If you own a sizable interest in a business, you no doubt already pay close attention to the federal income taxes that your stake in the company generates. But now there’s a new tax wrinkle to contend with: the 3.8% Medicare surtax on investment income. Depending on your level of business activity, you might have to pay this new tax in addition to any other federal income tax you owe.
Beginning with the 2013 tax year, the 3.8% Medicare surtax applies to the lesser of (1) net investment income (NII) or (2) the amount by which your modified adjusted gross income (MAGI) exceeds a threshold amount. That threshold is $200,000 for single filers and $250,000 for joint filers.
NII includes items such as interest, dividends, annuity distributions, rents, royalties, and net capital gains on property you sell. Significantly for business owners, it also includes income derived from passive activities. Net investment income doesn’t include salaries, wages, or bonuses; distributions from IRAs or qualified plans; income used to calculate self-employment tax; gains from selling an active interest in a partnership or S corporation; and income from tax-exempt bonds and other items not subject to income tax.
As you can see, it makes a big difference for tax purposes whether you’re characterized as an “active” or “passive” investor in a business. As a passive investor, the income you receive counts as NII for purposes of the 3.8% surtax.
The tax law provides some basic rules governing passive activities. Generally, a passive activity is a business activity in which you do not “materially participate.” Material participation occurs when you’re involved in the activity’s operation on a regular, continuous, and substantial basis. Rental activities—including renting out real estate—are generally treated as passive activities, even if you materially participate. However, rental real estate activity isn’t passive if you qualify as a real estate professional.
There are several tests for qualifying as a material participant. For instance, you are treated as materially participating if you’re involved in the activity for more than 500 hours during the year; your participation accounts for virtually all of the participation of anyone involved in the activity for the tax year; or if you participated in the activity for more than 100 hours during the tax year and participated at least as much as any other person (including those who don’t own any interest in the activity) for the year.
The rules for real estate professionals are even more stringent. Typically, to qualify as materially participating you have to log more than 750 hours.
If it’s a close call, put in the extra time to qualify as an active investor. It may help you avoid the 3.8% surtax.
This article was written by a professional financial journalist for KDM Investment Management Inc and is not intended as legal or investment advice.