As advisers ready clients for year-end tax planning, they continue to grapple with complexities tied to clients' ownership of business interests: Will they or won't they be subject to the 3.8% Medicare surtax?
Tax gurus have spent a good part of 2013 helping clients navigate the American Taxpayer Relief Act of 2012, a key piece of legislation that was passed hastily Jan.1 to avert the fiscal cliff. They're particularly befuddled by the 3.8% Medicare surtax, which is also known as the net investment income tax, which will apply to income from rentals, annuities and capital gains if a taxpayer has modified- adjusted-gross income over $200,000 for those who are single, or $250,000 for those who are married and filing jointly.
In the simplest terms, taxpayers who have a “material” interest in a business are not subject to the 3.8% Medicare surtax. But if their interest is “passive” — such as a landlord who collects rent from a tenant who maintains the property — they will owe the surtax.
Though tax experts have crafted a couple of workarounds to mitigate the impact the tax will have on clients' investment portfolios, questions aplenty remain about how to help those who own rental properties and businesses.
The problem is that the tax code is vague with respect to how to define a trade or a business activity, which can leave certain clients in limbo – namely, those who own property and rent out the space, as well as certain trusts that hold real estate. Planning around the 3.8% surtax with respect to those business interests can be hazy.
“Is the trustee actively involved in the real estate? To what degree are you materially participating in the management of the business?” asked Ronni Davidowitz, head of Katten Muchin Rosenman's trusts and estates practice. “We're looking for guidelines around what those bright-line tests are. What will be viewed as material participation in the management of the asset?”
The tax code dictates what's considered “material participation” in a business: Basically, a taxpayer works on a regular, continuous and substantial basis in operations. That individual must spend at least 500 hours per year in an active role in the business. On the other hand, the IRS considers collecting rent a passive activity.
But those lines can be blurry in certain cases, according to Mark W. Miller, a partner at Sikich. For example, it is unclear what to do in a situation where an individual owns property and their business is situated there. Whether that person participates passively or materially depends on how he or she interacts with the property.
“Someone who owns a 256-unit apartment building and arranges landscaping and snow-plowing, and perhaps this building has a clubhouse — this is clearly a trade or business activity,” said Mr. Miller. “This trade or business [itself] isn't subject to the 3.8% surtax.” Bear in mind, however, the rental income the owner receives — regardless of his or her relationship to the business — will still be subject to the surtax.
There are plenty of gray areas on both the level of activity and who is carrying out the services. For instance, one of the conditions that needs to be met in order to be considered a “material participant” in the business, the IRS requires that the taxpayer perform substantially all the work in the activity.
But there are situations where this might not be clear. A property like a warehouse might not require a lot of service from the owner, for example. The facts and circumstances of a given case are a major factor in the extent to which the owner interacts with the property, Mr. Miller said.
Aside from assessing the facts and circumstances of these clients and their properties to determine whether they are passive or material participants, tax gurus are coming up with a couple of strategies for certain entrepreneurs to make sure they are able to meet that 500-hour requirement and avoid the 3.8% surtax.
For instance, there is grouping, wherein related business or trades owned by one individual are pulled together to form what the IRS calls an “appropriate economic unit.” Generally, the businesses need to have common ownership, shared resources and a common geographical location. Multiple businesses that are grouped can be treated as one activity, permitting the owner to meet the 500-hour threshold necessary to be a material participant.
"It behooves people to keep contemporaneous books and records [for appropriate economic units] and to document your participation,” said William Zatorski, a partner in the personal financial services department at PricewaterhouseCoopers. “We like to see clients be involved in management decisions.”
The Medicare surtax rules permit a one-time regrouping election, which can be made in 2013 or 2014, according to Mr. Miller. Again, grouping alone does not mean the rental income won't be subject to the Medicare surtax. Further, grouping tends to be an irrevocable decision.
In some situations, it's worth considering whether a client with ownership in a business wants to adjust his or her participation in an activity to be either a material or passive participant.
For instance, a retired father and his son have a 50-50 ownership in a business. If the father isn't a material participant in the business, his interest in it will be subject to a 3.8% surtax. If he is a material participant, he could potentially be subject to a self-employment tax of 15.3%.
Mr. Miller warned that advisers and clients need to consider the real-life implications of changing an owner's role in the business, though, and not just fixate on tax savings.
“I may want to have a 50-50 say in the business, and if I give that up, there are economic considerations,” he said. “It's not just whether you want to give up those rights, but rather, you are ceding business decisions to the other person in the business.”