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Take an active role in the business

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in Small Business Tax,Small Business Tax Deduction Strategies

Usually, a small business owner works long hours at his or her trade. But you might own a significant interest in another business operation, or perhaps your main business, where you mostly sit on the sidelines.

Strategy: Turn your “passive” busi­­ness interest into an “active” one. As a result, you might avoid an unexpected tax hit from the new 3.8% Medi­­­­care surtax.

The 3.8% surtax, which was authorized by the 2010 health care law, might apply to income you realize as a passive investor. But an active business owner can escape the noose.

Here’s the whole story: Beginning in 2013, the 3.8% Medicare surtax applies to the lesser of “net investment income” (NII) or the amount by which your modified adjusted gross income (MAGI) exceeds a threshold amount. The threshold is $200,000 for single filers and $250,000 for joint filers.

The definition of NII covers in­­come items such as interest, dividends, annuity distributions, rents, royalties and net capital gain derived from the disposition of property. Sig­­nifi­­cantly, it also includes income derived from passive activities. On the other hand, some of the income items specifically excluded from NII include salary, wages or bonuses; ­distributions from IRAs or qualified plans; income taken into account for self-employment tax purposes; income from an active business activity (including activities held via partnerships and S corporations), gain from selling an active interest in a partnership or S corporation; and items other­­wise excluded from income tax (e.g., interest from tax-exempt bonds and excluded  gain from the sale of a principal residence).

When you’re a passive investor, the income received from the activity counts as NII (net investment income) for purposes of 3.8% surtax, but income from an active business doesn’t.

Generally, a passive activity is an activity in which you do not “materially participate.” Material participation occurs when you’re involved in the activity on a “regular, continuous and substantial” basis.

There are several ways to establish material participation in an activity (see box below).

Exception: Rental real estate activities are generally treated as passive activities even if you qualify as a material participant. However, you can avoid this outcome if you meet the more stringent requirements for a “real estate professional.” To qualify, you must log more than 750 hours in real estate activities in which you materially participate, and that time must be more than 50% of the hours you devote to rendering personal services.

Tip: If you’re close to qualifying as an active investor, put in the extra time if it will reduce or eliminate the 3.8% surtax you’d have to pay for 2013.

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