As you reflect on 2014 and start thinking about tax planning for 2015, you may discover that your income could be subject to an additional 3.8% tax. Thankfully, smart planning can help you reduce that additional tax burden.
The 3.8% Medicare tax on net investment income became effective in 2013 and applies if your adjusted gross income exceeds $200,000 if single or $250,000 if filing jointly. The tax is levied against investment income like capital gains, dividends, interest, rents, annuities, royalties (unless earned in an active trade or business). More importantly, it applies to all passive business income regardless of character.
Whether you pay an extra 3.8% tax on your business income will likely hinge on whether the activity is "passive." Here's some history: In 1986, Congress enacted tax laws to prevent taxpayers from taking losses from passive activities against other kinds of income, like salary, investment gains, and active trade and business earnings. If your business has always generated income instead of losses, you may never have worried about the passive activity rules. Those rules now matter for taxpayers who've been lucky enough to see their businesses thrive.
Your business income is generally passive, meaning you will pay an additional 3.8% in tax, unless you "materially participate" in the activity. IRS rules allow you to establish material participation by meeting any one of seven tests set out in the regulations. The most common test is to work in the business for at least 500 hours during the year.
The IRS regards almost any work performed in a business as an owner, manager or employee — as long as it isn't an investor activity — to be participation in that business. Investor hours spent on activities such as studying financial statements, preparing financial analyses or summaries, or monitoring the finances and operations don't count as participation.
There is a separate opportunity for taxpayers who will not meet the 500-hour threshold. Income from an activity in which a taxpayer "significantly participates" can be recharacterized as nonpassive. The final regulations under the Medicare tax generally hold that income recharacterized under this rule is also nonpassive for purposes of the 3.8% tax.
To significantly participate, you must participate for just 100 hours. However, the IRS is expected to scrutinize significant participation claims closely and will check if you treated the activity as a significant participation activity in past years. You must be able to document your activities, and there is a special calculation to determine how much of your income is recharacterized under this rule.
Regarding documentation, as a taxpayer and business owner, you must be able to substantiate your participation. IRS regulations allow you to use any reasonable means, and you don't necessarily need contemporaneous time logs. However, the courts and the IRS won't let you make guesstimates after the fact. Make sure you are documenting the hours you're spending in calendar and appointment books, emails, and narrative summaries.
There may still be time to mitigate the tax impact on your 2014 return. Perhaps you have been working in your business to the level the IRS considers participation. By keeping track of time and working with a tax adviser to make sure you're compliant with the tax law, you can reflect on a year of hard work knowing you're not losing out to the IRS.
Credit: Grant Thornton