Take an active role in the business

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).

Book of Company Policies D

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.

Material participation: Do the time

The IRS treats a taxpayer as materially participating in an activity if he or she meets any one of these seven tests based mainly on time.

  1. The taxpayer works 500 hours or more during the year in the activity.
  2. The taxpayer does substantially all the work in the activity.
  3. The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
  4. The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
  5. The taxpayer materially participated in the activity in any five of the prior 10 years.
  6. The activity is a personal service activity and the taxpayer materially participated in that activity in any three prior years.
  7. Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous and substantial basis during such year.  However, this test only applies if the taxpayer works at least 100 hours in the activity, no one else works more hours than the taxpayer in the activity, and no one else receives compensation for managing the activity.