I owe $47,000 because of it.

A: You have a lot to unpack here, so I will walk you through the rules step-by-step, and include some citations to the law to help your tax preparer. In the end, I think you will avoid the $47,000 surtax.

Section 1411 of the tax law imposes this 3.8% surtax. Surtax means it is a tax on top of any other tax that you pay. It applies to “net investment income” (NII).

NII is defined to include business income that is a “passive activity” with respect to the person who earned that income. Section 469 defines a passive activity to be one in which you do not “materially participate” for the year.

There are seven tests for material participation, but with full-time employees you will probably be left with “test one,” which is more than 500 hours of participation for the year.

At this point, I agree that your business is a passive activity to you for 2022. The passive activity rules were enacted to attack loss activities. Passive income is generally a good result under those rules.

To limit the ability for a taxpayer to use passive income for their benefit, the regulations adopted “recharacterization” rules. These rules mean that in certain cases, passive income can be recast as active.

One such rule is called the “SPA” rule. This is an acronym for a “significant” participation activity, which means one in which the taxpayer works more than 100 hours for the year.

If you work more than 100 hours in 2022, but not more than 500 hours, the business is a SPA. If a loss results, the loss is passive. If income, the income is instead active.

This rule is in Regulation 1.469-2T(f)(2). It means that your 2022 income from the business is active, not passive.

However, the activity itself is still passive. So if NII comes from a passive activity, even if recast as active, it would seem that the income you earned remains NII.

This requires one more step to solve your problem. Regulation 1.1411-5(b) says that the passive loss rule that recasts the income as active will also apply for the net investment income tax.

The end result is: (1) Your business is a passive activity in 2022; (2) Despite that status, since it is also a SPA the income is treated as active for the passive loss rules; (3) The NII regulations say it is then also active for the surtax determination.

You will be able to avoid the surtax on any portion of the $1,232,657 that is business income. I can’t say if that is all of it because it depends on the business status of the assets sold.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at [email protected]

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